We have been hearing (and writing) for some time now about the wave of consolidation expected to ripple through the banking industry, especially with respect to the community bank sector. Although the pace of mergers and acquisitions has been healthy, the industry has yet to see the anticipated wave of consolidation. However, legislative, regulatory, and economic changes are creating an environment ripe for mergers, acquisitions, and other strategic transactions in the banking sector. As we examine in this article, the changes that have occurred in the last year are opening the gates for consolidations, but it remains to be seen whether such consolidations are pursued and can successfully overcome the challenges of deal making.
Legislative Changes
Congress recently passed the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018 (the Crapo Act),[1] which provides regulatory relief for many banks, and will have a substantial effect for the community bank sector.[2] The Crapo Act grants relief to community banks on a few important fronts.[3] Relief from the Crapo Act includes capital simplification, extended examination cycles, reduced reporting requirements, and increased simplicity for small bank holding companies to finance bank acquisitions.
Specifically, the Crapo Act raised eligibility thresholds for an extended examination cycle from $1 billion to $3 billion in assets and made short-form call reports available for banks under $5 billion.[4] Community banks, generally those banks with assets less than $10 billion, are also granted relief from the prohibitions on proprietary trading and relationships with hedge funds and private equity funds under the so-called Volcker Rule, at least to the extent that they were actually engaged in those relationships.[5]
In addition, with the Democratic takeover of power in the U.S. House of Representatives in the 2018 mid-term elections, Representative Maxine Waters (D-CA) has taken the helm of the House Financial Services Committee. The banking sector generally should expect heightened scrutiny from the new chair, but this is likely to focus at least initially on the larger banks with more publicized regulatory challenges. This also means that the relief granted by the Crapo Act is likely the only legislative relief for the banking sector for the foreseeable future.
Regulatory Change
For bank holding companies, the Crapo Act amended the asset threshold for applicability of the Federal Reserve’s Small Bank Holding Company Policy Statement (the Policy Statement), which was implemented in August of 2018 and became effective the same day the interim final rule was released. Through the legislation, the asset threshold was raised from $1 billion to $3 billion in total consolidated assets.[6] The Policy Statement also applies to savings and loan holding companies with less than $3 billion in total consolidated assets.
In 1980, recognizing the challenges of small bank holding companies accessing the capital markets through equity financing, the Federal Reserve adopted the Policy Statement to permit small bank holding companies to assume debt at levels higher than typically permitted for larger bank holding companies.[7]
Under the Policy Statement, holding companies meeting the specific qualitative requirements may use debt to finance up to 75 percent of an acquisition, subject to the following ongoing requirements:
Small bank holding companies must reduce their parent company debt consistent with the requirement that all debt be retired within 25 years of being incurred. The Federal Reserve also expects that these bank holding companies reach a debt-to-equity ratio of .30:1 or less within 12 years of the incurrence of the debt. The bank holding company must also comply with debt servicing and other requirements imposed by its creditors.
Each insured depository subsidiary of a small bank holding company is expected to be well capitalized. Any institution that is not well capitalized is expected to become well capitalized within a brief period of time.
A small bank holding company whose debt-to-equity ratio is greater than 1:1 is not expected to pay corporate dividends until such time as it reduces its debt-to-equity ratio to 1:1 or less and otherwise meets the criteria set forth in Regulation Y.[8]
This update to the asset threshold is the third time the Policy Statement has been amended.[9] When the Policy Statement was first adopted in 1980, there were more than 14,000 commercial banks according to the FDIC’s Historical Bank Data. Today, there are less than 4,800 commercial banks.[10] Bank failures have played a role in the decline in the number of banks, but so have mergers and acquisitions. For example, in the past decade there have been approximately 2,300 bank mergers in the United States.[11] This increased asset threshold for small bank holding companies to take advantage of the Policy Statement should encourage further consolidation in the community bank sector.
Economic Conditions
In addition to the legislative and regulatory changes over the past year that have further opened the gates for bank consolidation, the economic climate also appears to be a significant factor; however, it is perhaps a challenge for some banks as well. Banks are making money and growing. With rising interest rates, solid earnings, and healthy valuations, it would appear that the market is ripe for deals. Despite the healthy economy over the last few years, however, banks and investors are searching for deals at the right price with long-term sustainability. Some would-be acquirers are sitting out until valuations come down or a clearer path to long-term deposit and earnings growth emerges.
Overall in 2018, the underlying theme for bank deals involved “sellers in high-growth markets finding buyers willing to pay healthy premiums for market share.[12] The average premium paid was 172 percent of tangible book value of the seller, which was an increase over the 165-percent average premium from 2017.[13] Acquirers continue to search for core deposits and low loan-to-deposit ratios, even in remote markets. For example, earlier in 2018, Trinity Capital in Los Alamos, NM, sold itself to Enterprise Financial Services in Missouri after going to market to sell itself. In that deal, Trinity Capital’s strong core deposits and loan-to-deposit ratio of 65 percent rewarded the bank with a price that was 202 percent of its tangible book value.[14]
Although less remote compared to its current footprint, Delmar Bancorp in Maryland agreed in 2018 to purchase Virginia Partners Bank in Virginia, where the deal will bring Delmar its first branches in the neighboring state. In another deal announced in 2018, Cambridge Bancorp in Massachusetts agreed to buy Optima Bank and Trust in New Hampshire with a valuation of 191 percent of tangible common equity. In that deal, Cambridge indicated that the deal was consistent with its growth strategy because of the focus on growth in its wealth-management business line.
At the end of the day, increasing shareholder value is paramount, and whether that is accomplished through organic growth, partnerships, or acquisitions will depend on the institution’s board of directors and particular growth strategy.
Ongoing Challenges
Despite the encouragement for consolidation, challenges persist. Some banks are sidelined with compliance struggles, whereas others are finding it difficult to get to the right price for shareholders. Bank boards of directors are having difficulty in some cases determining the right price at which to buy another institution or sell itself. In many cases, the price targets for the buyer and the seller are just too far apart as sellers seek healthy valuations and buyers worry about the potential short-term devaluation in share price and, in many cases, the longer-term view of the economy.
Banks also continue to face the challenges of financial technology companies, both from competition and partnership opportunities. Financial technology firm Robinhood Financial, for example, recently announced that it would be offering a version of a bank account, Robinhood Checking & Savings, which promises a three-percent interest rate. Although not subject to the same regulations, banks are struggling to compete with these financial institutions nonetheless.
Finally, there are the ongoing challenges of the regulatory approval process after the deal is struck. Filing requirements, newspaper notices, and timing considerations present an entirely separate stage of challenges in the M&A process that must be managed with precision through consummation.
Conclusion
Although it is too early to tell whether 2019 will finally be the year of the merger wave, recent legislation, regulatory relief, and current economic conditions appear to have opened the gates to consolidation, as evidenced by the recent announcement of the proposed merger between SunTrust and BB&T. However, the market will ultimately tell us whether the challenges associated with successful deal making have been overcome by the many or the few.
[1] Economic Growth, Regulatory Relief, and Consumer Protection Act, Pub. L. 115-174 (hereinafter Crapo Act).
[2] Federal Reserve Statistical Release, Large Commercial Banks as of March 31, 2018; see also, Federal Reserve, National Information Center (there were 4,748 commercial banks, 489 savings banks, and 172 savings and loans chartered in the United States with assets less than $10 billion as of March 31, 2018).
[3]See Gregory J. Hudson & Joseph E. Silvia, Crapo Helps Community Banks, 135 Banking L. J. 456 (Sept. 2018) (discussion on how the Crapo Act reduces the regulatory burden for community banks).
[4]See Gregory J. Hudson & Joseph E. Silvia, Recent Legislation Encourages Bank M&A Activity, Bus. Law Today, Dec. 2018 (discussion on how the Crapo Act encourages mergers and acquisitions in the community bank sector).
[5]See Crapo Act, supra note 1, at § 203. On December 21, 2018, the federal banking agencies, as well as the Securities Exchange Commission and the Commodity Futures Trading Commission, released a Notice of Proposed Rulemaking to implement this section of the Crapo bill exempting community banks from certain prohibitions under the Volcker Rule. With the legislative revisions to the Volcker Rule, banks under $10 billion in assets will be exempt from the Volcker Rule’s restrictions if the bank’s total trading assets and trading liabilities are no more than five percent of the bank’s total consolidated assets.
[7] Regulation Y, 12 C.F.R. § 225, Appendix C to Part 225 (Small Bank Holding Company and Savings and Loan Holding Company Policy Statement).
[8]See 12 C.F.R. §§ 225.14(c)(1)(ii), 225.14(c)(2), and 225.14(c)(7).
[9] The Small Bank Holding Company Policy Statement was previously amended in 2006 to raise the asset threshold from $150 million to $500 million. See 71 Fed. Reg. 9902 (Feb. 28, 2006). In 2015, the asset threshold was raised from $500 million to $1 billion, and the scope of the Policy Statement was expanded to include savings and loan holding companies. See 80 Fed. Reg. 20158 (Apr. 15, 2015).
[10]See FDIC Statistics at a Glance (Sept. 30, 2018).
[11]See FDIC Statistics at a Glance, Historical Trends (Sept. 30, 2018).
[12] See Davis, Paul, Top bank M&A deals of 2018, Am. Banker, Dec. 23, 2018.
The organizational law of limited liability companies (LLCs) and partnerships has always fundamentally embraced an idea known as the “pick-your-partner principle,” under which transfers of a member’s or partner’s ownership interest are restricted by statute, and those restrictions may be tightened or loosened by agreement. In recent years the pick-your-partner principle has interacted in complex and not always practical ways with Article 9 of the Uniform Commercial Code (UCC). Since 2001, UCC §§ 9-406 and 9-408 have overridden a broad range of statutory and agreement-based anti-assignment provisions, subject to complex exceptions that have tended to protect the pick-your-partner principle in many significant respects, while also proving analytically very difficult to handle. Recently, however, in an important step forward, Article 9’s overrides of anti-assignment provisions have been amended to make them simply inapplicable to LLC and partnership interests.
One hopes that these amendments to Article 9’s overrides (hereinafter the “2018 amendments” because they were approved last year) will soon be enacted by the states, but in the meantime, the current overrides will remain on the books in various jurisdictions with all of their existing complexities. Accordingly, this article focuses not only on the 2018 amendments, but also on an analysis of the overrides as they now stand, as applied to LLC and partnership interests. The amendments themselves are quite simple, but the article discusses them only after analyzing the overrides because the amendments are more easily understood against that background.
I. Background on Unincorporated Organization Law and UCC Article 9
Any co-owner of a privately held business organization may have a substantial stake in determining who the other co-owners are. If a second co-owner has the power to transfer its interest to a stranger, then the second co-owner can, in effect, force the first co-owner into a venture with the stranger/transferee without the first co-owner’s consent. The policy and effect of the pick-your-partner principle under LLC and partnership law is to prevent such an outcome.
UCC Article 9, by contrast, has the very different policy orientation of facilitating voluntary transfers of personal property. Article 9’s most familiar application is to transfers of property as security for the repayment of loans, but Article 9 also applies to outright sales of certain types of personal property. Some of these transfers and outright sales are precisely those that the pick-your-partner principle seeks to prevent, and as a result, for personal property consisting of LLC or partnership interests, the interaction of the pick-your-partner principle with Article 9 has been complex and thorny. Some have even called it recondite.
Ownership interests in a business organization, particularly one that is unincorporated, can be formally or informally bifurcated into governance rights and economic (or financial) rights. Governance rights consist of the owner’s right to vote on, consent to, or otherwise make decisions about the organization’s activities, and the right to receive information about the organization. Economic rights consist of the owner’s entitlement to receive monetary distributions from the organization, whether from its profits or from an eventual dissolution and winding up. A complete ownership interest typically comprises both governance rights and economic rights. A good example of purely economic rights is a transferable interest in an LLC or limited partnership. See, e.g., Uniform Limited Liability Company Act (ULLCA) § 102(24) (2013).
Article 9 broadly covers ordinary security interests in both of the above aspects of ownership rights as well as in virtually all other personal property, plus the outright sales of some types of personal property, to be explained below. In light of this vast coverage, and in order to provide appropriately tailored rules for particular patterns of transaction, Article 9 subdivides personal property into an array of statutorily defined “types,” or classifications. The most important classification for purposes of this article is general intangibles, which is Article 9’s residual or catch-all classification, meaning that it includes any personal property that does not fall within the other Article 9 classifications. Hence, an asset is a general intangible only if it is not, for example, inventory or other goods, accounts, instruments, chattel paper, or securities or other investment property. See UCC § 9-102(a)(42). Examples of general intangibles range from trademarks to taxicab medallions, and centrally for purposes of this article, the category includes most LLC and partnership interests. (LLC or partnership interests may alternatively be classified as securities, using an opt-in process discussed in Part II.C.)
The other key type of property for purposes of this article is payment intangibles, which is a subset of general intangibles. The distinction between a general intangible that is also a payment intangible on one hand, and a general intangible that is not a payment intangible on the other, is that the former includes only general intangibles under which the “principal obligation” of the “account debtor” is “a monetary obligation.” § 9-102(a)(62). In this article, the important term “account debtor” may be understood simply as the entity that is obligated on a payment intangible or other general intangible, i.e., the LLC or partnership itself as opposed to its members or partners. To determine whether the “principal obligation” is “monetary,” one must weigh the relative importance of a member’s or partner’s governance and economic rights: if the LLC’s or partnership’s principal obligation in respect of the ownership interest is economic and thus “monetary,” then the ownership interest is a general intangible that is also a payment intangible (or simply “payment intangible” for short). Otherwise, the ownership interest is a general intangible that is not a payment intangible. In general, if a member or partner has governance rights that the LLC or partnership is obligated to respect, the ownership interest is likely a general intangible that is not a payment intangible.
This distinction between payment intangibles and other general intangibles affects Article 9’s scope, which is crucial to understanding the overrides because of course the overrides apply only within that scope. Article 9’s scope includes two principal types of transactions relevant to this article: interests in either payment intangibles or other general intangibles that secure a loan or another obligation (referred to in this article as ordinary security interests), and outright sales of payment intangibles. In fact, outright sales of payment intangibles are statutorily defined in Article 9 as “security interests,” purely as a matter of terminological convenience, because many (though not all) of Article 9’s rules for ordinary security interests also apply directly to sales of payment intangibles. By contrast, Article 9’s scope does not include outright sales of general intangibles that are not payment intangibles, because most of such sales have little enough in common with ordinary security interests that inclusion would not be sensible. (The boundary between an outright sale of property and an ordinary security interest in the property is not always self-evident, but that topic is beyond the scope of this article. See, e.g., § 9-109 cmt. 4.) One final note on Article 9’s scope is that transfers by gift or, generally, transfers by operation of law are not covered.
Bringing these strands together, Article 9 typically does not apply at all to the most common kind of transfer in this area—namely, outright sales of a member’s or partner’s complete ownership interest—because such a transaction is typically the sale of a general intangible that is not a payment intangible. By the same token, Article 9 does not apply to outright sales of a member’s or partner’s governance rights alone. But Article 9 does apply, and hence its overrides discussed below might apply, to ordinary security interests in complete ownership interests; to ordinary security interests in economic rights alone; and to outright sales of economic rights alone.
The fact that Article 9 applies to a particular transaction, though, does not necessarily mean that there is a practical conflict between an Article 9 override and the pick-your-partner principle. Whether a practical conflict exists depends on three elements. First, do the applicable statutes governing the organization directly restrict transfers? Such restrictions are universal or nearly so in the case of governance rights and complete ownership interests (e.g., ULLCA § 407(b)(2) (2013)), but they are nonexistent or nearly so in the case of economic rights (e.g., id. § 502(a)). Second, do the LLC’s or partnership’s own organic documents alter (or perhaps track) the statutory law just mentioned, for example by restricting transfers of economic rights? Organizations may indeed adopt restrictions on the transfer of economic rights, in order to ensure that all owners retain their economic stake in the organization and, as a result, have reasonably well-aligned governance incentives. And finally, if a restriction on transfer is imposed by either of the foregoing sources, does one of the Article 9 overrides invalidate or limit the restriction?
II. Navigating Unamended §§ 9-406 and 9-408
Part of what makes Article 9’s overrides of anti-assignment provisions difficult is that they appear in two separate sections that are phrased quite similarly, but have subtle distinctions, and do not overlap. The first override, in § 9-406, is relatively strong and simple in its effects, but it applies to only a narrow set of transactions. The second override, in § 9-408, applies more broadly and is more complex in its provisions that apply to LLC and partnership interests, but it has only relatively weak effects on the transactions to which it applies. Taking into account the narrowness of the first and the weakness of the second, plus the availability of the opt-in process discussed in Part II.C, the overrides have generally not posed substantial problems for those who seek the protection of the pick-your-partner principle. On the other hand, general conclusions only take one so far in particular transactions.
A. Section 9-406
Article 9’s first override, beginning at § 9-406(d), invalidates any “term in an agreement between an account debtor and an assignor” to the extent that that term “prohibits, restricts, or requires the consent of . . . the account debtor” to “the assignment or transfer of, or the creation, attachment, perfection, or enforcement of a security interest in . . . the payment intangible.” The simplicity of this provision is evident from its shortness, and the strength of this provision is that it overrides restrictions on all aspects of security interests, including “enforcement,” as further discussed below.
The § 9-406 override is narrow, however, in three important ways. First, it applies only to payment intangibles (leaving aside its application to other types of property not relevant to this article), and only to ordinary security interests in them. See § 9-406(e). In other words, the override does not apply to transfers of governance rights, in either an outright sale or an ordinary security interest; and it does not apply to transfers of a complete ownership interest in either an outright sale or an ordinary security interest, assuming that the complete ownership interest is a general intangible that is not a payment intangible. Nor does the override apply to an outright sale of a payment intangible (other than a foreclosure sale or a secured party’s acceptance of the payment intangible in satisfaction of the obligation it secures). See the discussion of § 9-408 in Part II.B. The narrowness of the § 9-406 override is important as a practical matter because when an LLC’s or partnership’s organic documents impose restrictions on transfer, the restrictions sometimes apply by their own terms only to governance rights or complete ownership interests, not to purely economic rights (classified as payment intangibles) in the first place.
Second, the § 9-406 override has no effect on an anti-assignment clause in an agreement among the organization’s members or partners inter se, as opposed to terms in an agreement with the organization itself. This is because the override applies only to terms in an agreement with “an account debtor” and the assignor/transferor, and as noted in Part I, the LLC or partnership itself, rather than the other members or partners, is the account debtor in this context. Moreover, there may be substantial grounds to question whether the override applies even to an anti-assignment clause that is set forth directly in the organization’s operating agreement, partnership agreement or other organic documents, because as a formal matter, an LLC or partnership is usually not a party to these agreements. On the other hand, substance-over-form arguments should be borne in mind on this point.
Third and relatedly, if the term of the agreement imposes a consent requirement, the override applies only if the consent required is that of the LLC or partnership itself, as opposed to one or more members or partners. For example, if an LLC is member-managed, the agreement will almost certainly require the consent of the members, and accordingly, the override will not apply to that requirement.
B. Section 9-408
Article 9’s other override, beginning at § 9-408(a), invalidates any term in “an agreement between an account debtor and a debtor which relates to . . . a general intangible” that “prohibits, restricts, or requires the consent of . . . the account debtor” to “the assignment or transfer of, or creation, attachment, or perfection of a security interest in . . . the . . . general intangible.” It also invalidates any provision of a statute or other rule of law that similarly “prohibits, restricts, or requires the consent of . . . [an] account debtor” to “the assignment or transfer of, or creation of a security interest in, a . . . general intangible.” Thus § 9-408 is more complex than § 9-406 as applied to LLC and partnership interests, because it overrides not only terms of agreements, but also statutes or other rules of law. (Although § 9-406 also overrides some statutes or other rules of law, it does so only for classifications of collateral that are not relevant to this article.)
Section 9-408 is also broader than § 9-406 in two additional ways. First, it applies to a broader range of transactions, namely outright sales of payment intangibles (statutorily included in Article 9’s term “security interest,” as noted in Part I) and ordinary security interests in general intangibles that are not payment intangibles. Outright sales of economic rights, covered here, perhaps are more common than ordinary security interests in them, covered in §9-406; and certainly general intangibles that are not payment intangibles is the most common classification of an LLC or partnership interest.
Second, the statutes that § 9-408 overrides are of broad applicability because they are restrictions on the transfer of general intangibles that are not payment intangibles, i.e., virtually all complete ownership interests, plus all governance rights taken alone. As a practical matter, such statutory restrictions are nearly universal in this area, though a particular organization’s organic documents may sometimes alter the statutory default rules.
On the other hand, just as for § 9-406 above, § 9-408 does not apply to an anti-assignment clause in an agreement among the organization’s members or partners inter se, as opposed to an agreement with the organization itself. Similarly, and again just as for § 9-406, if the term of the agreement imposes a consent requirement, § 9-408 applies only if the consent required is that of the organization itself, as opposed to one or more members or partners. This override of consent requirements, in § 9-408 unlike § 9-406, extends to statutes as well as terms in an agreement, but nonetheless only if the consent required is that of the organization itself as opposed to one or more members or partners—but this is not how the LLC and partnership statutes work. Instead, the statutes place the power to give or withhold consent in the hands of the members or partners themselves.
The feature of this override that makes its effects relatively weak, and thereby substantially accommodates parties seeking the protection of the pick-your-partner principle, is that § 9-408 invalidates restrictions only on the “creation, attachment, or perfection” of security interests. It does not, unlike § 9-406, invalidate restrictions on “enforcement” of security interests. Subsection 9-408(d) amplifies on this point by specifying among other things that, even giving effect to the § 9-408 override, a security interest that is subject to an otherwise enforceable restriction is “not enforceable” against the “account debtor” (i.e., the LLC or partnership itself), and “does not entitle the secured party to enforce the security interest.” In other words, under § 9-408, a security interest (including an outright sale of a payment intangible) may go forward as between the transferor and transferee, but not as between the transferee and the LLC or partnership. The secured party acquires property rights (an ordinary security interest or an ownership interest) to the transferring member’s or partner’s ownership interest, and the value of these rights would be respected, for example in a bankruptcy of the transferor, or as applied to proceeds from a transfer not affected by a restriction. See UCC § 9-408 cmt. 7. But the secured party is nonetheless without power of its own to step into the transferor’s shoes and exercise the transferor’s governance or economic rights.
Summarizing the substance of the two overrides, it is useful to think in terms of four permutations, based on the two classifications of collateral and the two forms of transaction. First, an outright sale of a general intangible that is not a payment intangible is not within the scope of Article 9, so neither override applies. Second, with an ordinary security interest in a general intangible that is not a payment intangible, the relatively weak override in § 9-408 applies, so that the secured party cannot enforce the transferred governance or economic rights against the organization. Third, with an outright sale of a payment intangible, again the relatively weak override in § 9-408 applies, so that the secured party cannot enforce the transferred rights against the organization. And fourth, with an ordinary security interest in a payment intangible, the relatively strong override in § 9-406 applies, so that the secured party can enforce the transferred rights against the organization. The Permanent Editorial Board for the Uniform Commercial Code (P.E.B.) is considering issuing a report that would further detail the application of both overrides to LLC and partnership interests.
C. Opting into Article 8
Neither of the Article 9 overrides applies to property that is a security as defined in UCC Article 8. This is because securities are classified by Article 9 as “investment property” rather than as general intangibles or, a fortiori, payment intangibles.
The term “security” generally does not include ownership interests in LLCs and partnerships, but it does include them if the “terms” of the ownership interest “expressly provide that it is a security” governed by Article 8. See §§ 8-102(a)(15), 8-103(c). Hence, one established way for transactional lawyers to avoid the overrides altogether is to have the organization “opt in” to Article 8 by adopting appropriate provisions in its organic documents. Related measures include providing for the security to be certificated or uncertificated, and preventing the organization from opting back out of Article 8 without the consent of the parties concerned.
III. The 2018 Amendments, Non-Uniform Amendments, and Choice of Law
Compared to the complex analysis in Part II, enactment of the 2018 amendments will markedly simplify the law in this area, eliminating the possible conflicts with the pick-your-partner principle that can remain despite the exceptions in §§ 9-406 and 9-408, and without the need for an Article 8 opt-in.
The 2018 amendments statutorily provide that Article 9’s overrides do not apply to “a security interest in an ownership interest in a general partnership, limited partnership, or limited liability company.” (In § 9-406, this language appears in a new subsection (k), which explicitly applies to subsections (d), (f), and (j). In § 9-408, the same language appears in a new subsection (f), which explicitly applies to the entire section.) A new comment to § 9-408 reads:
This section does not apply to an ownership interest in a limited liability company, limited partnership, or general partnership, regardless of the name of the interest and whether the interest: (i) pertains to economic rights, governance rights, or both; (ii) arises under: (a) an operating agreement, the applicable limited liability company act, or both; or (b) a partnership agreement, the applicable partnership act, or both; or (iii) is owned by: (a) a member of a company or transferee or assignee of a member; or (b) a partner or a transferee or assignee of a partner; or (iv) comprises contractual, property, other rights, or some combination thereof.
A new comment to § 9-406 provides that the § 9-408 comment applies to § 9-406 as well.
By excluding from the overrides a “security interest” in an ownership interest, when other law prevents outright sales of payment intangibles, ordinary security interests in payment intangibles, or ordinary security interests in general intangibles from going forward (and the relevant property is an ownership interest), Article 9 does not interfere with the effect of that other law. On the other hand, the overrides remain in effect (so that transfers continue to be enabled) for general intangibles that are not LLC or partnership interests and for other classifications of personal property that are not relevant to this article.
The 2018 amendments were initially recommended by the P.E.B. in conjunction with representatives from the Joint Editorial Board on Uniform Unincorporated Organization Acts. They were then approved in accordance with the respective procedures of the UCC’s two sponsoring organizations, the American Law Institute and the Uniform Law Commission. As a result, they are now a part of the UCC’s official text.
At the time of this writing, it is too early for the 2018 amendments to have been enacted in any jurisdiction. On the other hand, in recent years a number of states, led by Delaware, have enacted non-uniform provisions having the same thrust. Some of the non-uniform provisions appear in the enacting states’ UCC; others appear in their LLC and partnership organizational statutes; and others appear in both spots, as belt and suspenders and to ensure they will be found.
An important conflict-of-laws question can arise if a transaction involves elements from more than one jurisdiction, one of which has the unamended Article 9 overrides, and another of which has an eventual enactment of the 2018 amendments (or an existing, comparable non-uniform provision). Article 9’s conflicts rule for perfection and priority of security interests in general intangibles does not apply to the treatment of transfer restrictions, because this issue is neither “perfection,” “the effect of perfection or nonperfection,” nor “priority.” See § 9-301(1). Article 1’s main catch-all conflicts rule, which leaves some conflicts questions to the agreement of the parties, would also generally be inappropriate here because transfer restrictions inherently present a three-party question that is not amenable to treatment by two-party agreement. See § 1-301(a). Accordingly, a choice-of-law clause in the security agreement or other agreement between transferor and transferee does not control, as Comment 3 to § 9-401 makes clear. Instead, one would hope that a court would apply the version of the overrides enacted by the jurisdiction in which the entity is organized, as the same Comment assumes. (The “internal affairs” doctrine in business entity law would also be consistent with such an outcome, although of course, restrictions on transfers to nonmembers or nonpartners are not strictly internal affairs issues.) In any case, the bottom line is that real certainty in this area will most promisingly have to come from broad enactment of the 2018 amendments. The members of each state’s Uniform Law Commission delegation can often be of direct help in those enactment efforts.
IV. Conclusion
The 2018 amendments will protect the pick-your-partner principle while also greatly simplifying and clarifying its interactions with Article 9. By the same token, as is often true of simple rules, the 2018 amendments may also sometimes reach more broadly than really needed, for example by preventing simple attachment and perfection, without enforcement, of a security interest in a complete ownership interest. However, those transactions can continue to go forward despite the 2018 amendments by means of, for example, the Article 8 opt-in, or other amendment or waiver of the organization’s organic documents. On balance, the gains in this area from simplicity and clarity should clearly outweigh the losses from the occasional extra burden to an Article 9 transaction.
*Carl S. Bjerre is Kaapcke Professor of Business Law at the University of Oregon School of Law. Daniel S. Kleinberger is Emeritus Professor of Law at Mitchell Hamline School of Law. Edwin E. Smith is a partner at Morgan, Lewis & Bockius LLP. Steven O. Weise is a partner at Proskauer Rose LLP.
For the first time in 15 years, Rule 23 of the Federal Rules of Civil Procedure has been amended. The amendments mostly address class settlements, and they come during a pivotal time for class litigation. With changeups in the composition of the Supreme Court and circuits across the nation split on many class action issues, the long-term impact of these amendments on federal class action practice is likely to be significant.
The changes further codify precedent establishing that Rule 23’s requirements are rigorous, including in the context of settlement. On the one hand, the changes should afford more certainty in the settlement process. On the other, the amendments may be a harbinger of stricter standards for class-wide settlements. The new rules contemplate increased court involvement and scrutiny, and will likely increase settlement costs and, by extension, the potential for more class action trials.
In this article, we briefly describe the amendments to Rule 23, dive into the commentary, and flag some of the more nuanced changes that may be coming for all involved in class litigation.
Rule 23’s New Notice Requirements
Rule 23(c)(2), which governs notice to class members, has long required “the best notice [to class members] that is practicable under the circumstances,” without explaining how that notice should happen. The new amendments clarify that notice can be conveyed by various means including electronically. At first glance, this amendment appears to simply reflect the trend of allowing notice via modern technology, a boon to settling defendants who previously have incurred substantial printing and mailing costs.
But the amendments do more than simply indicate courts can allow notice by means like email. The place to dig in is the extensive commentary, which suggests that courts take a harder look at what notice will be “appropriate” under the circumstances. Whereas before all courts had to consider was the “best practicable” standard, now courts must consider what is “appropriate.” The comments confirm that the difference matters.
The advisory committee cautions that the appropriate form of notice will depend on the characteristics of each particular class, and it will be important to evaluate the unique circumstances of each case in choosing the right method (or combination of methods). For example, notice by electronic means may make sense in a class action asserting technology-based claims. But such means might not be appropriate in other contexts, especially when (for example) the notice is being provided to a special population, such as the elderly.
Indeed, the committee emphasizes that in deciding what is an “appropriate” notice, courts should evaluate the “content and format” of the notice, depending on the audience. This signals that courts will be expected to take a more active role in ensuring that notice fairly informs the class members of their rights in an understandable, reasonably clear manner.
The committee explains that the overall governing standard is to enable the class to make “informed decisions” about whether to opt-out, saying that “attention should focus” on ensuring that there is a “convenient as possible” method. Note the committee did not say a practical or appropriate method—but the most “convenient” after being sufficiently informed. What information class members will need to be sufficiently informed, and what will be a sufficiently convenient opt-out mechanism will certainly be adjudicated in the months to come.
All of this commentary suggests that courts might accept the invitation to take a harder look at the notice process, pushing the parties and counsel to spend more time and resources (and potentially seek expert help) to create—and validate—a notice process. Defense counsel may use the changes to press for less costly notice methods (e.g., those not requiring postage); plaintiffs’ counsel may use them to push for multiple notice methods to try to up the claim rate.
Preliminary Class Settlements on the Ropes
The amendments upend the standard for seeking preliminary approval before class notice is sent out. The commentary highlights that giving notice “is an important event” and should only be done if there is a “solid record supporting the conclusion that the proposed settlement will likely earn final approval.” Parties seeking settlement approval under Rule 23(e)(1) must now show that the court will be able to approve the settlement and, if no class is certified yet, “certify the class for purposes of judgment on the proposal.”
Overall, these changes suggest that parties must make a much higher showing at the preliminary stage. That includes details about anticipated litigation outcomes, the risks of continuing the litigation, and other pending or anticipated litigation that is related. Courts already generally considered such factors, but the amendments now suggest they should always be assessed. As a practical matter, these amendments are likely to lead to more aggressive class discovery earlier in the case. At the point at which the parties seek preliminary approval, the parties must now demonstrate both class certification and final approval are warranted. Indeed, the commentary suggests that the parties should be ready to submit all facts and arguments that they would typically raise in the final approval hearing at the “new” preliminary approval stage.
The committee notes now also make clear that defendants will not be prejudiced if things go south during the settlement approval (perhaps anticipating fewer proposed settlements will be approved under this new rubric): “[i]f the settlement is not approved, the parties’ positions regarding certification for settlement should not be considered if certification is later sought for purposes of litigation.”
Another point raised by the commentary is the concern about the disconnect in many cases between attorney fees and benefits to the class. The committee notes that “[i]n some cases, it will be important to relate the amount of an award of attorney’s fees to the expected benefits to the class. One way to address this issue is to defer some or all of the award of attorney’s fees until the court is advised of the actual claims rate and results.” In other words: courts should see what benefit goes to the class before approving the settlement and fees. This concern about class relief and attorney’s fees is commonly raised in courts across the country, and many believe the Supreme Court will wade into the issue soon. The increased scrutiny on plaintiffs’ counsel fee awards make another appearance in the new settlement standards, which we tackle next.
Changing Up Class Settlements
Rule 23(e)(2) requires that a court approve a settlement “after a hearing and only on finding that it is fair, reasonable, and adequate.” The big change is that Rule 23 now sets out criteria for making this determination, codifying a standard that previously varied from court to court. Such considerations include:
The adequacy of class representatives and class counsel;
Whether the settlement was negotiated fairly;
The adequacy of the relief provided to the class; and
Whether class members were treated equitably relative to each other.
The streamlining alone provides increased certainty. There should be fewer questions as to what factors will direct the court’s decision; before, there could be a dozen factors (or more). This made settlements unpredictable and drove up litigation costs. Under the new criteria, it should also be easier to determine the likelihood of settlement approval—but that increased certainty comes at a cost.
By picking some factors and leaving out others, the amendments change the state of play. First, the amendments and commentary place a stronger emphasis on the parties’ process for litigating the case and negotiating. This may require counsel to engage in more thorough negotiations—and keep better documentation of the process. The notes also point out that involving a mediator or other neutral party can help.
Another new focus is the relief provided to the class and attorney’s fees. This is a hot-button issue, as the “relief actually delivered to the class” will now be a “significant factor” in approving attorney awards. The committee is also “concern[ed]” about “inequitable treatment of some class members vis-à-vis others.” This is likely a nod to creative settlement strategies like cy pres and pro rata distributions. Tightening the standards for attorney fees and class relief may make it nearly impossible to settle cases alleging de minimis damages and difficult-to-ascertain classes (like the Frank v. Gaos case at the High Court right now).
The committee notes also suggest more scrutiny should be leveled on class counsel and the class representative. Rather than just rely on the resumes and boilerplate submitted by the attorneys, the committee presses courts to look at how counsel has handled the case itself.
Cracking Down on Bad-Faith Objectors
The rise in “professional objectors” has not been well received. These rent-seeking attorneys hope one or both of the parties will quickly pay them rather than risk delaying the settlement. The Rules used to allow any class member to simply object. Now, an objection must “state whether it applies only to the objector, to a specific subset of the class, or to the entire class, and also state with specificity the grounds for the objection.” This specificity requirement puts a new burden on those seeking to challenge settlements. Perhaps most importantly, any “payment in connection with an objection” must be disclosed and approved by a court, further discouraging counsel who might wish to buy off objectors from doing so. This means, in turn, that negotiating parties will need try to address the kinds of issues that might draw objections (e.g., relatively small relief versus the claims alleged, varying relief to class members based on criteria that does not withstand scrutiny, or a negotiating process that could be attacked as insufficient).
Concluding Thoughts
Rule 23’s amendments should in some ways lead to a more streamlined, predictable class action settlement process. Predictability should make navigating settlement easier. But there are big changes here, especially when you dive into the extensive commentary.
These rule changes may be signaling changing winds in the notice process and class settlements more generally. Courts will need to consider what constitutes appropriate notice in each case. And the additional scrutiny on class relief and attorney’s fee awards is likely to raise the stakes for plaintiffs and defendants alike.
One of the most famous scenes in the movie “Minority Report” features Tom Cruise’s character Jon Anderton walking through a shopping mall as discrete scanners using iris recognition technology are hard at work, scanning his (and other shoppers’) irises. The scanners identify everyone individually to create a personalized shopping experience through targeted video screen advertisements that we can see change and move as Tom does. Far-fetched fictional technology? In the past 16 years the potential uses for biometric technology has grown (see, e.g., “Minority Report” May Come to Real World with Iris Recognition, Bloomberg Tech., Feb. 1, 2011) and today it is almost reality (see Princeton Identity looks to make “Minority Report” tech a reality, SecurityInfoWatch.com, Sept. 25, 2018).
This article briefly defines and describes some biometric applications presently in use, reviews one state’s statutory response to biometrics, and looks at how some courts are handling lawsuits over the use of biometrics and related privacy law and contract law issues. The article concludes with some practical pointers for businesses and their professional advisers to consider when implementing biometric applications into the business process.
What Are Biometrics?
Biometrics measure and analyze people’s unique physical and behavioral characteristics. Biometrics’ many uses include identification, access controls, testing, and numerous other rapidly evolving business applications. Like all technology, biometrics present both many beneficial applications for businesses and individuals, as well as legal risks.
Examples of biometrics include an individual’s DNA, fingerprints, eyeballs/irises/retinas, voiceprints, handprints, and facial geometry, to name just a few. Some biometrics, like fingerprints and retinal blood vessel patterns, generally do not change over time. Others, like facial geometry, can change over time due to age, illness, or other factors, and thus may adversely impact the accuracy of the biometrics. The uniqueness and potential permanence of biometrics are advantageous from a security perspective to accurately identify and distinguish individuals, plus you do not have to worry about forgetting your biometric password.
How Are Biometrics Used in Business Today?
Businesses presently use, and will continue to use, biometrics (and related technologies) in a wide variety of applications to improve their business processes and their customer and employee interactions, conveniences, and trustworthiness. Some examples include:
Workforce management. Consider a modern update to the time clock for employees logging in and out of work. Instead of workers having to wait in line to retrieve a time card, punch the card into a time-stamping machine, and then replace the time card into its slot, biometric readers allow workers to simply tap their fingerprints onto a biometric fingerprint scanner. This can prevent buddy time-punching and time theft, and increase accountability and security. See the Dixon case discussed below.
Hospitals. Although credit-card data breaches make for major headline news, medical identity theft events plus mistakes caused by hospital physicians and staff mixing up patients’ files are increasingly common, costly, and potentially life-threatening. Biometric technologies can help hospitals and other medical providers avoid these risks.
Banking. The banking industry has been looking into and adopting biometric technologies to help reduce identity theft and improve efficiencies and customer experience in the banking process.
Retail. Tanning salons, health clubs, or similar member-model-based businesses allow their customers to easily enter and use the business facility by using a fingerprint scanner at any of the businesses’ locations for customer identification. See the Sekura case discussed below.
Automotive. Biometrics can be used instead of key fobs to enter and operate an automobile, or to recognize whether the driver is becoming impaired (e.g., tired or texting), which could put the occupant(s) of the vehicle and other people and vehicles around it at risk.
However, if compromised, the same characteristics and advantages of biometrics present a potential threat to the individual owner of the biometric markers and risks to the businesses that use, and are the stewards of, biometric data.
Biometrics are unlike other unique identifiers that are used to access finances or other sensitive information. For example, social security numbers, when compromised, can be changed. Biometrics, however, are biologically unique to the individual; therefore, once compromised, the individual has no recourse, is at heightened risk for identity theft, and is likely to withdraw from biometric-facilitated transactions. (740 ILCS 14/5(c)).
Biometric Information Privacy Statutes
Biometric Information Privacy (“BIP”) is permanently ingrained into the privacy legal risk matrix confronting businesses and individuals, and is under review by state and federal legislators and regulators in the United States and other governments and regulators in the international community. October 2018 marked the 10th anniversary of the Illinois Biometric Information Privacy Act (“BIPA”), 740 ILCS 14/1 et seq., a comprehensive BIP statute that has given rise to a number of class-action lawsuits against businesses.
In addition to the Illinois BIPA, other state and federal legislators have considered, or are considering, legislation concerning biometric information privacy. A couple of states (e.g., Texas, 2009; Washington, 2017) have passed biometric information privacy statutes. Other states have considered, or currently are or will be considering, comprehensive legislation regarding biometric information privacy, or currently mention some biometric information (e.g., fingerprints) in their existing statutes. New legislation concerning BIP is under consideration as the legislative and judicial branches of state and federal governments try to understand the impact BIP has on individuals and businesses today, and whether and how biometric information should be regulated. The Illinois BIPA states: “The public welfare, security, and safety will be served by regulating the collection, use, safeguarding, handling, storage, retention, and destruction of biometric identifiers and information.” 740 ILCS 14/5(g). This fundamental concept is applicable to and should be considered in all BIP legislation, and viewed in light of the unique permanence of biometric data.
BIPA (740 ILCS 14/20) provides that for each negligent violation of the act, a prevailing plaintiff may recover liquidated damages of $1,000 or actual damages, whichever is greater, in addition to obtaining other relief such as an injunction. For each intentional or reckless violation of the act, the plaintiff may recover the greater of liquidated damages of $5,000 or actual damages. In addition, the plaintiff may recover reasonable attorney’s fees and costs, including expert witness fees and other litigation expenses, plus other relief, including an injunction, as the state or federal court may deem appropriate.
In February 2018, SB 3053 was introduced in the Illinois legislature to narrow the application of the Illinois BIPA. The present version of SB 3053 would add language to the Illinois BIPA narrowing it as follows:
(f) Nothing in this Act shall be deemed to apply to an entity collecting, storing, or transmitting biometric information if: (i) the biometric information is used exclusively for employment, human resources, fraud prevention, security purposes; (ii) the private entity does not sell, lease, trade, or similarly profit from the biometric identifier or biometric information collected; or (iii) the private entity stores, transmits, and protects the biometric identifiers and biometric information in a manner that is the same as or more protective than the manner in which the private entity stores, transmits, and protects other confidential and sensitive information.
The proposed SB 3053 amendments to Illinois BIPA may appear to help certain businesses avoid legal liability as described in the proposed amendment, but at the end of the day it does not change the fact that biometric data, if compromised, will potentially increase the risks to the individual represented by the biometric data. Further, such a change in the statute may not lessen the legal risks of those businesses collecting and using employee and/or customer biometric data, or improve the business’s appearance of trustworthiness in the minds of the employees and/or customers (particularly after that individual’s biometric information has been compromised). In addition, a further consideration is how this proposed amendment impacts and furthers BIPA’s stated legislative findings and intent (740 ILCS 14/5). As of this writing, the SB 3053 proposed amendment to the Illinois BIPA has not been passed into law.
BIP presents complex business, legal, and technology issues for legislators to consider. Thus, careful, critical thinking and thoughtful drafting is required in crafting legislation addressing BIP. Congress, state legislators, government regulators, and legislative bodies and regulators in other countries, as well as drafters of international treaties, have been considering, and will continue to consider, legislation regarding BIP. Like most legislation dealing with technologies, BIP legislation will continue to evolve as the law and legislation tries to catch up to rapidly evolving technologies and to the impact of these technologies on society in our global community.
Recent BIPA Court Decisions
Several court decisions regarding BIPA have found that simply alleging a violation of BIPA’s notice and consent provisions alone are not sufficient to support standing to bring the lawsuit. However, other court decisions have found standing when the allegations went beyond merely alleging a failure of notice and consent.
A recent example of one of these BIPA lawsuits is a September 2018 class-action lawsuit filed in the Circuit Court of Cook County against Wendy’s International LLC (the fast food restaurant). Other businesses that have found themselves defending against BIPA lawsuits include Facebook, Lowes Chicago Hotel Inc., Omnicell Inc., Southwest Airlines, and United Airlines. BIPA lawsuits are industry independent and may occur in any industry acquiring and using biometric data. The ultimate outcomes of these and other recently filed BIPA cases is yet to be determined.
In a recent court decision, an Illinois appellate court in Sekura v. Krishna Schaumburg Tan, Inc., 2018 Ill. App. (1st) 180175 (Ill. App. Sept. 28, 2018), had occasion to review BIPA. The plaintiff, Sekura, alleged, among other things:
Defendant, a franchisee of L.A. Tan Enterprises, Inc. (“L.A. Tan”), required customers enrolling in L.A. Tan’s national membership database to have their fingerprints scanned (to allow the customer to use their membership at any of L.A. Tan’s locations). Every time the plaintiff visited an L.A. Tan location, plaintiff was required to scan her fingerprints before using the services.
Plaintiff alleged she had never been:
informed of the specific purposes or length of time for which defendant collected, stored, or used her fingerprints;
informed of any biometric data retention policy developed by defendant or whether defendant will ever permanently delete her fingerprint data;
provided with nor signed a written release allowing defendant to collect or store her fingerprints; and
provided with nor signed a written release allowing defendant to disclose her biometric data to SunLync (the third-party vendor receiving the L.A. Tan biometric data) or to any other third party.
In addition, plaintiff alleged that “in 2013, more than 65% of L.A. Tan’s salons were in foreclosure and that defendant’s customers have not been advised what would happen to their biometric data if defendant’s salon went out of business” and that plaintiff “becomes emotionally upset and suffers from mental anguish when she thinks about what would happen to her biometric data if defendant went bankrupt or out of business or if defendant’s franchisor, L.A. Tan, went bankrupt or out of business, or if defendant shares her biometric data with others.”
The only issue before the appellate court was “whether a harm or injury, in addition
to the violation of the Act itself, is required in order to have standing to sue under the Act.” In its statutory interpretation of BIPA, the court carefully parsed the words of BIPA and examined the available legislative intent. The court concluded that the plaintiff did have standing, reversed the trial court’s dismissal, and remanded the case back to the trial court for further proceedings.
In its analysis, the court distinguished another Illinois Appellate court decision concerning BIPA, Rosenbach v Six Flags Entertainment Corporation, 2017 IL App (2d) 170317 (2017), concluding
…even if Rosenbach was correctly decided and an additional “injury or adverse effect” is required, Rosenbach is distinguishable from this case, in the following two ways. Rosenbach, 2017 IL App (2d) 170317, ¶ 28 (requiring an “injury or adverse effect,” in addition to violation of the Act). First, as the federal district court similarly found, disclosure to an out-of-state third-party vendor constitutes an injury or adverse effect, and plaintiff in the instant case alleged such a disclosure, while the Rosenbach plaintiff did not. Dixon, 2018 WL 2445292 *12. Second, the mental anguish that plaintiff alleges in her complaint also constitutes an injury or adverse effect. E.g., Chand, 335 Ill. App. 3d at 823, 269 Ill.Dec. 543, 781 N.E.2d 340 (Kuehn, J., concurring in part and dissenting in part) (actual damages may include “mental anguish”). For these reasons, we must reverse and remand.
The Illinois Appellate Court for the 2nd District decision in Rosenbach was appealed to the Illinois Supreme Court and reversed. In Rosenbach v Six Flags Entertainment Corporation, 2019 IL 123186 (January 25, 2019) the Illinois Supreme Court held “…an individual need not allege some actual injury or adverse effect, beyond violation of his or her rights under the Act [BIPA], in order to qualify as an ‘aggrieved’ person and be entitled to seek liquidated damages and injunctive relief pursuant to the Act.”
In reversing the appellate court, the Illinois Supreme Court stated: “While the appellate court in this case found defendants’ argument persuasive, a different district of the appellate court subsequently rejected the identical argument in Sekura v. Krishna Schaumburg Tan, Inc., 2018 IL App (1st) 180175. We reject it as well, as a recent federal district court decision correctly reasoned we might do. In re Facebook Biometric Information Privacy Litigation, 326 F.R.D. 535, 545-47 (N.D. Cal. 2018).”
In Dixon v Washington and Lee Smith Community-Beverly, et al., 2018 WL 2445292 (USDC IL ND, 20180531), the Illinois district court was presented with the plaintiff-employee alleging, among other things, that her employer, the defendants, had violated BIPA by requiring employees to clock in and out of work by scanning their fingerprints onto a biometric timekeeping device provided by a third-party vendor, and failed to disclose to plaintiff that her fingerprint data was disclosed to or otherwise obtained by a third party. Defendants argued, in part, that plaintiff lacked standing on the ground that the procedural injuries plaintiff alleged are insufficient to support a cause of action under BIPA or a negligence claim. Plaintiff argued that although defendants’ argument is ostensibly aimed at the meaning of “aggrieved” in BIPA, it directly questions whether plaintiff alleged a cognizable injury sufficient to meet Article III standing necessary for federal jurisdiction. “The Court concludes that this alleged violation of the right to privacy in and control over one’s biometric data, despite being an intangible injury, is sufficiently concrete to constitute an injury in fact that supports Article III standing.”
Another recent BIPA related development concerns insurance coverage in BIPA lawsuits. As a result of a lawsuit, Mazya v. Northwestern Lake Forest Hospital, et al., 2018-CH-07161 (June 6, 2018), in the Circuit Court, Cook County, Illinois, one of the defendants, Omnicell Inc., tendered the suit to Zurich American Insurance Co., its insurance company, to defend and indemnify Omnicell in that lawsuit. Zurich responded by filing on August 30, 2018, a lawsuit in the U.S. District Court for the Northern District of California alleging that Omnicell’s general liability policy expressly excludes coverage for alleged violations of state or federal laws that prohibit collection of personal information. The final outcomes of the Mazya case and other BIPA cases discussed in this article are yet to be determined as the courts further explore the facts and the applicable law, and further define the BIP legal landscape.
Practice Pointers
Although not exhaustive, here are some practical pointers for consideration by businesses and their professional advisers regarding the use of biometric applications in business processes:
Develop written policies addressing how the business will collect, use, distribute, and destroy biometric data.
Follow those written policies. It does not look good to a judge, arbitrator, or a government regulator (or to employees and customers) when a business’s written policies say one thing, but the facts show they are actually doing something else. If you need an economic perspective on this, consider the enhanced statutory penalties found in some statutes when a business is found to have intentionally or recklessly violated the statute.
Inform and disclose. Clearly, concisely, and consistent with statutory obligations, notify your employees and customers how you are handling their biometric data. For instance, a. How long will the business keep the biometric data? b. When (and how) will the biometric data be destroyed? c. Will the biometric data be shared with (e.g., processed by) a third-party vendor? d. How will the biometric data be handled if the business is sold, closes, or enters bankruptcy?
Secure with encryption the biometric data at rest and in transit.
Limit the access to the biometric data. If you must distribute the biometric data to a third-party vendor, carefully and concisely craft the contract with that third-party vendor to clearly express the parameters surrounding the biometric data.
Consider storing less than 100 percent of the entire biometric dataset for an individual (i.e., only enough of the dataset to confirm an accurate match between the individual and the individual’s biometric dataset to satisfy the business’s need to use the biometric information).
Consider, when practical, having employees and customers use two-factor authentication in conjunction with biometric information. Use the nonbiometric (second factor) data to randomize the biometric information that is authenticated only when both the biometric information and the second factor are present.
If plaintiffs are alleging BIPA violations, courts will look for allegations that go beyond merely alleging a failure to provide notice or obtain consent and will look for specific factual allegations that constitute an actual and concrete injury as contemplated by the applicable statute(s).
Appropriately address your legal, statutory, obligations regarding biometric data in all of your contracts with your customers, contracts with your vendors accessing or handling biometric data for which you are the steward of that biometric data, and your employee policies/handbooks.
Consider the business’s general commercial liability insurance coverage and whether it provides adequate coverage for BIPA risks, and how (or if) the insurance carrier helps insureds in understanding and managing these risks.
The application of these practical pointers may vary depending on the business and applicable laws, and are not exhaustive of all the considerations regarding the use of biometric applications in business processes.
Conclusion
Biometric data and devices and applications that collect, process, and analyze biometric data are now, and will become even more, ubiquitous. An increasing number of businesses in a variety of industries will increasingly confront BIP issues in their business processes as they begin to realize and recognize the return on investment biometric technologies can provide to the business. The bottom line is that these businesses and their professional advisers must understand and proactively address the legal risks attendant to biometric information and the use thereof with customers, employees, and third-party vendors.
Introduction. The Patient Protection and Affordable Care Act and related statutes passed in 2010 (collectively the Affordable Care Act or ACA) created a complex but comprehensive approach to closing gaps to availability and affordability of major medical coverage.[1] The ACA was passed by a Democratic majority in Congress and signed into law by President Obama. Although the health care and health insurance industries came to the negotiating table and impacted the final version of the bill, Republicans almost unanimously opposed the bill in Congress and have continued to oppose key parts of it.
With both a Republican administration and Congress beginning in 2017, efforts began almost immediately to repeal the ACA, but the law has remained resilient, and efforts to completely repeal the law have been unsuccessful. Over the course of 2018, more Republicans expressed support for the law’s popular ban on preexisting conditions. It is not clear, however, what cost and risk-pool protections would go in place to help offset the added costs to insurers of covering high-risk individuals and high-risk preexisting illnesses in lieu of those in the ACA. One of the key tools to offset added risk to the preexisting condition ban in the ACA is the individual mandate to purchase coverage or face a tax penalty. As will be addressed in later parts of this three-part series, in late 2017, Congress reduced the penalty to zero, and on Friday, December 14, 2018, a Texas federal judge struck down the law in its entirety based on Congress no longer exercising its tax power. Although the judge stayed his own ruling on December 30 and his ruling will not be enforced while it is appealed, the ruling opens the possibility that the entire law, including the preexisting condition ban, will be struck down by the courts, leaving a divided Congress and individual states to pick up the pieces.
In this first abstract of a three-part series, we first briefly discuss laws governing comprehensive health care before the ACA and then discuss the key changes introduced to health coverage in America by the ACA. We then discuss efforts by Congress and the Trump Administration to address particular issues with the ACA after the failure of repeal and also alternative paths to health coverage and the continued impact of litigation. Finally, we discuss state responses to the federal activity, including requests for waivers that would permit states to best tailor the ACA framework to their particular circumstances.
Healthcare coverage in the pre-ACA era. Prior to implementation of the ACA, there were gaps across the country in availability and affordability of health care. Insurance is primarily regulated by the states, and state laws varied in their requirements related to comprehensive healthcare coverage. The federal HIPAA portability laws passed in the 1990s[2] made employer-based coverage available with no preexisting-condition exclusions to small employers,[3] and made insurance portable among all employers. Portability applied to carriers offering coverage to employers and also applied to most employers who self-funded coverage.
HIPAA did not prohibit carriers from denying coverage to large employer groups as a whole or applying minimum requirements based on a percentage of employees participating or based on a percentage of premium contribution paid by the employer. Although small-group coverage was guaranteed issue, small group premiums could be high based on a group’s risk score and limited restrictions on small-group rating.
Coverage gaps persisted in the individual market as well. States were permitted, but not required, to prohibit carriers from excluding individuals based on preexisting conditions, and most states did not do so. Instead, consistent with HIPAA, most states created risk pools that acted as insurers of last resort in the individual market and allowed carriers to wholly or partially deny coverage to individuals. Such individuals could then purchase coverage in risk pools, but coverage was expensive, there were very few subsidies or other mechanisms to lower the cost of coverage, and coverage often was subject to a waiting period. About one-fifth of Americans remained uninsured.
The ACA and some of its key provisions. The following describes some of the most impactful components of the ACA:
Preexisting condition exclusions prohibited. Under one of the most comprehensive changes of the ACA, a health insurance issuer may not deny or limit coverage based on preexisting-condition exclusions. See 45 C.F.R. § 147.108. The prohibition against preexisting-condition exclusions applies in all markets offering comprehensive health coverage—individual, small and large employer group insured coverage, and self-funded employer coverage.
Allowing dependents to stay on plans until age Another popular provision of the ACA, this also applies to all forms of employer health coverage (individual, small-group insured, large-group insured, and self-funded). See 45 C.F.R. § 146.120.
Essential health benefits. The ACA requires that 10 essential health benefits (EHBs) be offered by carriers in individual and small employer health plan markets, and has eliminated any annual or lifetime benefit limits on these In each state there is a benchmark plan to help establish the parameters of these benefits. See 45 C.F.R. § 156.100. The mandate to offer EHBs does not apply to large group health plans or self-funded employer plans, but to the extent that these plans offer EHBs, they must do so without annual or lifetime benefit limits on the EHBs. See 42 U.S.C. § 300gg-6; 45 C.F.R. § 147.150.
Key individual and small employer group reform. The ACA created either state-based or federally facilitated marketplaces in which individual consumers and small employers can shop for and purchase coverage that contain a variety of more standardized benefits from rich to less robust. Both in and out of these marketplaces, individuals and small employer groups are subject to modified community rating, with the only permissible rating factors including geography, tobacco use, and age.
Individual mandate. Beginning January 2014, individuals had to maintain minimum essential health insurance coverage, qualify for an exemption, or pay a penalty (upheld by the U.S. Supreme Court as constituting a tax). See 26 U.S.C. § 5000A; NFIB v. Sebelius, 567 U.S. 519 (2012). Exemptions are primarily income-based, but there are also several other exemptions, including religious-based exceptions and exemptions based on being out of the country, incarcerated, or uninsured for no more than three months. The late-2017 changes to the penalty portion of this law by Congress and the recent court decision upending the entire ACA based on that change will be discussed in future parts of this abstract.
Large employer ACA-related taxes. Another way the ACA seeks to ensure coverage is through a tax on a large employer that does not offer ACA-compliance health coverage and any of its full-time employees report a premium tax credit on their individual income tax returns for health insurance they purchase through a state-based or federal marketplace. Calculations are complicated, but employers must offer minimum essential coverage and coverage at or above a minimum value. The IRS notifies large employers who appear to be out of compliance and the amount of the tax penalty based on the noncompliance. The large employer has an opportunity to respond before payment is made.
Reduction of the number of uninsured through Medicaid expansion. Although the Supreme Court in NFIB ruled that states must be allowed to opt out of Medicaid expansion, 37 states now are or soon will be participating in expanding Medicaid to 138 percent of the FPL with an enhanced federal match. See the Kaiser Family Foundation interactive map on the status of Medicaid expansion, which has dramatically reduced uninsured rates in some states.
Medical loss ratios. The ACA limits what carriers can spend on administrative costs versus spending on claims and quality improvement measures. In the individual and small-group market, insurers must spend at least 80 percent on claims and quality improvement, and in the large-group market, insurers must spend at least 85 percent on claims and quality improvement. If carriers fail to meet these benchmarks, insureds receive premium rebates.
Risk adjustment mechanisms. The ACA also built in buffers against the added risk that carriers had to accept because of the ban on preexisting-condition exclusions. The risk adjustment mechanisms are complicated, but include payments from plans with lower-risk individuals to plans with higher-risk individuals to help lessen the impact of the higher claims costs.
Coming up in part 2 of this series: Results of ACA Implementation and Trump Era Rollbacks.
[1] The ACA regulates “major medical,” or comprehensive health coverage, which is coverage that typically provides preventive care and coverage for illness (including mental illness) and injury, along with prescription drugs. The ACA does not govern supplemental health coverage, such as cancer indemnity plans or hospital indemnity plans.
[2] Health Insurance Portability and Accountability Act of 1996 (HIPAA), Pub. L. No. 104-191.
[3] In most states, “small employer” means no more than 50 employees for the purposes of state and federal law. In some states, a “small employer” means up to 100 employees. Large employers are any employers larger than small employers.
An investor or lender to an operating or real estate limited liability company may obtain a security interest in the membership interests in the LLC. The lender may have security interests in the assets of the LLC, and the security interest in the membership interests may be viewed as additional collateral. Alternatively, when the lender is a junior or mezzanine lender, it may have no security interests in the assets of the LLC, and its collateral may be limited to the pledge by the LLC’s owner of the membership interests in the LLC. In either case, if the lender must exercise its power of sale with respect the membership interests, the unique nature of the collateral requires careful planning and implementation of the sale.
Section 9-610(a) of the Uniform Commercial Code (UCC) generally permits a secured lender, after default, to “sell, lease, license, or otherwise dispose of any or all of the collateral . . . .”[1] UCC § 9-610(b) further provides, “[i]f commercially reasonable, a secured party may dispose of collateral by public or private proceedings . . . .” However, UCC § 9-610(c) imposes a significant limitation if the secured lender seeks to purchase the collateral itself:
(c) A secured party may purchase collateral:
(1) at a public disposition; or
(2) at a private disposition if the collateral is of a kind that is customarily sold on a recognized market or the subject of widely distributed standard price quotations.
Few closely held LLCs will qualify under UCC § 9-610(c)(2), meaning that the only way a lender whose loan is secured by membership interests in a closely held LLC can purchase the collateral at the foreclosure sale is if the foreclosure sale is a “public disposition.”
The rub is that membership interests in LLCs may be viewed as securities under state and federal law, and their sale may be subject to registration of such securities, or compliance with an applicable exemption from registration.
The commentary to the UCC acknowledges this issue:
8. Investment Property. Dispositions of investment property may be regulated by the federal securities laws. Although a “public” disposition of securities under this Article may implicate the registration requirements of the Securities Act of 1933, it need not do so. A disposition that qualifies for a “private placement” exemption under the Securities Act of 1933 nevertheless may constitute a “public” disposition within the meaning of this section. Moreover, the “commercially reasonable” requirements of subsection (b) need not prevent a secured party from conducting a foreclosure sale without the issuer’s compliance with federal registration requirements.
Unfortunately, the UCC commentary is not law and certainly does not override federal securities laws, rules, or regulations. Further, there is no specific federal exemption from securities registration for the conduct of a creditor sale under the UCC.
Nevertheless, precedent exists for conducting a sale that qualifies as a “public disposition” under the UCC while steering clear of federal registration requirements. The Securities Exchange Commission has issued no-action letters that permit UCC sales without registration.[2] The factors that typically have existed or been cited by the SEC in providing no-action letters include:
the pledged securities will be sold only as a block to a single purchaser, and will not be split up or broken down;
the purchaser must represent that the securities will be purchased with investment intent for the purchaser’s own account, and not with a view toward sale or distribution of such securities;
the securities will be subject to transfer restrictions prohibiting sale or transfer without registration or a valid exemption;
the seller will provide on request to any prospective purchaser the information that seller has regarding the issuer of the securities;
the public auction of the securities would be conducted in accordance with the UCC;
the lender believed that the loan would be repaid in accordance with the loan documents, and there would be no need to foreclose on the collateral (including the securities);
the lender is not an affiliate of the pledgor or issuer of the securities, but was merely an arms-length lender;
notice of the sale would be given to every person required by law and would be published in one or more newspapers, and where applicable trade journals;
the lender is likely to be the purchaser of the pledged securities at the foreclosure sale; and
no public market exists for the securities.
Other factors should be considered to maximize the prospect that the sale is found to be commercially reasonable under the UCC and to minimize the prospect that the sale is challenged as a violation of securities laws:
limiting the sale to purchasers who would qualify for an exemption in connection with the private sale of securities (commonly referred to as “accredited investors”);
demanding from the borrower/pledgor and the LLC all relevant information and documentation regarding the LLC, its assets, liabilities, and operations;[3]
preparing a data room containing all relevant information and documentation that is available to the lender;
engaging a qualified auctioneer (depending on the scope of the auctioneer’s role, the lender should consider engaging an auctioneer who is registered as a securities broker/dealer);[4]
engaging a qualified broker to market the assets;
Establishing a marketing plan that appropriately balances the exigencies of the LLC’s business and the time needed to maximize the sale price;
Advertising the sale in a manner that maximizes the prospect of a meaningful sale;[5] and
preparing and disseminating to all qualified buyers an information packet (akin to a private placement memorandum) regarding the LLC, its assets, liabilities, and operations.
In sum, a lender can foreclose on LLC membership interests, but the lender should understand that care is required to avoid pitfalls, and that a foreclosure on such interests can be more costly and time-consuming than a foreclosure on other, more conventional forms of collateral. Subsequent installments will address other issues arising in connection with security interests in LLC membership interests.
[1] This article refers to the UCC. The specific implementation of the UCC in the state or jurisdiction whose law governs should be reviewed.
[3] Even if the borrower or the LLC fails to provide the requested information, the lender’s effort to obtain such information may prove valuable to rebut arguments by the borrower or its affiliates that the lender failed to provide sufficient information to prospective purchasers, thus chilling the sale.
[4] The SEC has issued a no-action letter relating to broker-dealer regulation in connection with the sale of control of an operating business. See M&A Brokerage Activities, 2014 SEC No-Act. LEXIS 92 (Jan. 31, 2014). The SEC opined that registration under the Financial Industry Regulatory Authority (FINRA) would not be required if the transaction, and the broker, complied with conditions set forth in the no-action letter.
[5] If the assets of the LLC are real estate, the lender would be well served by advertising, at a minimum, in the manner prescribed by local law for foreclosure on real estate.
You just keep thinkin’, Butch. That’s what you’re good at.
– The Sundance Kid
The Standing Committee on Ethics and Professional Responsibility issued Formal Opinion 464 in 2013 interpreting Model Rules 1.5 and 5.4:
Lawyers subject to the Model Rules may work with other lawyers or law firms practicing in jurisdictions with rules that permit sharing legal fees with nonlawyers. Where there is a single billing to a client in such situations, a lawyer subject to the Model Rules may divide a legal fee with a lawyer or law firm in the other jurisdiction, even if the other lawyer or law firm might eventually distribute some portion of the fee to a nonlawyer, provided that there is no interference with the lawyer’s independent professional judgment.
Much like an ember from a blaze, this opinion set off certain members of the bar who were outraged with the opinion as an assault on the core principles of lawyering, specifically the professional independence of lawyers. Similarly, during the debate over Ethics 2000 and Ethics 20/20, the same arguments were raised. The debate has focused on so-called alternative business structures and multiple disciplinary practices. However, as Mike Stoller and Jerry Leiber wrote for Peggy Lee, “is that all there is?”
Having seen this debate extend for many years, I would argue that it has hardened into distortion. The questions of professional independence of the lawyer, dividing or sharing fees, and nonlawyer investment in law firms are not simple binary concepts. Rather, Rule 5.4 should be considered in its constituent parts.
For example, what is the meaning of “share legal fees with a nonlawyer?” One envisions a lawyer being paid by the client and then taking that cash and giving part of it to a nonemployee, nonlawyer individual, such as a “runner,” who brought the client to the lawyer. From that simplistic vision, the real politick of so-called sharing legal fees with a nonlawyer has evolved to allow payment to a lawyer’s estate and/or heirs (Rule 5.4(a)(1)); payment as part of the sale of the law practice under Rule 1.17 (Rule 5.4(a)(2)); payment to nonlawyer employees as part of a retirement or profit-sharing plan (Rule 5.4(a)(3)), with mandates in some states that there be no link to a specific matter; and payment to a nonprofit organization a part of the matter (Rule 5.4(a)(4)).
So, what is the meaning of Rule 5.4(a)? Rule 5.4(a)(1) and (3) do not appear to be the sharing of legal fees. Rather, they appear to be distributions of the general revenue from the firm. Rule 5.4(a)(2) could and (4) must come from individual cases or from general revenue.
Given the operation of modern law firms, including solo and small firms (as well as current tax laws), it is difficult to envision that individual fees are subject to inappropriate division or sharing.
There is no definition of “fees” in the terminology section of the Model Rules. Looking at Rule 1.5 and the discussion of “fees” throughout the rule and comments, there is no indication that the term is intended to apply to something more than the fee in a particular case. Put another way, “fee” does not appear to apply to a law firm’s general operating account. Indeed, Model Rule 1.15 and innumerable articles and ethics opinions discuss the obligation of a lawyer to put client money in trust accounts, but to transfer any money belonging to the lawyer into the lawyer’s personal or operating accounts. Does this not demonstrate that once money is transferred into the lawyer’s account, it is transmuted from a “fee” to a lawyer’s property?
Interpreting “fee” in this way would arguably obviate the necessity of any change to Rule 5.4(a), but what about Rule 5.4(b)? The terminology section defines “partner” as a “member of a partnership, a shareholder in a law firm organized as a professional corporation, or a member of an association authorized to practice law.” Although the drafting is inartful, it is reasonable to rely on that definition for interpreting the prohibition on forming a “partnership with a nonlawyer.”
Historically, however, and particularly in the practice of law, “partnership” was a term of art. Other than solo practice, the only “organization” in which more than one lawyer could practice law was a partnership, and at law, partners were/are jointly and severally liable for all acts of the partnership. This was heightened by the responsibility of a lawyer to a client.
Although that law is still extant, few lawyers now practice in a pure partnership. The evolution of the law and legal practice since the 1980s has revolutionized law firm organization. To paraphrase, “Where have all the partnerships gone?” They are PC, LLC, LLP, etc., and are generally no longer jointly and severally liable for the lawyer in the next office. In effect, has Rule 5.4(b) become moot?
Of more currency is Rule 5.4(c). The obligation of a lawyer to maintain independent professional judgment is the sine qua non of the rule. It is the title and prime directive of the rule. What is unclear is whether, in the 21st century, the same fears of the past should prevent adjustments for the future. Will the professional independence of the lawyer be impinged by some degree of financial relationship with nonlawyers?
Returning to the proposition that the discussion is not a binary question, would allowing a degree of financial participation in a law firm by a nonlawyer interfere with professional independence any more than a bank loan or other line of credit? Rule 5.4(d) prohibits any practice including a nonlawyer or alternative form of practice, but those two restrictions need not be combined. The rules could authorize nonlawyer financial participation without authorizing alternative business structures.
One proposal previously discussed in North Carolina suggested up to a 49-percent ownership of stock in a professional corporation by nonlawyers with provisions guaranteeing a lack of interference with the attorney-client relationship. This is significantly different than the fear bandied about in the past—then called the “fear of Sears” (although now Walmart or Amazon would be more appropriate)—that large commercial consumer corporations would market legal services. Would this or other proposals that keep the lawyer in charge interfere with a lawyer’s independent judgment? It has always been a significant challenge for both in-house corporate counsel or “captive” insurance counsel and others similarly situated to vigorously work to preserve their independent judgment in practice for their clients. See Rule 1.13.
None of this addresses the question of alternative business structures or practice; that may be a meditation for another time—or a bridge too far.
Despite the continued, consistent protest that any change to Rule 5.4 is an assault to the core values of the profession, there is a compelling need to evaluate what exactly is the core value and what is simply nostalgia for days gone by or misapprehension of today’s needs. It seems peculiar that the Model Rules view filthy lucre as the greatest threat to the core value of a lawyer’s exercise of independent professional judgment. The other core value to consider was said by Heraclitus: “The only thing that is constant is change.”
Material adverse effect (MAE) or material adverse change (MAC) clauses are common in acquisition agreements, and yet until recently, no Delaware court has determined that a buyer had ever validly terminated a merger agreement pursuant to such a clause. That all changed on October 1, 2018, when the Delaware Court of Chancery in Akorn, Inc. v. Fresenius Kabi AG, a blockbuster, 246-page opinion, determined for the first time that such a clause was properly evoked.
Due to “overwhelming evidence of widespread regulatory violations and pervasive compliance problems” as well as the fact that target’s financial performance “dropped off a cliff,” the court ruled that a MAE occurred. Although the Akorn decision, as the first decision applying Delaware law that found an MAE warranting a buyer’s exercise of merger termination rights, may embolden future buyers to test the power of their own provisions, commentators are cautioning that the court decided Akorn based on extraordinary facts and that it awaits review by the Delaware Supreme Court.
MAC or MAE clauses appear in merger agreements in several locations. They may be embedded in a representation or warranty, appear as a condition precedent to closing, or sometimes even be a condition to exercise termination rights. Regardless of where they appear, merger agreements usually define the MAC or MAE vaguely as events materially adverse to the business of the seller. The intended purpose of these clauses is to protect the buyer against unanticipated changes in the target’s business between signing and closing.
Moreover, when buyers do try to evoke these provisions, they rarely proceed to litigation. The vagueness of the MAE and MAC provision itself provides incentive for the parties to negotiate and reprice the deal. After all, who knows what a court would hold? (Although with MAE’s and MAC’s judicial track record, one would think that this incentive would favor the target during negotiations).
When the MAE or MAC provision does come before a court determining whether a MAE or MAC occurred, the issue turns on “whether there has been an adverse change in the target’s business that is consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.” Hexion Specialty Chemicals v. Huntsman, 965 A.2d 715, 738 (Del. Ch. 2008). The Huntsman standard has been historically tough to meet. In Huntsman itself, the seller’s six-month decline in EBITDA, repeated failure to meet EBITDA forecasts, and an increase in debt contrary to projections were all, even in totality, insufficient to meet the standard. It seemed like only a true catastrophe would lead a Delaware court to find a MAC or MAE clause correctly evoked.
Akorn was that catastrophe. Akorn’s conduct and financials were so bad that although the conclusion that an MAE occurred is unprecedented in Delaware, it was not surprising.
On April 24, 2017, Fresenius Kabi AG, a German pharmaceutical company, agreed to acquire Akorn, Inc., an Illinois pharmaceutical manufacturer. Fresenius agreed to buy Akorn in a $4.75 billion transaction, subject to the satisfaction of customary closing conditions. Akorn made the usual representations and warranties about its business and compliance with applicable regulatory requirements. Fresenius’s obligation to close was conditioned on Akorn’s representations being true and correct both at signing and at closing, except where the failure to be true and correct would not reasonably be expected to have an MAE.
Then, during the post-signing period, Akorn experienced consecutive year-over-year declines in quarterly revenue. Akorn’s operating income was down 84, 89, 292, and 134 percent, respectively, in the four quarters after it signed the merger agreement. Akorn’s revenue was down 29, 29, 34, and 27 percent, and earnings per share were down 96, 105, 300, and 170 percent. Akorn’s stock price dropped from $32.13 per share before signing to between $5.00 and $12.00 per share after signing. Commenting on Akorn’s financial decline, Chancellor Stine remarked:
Akorn’s dramatic downturn in performance is durationally significant. It has already persisted for a full year and shows no sign of abating. More importantly, Akorn’s management team has provided reasons for the decline that can reasonably be expected to have durationally significant effects.
Not only had Akorn’s financial situation “dropped off a cliff,” Fresnius soon also learned of serious deficiencies in Akorn’s data integrity processes. Dramatically, these issues were first identified in an anonymous whistleblower letter. Upon review of the letter, Fresnius performed its own investigation. Fresnius discovered that Akorn was “in persistent, serious violation of FDA requirements” and had “a disastrous culture of noncompliance.” The investigation by Fresenius also uncovered the possible use of fabricated data in Akorn’s FDA submissions. Additionally, as soon as the parties signed the merger agreement, Akorn had canceled regular audits, assessments, and inspections of known problems.
Upon these findings, Fresnius attempted to terminate the merger agreement. Akorn argued that the merger agreement should be specifically enforced. Fresnius counterclaimed, seeking a ruling that it properly terminated the merger agreement. The rest, as they say, is history.
The court determined that the unexpected and nonstop drop in Akorn’s business performance constituted a “general MAE” (that is, the company itself had suffered an MAE), and that because Akorn’s representations of regulatory compliance were not true and correct, the deviation between the as-represented condition and its actual condition would also result in an MAE.
Parsing the court’s analysis shows that a buyer claiming that a representation given by the target at closing fails to satisfy the MAE standard must demonstrate such failure, both qualitatively (i.e., the suddenness of the financial decline, whether in revenue or EBITDA, and/or the presence of factors suggesting “durational significance”) and quantitatively (i.e., the magnitude and length of the downturn). Merely showing qualitative failure without quantative failure, or vice versa, would not be enough given the court’s discussion in Akorn. Throughout the opinion, the court cautioned buyers in regard to evoking a MAE or MAC clause. The court emphasized the steep climb and heavy burden faced by a buyer in establishing an MAE or MAC.
The court reaffirmed that “short-term hiccups in earnings” do not suffice; rather, the adverse change must be “consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.” Akorn’s data integrity problem was not directly relevant upon the court’s finding of a MAE, but it most certainly informed the court’s overarching conclusion that this was not a case of buyer’s remorse. The compliance issues in effect presented the qualitative failure the court was looking for.
As previously stated, the conclusion that an MAE occurred in Akorn was not that surprising given the facts, and although significant, the decision is unlikely to lower the already high bar to proving a MAC or MAE had occurred. Yet, Akorn importantly shows that, yes, such a bar could be met, and that MACs or MAEs are not mere hypotheticals over which lawyers spend hours negotiating. Moreover, Akorn provides some additional lessons.
Akorn tried to advance the argument that an MAE could not have occurred because the purchaser would have generated synergies through the combination, which would have generated profits from the merger. The court rejected this argument, finding that the MAE clause itself was focused on the results of operations and the financial condition of the target and its subsidiaries, instead of the results of operations and financial condition of the surviving corporation or the combined entity. The court determined that the MAE clause in Akorn carved out any effects arising from the “negotiation, execution, announcement or performance” of the merger agreement or the merger itself, including “the generation of synergies.” The drafting lesson learned is that buyers going forward should consider including express references to synergies in defining the concept of an MAE in their merger agreements.
Next, Akorn tried to claim that it faced “industry headwinds” that caused its decline in performance. Akorn pointed to heightened competition and pricing pressure as well as regulatory actions that increased costs. The court rejected this argument as well. However, the court’s rejection was not due to the argument itself, but rather the fact that evidence was provided showing that Akorn’s EBITDA decline vastly exceeded its peers. Presumably, if Akorn’s decline were similar to its competitors, the court would have accepted that Akorn’s failure was an industry-wide failure, which would not have been a MAE. The drafting lesson learned from this is that buyers should think of including “disproportionate effects” qualifications in MAE carve-outs with respect to industry-wide events.
Finally, less of a drafting lesson and more of a philosophical lesson, the court seemed to conceive of the MAE clause as a negotiating tool. The court delved into existentialism and examined why MAE or MAC clauses exist. Vice Chancellor Laster wrote:
Despite the attention that contracting parties give to these provisions, MAE clauses typically do not define what is “material.” . . . [P]arties find it efficient to leave the term undefined because the resulting uncertainty generates productive opportunities for renegotiation. . . . What constitutes an MAE, then, is a question that arises only when the clause is invoked and must be answered by the presiding Court.
The court essentially determined that MAE or MAC clauses exist in order to create incentives for both sides to reprice the deal and stay out of court. MAE and MAC clauses essentially recognize that mergers are less about strict legal rights and more about relationships. The drafting of a MAE or MAC should keep that in mind.
On October 1, 2018, two law school professors—Cynthia Williams of York University and Jill Fisch of the University of Pennsylvania—together with numerous institutional investors that collectively manage more than $5 trillion in assets submitted a petition for rulemaking to the Securities and Exchange Commission (“SEC”) calling for the SEC to develop a standardized comprehensive framework under which public companies would be required to disclose identified environmental, social, and governance (“ESG”) factors relating to their operations.
The Petition
The petition represents the latest in a series of concerted efforts over the past decade to pressure the SEC to adopt mandatory disclosure requirements for certain ESG matters, which would bring the United States in line with the nearly two dozen other countries that require public companies to provide such disclosures to investors. In addition, seven stock exchanges already require ESG disclosures as part of their listing requirements, and many other countries, including the U.K. and Sweden, require public pension funds to disclose the extent to which the fund incorporates ESG information into their investment decisions.
The petition references the SEC’s 2016 Concept Release that requested public comment on various potential disclosure reforms, including potential new requirements for disclosures related to sustainability, public policy, and climate change, and the comments responding to the questions about enhanced climate change. The petition also cites public comments to the Concept Release to support the need for a mandatory disclosure framework for ESG disclosures in SEC filings. The petitioners argue that the SEC has the express statutory authority to create ESG disclosure rules under Sections 2(b) of the Securities Act of 1933 and Section 23(a)(2) of the Securities Exchange Act of 1934, both of which provide that the SEC may engage in broad rulemaking that “promote[s] efficiency, competition, and capital formation.” Because ESG issues have potentially huge impacts on large swathes of the national economy, the petitioners posit that they implicate the ability of public companies to be globally competitive and to efficiently form capital. For example, the petitioners note that the Sustainability Accounting Standards Board (“SASB”) concluded that 72 of 79 industries, representing 93% of U.S. capital market value, are vulnerable to material financial implications from climate change.
The petition argues that ESG disclosures not only impact a large cross-section of the U.S. economy but are also currently the subject of a patchwork of poorly-organized corporate disclosures that magnify the burden on public companies while inhibiting the flow of useful information to the investing public. Leading institutional investors have noted that the inconsistent and haphazard nature of corporate ESG disclosures makes it difficult to compare and analyze this information for companies in the same industry. Michael Bloomberg encapsulated the concern of many such investors when he stated in his 2015 Impact Report:“[F]or the most part, the sustainability information that is disclosed by corporations today is not useful for investors or other decision-makers… The market cannot accurately value companies, and investors cannot efficiently allocate capital, without comparable, reliable and useful data on increasingly relevant climate-related issues.”
SEC Disclosure Framework
There is reason to be skeptical about any forthcoming ESG rulemaking from the SEC, at least in the immediate future. The adoption of specific rules governing ESG disclosures runs counter to the SEC’s long-standing principles-based disclosure framework which centers almost entirely on materiality. The Supreme Court defined materiality in TSC v. Northway, stating that information is material if it is information that a “reasonable shareholder might consider important” to his or her investment decision. In Basic v. Levinson, the Supreme Court held that the standard for materiality is whether a reasonable investor would have viewed the undisclosed information as having significantly altered the total mix of information made available. Materiality forms the core of information required to be disclosed in periodic filings and registration statements pursuant to SEC Regulation S-K. Therefore, unless a specific ESG issue is material to a public company’s investors, its disclosure would not be required under the current statutory framework and rules and regulations dictating disclosure requirements in filings with the SEC.
This deference to materiality is the approach previously applied by the SEC in 2010 when it published interpretive guidance on the issue of climate change. While this guidance provided some clarity around the types of issues that companies should consider when crafting their disclosures concerning climate change, the SEC ultimately left it up to the individual companies to decide what information should be disclosed on the basis of materiality. In the absence of a mandatory SEC statutory framework for reporting on climate change or other ESG metrics, a number of other reporting frameworks have been used by U.S. public companies to report certain ESG metrics on a voluntary basis. As a result, disclosures vary greatly within each industry, with some opting to make limited ESG disclosures in periodic reports, while others issue stand-alone sustainability and corporate social responsibility reports (“CSRs”). For example, while some oil and gas companies disclose a proxy carbon cost estimate that factors in the anticipated costs of future regulation related to the extraction, transportation, and refinement of hydrocarbons, there is no uniform methodology for calculating such estimates, and companies report a wide range of different metrics which are difficult to compare.
The petition asks the SEC to develop a “comprehensive framework for clearer, more consistent, more complete, and more easily comparable information relevant to companies’ long-term risks and frameworks” to provide clarity on ESG reporting for U.S. public companies; additionally, the petition argues that ESG disclosures should be required under the existing SEC reporting framework because such disclosures are per se material to the decision-making of investors. The petitioners cite a litany of recent reports and analyses performed by top-tier investment banks, research institutes and scholars that suggest that ESG information is material under the existing case law interpreting the materiality standard and form the type of information that a reasonable shareholder would consider important when making investment decisions. The petition also notes the substantial amount of capital—$64.8 trillion—managed by investors that are committed to incorporating ESG factors in their investing and voting decisions under the United Nations Principles for Responsible Investment and growing investor interest in non-financial information across all sectors as further support for specific ESG disclosure requirements.
A decision by the SEC to create specific rules for ESG disclosures would not be entirely unprecedented. In 2011 and 2018, the SEC issued interpretative guidance related specifically to cybersecurity that went beyond the standard materiality analysis in response to increased investor concerns on disclosure of cybersecurity risks. This is an example of the SEC maintaining materiality as its key principle while providing specific guidance on an issue that it believes is per se material to investors. Accordingly, it is possible that such an approach could be applied by the SEC to require disclosure regarding certain ESG issues.
However, given the current political climate, the SEC is unlikely to initiate a special rulemaking process addressing ESG disclosures. Although key issues such as sustainability and global climate change remain at the forefront of many investors’ minds, it is no secret that the Trump administration does not consider these top policy priorities. Recent actions such as withdrawal from the Paris Climate Agreement and repeal of the Clean Power Plan make it clear that the current political environment may not be favorable for enhanced ESG disclosures. Comments from SEC commissioners and staff since the filing of the petition also indicates that specific ESG rulemaking is unlikely to happen any time soon and that the SEC will continue to evaluate the need for specific ESG disclosures by public companies based on the standard of materiality.
Practical Guidance
In the absence of additional SEC guidance, as companies look to the future and consider the adequacy of their own disclosures, it is paramount to consider the material risks relating to ESG factors on the operations and financial results of the company. ESG issues will continue to prove important to both investors and regulators. Whether or not the SEC responds to this particular call for rulemaking concerning ESG disclosures, the impact of global climate change and related issues are not going away. One market report estimates that the number of investors who fully integrate ESG into their investment process are managing more than 10% of the shares in listed companies globally, and that this percentage is above 50% when investors that consider some aspects of a company’s ESG performance are included. Investor support for ESG shareholder proposals, particularly environmental and social proposals, also continues to rise. Only days after the petition was submitted to the SEC, the United Nations Intergovernmental Panel on Climate Change released a major new report warning that global temperatures could reach an irreversible tipping point as soon as 2030. And in late fall 2018, Senator Elizabeth Warren introduced the Climate Risk Disclosure Act of 2018, which would require public companies to disclose a substantial amount of new climate-related information in their SEC filings. While this legislation is unlikely to pass during the Trump administration, private ordering may still result in enhanced ESG disclosures on a company-by-company basis even without legislation or SEC rulemaking action.
In the wake of the petition and given the current environment, public companies should evaluate their current sustainability and CSR reporting as well as their SEC reports to avoid pitfalls.
Carefully review sustainability and CSR reports, website disclosures, and other materials prepared for investors to ensure that these materials do not conflict with prior disclosures or internal analyses. Any discrepancy may form the basis for a lawsuit, as in the recent high-profile case brought by the New York State Attorney General against Exxon alleging that it essentially kept two separate sets of books when accounting for the potential impacts of climate change.
Similarly, review SEC filings and other public statements for consistency with sustainability and CSR reports and other public statements on ESG factors. A company’s SEC filings should address all material risks to the company’s business, including ESG-related risks. The anti-fraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder prohibit companies from making any untrue statement of material fact, or failing to state a material fact necessary to make a statement not misleading, and the anti-fraud provisions apply to all corporate communications, and not just SEC filings.
Review the company’s process for preparing sustainability and CSR reports. The need for public companies to maintain effective disclosure controls extends beyond the corners of the company’s SEC filings. Ensure that legal, operations, and all other internal stakeholders who collect data and respond to requests for information or questions on ESG topics are represented in the review process.
Verify the data in sustainability and CSR reports, particularly specific statistics (such as carbon or greenhouse gas emissions or targets) contained in such reports. Sustainability and CSR reporting documents should be vetted through internal audit or some other independent fact check process to guard against inadvertent errors that may give rise to claims if investors rely on the inaccurate data in making an investment decision.
Conclusion
The petition for ESG rulemaking is the latest in a series of efforts to require mandatory ESG disclosures for U.S. public companies. While it is unlikely that the SEC will act on the petition, given the focus on ESG factors by investors in the current environment, companies should carefully review their ESG voluntary reporting and SEC filings under the lens of the heightened investor scrutiny on ESG issues to minimize potential liability under the federal securities laws.
Planning for the sale of a business must extend beyond the close of the actual transaction. Preparations must be made to simplify the resolution of disputes that could arise between buyers and sellers. Litigation in connection with the sale may occur over a variety of reasons, including breaches of the seller’s representations and warranties, or determining post-sale milestones that trigger contingent purchase price payments. The most common post-sale dispute, however, involves determining the working capital of the sold business. The difference between a buyer’s determination of working capital at closing and the amount perceived by a seller is often tens or hundreds of thousands of dollars. The poster child for the importance of this issue is the 2015 dispute between Westinghouse Electric and Chicago Bridge & Iron, where the dollar differential was in excess of $2 billion. Litigation lasted over two years.
To operate a business in its traditional manner, whether the sale of the enterprise is an equity or asset sale, all buyers expect that the business will be left with sufficient working capital to operate on a day-to-day basis. The parties must recognize that a business is not a stagnant creature. Every day, products are shipped, receivables are collected, and invoices are paid. The sale price should not be affected by the happenstance of a day’s collection of receivables or that the closing occurs the day prior to the weekly check run. The absolute value of the business doesn’t change; therefore, neither should the purchase price.
In planning for the sale, the parties should agree on what is a normal working capital amount, as well as the elements of working capital. Working capital generally consists of accounts receivables, inventory, and other current assets less accounts payables, accrued payroll, customer deposits, and other current liabilities. Cash is generally retained by a seller, even in equity sales. Accordingly, cash is excluded from the working capital calculation.
The parties often average the month’s ending working capital amount over a six- to twelve-month period. The seasonality of a business may necessarily be factored into account. Further, in a fast-growing business, a working capital target based on anticipated growth may be more appropriate than one based on historic performance. This is especially true if the purchase price is primarily based on anticipated future revenues or profits. The parties agree that if the actual working capital is over the predetermined amount, the buyer will pay the difference. However, if the actual working capital is below the target, the purchase price is reduced. Recognizing that working capital will change daily, rather than agreeing on a fixed number, parties may agree on an average range. This eliminates the need for a seller to micro-manage the business in the days preceding the sale. Moreover, it may also negate a seller’s tendency to accelerate the shipment of product to a date before closing and convert inventory into higher-valued receivables. For example, if the range is between $1 million and $1.2 million, then a price adjustment occurs only if the actual number is above or below the range.
In many instances, a buyer in an asset transaction will not want to acquire any liabilities (other than contracted obligations for future performance). In those instances, the working capital adjustment will look only at current assets. In some instances, however, a buyer may assume vacation and sick-day accruals to employees. Otherwise, although the seller may make these payments at closing, when the employee takes the time off, there will be no payments to him or her, potentially creating an employee morale issue.
In setting both the working capital target and the closing date working capital amount, it is critical that the parties utilize the same measurements. Measurements utilized by the seller in its operation of the business are often not used by the buyer in determining the closing date amount. To illustrate, a buyer will insist on utilizing GAAP accounting practices. These rules would impose bad-debt reserves and/or inventory reserves for slow-moving or obsolete items that were not factored in setting the target number. Many private or small businesses do not utilize such reserves. The inclusion of these reserves would then artificially reduce the purchase price amount where there has been no true change in the business. Other adjustments may be proposed by a buyer that depart from the practices used by a seller. On the other side of the equation, if a buyer accepts that there will be no bad-debt reserve, the seller may be asked to guaranty collections. If a receivable isn’t collected within, for example, 90 days from closing, the seller will pay the buyer the receivable amount, and the receivable is transferred back to the seller.
I have found it extremely useful to include as an exhibit to the purchase agreement an example of working capital as of a prior historical date and a statement that the closing date working capital must be determined utilizing the exact same accounting principles as were used in determining the example’s working capital. The example may also show all categories of current assets and current liabilities used in the calculation, even if the dollar amount in a category in the example is zero. By listing all categories, disputes are eliminated as to whether a current asset or liability is to be included.
Once the buyer prepares the closing date working capital statement, the seller generally is given 20 to 30 days to review the statement. If the seller agrees with the conclusions, the closing adjustment amount is paid either by the buyer (if the working capital target is exceeded), or by the seller (if there is a deficiency). If the seller disputes these calculations, the buyer and seller generally are provided a few weeks to see whether they can resolve the dispute themselves. If they can’t, the matter should be referred to a neutral accountant for resolution.
Due to the nature of the conflict, a working capital dispute is best resolved by an accountant rather than by a judge in a lawsuit or by an arbitrator. Restrictions are often placed on the accountant to decide wholly in favor of one side or the other on individual matters and not to try and mediate a compromise. Selection of the accountant should be made before a dispute arises, and the name of the independent accountant should be specified in the purchase agreement. Accountant fees can be either split equally between the parties, or paid by the party who fails to prevail in the dispute resolution.
Finally, sellers must be aware that, similar to a holdback or escrow utilized by buyers to protect themselves against breaches of the representatives and warranties, buyers generally want a short-term holdback or escrow for the working capital adjustments. Buyers generally do not want to chase sellers for monies owed. If there is already an escrow established for the buyer’s benefit for breaches of representations or warranties, then including the working capital holdback should not be an issue. However, if there is no existing escrow, then a short-term holdback is likely more cash efficient.
As noted at the beginning of this article, controversies on working capital adjustments are the most common dispute between buyers and sellers. Careful planning in the purchase agreements can greatly diminish such issues.
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