Introduction

The economic shutdowns related to the COVID-19 pandemic (COVID-19) have created both shortages and surpluses in supply chains; in other words, ripe conditions for a surge in unauthorized gray-market goods (products with genuine trademarks sold outside authorized distribution channels). In the short term, for example, shortages and price gouging have inhibited healthcare systems’ and their suppliers’ access to vetted sources of genuine supplies, including for personal protective equipment (PPE) and pharmaceuticals. Although these market conditions may invite the substitution of gray-market goods for genuine ones based on availability, the inherent material differences in gray-market goods can pose serious health risks, often unbeknownst to end users. As another example, in the longer term, retailers may elect to liquidate unsold, out-of-date seasonal inventory, such as apparel, in international markets to mitigate losses, but risk unauthorized gray-market resellers later importing those goods back into the U.S. market to compete with next year’s fashions at a discount.

Although federal and state trademark and unfair competition laws offer protection to trademark holders against the unauthorized resale of gray-market goods, COVID-19-related closures and restrictions of state and federal district courts across the country have all but suspended activity in many of those venues for civil actions. However, owing in part to its relatively quick investigation-resolution timeframe mandates and not needing to empanel juries, the International Trade Commission’s (ITC) potential to maintain its pre-COVID-19 pace of operations adds to its already powerful ability to exclude unauthorized gray-market goods from importation[1] to make the ITC a key resource for trademark holders in today’s environment.

How Has COVID-19 Created the Potential for Gray-Market Problems?

In the short term, COVID-19 has created shortages and price gouging in numerous product categories, from healthcare to daily household essentials to sports and leisure products, as distribution chains adjust to the new “normal” of life in a pandemic. From the earliest days of the pandemic, however, no impact has been as apparent or as impactful as healthcare systems’ and individuals’ inability to access vetted sources of PPE and pharmaceuticals. These shortages and price gouging may tempt healthcare providers and individuals to turn to gray-market goods to fill the gap, but inherent material differences between the goods can pose serious health risks. For example, when third parties purchase gray-market goods and later resell them, there is no way to verify that those third parties have complied with safe storage and handling or restrictions on one-time use. This is particularly important for PPE and pharmaceuticals; dire consequences can result from using poorly handled pharmaceuticals or used N95 masks.

As just one example, 3M has filed multiple suits against companies attempting to sell its N95 masks and other PPE at multiple times the list price, alleging trademark infringement and other claims.[2] Summing up the concerns, one preliminary injunction order obtained by 3M noted that “[t]he public has an interest in avoiding confusion about the source and quality of goods and services” and that “[t]his is especially true during the global COVID-19 pandemic, when consumers, including experienced governmental procurement officials, are relying on the 3M Marks and 3M Slogan to indicate that goods and services offered thereunder originate from 3M, and are of the same quality that consumers have come to expect of the 3M brand.”[3]

In the longer term, large amounts of unsold inventory that accumulated during the shutdowns portends gray-market goods problems for retailers for years to come. For example, with the public staying home and spending less, apparel retailers may find themselves faced with unsold professional, luxury, seasonal, and vacation clothing. This surplus may be liquidated in international markets at steep discounts to mitigate losses. However, even in normal times this practice invites the later unauthorized importation of those goods back into the United States, where they compete at a discount against trademark owners’ latest fashions.

To prevent serious consequences to the public health in the short term, and to protect the trademark holders’ goodwill and ward off dilution and price erosion in the long term, trademark holders must remain vigilant to police and pursue any unauthorized sellers of trademarked goods due to the COVID-19 pandemic.

How Can the ITC Protect against Gray-Market Goods?

Under what is known as the first-sale doctrine, a person who buys a trademarked good may ordinarily resell that product without infringing the mark. However, this doctrine applies only to the resale of genuine goods and does not apply to the unauthorized resale of a trademarked good that is “materially different” from the genuine goods sold by the trademark owner—such a resale is still trademark infringement. Sections 32, 42, and 43 of the Lanham Act allow trademark owners and their exclusive and nonexclusive licensees to stop unauthorized resellers from selling gray-market goods upon showing a material difference between the authorized and unauthorized goods.

The ITC is empowered by statute to protect American industries from unfair methods of competition and unfair acts in the importation of articles as well as from importation into the United States of articles that infringe a valid and enforceable U.S. trademark.[4] In contrast with federal district courts, however, the ITC exercises in rem jurisdiction over imported articles, which enables the ITC to issue general exclusion orders in certain circumstances that block the importation of all infringing articles, regardless of whether importers participate in the ITC’s investigation. In addition, service of process against accused importers is less rigorous than in district courts in that attempted service by regular mail is all that is required. Finally, unlike in district court, one investigation in the ITC can name many different unauthorized reseller respondents, consolidating resources and avoiding unnecessary multiplication of efforts.

There are also potential advantages to the ITC as an enforcement forum in the COVID-19 environment. First, the ITC has a speedy schedule and time to final determination, which is important when considering the cumulative and continuous loss of goodwill that results from the sale of gray-market goods. The average time to a final decision for 2019 was 14.1 months.[5] The ITC can also grant a form of temporary relief “to the same extent as preliminary injunctions and temporary restraining orders” when the time period until a final determination is only 90 days in most cases and 150 days in “more complicated” cases.[6]

The ITC may also be more suited to maintain its pre-COVID-19 pace of operations than other forums, particularly considering its statutory obligation to conclude section 337 proceedings “at the earliest practicable time.”[7] In fact, a review of investigations that have been instituted since mid-March (Nos. 1192–1202) shows that the target dates have remained on a fairly typical schedule of 15–19 months, showing no significant slowdowns due to COVID-19. For example, in Investigation No. 1200, the respondents proposed that the target date be set for 19 months to allow for flexibility due to COVID-19, and the judge declined, setting the target date for 16 months.[8]

Moreover, because the ITC does not offer jury trials, it has more flexibility in conducting virtual bench trials as well as virtual hearings. Even before the pandemic, the ITC regularly held telephonic hearings and conferences when other courts may have more frequently required in-person attendance. The ITC may also be uniquely prepared to handle remote and alternative formats for trial because it already often uses written witness statements. For example, in Investigation No. 1162, the judge issued a notice and order regarding alternate hearing procedures suggesting that the parties could take depositions of witnesses regarding their written witness statements, and the parties could use that deposition testimony in lieu of live cross-examination. The judge stated that “there is a possibility of conducting the evidentiary hearing without any real-time participation by me at all,” showing the creative solutions the ITC is proposing to keep cases proceeding as quickly as possible.[9] Finally, although the ITC initially suspended in-person hearings, that restriction is set to lift on July 10, 2020.

Overall, the ITC has proven itself to be a speedy and highly adaptable forum. The ITC may be uniquely positioned to help trademark holders end gray-market problems, both generally and in view of the COVID-19 pandemic.

Conclusion

COVID-19 has unfortunately provided the potential for unauthorized gray-market goods to flourish. In the short term, such goods can threaten public health and safety when they affect the supply and quality of PPE and pharmaceuticals. In the long term, trademark holders may be battling against unauthorized gray-market goods sales and damage to their goodwill for years to come. Given its powerful remedies, practical benefits, and potential to maintain pre-COVID-19 operations, the ITC has shown itself to be a strong and effective partner to protect domestic trademark owners’ rights against unauthorized gray-market importers.

[1] See Paul Tanck & Neal McLaughlin, Combating Gray Market Goods: Using the ITC to Solve the Gray Market, Bus. L. Today, July 2, 2019 (explaining that “[t]he International Trade Commission has emerged as the go-to venue in the fight against the importation of gray-market goods”).

[2] Bill Donahue, 3M Sues Amazon Seller Over Fake N95 Masks, Law360, June 8, 2020.

[3] 3M Co. v. Performance Supply, LLC, No. 1:20-cv-02949-LAP (S.D.N.Y. May 4, 2020) (Dkt. 22).

[4] 19 U.S.C. § 1337.

[5] U.S. International Trade Commission, Section 337 Statistics: Average Length of Investigations (last accessed June 9, 2020).

[6] 19 U.S.C. § 1337(e)(2)–(3).

[7] 19 U.S.C. § 1337(b)(1).

[8] In the Matter of Certain Electronic Devices, Inv. No. 337-TA-1200, Order No. 6 (June 17, 2020); id., Joint Discovery Statement, EDIS Doc. No. 712615 (June 12, 2020).

[9] In the Matter of Certain Touch-Controlled Mobile Devices, Inv. No. 337-TA-1162, Order No. 54 (June 5, 2020).

Official committees can play an important role in a bankruptcy case, and chapter 9 municipal bankruptcy is no exception. Committees can ensure efficient, adequate representation of large stakeholder groups, including retirees, equity owners, and of course creditors. They bring together similarly situated parties, allowing the group to develop ideas and take positions that are representative of multiple parties with important interests at stake. Committee ideas and positions can thus be more powerful and persuasive than the views of any one stakeholder in a case.

Some recent decisions may threaten the appointment of official committees in chapter 9, however. Two bankruptcy judges have held that section 1102(a)(1) of the U.S. Bankruptcy Code does not authorize a committee’s appointment in chapter 9 and that, therefore, the committees the U.S. Trustee had appointed in each case should be disbanded.[1]

Section 1102(a)(1) provides, in relevant part, that “as soon as practicable after the order for relief under chapter 11 of this title, the United States trustee shall appoint a committee of creditors holding unsecured claims and may appoint additional committees . . . as the United States trustee deems appropriate.”[2] It is found in chapter 11 of the Bankruptcy Code but is incorporated in chapter 9 cases through section 901(a).[3] Even though section 1102 as a whole is incorporated into chapter 9, the courts in In re Coalinga Regional Medical Center and In re Detroit each found that section 1102(a)(1)’s reference to chapter 11 relief necessarily precluded that provision from applying in chapter 9 cases because there is no “order for relief under chapter 11” in a chapter 9 case. Both courts reached this conclusion based on the idea that it is important to give effect to every word in a statute.

Although both the Coalinga and Detroit courts disbanded the committees formed under section 1102(a)(1), both left the door open to the possibility that they could order the U.S. Trustee to appoint an official committee under section 1102(a)(2).[4] Under this provision, “[o]n request of a party in interest, the court may order the appointment of additional committees . . . if necessary to assure adequate representation. . . .”[5] However, the idea that a court could use section 1102(a)(2) to order the appointment of an initial committee does not give effect to every word of the statute: the word “additional” in that provision implies that there has already been a committee appointed in the case—a committee that the courts in Coalinga and Detroit have now held cannot be appointed. Coalinga and Detroit have thus raised the possibility that a court could hold that a chapter 9 committee cannot be appointed at all—not even with the consent of all parties.

However, this possibility is not an inevitable outcome. First, courts could adopt the U.S. Trustee’s position that Congress intended to incorporate section 1102 in its entirety into chapter 9 and knew how to exclude particular subsections if it wanted to.[6] Alternatively, courts could look to section 105(a) of the Code, which allows the court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”[7] Both Coalinga and Detroit contended that section 105(a) gave the court the power to disband committees[8] in that the Code does not explicitly prohibit this action.[9] Following this reasoning, a court could arguably interpret section 105(a) to accept committee appointments because the Code does not explicitly prohibit the court from ordering or allowing the appointment of committees, either.

Given the valuable role committees can play in a case, it is troubling that some courts have seemingly found a route to prohibit committee appointments in chapter 9 outright. To some extent, this is a statutory drafting issue that Congress should address, but courts may also have the statutory tools to fix the very problem they have created.

[1] In re Coalinga Regional Medical Center, 608 B.R. 746, 747–48 (Bankr. E.D. Cal. 2019); In re City of Detroit, Mich., 519 B.R. 673, 675 (Bankr. E.D. Mich. 2014).

[2] 11 U.S.C. § 1102(a)(1).

[3] 11 U.S.C. § 901(a) (“Section[] . . . 1102 . . . appl[ies] in a case under this chapter.”).

[4] Coalinga, 608 B.R. at 759 (continuing creditor’s motion to appoint a committee under section 1102(a)(2)); Detroit, 519 B.R. at 678 (“The U.S. Trustee’s authority to appoint committees in chapter 9 is therefore limited to the authority granted in subsection (a)(2) of § 1102.”).

[5] 11 U.S.C. § 1102(a)(2).

[6] Coalinga, 608 B.R. at 750. See, e.g., 11 U.S.C. § 901(a) (incorporating five out of sixteen subsections of section 1129(a)).

[7] 11 U.S.C. § 105(a).

[8] The U.S. Trustee’s arguments in Coalinga suggest that this would be an expansive reading. Coalinga, 608 B.R. at 750 (arguing that, when section 1102 was amended, it “eliminat[ed] the court’s role in committee formation and limit[ed] court review of committee composition.”).

[9] See Detroit, 519 B.R. at 680 (“[N]owhere does the bankruptcy code explicitly prohibit the bankruptcy court from disbanding an unsecured creditors’ committee.”).

The COVID-19 pandemic (COVID-19) has created unparalleled uncertainty for nearly all businesses in that companies are unable to predict when and how businesses and consumers will resume buying their goods and services. This unpredictability has made it more difficult for dealmakers to use historical earnings to predict a company’s future earnings, and accordingly their valuation, which has severely curtailed the number of M&A transactions at the present time. Somehow, however, a trickle of deals are getting done and others are being pursued, although at a much slower pace than in 2019.

Why Would Buyers and Sellers Want to Do a Deal in This Environment?

Buyers with available funds may find that the current environment provides opportunities that would not have existed before the pandemic. In particular, strategic buyers with deep industry expertise will look for transactions that will allow them to add a new product or service, acquire new technology or a set of skilled employees, or some combination thereof. Private equity buyers have a lot of available funds to invest and will need to deploy capital, especially if they perceive this to be a buyer’s market. One of the pandemic’s principle effects for M&A transactions has been to lower seller valuation expectations, motivating sellers to be more flexible than they were only a few short months ago. As a result, valuation expectations are materially lower for sellers, making it easier to structure a transaction that makes sense for both parties.

Throughout this article, reference to “private equity” generally means platform acquisitions by a private equity fund, which are acquired to be a standalone portfolio company, as opposed to a “tuck-in” acquisition by a portfolio company. “Strategic buyer” generally means an existing company already operating in an industry, which can include both public and private companies, and can include a private equity portfolio company looking for a tuck-in acquisition.

Many young start-ups and technology companies may lack sufficient cash resources to weather the COVID-19 storm and may be unable to find additional funding quickly enough. This predicament may increase the attractiveness of a larger strategic buyer capable of providing stability and added resources that the seller and its employees sorely need. Sellers may have other reasons to seek a sale, including the death or divorce of a founder, the need for liquidity to provide some diversification for the owners, or a management team that has reached its limits for moving the company forward. Such sellers may have been trying to find a buyer before COVID-19 and do not have the luxury of waiting a year or longer for a more favorable selling environment. There are also distressed situations in which a company may face insolvency and bankruptcy, but transactions involving bankruptcy have very different rules and considerations which are beyond the scope of this article.

How Has Due Diligence and the M&A Process Changed in the Post-COVID-19 Environment?

Acquisitions typically are the start of a long-term relationship between the seller’s management team and the buyer, the success of which depends heavily on the seller’s key employees. For buyers, face-to-face meetings with the seller’s management team remain a critical component of deal-making and due diligence, and few buyers will be willing to close a transaction without several opportunities to interact in person with the management team. Most deals closing today were likely underway before the pandemic, so the buyer already had spent time with the seller and the seller’s management team. Due to the challenges posed on travel by COVID-19, the nature of due diligence on the management team is likely to change. For new transactions in which the buyer has no prior relationship with the seller, video conferences will allow the sale process to get started between motivated parties. For now, however, buyers will likely insist on meeting the management team in person before they are willing to close the deal.

If travel remains constrained for an extended period, buyers may need to rethink their dependence on face-to-face meetings. Similar to hiring decisions, buyers will become more comfortable sooner or later with video conferencing, both for getting to know the management team during due diligence and for interacting with them post-closing. Buyers may also increase their use of personality tests and similar assessment tools to better understand the management teams of the seller during due diligence. You can also expect to see buyers becoming more structured in their due diligence discussions on video conferences, similar to the hiring methodology Geoff Smart and Randy Street recommend in their book, Who—The A Method for Hiring. Although right now partners at private equity funds and strategic buyers may say that they would never buy a company without extensive meetings with the management team in person, this attitude could change if the effects of the pandemic persist.

The inability to meet with the seller’s management in person is one of several reasons to extend the due diligence time period. An extended due diligence period allows the buyer more time to assess more accurately COVID-19’s impact on the seller and to find any needed financing for the deal. As a result, look for the exclusivity period in letters of intent to be extended from the typical period of 60 days pre-COVID-19 to 90 or 120 days, if not longer.

The nature of due diligence will strongly depend on whether the key assets of the seller are intellectual property, such as for a software company, or whether the key assets are physical, such as inventory or a factory or distribution facility. The more the key assets are physical, the more likely the buyer (and the buyer’s lenders) will require physical inspections that will lengthen the closing timetable.

Certain physical assets, such as a factory or distribution facility, will require more rigid due diligence on new health and safety measures put into place to protect workers at the facility. Similar to having Phase I environmental reports for real property, third-party health and safety inspections must be added to due diligence checklists for physical facilities.

The pandemic provides new lines of questions to ask the management team to better assess its capabilities and the operations of the target business.

• What decisions did you make to cope with the pandemic and why? How did they turn out? How did you treat your employees and vendors? What did you learn, and what would you do differently?
• What is the seller’s supply chain vulnerability, especially to China and other overseas sources? What plans does management have to change the supply chain in a post-COVID-19 world?
• What additional operating costs are required to operate in a post-COVID-19 world?
• What plans does management have if the pandemic re-emerges in the Fall?

Buyers will also ask if the seller received a loan under the Paycheck Protection Program (PPP), and especially if the loan was for more than $2.0 million so that it is subject to the automatic audit promised by the Small Business Administration (SBA). Buyers should ask about the seller’s eligibility for a PPP loan under the SBA’s affiliation rules. Buyers will be leery about buying a company subject to an SBA audit when the seller’s eligibility was questionable, or there are questions regarding the seller’s good-faith certification regarding the “necessity” of the loan.

Due to the shift from a seller’s market to a buyer’s market, sellers must find ways to distinguish themselves. One way to do that is to make due diligence easier and more transparent for the buyer. In this new environment, sellers should make the up-front investment in pre-sale due diligence. This will include investing in a more thorough quality of earnings (Q of E) review before starting the sale process. The Q of E will provide the buyer with better visibility into the seller’s pre-COVID-19 financial performance and how the seller will manage through the disruptions caused by the pandemic. A seller will also want to prepare a “stress test” analysis for its business under different possible scenarios in a post-COVID-19 world. Buyers will find sellers with more transparent financial data and a plan for an uncertain future to be much more attractive. These types of “stress test” analyses are critical to help develop more creative deal structures required under the current environment, as discussed below.

What Are Ways to Bridge the Valuation Gap, Given the Uncertainty in the Seller’s Future Financial Performance?

I. Setting the Stage—Valuation Methodologies and Changing Expectations

Three common ways to value target companies are:

• Multiple of prior 12 months of EBITDA, which is used for companies with earnings. This is the most common valuation methodology.
• Multiple of revenues, most commonly used for software and other technology companies that have been able to build significant sales but are not at the stage of having earnings.
• A “build versus buy” analysis, in which the buyer assesses the cost to duplicate the functionality of the seller’s product or technology from scratch, versus the cost to buy the seller and its employee team. This measure is most commonly used for early-stage software and other technology companies prior to them having significant sales revenues. Acquisitions of these types of companies are especially attractive if they have a skilled set of employees who can jump-start the buyer’s efforts to add a new product or service or technology. This valuation methodology generally leads to lower valuations, but not always, depending on the immediate needs of the buyer. When Facebook paid $1 billion for Instagram in 2012 for a one-year-old company with 13 employees, it sounded insanely high at the time, but in retrospect, it has turned out to be a bargain.

A seller’s historical earnings are no longer a predictable measure of future performance due to the uncertainty caused by COVID-19. Before the pandemic, in a seller’s market, the multiples of EBITDA and revenue used to value sellers were at all-time highs, with auctions attracting a large number of potential buyers. Using trailing 12 months (TTM) of EBITDA or TTM of revenues were reasonable ways for buyers to predict future financial performance. COVID-19, however, has upended these metrics as a way to value companies. How do you value a company after COVID-19 when you cannot predict with any certainty how a company will perform over the next 12 to 18 months? For the “build versus buy” valuation analysis, the changed environment probably will not materially change the buyer’s analysis, but it has substantially changed the seller’s expectations, making them more receptive to an acquisition.

One big difference between the current environment and prior recessions, such as the recession of 2008–09, is that sellers have quickly grasped the uncertainty caused by the pandemic. In prior recessions, it took 12 to 18 months for sellers to fully understand the new reality. Today, sellers’ expectations have reset almost immediately. Sellers that have the staying power and resources to wait may be content to do so until conditions improve. Sellers that have other pressures may be more motivated to sell, notwithstanding the current uncertainty, and more willing to share the risks with the buyer. From the buyer’s perspective, and especially for strategic buyers, if a target company is a strategic fit that provides a new product or service, or a new technology or skilled group of employees, this may be an excellent time to make an acquisition. If both the buyer and seller are motivated and are willing to be more flexible than before the pandemic, then deals can still happen.

How do you bridge the valuation gap to deal with the uncertainty caused by COVID-19? The answer is to creatively allocate the uncertainty risk between buyer and seller. The tools to do this can differ for private equity and strategic buyers.

II. Tools to Bridge the Valuation Gap

1. Reduced Total Purchase Price and Reduced Cash at Closing. Companies that are valued as a multiple of earnings or revenues are not worth as much today as they were in January 2020 in the pre-COVID-19 world. Particularly attractive companies that were in auction processes in January 2020 with multiple bidders may have received bids of 10 times 2019 EBITDA, with 90% or more of the purchase price paid in cash at closing. In the current environment, however, a more realistic multiple might be eight or nine times 2019 EBITDA, with only 50% to 60% of the purchase price paid in cash at closing. The remaining portion of the purchase price will be contingent, deferred, or subject to an equity rollover, using some of the tools laid out in more detail below.

2. Earn-outs. Earn-outs are a tool that can be used by both private equity and strategic buyers. According to the 2020 M&A Deal Terms Study by SRS Acquiom (the SRS Study), which analyzed 1,200+ private-target acquisitions from 2015 to 2019 (i.e., the pre-COVID-19 period), earn-outs for non life-science deals were used in an average of approximately 18% of transactions over the past four years, as shown in the chart below. Given that earn-outs are used more frequently in life-science transactions, the SRS Study excluded those transactions to get a better measure of how earn-outs are used outside of life-science transactions. For transactions with earn-outs, the metrics used were revenues, EBITDA, and other milestones (such as unit sales or product launches), or sometimes combinations of these metrics, depending upon the business and the stage of development of the target company. The chart below shows how the use of these metrics has changed.

Source: 2020 M&A Deal Terms Study by SRS Acquiom

According to the SRS Study, the chart below show that in non life-science transactions with earn-outs, the earn-out potential as a percentage of the closing payment generally hovered around 40%, and the length of the earn-out period ranged from less than one year to more than five years, with a median of 24 months.

Source: 2020 M&A Deal Terms Study by SRS Acquiom

Before COVID-19, both buyers and sellers were wary of using earn-outs. Earn-outs have often half-jokingly been referred to as “litigation magnets” because disputes regarding whether the earn-out has been achieved are common. Some of the reasons for the disputes have been due to ambiguous metrics for determining whether the earn-out has been met, changes in the buyer’s operations post-closing, the allocation of expenses, and the difficulty caused by changing circumstances, especially when the earn-out period is long (more than two years). As a result, before COVID-19, earn-outs were imperfect tools that were used only when absolutely necessary to bridge the valuation gap between buyer and seller.

After COVID-19, however, earn-outs will become increasingly popular to allocate more risk to the seller for the uncertainty of future performance. As a result, these are likely changes for earn-outs:

• Earn-outs will be used in a higher percentage of transactions, from the current 18% to perhaps 30% to 40% of deals, or higher.
• The time period for earn-outs will increase from the current median of 24 months to longer timeframes. Given the uncertainty with how long it will take for companies to recover from COVID-19, most companies have no visibility into what their results will be for 2020, and even into 2021. Therefore, earn-out periods may extend into 2022, 2023, and longer to give the seller more opportunity to achieve the earn-out.
• The earn-out potential as a percentage of the closing payment can be expected to increase from the current 40% to 50% or higher.

3. Equity Rollovers. Equity rollovers are a tool used almost exclusively by private equity buyers in platform acquisitions, and sometimes for tuck-in acquisitions. Equity rollover transactions typically involve rollover participants taking between 10% and 40% of the purchase price in the form of equity in the buyer. Equity rollovers are generally restricted to founders and other members of the seller’s management team who are joining the buyer post-closing. This provides founders and management with a meaningful equity stake in the buyer to align their respective interests to grow and sell the target company. Generally, existing equity holders in the seller who are not founders or part of the management team (i.e., venture capital, private equity, or angel investors) are excluded from the equity rollover because they have no ongoing role with the buyer post-closing and would rather exit the investment in the seller. Private equity buyers also like equity rollovers because they serve as a form of seller financing that reduces the buyer’s up-front cash payments at closing.

Equity rollovers were already very common before COVID-19. In the future, they will likely be used as a tool to allocate more risk to the seller to deal with the unpredictability of post-COVID-19 financial performance. Below are some of the changes we are likely to see.

• The equity rollover percentage is likely to increase. Prior to the pandemic, a private equity buyer might have been agreeable to only a 10% or 20% rollover by the founders and management team. In the post-COVID-19 world, the equity rollover percentage will likely increase to 30% or 40% as a means of shifting more of the risk to the seller and decreasing the need for outside financing.
• The seller participants in the equity rollover are likely to expand to include more of the equity holders in addition to the founders and management team. The buyer may insist on having venture capital, private equity, or angel investors included in the equity rollover. This may not be ideal for those investors who may have wanted to completely exit their investment, but they may have no choice in the current environment. For the buyer, this shifts the post-COVID-19 risk to more of the seller’s equity holders and increases the amount of seller financing.
• The private equity buyer may insist on having a liquidation preference for its equity, which will be paid out prior to the equity rollover received by the seller participants. Before COVID-19, it was typical for the seller participants to receive rollover equity with the same economic rights and preferences as the private equity buyer. In the current environment, however, private equity buyers are more likely to insist on receiving a 1X liquidation preference, or a 1X plus a return of some amount (i.e., 8%), to provide downside protection to the buyer. The buyer will argue that the seller participants have already cashed out a significant portion of their investment so it is only fair for the buyer to be protected if the post-COVID-19 performance of the seller is significantly worse than expected.

4. Targeted Incentive Bonus Plans for the Management Team. Strategic buyers generally will not use equity rollovers. The reasons include that the strategic buyer will have no timeline to sell the target company, so the rollover recipient will never be able to exit the investment, or the strategic buyer may be privately owned by a family or other small group and have no desire to have any minority equity holders.

Strategic buyers also may not want to use earn-outs if the management team that is joining the buyer has only a small equity stake in the seller. Therefore, an earn-out may increase the purchase price for the other equity holders of the seller (i.e., venture capital, private equity, or angel investors), but the management team will not receive much of the earn-out due to its small equity holding in the seller. As a result, the management team will not have the needed incentives to help the buyer achieve the desired results post-closing. This is particularly needed when the buyer is making the acquisition to acquire new software or other technology, as well as the skilled group of employees responsible for developing the technology (i.e., a so-called acqui-hire).

This situation, especially in a post-COVID-19 world, requires the strategic buyer to be more creative in designing a structured incentive bonus plan for the management team. Even in a post-COVID-19 world of higher unemployment, talented technology employees (and especially the “A” players) may still be able to find other attractive jobs or may be motivated to start a new company. As a result, the buyer must design targeted incentive bonus plans that may be outside the norm for the buyer and are specifically tailored to incentivize the management team to achieve specific buyer goals for the transaction. Below are some thoughts for what a targeted incentive bonus plan might include:

• Specific milestones that could include the development of new software or other products, or improving existing software or other products to meet market needs, in both cases using the larger resources of the buyer. These milestones may be part of a long-term project that may take two to five years to achieve; accordingly, the incentive plan must have a longer-term horizon that matches the achievement of specific milestones.
• Specific milestones that could include sales or other financial targets for the software or other technology products acquired in the acquisition to connect the management team to the sales efforts for their products. These milestones may be combined with the other milestones in the prior bullet.
• Monetary rewards that are large enough to provide sufficient incentives for the management team to stay with the buyer. If the management team is being asked to create significant value for the buyer, then they should share in a portion of the value they create.

5. Purchase Less Than 100% of the Target Company’s Equity (With Deferred Purchase Options for the Balance). In the typical rollover structure, the rollover participants cannot sell their rollover equity until the private equity fund sells the entire company. As discussed above, strategic buyers are unlikely to use rollover equity. However, a hybrid rollover structure that can be utilized by strategic buyers is to:

(i) purchase less than 100% of the target company’s equity in the initial closing (typically more than 50% of the equity, but less than 80% (to avoid consolidation for tax purposes)); and

(ii) purchase the balance of the equity at a later date, perhaps two to three years after the initial closing, based upon a pre-set formula to determine the purchase price based upon future performance.

This structure allows the seller’s equity holders to sell a portion of their equity at the initial closing and provide some partial liquidity for their investment. In the post-COVID-19 environment, the pricing multiple for the portion of the equity purchased at the initial closing may reflect some of the uncertainty for how quickly operations of the target company will get back to pre-COVID-19 levels.

The second-step purchase of the remaining equity can use a preset formula to determine the purchase price, which will be based on the financial performance of the target company during a future time period. This structure provides potential upside to the seller if the financial performance improves within a reasonable time period, while at the same time providing downside protection to the buyer if the financial performance is permanently impaired or takes an extended time period to get back to pre-COVID-19 levels. A variation of this structure is to provide for a combination of puts to allow the seller to require the purchase of the remaining equity at a preset formula, and calls to allow the buyer to require the sale of the remaining equity based on the pre-set formula, in each case at future dates.

For example, assume that the buyer purchases 60% of the seller’s equity at the initial closing at an 8X multiple of EBITDA (which might have been a 9X or 10X multiple in January 2020). The purchase agreement would provide that the remaining 40% of seller’s equity will be purchased by the buyer based on an 8X multiple of 2021 or 2022 EBITDA, perhaps with some minimum price to provide some downside protection to the seller’s equity holders. This structure allocates the downside risk to the seller of a slow or extended recovery while providing upside incentives to the seller if the target company’s financial performance improves more quickly. This structure can be especially advantageous for a smaller target company with limited sales and distribution resources for its products, or a new product with adoption risk, being acquired by a larger company with more extensive sales and distribution channels. Obviously, there can be many variations of this structure to fit the specific circumstances of the target business and to fairly allocate post-COVID-19 uncertainty between the seller and the buyer.

How Do Buyers Finance Acquisitions in the Current Environment?

In January of 2020, senior and mezzanine lenders were avidly competing to loan money to finance acquisitions. This led to an increase in the percentage of the purchase price that buyers could borrow to finance a deal and favorable loan terms with low interest rates and relaxed financial covenants. Life was good for buyers before the pandemic hit!

Today, the environment is different because lenders are much more cautious. It will take time for lenders to become more comfortable after the economy opens up and they can get real-time information on the target company’s financial performance in the new environment. As a result, many senior and mezzanine lenders are sitting on the sidelines or simply moving slowly until the smoke clears to permit some visibility on how the target company is likely to perform over the next 12–36 months.

When lenders are willing to move forward, their appetite for risk is likely to be substantially reduced, meaning that buyers can expect the following changes:

• Due diligence will take longer and be more involved, especially when there are physical assets and facilities that must be inspected. Mezzanine lenders in particular may look closer to home for financing transactions to eliminate the need to travel far to meet the management team.
• Lenders will reduce the percentage of the purchase price they are willing to finance, which will require the buyer to provide more equity.
• Interest rates and other fees and expenses will be higher than before. Interest rates may increase by 200 basis points or more than in 2019 to account for the increased risks. Closing fees and due diligence costs will also be larger than before the pandemic.

If outside financing is not obtainable at all, or not available at the desired level, then sellers and buyers must find new ways to allocate the financing risk in the post-COVID-19 environment. We expect some combination of the following structures to be used in the coming months, some of which have already been discussed above:

1. Reduce the cash portion of the purchase price payable at closing, and increase the amount of the equity rollover, and/or add an earn-out.
2. Bridge any financing gap with seller notes, which would be subordinated to any senior or mezzanine lenders. In the current environment, this may be the only way to get a transaction financed. Although the seller may request collateral or guarantees from the private equity fund or strategic buyer, buyers can be expected to react adversely to these requests and expect the seller to bear the risk with the seller notes until the entire company can be recapitalized and the seller notes can be repaid.
3. Provide for the buyer to pay an increased portion of the purchase price in cash at closing, and then recapitalize the company with an appropriate amount of debt after the lenders have better visibility on the target company’s financial performance in the post-COVID-19 environment.

Like the rest of the economy, M&A participants and their advisors are having to deal with an extraordinary amount of uncertainty as a result of COVID-19. As a result, due diligence efforts and transaction structures are expected to change from a pro-seller environment to one in which buyers and sellers must be more flexible and creative in how they allocate the valuation and financing risks between them. If a seller can wait for a more favorable environment, then they will do so, but many sellers will not be able to wait and will still desire to get a transaction closed. Similarly, private equity buyers have a lot of funds to invest and will need to deploy capital at some point, especially those with funds that have investment periods coming to a close. Cash-rich strategic buyers, especially those looking for companies with new products and technology, may find this an attractive opportunity to acquire companies that are a strategic fit. This environment may present strategic buyers already familiar with the industry and the target company with great opportunities, especially if they are willing to move quickly and are willing to be more creative with their deal structures.

Paul Pryzant, a partner at Seyfarth Shaw LLP, has represented clients in a variety of mergers and acquisitions, equity and debt financings, and other corporate transactions for over 35 years.

The author thanks Axial, which has been hosting a series of COVID-19 virtual roundtables each week with different sets of middle-market deal professionals who have been sharing their views on how COVID-19 has been changing the way they view transactions in the current environment. The virtual roundtables can be accessed at this link. These virtual roundtables inspired some of the ideas for this article.

Delaware Bankruptcy Court Holds That Minority Shareholder Blocking Rights Are Void

A little over two years ago, I reviewed a handful of decisions confirming the public policy against permitting limited liability companies from contracting away the right to seek bankruptcy protection in operating agreements.[1] In those cases, courts held that notwithstanding state law policy of freedom of contract in LLC agreements, so called blocking rights that give a creditor the ability to bar an entity from filing a bankruptcy petition may be void under federal law.[2]

Whereas “parties to an operating agreement generally have the freedom to contract limited only by the parameters in the relevant articles of organization and statutory law,” courts have recognized “a strong federal public policy in favor of allowing individuals and entities their right to a fresh start in bankruptcy.” Last month, in a ruling from the bench,[3] the Bankruptcy Court for the District of Delaware affirmed and strengthened that public policy as it relates to a debtor’s minority shareholder’s blocking rights, setting up a potential split between the Third and Fifth Circuits.[4]

On May 5, 2020, in In re Pace Industries, LLC, Case No. 20-10927 (MFW) (Bankr. D. Del.), Bankruptcy Judge Mary Walrath, in denying a motion by Macquarie Septa (US) I, LLC (Macquarie) to dismiss the debtor’s chapter 11 case, ruled that a minority shareholder’s blocking rights were “void” in the face of the debtor’s constitutional right to file bankruptcy. Judge Walrath explained:

I do recognize that there is no case directly on point, holding that a blocking right by a shareholder who is not a creditor is void as contrary to federal public policy that favors the constitutional right to file bankruptcy. But I think that, based on the facts of this case, I am prepared to be the first court to do so, and therefore conclude that the motion to dismiss must be denied.[5]

After Pace Industries and certain affiliates commenced their chapter 11 cases, Macquarie moved to dismiss the filings. Macquarie, which had made a $37 million investment in the debtor’s preferred stock, argued that the filing was unauthorized because the debtor did not obtain Macquarie’s consent, as provided for in the applicable corporate governance agreements. Macquarie argued that its right to block a bankruptcy filing was a heavily negotiated and critical component of its investment.

Macquarie acknowledged the cases holding that blocking rights in the hands of certain creditors might violate public policy, but attempted to distinguish those cases—including Intervention Energy and Lake Michigan[6]—on the basis that those cases involved shareholders who were also creditors, and that the equity stakes at issue were in the nature of “golden shares” intended only to vest the creditor with the blocking right. Here, however, Macquarie held only preferred equity—indeed, a substantial, albeit minority, stake—and was not a creditor. Accordingly, Macquarie argued that the court was constrained by U.S. Supreme Court precedent in Price v. Gurney, 324 U.S. 100, 106 (1945), to dismiss the bankruptcy petition where those who purported to act on behalf of the corporation lacked authority to do so under applicable state law. Based on the Fifth Circuit’s Franchise Services decision, which applied Delaware law, Macquarie argued that as a minority shareholder, it was not a controlling shareholder that owed any fiduciary duties and, specifically, the fact that Macquarie was not given opportunity to even exercise its consent rights prior to the chapter 11 filing shows that it did not control the board. In Franchise Services, the Fifth Circuit held that a shareholder with a blocking right did not have control over the debtor’s conduct and concluded that not being consulted as to a bankruptcy filing where it held such a consent right was indicative of a lack of control; accordingly, the Fifth Circuit did not reach the issue of whether it breached any purported fiduciary duty.[7]

Judge Walrath rejected those arguments, however, and denied Macquarie’s motion to dismiss, holding that:

under Delaware state law, contrary to the Fifth Circuit, my interpretation of the law would and does find that blocking rights, such as exercised in the circumstances of this case, would create a fiduciary duty on the part of the shareholder; a fiduciary duty that, with the debtor in the zone of insolvency, is owed not only to other shareholders, but to all creditors.[8]

In declining to follow Franchise Services, Judge Walrath began by focusing on the debtor’s clearly deteriorated financial condition, stating that “[t]here is no contest that the debtor needs a bankruptcy,” having closed its plants and furloughed workers, and having effectively no liquidity.[9] She went on to find that the bankruptcy case would “benefit most stakeholders” because the debtor’s lenders had agreed to a proposal that would pay all creditors in full if the plan were confirmed.[10] The court determined that under such circumstances, Macquarie’s blocking rights did create a fiduciary duty, and that allowing a shareholder like Macquarie to block a bankruptcy filing to advance its own interests offends federal public policy and interferes with a company’s constitutional right to seek bankruptcy relief. The court saw “no reason to conclude that a minority shareholder has any more right to block a bankruptcy—the constitutional right to file a bankruptcy by a corporation than a creditor does,” and therefore broke from the Franchise Services decision.^[11]

In conclusion, Judge Walrath stated, “whether or not the person or entity blocking access to the Bankruptcy Courts is a creditor or a shareholder, federal public policy does require that the Court consider what is in the best interest of all, and . . . whether the party seeking to block [the filing] has a fiduciary duty that it appears it is not fulfilling[.]”^[12] Importantly, Macquarie had conceded that it was “not considering the rights of others in its decision to file the motion to dismiss.”[13] Thus, Judge Walrath’s decision should put minority shareholders seeking to block a chapter 11 case—at least one filed in Delaware—on notice that such efforts will likely be met with strong resistance, and could even give rise to liability for breach of fiduciary duties if the efforts to prevent a debtor’s filing result in harm to other stakeholders. In addition, minority shareholders seeking to negotiate such blocking rights in connection with an investment should understand that going forward, such provisions in an entity’s corporate governance documents may be of little value. Thus, if the blocking rights are so essential to the deal terms, an investor might be well-advised to walk away.

[1] Brett S. Theisen is the director and vice-chair of the Financial Restructuring and Creditors’ Rights department at Gibbons P.C.

[2] See, e.g., In re Lexington Hosp. Grp., LLC, 2017 WL 4118117 (Bankr. E.D. Ky. Sept. 15, 2017); In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016); In re Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).

[3] See Docket No. 173. At present, the court’s docket does not indicate that a written decision will be forthcoming.

[4] See In re Franchise Servs. of N. Am., Inc., 891 F.3d 198, 206–08 (5th Cir. 2018), as revised (June 14, 2018).

[5] Tr. of Hr’g, dated May 5, 2020 (Case No. 20-10927(MFW) (Bankr. D. Del.), at 38:10-13.

[6] See infra, note 1.

[7] 891 F.3d at 213. 

[8] Tr. of Hr’g, dated May 5, 2020 at 40:22–41:3.

[9] Id. at 38:17-25.

[10] Id. at 39:1-4.

[11] Id. at 40:14-17.

[12] Id. at 41:24–42:4.

[13] Id. at 42:5-7.

In the beginning of the treatise On War, Carl Von Clausewitz explained war as follows:

I shall not begin by expounding a pedantic literary definition of war, but go straight to the heart of the matter, to the duel. War is nothing but a duel on a larger scale. Countless duels go to make up war, but a picture of it as a whole can be formed by imagining a pair of wrestlers. Each tries through physical force to compel the other to do his will; his immediate aim is to throw his opponent in order to make him incapable of further resistance.[1]

Insurance policies often contain so-called war exclusions. These provisions, which can differ significantly in how they are worded, purport to limit coverage for losses arising out of war or warlike actions.[2]

The issue came into recent prominence in 2018 as a result of litigation initiated by Mondelez International, Inc. against Zurich American Insurance Company. Mondelez suffered losses as a result of the malware known as “NotPetya.” According to a Wired article, “[NotPetya’s] goal was purely destructive. It irreversibly encrypted computers’ master boot records, the deep-seated part of a machine that tells it where to find its own operating system. Any ransom payment that victims tried to make was futile. No key even existed to reorder the scrambled noise of their computer’s contents.”[3] Per Mondelez’s complaint, Zurich denied Mondelez’s claim for insurance coverage based on a war exclusion which purported to exclude coverage for a “hostile or warlike action. . . .”

Although much has been written on the subject of the “war” exclusion, this article seeks to take a deeper dive into cyber threats.

Cyber Threats and the War of Words

States, nonstate actors, and criminal groups regularly engage in malicious cyber activities that eschew easy classification[4] in that subtle differences are often all that separates cyber crime, espionage, terrorism, and “hacktivism.”[5] Cyber crime, in its most simple distillation, is characterized as a crime that involves the use of computer-based means to commit an illegal act.[6] Cyber criminals develop and use various tools that delve deeply and covertly into public, commercial, and private networks[7] and are motivated, for the most part, by financial gain. According to Interpol:

[c]ybercrime is one of the fastest growing areas of crime. More and more criminals are exploiting the speed, convenience and anonymity that modern technologies offer in order to commit a diverse range of criminal activities. These include attacks against computer data and systems, identity theft, the distribution of child sexual abuse images, internet auction fraud, the penetration of online financial services, as well as the deployment of viruses, Botnets, and various email scams such as phishing.[8]

In contrast, the sine quo non of cyber espionage is gathering intelligence—governmental, corporate, or individual[9]—and often involves stealing trade secrets, intellectual property, and confidential government information. Despite the military nexus, and the “real and serious threat” to the state, cyber espionage typically will not trigger “application of international law on the use of force” but rather require a domestic or international criminal law response.[10]

Cyber terrorism and “hacktivism” are also commonly used in describing hostile cyber practices. Cyber terrorism has been defined as “the intimidation of civilian enterprise through the use of high technology to bring about political, religious, or ideological aims, and actions that result in disabling or deleting critical infrastructure data or information.”[11] In turn, a “hacktivist” is a “private citizen who on his or her own initiative engages in hacking for, inter alia, ideological, political, religious, or patriotic reasons.”[12] Both of these activities can obviously cause significant damage to a state.[13]

Though certain cyber activities occur “below the level of a ‘use of force’ as this term is understood in the jus ad bellum,”[14] a “lack of agreed upon definitions, criteria, and thresholds for application” coupled with “the rapidly changing realities of cyber operations” continue to raise questions concerning law enforcement versus military responses.[15] Determining the appropriate response may be possible only by discerning the goals and motives underlying the activity,[16] which is usually very difficult in that transparency and attribution are often nonexistent in cyberspace.

Cyber warfare, by contrast, generally “trigger[s] the international law governing the resort to force by States as an instrument of their national policy,” the Law of Armed Conflict,[17] and the associated risks of traditional hostilities.[18]

 Universal Cable Productions

A September 2019 decision regarding the war exclusion, albeit not in the cyber context, addressed some of these issues.[19] In that case, the U.S. Court of Appeals for the Ninth Circuit reviewed a lower court decision regarding an insurance claim by two production companies who were forced to relocate the production of a television program from Jerusalem due to Hamas rocket attacks.[20] The insurance company denied coverage on the grounds that the covered expenses were barred by virtue of exclusions for “war” and “warlike action by a military force.”[21] The Ninth Circuit rejected these arguments and held that “war” in the insurance context is limited to hostilities between sovereigns, and that although Hamas has control over Gaza, “Gaza is part of Palestine and not its own sovereign state” and that Hamas “never exercised actual control over all of Gaza.”[22]

Resolving Cyber Insurance Disputes

As cyber threats increase in the face of COVID-19 distractions,[23] it is likely that there will be related insurance claims and disputes regarding such claims. Policyholders, brokers, CFOs, and risk-management professionals should pay close attention to the wording of “war” exclusions to assess whether insurers may seek to invoke those provision in the event of a claim.

Should a dispute arise, stakeholders may want to consider utilizing alternative dispute resolution methods. As discussed in a prior article by the authors, there may be unique advantages to doing so in the context of a cyber insurance dispute, including, among other things, confidentiality and the ability to select a neutral who is versed in the key technical issues.[24] Doing so will allow the parties to go straight to the heart of the matter and perhaps, to the chagrin of Clausewitz, avoid the duel.

[1] Carl Von Clausewitz, On War 75 (Michael Howard & Peter Paret, eds., 1989 ed.).

[2] IRMI, “War Exclusion.”

[3] See Andy Greenberg, The Untold Story of NotPetya, the Most Devasting Cyberattack in History, Wired, Aug. 22, 2010.

[4] See Scott J. Shackelford, In Search of Cyber Peace: A Response to the Cybersecurity Act of 2012, 64 Stan. L. Rev. Online 106 (Mar. 8, 2012).

[5] See Tom Bradley, When Is a Cybercrime an Act of Cyberwar?, PC World, Feb. 20, 2012; see also Brad Lunn, Strengthened director duties of care for cybersecurity oversight: Evolving expectations of existing legal doctrine, 4 J. L. & Cyber Warfare 1, 109–137 (2014).

[6] Oona A. Hathaway, Rebecca Crootof, et al., The Law of Cyber-Attack, 100 Cal. L. Rev. 817, 834 (2012); Gary Solis, Cyber Warfare 1 (unpublished manuscript) (on file with authors).

[7] See Chris C. Demchak, Wars of disruption and Resilience: Cyber Conflict, Power, and National Security 8 (2011).

[8] Interpol (last visited April 23, 2015).

[9] Tallinn Manual on the International Law Applicable to Cyber Warfare 193 (Michael Schmitt ed., 2013) [hereinafter Tallinn Manual] (defining cyber espionage narrowly as “any act undertaken clandestinely or under false pretences [sic] that uses cyber capabilities to gather information.”). The Tallinn Manual was developed “to help governments deal with the international legal implications of cyber operations.” See, e.g., Manual Examines How International Law Applies to Cyberspace, IT World (Sept. 3, 2012) (noting that The Cooperative Cyber Defense Center of Excellence, which “assists NATO with technical and legal issues associated with cyber warfare related issues,” created the Tallinn Manual to address a variety of cyber legal issues). The Tallinn Manual examines the “international law governing cyber warfare” and encompasses both jus ad bellum and the jus in bello. Tallinn Manual, supra, at 4.

[10] Tallinn Manual, supra note 9, at 4.

[11] William L. Tafoya, Cyber Terror, FBI Law Enforcement Bulletin (Nov. 2011).

[12] Tallinn Manual, supra note 9, at 259.

[13] See, e.g., Nicole Perlroth, Anonymous Attacks Israeli Web Sites, N.Y. Times, Nov. 15, 2012; Michael Rundle, ‘Anonymous’ Hackers Declare Cyber War On North Korea, Claim Internal Mail System Hacked, Huff. Post UK, Apr. 4, 2013.

[14] Id.

[15] Id. at 42.

[16] See Bradley, supra note 5.

[17] Tallinn Manual, supra note 9, at 4.

[18] See Philippa Trevorrow, Steve Wright, et al., Cyberwar, Netwar and the Revolution in Military Affairs 1, 3 (2006) (discussing how modern societies are, for the most part, highly dependent on the continuous flow of information); Michael McMaul, Hardening Our Defenses Against Cyberwarfare, Wall St. J., Mar. 6, 2013, at A19 (“Digital networks could be used as a conduit to gas lines, power grids and transportation systems to silently deliver a devastating cyberattack to the U.S.”).

[19] Peter Halprin & Nicolas Pappas, Cyber Insurance for Critical Infrastructure and Debate About War, IIoT World Cybersecurity Blog (Nov. 5, 2019); see also Michael Gervais, Cyber attacks and the laws of war, J. L. & Cyber Warfare 1.1, 8-98 (2012).

[20] Universal Cable Productions, Inc., v. Atlantic Specialty Ins. Co., 929 F.3d 1143 (9th Cir. 2019).

[21] Id. at 1147.

[22] Id. at 1148.

[23] See, e.g., Peter A. Halprin & Jacquelyn Mohr, COVID-19 Cybersecurity and Insurance Coverage, N.Y.L.J. (Apr. 20, 2020).

[24] See, e.g., Peter A. Halprin & Daniel Garrie, Arbitrating Cyber Coverage Disputes, 29 Coverage Magazine 1 (Winter 2019); see also Michael Gervais, Cyber attacks and the laws of war, J. L. & Cyber Warfare 1.1, 8-98 (2012).

Market turmoil due to COVID-19 has halted many IPO plans, but IPOs by SPACs (special acquisition companies) are actually picking up in pace. Indeed, according to my sources at the Nasdaq, 40% of proceeds raised in IPOs to date this year have been from SPACs. And, as night follows day, more SPAC IPOs will lead to more SPAC litigation.

© Nasdaq 2020, Used with Permission

Compared to traditional IPOs, SPACS have not been involved in much litigation at all. But now is not the time for directors of SPACs to become complacent about litigation risk—if the past is any guide, there are several categories of SPAC suits worth guarding against.

As I discuss below, some of these suits are more problematic than others, with bankruptcy presenting particular difficulties. I’ll also discuss ways to mitigate your litigation risk, including through insurance.

Here are five types of private litigation that may be of concern to SPACs, one of which is likely only a theoretical category. Outside the scope of this article are potential SEC enforcement actions, which are of course also a concern for SPACs.

1. SPAC IPO Suits

When a SPAC first raises money in the public market, it is technically undertaking an initial public offering of its securities pursuant to an S-1 registration statement. We do not typically see Securities Act Section 11 litigation against these registration statements. As a reminder, in a Section 11 case, a plaintiff alleges liability for damages for material misrepresentations or omissions of facts in the registration statement.

This is not a surprise given that SPACs are shell companies with the sole purpose of raising capital in an IPO to acquire or merge with a private operating company and take it public. In other words, they are not operating companies that are doing things like missing guidance and other activities that tend to draw lawsuits against traditional IPO companies.

In addition, the funds raised in a SPAC are kept in a trust, and investors have the ability to opt out of the SPAC by redeeming their shares or by voting against future proposed acquisitions.

As a result, absent a great, big, effortful fraud, we would not expect to see much in the way of securities class action suits against the SPAC related to its IPO.

2. M&A Suits Challenging the SPAC Business Combination

One type of suit that pops up with SPAC transactions challenges the completeness of the proxy statement filed in connection with the SPAC’s acquisition of an operating company (also known as the “De-SPAC transaction”).

The suit filed in the United States District Court of Delaware against Greenland Acquisition Corporation is typical. In this kind of litigation, plaintiffs file suit alleging deficiencies in a proxy statement in violation of the ’34 Act, and then go away relatively quickly for a relatively low mootness fee once the defendants amend the proxy statement with some additional disclosures.

3. M&A Suits When the Target Company Does Poorly

Another type of SPAC-relevant M&A suit is brought after the merger when plaintiffs are unhappy about how things turned out. A critical element of these suits is the allegation that shareholders learned of the true shabbiness of the target company only after the merger was completed.

The China Water Case

One example is the Heckman case (aka the “China Water” case), which settled in 2014 for $27 million. Heckman was a SPAC that raised $433 million in its 2007 IPO. In 2008, Heckman and its board solicited shareholder approval of China Water and Drinks Company, a Nevada corporation.

The plaintiffs alleged that the proxy statement misstated China Water’s operations, finances, and business prospects, among other things. The plaintiffs also alleged ’34 Act Section10(b) fraud violations. Finally, the plaintiffs complained about Heckman’s diligence of China Water’s finances, internal controls and management.

The Waitr Case

For another example, consider the 2019 case of Welch v. Meaux . The plaintiffs in this case brought both Section 11 and Section 10(b) claims against officers and directors of the publicly traded company in connection with a de-SPAC transaction. The case also included a claim concerning the subsequent follow-on offering.

The SPAC in question, Landcadia, had raised $250 million in its 2016 IPO. Landcadia had 24 months to complete its business combination before being forced to return the proceeds to its investors. With two weeks to go before the deadline, Landcadia agreed to buy a mobile food ordering and delivery company.

Things did not go well with the target company after it became publicly traded. Plaintiffs ultimately brought suit, alleging material deficiencies in the proxy statement and subsequent registration statement.

Their allegations included the charge that when the target company began publicly trading, investors were not told of all the risks being foisted onto them. Moreover, the plaintiffs alleged that they were deceived as to the company’s prospects for profitability. This case is still pending.

4. Securities Class Action Suits Against the SPAC-Funded Operating Company

Once a SPAC has completed the business combination that results in a publicly traded operating company that new operating company is subject to the same scrutiny and potential for litigation as any public company.

Consider the April 2020 case of Akazoo, a music streaming company. Akazoo became a publicly traded company through a reverse merger in 2019 with Modern Media Acquisition Corp., a SPAC.

The plaintiffs in this federal securities class action case allege that Akazoo made false and misleading statements about its revenue, profits, and operations, among other things, and that consequently shareholders purchased securities at artificially inflated prices.

Specifically, Defendants made false and/or misleading statements and/or failed to disclose that: (1) Akazoo overstated its revenue, profits, and cash holdings; (2) Akazoo holds significantly lesser music distribution rights than it has stated and implied; (3) as opposed to Akazoo’s continued statements, it does not operate in 25 countries; (4) Akazoo has a significantly smaller user base than it states; (5) Akazoo has closed its headquarters and other offices around the world; and (6) as a result, Defendants’ public statements were materially false and/or misleading at all relevant times.

None of the SPAC directors were named in this Section 10(b) suit. This case is still pending.

5. Bankruptcy Suits

During bankruptcy, directors and officers are especially susceptible to being sued, and the bankruptcy of a company that becomes publicly traded through a SPAC is no exception.

SPAC board members that become directors and officers of the operating company they acquired might have some additional risk compared to other board members. This is due to the way SPACs are traditionally structured when it comes to the incentives provided to SPAC sponsors, people who are usually also the SPAC’s board members. The situation faced by the board of Paramount Acquisition Corp. in a is a cautionary tale.

This SPAC raised over $50 million in 2005, and had two years to find a suitable target. Very close to the final drop-dead date, Paramount acquired Chem Rx. Unfortunately, within 18 months, Chem Rx was in violation of the financial covenants on its credit facilities.

Chem Rx ultimately filed for bankruptcy in 2010. When the company was liquidated, a litigation trust was established to pursue claims on behalf of Chem Rx’s unsecured creditors.

The litigation trust brought suit against the six members of the board of directors of Paramount on behalf of Chem Rx. On behalf of the creditors, the plaintiffs alleged that entering into the Chem Rx transaction was itself a breach of fiduciary duties by the Paramount directors.

The plaintiffs argued that the court could not let the directors have the benefit of the business judgment rule when it came to the acquisition of Chem Rx because the directors were self-interested. The directors had an economic interest in the acquisition of Chem Rx that went beyond what all shareholders would get if the transaction went well.

As explained by the law firm McDermott:

[U]nder Paramount’s certificate of incorporation, if a shareholder-approved acquisition of a health care entity failed to close by a “drop-dead” date . . .October 27, 2007 (24 months after Paramount’s IPO) . . .Paramount would dissolve. In such an event, the IPO proceeds held in the trust account would be distributed in liquidation to Paramount’s public stockholders, and all of Paramount’s warrants (including those purchased by the directors) would expire worthless.

The directors had purchased two million warrants for $1.3 million. They also had acquired more than two million shares of Paramount founder stock for $25,000 (which compared very favorably to the IPO price in which the purchase price per unit was $6 [consisting of one common share and two warrants per unit]).

This type of arrangement is common for a SPAC, as is the proviso that the investment by the SPAC founders becomes largely worthless if the SPAC is unable to complete a de-SPAC transaction. On the other hand, the arrangement is highly profitable should things go as planned.

This financial arrangement is intended to motivate and reward the founders for spending their time, energy, and funds organizing the SPAC, taking it through the IPO process, and finding a good acquisition target.

Unfortunately, a New York court found that this structure was sufficient to keep the directors from winning their case on a motion to dismiss based on the business judgment rule. In other words, the plaintiff’s claims as to the breach of fiduciary duty due to self-interested motivations was sufficient for the case to move forward.

A SPAC’s favorable financing arrangement with its founders may not always leave the founder directors unable to rely on the business judgement rule. According to the McDermott memo, a shareholder vote based on good information would give back to directors the benefit of the business judgment rule:

[T]here are numerous Delaware court decisions holding that the legal effect of a fully informed stockholder vote of a transaction is that the business judgment rule applies and insulates the transaction from all attacks other than on the grounds of waste, even if a majority of the board approving the transaction was not disinterested or independent. See In re KKR Financial Holdings LLC Shareholder Litigation, C.A. No. 9210-CB (Del. Ch. October 14, 2014)

This obviously puts a lot of pressure on the quality of the disclosures in the proxy statement sent to shareholders to ask for their vote for a business combination.

How Can Your SPAC Avoid Litigation?

The cases above demonstrate some clear lessons:

1. Keep the timeline top of mind. If a business combination takes place close to when a SPAC is about to expire, the timing will definitely come up in the shareholder complaint should things end badly.
2. Be diligent. Ensure you have a complete, well-written proxy statement for the business combination. This seems obvious, but the facts in some of these cases makes it worth repeating.
3. Implement federal forum provisions. This is also known as the “Grundfest Solution.” While we have not yet seen a slew of SPAC-related cases brought in state court, we know that . The result is usually a much more expensive case compared to a case brought in federal court. For this reason, make it a priority to in all relevant charter documents.
4. Use a sophisticated approach for your D&O insurance program. The cases summarized above are complicated, which indicates the need for a thoughtful approach when it comes to your D&O insurance needs. You will want to work with an insurance broker who has a lot of experience with these types of transactions, and the types of claims that can arise from them.

Insurance litigation with respect to COVID-19 claims inevitably will be impacted by state and possible federal legislative initiatives currently being proposed. Businesses and insurers should particularly monitor legislative efforts at the state level designed to address civil liability claims derived from COVID-19 as businesses assess reopening scenarios and insurers assess the attendant potential litigation risks.

Various states, including North Carolina, Oklahoma, Utah, Wyoming, Louisiana and Kansas, have already adopted state legislation providing businesses with some type of limited civil liability immunity if customers and employees contract COVID-19 at their premises. In some of these states, the laws cover acts or omissions arising after the date of the emergency order, while in other states, the laws are effective from and after the date of adoption. For example, Iowa’s legislature has approved a measure supported by the Iowa Insurance Institute and NAMIC that provides retroactive immunity from COVID-19 lawsuits.

Under the legislation adopted in these states, businesses in compliance with state and federal guidance, such as that issued by the Centers for Disease Control and Prevention, the Occupational Safety and Health Administration, and/or the state’s Department of Health, would be afforded  liability shield protection for potential claims of persons alleging that they contracted COVID-19 on the businesses’ premises. However, immunity typically would not be available if the business acted in a manner deemed to constitute gross negligence, recklessness, or the intentional infliction of harm.

There are few differences in the legislation enacted by these states. In North Carolina, civil immunity is afforded to an emergency response entity or an “essential business” (as listed in the North Carolina Stay at Home Order; as amended, including industries such as health care, critical infrastructure, law enforcement, grocery, hardware stores, pharmacy, banking, eateries for takeout, and lawyers). North Carolina law provides this immunity for acts or omissions taking place on or after March 27, 2020, and until such time as North Carolina’s emergency declaration is rescinded or expires. In Oklahoma, Utah, and Wyoming, the immunity is not limited to essential businesses and appears to be provided to every type of business.

This legislative liability immunity would not necessarily prevent potential plaintiffs from asserting their COVID-19 claims against a business, but it would work as a defense against such claims. To preserve this defense, businesses would need to document the policies they adopted and are maintaining with respect COVID-19, and likewise they would need to record any event in which procedures were not followed, along with the corrective action taken to remedy the breach, in order to combat potential civil claims.

Wyoming faced challenges in adopting its immunity legislation, which was not approved as a standalone bill, but as an amendment to another bill discussed in the Wyoming House and the Senate. The amended law, which applies only during declared public health emergencies, provides immunity to businesses that act in ”good faith” and follow state health orders at the time of the alleged exposure to the coronavirus.

In Kansas, Bill HB 2016 was approved by the House and the Senate on June 4, 2020 and signed by the Governor on June 9, 2020. The legislation gives any person conducting business in Kansas immunity from liability in a civil action for a COVID-19 claim if such person was acting pursuant to, and in substantial compliance with, public health directives applicable to the activity giving rise to the cause of action when the cause of action accrued. The protection will expire on January 26, 2021.

In addition to these state initiatives, the business community is pushing Congress to adopt legislation that would provide legal protection in the face of concerns that businesses could face an avalanche of lawsuits as they begin to reopen. In response, Senator Majority Leader Mitch McConnell is promoting a proposal which he envisions will be introduced soon, intended to expand liability protections for businesses. Such protections would provide liability safe harbors for businesses that comply in good faith with governmental guidance.

This liability protection would not be offered to those businesses that are grossly negligent or that act with intentional or willful disregard for safety. It is possible that this legislation could act as the minimum standard for liability protections that could facilitate uniformity among those states adopting similar legislation, beyond which states could always enact more strict immunity protection.

Senator McConnell has indicated that he intends to include this proposal in any further relief or stimulus proposals, including potentially the proposed Heroes Act discussed below. The proposal would give employers latitude to abide by the guidelines of the Centers for Disease Control and Prevention or the guidelines of other federal, state, or local governmental entities. The proposal would be retroactive to 2019 and would provide protection against lawsuits through 2024.

House Democrats recently introduced a new stimulus relief package known as the Heroes Act, which will likely exceed $2.2 trillion in stimulus funding, and is expected to include new state and local aid, more direct payments to Americans, and an increase in food assistance. The Heroes Act does not include liability immunity for businesses. Senator McConnell has countered that any new stimulus package would need to include liability immunity, such as the proposal he is advancing.

Several organizations and associations, including the National Association of Mutual Insurance Companies, the National Association of Professional Insurance Agents, the American Property Casualty Insurance Association, and the Independent Insurance Agents & Brokers of America, sent a letter to Congress on May 27, 2020, asking Congress to enact liability relief legislation affording immunity to businesses as a consequence of COVID-19 claims from employees and customers.

The legislative grant of immunity to a business from civil suit due to COVID-19 would undoubtedly impact the insurance industry, particularly those carriers issuing comprehensive general liability coverage (GCL). It is beyond the scope of this article to address the interplay of legislation providing immunity from liability and workers’ compensation insurance, and that certainly merits consideration.

GCL policies would cover “bodily” injury caused to third parties on the insured (i.e., business) premises. A claim made by customer or third-party or conceivably by an employee, alleging COVID-19 harm caused by an insured that failed to exercise reasonable care in implementing and enforcing policies with respect to potential exposure to the novel coronavirus, could be covered by a GCL policy, absent a specific exclusion. To the extent that immunity is granted to businesses for any harm caused by coronavirus, there arguably would be fewer claims made against those businesses under CGL policies. This, in turn, could translate into fewer claims to be paid, and thus may afford a benefit to CGL insurers. How this evolves in the future is uncertain but bears watching.

Part I: The SEC Should Strengthen the Custody Rule for Investment Advisers

Introduction

The Securities and Exchange Commission (SEC or Commission) should strengthen the custody rules for investment advisers. The SEC’s current rules may not be sufficiently rigorous to prevent the “next Madoff.” Although the Commission amended its custody rule, i.e., Rule 206(4)-2[2] in 2009, these amendments would not prevent a determined fraudster from repeating Bernie Madoff’s heinous financial crimes. This article explains why the SEC should strengthen the rule to require that an investment adviser keep client assets at a custodian that is unaffiliated with that adviser.

Background

In 1962, the SEC adopted a custody rule for registered investment advisers under the authority of the general antifraud provision of section 206.[3] In its adopting release, the Commission explained the rule’s requirement.[4] Briefly, the SEC required registered advisers to hold customers’ securities in a reasonably safe place, to provide clients with an itemized statement of their holdings every three months, and to retain an independent accountant to conduct a surprise audit of the customers’ funds and securities.

The SEC made only minor changes to the custody rule between 1962 and 1997.[5] In 2003, the Commission amended the rule to eliminate the requirement that the adviser retain an independent public accountant to conduct a surprise audit under certain circumstances.[6] The Commission noted in the 2003 Adopting Release:

Under the amended rule, when qualified custodians send quarterly account statements directly to advisory clients, the adviser is no longer required to send its own quarterly statements or to undergo an annual surprise examination. Receiving quarterly account statements directly from the qualified custodians will enable advisory clients to identify questionable transactions early and allow them to move more swiftly than relying on an annual surprise examination.[7]

The Current Custody Rule

After the Madoff[8] and other scandals,[9] the SEC reexamined the custody to rule to consider whether to adopt further changes. As discussed below, on December 30, 2009, the Commission adopted substantial changes to the rule.[10] In particular, the SEC reexamined its decision to eliminate the surprise audit provision.[11] When it adopted the final rule, the Commission restored that provision.[12]

In its current iteration, the custody rule affords significant protections to the customers of investment advisers. Briefly, Rule 206(4)-2 requires an adviser registered or required to be registered under section 203 of the Advisers Act to comply with the following requirements:

• Use a qualified custodian to hold customers’ funds and securities.[13] The qualified custodian must maintain the customers’ funds and securities either in a separate account under each client’s name or in accounts that contain only the clients’ funds and securities in the adviser’s name as agent or trustee.[14] Rule 206(4)-2(d)(6) defines a “qualified custodian” as a regulated bank, savings association, broker-dealer, futures commission merchant, or certain foreign financial institutions.[15]
• Notify each client of the name and other information about the custodian;[16]
• Have a reasonable basis for believing that the custodian sends account statements to the customers.[17]
  • NB: In the 2009 Amendments, the Commission “eliminate[d] an alternative to the requirement under which an adviser can send quarterly account statements to clients if it undergoes a surprise examination by an independent public accountant at least annually.”[18]
• Have an independent public accountant perform a surprise audit at the custodian to verify the customers’ funds and securities.[19]
  • NB: Hedge fund managers are exempt from the surprise audit requirement if they retain an independent accounting firm that is subject to oversight by the Public Company Accounting Oversight Board (PCAOB) to conduct an annual audit of the custodian.[20]  The hedge fund industry did not believe that the surprise audit was workable and urged the SEC to adopt a more rigorous audit requirement for custodians for private funds than is otherwise required. The SEC agreed.[21]

When the Commission proposed amendments to the rule, it proposed additional safeguards for when an adviser or related person maintains client funds or securities as a qualified custodian.[22] In addition, the Commission asked whether it should require that custodians be independent of the investment adviser:

We request comment on whether, as an alternative to our proposal to impose additional conditions on advisers that serve as, or have related persons that serve as, qualified custodians for client assets, we should simply amend rule 206(4)-2 to require that an independent qualified custodian hold client assets. The use of a custodian not affiliated with the adviser would address the conflict, and potentially greater risks to client assets, that may be presented when an adviser or its related person acts as custodian for client assets.[23]

The Commission declined to require that the custodian be independent from the adviser.[24] It made only modest changes to that portion of the proposed rule. The final rule provides that if the adviser maintains, or has custody because a related person maintains, client funds or securities pursuant to this section as a qualified custodian in connection with advisory services that the adviser provides to clients,” then the independent public accountant that the adviser hires to perform the independent verification (including the surprise audit) required in subsection (a)(4) must be registered with and subject to the regular inspection by the PCAOB. In addition, the adviser must obtain (or receive from its related person) a periodic internal control report prepared by that independent public accountant. That report must:

• opine on whether the controls are adequate to protect the customers’ funds and securities;
• verify that the funds and securities are reconciled to a custodian other than the adviser or its related person; and
• subject the independent reporting accountant to PCAOB oversight.[25]

The custody rule also includes an exemption from the surprise examination requirement in subsection (a)(4) where the adviser is operationally independent of the related person custodian.[26]

In the intervening years, the SEC and its staff have identified significant concerns regarding investment advisers’ compliance with the custody rule.[27] The SEC’s Office of Compliance, Inspections, and Examinations (OCIE) stated in its 2014 Exam Priorities:

[The National Examination Program] continues to observe non-compliance with . . . the Custody Rule. In March, 2013, the NEP published a Risk Alert, sharing observations regarding the most common issues of non-compliance. Given the importance of this requirement for a fiduciary, the staff will continue to test compliance with the Custody Rule and confirm the existence of assets through a risk-based asset verification process. Examiners will pay particular attention to those instances where advisers fail to realize they have custody and therefore fail to comply with requirements of the Custody Rule.[28]

That document refers to another OCIE Risk Alert documenting a wide variety of violations of the custody rule that OCIE identified during investment adviser examinations.[29] The SEC continues to bring enforcement actions against investment advisers for custody rule violations, even if the amounts of the settlements have been relatively modest.[30]

Recommendation

As outlined below, the SEC could do more to enhance the investor protections of the custody rule. The 2009 Amendments, and in particular the changes that the SEC added in subsection (a)(6) of the rule, are very helpful. Requiring that the adviser retain an independent accounting firm under PCAOB oversight to verify custody should reduce the likelihood that a fraudster will not deposit the necessary funds and securities with the custodian or remove them illegally. Nonetheless, it is my view that the SEC should take the next step and require the adviser to use a custodian that is unaffiliated in any way with the adviser.

The Madoff fraud itself indicates that an adviser using an affiliated custodian may more easily commit fraud than if the custodian were unaffiliated. The indictment and plea notes that Bernard L. Madoff Investment Securities (BLMIS) was registered with the SEC as both a broker-dealer and as an investment adviser.[31] The indictment alleges that “the BLMIS ADV contained false statements made for the purpose of deceiving the SEC and hiding the defendant’s unlawful conduct. . . . The BLMIS ADV filed with the SEC provided, among other things, that BMLIS had custody of advisory clients’ securities.”[32] In the Plea Allocution of Bernard L. Madoff, Mr. Madoff states, “I . . . knowingly gave false testimony under oath that . . . my firm had custody of the assets managed on behalf of my investment advisory clients.”[33]

If the SEC had required BLMIS to use a separate entity, Mr. Madoff would have needed many more confederates to commit his fraud. The current requirement that a PCAOB-inspected auditor review the custody arrangements is an important reform, but a clever fraudster might be able to circumvent that requirement. It is obvious that the more people necessary to commit a fraud, the less likely it is that the fraudsters will be able to keep their scheme a secret.[34]

The SEC should amend the custody rule so that a registered investment adviser must use a custodian that has no relation to the adviser. When the Commission declined to adopt the independent custodian requirement, it expressed concern that the requirement would be inconsistent with some business models.[35]

Although I commend the Commission for its consideration of cost factors and varying business models,[36] I believe that it should reconsider this decision. After the SEC adopted its rule, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), which includes the Volcker Rule.[37] As a consequence of that requirement and pressure from institutional investors, nearly all hedge fund managers use unaffiliated custodians. In addition, many retail investment advisers use platforms operated by large broker-dealers to execute trades and maintain custody.

If the Commission were to revise the custody rule, it should examine the existing exemptions. After 10 years of experience with the rule, the Commission should consider whether it needs to expand, retain, or reduce current exemptions.[38]

Some investment advisers probably could reconfigure their arrangements to accommodate a requirement of an independent custodian, though others might not be able to do so easily. It is my view that the benefit of requiring a separate custodian substantially would outweigh the cost. Retail and institutional investors would have many investment advisers from which to choose, and their assets would enjoy a greater level of protection.[39]

The current custody rule is a substantial improvement over the 2003 iteration. Nonetheless, we should not wait for another Madoff to steal yet another horse before locking the barn door.

Part II: Congress Should Augment the SEC’s Rulemaking Authority; SEC Should Make Better Use of Existing Authority

Introduction

Congress should enact a general rulemaking provision for the Advisers Act that is analogous to section 15 of the Securities Exchange Act of 1934 (Exchange Act) for broker-dealers. Initially, Congress enacted the Advisers Act as a broad statement of principles with relatively few specific mandates. As fiduciaries, the Advisers Act requires investment advisers to act in the best interests of their clients. Given that advisers are fiduciaries, the SEC adopted relatively few rules under the Advisers Act compared to the SEC’s and FINRA’s regulation of broker-dealers.

Over time, Congress and the SEC have imposed more specific requirements on investment advisers. Unfortunately, Congress did not grant the SEC general rulemaking authority under the Advisers Act. Accordingly, the SEC has had to use its broad antifraud authority under section 206 as the basis for adopting a number of rules that, arguably, the Commission could better address under a grant of general rulemaking. Consequently, an investment adviser that fails to satisfy rules that are prophylactic in nature will find that it has violated an antifraud rule, which may have unduly harsh consequences for the adviser. To remedy this problem, Congress should grant the SEC broader authority to adopt prophylactic rules under the Advisers Act. The SEC should have the authority to delineate those offences that are inconsistent with its regulatory mandates from those that are deceptive and fraudulent. The SEC itself has the authority to begin this process, which Congress could then augment. I explain the basis for my suggestions below.

Discussion

In the seminal case SEC v. Capital Gains Research Bureau,[40] the Supreme Court explained the general purpose and operation of the Advisers Act. The court rejected the adviser’s argument that it was legal for it to recommend a stock that it secretly bought for itself and then sold, even if its recommendation was legitimate. The court explained:

The Investment Advisers Act of 1940 was “directed not only at dishonor, but also at conduct that tempts dishonor.” United States v. Mississippi Valley Co., 364 U.S. 520, 549. Failure to disclose material facts must be deemed fraud or deceit within its intended meaning, for, as the experience of the 1920s and 1930s amply reveals, the darkness and ignorance of commercial secrecy are the conditions upon which predatory practices best thrive. To impose upon the Securities and Exchange Commission the burden of showing deliberate dishonesty as a condition precedent to protecting investors through the prophylaxis of disclosure would effectively nullify the protective purposes of the statute. Reading the Act in light of its background we find no such requirement commanded. . . . The statute, in recognition of the adviser’s fiduciary relationship to his clients, requires that his advice be disinterested. To insure this it empowers the courts to require disclosure of material facts. It misconceives the purpose of the statute to confine its application to “dishonest” as opposed to “honest” motives. . . . The high standards of business morality exacted by our laws regulating the securities industry do not permit an investment adviser to trade on the market effect of his own recommendations without fully and fairly revealing his personal interests in these recommendations to his clients. [Emphasis added.][41]

In the intervening years, the SEC adopted rules that impose obligations on investment advisers that are more specific than a general fiduciary standard would require. For example, the SEC adopted Rule 206(4)-7 in 2003 requiring advisers to have written policies and procedures to prevent a violation of the Advisers Act and its rules, to review the adequacy of those policies annually, and to appoint a chief compliance officer.[42] There are several others.[43]

A compliance rule probably is wise policy, but the failure to appoint a chief compliance officer without any other wrongdoing should not be fraudulent conduct by the adviser that is a violation of section 206 of the Advisers Act. Investment advisers operated for decades under the Advisers Act without appointing a chief compliance officer, and most did so without violating their fiduciary obligations to customers or committing fraud. Given the limitations of the Advisers Act, the SEC had little choice but to adopt this rule under section 206. However, a violation of Rule 206(4)-7 does not mean that an adviser behaved wrongfully with respect to its clients; that rule is only a means to the end of ensuring that the adviser complies with the law and protects its clients. Indeed, it is possible that a tenacious litigant and a friendly court might conclude that Rule 206(4)-7 is not an antifraud rule. If a court so concluded, it could find that the custody rule exceeds Congress’s grant of authority.

A better answer is for Congress to amend the Advisers Act and to grant the SEC authority analogous to its authority over broker-dealers. The Exchange Act grants broad authority to the Commission to prohibit fraudulent practices at broker-dealers, but Congress also granted the SEC authority to adopt prophylactic rules.

Below are two examples of antifraud rules that the SEC adopted to regulate broker-dealers. The SEC adopted these rules under section 10 of the Exchange Act, that statute’s broad antifraud provision:

• Regulation SHO, which governs short sales. Subsection 10(a)(1) of the Exchange Act grants the Commission specific authority to regulate short selling.[44]
• Rule 10b-3, which prohibits broker-dealers from engaging in certain fraudulent activities.[45] The better-known Rule 10b-5 applies to any person.

By comparison, in section 15(c)(3) of the Exchange Act,[46] Congress grants the SEC authority to establish financial responsibility rules, separate and apart from the antifraud authority in section 10. The SEC used this authority to adopt the net capital rule[47] and the customer protection rule,[48] both of which are essential to protecting customers’ assets held at a broker-dealer. A broker-dealer must be able to demonstrate “moment to moment” compliance with the net capital rule.[49] A broker-dealer that violates the net capital rule must begin liquidation. Neither rule is an antifraud rule.

Congress should enact legislation analogous to section 15 of the Exchange Act that would grant the SEC authority to adopt additional prophylactic rules under the Advisers Act without having to invoke the antifraud authority of section 206.

Some critics might object to this suggestion, arguing that such additional authority would water down or diminish the SEC’s current prohibitions. For example, they might fear that enacting such a provision would diminish the importance of an adviser complying with the insider trading prohibitions under section 10(b) of the Exchange Act and Rule 10b-5. In fact, the opposite is true. When Congress enacted section 204A of the Advisers Act, it required advisers subject to the reporting requirements of section 204 to maintain and enforce policies and procedures reasonably designed to prevent insider trading.[50] Congress added this provision in section 3 of the Insider Trading and Securities Fraud Enforcement Act of 1988. An investment adviser violates section 204A if it fails to establish, maintain, and enforce such a system, even if the adviser never trades on insider information. Section 204A is a separate, prophylactic requirement and is independent of the insider trading prohibitions in section 10(b) of the Exchange Act and Rule 10b-5, as well as section 206 of the Advisers Act. Clearly, Congress deemed it important to ensure that the SEC had independent authority to ensure that investment advisers adopted policies and procedures designed to prevent insider trading.

The SEC could use its current authority to demonstrate the importance of separate authority to adopt prophylactic rules in addition to antifraud rules. Congress added a separate and explicit custody provision to the Advisers Act itself after the financial crisis of 2008 and the Madoff scandal. Section 411 of the Dodd-Frank Act amended the Advisers Act to include the following provision:

Section 223. An investment adviser registered under this title shall take such steps to safeguard client assets over which such adviser has custody, including, without limitation, verification of such assets by an independent public accountant, as the Commission may, by rule, prescribe.[52]

Further, as noted, the SEC amended the custody rule after the Madoff fraud, but before Congress enacted section 223 as part of the Dodd-Frank Act. After notice and comment, the SEC could adopt the text of the custody rule under the authority of section 223. It then could adopt a separate rule providing that the willful violation of the custody rule is a violation of section 206, the antifraud provision.

This change would make clear that an adviser that was merely negligent did not violate the Advisers Act’s antifraud provisions. It also would remove any doubt as to the validity of a custody rule because the statutory basis would not be section 206, the antifraud provision.

The SEC should have the authority to distinguish between negligence and Madoff-style fraud. Advisers who make a minor error complying with the custody rule should not have to explain to their clients why a technical error is not really fraud. This first step could demonstrate to Congress the wisdom of augmenting the SEC’s power.

Similarly, if Congress expanded the SEC’s power, it could adopt prophylactic rules regarding advertisements by investment advisers; cash payments for client solicitations; political contributions by certain investment advisers; and proxy voting.[53] The Commission could then adopt antifraud rules for each of these provisions prohibiting willful violations. Accordingly, an investment adviser that makes a minor mistake with regard to any of these rules would not be subject to a charge that it had committed fraud.[54] By the same token, the SEC would retain the authority to charge a violation of both the prophylactic rule and the antifraud rule in egregious cases.

The current framework does nothing to distinguish serious violations from negligent errors. An adviser that commits a minor violation must explain why a fraud charge overstates the nature of the wrongdoing. For example, an adviser to a hedge fund would find it awkward to explain a minor mistake to the board of an institutional investor. Indeed, the adviser might be reluctant to settle an enforcement action with the SEC for that reason. By the same token, an adviser that commits serious fraud may try to excuse its behavior to less sophisticated investors by saying that the SEC calls any minor transgression fraud. The law should not paint the serious wrongdoer and the minor transgressor with the same brush.

To be clear, I am not suggesting that Congress should alter the existing fiduciary duty inherent in the Advisers Act. Congress should not, as the Supreme Court cautioned, “impose upon the Securities and Exchange Commission the burden of showing deliberate dishonesty as a condition precedent to protecting investors through the prophylaxis of disclosure would effectively nullify the protective purposes of the statute.” I am suggesting that Congress should grant the SEC greater flexibility so that its rulemaking authority would better match the evolution of the regulatory framework. The SEC should have greater authority to impose a broader range of prophylactic rules in addition to its antifraud rules.

Conclusion

The SEC has listed a review of the custody rule as a priority on its regulatory agenda.[56] That is a wise decision. More than 10 years have passed since the Commission adopted its last set of amendments to the custody rule. Regulators should reassess any rule after a significant period of time has elapsed to determine what has worked well and what could work better. Even the most brilliantly drafted rule may need adjustments in light of external developments.[57] The forthcoming review of the custody rule will afford the SEC the opportunity to consider suggestions from the public, including those outlined above.

[1] © Stuart J. Kaswell 2020, who has granted permission to the ABA to publish this article in accordance with the ABA’s release, a copy of which is incorporated by reference. Stuart Kaswell is an experienced financial services attorney. The views he expresses are entirely his own and do not reflect the views of any prior employers, former colleagues, clients, or Business Law Today. The author wishes to thank Stephen A. Blumenthal, Esq., Thomas P. Lemke, Esq., and David Vaughan, Esq. for their thoughtful comments. Any errors are entirely the author’s responsibility.

[2] 17 C.F.R. § 275.206(4)-2 (the custody rule or the rule).

[3] Section 206 of the Advisers Act provides:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly—

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;

(3) acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction. The prohibitions of this paragraph (3) shall not apply to any transaction with a customer of a broker or dealer if such broker or dealer is not acting as an investment adviser in relation to such transaction; or

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.

The Commission stated that it also was relying on authority that Congress granted in another portion of the Advisers Act. Part II of this article highlights the limitations of the Commission’s rulemaking authority under the Advisers Act and recommends an alternative.

[4] The Commission stated that:

The rule makes it a fraudulent, deceptive or manipulative act, practice or course of business for any investment adviser who has custody or possession of funds or securities of clients to do any act or to take any action with respect to any such funds or securities unless (1) all such securities of each such client are segregated, marked to identify the particular client who has the beneficial interest therein, and held in safekeeping in a reasonably safe place; (2) all funds of such clients are deposited in one or more bank accounts which contain only clients’ funds; such accounts are maintained in the name of the investment adviser as agent or trustee for such clients; and the investment adviser maintains a separate record for each such account showing where it is, the deposits and withdrawals, and the amount of each client’s interest in the account; (3) the adviser, immediately after accepting custody or possession, notifies the client in writing of the place and manner in which the funds and securities will be maintained; (4) the adviser sends each client, at least once every three months, an itemized statement of the funds and securities in his custody or possession at the end of such period and all debits, credits and transactions in the client’s account during the period; and (5) at least once each calendar year the funds and securities are verified by actual examination by an independent public accountant in a surprise examination and a certificate of the accountant, stating that he has made the examination and describing the nature and extent of it, is sent to the Commission promptly thereafter.

Investment Advisers Act Release No. 123 (Feb. 27, 1962); 27 FR 2150 -1, (Mar. 6, 1962).

[5] 54 Fed. Reg. 32049 (Aug. 4, 1989); 62 Fed. Reg. 28135 (May 22, 1997). The 2009 Proposing Release, infra note 10, states at note 13:

In 1997, we amended the rule to make it applicable only to advisers who are registered, or required to be registered, with the Commission. Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 1633 (May 15, 1997) [62 FR 28112 (May 22, 1997)] at Section II.I.5.

[6] Adoption of Rule 206(4)-2 under the Investment Advisers Act of 1940, Investment Advisers Act Release No. 123 (Feb. 27, 1962) [27 Fed. Reg. 2149 (Mar. 6, 1962)] cited in the 2009 Proposing Release, infra note 10.

[7] Release IA- 2176 (Sept. 25, 2003; 68 Fed. Reg. 56692 (Oct. 1, 2003), at 56697 (citations omitted). The Commission made provision for “the small group of advisers that cannot use the new approach and therefore must continue to undergo an annual surprise examination,” Id (citation omitted).

[8] Numerous government documents, news articles, books, and movies have described Bernard L. Madoff’s Ponzi scheme. Briefly, Madoff, who had earned respect for his broker-dealer operations, ran a massive Ponzi scheme through a separate investment adviser.

[9] 2009 Proposing Release, infra note 10.

[10] Release IA-287 (May 20, 2009); 74 Fed. Reg. 25354 (May 27, 2009) (2009 Proposing Release); Release IA-2698 (Dec. 30, 2009), 75 Fed. Reg. 1456 (Jan. 11, 2010) (2009 Adopting Release).

[11] The 2009 Proposing Release states at 25356:

In 2003, we amended the rule to eliminate the annual surprise examination with respect to client accounts for which the adviser has a reasonable belief that ‘‘qualified custodians’’ provide account statements directly to clients. We believed that direct delivery of account statements by qualified custodians would provide clients confidence that any erroneous or unauthorized transactions would be reflected and, as a result, would be sufficient to deter advisers from fraudulent activities.

We have decided to revisit the 2003 rulemaking in light of the significant enforcement actions we have recently brought alleging misappropriation of client assets. [footnotes omitted.]

[12] Rule 206(4)-2(a)(4).

[13] Rule 206(4)-2(a)(1). The custody rule provides certain exemptions from the qualified custodian requirement. Rule 206(a)(4)-2(b) provides six exceptions from the qualified custodian requirement. For example, subsection (2) exempts certain privately offered securities:

(i) You are not required to comply with paragraph (a)(1) of this section with respect to securities that are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;

(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and

(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

The SEC staff also has provided guidance exempting privately placed securities in certificated form from the custody rule under certain circumstances.

The Division would not object if an adviser does not maintain private stock certificates with a qualified custodian, provided that (1) the client is a pooled investment vehicle that is subject to a financial statement audit in accordance with paragraph (b)(4) of the custody rule; (2) the private stock certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer; (3) ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client; (4) the private stock certificate contains a legend restricting transfer; and (5) the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.

SEC, Division of Investment Management, IM Guidance Update, Aug. 2013, No 2013-04 [citations omitted], as referenced in Lemke & Lins, infra note 25, at §3:63, n.3.

[14] Rule 206(4)-2(a)(1)(i) and (ii).

[15] Rule 206(4)-2(d)(6)(i) – (iv).

[16] Rule 206(4)-2(a)(2).

[17] Rule 206(4)-2(a)(3).

[18] 2009 Adopting Release at 1457

[19] Rule 206(4)-2(a)(4).

[20] Rule 206(4)-2(b)(4) provides:

Limited partnerships subject to annual audit. You are not required to comply with paragraphs (a)(2) and (a)(3) of this section and you shall be deemed to have complied with paragraph (a)(4) of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d)))[if]:

(i) At least annually [the investment adviser] and [sic] distributes its [i.e., the partnership’s] audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year;

(ii) [Such audited financials are reviewed] By an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

(iii) Upon liquidation [of the fund, the adviser] and [sic] distributes its [i.e., the partnership’s] audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) promptly after the completion of such audit.

[21] 2009 Adopting Release at 1460 and discussion at note 47. See also letter from Stuart J. Kaswell, Executive Vice President and Managing Director, General Counsel, Managed Funds Association, July 28, 2009, and Testimony of Stuart J. Kaswell, Hearing Before the Committee on Financial Services, U. S. House of Representatives, 111th Cong., 1st Sess., Oct. 6, 2009, Serial No. 111-84, at 55–56.

[22] 2009 Proposing Release at 25374, Proposed Rule 206(4)-2(a)(6)(i) and (ii).

[23] 2009 Proposing Release at 25361.

[24] The Commission noted:

Some commenters supported requiring an ‘‘independent’’ qualified custodian, although many commenters opposed the requirement. Several argued that use of an independent custodian would be an impractical requirement for many types of advisory accounts held by smaller investors with broker-dealers, such as wrap fee accounts, in which a client receives bundled advisory and brokerage services from a single firm (or related firms) regulated as both an investment adviser and a broker-dealer. It is common for institutional clients to maintain assets in a custodial account, often with a bank that is unaffiliated with the client’s adviser. We are concerned, however, that requiring an independent custodian could make unavailable many advisory accounts popular with smaller investors, which are today maintained by the adviser or its affiliated brokerage firm or bank. Therefore, we are not amending the rule to require use of an independent custodian, although we encourage the use of custodians independent of the adviser to maintain client assets as a best practice whenever feasible.

2009 Adopting Release at 1462 [citations omitted].

[25] Rule 206(4)-2(a)(6)(i),(ii)(A),(B), and (C),

[26] Rule 206(4)-2(b)(6)(i) and (ii). As one treatise explains:

The rule includes an exception to the surprise examination requirement where the adviser is “operationally independent” of the related person custodian. In these situations, the surprise examination requirement would not apply, although the requirements relating to client notification, custodian account statement and an internal control report would continue to apply.

An adviser is operationally independent if: (i) the client assets are insulated from creditors; (ii) the adviser’s personnel do not have access to the clients’ assets; (iii) the advisory personnel and the custodian are not under common supervision; and (iv) the advisory personnel do not hold any position with or share premises with the related person. Lemke & Lins, Regulation of Investment Advisers § 2:53 (2017); See also Rule 206(4)-2(d)(5). One can only wonder if Bernard Madoff would have asserted that the separation of its broker-dealer from its adviser qualified as “operationally independent” under this exception.

[27] Lemke, Lins, Hoenig & Rube, Hedge Funds and Other Private Funds: Regulation and Compliance § 3:62 (2017–18) (“the SEC staff has identified investment adviser and fund manager custody issues as an examination priority.”) (emphasis in original).

[28] National Exam Program, OCIE, Examination Priorities for 2014.

[29] OCIE, Significant Deficiencies Involving Advise Custody and Safety of Assets, Vol. III, Issue 1, Mar. 4, 2013.

[30] See, e.g., In the Matter of ED Capital Management et. al, Investment Advisers Act Release 5344 (Sept. 13, 2019). Among other things, the adviser “failed to distribute annual audited financial statements prepared in accordance with Generally Accepted Accounting Principles (“GAAP”) to the investors in the largest private fund that it advised in each fiscal year from 2012 through 2016, in violation of Section 206(4) of the Advisers Act and Rule 206(4)-2 thereunder. . . .” See also In the Matter of Hudson Housing Capital, LLC, Investment Advisers Act of 1940, Release No. 5047 (Sept. 25, 2018).

[31] U.S. District Court, Southern District of New York, Information 09 Cr., at 1.

[32] Id. at 16.

[33] The Plea Allocution of Bernard L. Madoff at 3, included in United States of America v. Bernard L. Madoff, U.S. District Court for the Southern District of New York, 09 CR 213 (DC), included in Full Madoff Court Transcript, Mar. 12, 2009.

[34] B. Franklin, Poor Richard’s Almanack (1735) (“Three may keep a Secret, if two of them are dead.”).

[35] See supra note 24 .

[36] See section 202(c) of the Advisers Act.

[37] Section 619 of the Dodd-Frank Act added section 13 of the Bank Holding Company Act of 1956 (BHC Act), also known as the Volcker Rule. The Volcker Rule “generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund.” Department of the Treasury et al, 12 C.F.R. pt. 44, [Docket No. OCC–2018–0010] RIN 1557–AE27, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 84 Fed. Reg. 61974 (Nov. 14, 2019). Given that the Volcker rule prevents banks and certain affiliates from sponsoring hedge funds, they may not sponsor and serve as a custodian for the same fund.

[38] As noted, Rule 206(a)(4)-2(b) provides exceptions from the qualified custodian requirement. In the absence of evidence to the contrary, it would be wise to continue such exemptions.

[39] I am not suggesting that the Commission should make any changes to other aspects of the rule. For example, I would not alter Rule 206(4)-2(b)(3)(i) that exempts the adviser from obtaining an independent verification of client funds and securities if the adviser has custody solely as a consequence of having the authority to make withdrawals from client accounts to pay its advisory fees. In addition, I am not suggesting that the SEC should not permit broker-dealers to retain possession and control of customers’ funds and securities. Congress and the SEC have instituted requirements to ensure the protection of customer property. See the discussion, infra, of section 15(c) of the Exchange Act and Rules 15c3-1 and 3-3.

[40] 375 U.S. 180 (1963).

[41] Id. at 200–01.

[42] 17 C.F.R. § 275.206(4)-7 (compliance procedures and practices):

If you are an investment adviser registered or required to be registered under section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3), it shall be unlawful within the meaning of section 206 of the Act (15 U.S.C. 80b-6) for you to provide investment advice to clients unless you:

(a) Policies and procedures. Adopt and implement written policies and procedures reasonably designed to prevent violation, by you and your supervised persons, of the Act and the rules that the Commission has adopted under the Act;

(b) Annual review. Review, no less frequently than annually, the adequacy of the policies and procedures established pursuant to this section and the effectiveness of their implementation; and

(c) Chief compliance officer. Designate an individual (who is a supervised person) responsible for administering the policies and procedures that you adopt under paragraph (a) of this section.

[43] Other rules under section 206 of the Advisers Act that are prophylactic in nature are 17 C.F.R. §§ 275.206(4)-1 (advertisements by investment advisers); 275.206(4)-3 (cash payments for client solicitations); 275.206(4)-5 (political contributions by certain investment advisers; and 275.206(4)-6 (proxy voting).

[44] In the release proposing Regulation SHO, the SEC notes that “[s]ection 10(a) of the Exchange Act gives the Commission plenary authority to regulate short sales of securities registered on a national securities exchange (listed securities), as necessary to protect investors.” Release 34-48709 (Oct. 28, 2003); 68 Fed. Reg. 62972, 62973 (Nov. 6, 2003). In the adopting release for Regulation SHO, the Commission invoked the following provisions as the basis for its authority: “pursuant to the Exchange Act and, particularly, Sections 2, 3(b), 9(h), 10, 11A, 15, 17(a), 17A, 23(a), and 36 thereof, . . ., the Commission is adopting §§ 242.200, 242.202T, 242.203, along with amendments to Regulation M, Rule 105, and interpretative guidance set forth in part 24.” 69 Fed. Reg. 48008, 48029 (Aug. 6, 2004). As a matter of caution, the SEC always cites to multiple statutory provisions as the basis for its rules.

[45] Rule 10b(3)(a) provides:

It shall be unlawful for any broker or dealer, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, to use or employ, in connection with the purchase or sale of any security otherwise than on a national securities exchange, any act, practice, or course of business defined by the Commission to be included within the term “manipulative, deceptive, or other fraudulent device or contrivance”, as such term is used in section 15(c)(1) of the act.

[46] That provision provides:

(3)(A) No broker or dealer (other than a government securities broker or government securities dealer, except a registered broker or dealer) shall make use of the mails or any means or instrumentality of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security (except a government security) or commercial paper, bankers’ acceptances, or commercial bills) in contravention of such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest or for the protection of investors to provide safeguards with respect to the financial responsibility and related practices of brokers and dealers including, but not limited to, the acceptance of custody and use of customers’ securities and the carrying and use of customers’ deposits or credit balances. Such rules and regulations shall (A) require the maintenance of reserves with respect to customers’ deposits or credit balances, and (B) no later than September 1, 1975, establish minimum financial responsibility requirements for all brokers and dealers.

[47] 17 C.F.R. § 240.15c3-1.

[48] 17 C.F.R. § 240.15c3-3.

[49] NASD Notice to Members 07-16 (Apr. 2007). See also FINRA, Accuracy of Net Capital Computations; News Release, FINRA Expels Maximum Financial for Net Capital, AML, Other Violations, Aug. 18, 2009.

[50] Section 204A provides that:

Every investment adviser subject to section 204 of this title shall establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser’s business, to prevent the misuse in violation of this Act or the Securities Exchange Act of 1934, or the rules or regulations thereunder, of material, nonpublic information by such investment adviser or any person associated with such investment adviser. The Commission, as it deems necessary or appropriate in the public interest or for the protection of investors, shall adopt rules or regulations to require specific policies or procedures reasonably designed to prevent misuse in violation of this Act or the Securities Exchange Act of 1934 (or the rules or regulations thereunder) of material, nonpublic information.

ITSFEA includes a parallel provision for broker-dealers in what is now section 15(g) of the Exchange Act.

[51] Pub. L. No. 100-704, 102 Stat. 4680. See Kaswell, An Insider’s View of the Insider Trading and Securities Fraud Enforcement Act of 1988, 45 Bus. Law 245 (1989), revised & republished in American Bar Association, Securities Law Administration, Litigation, and Enforcement, Selected Articles on Federal Securities Law, Vol. III (1991) at 252.

[52] Aug. 22, 1940, ch. 686, tit. II, § 223, as added Pub. L. No. 111–203, tit. IV, § 411, July 21, 2010, 124 Stat. 1577. The Dodd-Frank Act also amended the Advisers Act to require registration of investment advisers to private funds, i.e., hedge funds. Congress included these changes in a comprehensive expansion of the SEC’s authority in Title IV of the Dodd-Frank Act. By comparison, Congress included custody requirements for registered funds in the original Investment Company Act of 1940 (1940 Act). Section 17(f) of the 1940 Act establishes custody requirements for registered management companies. Other provisions of the 1940 Act establish custody requirements for other types of investment companies, e.g., section 26(a) for unit investment trusts.

[53] See supra note 43.

[54] As discussed below, such a process could include the Commission’s reassessment of those rules and whether it should make any revisions.

[55] SEC v. Capital Gains Research Bureau, 375 U.S. 180 (1963). See also Commission Interpretation Regarding Standards of Conduct for Investment Advisers, IA-5248 (June 5, 2019); 84 Fed. Reg. 33669 (July 12, 2019) (hereinafter Interpretive Release). The Interpretive Release at note 20 discusses whether negligence or scienter is sufficient for a violation of section 206:

Claims arising under Advisers Act section 206(2) are not scienter-based and can be adequately pled with only a showing of negligence. Robare Group, Ltd., et al. v. SEC, 922 F.3d 468, 472 (D.C. Cir. 2019) (‘‘Robare v. SEC’’); SEC v. Steadman, 967 F.2d 636, 643, n.5 (D.C. Cir. 1992) (citing SEC v. Capital Gains, supra footnote 2) (‘‘[A] violation of § 206(2) of the Investment Advisers Act may rest on a finding of simple negligence.’’); SEC v. DiBella, 587 F.3d 553, 567 (2d Cir. 2009) (‘‘the government need not show intent to make out a section 206(2) violation’’); SEC v. Gruss, 859 F. Supp. 2d 653, 669 (S.D.N.Y. 2012) (‘‘Claims arising under Section 206(2) are not scienter-based and can be adequately pled with only a showing of negligence.’’). However, claims arising under Advisers Act section 206(1) require scienter. See, e.g., Robare v. SEC; SEC v. Moran, 922 F. Supp. 867, 896 (S.D.N.Y. 1996); Carroll v. Bear, Stearns & Co., 416 F. Supp. 998, 1001 (S.D.N.Y. 1976).

This article is not urging that the Congress or the Commission reduce the SEC’s antifraud authority. Instead, the Commission should have greater flexibility to characterize some behavior as fraud and other behavior as wrongful, but of less severity. It is interesting that the Interpretive Release does not specifically discuss custody with regard to an adviser’s fiduciary duty. For example, the Interpretive Release provides that an adviser’s fiduciary duty includes the duty of care. It then notes that:

The duty of care includes, among other things: (i) The duty to provide advice that is in the best interest of the client, (ii) the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades, and (iii) the duty to provide advice and monitoring over the course of the relationship.

Id. at 33672. Without question, an investment adviser has a fiduciary duty to protect the assets over which it has custody. Lemke & Lins, supra note 26.

[56] Office of Information and Regulatory Affairs, Office of Management and Budget, Executive Office of the President, Securities and Exchange Commission, Amendments to the Custody Rule, RIN 3235-AM32, Fall 2019. The Division is considering recommending that the Commission propose amendments to existing rules and/or propose new rules under the Investment Advisers Act of 1940 to improve and modernize the regulations around the custody of funds or investments of clients by investment advisers.

[57] Many investment advisers consider the custody rule to be extremely complex. Lemke et al., supra note 27, at § 3:62.