On June 28, 2021, while both congressional bodies continue to introduce and consider numerous legislative proposals to “reform” and amend the existing legal analytical framework, the U.S. District Court for the District of Columbia dismissed two high-profile antitrust cases simultaneously brought by the Federal Trade Commission (FTC) and 46 states. Both cases alleged that Facebook illegally maintained a monopoly in the social networking space through its acquisition of nascent competitors, including WhatsApp and Instagram, as well as by placing restrictions on developers that access Facebook’s networks.
The key difference between the decisions is that the court granted the FTC leave to amend its complaint to better address Facebook’s alleged monopolization. Therefore, while the states’ case is finished (unless they file an appeal), the FTC retains a number of options, including trying to bolster its monopolization claim or pursuing the case through the FTC’s administrative proceedings.
Members of both political parties and from both congressional chambers condemned the decisions:
The FTC should pursue this case, but we shouldn’t count on regulators and the courts alone to save us. Keeping our markets competitive, open and fair? It will require the Congress to act.
Facebook is clearly a monopoly. The district court ruling shows the need for Congress to reform the antitrust laws. Our bipartisan bills give additional resources to law enforcement agencies and brings greater scrutiny to mergers. We have to act now.
The FTC and 46 states separately sued Facebook in December 2020, alleging that Facebook violated Section 2 of the Sherman Act[3] through its alleged “buy or bury” strategy of acquiring Instagram (2012) and WhatsApp (2014) and by adopting policies that prevented app developers that Facebook viewed as potential competitive threats from accessing Facebook’s platform interfaces (API Policies). The states also sought relief under Section 7 of the Clayton Act[4], which prevents acquisitions that tend to substantially lessen competition.
District Court Judge James Boasberg dismissed each case on different grounds.
The FTC Case. Judge Boasberg dismissed the FTC’s monopolization claim for a failure to plausibly allege facts that Facebook has monopoly power.[5] The FTC defined the relevant product market served by Facebook as one for “Personal Social Networking Services,” which the FTC described as “online services that enable and are used by people to maintain personal relationships and share experiences with friends, family, and other personal connections in a shared social space.”[6] The FTC alleged that Facebook held a market share “in excess of 60%,” and there were no substitutes for Facebook. The decision criticized the FTC for failing to offer any measure or metrics for this analysis and failing to name even a single Facebook competitor. The court therefore observed that “[i]t is almost as if the [FTC] expects the Court to simply nod to the conventional wisdom that Facebook is a monopolist. After all, no one who hears the title of the 2010 film ‘The Social Network’ wonders which company it is about.”[7]
The court also expressed concern with the FTC’s claims regarding Facebook’s API Policies, cautioning the FTC that generally antitrust law does not impose a duty to deal on monopolists.[8] Although the court made plain that the FTC “to be sure, has alleged several specific refusals to deal that in fact may meet [antitrust law’s] requirements” for pleading a claim, the court explained that injunctive relief is not available under Section 13(b) of the FTC Act[9] because the FTC does not allege ongoing or imminent anticompetitive conduct.[10]
The States’ Case. The states similarly premised their claims on Facebook’s alleged monopoly, but Judge Boasberg found additional grounds for dismissal with prejudice under the doctrine of laches, which does not apply to the U.S. government. More specifically, the court found that laches precluded the states’ claims because it viewed the Clayton Act’s four-year statute of limitations as “the starting presumption” for when an aggrieved plaintiff may file a complaint.[11] The court then pointed to the states having waited six and eight years, respectively, to claim that the WhatsApp and Instagram acquisitions violated antitrust laws and found “no case … in which a plaintiff other than the United States (against which laches does not apply), whether a state or a private party, was awarded equitable relief after such long post-acquisition delays in filing suit.”[12]
The court explained that laches was particularly appropriate because (1) the Instagram and WhatsApp acquisitions were widely publicized at the time; (2) it was well-understood at the time that Facebook was “the dominant player” in online social networking; (3) the FTC’s extra scrutiny of the Instagram transaction was publicized; (4) analysts had expressly commented that Facebook was acquiring WhatsApp to “eliminate[e] a potential competitor poised to mount a major challenge to Facebook’s monopoly;” and (5) significant prejudice to Facebook was apparent, given that the states sought a divestiture of longtime core Facebook assets.[13]
The attorneys general are appealing the decision.
Two Key Takeaways
Laches Applies to Everyone Besides the US GovernmentThe court found that the United States — not the states — is the proper enforcer of the federal antitrust laws, as Congress, when passing the Clayton Act, had not articulated a special role for the states in enforcing those laws, making them akin to private plaintiffs against which equitable defenses applied.[14] Indeed, even prior to the Facebook decision, the states had tacitly admitted this, as the National Association of Attorney Generals recently urged Congress to expand the states’ role as antitrust enforcers.[15] By contrast, at no point did the court question the ability of the FTC to complain about Facebook’s acquisitions of competitors that occurred well before the Clayton Act’s four-year statute of limitations. Timing may eventually impact the FTC if it repleads its refusal to deal claim or asserts other claims based on non-acquisition conduct that is not more recent or ongoing in nature.
The FTC’s Next Move May Implicate Chair Khan’s New PlaybookThe court criticized the FTC for making a conclusory claim of Facebook’s 60% “market share,” but also noted that it “believes that the agency may be able to ‘cure [the] deficiencies’ by repleading.” To strengthen its market power allegations, the FTC would likely need to include additional information regarding the basis of its market share calculation, allegations regarding whether Facebook’s market share remained constant or how it otherwise shifted since 2011 (the period that the FTC itself references), the identity of at least some of the other firms that account for the remaining 30-40% of the market, and proof that people value Facebook more than its social media substitutes and connect the popularity of Facebook’s social media services to the advertising dollars that popularity helps generate.
The decision may also lead the FTC to pivot under new Chair Lina Khan. Although the FTC filed the case in federal court and has advised the court that it would file an amended complaint, it also could have chosen to bring an action through its in-house administrative process, where FTC commissioners themselves would review an order from the FTC’s administrative law judge and render a decision that can be appealed to federal courts. Such a strategic decision could dovetail with the FTC’s withdrawal of its 2015 guidance on standalone use of Section 5 of the FTC Act, which prohibits “unfair methods of competition” — a broader standard than antitrust claims under Sections 1 and 2 of the Sherman Act and Section 7 of the Clayton Act.
[8]Id. at 39-41. Specifically, the court noted that “to be actionable, such a scheme must involve specific instances in which that policy was enforced (i) against a rival with which the monopolist had a previous course of dealing; (ii) while the monopolist kept dealing with others in the market; (iii) at a short-term profit loss, with no conceivable rationale other than driving a competitor out of business in the long run.”
In the wake of the Colonial Pipeline hack, President Biden released a long-anticipated Executive Order (EO) intended to strengthen U.S. cybersecurity infrastructure. [1][2] The EO highlights the government’s interest in public-private partnerships in the realm of cybersecurity by triggering a rulemaking process that will impose cybersecurity standards on private companies that contract with the federal government in the areas of information technology (IT) and operational technology (OT). The EO is only one of many steps the new administration is taking to improve cybersecurity. In line with the government’s vision, the Department of Energy also released a 100-day cybersecurity pilot program,[3] and the Federal Energy Regulatory Commission took steps to establish incentive-based programs for cybersecurity investments.[4]
Dan Sutherland, Chief Counsel for the Cybersecurity & Infrastructure Security Agency (CISA), and Jen Daskal, Deputy General Counsel at the Department of Homeland Security (DHS), spoke at an Infragard webinar on May 19, 2021 about the new Executive Order (EO).[5]
Before delving into the EO, the speakers gave a brief introduction to the roles of DHS and CISA. DHS takes a “whole of government” approach to cybersecurity, and deals with cybersecurity issues through the United States Secret Service and Immigration and Customs Enforcement (ICE), which focuses on prosecuting cyber-enabled crime. It also works through the Transportation Security Administration (TSA) and Coast Guard, which focus on cybersecurity in surface transportation. CISA, on the other hand, is an independent federal agency under DHS oversight. It focuses specifically on the United States’ cybersecurity and communications infrastructure. Acting more as a risk advisor and research arm, rather than enforcer, CISA aims to keep the nation’s critical infrastructure secure, robust, and capable of defending itself against cyber-attacks.
Both speakers briefly discussed three pieces of legislation that give CISA more authority to perform their work:
The National Defense Authorization Act (NDAA), which is a product of the Cyberspace Solarium Commission, provides 11 substantive new authorities for CISA, including: the ability to issue administrative subpoenas, the authority to do more to protect federal networks, and the wherewithal to provide capabilities and tools to other federal agencies without reimbursement. However, CISA’s subpoena authority is very limited. It mainly involves the power to collect public-facing IP information from internet service providers (ISPs) when the information is not otherwise available. Under this authority, ISPs must provide identifying information attached to IP addresses. CISA, of course, claims to have no interest in overstepping privacy rights or civil liberties.
The last legislation the speakers highlighted was the American Rescue Plan Act of 2021, which gave CISA $650 Million to improve federal network security. CISA will operate a pilot cloud environment featuring heightened security systems. This could signal a significant new path for CISA to provide services to agencies rather than merely issuing policies and directives.
Executive Order on Improving the Nation’s Cybersecurity
The Executive Order has been a priority for the Secretary of the DHS, Alejandro Mayorkas. When he outlined his vision for DHS’s cybersecurity efforts on March 31, 2021, Secretary Mayorkas said, “[m]ake no mistake: a free and secure cyberspace is possible. We will champion this with words and action.”[6]
The speakers highlighted the importance of the role the EO plays in the federal government’s commitment to modernize cybersecurity defenses and protect the federal government’s infrastructure. While executive orders cannot direct the private sector or create new authorities that do not already exist, they can leverage the power of the White House to signal priorities and support the use of existing authorities to implement key priorities. All the EO provisions outlined by the speakers build on the maturation of the cybersecurity mission and are intended to address recent cybersecurity incidents.
The EO has several innovative aspects. It leverages the procurement power of the federal government to impose reporting requirements and standards for service providers with which the federal government contracts. This has the potential to have a ripple effect for the private sector; to set standards of care and best practices beyond the provision of services to the federal government.
The EO also focuses on improving information sharing about potential incidents in the inter-agency process and through procurement power. It eliminates roadblocks for private entities to share information with government and assists the government in preventing incidents from occurring in the first place. The federal government observed that IT and OT service providers who contract with the government are hesitant and sometimes unable to share information with CISA and the FBI. They often claim that their contracts prevent the sharing of information to any agency outside of their contracting partners. The EO requires CISA to develop standard contractual clauses to be implemented through the federal acquisition regulation process. IT and OT service providers will thereby be required to collect, preserve, and share data and to collaborate during investigations. The EO goes beyond information sharing and provides standard formats to assist with investigation and remediation. Section 2(g)(I) of the EO outlines the types of reporting that should be included in the contracts.
Additionally, the EO creates a new Cybersecurity Safety Review Board, which will analyze broader, nationally significant cyber incidents affecting federal civilian information systems or non-federal systems, and make concrete recommendations for improving cybersecurity. CISA is actively working to develop this Board.
The EO provides authorities to conduct threat-hunting authorities, ensuring that there is government-wide buy-in on CISA’s ability to use these authorities effectively. It also includes desired improvements in cloud security and in the development of software used in the supply chain.
Recent cyber security incidents have revealed a lack of visibility into the cloud environment. To address this, the EO requires CISA to develop a set of security principles that govern the cloud environment for federal agencies. The EO also requires the Secretary of Commerce, in coordination with National Institute of Standards and Technology (NIST), to publish minimum elements of the bill of materials and a definition of “critical software.” The Secretary of Commerce is also responsible for recommending minimum standards for testing of third-party software source code by the third-party licensors.
In addition, CISA can help federal agencies by providing a federal incident-response playbook and improving methods for detecting vulnerabilities. Because currently CISA sees internet traffic only at the perimeter but not at the object (computer) level, the EO requires organizations to give CISA access to monitor object-level data and provide endpoint detection capabilities, allowing CISA a greater ability to look for malicious code and vulnerabilities.
When asked whether the EO sufficiently protects critical infrastructure, Dan Sutherland stated that CISA was taking substantial new steps to address recent issues. Regarding possible metrics of success, he said that these metrics may include measurements of efforts and results and, since the EO has many short, aggressive deadlines, people should expect to see results such as patching happening quickly.
The final point the speakers addressed was on inter-agency sharing of information. Under the Federal Information System Moderation Act (FSMA), every agency is responsible for its own security, while CISA provides only guidance and policies. After the data breach at the federal Office of Personnel Management,[7] there was more cooperation and collaboration in the federal civilian executive branch. The EO is further prompting federal agencies to work collaboratively. In that regard, the EO calls for procedures for the Secretary of DHS and the Department of Defense to share all directives applying to their respective information networks. To take this a step further, the speakers recommended the cultivation of greater information sharing between the federal system and the private industry.
Our next article will focus on steps the private sector should be taking in light of new standards under the EO.
On July 7, 2021, Colorado Governor Jared Polis signed into law the Colorado Privacy Act (CPA). By enacting the CPA, Colorado becomes the third state in the nation to implement a generally applicable consumer data privacy law, after California with the California Consumer Privacy Act (CCPA) and Virginia with the Virginia Consumer Data Protection Act (VCDPA). While the CPA is similar to the CCPA and VCDPA in many respects, it has a different scope and different obligations than those two laws. Accordingly, impacted businesses must conduct a separate scope analysis, and, if subject to the CPA, they will need to set up different business rules to comply with the law.
The CPA applies to person(s) that conduct business in Colorado or that produce products or services that are intentionally targeted to Colorado residents and that either (1) control or process personal data of at least 100,000 Colorado residents during a calendar year, or (2) derive revenue or receive a discount on the price of goods or services from the sale of personal data and process or control the personal data of at least 25,000 Colorado residents. The CPA applies to information that is linked or reasonably linkable to an identified or identifiable person acting in an individual or household context. The law also provides special protections for sensitive data, which includes personal data revealing racial or ethnic origin, religious beliefs, mental or physical health condition or diagnosis, sex life or orientation, citizenship or citizenship status, and personal data from a known child.
However, the CPA does not apply to, among other things:
financial institutions or data subject to the federal Gramm-Leach-Bliley Act;
certain activities regulated by the Fair Credit Reporting Act;
information on persons acting in a commercial or employment context;
deidentified data or, in some contexts, pseudonymous data; or
publicly available information.
Consumer Rights
The CPA provides consumers with a number of rights related to their personal data, several of which are similar to rights available under the CCPA and VCDPA. Under the CPA, consumers have the right to:
confirm whether or not a controller (the person that determines the purpose and means of processing personal data) is processing personal data;
access their personal data;
correct inaccuracies in their personal data, taking into account the nature of the personal data and the purposes for processing the personal data;
delete personal data concerning them;
obtain a portable copy of personal data that they access from the controller;
opt out of the processing of personal data for (1) targeted advertising, (2) the sale of personal data, or (3) profiling in furtherance of decisions that produce legal or similarly significant effects concerning the consumer; and
appeal a refusal to take action on a request to exercise a right under the CPA.
The CPA also requires controllers to adopt and offer, by July 1, 2024, a universal opt-out mechanism to allow consumers to opt out of the sale of personal data and opt out of the processing of personal data for purposes of targeted advertising under technical specifications to be established by the Colorado attorney general.
Controller Obligations
The CPA imposes different obligations depending on whether the business is a controller or a processor (the entity processing personal data on behalf of the controller). Therefore, a business will need to analyze whether it is acting as a controller or a processor when engaging in any personal data processing.
Under the CPA, controllers must, among other things:
provide a Privacy Notice containing specific disclosures, including the categories of personal data collected, processed, and shared, the purposes for which personal data are collected and processed, the categories of third parties with whom the controller shares personal data, and, if selling personal data or processing personal data for targeted advertising, a clear and conspicuous disclosure of the sale or processing and how a consumer can opt out;
limit processing personal data to what is adequate, relevant, necessary, reasonable, and proportionate in relation to the specified purposes for which such personal data is processed;
not process personal data for purposes that are not reasonably necessary or compatible with specified purposes, unless the controller obtains consumer consent;
take reasonable measures to secure personal data during both storage and use from unauthorized acquisition;
not process personal data in violation of discrimination laws; and
not process sensitive data without consent.
The CPA also requires controllers to conduct and document data protection assessments when conducting data processing that presents a heightened risk of harm to a consumer. Processing that presents a heightened risk of harm to a consumer includes engaging in the following activities:
the processing of personal data for purposes of targeted advertising;
the sale of personal data;
the processing of personal data for purposes of profiling, where such profiling presents a reasonably foreseeable risk of certain types of harm to consumers; and
the processing of sensitive data.
Processor Obligations
A processor must follow a controller’s instructions and must assist the controller in:
responding to consumer rights;
meeting data security and breach notification obligations; and
providing information to enable the controller to conduct and document data protection assessments.
There are also requirements for contracts between controllers and processors as well as requirements for engaging subcontractors.
Enforcement
The Colorado attorney general and district attorneys have exclusive authority to enforce the CPA. The attorney general and DAs may seek civil penalties of up to $20,000 for each violation of the CPA, in addition to injunctive relief. The CPA provides for a 60-day right to cure.
The CPA does not provide for a private right of action.
Do you know what an ombudsman does? Did you know that the Board of Governors of the Federal Reserve System (“Board”) has an Ombudsman Office that serves individuals and financial institutions affected by the Federal Reserve System’s (the “Federal Reserve”) regulatory and supervisory activities? This article provides an overview of the Board’s Ombudsman Office and explains recent amendments to the Federal Reserve’s procedures for an institution to appeal a rating or other supervisory action (material supervisory determination (“MSD”) appeals process).[1]
What Is an Ombudsman?
The term “ombudsman” is Swedish in origin (literally translated, it means “representative”), and an ombudsman’s function is to assist “individuals and groups in the resolution of conflicts and concerns.”[2] The ombudsman profession dates back to 1713, when King Charles XII of Sweden appointed an ombudsman to help promote good governance and conflict mitigation.[3] The use of ombudsmen has continued to evolve, spreading throughout the public, private, and academic sectors around the world.[4] Examples of organizations and businesses that employ ombudsmen include the United Nations, the International Monetary Fund, the American Red Cross, the Inter-American Development Bank, the United States Olympic Committee, American Express Company, The Coca-Cola Company, Mars Inc., and United Technologies Corporation.
This article presents an outline of the office’s methods and purpose from the perspective of the Federal Reserve’s Ombudsman Office employees, past and present.
The Federal Reserve System’s Ombudsman Office
Establishment of the Ombudsman Office
The Board established the position of Ombudsman in 1995, as required by the Riegle Act.[5] Other financial regulators, including the Consumer Financial Protection Bureau, Federal Deposit Insurance Corporation, National Credit Union Administration, and Office of the Comptroller of the Currency, also have ombudsmen. The Riegle Act directed each federal banking agency to appoint an ombudsman to:
(A) act as a liaison between the agency and any party with any problem the party may have in dealing with the agency as a result of its regulatory activities; and
(B) ensure that safeguards exist to encourage complainants to come forward and preserve confidentiality.[6]
What We Do and How We Do It
The Board’s Ombudsman Office is guided by four core principles: independence, informality, fairness, and confidentiality. We operate outside of the Federal Reserve’s supervisory and regulatory processes and are therefore independent. The Ombudsman Office is located in the Board’s Office of the Secretary, and Ombudsman staff do not report to the Board’s supervisory divisions.
The Ombudsman Office has three major functions. Primarily, we are available to facilitate the fair and timely resolution of complaints related to the Federal Reserve’s supervisory and regulatory activities. In performing this function, we most commonly hear from representatives of state member banks (for which the Federal Reserve is the primary federal regulator) about a specific supervisory determination. For example, financial institutions have contacted our office about supervisory component and composite ratings; findings in safety and soundness examinations and consumer compliance exams; timing, process, or other concerns relating to exams; and the review and approval of pending applications. To help resolve such matters, we work collaboratively with representatives of the supervised institution and with senior staff at the Board or Reserve Bank, as appropriate. In short, we do our best to facilitate productive communication and to keep the resolution process on track.
Depending on the severity of the problem, the Board’s general practice is to attempt to resolve problems informally, when appropriate. In keeping with this policy, our office typically assists individuals or financial institutions before a formal process is initiated, often obviating the need to use a formal process. Moreover, our office can continue to assist an individual or institution in resolving a dispute even if it has escalated to a formal process. We have informally assisted financial institutions during the pendency of an MSD appeal to provide information and to help address, for example, communication or delay issues.
We also serve as an intake point for whistleblower complaints against supervised institutions or institution-affiliated parties. We generally gather information from the complainant and share the information with appropriate Board or Reserve Bank staff. However, if an individual wants to remain anonymous outside of discussions with the Ombudsman Office, we will not share any identifying information.
The second major function of our office is to investigate any claim that Federal Reserve staff has retaliated against a supervised institution. The Board has a strict policy prohibiting retaliation. The Ombudsman Office defines retaliation as any action or decision by Board or Reserve Bank staff that causes a supervised institution to be treated differently (e.g. more harshly) than other similarly situated institutions because the institution has attempted to resolve a complaint by filing an MSD appeal or has utilized any other Board mechanism for resolving a complaint.[7] Because of the ongoing relationships between financial institutions and the Board, we recognize how difficult it can be for an institution to raise retaliation claims, and we ensure that all such claims are fully investigated. During this process, our office collects and reviews relevant documents, interviews witnesses, and consults with Board or Reserve Bank subject matter experts.[8] Throughout the course of our investigation, we also attempt to resolve retaliation claims informally, such as through discussions with the complaining institution and relevant Board or Reserve Bank staff.[9] At the conclusion of an investigation, our office determines if retaliation occurred and reports its factual findings and determination to the appropriate Federal Reserve internal resources.[10] We may also recommend to the appropriate division director that personnel involved in the claimed retaliation be excluded from the next examination of the institution or review that may lead to an MSD. However, the division director will make the final decision regarding any exclusions of Federal Reserve personnel from future examinations.
Our third function is to provide feedback on patterns of issues.[11] This function includes reporting to Board members and senior staff on issues that are likely to have a significant impact on the Federal Reserve’s missions, activities, or reputation that arise from the Ombudsman’s review of complaints, such as patterns of issues that occur across multiple complaints. This information includes aggregate data, and may also include particular issues raised by institutions. To maintain confidentiality, we do not share any identifying information about an institution in these reports, unless expressly authorized to do so by the institution. This reporting function enables us to share directly with Board members and senior staff our perspective based on the concerns of individuals and financial institutions affected by the Federal Reserve’s supervisory or regulatory activities.
Due to the nature of the Ombudsman Office’s functions, we have established safeguards to protect the identity of the individuals and financial institutions that contact our office. We also protect the confidentiality of the information they share, upon request. Our email address and telephone line are not accessible to anyone other than Ombudsman Office staff. We share identifying and other information with Federal Reserve staff only if the individual or financial institution has explicitly authorized us to do so (except if disclosure is required by law, in the event of imminent risk of serious harm, or in the case of fraud, waste, or abuse).
In sum, our office serves in most instances as an informal resource, and we advocate for a fair and timely resolution of disputes or concerns. An institution’s participation in a resolution process with the Ombudsman is voluntary. If a financial institution or individual no longer wants to pursue resolution through our office, it is free to terminate the process at any time.
The MSD Appeals Process
The Riegle Act also directed the federal banking agencies to establish an “independent intra-agency appellate process” for the review of “material supervisory determination[s]” and to ensure that “appropriate safeguards exist for protecting the appellant from retaliation by agency examiners.”[12] In response, the Board established an MSD appeals process in March 1995. Last year, the Board adopted an amended MSD appeals process, drawing on experience with and feedback on the original policy.[13] The purpose of the revised process is to improve and expedite the appeals process. Highlights of the amendments, which became effective on April 1, 2020, are summarized below.
The original process defined an MSD to include determinations related to examinations or inspection composite ratings, the adequacy of loan loss reserves, and significant loan classifications. The revised process clarifies that Matters Requiring Attention (MRAs) and Matters Requiring Immediate Attention (MRIAs) constitute appealable MSDs. Specifically, the revised process states that an MSD includes, but is not limited to, “any material determination relating to examination or inspection composite ratings, material examination or inspection component ratings, the adequacy of loan loss reserves and/or capital, significant loan classification, accounting interpretation, Matters Requiring Attention (MRAs), Matters Requiring Immediate Attention (MRIAs), Community Reinvestment Act ratings (including component ratings), and consumer compliance ratings.” The revised process clarifies that it excludes any referral of a matter to another government agency from an appealable MSD. Finally, the revised process continues to exclude any supervisory determination for which an independent right of appeal exists.
The original appeals process consisted of three levels—an initial review panel, an appeal to the president of the Reserve Bank that issued the MSD, and an appeal to the appropriate Governor at the Board. The revised process only includes two levels—an initial review panel and a final review panel—both of which have three members. Under the revised process, all appeals are filed with the Ombudsman Office. Generally, the initial review panel consists of three Reserve Bank employees, with the option for a Board employee to be appointed as one of the three members in appropriate circumstances. The final review panel must consist of at least two Board employees, at least one of whom must be an officer of the Board at the level of associate director or higher. Members of the review panels must not have been substantively involved in, or directly or indirectly report to someone else who was involved in, the MSD being appealed. Additionally, none of the panel members may be employees of the Reserve Bank that made the MSD being appealed.
Under the revised, streamlined process, an institution must file an initial appeal within 30 calendar days of receipt of the MSD, and the initial review panel will issue a decision within 45 calendar days of the date the appeal is received.[14] An institution must file a final appeal within 14 calendar days of the initial review panel’s decision, and the final review panel will issue a decision within 21 calendar days of the filing of a final appeal.[15]
The revised process also addresses a potential timing conflict between the Prompt Corrective Action (PCA) framework[16] and the original MSD appeals process by expediting the appeals process. If an MSD being appealed relates to or causes an institution to become critically undercapitalized, the appeals process is further expedited. An institution must still file an initial appeal within 30 calendar days of receipt of the MSD, but the initial review panel will issue a decision within 35 calendar days of the date the appeal is received.[17] An institution must file a final appeal within seven calendar days of the initial review panel’s decision, and the final review panel will issue a decision within 10 calendar days of the filing of a final appeal.
The revised process also defines specific standards of review applicable at each level of the appeal. The initial review panel considers whether the MSD being appealed is consistent with applicable laws, regulations, and policy, and is supported by a preponderance of evidence in the record. The initial review panel will make its own supervisory determination and will not defer to the judgment of the Reserve Bank staff that made the MSD being appealed. The initial review panel may, however, rely on any examination work papers developed by the Reserve Bank or materials submitted by the institution if it determines it is reasonable to do so. The final review panel determines whether the initial review panel’s decision was reasonable.
Finally, the Ombudsman Office may attend, as an observer, meetings or deliberations relating to the appeal, if requested by either the institution or Federal Reserve personnel. Ombudsman staff will also follow up with institutions that have filed an MSD appeal to inquire whether retaliation has occurred. As in the prior policy, the Ombudsman Office is the authorized recipient of all retaliation claims made by supervised institutions involving the Federal Reserve.
Conclusion
As explained above, the three main functions of the Ombudsman Office are: (1) to facilitate the fair and timely resolution of complaints related to the Federal Reserve’s supervisory and regulatory activities; (2) to investigate any claim that Federal Reserve staff has retaliated against a supervised institution; and (3) to provide feedback on patterns of issues. The Board’s Ombudsman Office staff is here to assist you, and we are dedicated to helping the Federal Reserve and its constituents resolve issues efficiently and effectively. If you have any questions, please contact us via email at [email protected] or by calling 1-800-337-0429.
[1] The authors of this article would like to acknowledge the valuable contributions of former staff members of the Ombudsman Office who contributed to the development of this article.
[2] The International Ombudsman Association, https://www.ombudsassociation.org/what-is-an-organizational-ombuds.
[3] C. McKenna Lang, A Western King and an Ancient Notion: Reflections on the Origins of Ombudsing, Journal of Conflictology, Vol. 2, Issue 2 (2011).
[5] Riegle Community Development and Regulatory Improvement Act of 1994, 12 USC §§ 4701 et seq.
[6] 12 U.S.C. § 4806(d)(2). In addition, when Congress created the Consumer Financial Protection Bureau in 2010, it directed that the Consumer Financial Protection Bureau appoint an ombudsman to carry out these roles. 12 U.S.C. § 5493(a)(5).
[7] “Internal Appeals Process for Material Supervisory Determinations and Policy Statement regarding the Ombudsman for the Federal Reserve System,” 85 Fed. Reg. 15175, 15182 (March 17, 2020).
[13] “Internal Appeals Process for Material Supervisory Determinations and Policy Statement regarding the Ombudsman for the Federal Reserve System,” 85 Fed. Reg. 15175 (March 17, 2020).
[14] The initial review panel may extend the period for issuing a decision by up to 30 calendar days if the panel determines that the record is incomplete, and that additional fact-finding is necessary for the panel to issue a decision.
[15] The final review panel may extend the period for issuing a decision by up to 30 calendar days if the panel determines an extension is appropriate.
[17] This period may be extended by up to an additional seven calendar days if the initial review panel decides that such time is required to supplement the record and consider additional information received.
May 26, 2021 was a landmark day for Big Oil. Its inner sanctums were put on notice by stakeholders that the companies must take meaningful steps now to address climate change. 61% of Chevron Corporation (“Chevron”) shareholders voted to approve a resolution seeking Chevron’s reduction of Scope 3 greenhouse gas (“GHG”) emissions.[1] Three directors, who were nominated by a small hedge fund to make Exxon more accountable for all of its carbon emissions, were elected to Exxon Mobil’s Board of Directors at Exxon’s annual meeting.[2] A Dutch trial court ordered Royal Dutch Shell to cut its GHG emissions by 45% by the year 2030.[3] While these events are unprecedented for Big Oil, how they came about and their actual impact are worth a closer look. Perhaps what’s most noteworthy is the prospect that years of shareholder activism may suddenly be yielding dividends.
I. Chevron and Its Shareholders
At Chevron’s annual meeting on May 26th, shareholders approved the following resolution:
“RESOLVED: Shareholders request [Chevron] to substantially reduce the greenhouse gas (GHG) emissions of their energy products (Scope 3) in the medium- and long-term future, as defined by the Company. To allow maximum flexibility, nothing in this resolution shall serve to micromanage the Company by seeking to impose methods for implementing complex policies in place of the ongoing judgement of management as overseen by its board of directors.”[4]
The resolution was proposed by Follow This, a Dutch activist fund. Chevron had initially sought to exclude the proposal from a vote and requested no-action relief from the SEC on the basis that (i) the proposal related to the Company’s “ordinary business” operations and sought to “micromanage the Company’s actions to direct its GHG emissions management program,” which made it excludable from proxy materials under Rule 14a-8,[5] and (ii) the proposal duplicated a prior proposal.[6] On March 30, 2021, the SEC denied Chevron no-action relief, indicating on its website that the SEC was “[u]nable to concur with exclusion on any of the bases asserted.”[7]
Also considered during this stockholder meeting were resolutions (a) directing the Board of Chevron to issue an audit report discussing “whether and how a significant reduction in fossil fuel demand, envisioned in the IEA [International Energy Agency] Net Zero 2050 scenario, would affect its financial position and underlying assumptions,” and (b) seeking to convert Chevron to a Public Benefit Corporation under Delaware law, the purpose of which would have been to enable Chevron to adopt and adhere to sustainability goals consistent with the public interest. The Board of Directors of Chevron opposed all three resolutions.[8]
Only the first of the proposed resolutions, identified as Item 4 on the proxy card, passed. What does Item 4 actually obligate Chevron and its Board to do? On its face, very little. It “request[s],” but does not mandate, that the company reduce its Scope 3 emissions.[9] It contains no firm climate change benchmarks that the company must achieve. The timeframe for accomplishing these reductions, in the “medium and long term future,” is not specific. And furthermore, Chevron’s governance rules only commit the Board to “reconsider any stockholder proposal not supported by the Board that receives a majority of the votes cast at its Annual Meeting . . . .”[10] From management’s perspective, Item 4 could be viewed as more advisory than mandatory.
Nevertheless, the impact of the resolution’s passage is far from illusory. It is after all the first resolution calling for any reduction in GHG emissions passed by Chevron’s shareholders, and the fact that it does not impose specific targets or requirements is due to the limitations of Rule 14a-8, which allows shareholders owing certain amounts of securities to place proposals in the company’s proxy materials for vote at shareholder meetings, subject to certain procedural requirements and substantive exclusions. One such exclusion is proposals that relate to the company’s “ordinary business operations,” which could result in impermissible micro-management of the company by shareholders.[11] Follow This expressly limited its proposal to calling for a reduction in emissions only, appropriately leaving the specifics of accomplishing the reduction to management: “Had the Proponent not been required to draft this proposal with pointed consideration of the potential for exclusion on grounds of micromanagement, the Proponent would have requested much more specific and progressive reductions.”[12] Going forward, should Chevron’s Board ignore the resolution, its directors could be at greater risk of being replaced over time by the same shareholders who voted for the resolution.
II. Exxon Mobil’s Three New Directors
Engine No. 1, a hedge fund with a .02% holding in Exxon Mobil, proposed a slate of four directors for election to Exxon’s twelve-member board at its annual meeting on May 26, 2021. Engine No. 1’s stated goal was to infuse the Exxon Board with people who will push the energy giant to recognize the significance of global climate change and respond constructively to the goals of the Paris Climate Agreement. Engine No. 1 succeeded in electing three of its four nominees, garnering critical support from Exxon’s three largest shareholders (and the three largest asset managers in the world) BlackRock, Vanguard and State Street, as well as major shareholders such as CalPERS and the New York State Common Retirement Fund.[13] In fact, Engines No. 1’s three directors received the highest number of votes of all nominees.[14]
In the case of Exxon, Engine No. 1’s success appears to have been based on excellent timing and a compelling slate of candidates. Going into the annual meeting, Exxon had faced “mounting criticism for its reluctance to invest more in renewable energy and for years of weak financial performance.”[15] New York State’s Comptroller said investors had “received platitudes and gaslighting in response” to concerns about climate change for years.[16] Meanwhile, Exxon’s three largest shareholders have placed themselves at the forefront of the Environmental, Social, and Governance (ESG) movement as members of the NetZero Asset Managers Alliance among other things.[17] BlackRock in particular all but foreshadowed its vote in its 2021 annual letter to clients:
“We expect the issuers we invest in on our clients’ behalf to be adequately managing the global transition towards a net zero economy…. Where we do not see progress in this area, and in particular where we see a lack of alignment combined with a lack of engagement, we will not only use our vote against management for our index portfolio-held shares, we will also flag these holdings for potential exit in our discretionary active portfolios because we believe they would present a risk to our clients’ returns.”[18]
Engine No. 1 provided a slate of qualified candidates to garner the votes, including highly regarded industry executives with success in both conventional and renewable energy transition (Gregory Goff and Kaisa Hietala) and a former U.S. Asst. Secretary of Energy and clean tech entrepreneur with expertise in energy infrastructure, R&D and policy (Alexander Karsner).[19] Shareholders recognized that Exxon needs diversity of expertise, background and perspective on its board to move towards sustainability, and voted accordingly.[20]
III. Royal Dutch Shell in The Hague
Potentially the most significant of the May 26th events was the decision by the Hague District Court to order Royal Dutch Shell (“RDS”) to cut its GHG emissions by net 45% by 2030 compared to 2019 levels.[21]
There are many significant elements of the Judgment, starting with the Court’s recognition of the effects of climate change. The Court accepted as fact that mankind’s use of fossil fuels leads to the release of carbon dioxide which traps heat within the ozone layer and causes temperatures on earth to rise.[22] It discussed the so-called carbon budget, which is the total remaining capacity of the earth to absorb GHGs, and accepts as fact the conclusions by various international organizations about the effects of climate change.[23] In particular, the Court accepted as fact that The Netherlands generates more CO2 emissions than many other European countries and there is a direct connection between those activities and future disruptions to human existence.[24]
The plaintiffs asserted that RDS had duties under Dutch law to prevent climate change through its corporate policies and to ensure that its carbon emissions comply with levels deemed acceptable under, for example, the IEA’s Net Zero 2050 plan. The Court concluded that RDS’ corporate policies, policy intentions and ambitions are incompatible with CO2 reduction targets prescribed in the Paris Climate Agreement, the IEA Net Zero 2050 and other global climate change policies. It ordered RDS to reduce its Scope 1, 2 and 3 emissions by a net 45% of 2019 levels by the end of 2030 through the adoption and implementation of new corporate policies that will actually enable these results.
Given the breadth and impact of the Judgment, it is likely that RDS will appeal. If so, the Hague Court of Appeal would review the case do novo, i.e. it may re-examine the facts and reach its own conclusions about the facts and the outcome of the case.[25] While this story is not over, it remains to be seen what effect (if any) the case may have on future U.S. public policy and legislation.
IV. Measuring Progress Toward Net Zero
Much of the world now pays ever closer attention to the consequences of our reliance on fossil fuels. As the reality of climate change is now in the boardrooms of Big Oil, there is growing demand from the investor community for companies to, as Bill Gates puts it, go from emitting 51 billion tons of GHGs each year to zero.[26]
On June 10, 2021, The Investor Agenda published a “Statement to Governments” signed by 457 investment firms and individuals representing US$41 trillion in assets urging governments to issue standards for measuring and quantifying climate risk so that investors can properly assess those risks and invest wisely.[27] The Statement calls on all governments to take broad action in 2021, including:
strengthening NDCs for 2030;
committing to “decarbonization roadmaps” for carbon-intensive sectors;
Like BlackRock’s 2021 annual letter to clients, the Statement invokes the need for greater transparency in climate risk disclosures.[29] The inability of investors to obtain material information about company carbon emissions impedes investors’ efforts to invest the capital required to achieve Net Zero. Extraordinary associations and statements such as these underscore the growing urgency with which climate change and ESG issues are being considered. While the full significance of May 26, 2021 remains to be seen, the day may hopefully be remembered as the beginning of a shift of consciousness in Big Oil from avoidance to constructive engagement with the forces of climate change.
[11] See 17 CFR §240.14a-8(i)(7). See also Exchange Act Release No. 40018 (May 21, 1998). The policy underlying the ordinary business exclusion is “to confine… ordinary business problems to management and the board…, since it is impracticable for shareholders to decide how to solve such problems at an annual shareholders meeting,” and to consider “the degree to which the proposal seeks to ‘micro-manage’ the company by probing too deeply into matters of a complex nature upon which shareholders… [are not] in a position to make an informed judgment.” Id.
In re Nine WestLBO Securities Litigation (“Nine West”) is a recent case decided by the Southern District of New York in which the court left open the possibility that directors of a target company involved in a leveraged buyout (“LBO”) could be held liable for breach of fiduciary duty in approving the LBO if the post-merger company later becomes insolvent due to the impact of the LBO and related foreseeable transactions by the successor board, including taking on significant debt as part of the LBO.
The case has the potential of expanding the paradigm of fiduciary duties owed by directors to include the successor acts of the surviving company’s board.
A Delaware court would likely reach a similar outcome in deciding a case like Nine West; however, it would be reluctant to require directors to prioritize the post-merger solvency of a new surviving company over maximizing stockholder value.
Introduction
In recent years, there has been a small slowdown in the trend of highly leveraged buyouts of companies by private equity firms. Private equity firms continue to target struggling, undervalued, or poorly managed companies, and use significant debt to complete the leveraged buyout of those companies, often flipping the target company (or spinning off its profitable portions) a few years later, resulting in significant profits. Unsurprisingly, Delaware courts have seen a consistent flow of cases where stockholders of target companies claim that directors breached their fiduciary duties in connection with orchestrating and approving an LBO. The focus of these cases has been almost entirely on whether the directors exercised valid business judgment and maximized shareholder return in approving the LBO. What happens to the acquired company after the LBO is completed – including the debt it took on as part of the LBO and its post-merger solvency – has not received significant focus in analyzing the personal liability of the directors approving the sale. But that may no longer be the case.
A recent decision by a U.S. District Court for the Southern District of New York, In re Nine West LBO Securities Litigation, has created buzz in the legal and business communities because of its potential for causing a paradigm shift in director liability in approving the sale of a company through an LBO. The Nine West decision contemplates that directors of a target company involved in an LBO could be held liable if the surviving, post-merger company later becomes insolvent, at least partially because the target company’s directors failed to consider the foreseeable impact that taking on considerable debt as part of the LBO would have on the surviving company. The Nine West decision also hints that directors could be liable for foreseeable “successor acts” of the new board, in addition to facing liability for aiding and abetting the new board’s post-sale breaches of fiduciary duties.
Faced with this possible increased liability risk for approving an LBO, directors may be more hesitant to pursue and approve such deals moving forward, creating a chilling effect on the trend of highly leveraged private equity sales. This article explores the Nine West decision and Delaware fiduciary duty law as applied to LBOs, ultimately predicting that a Delaware court would reach a decision similar to Nine West given the structure of the LBO at issue in that case. However, a Delaware court would likely be reluctant to require directors to prioritize the post-merger solvency of a new surviving company over maximizing stockholder value, and would also likely decline to extend the liability paradigm for directors to reach successor acts of a succeeding board absent special circumstances.
Fiduciary Duties and Related Issues Under Delaware Law
In carrying out their responsibilities, directors and officers have a fiduciary duty to protect the interests of the corporation and act in the best interests of the corporation and its stockholders. Delaware law has long recognized two principal fiduciary duties owed by officers and directors alike: the duty of loyalty and the duty of care.
Duty of Loyalty
The duty of loyalty requires an officer or director to place the interests of the corporation and its stockholders above personal interest when making decisions that affect the corporation. Included in the duty of loyalty is a requirement that officers and directors act in good faith, motivated by “a true faithfulness and devotion to the interests of the corporation and its shareholders.”[1] A director or officer who intentionally acts with a purpose other than that of advancing the best interests of the corporation may be found to have acted in bad faith; however, another hallmark of bad faith involves a director or officer acting with deliberate indifference or failing to act in the face of a known duty.
Duty of Care
The duty of care requires corporate fiduciaries to act in a fully informed manner. Officers and directors are required to fully inform themselves of all material information reasonably available to them before making a decision on behalf of the corporation. They are expected to exercise the degree of care and prudence that would be expected of them in the management of their own affairs. In addition, having become so informed, directors and officers must then act with care in the discharge of their duties. In determining whether an officer or director failed to make a sufficiently informed decision and so violated the duty of care, Delaware courts apply a “gross negligence” standard, analyzing whether the officer or director acted outside “the bounds of reason” or with “reckless indifference to or a deliberate disregard of the stockholders … or actions which are without the bounds of reason.”[2]
Exculpation
Delaware corporations can include in their certificate of incorporation an exculpation provision pursuant to 8 Del. Code 102(b)(7) (“Section 102(b)(7)”) that eliminates (or limits) the personal liability of a director to the corporation or its stockholders for monetary damages for any breach of the duty of care. Even grossly negligent acts can be shielded by a Section 102(b)(7) exculpatory provision. Such a provision, however, does not eliminate or limit liability of a director for breach of the duty of loyalty or for acts not taken in good faith.
Business Judgment Rule
Under Delaware law, directors and officers are entitled to a “presumption that in making a business decision [they] acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”[3] This presumption is known as the business judgment rule, and it exists to protect and promote the full and free exercise of powers granted to directors and officers of a Delaware corporation. The presumption that directors and officers acted loyally can be rebutted by establishing that the officers or directors were either interested in the outcome of the transaction or otherwise lacked the independence to consider whether the transaction was in the best interest of the company and all of its stockholders. If a plaintiff challenging a corporate transaction successfully rebuts the presumption, defendant officers and directors lose the protection of the business judgment rule, and the burden of proof shifts to the directors and officers–the proponents of the challenged transaction–to prove the entire fairness of the transaction to the corporation and its stockholders.[4]
Nine West
Background
In 2014, the private equity firm Sycamore Partners Management L.P. (“Sycamore”) completed a highly leveraged buyout of the Jones Group, a publicly traded Pennsylvania apparel company with brands like Nine West.[5] Like many companies targeted by private equity firms, the Jones Group was struggling financially in the years leading up to 2014, although two of its signature brands, Kurt Geiger and Stuart Weitzman, were hitting earnings targets and were showing consistent growth. Due to the struggles of its other brands, however, Jones Group sought to sell the business and retained Citigroup to serve as its advisor. Citigroup advised the Jones Group that it could support a deal resulting in a debt to EBITDA ratio of 5.1 times its 2013 estimated EBITDA.
Sycamore offered to buy Jones Group for $15 per share ($2.15 billion enterprise value), with a Sycamore affiliate (run by Sycamore) acting as the surviving company, to be named Nine West Holdings, Inc. (“Nine West”). As part of the original agreement and plan of merger (“Merger Agreement”), the stockholders of Jones Group would be cashed out at $15 per share and they would thus no longer hold interests in Jones Group nor would they acquire interests in Nine West. Sycamore was to contribute at least $395 million in equity and Nine West would increase its debt from $1 billion (the Jones Group’s pre-merger debt) to $1.2 billion. Nine West’s two successful brands would act as “carve-out businesses” and would be sold separately to other Sycamore affiliates for less than their fair market value. Thus, the struggling non-carve-out brands of Jones Group would become Nine West, while the two successful brands, Kurt Geiger and Stuart Weitzman, would be sold separately as part of a nearly concurrent sale to Sycamore. The Merger Agreement contained a “fiduciary out” which allowed the Jones Group directors to withdraw their recommendation in favor of the deal if they determined doing so was required in order to comply with their fiduciary duties.
The Jones Group board voted unanimously to approve the Merger Agreement. However, before closing, Sycamore changed the deal terms drastically and reduced its planned equity contribution from $395 million to just $120 million. To offset this adjustment, Sycamore arranged for Nine West to increase its debt from $1 billion to $1.55 billion rather than from $1 billion to $1.2 billion as originally planned. These changes resulted in a post-merger debt ratio of 7.8 times Nine West’s EBITDA. Throughout the deal process, the Jones Group board thoroughly investigated and considered the fairness of the proposed offer of $15 per share, concluding that it was a fair price for stockholders, but it allegedly did not consider the fairness or impact of the additional debt that would be taken on by the post-merger company, Nine West. The board also allegedly did not investigate or consider the impact of the sales of the carve-out businesses on Nine West’s solvency or financial state.
To get to a cheaper price for the carve-out businesses, Sycamore allegedly created unjustified EBITDA projections for the non-carve-out remaining businesses, as more value attributed to those businesses would make it easier to justify a discount sale price on the profitable carve-out businesses. The Jones Group board was unaware of Sycamore’s alleged manipulations but did receive consistent updates on the struggles and financial decline of the non-carve-out businesses, along with optimistic projections for the carve-out businesses. After the merger closed in 2014, Sycamore’s principals, Stefan Kaluzny and Peter Morrow, became the sole directors of Nine West. As planned, Kuluzny and Morrow then immediately sold the carve-out businesses to a Sycamore affiliate for $641 million, despite an alleged $1 billion fair market value. In connection with the Sycamore-Jones Group merger, stockholders brought a derivative suit against the Jones Group’s directors and officers. That case settled in 2015.
Four years after the merger with Sycamore closed, Nine West filed for bankruptcy. As part of the Chapter 11 bankruptcy plan, a litigation trust was established, and the litigation trustee (hereinafter, “Plaintiff”) was empowered on behalf of the unsecured creditors to pursue all claims against directors and officers of Jones Group arising out of the 2014 transaction with Sycamore. Plaintiff sued the directors and officers of Jones Group for breach of fiduciary duty and aiding and abetting breach of fiduciary duty, among other claims. At their core, Plaintiff’s claims were based on the premise that the Jones Group directors and officers breached their fiduciary duties by not investigating whether the transaction “as a whole” would lead to the post-merger company’s bankruptcy, and relatedly whether they aided and abetted the subsequent breaches of fiduciary duties by the successor Nine West board (i.e., Sycamore). The former directors of Jones Group moved to dismiss the Plaintiff’s claims for breach of fiduciary duty and aiding and abetting fiduciary duty.
Legal Analysis
The Court denied the directors defendants’ motion to dismiss the breach of fiduciary duty and aiding and abetting claims. In so holding, the Court, applying Pennsylvania law, began by analyzing whether the business judgment rule applied to the challenged transaction. Plaintiff argued that the business judgment rule did not apply because the directors benefited from the deal by cashing out their own shares and were thus not disinterested. The Court rejected this argument and explained that under Pennsylvania law, a director does not stand on both sides of a transaction solely because the director owns shares of the corporation and stands to benefit financially from a challenged transaction as a result of that ownership. Nevertheless, the Court determined that the business judgment rule did not apply for the alternative reason that the director defendants did not (Plaintiff alleged) conduct a reasonable investigation into whether the transaction as a whole would render the surviving company insolvent. The Court rejected the director defendants’ argument that they were not required to consider factors such as the additional debt Nine West would be taking on or the fairness of the sale of the carve-out businesses because such actions were technically completed by a subsequent board after defendants’ tenure as directors ended. In rejecting this argument, the Court explained that multi-step LBO transactions like the one at issue can be treated as a single integrated plan for purposes of a fiduciary duty analysis, and that the director defendants ignored obvious red flags suggesting that the transaction would render Nine West insolvent post-merger. As the business judgment rule presupposes directors made a business judgment, the Court would not afford the director defendants the protection of the rule with respect to matters that they allegedly did not consider.
The Court then determined that the Jones Group’s exculpatory provision did not preclude liability. Pennsylvania law permitted the Jones Group to adopt bylaws limiting director liability except for cases where the breach constituted “self-dealing, willful misconduct, or recklessness.”[6] The Court first confirmed that Plaintiff did not allege self-dealing, adopting the Delaware law approach where self-dealing meant that the director stood on both sides of the transaction. Next, the Court found that Plaintiff alleged that the director defendants acted recklessly, such that the exculpatory bylaw did not shield them from liability. The Court explained that the director defendants were alleged to have consciously disregarded the transactions involving the carve-out businesses and that the director defendants ignored red flags, such as the additional debt taken on and resulting EBITDA ratio, that, if adequately investigated, should have alerted them to the imminent insolvency of Nine West as a result of completing the unified Sycamore deal.
In ultimately holding that Plaintiff adequately pled a claim against the directors for breach of fiduciary duty, the Court focused on (i) the treatment of the Sycamore LBO as a single unified transaction, and (ii) the director defendants’ failure to heed alleged red flags concerning Nine West’s potential post-transaction bankruptcy. The Court explained that the actual merger, the post-merger sale of the carve-out businesses, and the planned increase in additional debt to be taken on by Nine West could be “collapsed” into a “single integrated plan,” essentially opening the door for liability for the directors based on their failure to consider “foreseeable” harm to the post-merger company stemming from the unified deal they approved. Citing a District Court of Delaware case that applied Delaware law,[7] the Court made clear that even if directors do not approve a component of a transaction, they can be liable for the harm that the entire unified transaction causes the post-merger company. The Court then explained that Plaintiff adequately alleged that the director defendants ignored red flags and failed to investigate the impact of the additional debt (and decreased equity) that would be taken on by Nine West due to Sycamore’s last-minute change to the deal structure. Specifically, Plaintiff adequately alleged that the directors ignored the fact that the leverage ratio resulting from the additional debt would far exceed the amount recommended by their financial advisor. The Court also explained that the directors failed to investigate the adequacy of the purchase price for the carve-out businesses and its impact on Nine West’s solvency given the additional debt Nine West was taking on, stating:
The $2.2 billion valuation the company received in the 2014 transaction [with Sycamore], less the company’s $800 million historical purchase price for the carveout businesses, implied that [the non-carve-out businesses were] was worth no more than $1.4 billion. That knowledge should have alerted the director defendants that they needed to investigate [Nine West’s] solvency, given that Sycamore arranged, with their knowledge, for [Nine West’s] debt to be increased to $1.55 billion.
The Court also denied the director defendants’ motion to dismiss the claim for aiding and abetting the Nine West board’s breaches of fiduciary duty. Applying Delaware law to this claim, the Court determined that the director defendants had knowledge that Kaluzny and Morrow, as directors of the post-merger company, would carry out the planned sales of the carve-out businesses, and that these planned transactions were reasonably likely to lead to Nine West’s insolvency. The Court rejected the director defendants’ “senseless” argument that aiding and abetting can only occur when the fiduciary duty exists (i.e., after Kaluzny and Morrow became Nine West’s directors post-merger), thereby suggesting that if breaches of fiduciary duty by a successor board post-merger are foreseeable to the target company’s board pre-merger, and the merger is nevertheless approved by the preceding board, the preceding board can be liable for aiding and abetting the successor board’s breaches of fiduciary duty.
Potential Impact of Nine West on LBOs
While the court in Nine West was only ruling on motions to dismiss (and thus made no factual findings or findings of liability), the decision could nevertheless have a chilling effect on the trend of leveraged buyouts by private equity firms. While the decision is unlikely to change how private equity firms pursue, structure and carry out LBOs, it has the potential of giving directors of target companies pause in approving these kinds of transactions. If directors face liability based on the impact an LBO has on the solvency and financial state of the surviving company, they may be less likely to approve the LBO, as directors’ focus will not be simply on maximizing shareholder value in the short-term, as is customary in a company sale situation. Directors will be inclined to investigate the impact of debt taken on by the surviving company, seek additional fairness opinions, and even inquire into the acquiror’s financing obligations. This could slow down a proposed LBO or cause it to be voted down by a cautious board.
Delaware Courts’ Approach to Reviewing LBOs
A discussion of Delaware courts’ approach to director fiduciary duties in connection with LBO’s must begin with acknowledging the seminal decision, Smith v. Van Gorkom, which was the first decision in which the Delaware Supreme Court had the chance to review an LBO.[8] In Van Gorkom, the Court analyzed the fairness of a leveraged purchase of TransUnion arranged by its CEO, and examined the related fiduciary duty obligations of TransUnion’s directors. The Court held the directors monetarily liable for breaching their fiduciary duty of care as a result of not being fully informed about the transaction and the fairness of the price. The Court then provided guidelines for directors to follow in orchestrating and approving LBOs – a transaction type the Court criticized but did not prohibit. The Delaware Supreme Court focused on the steps a board should take in informing itself of the adequacy of the price per share offered, and implied that a board should seek an outside valuation and fairness opinion in connection with evaluating an LBO. Notably, however, the Court made no mention of a board’s obligation to discuss the impact of the transaction on the surviving company’s solvency or financial state.
Delaware cases reviewing LBOs since Van Gorkom have similarly focused on the adequacy of the cash-out share price, the process in investigating and determining the fairness of the deal to the target stockholders, and the duty that directors have to maximize value for the stockholders. The well-known Revlon decision, for example, involved a hostile takeover attempt by Pantry Pride, and a subsequent bidding war between Pantry Pride and a private equity “white knight.”[9] The Delaware Supreme Court in Revlon explained that once it became clear that the LBO was imminent, “[t]he directors’ role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.” Similar to the guidelines prescribed in Van Gorkom, the Court articulated context-specific “Revlon duties” which focused on a board’s obligation to maximize stockholder value and become fully informed of the fairness of the merger consideration to be paid to stockholders – again, with no consideration given to the financial state of the surviving company. Years later, the Delaware Supreme Court, reviewing another LBO in Lyondell Chem. Co., confirmed that “directors must engage actively in the sale process, and they must confirm that they have obtained the best available price either by conducting an auction, by conducting a market check, or by demonstrating ‘an impeccable knowledge of the market.’”[10] Again, no considerations were given by Delaware’s high court to the impact that the LBO (and associated assumption of significant debt) would have on the surviving post-merger company.
Based on these cases, it appears there is no Delaware precedent that a Delaware court could rely on in reaching a holding similar to Nine West. Nevertheless, in Time-Warner, the Delaware Supreme Court previewed the potential dueling considerations of a board in approving a deal that it believed aided the long-term interest of the company versus a deal that provided maximum short-term value for stockholders, stating:
First, Delaware law imposes on a board of directors the duty to manage the business and affairs of the corporation. 8 Del. Code § 141(a). This broad mandate includes a conferred authority to set a corporate course of action, including time frame, designed to enhance corporate profitability. Thus, the question of “long-term” versus “short-term” values is largely irrelevant because directors, generally, are obliged to chart a course for a corporation which is in its best interests without regard to a fixed investment horizon. Second, absent a limited set of circumstances as defined under Revlon, a board of directors, while always required to act in an informed manner, is not under any per se duty to maximize shareholder value in the short term, even in the context of a takeover.[11]
This language perhaps suggests that a board might have to consider the long-term solvency of the surviving company in approving a leveraged deal. However, the focus in Time-Warner was again on the fairness of the stock price to the stockholders when they were cashed out, with no focus on the financial state of the surviving company, despite the highly leveraged nature of the transaction at issue.
Indeed, no Delaware decisions appear to have analyzed whether a board has a fiduciary duty to investigate and consider the post-merger solvency of the surviving corporation in orchestrating and approving a transaction. Delaware courts have, however, explored the competing fiduciary duties owed to stockholders versus creditors by directors of struggling companies nearing the “zone of insolvency.” Such cases may shed light on whether directors of a Delaware corporation are required to consider the solvency of the separate, post-merger company, or if instead, they must maximize shareholder value irrespective of the impact that doing so has on the surviving company.
For example, in Trenwick America Litigation Trust, a litigation trustee of the bankrupt Trenwick America Corporation (Trenwick America) and its parent company, asserted claims against the prior directors of both Trenwick America and its parent company for breach of fiduciary duty stemming from several acquisitions and restructurings orchestrated and completed by both Trenwick boards when the companies were still solvent.[12] The Court of Chancery dismissed all claims, and noted that in approving the pre-insolvency transactions, the directors were “expected to seek profit for stockholders, even at risk of failure,” regardless of the organization’s solvency status. The Court also explained that because the company was solvent at the time of these challenged transactions, it owed no fiduciary duties to its parent company or the parent company’s creditors. While much of the decision turned on Delaware law concerning fiduciary duties owed by a subsidiary to a parent, the decision contains dicta suggesting that directors of a then-solvent company may not be held liable retroactively (and post-bankruptcy) for breaching a fiduciary duty to future creditors based on transactions that occurred while the company was solvent (as seen in Nine West). Indeed, the Court stated that “Delaware law does not . . . impose retroactive fiduciary obligations on directors simply because their chosen business strategy did not pan out.”
Predicting how a Delaware court would decide Nine West
Key to the Nine West decision was the New York court’s view that the multi-step LBO at issue ought to be considered as a single unified transaction, such that the impact of the additional debt taken on by the surviving company and the subsequent sales of the carve-out business were reasonably foreseeable by the Jones Group board, and should have thus been investigated and considered. Practically speaking, this view of this particular LBO finds support because the multiple post-merger transactions involving Nine West occurred nearly concurrently with the actual approved Jones Group-Sycamore merger. Moreover, the directors allegedly knew such transactions were certain to occur immediately, as the approved cash out price of $15 per share was expressly dependent on the additional debt and sale of the carve-out businesses. Given the nature and setup of this particular LBO, a Delaware court would likely follow the reasoning in Nine West and likewise view the multi-step LBO as one unified transaction for purposes of a fiduciary duty analysis.
Adopting that view, and given the plaintiff-friendly motion to dismiss standard, a Delaware court may similarly sustain breach of fiduciary duty claims against directors for approving such a unified deal, but it would likely do so with considerable hesitation. Specifically, a Delaware court would struggle with the notion that directors of a solvent company can retroactively owe fiduciary duties to creditors of a successor company, particularly when those directors approved the original deal (while solvent) in adherence with their duty to maximize shareholder value. The Court of Chancery has already hinted at its disapproval of this notion (albeit in a very different context) in Trenwick.
A Delaware court’s possible reluctance to expand the paradigm of fiduciary duties of directors in this broad way is justified given the derivation of a director’s fiduciary duties and the consequences of an LBO on a cashed-out stockholder. A board owes fiduciary duties to a corporation and its stockholders and is charged with acting in the best interest of the stockholders. In doing so, and in acting as an agent of the stockholders, the board must pursue a deal that serves the stockholders’ interests. An LBO like the one completed in Nine West results in the complete cash out and termination of the stockholders’ interests in the target company. It thus follows that the board can only serve the interests of the existing stockholders if it approves a deal that allows them to receive the highest value for their shares. That the private equity acquiror uses large amounts of borrowed money to purchase the company is irrelevant to stockholders, as they receive cash whether the money is borrowed or not. The post-merger transactions of the surviving company (in Nine West, the sale of the carve-out businesses) and their impact on the surviving company (Nine West) are similarly irrelevant to the stockholders, as they are to be cashed out, do not own shares of the surviving company, and thus are not impacted if the surviving company goes bankrupt due to these separate transactions. Thus, the natural question arises: shouldn’t these considerations, which are irrelevant to the stockholders, also be irrelevant to the board charged with acting in the stockholders’ best interests? A Delaware court may worry that requiring a director to account for the solvency of an entirely different, post-merger successor company (rather than simply maximizing shareholder value given that the shareholders are being cashed out) would run counter to the spirit of fiduciary duty law and inappropriately expand the range of fiduciary duties directors owe.
A Delaware court may also take a different approach than the New York court in applying the Jones Group’s exculpation bylaw and analyzing the associated pleading requirements under Delaware law. Unlike Pennsylvania law, Delaware law permits corporations to exculpate its directors for allegedly reckless acts. Plaintiff in Nine West pled recklessness to overcome the business judgment rule and exculpation provision under Pennsylvania law, but would have to plead more under Delaware law – specifically a breach of loyalty or absence of good faith – in order to plead a non-exculpated claim. A Delaware court thus might be more critical of the adequacy of the Plaintiff’s allegations, particularly as they concerned the director defendants’ knowledge and intent. However, one can safely assume that Plaintiff, if before a Delaware court, could have alleged a conscious disregard of duties by the director defendants, amounting to a lack of good faith, thereby pleading a non-exculpated claim that is not shielded by the Jones Group’s exculpatory bylaw.
Finally, a Delaware court would likely allow Plaintiff’s claim for aiding and abetting a breach of fiduciary duty to survive dismissal, just as the New York court did. If the Delaware court, as predicted, viewed the LBO as a unified transaction, then it follows that a Delaware court would view approval of that transaction – which included the additional debt and carve-out business sale nearly concurrently with the merger – as knowingly aiding the Nine West board in breaching their fiduciary duties by completing those transactions and rendering Nine West insolvent. However, a Delaware court would likely make this ruling based on the structure of the LBO and facts of the case, and would likely clarify that a board is not, as a general rule, responsible for “successor acts” of a succeeding board unless such acts were certain to occur if the core transaction was approved, as part of the unified transaction.
Practice Points For Directors
Price is not everything. Given the Nine West decision, directors of a target company are advised to consider all aspects of a potential transaction, including the impact that the deal will have on the solvency of the post-merger company. Doing so is particularly critical when directors are reasonably certain that the surviving company is taking on considerable debt and is completing potentially detrimental transactions concurrently with the merger or shortly after the merger is complete.
Directors should continue to seek outside valuations and fairness opinions concerning the merger consideration but are also well-advised to consult with experts concerning the financial impact of the LBO on the post-merger company. Directors should obtain solvency analyses, inquire about the private equity acquiror’s transactional plans post-merger, ask about the buyer’s financing obligations, and adequately document the efforts taken to investigate these matters.
If the private equity acquiror changes the deal terms late in the process, directors should ask questions, ascertain the reasons for the change, and thoroughly investigate the impact of these changes – particularly increases in the debt that is to be used by the buyer in completing the leveraged purchase.
Directors should not ignore red flags. The directors in Nine West were alleged to have blindly accepted manipulated EBITDA calculations provided by Sycamore, and failed to investigate several glaring red flags, resulting in potential liability.
The company and its board should always obtain director and officer liability insurance, particularly in light of the potential increased risk of liability in approving an LBO.
Directors should consult with outside counsel about fiduciary duty obligations and the fairness of all aspects of the LBO.
[1]In re Walt Disney Co. Deriv. Litig., 907 A.2d 693, 755-72 (Del. Ch. 2005).
[2]Rabkin v. Philip A. Hunt Chem. Corp., 547 A.2d 963, 970 (Del. Ch. 1986) (internal quotations omitted).
[3]Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1373 (Del. 1993).
[4]See, Cede & Co. v. Technicolor, Inc., 634 A.2d at 360-61.
[5]In re Nine W. LBO Sec. Litig., 2020 WL 7090277 (S.D.N.Y. Dec. 4, 2020).
[6] 15 Pa. Cons. Stat. § 1713(a). Thus, Plaintiff was required to allege recklessness or self-dealing. Compare with 8 Del. Code § 102(b)(7) (allowing corporation to exculpate directors for recklessness, but not breaches of the duty of loyalty or “for acts or omissions not in good faith or which involve intentional misconduct”).
[7]In re Hechinger Inv. Co.of Delaware, 274 B.R. 71, 91 (D. Del. 2002).
[9]Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).
[10]Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 243 (Del. 2009) (citations omitted) (internal quotation marks omitted).
[11]Paramount Commc’ns, Inc. v. Time Inc., 571 A.2d 1140, 1154 (Del. 1989) (emphasis added).
[12]Trenwick Am. Litig. Tr. v. Ernst & Young, L.L.P., 906 A.2d 168, 173 (Del. Ch. 2006), aff’d sub nom. Trenwick Am. Litig. Tr. v. Billett, 931 A.2d 438 (Del. 2007)
On June 11, in Yanbin Yu, Zhongxuan Zhang. v. Apple Inc., the Federal Circuit issued a decision finding that a claim directed to an improved digital camera was patent-ineligible under 35 U.S.C. § 101. This decision follows others from the Federal Circuit in which the court found claims containing mechanical components to be subject matter ineligible, including ChargePoint v. SemaConnect, 920 F.3d 759 (2019), The Chamberlain Group v. Techtronic Industries, 935 F.3d 1341 (2019), and American Axlev. Neapco, 939 F.3d 1355 (2019).
In the Yu case, the Federal Circuit considered the following claim:
An improved digital camera comprising:
a first and a second image sensor closely positioned with respect to a common plane, said second image sensor sensitive to a full region of visible color spectrum;
two lenses, each being mounted in front of one of said two image sensors;
said first image sensor producing a first image and said second image sensor producing a second image;
an analog-to-digital converting circuitry coupled to said first and said second image sensor and digitizing said first and said second intensity images to produce correspondingly a first digital image and a second digital image;
an image memory, coupled to said analog-to-digital converting circuitry, for storing said first digital image and said second digital image; and
a digital image processor, coupled to said image memory and receiving said first digital image and said second digital image, producing a resultant digital image from said first digital image enhanced with said second digital image.
In its eligibility determination, the court employed the two-step Mayo/Alice framework.[1] In step one, the court focused on the function of one of the components of the overall claim—the digital image processor—and found that the claim was directed to the abstract idea of “taking two pictures (which may be at different exposures) and using one picture to enhance the other in some way.” Plaintiffs argued the claims were directed to a patent-eligible application of the abstract idea. The court disagreed, noting that “the idea and practice of using multiple pictures to enhance each other has been known by photographers for over a century.”
The court further reasoned that (1) the claim recited only conventional camera components that perform their basic function, (2) the camera components describe a generic environment for carrying out the abstract idea, and (3) the solution described in the specification to problems identified in the prior art was the abstract idea itself. The court refused to give weight to the patent specification’s discussion of benefits and advantages over the prior art of a unique configuration of a four-lens, four-sensor embodiment because the claim was to a digital camera having two lenses and two sensors.
Finding that the claim was directed to an abstract idea, the court turned to step two of the Mayo/Alice test, concluding that the claim did not include an inventive concept sufficient to transform the claimed abstract idea into a patent-eligible invention. According to the court, the claimed configuration of two lenses, two sensors, and other mechanical and electrical components was not an advancement of the prior art and did not itself enhance one image by another. Plaintiff Yu argued that his configuration of the camera components was unconventional in nature and that the claim was allowed over a number of prior art references. The court responded by noting that even if a claim is novel, it is not necessarily patent-eligible.
Worth noting, Yu’s patent was found to be ineligible in the pleadings stage on a motion to dismiss before any discovery or expert testimony. The court dismissed Yu’s argument that the court should not find the patent ineligible without first hearing expert testimony.
In her dissent, Judge Newman stated that a statement of purpose or advantage—in this case, achieving a superior image—does not convert a device into an abstract idea. She viewed the claim to be for a digital camera having designated structure and mechanisms that perform specified functions, not for the general idea of enhancing camera images. She stated that the claimed digital camera “easily fits the standard subject matter eligibility criteria.” She criticized the majority’s decision as having enlarged the instability in technologic development created by the current state of section 101 law, stating “for the court holds that the question of whether the components of a new device are well-known and conventional affects Section 101 eligibility, without reaching the patentability criteria of novelty and nonobviousness.” Judge Newman concluded that the “fresh uncertainties engendered by the majority’s revision of Section 101 are contrary to the statute and the weight of precedent, and contrary to the public’s interest in a stable and effective patent incentive.”
The Federal Circuit’s decision in this case is another in which claims reciting structural limitations were found to be directed to an abstract idea. Even though the claim recited two image sensors arranged in a particular configuration with two lenses, circuitry, memory, and a digital image processor, it appears that because the claim also recited that the function of the digital image processor was to enhance a digital image, the Federal Circuit concluded that the claim is directed to ineligible subject matter. This begs the question—Would the result have been the same if the claim had not recited the function of enhancing a digital image? It’s possible the claim would have survived the pleadings stage and may have had a chance to be evaluated for the requirements of novelty and non-obviousness. In other words, patent drafters may want to carefully consider whether to include functional language in certain claims when doing so would expose the claim to the result reached in Yu v. Apple.
Looking at the broader issue, namely the continued extension of section 101 to claims that mostly recite structural elements, the decision seems to add more nuances to the Mayo/Alice two-step test. With respect to the first step, the decision suggests looking at the ultimate purpose of the claimed device to determine whether it is directed to an abstract idea, setting aside whether the claim includes structural elements. With respect to the second step, the decision emphasizes that if a claim is directed to an abstract idea, then the claim must include an inventive concept that matches the description of the advancement over the prior art in the patent specification.
Finally, because the court affirmed an invalidity determination at the pleadings stage, the evidence considered was limited to the complaint and the patent. For example, no expert testimony was considered on the question of whether the claimed two-lens, two-sensor configuration was capable of achieving the inventive concept of enhancing one digital image using a second digital image. Rather, the court only considered that each time the patent specification suggested an advancement over the prior art, it was in connection with a four-lens, four-sensor configuration, and the court concluded that a two-lens, two-sensor configuration was not an advancement over the prior art. Had Yu included an expert declaration along with the complaint, or had the case advanced past the pleading stage, then expert testimony regarding the inventive concept might have been given some weight along with the patent specification and the court’s own views regarding the inventive concept.
[1] This framework was derived from the Mayo Collaborative Services v. Prometheus Laboratories, 566 U.S. 66 (2012), and Alice Corp. v CLS Bank Int’l, 573 U.S. 208 (2014), decisions.
The importance of cyber governance has been elevated over the past two years due to:
Increased sophistication of cyber attacks resulting in significant business interruption losses and theft of confidential and proprietary data.
Information security governance standards and best practices that require specific actions of directors and senior management.
Increased legal and regulatory requirements mandating governance directors and officers take certain steps in overseeing information security.
Cyber-event driven litigation and a series of recent holdings in Delaware case law that collectively work to narrow, under certain circumstances, the deference given to boards, particularly with respect to meeting their duty of loyalty and good faith oversight.
General counsels and outside firms can play a significant role in helping directors and officers meet their fiduciary duty and avoid derivative shareholder suits by confirming a cyber governance framework is created that identifies key cyber risks, ensures appropriate data about these risks is reported to the board, and establishes a board process to review this information and monitor the risks.
Changes in the Cyber Threat Environment
The bad guys are still winning, and the pandemic gave them a boost. The cyber threat environment today is dramatically different than three years ago. There are four primary reasons:
Cybercriminals openly released a treasure trove of cyber offensive tools developed by the U.S. intelligence community
Nation state-sponsored cyber attacks and attacks using sophisticated malware have increased dramatically
Internet of Things (IoT) devices and Artificial Intelligence are being exploited by attackers
Cybersecurity programs have not matured to keep pace with the threat environment.
In 2016-17, a hacking group called the “Shadow Brokers” made five releases of NSA-developed cyber weapons that were capable of infecting millions of computers around the world. Between March-September 2017, Wikileaks made 23 releases of information and code on CIA-developed cyber tools used to hack smart phones, computers, and smart televisions. Combined, these releases of the U.S. Government’s cyber assets provided countries, cybercriminals, and terrorists around the globe with some of the most sophisticated offensive cyber weapons.
Many of the tools leveraged vulnerabilities in software that the U.S. intelligence community had discovered, but had not informed the software providers about. Thus, patches had not been developed, and all of the users of these systems were vulnerable. Any unpatched systems today remain vulnerable to these “clickless attacks” that do not require tricking someone to click on an attachment or link; the malware can enter a system by exploiting an unpatched software vulnerability.
Then came the pandemic. The cybercriminals realized that computer rooms were unmanned, cybersecurity personnel were not able to monitor the system as effectively, patches were not being applied as consistently, and people were working from devices that did not have an up-to-date operating system or current antivirus software. They also preyed on people’s desire for information on the coronavirus, the need to buy face masks and personal supplies, and the desperate need felt by so many for financial assistance.
Just a couple of months into the pandemic, the FBI’s Internet Crime Complaint Center reported a 300% increase in cybercrime complaints. Cybersecurity Ventures recently predicted the global cost of cybercrime will hit $6 trillion in 2021. The privacy/security company Blackfog reported that ransomware attacks were highest in the U.S. and U.K. Experts predicted that a company will be hit with ransomware every 11 seconds and the cost of these attacks will be $20 billion by the end of 2021.
Now, consider there are more than 20 billion IoT devices connected to the Internet, and many of them utilize artificial intelligence technologies. Most of these devices were not built with security in mind, and thus the data they collect and transmit are a rich target. Deloitte noted in a recent report that securing IoT systems is complicated by (1) the sheer amount of data being generated and collected, (2) the fact that much of the data is accessed or held by third parties, and (3) decentralized approaches to risk management. Cyber governance requires an enterprise approach.
Recent Holdings in Delaware Case Law & Increased Derivative Suits
The 1996 Delaware Caremark Derivative Litigation case set forth important case law regarding a board’s duty to ensure that it has adequate information flows to enable it to meet its fiduciary duty of loyalty and good faith oversight. Caremark involved a shareholder derivative action that alleged the board breached its fiduciary duty when it failed to detect and stop employee violations of state and federal laws applicable to health care providers, which resulted in the company paying $250 million in fines and payments to injured parties. The court noted that directors’ fiduciary duty includes a duty to act in good faith to ensure that an adequate corporate information and reporting system is established and monitored, and the failure to do so may cause a director to be liable for losses caused by compliance violations.
Caremark claims have been considered to be one of the most difficult cases to win, in that the plaintiff essentially had to prove that the directors acted in bad faith because they completely failed to implement an information and reporting system and failed to monitor it. In 2019 and 2020, Delaware courts issued four opinions that collectively work to narrow, under certain circumstances, the deference given to boards, particularly with respect to their oversight of compliance risks.
One of the cases, Clovis Oncology, noted that, “Delaware courts are more inclined to find Caremark oversight liability at the board level when the company operates in the midst of obligations imposed upon it by positive law yet fails to implement compliance systems, or fails to monitor existing compliance systems, such that a violation of law, and resulting liability, occurs.” The cases indicate that regulated industries and companies with a high level of compliance requirements should ensure that they have implemented board-level oversight systems, with appropriate information flows and reporting, to enable the board to monitor compliance and key risks and respond in a timely manner.
Information Security Governance Standards and Legal Requirements
The International Organization for Standardization (ISO) and International Electrotechnical Commission (IEC) standard, ISO/IEC 27001, is the “gold standard” for information security globally and is followed by most multinational corporations. The ISO/IEC issued the only global standard on governance of information security, ISO/IEC 27014, in 2013 and updated it at the end of 2020. Best practices on governance of cybersecurity also have been developed by the National Institute of Standards and Technology (NIST) and the Federal Financial Institution Examination Council (FFIEC) and other private sector organizations.
The New York Department of Financial Services (NYDFS) enacted Regulation 500, which became effective March 1, 2017, and requires financial institutions to establish a complete cybersecurity program, including policies and procedures, training, risk assessments, vulnerability scans and penetration testing, access controls, and encryption of non-public information. The board chair or an officer must submit a signed statement annually to NYDFS certifying that the organization is in compliance with the requirements of the rule. The National Association of Insurance Commissioners’ (NAIC) Data Security Model Law has similar governance requirements and has been adopted in eleven states. On a federal level, the Health Insurance Portability and Accountability Act (HIPAA) and the Federal Information Security Management Act (FISMA) also contain governance requirements.
Cyber governance standards may be deemed to have established a known duty to act, and laws require compliance. Today, D&Os that do not have a defined process for managing and overseeing cyber risks gamble being found liable for failure to act reasonably and in good faith to ensure their organization complies with legal or regulatory requirements and best practices regarding privacy and cybersecurity.
Management of Cyber Incidents
The management of a major cyber incident is more difficult – and risky – if the organization does not have well-developed and tested incident response plan (IRP) and business continuity/disaster recovery (BC/DR) plan. D&Os need to ensure their organization’s IRP is aligned with best practices and standards and they can restore data if it becomes corrupted, erased, or encrypted.
The board and senior management should ensure that digital asset inventories are developed in accordance with best practices, including assignment of owners, data classification, and application risk categorization. The IRP must be able to guide the organization through any form of attack. It should include an Incident Response Management Policy that has been approved by the board and defines roles and responsibilities during an incident, escalation of incidents, and steps to mitigate losses. Rosters of internal and external personnel that may be needed during a response are an essential component of an effective IRP.
Boards and senior management have an important role to play in managing a serious attack. They should take part in tabletop exercises to ensure the IRP is aligned with operations, roles and responsibilities are appropriate, and the plan can effectively guide the organization through various types of incidents.
Depending upon the severity of the incident, the board may wish to retain a trusted advisor to help it analyze the various data flows from an incident and review response options. All remediation efforts should be documented and presented to insurance carriers in an attempt to minimize insurance rate increases after the attack.
Conclusion
All of this means that the cybercriminals are winning and plaintiffs may be too if boards fail to ensure a cyber governance framework is established that identifies key cyber risks, ensures appropriate data flows on these risks, and establishes a board process to review this information and monitor cyber risks and compliance requirements. Such a failure may be viewed as a breach of the D&O duty of loyalty and a failure to act in good faith.
Boards and executives need to begin the hard work of governing cyber risks by following best practices and standards, allocating appropriate resources to cybersecurity, and developing risk transfer strategies. A Ponemon/AttackIQ report released in September 2019 indicated that “only 28% percent of respondents say their board and CEO determines and/or approves the acceptable level of cyber risk for the organization.” If companies focus on only one area of their cybersecurity programs this year, let it be cyber governance.
Through the first half of 2021, special purpose acquisition companies (SPACs) raised approximately $113 billion across 366 initial public offerings (IPOs).[1] That level far exceeded the previous records, which were set in 2020 ($83.4 billion raised in 248 IPOs) and 2019 ($13.6 billion in 59 IPOs).[2] Given their unique structure and rapid growth, it is not surprising that SPACs have attracted growing regulatory attention and are increasingly the subject of litigation and enforcement actions.
This article explores the role of due diligence in mitigating litigation and enforcement action risks associated with both the SPAC IPO and subsequent business combination (de-SPAC). Because SPACs involve a number of complexities and novel attributes, this article is sequentially structured with each section building on the foundational information conveyed in the sections that precede it. First, we explain SPACs and how they work, highlighting some of the structural features that have garnered the most controversy. We then summarize the relevant regulatory regime within which SPAC litigation typically arises and explain the role of due diligence (including explicit and implicit due diligence defenses) within that regime. Building on these foundational elements, we then examine recent regulatory developments and survey a sample of informative pending SPAC lawsuits. Finally, we offer insights regarding how many of the risks associated with SPACs may be mitigated through effective due diligence and related disclosure practices.
I. THE SPAC PROCESS
A. Overview
SPAC is an acronym for special purpose acquisition company. Initially, a SPAC is a shell company with no operations or assets. It is formed to raise capital through an underwritten initial public offering (IPO), the proceeds of which are intended to be used within a defined period of time to identify and acquire an existing operating company through a de-SPAC transaction.[3] Thus, at inception, a SPAC has only the cash proceeds derived from the IPO and investments associated with those cash proceeds.
SPACs are sponsored by entities (sponsors) that typically have expertise and experience in a given industry. While the sponsors may intend to acquire an operating company in a particular sector,[4] they typically have not identified a specific target at the time of the IPO. As a result, the offering documents contain more limited disclosures than are commonly associated with a traditional IPO. Given the relative simplicity of the process, including the limited disclosures and lower upfront costs, merging into a SPAC through a de-SPAC transaction has become a popular vehicle for achieving public company status.
Over its life cycle, a typical SPAC engages in a number of due diligence and related disclosure processes. These processes involve potential litigation risks for participants, including the sponsor, directors, and officers. In addition, the SPAC IPO involves risks for the underwriter(s), and the de-SPAC transaction involves risks for the advisory firm (which is sometimes affiliated with the original underwriter[5]).
B. SPAC IPO
Like a traditional IPO, a SPAC IPO involves the filing of a Form S-1 registration statement and prospectus with the Securities and Exchange Commission (SEC or Commission). However, given the absence of operations and assets, SPAC IPOs have a number of attributes that distinguish them from traditional IPOs.
For example, whereas a traditional IPO involves the issuance of shares of common stock, a SPAC IPO involves the issuance of a bundled unit of securities (a SPAC unit) consisting of one share of common stock and one warrant typically priced at $10 per unit. The warrant entitles the holder to purchase an additional share (or fraction thereof) of common stock from the company, typically at a price of $11.50 per whole share (i.e., higher than the initial SPAC unit offer price).[6] After the IPO, the SPAC unit initially trades on an exchange as a single combined security. Thereafter, the common stock and warrants may trade separately under independent trading symbols.[7]
In a traditional IPO, underwriters typically receive an underwriting discount at closing (a discount of the purchase price paid by the underwriters for the shares) approximating 5%–7% of the gross IPO proceeds.[8] In contrast, the typical discount at closing in a SPAC IPO is in the range of 2%, with an additional amount (often in the range of 3%–5%) deposited into the trust account and payable only upon consummation of the de-SPAC transaction.[9] Therefore, if the SPAC is unable to complete a subsequent de-SPAC business combination within the specified time period, the deferred portion of the underwriter’s compensation is never paid.
Sponsors of a SPAC also implicitly receive compensation. In exchange for a nominal initial investment and the work they will perform in identifying a potential business combination, sponsors typically receive fully diluted post-IPO shares in the range of 20%–25% (sponsor shares).[10] Sponsors also often make additional cash investments through the purchase of warrants. The proceeds of the latter are intended to cover the SPAC’s out-of-pocket IPO and initial operating costs.[11] Sponsor shares and warrants only have potential value if a business combination is consummated; they do not represent an interest in the trust funds and have no value if the trust dissolves.[12]
As explained later in this article, recent SPAC litigation has alleged that sponsors, directors, officers, and underwriters have an economic interest that favors consummation of a de-SPAC business combination whether or not it is in the best interests of the shareholders.[13]
C. De-SPAC
At closing, the net proceeds of the SPAC IPO are placed in trust. The trust invests those funds in U.S. treasury securities pending a subsequent business combination (typically a merger) between the SPAC and a target company. This transaction is commonly referred to as a “de-SPAC” or an “initial business combination.”[14] A de-SPAC transaction involves the merger of a private operating company (target) and a publicly traded SPAC (or a subsidiary of the SPAC). In the merger, target shareholders receive consideration consisting of either shares of the SPAC, cash, or a combination of both. If the merger consideration involves the issuance of shares of common stock, the SPAC must file a registration statement on Form S-4 with the SEC to register those shares. The S-4 is subject to review and comment by the SEC, and the SEC may request modified or additional disclosures.
The de-SPAC merger involves a number of activities and associated litigation risks. These include the solicitation of shareholder consent, the preparation and dissemination of an Information Statement, the registration and issuance of SPAC securities constituting part of the merger consideration, and the private offering and issuance of securities immediately prior to the merger to provide additional required capital.[15]
Upon consummation of the de-SPAC transaction, the target becomes a public company whose shareholders typically include non-redeeming SPAC IPO investors (i.e., those who did not exercise the redemption right discussed below), SPAC sponsors, and any entities that acquired shares as part of a pre-merger financing round (also discussed below). If the merger consideration includes shares of the SPAC, the shareholder base also includes former target company shareholders.
A SPAC must consummate a de-SPAC transaction within a disclosed time period, typically 24 months after the IPO (although some SPACs have elected shorter periods).[16] If it does not do so, then the funds held in trust (including interest earned on those funds) must be returned to the shareholders entitled to receive them.[17]
If the SPAC identifies a suitable business combination opportunity within the permitted window, SPAC shareholders will have the opportunity to redeem their shares (and receive their pro rata amount of the funds held in the trust account) and, in most cases, vote on the initial business combination transaction.[18] If a shareholder elects to exercise this redemption right, it no longer is a shareholder but retains the warrants (if the warrants were not sold) that were part of the bundled SPAC unit acquired in the IPO.[19] If the de-SPAC merger involves shareholder approval, the SPAC must file a proxy statement[20] pursuant to Section 14 of the Securities Exchange Act of 1934 (Exchange Act).[21] Where public shareholder approval is not required (for example, where the sponsors hold enough votes to approve the transaction independently), the SPAC will provide shareholders with an Information Statement on Schedule 14C. If the merger consideration includes SPAC shares, the Form S-4 and proxy are typically combined in a joint registration/proxy statement.
Depending upon the number of redeeming shareholders and the amount of cash required to satisfy the redemptions, a SPAC may require additional capital at the time of the de-SPAC transaction to fund the redemption obligations, finance operations, and meet the liquidity needs of the combined entity. This additional funding has typically been raised through a private placement of SPAC securities structured as a private investment in public equity (PIPE) transaction.[22] Thus, the sources of cash to fund a de-SPAC merger typically involve the initial capital raised in the IPO (net of redemptions), sponsor-purchased shares, and proceeds of the PIPE transaction.
While the PIPE offering is a private placement and therefore not subject to Section 11 of the Securities Act of 1933 (Securities Act),[23] claims for intentional misconduct or negligent misrepresentation may be based on the anti-fraud provisions of the Exchange Act,[24] common law, or state securities laws.[25]
Finally, within four business days after consummation of the initial business combination, the company must file with the SEC a Form 8-K (sometimes referred to as a “Super 8-K”) containing information substantially equivalent to that required in a traditional registration statement and similar to the information contained in the Form S-4.
II. DUE DILIGENCE: FUNDAMENTAL CONCEPTS
Given the number of disclosure events associated with a typical SPAC life cycle, it is not surprising that due diligence is often a central theme in SPAC litigation and enforcement actions. Our survey of pending cases shows that plaintiffs often allege due diligence failures that either led to material misstatements or omissions in the at-issue disclosure documents or that were elemental components of a breach of a defendant’s fiduciary duties (typically, the duty of care). Therefore, before addressing how effective due diligence and related disclosure practices can mitigate these risks, it is important to understand the concept of due diligence.
A. Due Diligence
The term “due diligence” is not defined in statutes or regulations. Instead, it is a term of art that is part of the regulatory, judicial, scholarly, and practical lexicon. In its simplest formulation, due diligence is the investigation conducted by and/or the reliance placed on others in a business transaction. At a more granular level, it is the process and practice of using reasonable efforts, appropriate in the context, to investigate (or reasonably rely on others regarding) the material aspects of a proposed transaction so that a reasonable person (such as a potential investor in a securities offering) can make an informed decision.
While due diligence is an affirmative obligation of underwriters,[26] all parties to a securities offering or other business transaction, including those involving SPACs, have an interest in conducting reasonable due diligence because, among other things, it:
Enhances investment and other business decisions
Minimizes the risk of post-closing disputes and litigation
Supports the material accuracy and completeness of disclosures in securities offering documents
Protects reputations and business franchises
Facilitates compliance with applicable laws and regulations, and
Establishes a basis for one or more affirmative due diligence defenses.
B. Reasonableness
The standard by which due diligence is measured is “reasonableness,” not “perfection.”[27] In the context of a lawsuit, reasonableness is a legal conclusion made by a court or trier of fact,[28] though the term also has a common understanding in the industry that mirrors the legislative, regulatory, and judicial understandings.[29] Under both, reasonableness is based on what a prudent person in a similar context would have done in the management of their own property.[30] Reasonableness is measured by a negligence standard[31] involving the use of “ordinary care.”[32]
Reasonableness is assessed in “a specific factual context.”[33] The Due Diligence Task Force of the American Bar Association (ABA) expressed this concept as follows: “as a standard of conduct, ‘reasonableness’ is meaningless except in a specific factual context.”[34] Similarly, the National Association of Securities Dealers (NASD), the predecessor of the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization for broker-dealers (including those acting as underwriters), has stated that the “type of due diligence investigation that is appropriate will vary….”[35] And the formal report of the SEC’s Advisory Committee on Corporate Disclosure[36] stressed that “the important point is that each subject person should evaluate the surrounding facts, including the extent of his prior relationship with the registrant, and utilize techniques of investigation appropriate to the circumstances of the offering….”[37]
As explained below, SPAC sponsors, officers, directors, underwriters, and financial advisors, among others, conduct due diligence at both the SPAC IPO and de-SPAC stages. This due diligence involves, for example, assessing the material accuracy and completeness of disclosures in public and private placement offering documents and the operational, financial, and other attributes of target companies. Given some of the novel attributes of SPACs, the scope and character of due diligence can differ from that associated with more traditional securities offerings and business combination transactions.
For example, traditional IPO offering documents contain a range of disclosures such as historical information about the issuer, its business, operations, management, and past financial performance. Because a SPAC is a shell company, these are not relevant (or even possible) disclosures in SPAC IPO offering documents.[38] As a result, FINRA has stated that the unique nature of SPACs leads to relatively less due diligence and disclosure at the SPAC IPO stage compared to a traditional IPO.[39]
Nonetheless, for the reasons explained above, sponsors, directors, officers, and underwriters conduct due diligence into the material accuracy and completeness of SPAC IPO disclosures.[40] However, given the narrower scope and more limited character of SPAC IPO disclosures, the risk of material misstatements or omissions in SPAC IPO offering documents clearly is more limited than in a traditional IPO (and correspondingly the prophylactic effects of due diligence, while still present, are less pronounced).
Moreover, investor redemption rights (whereby investors redeem their shares at a slight premium to their original IPO purchase price) substantially reduces the likelihood of a SPAC IPO investor incurring a loss (damages) on the investment. Indeed, based on our research, to date there have been no suits brought forth under Section 11 of the Securities Act related to SPAC IPOs, and, absent regulatory changes, it seems unlikely that SPAC IPO offering document disclosures will be a primary focus in future litigation and enforcement actions. At the de-SPAC stage, however, the topics addressed in disclosure documents expand significantly and litigation exposure is correspondingly increased.
Thus, both SPAC IPOs and de-SPAC transactions involve due diligence, and that due diligence, as explained below, can mitigate risk in litigation and enforcement actions.
III. DUE DILIGENCE IN THE SPAC LIFE CYCLE: REGULATORY REGIME AND DEFENSES
Based on our survey of recent cases, SPAC litigation often involves allegations of material misstatements and omissions in disclosure documents and unreasonable due diligence into those disclosures. These allegations have arisen in the context of claims asserted under the Securities Act, the Exchange Act, state securities laws, and various fiduciary duty laws. This section offers a brief overview of these laws and explains their relevance in the context of SPAC litigation.
A. Securities Act and Exchange Act
The Securities Act imposes civil liability for material misstatements and omissions in registered securities offering documents including those related to the SPAC IPO and the de-SPAC transaction.[41] In addition, the anti-fraud provisions of the Exchange Act prohibit fraudulent conduct in connection with securities transactions (both public offerings and private placements) and establish disclosure standards that are particularly relevant at the de-SPAC stage. While the two Acts employ different standards for determining liability (the Exchange Act, for example, requiring proof of scienter), taken together they are the bedrock of the regulatory regime governing modern securities issuances and trading in the United States.
Parties to SPAC transactions, including issuers, sponsors, directors, officers, underwriters, and advisory firms (such as an advisory firm in a de-SPAC transaction), are potential defendants under both Acts. However, a number of these potential defendants[42] can avoid liability by proving that they acted reasonably in conducting due diligence. For example, the Securities Act contains three affirmative “due diligence” defenses that are available to enumerated defendants including directors and underwriters. The first two are set forth in Section 11—reasonable investigation[43] and reasonable reliance.[44] The third—reasonable care—is set forth in Section 12(a)(2).[45] Each requires a “reasonableness” determination by the court.[46]
Parties to SPAC transactions also have potential fraud-based liability under the Exchange Act, including Section 10(b) and Rule 10b-5.[47] Unlike the Securities Act, the Exchange Act contains no express due diligence defenses. However, a number of courts have held that establishing a reasonable due diligence defense under the Securities Act negates the existence of scienter (a mandatory element of an Exchange Act fraud-based claim).[48]
As is clear from the formulation of each of the three express Securities Act due diligence defenses, and the implicit due diligence defense that arises from judicial interpretations of the implications of reasonable due diligence for the Exchange Act’s scienter requirement, reasonableness of due diligence is often a central issue in litigation arising under both Acts.
As explained earlier, each transaction is unique, and what is reasonable due diligence in one context may or may not be reasonable in another. Therefore, there is no one-size-fits-all checklist of mandatory or appropriate due diligence processes or practices to be followed in every context.
However, over the course of more than 60 years, a number of authoritative and informative sources have offered constructive guidance regarding what may constitute reasonable investigation and reliance (the two primary components of due diligence) in various contexts. These include the SEC;[49] special committees and task forces, such as the SEC Advisory Committee on Broker-Dealer Compliance,[50] the SEC Advisory Committee on Corporate Disclosure,[51] and the ABA Due Diligence Task Force;[52] self-regulatory organizations such as FINRA and its predecessor the NASD;[53] and judicial rulings.[54] While the pronouncements regarding reasonableness are not extensive in number and some are of early vintage, they involve a variety of transactional, situational, positional, and temporal contexts, and explore the issue of reasonableness in due diligence from a diverse range of perspectives. Taken together, they provide essential insight into reasonableness in securities offering due diligence, including for SPACs.
B. State “Blue Sky” Laws
In addition to the federal laws and regulations summarized above, each state has its own securities laws and regulations governing the offer and sale of securities within the state’s boundaries or to citizens of the state. These are commonly referred to as “Blue Sky” laws.[55] While such laws tend to mirror many core concepts of the federal regulatory regime, they can differ in some important ways. For example, Blue Sky laws typically require registration (or in the case of private placements, exemptions from registration) for securities offerings and establish a legislatively empowered state body (often a “state securities commission”) to regulate securities issuances and to deal with other matters such as the registration of broker-dealers and investment advisors. They may also contain different due diligence defenses and may potentially offer a wider range of protections than are available under federal law.[56]
C. Fiduciary Duty Laws
Finally, in addition to bringing claims under federal and/or state securities laws, shareholders may sue for breaches of fiduciary duties.[57] The majority of such SPAC-related lawsuits we have identified to date allege breaches of fiduciary duties by directors and/or officers regarding a de-SPAC business combination. However, some also include claims against the SPAC, the target company (and its board or officers), and/or others for allegedly aiding and abetting fiduciary duty breaches by the SPAC board.
A fiduciary is defined as “someone who is required to act for the benefit of another person on all matters within the scope of their relationship.”[58] Directors and officers[59] have a fiduciary relationship with the company and its shareholders. Directors are responsible for oversight and compliance.[60] Officers, as delegates of the board, are responsible for day-to-day operations. Both directors and officers must act in the best interest of the corporation when exercising their responsibilities[61] and must exercise reasonable care and diligence in performing their functions. Their conduct in these regards is assessed with reference to the conduct of a similarly situated prudent person.[62]
Director and officer fiduciary duties are addressed in, among others, state corporation laws (and such suits often are brought in state court). While fiduciary duty laws vary somewhat from state to state, most are based on the ABA’s Model Business Corporation Act (MBCA). The MBCA identifies two primary fiduciary duties of directors—the duty of care (sometimes called the “duty of care and diligence,” which incorporates a duty of good faith) and the duty of loyalty:
(a) Each member of the board of directors, when discharging the duties of a director, shall act:
(i) in good faith, and
(ii) in a manner the director reasonably believes to be in the best interests of the corporation.
(b) The members of the board of directors or a board committee, when becoming informed in connection with their decision-making function or devoting attention to their oversight function, shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.[63]
The duty of care requires that directors make informed decisions based on a reasonable process, including a reasonable due diligence process. The duty of loyalty requires directors to place the interests of the corporation above their personal interests and those of their affiliates.
If these duties are deemed to have been satisfied, the defendant’s conduct typically is measured according to the “business judgment rule,” which provides that the court will defer to the defendant’s judgment provided the decision was made in good faith and the defendant reasonably believed that he or she was acting in the best interests of the company.[64] Conducting reasonable due diligence is one of the ways defendants seek to establish that the duty of care was met.
When a defendant invokes the business judgment rule and the court finds that the presumption applies, then the burden of proof is on the plaintiff to prove that the business judgment rule does not apply. Plaintiffs typically endeavor to do so on the basis of bad faith, conflicts of interest, or gross negligence, including in connection with the defendant’s due diligence. If the court concludes that the plaintiff has met this burden of proof, then the court will judge the matter according to the “entire fairness standard” pursuant to which the defendant must prove that the process was fair and the decisions were informed.[65]
As explained below, our review of recent and pending SPAC litigation involving fiduciary duty breach allegations reveals a focus on allegations that the defendants conducted inadequate due diligence into the proposed target company merger, failed to conduct proper due diligence into statements made (or omitted) in de-SPAC stage disclosure documents, and/or had undisclosed or inherent conflicts of interest.
While the pending litigation is still at an early stage, given the potential for conflicts of interest inherent in SPAC business combinations, recent SEC and staff pronouncements, the large number of SPAC s formed to date, and the more than 400 de-SPAC transactions yet to be completed,[66] we anticipate an increase in fiduciary duty breach allegations. As explained above, that litigation is likely to present questions about the application of state-law rules, and in particular the application of the “business judgment rule” and the “entire fairness” standard with a focus on the defendant’s due diligence.
IV. RECENT SEC COMMENTARY, GUIDANCE, AND PRONOUNCEMENTS
A. Overview
In recent months, the SEC has issued guidance regarding SPAC due diligence and related disclosure and accounting practices. In addition, SEC staff members, including Chairman Gary Gensler and Acting Director of the SEC’s Division of Corporation Finance John Coates, have addressed SPACs in personal commentary.
For example, on April 8, 2021, Acting Director Coates issued a public statement (which was not officially endorsed by the SEC) confirming the Commission’s increased interest in and focus on SPACs and the disclosures made at both the IPO and de-SPAC stages (Coates Commentary). Among other things, Acting Director Coates stated: “The staff at the Securities and Exchange Commission are continuing to look carefully at filings and disclosures by SPACs and their private targets. As customary, and in keeping with the Division of Corporation Finance’s ordinary practices, staff are reviewing these filings, seeking clearer disclosure, and providing guidance to registrants and the public. They will continue to be vigilant about SPAC and private target disclosure so that the public can make informed investment and voting decisions about these transactions.”[67]
Subsequently, on May 26, 2021, Chairman Gensler summarized his concerns regarding SPACs as follows:
First and foremost, are SPAC investors being appropriately protected? Are retail investors getting the appropriate and accurate information they need at each stage—the first blank-check IPO stage and the second target IPO stage? Second, how do SPACs fit in to our mission to maintain fair, orderly, and efficient markets? It could be the case that SPACs are less efficient than traditional IPOs. One recent study shows that SPAC sponsors generate significant dilution and costs. SPAC sponsors generally receive 20 percent of shares as a “promote.” The first-stage investors can redeem when they find the target, leaving the non-redeeming and later investors to bear the brunt of that dilution. In addition, financial advisors are paid fees for the first-stage blank-check IPO, for the PIPEs, and for the merger with the target. Further, it’s often the case that the investors in these PIPEs are buying at a discount to a post-target IPO price. It may be that the retail public is bearing much of these costs. I’ve asked staff to consider what recommendations they would make to the Commission for possible rules or guidance in this area. Our Corporation Finance, Examinations, and Enforcement Division staffs will also be closely looking at each stage to ensure that investors are being protected. Each new issuer that enters the public markets presents a potential risk for fraud or other violations.[68]
According to a March 25, 2021 Reuters article, the SEC’s enforcement division recently sent voluntary cooperation letters of inquiry to at least four major investment banks seeking information about their fees, volumes, compliance, reporting, internal controls, and other matters associated with their involvement in SPAC IPOs and subsequent de-SPAC transactions.[69] The Commission’s decision to contact the investment banks reflects the fact that the original underwriter or an affiliate entity may “provide additional services such as identifying potential targets, providing financial advisory services, acting as a placement agent in a private offering or underwriting or arranging debt financing….”[70] Consistent with this, a July 13, 2021 article stated that the SEC was focused on better understanding potential conflicts when a bank is serving as both the underwriter and a financial advisor in the de-SPAC transaction.[71]
On June 11, 2021, the Commission announced a target date of April 2022 for proposed amendments to rules governing SPACs.[72] While it did not specify the precise nature of the forthcoming amendments, our analysis of the SEC’s recent guidance and commentary suggests that the amendments are likely to focus on several areas. The first is disclosures, especially those related to sponsor compensation and potential conflicts of interest that may incentivize SPAC participants to consummate a de-SPAC transaction not deemed to be in the best interests of SPAC shareholders. The second is due diligence processes and practices related to assessing the appropriateness of the potential de-SPAC target company and the statements made in the contemporaneous disclosure documents. Third is accounting treatment and related practices.
B. SPAC Due Diligence and Disclosure: IPO Stage
Despite the existence of a shareholder redemption right and the corresponding difficulty of proving damages, the SEC has shown an interest in heightened disclosure at the SPAC IPO stage, especially with respect to the relationship between the SPAC and its sponsor(s) and underwriters. For example, in a September 2020 interview, then-SEC Chairman Jay Clayton stated: “One of the areas in the SPAC space I’m particularly focused on, and my colleagues are particularly focused on, is the incentives and compensation to the SPAC sponsors… What are their incentives?”[73] Also, on December 22, 2020, the SEC issued CF Disclosure Guidance: Topic No. 11[74] (CF Disclosure Guidance) encouraging SPACs to include certain disclosures in the IPO offering documents regarding, among others:
The sponsors’, directors’, and officers’ potential conflicts of interest;
Whether and how sponsors, directors, and officers may be compensated for services to the SPAC, including whether any payments will be contingent on the completion of a business combination transaction and the amount of any such contingent payments;
The financial incentives of SPAC sponsors, directors, and officers to complete a business combination transaction, including how they differ from the interests of the public shareholders, and information about the losses the sponsors, directors and officers could incur if the SPAC does not complete a business combination transaction;
Whether the underwriter of the IPO may provide additional services such as identifying potential targets, providing financial advisory services, acting as a placement agent in a private offering or underwriting, or arranging debt financing, and what fees the SPAC may pay for such services;
Whether payment for any such additional services will be conditioned on the completion of a business combination transaction; and
Any conflict of interest the underwriter may have in providing such services if IPO underwriting compensation is to be deferred until the completion of a business combination transaction.[75]
C. SPAC Due Diligence and Disclosure: De-SPAC Stage
The Commission also has made recent statements regarding the de-SPAC business combination, and in particular the due diligence conducted in connection therewith.
For example, in an October 29, 2020 comment letter associated with Legacy’s de-SPAC merger with Onyx Enterprises Int’l Corp, the SEC specifically inquired about and sought revisions to the disclosure documents to include additional disclosures pertaining to the due diligence that was conducted as part of the de-SPAC merger, including, among others:
Comment 1: “Please tell us how you arrived at the Business Combination Consideration amount. Please include sufficient details and assumptions that went into determining the Business Combination Consideration, including any relevant industry and business stage information as well as any financial projections you may have relied upon. Revise to disclose the Aggregate Purchase Price, as of a current date, in order to give context to how this amount will be determined.”
Comment 3: “Please revise your disclosure to include the details surrounding your search [for possible target businesses], the basis on which you evaluated each potential target business, including why certain of the other potential target businesses were not pursued and what parties or advisors were involved in the process.”
Comment 4: “We note that the terms of the Business Combination were the result of ‘extensive arms’ length negotiations.’ Please revise your disclosure in this section to include a description of the negotiations relating to material terms of the transaction.”
Comment 6: “Please provide a summary of the financial, business, and legal due diligence questions that arose during your diligence meetings.”
Comment 9: “To the extent applicable, please include how valuations, comparable companies, and advisors played a role in approving and signing the Business Combination Agreement.”
Comment 11: “Explain how you determined the transaction to be fair to shareholders when it does not appear that the Board took into account the consideration to be received in exchange for Legacy shares.”[76]
In addition, the SEC’s CF Disclosure Guidance[77] also addressed de-SPAC stage disclosure. This component of the guidance was directed particularly to “SPAC sponsors, directors and officers” and to “the underwriter of the SPAC’s IPO [that] may have provided services in addition to those associated with the underwriting of the IPO….” [78] According to this guidance, de-SPAC-related disclosure documents should contain, among other things:
Detailed information about how the SPAC and its sponsors, directors, officers, and advisors evaluated and decided to propose the identified transaction, including why the target company was selected as opposed to alternative candidates and who initiated contact, including what material factors the board of directors considered in its determination to approve the transaction;
A clear description of any conflicts of interest of the sponsors, directors, and officers in presenting this opportunity to the SPAC, how the SPAC addressed these conflicts of interest, and how the board of directors evaluated the interests of sponsors, directors, and officers;
Detailed information regarding how the sponsors, directors, and officers will benefit from the transaction, including by quantifying any material payments they will receive as compensation, the return they will receive on their initial investment, and any continuing relationship they will have with the combined company;
Information on fees that the underwriter of the IPO will receive upon completion of the business combination transaction, including the amount of fees that is contingent upon completion of a business combination transaction; and
Information on services the underwriter provided, the cost of those services, and how the underwriter and/or its affiliates were compensated for those services, including disclosure of whether those services were conditioned on the completion of the business combination transaction and whether the underwriter may have a conflict of interest, given any deferred IPO underwriting compensation.[79]
Similarly, the Coates Commentary also addressed de-SPAC stage due diligence and related disclosure practices. Among other things, it queried whether “current liability provisions give those involved—such as sponsors, private investors, and target managers—sufficient incentives to do appropriate due diligence on the target and its disclosures to public investors.”[80] In addition, it challenged the notion that the Private Securities Litigation Reform Act (PSLRA) safe harbor for forward-looking statements (such as those related to projections and other valuation metrics)[81] applied to de-SPAC disclosures.[82] It further noted that, even assuming the PSLRA safe harbor provision applied to de-SPAC transactions, the safe harbor only applies to private litigation, and not to SEC enforcement actions.[83]
The Coates Commentary also expressed the view that the de-SPAC transaction is akin to a traditional IPO in that “it is the first time that public investors see the business and financial information about a company.”[84] It further indicated that the SEC could use rulemaking or guidance to explain its views regarding how, or if at all, the PSLRA safe harbor should apply to de-SPACs, and cautioned that any claim about reduced liability exposure for SPAC participants relative to a traditional IPO is “overstated at best, and potentially seriously misleading at worst.”[85]
Finally, Acting Director Coates questioned whether the SEC should reconsider the concept of an “underwriter” in de-SPAC transactions, and whether additional guidance is needed about how projections and related valuations are presented and used in de-SPAC transactions.[86] He concluded by stating that “we should focus the full panoply of federal securities law protections” on de-SPAC transactions, adding that “[i]f we do not treat the de-SPAC transaction as the ‘real IPO,’ our attention may be focused on the wrong place, and potentially problematic forward-looking information may be disseminated without appropriate safeguard.”[87]
D. Accounting and Reporting Considerations
In addition to commentary regarding due diligence and related disclosure practices, the SEC also has issued guidance related to SPAC accounting practices.[88] For example, on April 12, 2021, Acting Director Coates and Acting Chief Accountant Paul Munter issued a statement discussing “the potential accounting implications of certain terms that may be common in warrants included in SPAC transactions.”[89] The statement expressed the authors’ views that certain contractual provisions that are common in warrants issued in connection with a SPAC transaction (such as provisions related to settlement amounts and tender offers) should be analyzed to determine if the warrants should be accounted for as liabilities rather than equity, and if so, whether the impact of the change in accounting treatment is material, requiring a restatement of previously issued financial statements.[90] Warrants issued in connection with SPAC transactions have historically been classified as equity;[91] classifying warrants as liabilities would require a measurement of fair value, with changes in fair value reported in earnings for each period.[92]
Commentators have noted that the change in accounting treatment, if it were to become law, would require SPACs to perform quarterly valuations of warrants as debt (versus a one-time equity valuation), a process that would potentially make SPACs less attractive to targets and other investors.[93] In certain cases, the change in accounting treatment could also lead to restatement of prior financial statements.[94]
E. Summary
SPACs are an increasing area of focus for the SEC and its senior staff. Primary areas of interest include due diligence and disclosure practices involving potential conflicts of interest, investment banking involvement (including compensation) in the various phases of the SPAC process, and, at the de-SPAC stage, inadequate due diligence of the target catalyzed by potential conflicts of interest related to economic incentives to the sponsors and other parties.
This increased level of scrutiny and attention is not remarkable given the dramatic and rapid increase in SPAC activity (as noted above, through the first half of 2021, SPACs raised approximately $113 billion across 366 IPOs[95]). While recent developments suggest that this increased regulatory focus may be contributing to a decline in SPAC IPO activity (approximately 300 SPAC IPOs occurred during the first quarter of 2021 versus approximately 60 during the second quarter of 2021[96]), as of July 2021, more than 400 SPACs were seeking acquisition targets.[97]
Given the SEC’s recent guidance and commentary regarding SPACs, as well as the statements of senior SEC staff, we anticipate more developments, including in response to the new regulations that the SEC has stated are forthcoming. In the meantime, the pronouncements and statements made to date are clear indications of the Commission’s primary areas of concern, and they offer constructive insight regarding how effective due diligence can minimize risk to SPAC participants.
V. RECENT LITIGATION DEVELOPMENTS
A. Overview
According to the Stanford Law School Securities Class Action Clearinghouse, shareholders filed 30 federal class action lawsuits involving SPACs between January 2019 and July 2021, more than half of which were filed in 2021.[98] In addition, between October 2020 and April 2021, more than 60 shareholder lawsuits involving SPACs were filed in state courts (including in New York[99] and Delaware[100]). In many respects, the allegations made in these cases mirror the areas of concern addressed in the regulatory developments and commentary discussed above. These include allegedly inadequate due diligence and disclosures regarding sponsor compensation and potential conflicts of interest, and the extent and character of due diligence and disclosure related to the de-SPAC business combination. Following is a brief survey of some of these cases.
B. Securities Law Claims
On July 13, 2021, the SEC announced charges against SPAC Stable Road Acquisition Company (Stable Road), its sponsor, and its CEO, as well as against Momentus Inc. (Momentus)—the SPAC’s proposed merger target, an early-stage space transportation company—and Momentus’s founder and former CEO Mikhail Kokorich for misleading claims regarding Momentus’s technology and national security risks purportedly associated with Kokorich.[101] According to the SEC’s press release, it has filed a complaint against Kokorich in the U.S. District Court for the District of Columbia (all other parties have agreed to a settlement that includes total penalties of more than $8 million, certain investor protection undertakings, and, if the merger currently scheduled for August 2021 is approved, forfeiture by the SPAC sponsor of founder’s shares it stands to receive).[102]
The SEC claims include that:
Kokorich and Momentus repeatedly told investors that Momentus had “successfully tested” its propulsion technology in space whereas, according to the SEC, the company’s only in-space test “had failed to achieve its primary mission objectives or demonstrate the technology’s commercial viability.”
Momentus and Kokorich misrepresented the extent to which national security concerns associated with Kokorich “undermined Momentus’s ability to secure required governmental licenses essential to its operations.”
Stable Road repeated Momentus’s misleading statements in public filings related to the proposed merger and failed to satisfy its due diligence obligations to investors. According to the SEC, despite Stable Road’s claim that it conducted extensive due diligence of Momentus, it never received sufficient documents to assess the national security risks posed by Kokorich or reviewed the results of Momentus’s in-space test. Specifically, with respect to due diligence, Chairman Gensler stated:
This case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors. Stable Road, a SPAC, and its merger target, Momentus, both misled the investing public. The fact that Momentus lied to Stable Road does not absolve Stable Road of its failure to undertake adequate due diligence to protect shareholders. Today’s actions will prevent the wrongdoers from benefitting at the expense of investors and help to better align the incentives of parties to a SPAC transaction with those of investors relying on truthful information to make investment decisions.[103]
As a result of the alleged inadequate due diligence, Stable Road’s registration statements and proxy solicitations were inaccurate.[104]
According to the SEC, the SEC’s complaint against Kokorich includes factual allegations that are consistent with these claims.[105] Following the SEC’s announcement of these charges and partial settlement, a federal class action lawsuit was filed on July 15, 2021 by investors of Stable Road containing similar allegations.[106]
In re Akazoo S.A. Securities Litigation includes several consolidated federal and state securities class actions regarding Akazoo S.A., a global music streaming platform that was formed through a 2019 merger of Modern Media Acquisition Corp. (MMAC), a SPAC, and Akazoo Limited. Plaintiffs allege violations of Sections 10(b) and 14(a) of the Exchange Act, as well as Section 11 of the Securities Act (regarding statements made in the Form S-4 filed in connection with the de-SPAC merger). These alleged violations arise from purportedly false and misleading statements regarding the target company, including:
the number and growth of registered users and subscribers;
the company’s revenue and profit;
the size of the company and its services;
the areas in which the company operated; and
its relationships with mobile operators in various markets.
Sections 10b and 14(a) defendants include Akazoo, officers and directors of MMAC, and Akazoo Limited. Section 11 defendants include the same parties as well as Akazoo Limited’s independent auditor.[107] On April 23, 2021, the parties reached a $35 million partial settlement.[108] In addition, the SEC filed an enforcement action against Akazoo on September 30, 2020 seeking permanent injunction against Akazoo and disgorgement of allegedly ill-gotten gains,[109] which resulted in an agreed order of judgment on April 2, 2021 that permanently enjoins and restrains Akazoo under Section 17(a) of the Securities Act, and Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act.[110]
Pitman et al. v. Immunovant, Inc. et al, filed in the Eastern District of New York on February 19, 2021, involves the pharmaceuticals industry de-SPAC business combination of SPAC Health Sciences Acquisition Corp. (HSAC) and Immunovant Sciences, Ltd. (Immunovant). Plaintiffs allege violations of Section 10(b) and Rule 10b-5 of the Exchange Act resulting from allegedly inadequate pre-merger due diligence that plaintiffs assert would have revealed safety and efficacy problems with the target company’s clinical trials of a monoclonal antibody drug (the application was withdrawn after consummation of the business combination). Among other things, plaintiffs allege that:
HSAC performed inadequate due diligence into Immunovant prior to the merger;
defendants ignored or failed to disclose safety issues associated with Immunovant’s monoclonal antibody drug; and
the at-issue drug was less safe than the company had led investors to believe, which foreseeably diminished the drug’s prospects for regulatory approval, commercial viability, and profitability.[111]
Borteanu et al. v. Nikola Corporation et al. is a class action filed in the District of Arizona on September 15, 2020. Plaintiffs allege violations of Section 10(b) and Rule 10b-5 of the Exchange Act in connection with the de-SPAC acquisition of Nikola Corporation in June 2020 by VectoIQ Acquisition Corp. Among other things, the complaint asserts that the SPAC failed to “engage in proper due diligence,” which plaintiffs allege would have revealed misrepresentations by the target regarding its technology and business model. More specifically, the complaint alleges that:
VectoIQ did not engage in proper due diligence regarding its merger with Nikola;
Nikola overstated its in-house design, manufacturing, and testing capabilities; and
Nikola overstated its ability to lower the cost of hydrogen fuel and the work experience and background of key Nikola employees.[112]
Welch et al. v. Meaux et al., filed in the Western District of Louisiana on September 26, 2019 (amended October 16, 2020), involves a de-SPAC combination between SPAC Landcadia Holdings and Waitr, an online food ordering and delivery service. Plaintiffs allege violations of Section 10(b), Rule 10b-5, and Section 14(a) of the Exchange Act. The complaint alleges material misstatements in the de-SPAC Information Statement and other documents regarding:
the market opportunity for Waitr’s services;
Waitr’s business model and growth strategy; and
Waitr’s accounting practices and internal controls.
Section 14(a) defendants include Waitr, its directors and officers, and the investment bank involved in the de-SPAC transaction. Section 10(b) and Rule 10b-5 defendants include Waitr and its directors and officers; the complaint alleges, among other things, material misstatements after completion of the de-SPAC transaction in a scheme to artificially inflate and maintain the price of Waitr following the de-SPAC combination.[113]
C. Fiduciary Duty Claims
Delman v. Croskey is a shareholder derivative action filed in the Delaware Court of Chancery on May 24, 2021, arising from the combination of SPAC Live Oak Acquisition Corp. and Danimer Scientific (Danimer), which produces bioplastic replacements for traditional petrochemical-based plastics such as water bottles, food containers, and drinking straws. The plaintiff, a shareholder of Danimer, claims that Danimer’s board members breached their fiduciary duties by:
disseminating misleading statements about the biodegradability and future prospects of Danimer’s Nodax product in order to keep Danimer’s stock price above $18, the threshold at which Danimer’s board members and affiliated entities would be entitled to exercise stock warrants to buy shares at a discount;
misrepresenting the company’s capacity to manufacture Nodax products at a scale sufficient to meet revenue estimates; and
failing to maintain adequate internal controls in the company’s hiring practices.[114]
In Amo v. Multiplan Corp., filed in the Delaware Court of Chancery on March 25, 2021, a shareholder of Multiplan asserts breach of fiduciary duty claims under Delaware state law in connection with the merger of SPAC Churchill Capital Corp III and Multiplan, a provider of data analytics and technology management solutions to the U.S. healthcare industry. The complaint alleges that the sponsor of the SPAC and its board members breached their fiduciary duties by prioritizing their personal and financial interests in going forward with the de-SPAC merger to the detriment of shareholders. Specifically, the complaint alleges that the sponsor of the SPAC and its board members had conflicts of interest stemming from:
the need to complete a deal within the SPAC’s two-year expiry period to preclude the value of the “sponsor” or “founder” shares, which had been granted to both the sponsor and the outside directors, becoming worthless;
the board members’ alleged personal and financial ties to the sponsor; and
the SPAC’s retention of an entity affiliated with the sponsor to serve as its financial advisor, rather than an independent third party.
The complaint also asserts that the defendants breached their fiduciary duties because the disclosures surrounding the merger were allegedly false and misleading in that they highlighted the “extensive due diligence” performed and projected Multiplan’s financial success, while failing to disclose that one of Multiplan’s main customers, UnitedHealth Group Inc., was in the process of “abandoning MultiPlan in favor of its own competing data analytics platform.”[115] Notably, the Amo v. Multiplan Corp. complaint asserts that the defendants’ conduct should be judged under the “entire fairness standard” rather than the “business judgment rule,” which as discussed above is a level of heightened scrutiny that, if applicable, would require the defendants to demonstrate that the transaction was both procedurally and substantively fair.
VI. CONCLUSIONS AND INSIGHTS
Reasonable due diligence, both with respect to disclosures and target companies, can mitigate many of the litigation and regulatory enforcement action risks described in this article. Accordingly, we conclude with a few general recommendations. In considering these recommendations, it is important to understand that there is no one-size-fits-all approach to SPAC IPO, de-SPAC, or any other kind of due diligence. Each transaction is contextually unique; therefore, our recommendations should be considered a point of departure to be supplemented and tailored to the context as appropriate.
A. Monitor the Evolving Risk Landscape
The SPAC landscape is rapidly evolving, regulatory interest is mounting, and lawsuits alleging SPAC-related misconduct are proliferating. Accordingly, SPAC participants should monitor and consider developments, especially as they relate to sponsor compensation, potential conflicts of interest, and the extent and character of due diligence and disclosure related to the de-SPAC business combination. We anticipate more regulatory guidance and rulemaking (indeed, the SEC has announced as much), as well as new and novel allegations in litigation. Both should be monitored closely, and due diligence and disclosure practices adjusted in light of them.
B. Be Mindful of Fiduciary Duties and “Gatekeeping” Roles
Directors, officers, underwriters, and others involved in securities offerings sometimes are referred to as “gatekeepers.” Gatekeepers are persons or entities who have “the background and knowledge to conduct a sufficient investigation to protect the investor.”[116] In general terms, gatekeepers are deemed to “bear a duty to investors to monitor the quality of … disclosures.”[117] Or stated differently, they “are ‘reputational intermediaries’ in the securities markets.”[118] We anticipate future authoritative and informative guidance regarding the relevance and significance of the gatekeeper role in SPAC transactions. Until then, directors, investment banks, and other potential gatekeepers should be conscious of the commentary to date regarding gatekeeping and fiduciary roles, and should act accordingly.
C. Establish a Diligence Process and Conduct Guidance-Based Due Diligence
Authoritative and informative guidance over many decades makes clear that process matters in securities offering and business combination due diligence. Therefore, prior to a SPAC IPO and subsequent de-SPAC business combination, sponsors, boards, underwriters, advisors, and others should establish a due diligence process tailored to the context and consistent with historical guidance regarding what the SEC, courts, and other sources have considered reasonable. In tailoring that process, attention may be given to a range of factors, including, for example, staffing and leadership, scope and character of investigation and reliance, third-party support (such as legal opinions, negative assurance letters, and fairness opinions), and due diligence documentation.
As explained in this article, SPAC litigation and regulatory enforcement actions often involve allegations of inadequate due diligence and disclosures regarding sponsor compensation, potential conflicts of interest, the extent and character of due diligence and disclosure related to the de-SPAC business combination, and other matters. Thus, due diligence and related disclosures should be a focus at each stage of the SPAC process. Disclosure due diligence is guided by more than six decades of authoritative and informative publications and pronouncements, including from the SEC[119] and its Advisory Committee on Corporate Disclosure,[120] FINRA,[121] the ABA Task Force on Due Diligence Defenses,[122] SIFMA,[123] and an abundance of practitioner and scholarly literature.[124] While not a guarantee against litigation, following this guidance in conducting due diligence is likely to result in better due diligence and investment decisions and a corresponding level of mitigation of litigation exposure.
In summary, SPACs involve a range of legal risks, such as potential violations of the Securities Act, the Exchange Act, and state laws, including those addressing fiduciary duties. Many of these risks can be mitigated with securities offering and business combination due diligence that is consistent with longstanding, well-established authoritative and informative guidance.
[2] “SPAC Hot Streak Put on Ice by Regulatory Warnings,” The Wall Street Journal, April 16, 2021; https://spacinsider.com/stats/. Recent and ongoing developments regarding SPAC accounting treatment and other matters may slow the proliferation of SPACs in the future, but the trend to date has been one of strong and expanding growth.
[8]See generally, William K. Sjostrom, Jr., The Untold Story of Underwriter Compensation Regulation, 44 UC Davis L. Rev. 625 (Dec. 2010) at https://ssrn.com/abstract=1582498.
[18] In some cases, the sponsor and its affiliates may hold enough votes to approve the transaction. In that case, the SPAC does not solicit the approval of public shareholders, but rather provides shareholders with an Information Statement. In either case, typical disclosures include a description of the proposed merger, governance mechanisms, and extensive information about the target company including historical financial statements, management’s discussion and analysis (MD&A), and pro forma financial statements.
[20] Sometimes, though it is less common, a SPAC will opt to conduct a tender offer (giving the SPAC’s shareholders the option of tendering their shares), in lieu of seeking shareholder approval. “A New SPAC Structure May Lead to Renewed Interest in SPAC Offerings,” Bloomberg Law Reports, 2011.
[22] PIPEs are a type of secondary offering in which a publicly traded issuer sells equity at a discounted rate relative to the market price to an accredited investor. The PIPE funding ensures that the SPAC has sufficient capital commitments prior to entering into the definitive de-SPAC business combination agreement. These funds typically ensure that the SPAC has sufficient funds to consummate the de-SPAC transaction by, among other things, replenishing capital expended to redeeming shareholders (see, e.g., https://corpgov.law.harvard.edu/2018/07/06/special-purpose-acquisition-companies-an-introduction/#8b).
[24] 15 U.S.C. § 78j. While the anti-fraud provisions of the Exchange Act do not expressly provide for a private right of action (as does Section 11, for example), for many decades federal courts have recognized an implied right. See, e.g., Kardon v. National Gypsum Co., 69 F. Supp. 512, 514 (E.D. Pa. 1946). Moreover, the U.S. Supreme Court has confirmed the right. See Herman & MacLean v. Huddleston, 459 U.S. 375, 378 (1983).
[26] Although the SEC has observed that “there is no express provision in the [Securities] Act requiring an underwriter to conduct a due diligence investigation….” (“New High Risk Ventures,” Securities Act Release No. 33-5275, 1972 WL 125474 at *4 (July 27, 1972)), it has repeatedly expressed the view that underwriters have a non-statutory affirmative obligation to conduct reasonable due diligence (beyond having an affirmative defense). For example, as early as 1953, the SEC held that an underwriter “owe[s] a duty to the investing public to exercise a degree of care reasonable under the circumstances of the offering to assure the substantial accuracy of representations made in the prospectus….” (In re Charles E. Bailey & Co., 35 S.E.C. 33, 41, [1952–1956 Transfer Binder] Fed. Sec. L. Rep. [CCH] 76,218 (Mar. 25, 1953)). And, in a 1963 administrative proceeding, the SEC found a registration statement false and misleading and criticized the underwriter for failing to perform a reasonable investigation. In re Richmond, 41 S.E.C. 398, (1961–1964 Transfer Binder) Fed. Sec. L. Rep. (CCH) 76,904 (Feb. 27, 1963) at *7 (an underwriter: “[b]y associating himself with a proposed offering … impliedly represents that he has made such an investigation in accordance with professional standards. Investors properly rely on this added protection which has a direct bearing on their appraisal of the reliability of the representations in the prospectus. The underwriter who does not make a reasonable investigation is derelict in his responsibilities to deal fairly with the investing public.”). In another proceeding, the SEC emphasized the responsibilities of underwriters and selling agents. In re Hamilton Grant & Co., Securities Act Release No. 6724, 38 S.E.C. Docket 1030, 1987 WL 755965 (July 7, 1987) at *5. FINRA and its predecessor the NASD have expressed similar views regarding an underwriter’s affirmative duty to conduct reasonable due diligence despite the absence of an express statutory mandate.
[27]In re Int’l Rectifier Corp. Sec. Litig., No. CV91-3357-RMT (BQRX), 1997 WL 529600 (C.D. Cal. 1997) at *11.
[28] “Circumstances Affecting the Determination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief Under Section 11 of the Securities Act,” Securities Act Release No. 33-6335, 1981 WL 31062 (Aug. 6, 1981) (“SEC Release 33-6335”) at *13–14. See also, In re WorldCom Sec. Litig., 346 F. Supp. 2d 628, 670 (S.D.N.Y. 2004) (“the SEC cautioned that ‘only a court can make the determination of whether a defendant’s conduct was reasonable under all the circumstances of a particular offering’.”).
[29]See, e.g., National Association of Securities Dealers, “Special Report Due Diligence Seminars” (July 1981) (“NASD Special Report”) at 5; NASD Notice to Members 73-17, Proposed New Article III, Section 35 of the Rules of Fair Practice Concerning Underwriter Inquiry Standards Respecting Distributions of Issues of Securities to the Public, National Association of Securities Dealers, March 14, 1973 (“NASD Notice 73-17”); FINRA Regulatory Notice: Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings, Notice 10-22 (Apr. 2010) (“FINRA Notice 10-22).
[30] 15 U.S.C. § 77k (Section 11(c) of the Securities Act). While this definition is contained in the Securities Act and applies to public offerings of securities, the concept has been universally embraced as the appropriate standard of transactional due diligence in any context. The standard for reasonableness in due diligence is commonly described as one of negligence. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 208 (1976) (“the standard for determining ‘reasonableness’ in a ‘reasonable investigation’ and ‘reasonable ground for belief’ in the two affirmative [due diligence] defenses is a negligence standard, i.e., ‘that required of a prudent man in the management of his own property.’”).
[31]See, e.g., Joseph K. Leahy, The Irrepressible Myths of BarChris, 37 Del. J. Corp. L. 411, 455 (2012) (“The ‘prudent person’ standard, located in Section 11(c), was originally borrowed from the law of trusts. It is the standard to which a trustee is held [but that] standard…has evolved in ways that are not relevant to due diligence….”). See also, House Committee on Interstate and Foreign Commerce, “Report of the Advisory Committee on Corporate Disclosure to the Securities and Exchange Commission,” November 3, 1977 (SEC Advisory Committee Report), at 669 (“Negligence is the standard of liability….”).
[32]See, e.g., Joseph K. Leahy, The Irrepressible Myths of BarChris, 37 Del. J. Corp. L. 456 (2012) (“[the standard requires] ‘the exercise of reasonable care, skill, and caution.’ [citing Restatement Third of Trusts]. To this extent, the prudent [man] standard is simply a negligence standard-the duty to exercise ordinary care.”). See also, Memorandum of Law of Amicus Curiae the Securities Industry and Financial Markets Association in Opposition to Lead Plaintiffs’ Motion for Partial Summary Judgment,” In re Refco Inc. Securities Litigation, No. 05 Civ. 8626 (GEL) (S.D.N.Y May 6, 2009) at 14, available at https://www.sifma.org/wp-content/uploads/2017/05/refco-inc-securities-litigation.pdf (“Discussing the 1934 revision of the definition of reasonable inquiry, Professor Folk observed that the common law is ‘indispensable’ in interpreting a ‘prudent man’ standard, as it ‘resembles one of the classic common law tests of a director’s duty of care’ which requires ‘the same degree of care which a business man of ordinary prudence generally exercises in the management of his own affairs.’ [citing Folk, 55 Va. L. Rev. at 42-43]”.); Robert J. Haft, Arthur F. Haft, and Michelle Haft Hudson, Due Diligence—Periodic Reports and Securities Offerings, § 7:3, (West, 2015-2016 Ed.) (“Due diligence may be construed as a standard that depends to some extent on what constitutes commonly accepted corporate or commercial practice. If it can be established that the steps taken meet the standard of the trade as it presently exists, a court should not, in applying the Section 11(c) standard, hold one liable for not being duly diligent….”).
[33] Committee on Federal Regulation of Securities, “Report of Task Force on Sellers’ Due Diligence and Similar Defenses Under the Federal Securities Laws,” The Business Lawyer, Vol. 48, May 1993, 1185 (ABA Due Diligence Task Force Report) at 1232.
[35] National Association of Securities Dealers Notice to Members: 03-71, Non-Conventional Investments: NASD Reminds Members of Obligations When Selling Non-Conventional Investments (Nov. 2003), http://www.complinet.com/file_store/pdf/rulebooks/nasd_0371.pdf (NASD Release 03-71).
[38]https://www.finra.org/rules-guidance/notices/08-54. If a SPAC had identified potential acquisition targets prior the IPO, it would need to disclose information including the target’s financials in its registration statement which would lead to additional required due diligence. Also, as discussed more fully later in this article, some commentators and participants in SPACs have asserted that financial projections made in connection with a de-SPAC transaction fall within Private Securities Litigation Reform Act’s (PSLRA) safe harbor for forward-looking statements. Commentary from the SEC suggests that the Commission may disagree.
[39]https://www.finra.org/investors/insights/spacs (“One key difference between a traditional IPO and SPAC IPO process is that the SPAC IPO is much faster. From the decision to proceed with a SPAC IPO, the entire IPO process can be completed in as little as eight weeks and without much of the financial reporting, due diligence and disclosure involved in a traditional IPO. However, the later SPAC step of merging with the target company involves many (but not all) of the same requirements that would apply to an IPO of the target business, including audited financial statements and other disclosure items. In other words, the SPAC process back-loads the documentation requirements to the latter stages of the process, sometimes referred to as ‘De-SPACing.’”)
[40] For example, John Coates, the Acting Director of the SEC’s Division of Corporation Finance, stated on April 8, 2021: “To be clear, in the initial offering by a SPAC, when the shell company is first raising funds to finance all (or more commonly a portion) of its hoped-for acquisition of the yet-to-be-named target, disclosures clearly have a role to play under the federal securities laws. Investors need to know about sponsors and their financial arrangements, the procedural protections of the SPAC structure, and what kinds of returns the SPAC is likely to generate for investors absent a de-SPAC transaction or for those who choose to exit before the de-SPAC is completed. But it also is clear that investors at the time of the initial SPAC filing cannot understand all aspects of the long-term value proposition of the offering, precisely because a SPAC does not have operations or a business plan beyond a search for a target.” (https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws)
[41] Section 11 of the Securities Act provides a cause of action for material misstatements or omissions in offering documents. Section 12 of the Securities Act prohibits the selling of securities through distribution of a prospectus or oral communication that omits or falsifies material facts (15 U.S.C. § 77k(a), § 77e, § 77I(a)(2)).
[42] An issuer does not have a due diligence defense under Section 11 of the Securities Act. The situation under Section 12(a)(2) is more nuanced, but the result appears to be effectively the same. See SEC Advisory Committee Report at 451 (“The company [issuer] itself has no defenses under the 1933 Act.”); Jack C. Auspitz and Susan E. Quinn, Litigator’s View of Due Diligence, Conducting Due Diligence 2003 (2003) at 146 (citing Robert Alan Spanner, A Litigation Perspective on Prospectus Preparation Process for an IPO, 116 Sec. Reg. L.J. 115, 127 (1988)) (“There is no statutory due diligence defense for issuers under Section 11 or Section 12(a)(2). Issuers are held to the highest standards of liability, because for them ‘omniscience is virtually presumed and omnicompetence is required.’”). See also Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983) (“[l]iability against the issuer of a security is virtually absolute, even for innocent misstatements.”).
[46] SEC Release No. 33-6335 at *13 (“The Commission also believes that only a court can make the determination of whether a defendant’s conduct was reasonable under all the circumstances of a particular offering.”).
[48]In re Int’l Rectifier, No. CV91-3357-RMT (BQRX), 1997 WL 529600 at *12 (“by virtue of the extensive due diligence they conducted, they cannot be said to have acted “recklessly…the Underwriters’ establishment of a due diligence defense under Sections 11 and 12(2) of the 1933 Act negates the existence of scienter under Section 10(b) of the 1934 Act.”). See also,In re Software Toolworks Sec. Litig., 789 F. Supp. 1489 (N.D. Cal. 1992), aff’d in part and rev’d in part, 38 F.3d 1078 (9th Cir. 1994), opinion amended and sup’d, 50 F.3d 615, 626 (9th Cir. 1994) (“[b]ecause we conclude that the Underwriters acted with due diligence in investigating Toolworks’ Nintendo business and OEM revenues, we also hold that the Underwriters did not act with scienter regarding those claims.”).
[49]See e.g., 17 C.F.R. § 230.176 (2008) (Rule 176); The Regulation of Securities Offerings, Sec. Act. Release No. 33-7606A, 63 Fed. Reg. 67,174, 67,231 (Dec. 4, 1998) (proposing unadopted changes to Rule 176 that would have added six due diligence practices to be considered by a court when assessing the reasonableness of due diligence for certain offerings) [hereinafter Aircraft Carrier Release].
[50]See Report of the Broker-Dealer Model Compliance Program Advisory Committee to the Securities and Exchange Commission (Nov. 13, 1974).
[53]See, e.g., NASD Notice 73-17 and NASD Notice 75-33. Under the Securities Act, the SEC has authority to regulate broker-dealers, and Section 15(a) of the Exchange Act requires all broker-dealers who are engaged in interstate commerce involving securities transactions to register with the Commission. See 15 U.S.C. § 78o(b)(8). This regulatory oversight function is largely accomplished through FINRA. As the primary self-regulatory organization for broker-dealers in the United States, FINRA oversees the conduct of thousands of brokerage firms, including licensed investment banks and broker-dealers, all of which are legally required to be members of FINRA. FINRA was created in 2007 through the merger of the NASD’s and the New York Stock Exchange’s member regulation arms. https://www.finra.org/media-center/news-releases/2007/nasd-and-nyse-member-regulation-combine-form-financial-industry.
[54]See, e.g., Weinberger v. Jackson, 1990 WL 260676 at *2 (N.D. Cal. Oct. 12, 1990); Endo v. Albertine, 863 F. Supp. 708, 727-33 (N.D. Ill. 1994)
[55] The term is of unclear origin, but appears to derive from an early Supreme Court ruling in which Justice Joseph McKenna noted: “[t]he name that is given to the [state securities] law indicates the evil at which it is aimed, that is, to use the language of a cited case, ‘speculative schemes which have no more basis than so many feet of ‘blue sky.’” Hall v. Geiger-Jones Co., 242 U.S. 539 (1917).
[58] Black’s Law Dictionary, Ed. Bryan A. Garner (10th ed., Thomson Reuters, 2014) at 1257.
[59]See, e.g., Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009) (“…fiduciary duties of officers are the same as those of directors.”); Hampshire Grp., Ltd. v. Kuttner, 2010 WL 2739995, at *11 (Del. Ch. July 12, 2010) (“… duties of corporate officers are similar to those of corporate directors. Generally, like directors, [they are] expected to pursue the best interests of the company in good faith (i.e., to fulfill their duty of loyalty) and to use the amount of care that a reasonably prudent person would use in similar circumstances (i.e., to fulfill their duty of care).”).
[60]See generally National Association of Corporate Directors Center for Board Leadership, Report of the NACD Blue Ribbon Commission on Director Professionalism (National Association of Corporate Directors 2011).
[64]See, e.g., Aronson v. Lewis, 473 A.2d 805, 812 (1984); Kaplan v. Centex Corp., Del. Ch., 284 A.2d 119, 124 (1971); Robinson v. Pittsburgh Oil Refinery Corp., Del. Ch., 14 Del. Ch. 193, 126 A. 46, 49 (1926).
[65]See, e.g., Stephen B. Brauerman, Delaware Insider: When Business Judgment Isn’t Enough: The Impact of the Standard of Review on Deal Litigation, Business Law Today (2014).
[81] The safe harbor referred to bars private actions based on material misstatements or omissions regarding statements containing certain kinds of financial projections and future economic performance or describing targeted objectives or future plans. 15 U.S. Code § 78u–5 – Application of safe harbor for forward-looking statements.
[86] “[F]orward-looking information can of course be valuable. Modern finance and valuation techniques focus on risk and expected future cash flows. Investors and owners commonly view forward-looking information as decision-useful and relevant. That is true for companies being acquired, as well as for companies going public. But forward-looking information can also be untested, speculative, misleading or even fraudulent, as reflected in the limitations on the PSLRA’s liability protections, even when the safe harbor applies. Reflected in the PSLRA’s clear exclusion of ‘initial public offerings’ from its safe harbor is a sensible difference in how liability rules created by Congress differentiate between offering contexts. Private companies that combine with SPACs to enter the public markets have no more of a track record of publicly-disclosed historical information than private companies that are going through a conventional IPO. If there are risks to the use of cost-effective, complete, and reliable forward-looking information in any setting, those risks should be carefully evaluated in light of the goals of the federal securities laws. At the same time, the risk of misuse of such information should also be carefully evaluated in light of the economic realities of the capital formation process.” Id.
[100]See, e.g., Laidlaw v. Acamar Partners Acquisition Corp., filed on January 7, 2021; Pels v. Fintech Acquisition Corp. IV, filed on March 2, 2021; Amo v. Multiplan Corp., filed on March 25, 2021; and Delman v. Croskrey et al., filed on May 25, 2021.
[114] Delman v. Croskrey et al., Case No. 2021-0451-, May 24, 2021. On June 24, 2021, Delman v. Croskrey was stayed pending the resolution of motions to dismiss filed in several concurrent federal securities class actions filed in the Eastern District of New York and Middle District of Georgia involving similar alleged misstatements and claims brought forth under the Exchange Act (Rosencrants v. Danimer Scientific, Inc., Case No. 1:21-cv-02708-MKB-RLM (E.D.N.Y.) and Skistimis v. Danimer Scientific, Inc., Case No. 1:21-cv-02824-MKB-RLM (E.D.N.Y.); Caballero v. Danimer Scientific, Inc., et al., Case No. 1:21-cv-00095-LAG (M.D. Ga.) and Wilkins v. Danimer Scientific, Inc., Case No. 21-cv-00096-LAG (M.D. Ga.)).
[116] Arthur B. Laby, Differentiating Gatekeepers, 1 Brook. J. Corp. Fin. & Com. L. 119, 132 (2006).
[117] Peter Oh, Gatekeeping, 29 J. Corp. L. 735, 741 (Summer 2004).
[118] Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, 2 J.L. Econ. & Org. 53, 61 (note 20). As applied to underwriters, the term refers to the fact that underwriters perform due diligence on behalf of investors given that investors typically do not have the opportunity to conduct some kinds of due diligence activities independently.
[119]See, e.g., 17 C.F.R. § 230.176; see also, Securities Act Release No. 7606A at *92-99.
[120]See SEC Advisory Committee Report. While the Committee rejected the notion of rigid definitions and checklists, it did conclude that it would be advisable for the SEC to adopt a rule setting out several non-exclusive, contextually oriented factors courts might consider in assessing the issue of reasonableness as it relates to the due diligence defenses. Rule 176 was part of the response to this recommendation.
[121] FINRA (and its predecessor the NASD) have consistently stated that there is no one-size-fits-all approach to due diligence, and that what is appropriate can only be determined considering the context presented.
[122]See generally ABA Due Diligence Task Force Report at 1232-33; 1204 (quoting a November 6, 1981 letter from the Securities Industry Association Corporate Finance and Federal Regulation Committees to the SEC Committee: “We believe that what constitutes a reasonable investigation depends on all the surrounding circumstances, including, but not limited to, those described in proposed Rule 176. We believe these include the quality of the issuer (its size, the type and stability of business or businesses in which it is engaged, whether it is regulated, its financial condition, its earnings history and its prospects); the type of the security (including the terms of the security, the size of the issue and, if debt, its maturity and credit rating, if any); the quality of its management, auditors and outside counsel, if any, involved; the time available for an investigation and the degree of cooperation extended by management…”); 1232 (“As a standard of conduct, ‘reasonableness’ is meaningless except in a specific factual context.”).
[123] SIFMA Refco Brief (“Like any flexible standard of prudent conduct, the Section 11 due diligence defense has no content in the abstract. It only has meaning in a specific factual context, i.e., the conduct of underwriters of a particular registered public offering of securities. Congress did not enact a detailed code of specific obligations for underwriters, as it did with the extensive disclosure requirements imposed on issuers by a web of SEC rules and forms. Instead, it commanded judges and juries to determine what was ‘reasonable’ or ‘prudent,’ using those commonly-accepted common law terms as their only guide.”)
[124]See, e.g., Due Diligence in Business Transactions; Due Diligence: Investigation, Reliance & Verification; Robert J. Haft, Arthur F. Haft, and Michelle Haft Hudson, Due Diligence—Periodic Reports and Securities Offerings, § 7:3, (West, 2015-2016 Ed.
Supply chain management as a center of excellence within corporations emerged as a professional vocation in the 1980s. This need arose as the dual concepts of outsourcing and globalization gained prominence. During this time, specialization in supply chain disciplines emerged to meet the needs of businesses seeking to expand their operations into these emerging global markets. As this expertise developed, the power of the global market was unleashed and resulted in a decreased cost of production driven by higher efficiency, specialization, and having manufacturing facilities migrated to low-cost labor regions. As a result, the cost of goods decreased, access to goods and services increased, and profit margins rose over the following decades.
While profitability increased, so did supply chain complexity. No longer were traditional supply chains limited to local or regional hubs to find expertise in manufacturing and services. Modern supply chains now stretch across the globe. The diverse physical locations of parts and assembly services required to produce goods often mean that the components required to produce finished products will have come from multiple continents and traversed the globe several times before a product is completed. These global supply chains have established critical shipping lanes, ports, a need for logistics expertise, and service providers who specialized in moving products and materials across and through multiple jurisdictions. Shipping, air freight, rail, and truck transportation have also boomed, as goods traveled longer distances, requiring many modes of transportation to arrive at the customer’s desired location.
Another central motivation for outsourcing and globalization has been an increase in the cost of production resulting from increases in wages and regulatory controls in developed economies. While the cost of compliance has been studied and cost-conscious decisions were readily made, other considerations were rarely assessed. For example, consideration was rarely given to the reason the developed economy put the regulations in place by either the organization seeking to shift operations or the new country that was to become the new hub for manufacturing. As a result, not only were the manufacturing operations and associated jobs outsourced but also were the underlying pollution, safety/labor concerns, and product hazards.
This reality created a conundrum and generated the need for a new regulatory regime that was reoriented around the complexity of modern supply chains and the associated harms in the new production ecosystem. Regulations rarely occur in real time but will always follow innovation by business. Once the business processes have been established, industry standards will align around best practices and seek to deter undesirable and unethical actions. In time, this pattern and/or the resulting cases that highlight the consequences of failing to abide by industry norms will lead to defined laws. The laws, in turn, will establish rules that businesses and their suppliers are expected to abide by.
This pattern of regulatory evolution was coined the “race to the top,” meaning that once a best practice or undesirable activity was identified and regulated, others would all adapt to incorporate the new best practice. Historically, this trend has also led to traditional environmental and commerce regulation focused on the manufacturing process or point source regulations on facilities. Unfortunately, these existing point source laws were found to be insufficient by many major economies, as cases and problems began to emerge around supply chain actors or the finished products entering into a country. To close this gap, regulators began to establish a new series of laws that regulated the sale of products into the country that was receiving the goods.
To overcome issues of jurisdiction, regulations were oriented around the import of physical products and goods. Therefore, the jurisdictional hook became a call for transparency regarding what was in a product, what party/parties produced the product, and how the product was produced before it was imported into the country. These new regulations can be categorized into three groups:
Product Compliance: Regulations that mandate compliance with material restrictions in products, safety standards, and conformance with norms within the region. Failure to meet these product regulations results in a loss of the ability to sell into a market.
Vendor Management: Regulations that increase the cost of goods by requiring certain classifications and/or costs through the imposition of tariffs, fees, or sanctions. Failure to consider these vendor regulations results in an increased cost of goods and/or a loss of margin.
Corporate Social Responsibility (CSR): Regulations that mandate transparency disclosures if a business sells into a given market. Failure to perform adequate due diligence or to disclose the use of inhumane practices, engage in unethical practices, or environmental degradation during production can commonly result in fines, a loss of customer goodwill, and a net decrease of future sales opportunities.
In totality, these regulations have created market forces and legal obligations that frequently demand rapid changes and coordinated efforts from suppliers, contract manufacturers, distributors, logistics providers, customers, and solution providers. As a result, a growing need has emerged to have internal and external expertise dedicated to the supply chain compliance function within most businesses. These supply chain compliance professionals have emerged over the last decade as a critical component of managing the emerging risks associated with outsourcing and/or globalization strategy. To mitigate risk, companies have attempted to extend and shift the burden of compliance onto the supply chain and the importer of finished goods through warranties, contracts, and/or certifications of compliance. To accomplish this burden shifting, complex databases that can track, evaluate, and disclose due diligence records must be maintained and accessible by key personnel. These databases establish chains of custody and support the identification of where supply chain breakdowns are occurring through systematic record keeping.
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