Commercial real estate markets have experienced significant challenges over the last decade in all regions and sectors of the country, from retail to office to medical to senior living to golf courses. Some facilities and developments have thrived and continue to thrive, while others are subject to relentless external changes and influences in our economy. Every real estate sector in the country has experienced changes in their markets due to increases in internet and online sales, shifts in spending habits and interests, changes in demographics, declines in revenues, increases in over-built areas, increases in virtual offices, and declines in population centers, among other factors. Given these market challenges, the repurposing of commercial properties will likely focus on who the ultimate owner is to solve them, what the obstacles are in reshaping the property, and what some of the solutions to the challenges include. No doubt, innovation, creative thinking, and capital investment will be needed for the repurposing of spaces in these sectors.
As for retail, news articles are full of stories reporting that over 8,000 stores were closed in 2017, and 2018 is on track to see the same or a higher number of store closures. Some retailers have gone out of business completely; others have downsized significantly, decreasing the number of stores and concentrating on their more profitable areas. On the other hand, Amazon and other similar types of businesses with increasing online sales have expanded their distribution centers and are experimenting with ventures with other businesses in brick-and-mortar areas to fill in their business models. Consumers have changed their spending trends, which has caused retailers to chase them via online sales, thus choosing a different kind of shopping cart.
Landlords have been significantly impacted by store closings and have had to change their tenant mix and repurpose their shopping centers. The owner, the landlord, the lender, and the ultimate buyer of the property have all had to adjust and evolve to repurpose and redevelop their projects. Capital investment of course is needed. In some limited situations, shopping malls have been razed or “de-malled.” In others, significant renovations and redevelopment have taken place. There are multiple examples of landlords and owners changing the mix of shops and restaurants and activity centers to include theaters, gyms, walk-in medical centers, entertainment spaces, museums, aquariums, bowling alleys, arcades, and other experimental and service-oriented tenants in what has traditionally been retail sales space. Other changes include nonretail uses, such as charter schools, community colleges, call centers, libraries, multifamily housing, medical space, and a mix of uses to increase traffic and neighborhood involvement. Some proposals require zoning and other entitlement changes. It is plain to see that creativity, flexibility, and capital are needed to repurpose the changing landscape in retail space.
As for healthcare and senior living space, the aging population will continue to drive this sector for years to come. Trends toward more outpatient care have grown in order to provide lower costs and have impacted the traditional healthcare space. Medical office space has continued to increase, and hospitals have seen growth in metropolitan areas, although declining revenues have impacted community and rural hospitals. Driving the pressure were problems such as payment delays, bad mergers, overexpansion, reimbursement changes, rapid changes in the healthcare environment, and tort litigation, among others. Some of the senior living facilities also experienced challenges with deferred maintenance, capex constraints, slow revenue increases, and competition in increased outpatient care. In addition, the industry is complex due to nonprofit ownership, state regulatory structures, single tenant usage, and public financing. Solutions exist, including consolidation of uses and administrative costs, expansion into independent living, and repurposing of facilities to include other, additional medical usages, and where appropriate closing facilities or buildings and repurposing the property for nonmedical uses. Struggles continue, but like the other real estate areas, creativity, capital, and community involvement can give this sector a much-needed shot in the arm.
As for golf courses and recreational properties, the challenges to the industry appear to be caused by factors such as overbuilt facilities, extensive costs for maintenance of facilities, declining demographics, and flat markets, among others. However, membership alternatives and a variety of users seem to be the keys to driving improvements in golf and recreational properties. Expansion of categories of membership, expansion of family facilities, reconfiguration of the course, or even consolidation of other clubs and courses into a new program all seem to be in the mix to repurpose this sector.
In sum, innovation, creative thinking, and capital investment are necessary to surviving and repurposing the changing landscape in all of these sectors of commercial real estate. Owners must challenge their traditional thinking on uses and users and try different concepts. In today’s market, there are a growing number of creative ideas, innovation, and applications of capital that appear to be part of the solutions that must be made to make the properties and industries profitable and productive again.
November 19, 2018, marked the end of the comment period for the advance notice of proposed rulemaking (Notice) issued by the Office of the Comptroller of the Currency (OCC) to solicit ideas for transforming and modernizing the Community Reinvestment Act (CRA) regulatory framework.[1] The OCC’s Notice is just one of many recent attempts by both lawmakers and regulators to renew focus on, and jumpstart momentum for, CRA reform. The question nevertheless remains unanswered as to whether the Notice represents the first shot fired as part of CRA change and how differing views, and possibly priorities, among regulators will impact this much-needed reform.
The CRA was originally enacted in October 1977[2] to stop the practice of redlining and to encourage banks to meet the credit and deposit needs of communities that they serve, including low- and moderate-income communities.[3] Since that time, the CRA has been amended at the margins numerous times through legislative action.[4] Regulatory actions, including CRA regulations and interagency questions and answers regarding the CRA, have further modified and shaped the CRA framework.[5] The OCC, through the Notice and otherwise, has recognized that the current CRA regulatory framework no longer reflects how many banks and consumers engage in the business of banking.[6] The need for more fundamental, structural CRA reform is the result of changes in the financial services industry over the past decades, including the removal of interstate branching restrictions, the expanded and transformative role of technology, and shifting business needs and consumer behavior and preferences, not to mention increased competitive forces from nonbank competitors. The emphasis on financial inclusion in the financial technology space also points toward the need for a CRA regulatory framework that is more adapted to the digital transformation that is coming to the banking sector.
In principle, the need for CRA reform has also been acknowledged by representatives of the Board of Governors of the Federal Reserve System (the Federal Reserve) and the Federal Deposit Insurance Corporation (the FDIC), the two other federal bank regulatory agencies charged with CRA implementation. Federal Reserve Vice Chairman for Supervision Randal Quarles and Federal Reserve Governor Lael Brainard, as well as FDIC Chairman Jelena McWilliams and FDIC Director Martin Gruenberg, have acknowledged that the digital evolution of the banking industry will require changes to the CRA regulatory framework.[7] Lawmakers and other stakeholders in the financial industry also recognize the need for reform and have put forward their own CRA reform recommendations or proposals.[8]
Although there is broad consensus among the regulatory principals that CRA reform is needed, the question of how to reform the CRA regulatory framework remains open.[9] This article first analyzes the approach to reforming the CRA contained in the OCC’s Notice. It then discusses current dynamics among the CRA regulators to the extent they are publicly known, pointing out consistencies (and inconsistencies) among the OCC’s approach in the Notice and the approaches that at least some at the Federal Reserve and FDIC seem to prefer. The article concludes with a brief outlook on what we expect to happen next with respect to CRA reform.
I. The OCC Notice’s Approach to CRA Reform
The OCC under Comptroller Joseph Otting has recognized that aspects of the current CRA regulatory framework may be sufficient for certain locally focused and less complex banks, but this framework no longer reflects how many banks and consumers engage in the business of banking. The Notice offers few, if any, concrete proposals and instead focuses on soliciting comments pertaining to reform in four key areas of the existing CRA regulatory framework:
revising the current performance evaluation methods by establishing clear and objective measures to assess CRA performance;
revisiting the definition of “assessment areas” that banks serve;
expanding CRA-qualifying activities; and
reducing the administrative burden associated with CRA compliance in various ways.
As Comptroller Otting pointed out in his testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs (the Senate Banking Committee) on October 2, 2018, improvements in these key areas will “strengthen the CRA by encouraging more lending, investment, and activity where it is needed most—fulfilling the ultimate purpose of the CRA.”[10] Unsurprisingly, the Notice’s four key areas of reform are consistent with the approach that Comptroller Otting outlined in his June 2018 testimony before the Senate Banking Committee[11] and the U.S. House of Representatives Committee on Financial Services (the House Financial Services Committee).[12] Additionally, the Notice’s key reform areas have much in common with the key areas for CRA reform identified by the Department of the Treasury (the Treasury Department) in its memorandum regarding CRA modernization recommendations (the CRA Reform Memorandum),[13] and the Notice also builds on the OCC’s prior efforts to modernize the CRA regulatory framework.[14]
The following briefly summarizes the OCC’s considerations regarding CRA reform as shown through the four key areas for which the Notice solicited public comment.
A. CRA Performance Evaluations
The current CRA performance evaluation framework provides for six different types of banks that are evaluated on the basis of different tests.[15] Although there are common elements across performance evaluation tests, there are certain elements that are unique to each test.[16] The OCC points out that neither the CRA itself nor the current CRA regulations expressly define the term “community,” but instead implement the term through assessment areas, which are areas surrounding a bank’s main office, branch offices, and deposit-taking automated teller machines and the assessment areas’ delineation.[17]
With this background regarding the current CRA framework in mind, the Notice then outlines a transformational approach to CRA reform that would involve the creation of a metric-based performance measurement system with thresholds corresponding to the four statutory CRA rating categories.[18] This approach is consistent with the outline of CRA reform that Comptroller Otting gave in his June 2018 Congressional testimony, where he promoted “clearer, more transparent metrics for what banks need to do to achieve a certain CRA rating.”[19] The Notice explains that the relevant metrics could be calculated as a ratio between the dollar value of CRA-qualifying activities on the one hand, and other objective criteria, such as a banking organization’s domestic assets, deposits, or capital on the balance sheet, on the other hand.[20] The Notice solicits comments on appropriate benchmarks and how much weight should be given to certain categories of CRA-qualifying activities.[21]
The Notice’s metric-based approach stands in contrast to the more moderate, revisionary approach to reforming the CRA’s performance evaluation framework that has been discussed by members of the Federal Reserve and FDIC. This more moderate, revisionary approach focuses not on developing a new metric-based approach, but instead on amending the existing performance tests and standards to include a more flexible evaluation of retail or community-development activities for all banks.[22] The Notice recognizes this more moderate, revisionary approach by seeking comment on an alternative, tailored method for evaluating CRA performance that would take into account a bank’s “business model, asset size, delivery channels, and branch structure.”[23]
B.Definition of Assessment Area
The Notice’s focus on redefining a bank’s “community” and the “assessment areas” in which a bank engages in activity is guided by the recognition of evolving banking practices in a changed technological environment.[24] This reform proposal aligns with the Treasury Department’s recommendation in its CRA Reform Memorandum.[25] The Notice’s proposal regarding the definition of assessment area would both accommodate business models of banks that operate without—or beyond the scope of—a physical location, and recognize the ways in which banking, including the cost of operating branches, has evolved due to technological advances and shifting consumer and business needs.
Under the current CRA regulatory framework, which was developed when banking was based largely on physical branch locations as the primary means of delivering products and services, a bank’s assessment area (and thus its community) is limited to the physical area surrounding a bank’s main office, branch offices, or deposit-taking ATMs.[26] Comptroller Otting criticized this framework, expressing the belief that limiting “assessment areas to a bank’s branch-based footprint has become an impediment to investment and providing capital in areas of need that the bank may serve.”[27] Instead, he called for broadened thinking so that a bank’s assessment area includes all areas where institutions provide their services.[28]
The Notice also requests comment on whether a bank’s qualifying CRA activities outside of its traditional assessment areas should be considered and assessed in the aggregate.[29] The Notice specifically invites thoughts on how “the current approach to delineating assessment areas” could be “updated to consider a bank’s business operations.”[30] The OCC also considers weighing or grading investment areas to ensure that bank activities in low- and moderate-income geographies continue to receive appropriate focus from banks.[31]
C.CRA-Qualifying Activities
Beyond asking whether CRA credit should be available for activity outside of the current limited definition of “assessment area,” the Notice seeks to ensure that CRA consideration is given for a broad range of activities that support community and economic development while retaining a focus on low- and moderate-income populations and areas.[32] In his June 2018 Congressional testimony, Comptroller Otting explained that CRA consideration currently is too focused on single- and multi-family residential lending, even though residential lending is not the only activity that can have a meaningful impact in communities.[33] Comptroller Otting instead indicated that CRA reform should be an opportunity to encourage banks to “help neighborhoods become communities where families can make a living and not just reside,” and supported the CRA recognition of “small business lending, student lending, economic development opportunities, and in some cases, additional opportunities for consumers to access credit.”[34]
The Notice continues this line of arguments and invites comment on the types and categories of activities that should receive CRA consideration. Specifically, it solicits thoughts on ways to provide more clarity and certainty regarding community development, small-business lending, and retail service activities for which a bank may receive CRA consideration.[35] The Notice raises the question of whether financial education or literacy programs, including digital literacy, should be considered for CRA credit and whether bank activities to expand the use of small and disadvantaged service providers should receive CRA consideration.[36] The Notice solicits comments generally on the expansion of CRA-qualifying activities, the role of small-business credit, and the circumstances under which small-business loans should receive CRA consideration.[37] Other questions focus on the possibility of different weightings for loan purchases versus loan originations, and for loans originated for sale versus loans to be held in portfolio.[38]
D.Reducing Administrative Burden Associated with CRA Compliance
Last, but certainly not least, the Notice raises the concern that the current CRA regulatory approach does not facilitate regulatory tracking, monitoring, and comparisons of levels of CRA performance by banks and other stakeholders.[39] It argues that the OCC’s transformational, metric-based approach for CRA performance evaluation would allow stakeholders to better understand CRA performance and compare a bank’s CRA performance to that of its peers or the entire industry, and also would allow for differentiation of CRA activity by location, type, and other factors.[40]
II. The Current Dynamics: Federal Reserve and FDIC Views on CRA Reform
As indicated above, we believe there is agreement in principle among the federal bank regulatory agencies charged with CRA implementation that CRA regulatory reform is much needed. In addition to the Notice’s endorsement of CRA reform, both Federal Reserve Vice Chairman Quarles[41] and Governor Brainard[42] have repeatedly expressed their support for CRA reform. FDIC Chairman McWilliams and Director Gruenberg have also indicated that CRA reform is something that they hope to achieve.[43] Based on public statements, however, there is not yet consensus on how to accomplish that reform. Given the CRA’s history in the sins of redlining, and current social and political debates, this lack of consensus is not surprising.
At the Federal Reserve, Vice Chairman Quarles emphasized the importance of branches in rural communities,[44] which indicates a preference for a moderate approach to CRA regulatory reform, although he has not publicly provided more detail on his vision. Governor Brainard has been the most outspoken governor on this topic and repeatedly articulated the following five principles that she expects would guide the Federal Reserve’s commitment to regulatory CRA revisions:[45]
broadening the evaluation of banks’ CRA performances to appropriately reflect technological advances;
appropriately tailoring the CRA regulations, including assessment areas, to banks based on their sizes and business models;
redesigning CRA regulations with the goal of encouraging banks to seek opportunities in underserved areas;
promoting consistency and predictability in CRA evaluations and ratings; and
developing CRA reform in the context of mutually enforcing laws.
Although Governor Brainard’s principles of reflecting technological advances and promoting consistency and predictability in CRA performance are largely consistent with the Notice, some of her other principles are in tension with the OCC’s approach to CRA reform, specifically the goal of tailoring CRA regulations to banks based on sizes and business models. This principle indicates a desire to moderately adjust the current regulatory framework as opposed to following the transformational, metric-based approach outlined by the OCC in the Notice.
Likewise, FDIC Chairman McWilliams has defended the importance of branches in low- and moderate-income communities to the extent that consumers rely on branches in these areas more than they rely on digital services;[46] however, she has not yet publicly detailed her views on how to reform the CRA regulatory framework. Director Gruenberg also expressed a concern that “a single ratio of CRA performance” as proposed by the metric-based approach and the OCC’s Notice could be difficult to reconcile with CRA statutory requirements and the foundational community-based focus of the CRA.[47]
III. Outlook: What’s Next with Respect to CRA Reform?
Although there is clearly momentum for CRA reform, the above analysis of current dynamics among the federal bank regulatory agencies clearly shows that the agencies are not yet fully aligned on how to approach and implement such reform and underscores the difficult road ahead. Further discussion and compromise on the right path forward are needed. Our assumption is that in light of the need for CRA reform, serious but not yet public discussions are ongoing among the principals and their deputies on how to balance these difficult policy issues.
Hope for uniformity and compromise remains, however, in that since the release of the Notice, the OCC on the one hand and the Federal Reserve and the FDIC on the other have offered a conciliatory tone. Comptroller Otting has, for instance, noted an intent to cooperate and potentially compromise on CRA reform, emphasizing that he is looking forward to working with his “regulatory colleagues and other stakeholders,”[48] by which we believe he means direct outreach to community groups. Vice Chairman Quarles and Governor Brainard have publicly announced that the Federal Reserve will be reading the comment letters on the Notice, with both also signaling that the Federal Reserve anticipates working with the OCC and FDIC on a future joint proposal on CRA reform based on those comments.[49] FDIC Chairman McWilliams echoed this sentiment, stating that the FDIC and Federal Reserve will join in on a proposed rulemaking, downplaying the significance of the OCC acting alone.[50]
Key principals at the federal banking agencies have clearly signaled that they are aware of their differences in this area and have signaled their interest in a mutual solution that both furthers the goals of the CRA and reflects the realities of the modern banking system. It is hoped that they will be able to solve any differences and develop a unified approach to reforming and modernizing the CRA regulatory framework—an outcome that should be beneficial to both banks and the communities they serve. The key unknowns are timing and regulatory priorities.
The authors are members of the financial institutions practice of Davis Polk & Wardwell LLP. They thank Olivia C. Harrison and Eric B. Lewin for their contributions to this article. The authors note that this article was submitted for publication on November 5, 2018, and does not account for any subsequent developments.
[1] Office of the Comptroller of the Currency, Reforming the Community Reinvestment Act Regulatory Framework, 83 Fed. Reg. 45,053 (Sept. 5, 2018).
[2] Pub. L. No. 95-128, 91 Stat. 1147 (Oct. 12, 1977), codified at 12 U.S.C. § 2901 et seq.
[4] Acts that amended the statute include: (1) the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, Pub. L. No. 101-73, 103 Stat. 183 (Aug. 9, 1989); (2) the Federal Deposit Insurance Corporation Improvement Act of 1991, Pub. L. No. 102-242, 105 Stat. 2236 (Dec. 19, 1991); (3) the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, Pub. L. No. 103-328, 108 Stat. 2338 (Sept. 29, 1994); and (4) the Gramm-Leach-Bliley Act of 1999, Pub. L. No. 106-102, 113 Stat. 1338 (Nov. 12, 1999). For a brief summary of the changes imposed by these acts, see the Background and Introduction Section of the Notice, 83 Fed. Reg. at 45,054. For additional information on the origins and revolution of the CRA, see also Martin J. Gruenberg, Member, Board of Directors, FDIC, The Community Reinvestment Act: Its Origins, Evolution, and Future, Speech at Fordham University, Lincoln Center Campus, New York, New York (Oct. 29, 2018).
[5] The Notice points out that the first CRA regulations were released in 1978, with amendments in 1995 and 2005. See 83 Fed. Reg. at 45,054; seealso 43 Fed. Reg. 47,144 (Oct. 12, 1978); 60 Fed. Reg. 22,156 (May 4, 1995); 70 Fed. Reg. 44,256 (Aug. 2, 2005).
[7] Governor Brainard discussed the need for suggestions on “how we can broaden our evaluation of banks’ CRA performances to take into account the technological advances that have made it possible for banks to serve customers remotely.” See Lael Brainard, Governor, Federal Reserve, Community Investment in Denver, Speech at the Federal Reserve Bank of Kansas City, Denver, Colorado (Oct. 15, 2018). Vice Chairman Quarles stated that “the financial system is evolving and branches have a different role than they have had in the past,” and FDIC Chairman McWilliams testified that “we need to take a look at the way branches are playing the role in today’s community.” SeeTestimony of Randal K. Quarles, Vice Chairman for Banking Supervision, Federal Reserve, and Jelena McWilliams, FDIC Chairman, before the Senate Banking Committee (Oct. 2, 2018). FDIC Director Gruenberg confirmed that the central issue of CRA reform “will be to preserve the foundations of CRA—the community-based focus, the reliance on community input, and the consideration of discriminatory and other illegal credit practices in the CRA evaluations—while adapting CRA to a changing banking environment.” See Gruenberg, supra note 4.
[8] In April 2018, the Department of the Treasury released a memorandum regarding CRA modernization recommendations. See Treasury Department, Memorandum for the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (Apr. 3, 2018). Senator Elizabeth Warren released the American Housing and Economic Mobility Act in September 2018, which is intended to extend the CRA to “cover more financial institutions, promote[] investment in activities that help poor and middle-class communities, and strengthen[] sanctions against institutions that fail to follow the rules.” See Senator Elizabeth Warren, American Housing and Economic Mobility Act, Bill Summary (Sept. 26, 2018).
[9] It is noteworthy that the OCC was the first and only agency to issue the Notice and seek public comment. Although the federal banking agencies usually act jointly to the extent that more than one agency has rulemaking authority, the Federal Reserve and FDIC did not join the release, which is typically a strong indicator for lack of agreement among the agencies.
[10] Joseph M. Otting, Comptroller of the Currency, Testimony before the Senate Banking Committee (Oct. 2, 2018).
[11] Joseph M. Otting, Comptroller of the Currency, Testimony before the Senate Banking Committee (June 14, 2018).
[12] Joseph M. Otting, Comptroller of the Currency, Testimony before the House Financial Services Committee (June 13, 2018).
[13] The Treasury Department’s CRA Reform Memorandum (seesupra note 8) includes recommendations that focus on four key areas: (1) assessment areas, (2) examination clarity and flexibility, (3) examination process, and (4) performance, which largely overlap with the Notice’s key focus areas of revising the current performance evaluation methods, revisiting the definition of “assessment areas,” and reducing the administrative burden associated with CRA compliance.
[14] These prior efforts include, for example, the OCC’s revisions to its existing CRA examination and ratings policies to require a “logical nexus” between a discriminatory or illegal credit practice and a bank’s CRA lending before the bank’s CRA rating may be downgraded. See OCC Bulletin 2018-23: Revisions to Impact of Evidence of Discriminatory or Other Illegal Credit Practices on Community Reinvestment Act Ratings (Aug. 15, 2018).
[15] Large banks (more than $1.252 billion in assets) are subject to lending, investment, and service tests; intermediate small banks (between $313 million and $1.252 billion in assets) are subject to retail lending and community development tests; small banks (less than $313 million in assets) are subject to a retail lending test that may also consider community development loans; wholesale, limited purpose, and military banks are subject to their own differing tests and standards, and any bank can elect to be evaluated under a strategic plan that sets out measurable, annual goals for lending, investment, and service. See 83 Fed. Reg. at 45,055.
[17]Id. at 45,056. See also 12 C.F.R. § 25.12(c) (definition of “assessment area”), 12 C.F.R. § 25.41 (assessment area delineation provision).
[18] 83 Fed. Reg. at 45,056. The four statutory rating categories are outstanding, satisfactory, needs to improve, and substantial noncompliance. See 12 U.S.C. § 2906(b)(2).
[25]See supra note 8 (stating assessment areas should be updated to reflect the changing nature of banking arising from changing technology, consumer behavior, and other factors).
[41] John Heltman, CRA Needs to Come Off “Autopilot,” Fed’s Quarles Says, Am. Banker, Apr. 17, 2018 (describing Vice Chairman Quarles’s testimony before the House Financial Services Committee stating that the CRA must “move off of autopilot” and emphasizing the need to take a fresh look at modernizing the CRA to achieve its core purpose).
[42]Seesupra note 7; see also Lael Brainard, Governor, Federal Reserve, Keeping Community at the Heart of the Community Reinvestment Act, Speech at the Association of Neighborhood and Housing Development, Eighth Annual Community Development Conference Build.Community.Power, New York, NY (May 18, 2018).
[43]Seesupra notes 7, 4; see also Jon Hill, FDIC Chief Wants to Put the ‘Bank’ Back in Banking, Law360, Oct. 23, 2018.
Blockchains reduce the need for “trust” in legal transactions. From a legal perspective, trust has some specific meanings with respect to custody, control, and transactional risk. It can be accurately defined as “reliance on assurance of others to reduce transactional risk.” Blockchains radically shift the economics of providing transactional assurances.
For example, blockchains reduce the cost and complexity of obtaining assurances of asset ownership and control. Blockchain offers a cheaper and more reliable mechanism of creating, storing, and proving evidence.
Commercial and financial legal processes currently rely on numerous systems to reduce overall transactional risk and give people enough confidence to transact. A critical legal inquiry regarding any kind of property is, who owned title, when, and what is the transactional history? In asset transactions, property registries provide custodial and financial histories. To risk buying an item or making a loan secured by property, a buyer or creditor must be able to verify that the person purporting to own the property really does have title, and that there are no other enforceable inconsistent claims.
For high-value, complex transactions, this means obtaining assurances of (1) proof of authoritative title to an asset (title is clean and untampered), and (2) proof that the proof of title is reliable (the source of assurance (1) is clean and untampered). Underpinning it all is property law. Rules of property law apply whether the object in question is a house, a retail installment contract, or a digital token. Critical to property law is the concept of title, or ownership of property.
Legal systems have developed multiple property registries and custodial systems to manage information and give buyers, lenders, and invested parties the ability to verify whether a specific deal represents an enforceable obligation. Financial market infrastructure spends tremendous sums to maintain structures that provide assurances of things like chain of custody and title.
Registries. Creditors and other interested parties file notices with deeds registries, secretaries of state, departments of motor vehicles, and places a creditor checks for notice of an adverse interest. Common examples are land registries and, in the United States, the U.C.C.-1 filing registry within a state. The registry record is deemed authoritative for legal enforcement of contracts, and insurers, lenders, buyers, and sellers rely on it equally to track rights and obligations. The records produced by central property registries supply chain of title and custody details.
Registries like these developed out of need: without a reliable system for registering, or “perfecting,” one’s interest in property, market confidence in buying, selling, and lending is disincentivized. Functional registries make functional markets.
Custody and Control of Intangibles. Second-and-third order monetization of a value stream often involves intangible property. For example, financial products leverage contract rights and obligations to create additional assets and revenue streams like securities and derivatives. In pre-internet commerce, custody and control of intangible assets were proved by “possession”; a lender holding a note as a security pledge against a loan might actually take possession of the note. It is impractical to run valuable paper instruments from holder to holder in real time, so the notes were placed with a trusted third party who acted as intermediary, for example, holding the notes in custodial trust, matching and settling promises to pay. The market assigned possessory rights to custodial agents who held assets “in trust” and maintained their chain of title so deals were free to flow without paper slowing them down.
Electronic Contracts. With the advent of electronic contracts, the law evolved a new method of perfecting a security interest in digital originals of notes and chattel paper. The key, when vaulting an electronic contract, is to prevent multiple copies that might result in adverse claims, or “double spends” of the same obligation. Sounds familiar!
Electronic contracting laws like Uniform Electronic Transactions Act (UETA) established standards for vaulting and proving custody and control of digital assets. The UETA drafters, however, noted that their recommendations were based on late-20th-century technological capabilities to establish “control.” UETA’s custodial “control” requirements substitute for possession to perfect electronic contracts in the absence of a unique digital “token” to represent a contract. The drafters looked to the market to develop better systems of digital asset control.
Where Blockchain Comes In
A better property registry. Blockchain gives us a decentralized, tamper-evident record of what happened and when with respect to data stored in specific tokens. This tamper-evident ledger means less reliance on central authorities to prove the integrity of assets. A blockchain-based property registry proves its own transactional history.
Assets that prove their own chain of custody. Blockchain-based data objects can represent any number of property types extrinsic to the blockchain, as well as assets that are native to digital technology, e.g., tokens. A blockchain-native asset represented by a token is inherently and immutably tied to its transaction history. This means assets stored in a blockchain can prove their own titles, chains of custody, and transactional records.
Blockchains can get chain of custody right. Without structures that prove chain of custody, the lack of reliable proof structures has a chilling effect on legitimate commerce. Blockchain offers a low-cost way to scale legal infrastructure and build commercial rails on the bedrock of rule of law.
Poorly controlled legal proof structures are also a problem with existing custodial systems. For example, after the 2008 recession, we learned of multiple frauds in the system of keeping chain of custody of loan records. Many assets were so poorly tracked that when it came time to enforce legal rights, creditors were left holding assets with chains of custody any lawyer could challenge to defeat the creditor’s claim. Blockchain storage of contract assets solves this problem, ab initio.
Blockchain proof of title, custody, and transaction history reduces the need to rely on external assurances. This opens economic potential wherever there was previously a lack of reliable legal infrastructure. Along the way, blockchain will shed light upon, and drive the transition to, more efficient methods of proof in digital infrastructure.
On October 17, 2018, the Cannabis Act came into force in Canada, establishing a comprehensive legislative scheme governing the licensing, production, distribution, and sale of cannabis and related products for recreational use. Canada’s nascent recreational cannabis industry has faced its share of growing pains, but there is reason for optimism moving forward. Statistics Canada estimates that the illicit market for cannabis was worth approximately CDN$5 – $6 billion (US$3.79 – $4.55 billion) in 2015, while a 2018 Deloitte report suggests that the total Canadian cannabis market could generate up to CDN$7.17 billion (US$5.44 billion) in sales in 2019. If the sales figures forecast by the Deloitte report are achieved, that would put the cannabis market on the same footing as both the Canadian wine industry and the Canadian spirits industry.
Excitement surrounding legalization has led to a flurry of capital markets activity in Canada, resulting in billion dollar market capitalizations for several Canadian cannabis companies traded on the Toronto Stock Exchange (“TSX”), as well as the one Canadian cannabis company that currently trades solely on the NASDAQ.
Investor optimism is not fueled exclusively by the market potential that exists within Canada’s borders; rather, international opportunities represent a significant growth target. A 2018 report published by CIBC suggests that the global cannabis market could reach approximately CDN$25 – $30 billion (US$18.96 – $22.75 billion) in 2020. The U.S. could play a significant role in the global cannabis economy, as a study conducted by the Brightfield Group estimates that Canada and the U.S. will account for more than 86% of global cannabis sales in 2021.
Although cannabis is currently legal for recreational use in ten U.S. states and for medical use in 33 states and the District of Columbia, cannabis remains a Schedule 1 narcotic under the U.S. federal Controlled Substances Act. This classification has prevented Canadian cannabis companies from entering the U.S. market. Although cannabis may be exported from Canada for medical or scientific purposes under the Cannabis Act, an export permit may be refused if such exportation would contravene the laws of the country of import, or if such exportation would not comply with the permit for importation issued by a competent authority of the country of import.
Notwithstanding these obstacles, enthusiasm regarding the U.S. market was on full display when Tilray Inc.’s shares jumped 28.95% on the same day it was reported that the Canadian cannabis producer had received approval from the U.S. Drug Enforcement Agency to export cannabis to California for a clinical trial.
What does this mean for U.S. cannabis companies?
U.S. stock exchanges are regulated by federal legislation and, as a result, you will not find any pure play U.S. cannabis companies listed on the major American stock exchanges. Similarly, the TSX and its affiliated TSX Venture have taken the position that companies with operations or investments in the U.S. cannabis industry will be in violation of the listing requirements of their exchanges and thus subject to de-listing.
However, Canada’s more junior exchange, the Canadian Securities Exchange (the “CSE”), has welcomed Canadian and U.S. cannabis companies alike, listing 116 companies that operate in the cannabis industry, as of the date of this writing. Rather than prohibiting issuers with ties to the U.S. cannabis industry, the CSE has taken a disclosure-based approach, requiring its issuers to disclose the extent of its activities in the U.S. and the risk that its activities present from a U.S. legal standpoint.
Investor response to CSElisted cannabis companies has been extremely positive, with investors showing a particular appetite for companies offering exposure to the U.S. cannabis market. While historically being considered a “third-tier” Canadian stock exchange, the CSE is gaining notoriety, attracting industry-leading U.S. cannabis companies that have been denied access to more traditional exchanges.
For example, inMay 2018, MedMen Enterprises Inc., a leading cannabis retailer in the U.S., began trading on the CSE at an implied value in excess of US$1.6 billion and on November 16, 2018, filed to raise CDN$75 million (US$56.88 million) via bought deal. In October 2018, Curaleaf Holdings Inc., a vertically integrated cannabis cultivator and retailer, closed a private placement on the CSE which raised approximately US$400 million, implying a valuation close to US$4 billion. The most recent debut on the CSE was that of Acreage Holdings, a multi-state cannabis producer that boasts former House Speaker John Boehner and former Canadian Prime Minister Brian Mulroney as board members. Acreage Holdings began trading on the CSE on November 15, 2018, shortly after raising US$314 million in a private placement, implying an enterprise value of approximately US$2.1 billion.
How are U.S. cannabis companies becoming listed?
The most popular approach to listing on the CSE by far is the reverse takeover, or “RTO”. RTOs involve the entity acquiring a publicly-listed shell or dormant company to pursue listing. RTOs are typically completed by way of a statutory amalgamation or arrangement and may require approval of each company’s shareholders, depending on the structure of the transaction and constating documents of the companies.
Compared to an IPO, RTOs are generally less time consuming and expensive and do not necessarily need to be accompanied by a concurrent equity financing—although MedMen, CuraLeaf and Acreage Holdings each completed private placements connected to their respective RTOs.
Another primary driver of expediency in RTOs is that they do not require regulatory review by securities regulators, and rather only require approval of the stock exchange. While a document with prospectus-level disclosure is still a requirement, eliminating the review of the securities regulators is one less obstacle to face in an RTO process.
Looking forward
There has been growing support to amend federal cannabis laws in the U.S. On June 7, 2018, Senators Cory Gardner and Elizabeth Warren introduced the Strengthening the Tenth Amendment Through Entrusting States (STATES) Act in Congress, which would amend the Controlled Substances Act to make it impossible to prosecute individuals and corporations who are in compliance with U.S. state laws on cannabis. A companion bill was introduced on the same day in the House of Representatives by Representatitives Earl Blumenauer and David Joyce.
The STATES Act would not remove cannabis as a Schedule 1 narcotic, meaning that cannabis would remain federally illegal. However, the STATES Act provides that compliant transactions would not be considered trafficking and would therefore not result in the proceedings accompanying an unlawful transaction. With this distinction in mind, it remains unclear what impact the STATES Act, if passed, may have on the willingness of U.S. stock exchanges and federally regulated banks to participate in the U.S. cannabis industry.
While much uncertainty remains with respect to the long-term outlook of the U.S. cannabis market, there appears to be a significant appetite among investors to participate in this burgeoning industry. As of right now, the most attractive way for U.S. cannabis companies to capitalize on this enthusiasm and to access capital markets is to look north of the border, where the CSE awaits with open arms.
While hanging around the water cooler the other day, I took an informal survey of a few colleagues. “How many of you are finding the task of addressing private information in compliance with increasingly complex laws, regulations, and corporate mandates to be hugely fun?” Unsurprisingly, the feedback was unanimous; everyone was loving it. They couldn’t get enough. They clamored for greater records management responsibilities and litigation response obligations. They also mentioned that there is no better end to a long workday than an involved information-security training, provided that their lunchtime could be interrupted for dental work with no anesthesia.
As it turns out, employees in the real world don’t really like doing anything beyond their real jobs, and certainly don’t want to have anything to do with the perceived tedium of classifying their files according to a growing set of company rules. For the vast majority of people, information management is about as fun as a root canal. And yet, effectively managing information has always been essential and is more and more a differentiator for organizations. This capability impacts a company’s reputation, risk profile, and innovation initiatives.
What can companies do? They can’t outsource their obligations—even if a third party is brought in to do some of the legwork, ultimately the obligation to comply lies with the company. Neither can they ignore the issue because there are increasingly more laws that prescribe how companies and their employees must manage information from its creation to its proper destruction. Similarly, there are far more consequences in failing to get it right. It’s an unenviable position for companies; they need their employees protecting the company’s information assets, but most employees are disinterested at best, viewing themselves to be full up with “real” work that trumps a concerted focus on these efforts.
Generally, there are two kinds of employees: the ones who are motivated by carrots, and the ones who must be inspired by sticks. There are some employees who will follow rules because they are told to and because being proactive is good for the company. However, if there is no compelling reason for employees to do something, they often fall into the latter category of needing a consequence, a penalty, or a loss of some benefit or privilege before they will dream of doing a task at work outside of their perceived job scope.
That brings us to a confluence of realities: more downside, more attacks on the IT systems, more laws dictating what is required and penalizing companies when they fail to comply, and more employees behaving badly, uninspired to lift a finger to help your company better manage information.
Here are seven keys to fix such a problem.
1. Set the Tone at the Top. The CEO in some respects is the soul of the company in that he or she sets the big-picture objectives for the organization. This is commonly communicated through a mission statement, vision, and code of ethics. These concepts and values are then seen as calls to action by others in the organization and rapidly become operationalized. When the CEO or other executives message the importance of a company initiative or action, the employees (everyone below them) are more likely to listen and follow their lead. For example, if the CEO decides that being a “greener” company is important, then initiatives that advance that idea will get more attention and funding. Employees will more likely do what it takes to make the company greener. Thus, one thing that will be essential to making information activities come to life in the company is for the executive team and others in management to support the information project or program and message its importance to all employees. Another way they can show support is by funding such activities and publicly recognizing successful efforts.
2. Make It Part of the Job. One of the best ways to get folks to take on protecting private information is to make it a part of their job responsibilities. For many businesses, at most they develop policy and expect that employees will read, understand, and follow the directives. That is usually the last time the policy is addressed until something bad happens. Then everyone wants to know what went wrong. What commonly goes wrong is that employees have a black and white view of their roles and responsibilities. They disregard policies as irrelevant to their jobs if adequate context isn’t provided.
The company can “legitimize” the activity by making it a part of the employees’ job responsibilities in writing and by making it clear that failure to do as required will, for example, impact performance incentives. When compliance with a policy is tied to compensation, it tends to get employees engaged. That would be more of the stick approach.
In terms of the carrot, why not have high-potential employees nominated by senior leadership to serve as information stewards? Formalize the role, make it a coveted position, and recognize and reward them for participating. You will find that you have inspired these employees to be your eyes and ears in the business. This causes a chain reaction whereby those around them start caring more as well.
3. Train the Employees. A policy itself, no matter how comprehensive and clear, is only as good as the training and change-management that accompanies it. Parking a myriad of policies on a website and thinking employees will search to find and master them is wholly unrealistic. Not only that, but having policies that no one follows is a liability. “Isn’t it true that your company has a privacy policy, you didn’t know about the policy, and in fact were never trained on the policy . . .” You get the idea.
Providing a written policy or other directive tells employees what is expected; training them on it helps ensure they understand what they must do in greater specificity. In other words, policy is not enough. Training and perhaps even testing on the mastery of the training is far more effective.
Remember, however, that employees can’t take in endless training sessions on one topic after another. Be mindful to not put too much in front of them at once and spread it out to maximize the training’s effectiveness. In other words, limit how much training employees receive, given the law of diminishing returns.
Training should be an important tool in your arsenal when it comes to ensuring that employees are able to digest and apply vital policy concepts. It is a stepping-stone to behavioral change. One point of consideration is to consolidate trainings where possible. Companies often have a “code of ethics” or “code of conduct” that provides high-level principles regarding the company’s position on such matters as privacy requirements, books and records management, cyber-security fundamentals, and beyond. Publishing such a code for public/external consumption bolsters a company’s reputation for being trustworthy and of sound integrity. Is it possible to consolidate your trainings on various governance topics into one large “code of ethics” training that can be taken in modular format? This then strengthens and unifies the company’s position on various interdependent information-management directives while streamlining the training experience for employees.
4. Gamify. In the last few years, gamification of training has helped create better-trained employees and kept employees engaged with longer-term retention of the topic. Gamification is a process where an employee is engaged at a deeper level to make the training like a game. This means launching awareness campaigns that involve features like points, levels, and awards. The goals of gamification are to create a sense of intrinsic motivation, achievement, and mastery. The more employees interact with the training material or policy in a game context, the more likely they are to understand the material and be able to act upon it. Bottom line is that it works.
5. Auditing/Monitoring. The only real way to know whether employees are doing what is required of them is by looking. In the workplace, that is typically done by watching their actions in real time (monitoring) or looking at what they have done after the fact (auditing). Auditing and monitoring programs help ensure that employees are getting it right. These programs also allow the company to help employees better perform tasks and fix training or implementation issues across the company as they become known.
In highly regulated industries, auditing and monitoring are part of the normal course of business. In fact, internal audit and quality assurance teams can be excellent partners in building an audit readiness program and in conducting the audits themselves.
6. Whack with Love or Not, but Be Consistent. When employees get something wrong, there may be a need to reprimand them. Thus, when policies provide that noncompliance may result in disciplinary action, the company must follow through. Failure to discipline may result in claims that such policy or disciplinary action is applied in a discriminatory fashion. Remind and follow up with employees to ensure they are getting it right, and when they don’t, act swiftly, fairly, and consistently to address the failure. Remember, word travels fast, and others will take note, which tends to change behavior in a positive way.
7. Repeat. Training, behavioral change, and the business transformation that follows are not one-time projects or instantaneous outcomes. Begin the process of training on key topics from the very beginning of an employee’s tenure at your company during orientation. For topics that are essential for employees to master, such as information security, training should be routinized and part of an established schedule. Not only that, policy principles and core concepts should be patiently and persistently reiterated via meetings with communities of practice, company newsletters, annual refresher trainings, and embedded within spotlights on governance initiatives when there has been a “big win.” Making employees care about managing information well means making these conversations part of your company’s culture.
Conclusion
Information has become the lifeblood of organizations. Oftentimes, it’s pumping life without rhyme, reason, control, or direction, and that has to change. Unless leadership institutionalizes the management of information, the employees will likely do as little as possible or nothing at all. With value, volume, growth in legal requirements, and consequences all intensifying around information management, however, companies must have their work forces engaged. The seven keys may not build love, but they will build a reasonable, repeatable, and defensible process “hook” for litigators to hang their hats on when failure occurs, and it always does.
2018 Report and Model Contract Clauses from the Working Group to Draft Human Rights Protections in International Supply Contracts, ABA Business Law Section*
David V. Snyder (chair) and Susan A. Maslow (vice chair)**
I. INTRODUCTION
In cooperation with other groups in the ABA Business Law Section and the wider American Bar Association, the ABA Business Law Section formed the Working Group to Draft Human Rights Protections in International Supply Contracts (“Working Group”). This is part of a larger effort to achieve widespread implementation of the ABA Model Business and Supplier Principles on Labor Trafficking and Child Labor[1] as well as other human rights protections.
We cannot stand by when children are trafficked and traded or when workers die in factory collapses and fires. The hope is that following the steps outlined in the ABA Model Principles will help eradicate labor trafficking and child labor from supply chains, making a difference to real people—their health, safety, and freedom—and, in some cases, saving lives.
In addition, companies need to comply with an increasing number of human-rights-related laws and regulations. The clauses below are designed to be compatible with a company’s policies with respect to any human-rights-related subject, including anti-trafficking, worker safety, conflict minerals, antidiscrimination, and sustainability. In this sense, the clauses are agnostic as to subject. The substance and content of those policies is beyond the scope of this Working Group; they were the subject of earlier ABA work[2] and have also been the subject of similar projects at the United Nations, the Organisation for Economic Co-operation and Development (“OECD”), and elsewhere. The foundational idea behind the present work is to move the commitments that companies require, whatever they may be, from corporate policy statements to the actual contract documents where those policies may have greater impact.
At the same time, the clauses below seek to minimize the risks inherent in the adoption of any corporate policy. Claims have been made against companies based on those companies’ undertakings as buyers in the supply chain. In other words, there is risk for such companies, often unrecognized and inadequately addressed in current supply contracts. The disclaimers included below address these issues, although no risk can be eliminated entirely.
II. PROTECTION THAT IS LEGALLY EFFECTIVE AND OPERATIONALLY LIKELY
Adoption of policies at the corporate level, while a good start, is not always enough: principles need to be put into practice. One way to do so is to integrate the policies into supply contracts, purchase orders, and similar documents that are part of the operational as well as the legal life of buyers and suppliers. The contracts and related documents are what govern, and often guide, the behavior of the parties. Enlightened contractual terms have great potential to make a difference when combined with effective remedies for their violation and a willingness to enforce them.
III. READY-MADE LANGUAGE FOR TRICKY ISSUES: CLAUSESTO MANAGE RISK AND MINIMIZE EXPOSURE FOR COMPANIES WHILE PROTECTING WORKERSAND COMPLYING WITH REGULATIONS
The mission of the Working Group is to make available well considered clauses that protect workers and that are sensitive to the legal and business risks that companies face. The drafting is challenging. Sales law and contract law are keyed to production of conforming goods, like well-stitched soccer balls. The background law does not deal easily with the problem of soccer balls that are perfectly stitched but that were sewn by child slaves. Further, companies reasonably wish to minimize the litigation risk and liability exposure while remaining compliant with generally applicable laws, particular regulations (like the Federal Acquisition Regulation), and moral imperatives. The clauses suggested below aim to address these sometimes conflicting goals, and they recognize that there are inevitably risks, which can be mitigated and perhaps minimized but not eliminated. The proposed clauses include annotations to explain the choices made and their benefits and risks. For those who want in-depth treatment, an upcom-ing symposium will be published later this year in the American University Law Review.[3]
Companies may wish to adopt these clauses for a number of reasons:
Compliance with U.S. anti-trafficking statutes;[4]
Compliance with other U.S. laws, such as regulations or prohibitions of imports made with child labor or forced labor;[5]
Compliance with U.S. state laws, like the California law on supply chain transparency;[6]
Compliance with the Federal Acquisition Regulation (“FAR”);[7]
Compliance with foreign law,[8] such as the national transpositions of the EU non-financial reporting directive;[9] and
Mitigation of potential liability under state statutory and common law theories such as undertaking liability,[10] third-party beneficiaries,[11] and deceptive advertising.[12]
Whatever moral and legal commitments companies want to require can be accommodated in what this Working Group entitles Schedule P,[13] which the model clauses incorporate, but the actual content of Schedule P is beyond the scope of this Working Group.
CLAUSES TO BE INSERTED INTO SUPPLY CONTRACTS, PURCHASE ORDERS, OR SIMILAR DOCUMENTS FOR THE SALE OF GOODS
The following clauses are designed for supply contracts. They assume that assurances with respect to compliance with certain human-rights-related policies is desired or required by the buyer and that such policies will appear in an appendix to the agreement, Schedule P, just as the buyer’s specifications for goods themselves are likely to appear in an appendix. The clauses below are intended to make those policies legally binding and to provide enforceable remedies for their violation while also managing the risk that may come with such policies.
The ABA Model Principles and Policies[14] are an example of what might appear in Schedule P; many companies may wish to adopt or adapt them. Some companies may prefer or need something broader (see infra note 18 regarding certain laws that apply to some buyers), and other companies may need something broader still (e.g., to comply with the FAR, other human rights and health and safety standards, or moral obligations). Other possibilities include the OECD Guidelines and the UN Guiding Principles (the Ruggie Principles). Many companies will already have supplier codes of conduct or similar documents that they can use as the content of Schedule P, or Schedule P may simply require obtaining and maintaining certification from a designated third party. The content of Schedule P will likely vary significantly by industry and is beyond the scope of this Working Group.
The text proposed assumes that buyers are located in the United States and that the applicable law is the Uniform Commercial Code (the “U.C.C.”) or the United Nations Convention on Contracts for the International Sale of Goods (the “CISG,” a treaty to which the United States is a party). Buyers and suppliers in other jurisdictions may also find these clauses a useful starting point.
Note on negotiation stance. The proposed text is buyer-friendly, sometimes extremely so, and it could be perceived by some suppliers as unduly aggressive. The drafters have crafted the text this way because some buyers may have the leverage to use the proposed text, and in any case, these clauses are aimed primarily at companies in the role of buyer. The text as proposed gives an indication of what a company would want as buyer, and each company can decide if particular provisions need to be adjusted or eliminated based on its negotiating position and its stance in other transactions (given that most companies are sometimes in the position of buyer and sometimes in the position of seller).
1. Representations, Warranties, and Covenants on Abusive Labor Practices. Supplier represents and warrants to Buyer, on the date of this Agreement and throughout the contractual relationship between Supplier and the Buyer, that:
1.1 Compliance. Supplier and its subcontractors and [to Supplier’s [best] knowledge][15] the [shareholders/partners, officers, directors, employees, and] agents of Supplier and all intermediaries, subcontractors, consultants and any other person providing staffing for Goods[16] or services required by this Agreement [on behalf of Supplier][17](collectively, the “Representatives”) are in compliance with Schedule P.[18] Each shipment and delivery of Goods shall constitute a representation by Supplier and Representatives of compliance with Schedule P; such shipment or delivery shall be deemed to have the same effect as an express representation. [Supplier’s delivery documents shall include Supplier’s certification of such compliance.][19]
1.2 Schedule P Compliance Through the Supply Chain. Supplier and its Representatives shall make the performance of all of its Representatives subject to the terms and conditions in Schedule P and Supplier shall ensure that Supplier, its Representatives, and all of its and their respective Representatives acting[20] in connection with this Agreement do so throughout the contractual relationship only on the basis of legally binding and enforceable written contracts that impose on and secure from the Representatives terms [in compliance with] [equivalent to those imposed by] [at least as protective as those imposed by] Schedule P. To restate for clarity, each Supplier and each Representative shall require each of its Representatives’ compliance so that such obligations are required at each step of the supply chain. Notwithstanding anything contained herein to the contrary, Supplier shall be responsible for the strict observance and performance by Supplier and its Representatives of the terms and conditions in Schedule P and shall be directly liable to Buyer for any violation by Supplier or its Representatives of Schedule P.
1.3 Supplier’s Policies. Supplier shall establish and maintain throughout the term of this Agreement its own policies and procedures to ensure compliance with Schedule P (“Supplier’s Policies”), which shall include a reporting mechanism for Representatives to report potential and actual violations of Supplier’s Policies and/or Schedule P.[21] Within ___ days of (a) Supplier having reason to believe there is any potential or actual violation of Supplier’s Policies and/or Schedule P, or (b) receipt of any oral or written notice of any potential or actual violation of Supplier’s Policies and/or Schedule P, Supplier shall provide a detailed summary of (i) the factual circumstances surrounding such violation, (ii) the specific provisions of the Supplier’s Policies and/or Schedule P that are alleged to have been violated, and (iii) the investigation and remediation that has been conducted or that is planned. [22]
1.4 Provision of Information. Upon request, Supplier shall deliver to Buyer such information and materials as Buyer reasonably requires with respect to the subject matter of Schedule P.
2. Rejection of Goods and [Cancellation] [Avoidance] of Agreement.
2.1 Strict Compliance. It is a material term of this Agreement that Supplier and Representatives shall strictly comply with Schedule P.
2.2 Rejection. Buyer shall have the right to reject any Goods produced by or associated with Supplier or Representative that Buyer has reason to believe has violated Schedule P, regardless of whether the rejected Goods were themselves produced in violation of Schedule P, and regardless of whether such Goods were produced under this or other contracts. [23]
2.3 [Cancellation.] [Avoidance.] Noncompliance with Schedule P [substantially impairs the value of the Goods and this Agreement to Buyer][24] [is a fundamental breach of the entire Agreement][25] and Buyer may immediately [cancel] [avoid] [26]this entire Agreement with immediate effect and without penalty and/or may exercise its right to indemnification and all other remedies.[27] Buyer shall have no liability to Supplier for such [cancellation] [avoidance].
2.4 Timely Notice. Notwithstanding any provision of this Agreement or applicable law (including without limitation [the Inspection Period in Section ___ of this Agreement and] [Articles 38 to 40 of the CISG] [and U.C.C. §§ 2-607 and 2-608]),[28] Buyer’s rejection of any Goods[29] as a result of noncompliance with Schedule P shall be deemed timely if Buyer gives notice to Supplier within a reasonable time after Buyer’s discovery of same.
2.5 No Right to Cure. Supplier hereby acknowledges that it shall have no right to cure by substitution and tender of Goods created and/or delivered without violation of Schedule P if Buyer elects to refuse such tender, in Buyer’s sole discretion. [30]
3.1 Notice of Buyer’s Discovery. Buyer may revoke its acceptance, in whole or in part, upon notice sent [in accordance with Section ___] to Supplier of Buyer’s discovery of Supplier’s noncompliance with Schedule P, which the parties have agreed in Section 2 above is a nonconformity that substantially impairs the value of the Goods and this Agreement to Buyer.
3.2 Same Rights and Duties as Rejection. Upon revocation of acceptance, Buyer shall have the same rights and duties as if it had rejected the Goods before acceptance.
3.3 Timeliness. Notwithstanding any provision of this Agreement or applicable law (including without limitation [the Inspection Period in Section ___ of this Agreement and (U.C.C. § 2-608)], Buyer’s revocation of acceptance of any Goods as a result of noncompliance with Schedule P shall be deemed timely if Buyer gives notice to Supplier within a reasonable time after Buyer’s discovery of same.
4. Nonvariation of Matters Related to Schedule P.
4.1 Course of Performance, Established Practices, and Customs. Course of performance and course of dealing (including, without limitation, any failure by Buyer to effectively exercise any audit rights)[32] shall not be construed as a waiver and shall not be a factor in Buyer’s right to reject Goods, [cancel] [avoid][33] this Agreement, or exercise any other remedy. Supplier acknowledges that with respect to the matters in Schedule P, any reliance by Supplier on course of performance, course of dealing, or similar conduct would be unreasonable. Supplier acknowledges the fundamental importance to Buyer of the matters in Schedule P and understands that no usage or practice established between the parties should be understood otherwise, and any apparent conduct or statement to the contrary should not be relied upon.[34] The parties agree that no usage of trade, industry custom, or similar usage shall apply to this Agreement to the extent such custom or usage would lessen the protections provided or the obligations imposed by Schedule P. No person except [Title/Officer] has authority on behalf of Buyer to vary Schedule P or any provisions relating to it, and any such variation must be in a signed writing or an authenticated electronic communication.
4.2 No Waiver of Remedy. Buyer’s acceptance of any Goods in whole or in part will not be deemed a waiver of any right or remedy[35] nor will it otherwise limit Supplier’s obligations, including, without limitation, those obligations with respect to warranty and indemnification.
5. Remedies.
5.1 Notice of Breach. If Buyer has reason to believe, at any time, that Supplier or a Representative is not in compliance with Schedule P, Buyer shall notify Supplier [in accordance with Section ____]. [Buyer’s notice requesting remediation as well as Buyer’s notices of breach or rejection [or revocation][36] may be given orally or in writing.] A notice to remediate noncompliance with Schedule P also constitutes notice of breach of this Agreement. [37]
5.2 Investigation and Suspension of Payment. Buyer has the right to suspend all payments to Supplier, whether due under this Agreement or other agreements, if Buyer deems, in its sole discretion, that investigation of possible noncompliance with Schedule P is advisable. Such suspension of payments will continue during investigation. Supplier shall fully cooperate with investigation by Buyer or Buyer’s agents. Without limitation, such cooperation shall include, at Buyer’s request, working with governmental authorities to enable Buyer or its agents to enter the country, to be issued appropriate visas, and to investigate fully.[38]
5.3 Exercise of Remedies. Remedies shall be cumulative. Remedies shall not be exclusive of, and shall be without prejudice to, any other remedies provided at law or in equity. Buyer’s exercise of remedies and the timing thereof shall not be construed in any circumstance as constituting a waiver of its rights under this Agreement. In addition to the right to [cancel] [avoid] this Agreement, in whole or in part, and any other remedies available to Buyer, in the event that Supplier or a Representative fails to comply with Schedule P, Buyer may:
deem itself insecure and demand adequate assurance from Supplier of due performance in conformance with Schedule P;
obtain an injunction with respect to Supplier’s noncompliance with Schedule P, and the parties agree that noncompliance with Schedule P causes Buyer great and irreparable harm for which Buyer has no adequate remedy at law and that the public interest would be served by injunctive and other equitable relief;
require Supplier to remove an employee or employees and/or other Representatives;
require Supplier to terminate a subcontract;
suspend payments, whether under this Agreement or other agreements, until Buyer determines, in Buyer’s sole discretion, that Supplier has taken appropriate remedial action;
decline to exercise available options under this Agreement; and
5.4 Damages. [Supplier acknowledges that it may be difficult for Buyer to fix actual damages or injury to its business, prospects and reputation with respect to Goods produced in violation of Schedule P or associated with a company that has violated Schedule P, and the parties have therefore agreed to liquidated damages in an amount calculated as follows:________________.] [In the event Supplier or Representative fails to comply with Schedule P, Buyer shall be entitled to all general and consequential damages [together with the liquidated damages set forth above],[40] including but not limited to losses arising from:
procurement of replacement Goods;
non-delivery of Goods;
diminished sales of Goods arising not only from the Goods to have been sold under this Agreement, but to include other diminished sales caused by noncompliance with Schedule P; and
5.5 Return, Destruction or Donation[43]of Goods; Nonacceptance of Goods.
Buyer may, in its sole discretion, store the rejected Goods for Supplier’s ac-count, reship them back to Supplier or, if permitted under applicable law, destroy or donate the Goods, all at Supplier’s sole cost and expense.
Buyer is under no duty to resell any Goods produced by or associated with a Supplier or Representative who Buyer has reasonable grounds to believe has not complied with Schedule P, whether or not such noncompliance was involved in the production of the Goods. In an effort to reduce its possible damages and not as a penalty, Buyer is entitled to discard, destroy or donate to a charitable entity any such Goods. Notwithstanding anything contained herein to the contrary or instructions otherwise provided by Supplier, destruction or donation of Goods rejected [or as to which acceptance was revoked],[44] and any conduct by Buyer required by law that would otherwise constitute acceptance, shall not be deemed acceptance and will not trigger a duty to pay for such Goods.[45]
5.6 Indemnification. Supplier shall indemnify, defend and hold harmless Buyer and its officers, directors, employees, agents, affiliates, successors and assigns (collectively, “Indemnified Party”) against any and all losses, damages, liabilities, deficiencies, claims, actions, judgments, settlements, interest, penalties, fines, costs or expenses of whatever kind, including, without limitation, the cost of storage, return, or destruction of Goods, the difference in cost between Buyer’s purchase of Supplier’s Goods and replacement Goods, reasonable attorneys’ fees, audit fees, and the costs of enforcing any right under this Agreement or applicable law, in each case, that arise out of the violation of Schedule P by Supplier or any of its Representatives. This Section shall apply, without limitation, regardless of whether claimants are contractual counterparties, investors, or any other person, entity, or governmental unit whatsoever.
Buyer does not assume a duty to monitor Supplier or its Representatives, including, without limitation, for compliance with laws or standards regarding working conditions, pay, hours, discrimination, forced labor, child labor, or the like;[46]
Buyer does not assume a duty to monitor or inspect the safety of any workplace of Supplier or its Representatives nor to monitor any labor practices of Supplier or its Representatives;[47]
Buyer does not have the authority and disclaims any obligation to control (i) the manner and method of work done by Supplier or its Representatives, (ii) implementation of safety measures by Supplier or its Representatives, or (iii) employment or engagement of employees and contractors or subcontractors by Supplier or its Representatives;[48]
There are no third-party beneficiaries to this Agreement; and
Buyer assumes no duty to disclose the results of any audit, questionnaire, or information gained pursuant to this Agreement other than as required by applicable law.[49]
* This report is the product of the Working Group, as explained in the text, and reflects the rough (and sometimes debated) consensus of the Working Group. While produced under the auspices of the Uniform Commercial Code Committee of the American Bar Association Business Law Section, the report has not been approved or endorsed by the Committee, the Section, or the Association as of the time of publication. Accordingly, the report should not be construed to be the action of either the American Bar Association or the Business Law Section. Nothing contained herein, including the clauses to be considered for adoption, is intended, nor should it be considered, as the rendering of legal advice for specific cases or particular situations, and readers are responsible for obtaining such advice from their own legal counsel. This report and the clauses and other materials herein are intended for edu-cational and informational purposes only. The lawyer who advises on the use of these clauses must take responsibility for the legal advice offered.
**David Snyder as chair and Susan Maslow as vice chair served as principal drafters of the report. David Snyder is Professor of Law and Director of the Business Law Program at American University Washington College of Law in Washington, D.C., and would like to acknowledge grant funding from the law school as well as travel funding from the American Bar Association. He would also like to thank Michael T. Francel, Chiara Vitiello, and Katherine Borchert for excellent research assistance. Susan Maslow is a partner at Antheil Maslow & MacMinn, LLP in Bucks County, Pennsylvania.
[1] There are both ABA Model Business and Supplier Principles on Labor Trafficking and Child Labor (“ABA Model Principles”) and ABA Model Business and Supplier Policies on Labor Trafficking and Child Labor (“Model Policies”) (emphasis added). The ABA Model Principles are the high level articulation of the detailed material in the Model Policies. The ABA Model Principles also form Part II of the Model Policies. Only the ABA Model Principles were adopted by the ABA House of Delegates, so only the ABA Model Principles represent the official position of the American Bar Association. For a detailed discussion, see E. Christopher Johnson, Jr., Business Lawyers Are in a Unique Position to Help Their Clients Identify Supply-Chain Risks Involving Labor Trafficking and Child Labor, 70 BUS. LAW. 1083 (2015). See also the Model Principles Task Force website.
[2] See supranote 1.
[3] 68 AM. U. L. REV. (forthcoming 2019).
[4] See, e.g., Trafficking Victims Protection Act of 2000, 22 U.S.C. §§ 7101–7114 (2018); see also 18 U.S.C. §§ 1589–1592 (2018) (criminal sanctions for forced labor, trafficking, and peonage); Trafficking Victims Protection Reauthorization Act of 2013 (TVPRA) (Title XII of the Violence Against Women Reauthorization Act of 2013, Pub. L. No. 113-4, 127 Stat. 54 (2013)).
[5] See, e.g., Trade Facilitation and Trade Enforcement Act of 2015 (TFTEA), Pub. L. No. 114-125, 130 Stat. 122 (2016).
[6] CAL. CIV. CODE ANN. § 1714.43 (West 2018).
[7] Federal Acquisition Regulation, 48 C.F.R. §§ 52.222–50 to 52.223-7 (2018).
[8] See, e.g., UK Modern Slavery Act 2015, c. 30 (Eng.); France’s Corporate Duty of Vigilance Law, Loi no 2017-399 du 27 mars 2017 relative au devoir de vigilance des sociétés mères et des entreprises donneuses d’ordre, Journal officiel de la République française.
[9] See Directive 2014/95/EU, of the European Parliament and of the Council of 22 October 2014 Amending Directive 2013/34/EU as Regards Disclosure of Non-Financial and Diversity Information by Certain Large Undertakings and Groups, 2014 O.J. (L 330) 1.
[10] See Rahaman v. J.C. Penney Corp., No. N15C-07-174MMJ, 2016 WL 2616375, at *9 (Del. Super. Ct. May 4, 2016).
[11] See Doe I v. Wal-Mart Stores, 572 F.3d 677, 681–82 (9th Cir. 2009).
[12] See, e.g., Nat’l Consumers League v. Wal-Mart, Inc., No. 2016 CA 007731 B, 2016 WL 4080541, at *7 (D.C. Super. Ct. July 22, 2016) (order denying defendant’s motion to dismiss); the chocolate cases, such as Hodsdon v. Mars, Inc., 162 F. Supp. 3d 1016 (N.D. Cal. 2016), aff’d, 891 F.3d 857 (9th Cir. 2018); McCoy v. Nestle USA, Inc., 173 F. Supp. 3d 954 (N.D. Cal. 2016), aff’d, No. 16-15794, 2018 WL 3358227 (9th Cir. July 10, 2018); Dana v. Hershey Co., 180 F. Supp. 3d 652 (N.D. Cal. 2016), aff’d, No. 16-15789, 2018 WL 3358223 (9th Cir. July 10, 2018) and the fishermen cases, such as Sud v. Costco Wholesale Corp., No. 15-cv-03783-JSW, 2016 WL 192569, at *1 (N.D. Cal. Jan. 15, 2016). Other cases are pending and some have recently been filed. For more comprehensive consideration of recent and pending litigation in this area, see generally Ramona L. Lampley, Mitigating Risk, Eradicating Slavery: The Business Case for Eradicating Slave Labor in the Supply Chain to Reduce Domestic Liability, 68 AM. U. L. REV. (forthcoming 2019).
[13] The letter “P” was chosen to designate the schedule because it stands for “Principles” or “Policies” such as the ABA Model Principles and Policies.
[14] See supranote 1.
[15] An unqualified representation supports Buyer’s goals to allocate the risk of undiscovered issues to Supplier and contractually encourage Supplier to gather accurate information about its subcontractors. The parties may negotiate the knowledge qualifier and the degree of knowledge required as it relates to additional levels of subcontractors and any other third party and whether “best” knowledge should be defined to include the imposition of certain periodic inquiry obligations on Supplier. It can also reinforce the Buyer’s right to revoke acceptance under U.C.C. section 2-608.
[16] “Goods” is assumed to be defined earlier in the Agreement (and not defined in Schedule P). See also infra note 29 (on the definition of “Nonconforming Goods”).
[17] Supplier may attempt to negotiate the use of the phrase “on behalf of Supplier” here, but such a phrase might allow Supplier to argue that the breaching Representative did so without Supplier’s knowledge or authority, which defeats the purpose of a strict representation and covenant.
[18] The content of Schedule P is beyond the scope of this document, but note that some suggest the best practice is to avoid reference to specific laws in favor of a general reference because legislative initiatives in some countries are broader than in others. In the event that the drafter nevertheless wishes to require that Supplier specifically represent compliance with anti-trafficking and similar legislation, consider avoiding the term “applicable,” which will limit required adherence by companies that do not meet the size or revenue requirements of certain legislation. Prominent guidance can be found, for example, in the sources listed at supra note 4, as well as the U.N. Guiding Principles on Business and Human Rights (often called the Ruggie Principles); see John Ruggie (Special Representative of the Secretary-General), Guiding Principles on Business and Human Rights: Implementing the United Nations “Protect, Respect and Remedy” Framework, U.N. Doc. A/HRC/17/31, annex (Mar. 21, 2011), https://www.ohchr.org/Documents/Issues/Business/A-HRC-17-31_AEV.pdf. Note again however, that specific guidance with respect to law that might be desired by Buyer or Supplier to be included in Schedule P is beyond the scope of this document, and this note does not attempt to be exhaustive (omitting, for example, certain anti-trafficking legislation as well as conflict mineral issues and the EU rules on non-financial and diversity information).
[19] The bracketed sentence may support Buyer’s continuing reliance upon Supplier’s monitoring and compliance. The actual express representation would arguably make reliance more reasonable, and such reliance may delay Buyer’s discovery and could help explain periodic rather than constant or continual audits by Buyer. See also infra section 2.4. Delivery documents could include commercial invoices, packing lists, beneficiary’s certificates, or an additional document delivered with the goods or tendered through banking channels to obtain payment for the goods. See infra note 38. If the bracketed language is included, the second clause of the preceding sentence should be deleted.
[20] Supplier may again attempt to negotiate the use of the phrase “acting on the behalf of Supplier” here. Buyer, if possible, will want to avoid such language. See supra note 17.
[21] As part of Buyer’s due diligence in choosing its Supplier, it should request copies of all anti-trafficking policies, as well as similar policies, and should determine, for example, how and when training is conducted and to whom it is given, how Supplier’s policies are monitored, and how compliance is checked and certified. If Supplier does not have its own policies against forced and child labor, including worker health and safety, for example, or if Buyer prefers, Supplier can be required to adopt Buyer’s policies.
[22] All of the covenants set forth above are prospective. Counsel to Buyer may consider requiring Supplier to state that it has no history of using forced labor or underage workers, subjecting workers to hazardous conditions or other similar conduct, and has never been the subject of investigations or proceedings relating to such conduct. In some industries and for some companies, such historical assurances cannot be made or expected, even though the companies are currently compliant and may have been compliant for a number of years.
[23] See U.C.C. §§ 2-601, 2-602 (2011).
[24] Because installment contracts under Article 2 of the U.C.C. do not enjoy the “perfect tender” rule applicable to a single-delivery contract, such installment contracts should include the phrase within the first bracket. The additional phrase within the first bracket “and this Agreement” should be included if Buyer wishes not only to reject goods based on noncompliance with Schedule P but also wishes to terminate the installment contract in its entirety in light of, for example, Buyer’s internal policy, the possible damage to Buyer’s reputation, or justifiable fear of a repeated breach by Supplier.
[25] The phrase within the second bracket is applicable for agreements to which the CISG applies, whether for a single delivery or an installment contract, under article 49.
[26] “Cancellation” occurs when a “party puts an end to the contract for breach by the other” under U.C.C. section 2-106(4). “Avoidance” is the appropriate term under CISG article 49.
[27] This section expressly provides for cancellation as a remedy in the event of Supplier’s failure to comply with a human rights policy adopted as part of a supply contract. Ultimately, without a contract clause expressly permitting cancellation for human rights policy breaches, Buyer may have a difficult time assembling compelling evidence that the value of the goods was fatally and “substantially impaired” due to the violation of the policy. The value of a particular good supplied in violation of a human rights policy might not necessarily change in the marketplace due to the troubled and tainted background of manufacture.
[28] Articles 38 to 40 of the CISG require that Buyer examine the goods or cause them to be examined within as short a period as is practicable. Buyer loses the right to rely on a lack of conformity of the goods if it does not give Supplier notice within a reasonable time after Buyer discovers or ought to have discovered a defect and, at the latest, within two years of the date of delivery (or other contractual period) unless Supplier knew or could not have been unaware of the defect. Because U.C.C. section 2-607(3)(a) provides a similar argument that Buyer’s failure to notify Supplier of a breach within a reasonable time bars any remedy, it is suggested that the contractual text be included to limit disputes about what constitutes a reasonable time. If the U.C.C. is referenced in the text, the applicable state version should be cited.
[29] “Nonconforming Goods” and “Inspection Period” are assumed to be defined earlier in the Agreement (and not defined in Schedule P). The definitional portion of the Agreement must include as “Nonconforming Goods” any goods received by Buyer that Buyer has reasonable grounds to believe (i) include any materials in fabrication, assembly, packaging, or shipment, directly or indirectly, that do not comply with Schedule P; or (ii) originate from or are associated with a Supplier or Representative that [may have] [is reputed to have] [has] violated human rights protections similar to Schedule P.
[30] This clause negates Supplier’s right to cure under U.C.C. section 2-508 and CISG articles 37 and 48. In cases of mere technical or recordkeeping violations, Buyer may elect to accept the tender of a cure. In other cases, Buyer may not want to do business with a Supplier that violates Schedule P. Under the provision as drafted, Buyer retains discretion here. Many parties, however, may prefer to provide a right to cure; experience suggests that many violations may consist of recordkeeping problems or other clerical shortcomings. Even in cases of substantive violations of health and safety standards, for example, the parties may prefer to institute a program to alleviate the problems (e.g., by providing for appropriate working conditions) rather than to end the Agreement and throw the employees out of work. For these reasons, a “notice and cure” clause may be preferable to the elimination of any cure right for Supplier. In such a situation, this section should add, “Except as provided in Section ___,” at the beginning. Another section can then provide for Buyer to give notice of default to Supplier. That default notice would trigger a cure period, either set by this Agreement or by the notice (as the parties prefer), and if cure is not effected within that period, then Supplier would be in breach, which would then trigger the remedies provided in the Agreement. In this way, a Supplier who does not comply with Schedule P is in default but is given a chance to fix the problem. A Supplier who implements a successful fix thus avoids breach, and Buyer will have no right to a remedy (but perhaps no need for one either). A notice-and-cure mechanism may make the Agreement more palatable to Supplier, although Buyer may prefer the stronger rights provided in the text as drafted, or Buyer may need them under the FAR. See 48 C.F.R. § 22.1703(c) (2018) (requiring contractor certification (within threshold limits) that it will “monitor, detect, and terminate the contract with a subcontractor or agent engaging in prohibited activities” (emphasis added)). The text as drafted avoids the problem of disputes about whether a cure is successful. Further, nothing in the text as drafted prevents Buyer from forbearing to exercise its remedies and giving Supplier a period to cure if Buyer thinks a cure would be appropriate. The provision on Notice of Breach appears in section 5.1. Any forbearance should include an appropriate notice of reservation of rights.
[31] The clauses on revocation of acceptance are designed primarily for use in contracts governed by the U.C.C. and are drafted with U.C.C. section 2-608 in mind. They should be omitted in contracts governed by the CISG. For this reason, section 3 is bracketed.
[32] What audit rights Buyer has, if any, are beyond the scope of this document and should be set forth in Schedule P.
[33] “Cancel” for agreements under the U.C.C., “avoid” for the CISG. See supra note 26.
[34] The first phrase uses the terminology of U.C.C. section 1-303 and the second phrase uses the terminology of CISG article 9(1).
[35] U.C.C. § 2-601 (2011).
[36] Again, revocation language should be used in U.C.C. but not CISG contracts.
[37] This section addresses notice requirements under Article 2 of the U.C.C. For instance, section 2-607(3)(a) requires notice of a breach within a reasonable time after constructive discovery of the breach. A buyer who fails to give such notice will find its claims barred, with many courts holding that pre-suit notice is required.
[38] Some supply contracts will call for payment by letter of credit, which will complicate the right to suspend payment. When a documentary credit is involved, the supply contract and letter of credit should require presentation of a certificate of compliance with Schedule P. Ideally the certificate would be issued by a third party that has audited the Supplier or Representatives, but a beneficiary’s certificate may also be helpful if a third-party certificate is impractical. Under U.S. law, a false beneficiary’s certificate could allow an injunction against payment on grounds of “material fraud by the beneficiary on the issuer or applicant.” See U.C.C. § 5-109(b) (2011). Purposeful falsity of the certificate might perhaps be helpful even if suit must be in London or in a jurisdiction following English law, which requires fraud on the documents. The leading case from the House of Lords is United City Merchants (Invs.) Ltd. v. Royal Bank of Canada, [1983] A.C. 168, 183 (referring to “documents that contain, expressly or by implication, material representations of fact that to his knowledge are untrue”); see also Inflatable Toy Co. Pty Ltd v. State Bank of New South Wales Ltd, [1994] 34 NSWLR 243 (applying Australian law). If the violation of Schedule P constitutes an illegal act, the illegality theory may also be useful in a suit governed by English law. In any case, the certificate should be required to be dated within a reasonably short time of the draw. Many banks probably will not object to the requirement of an additional certificate as certificates (e.g., by SGS) are commonplace in such transactions, and environmental certificates are similar to (and in some cases may be the same as) a certificate of compliance with Schedule P. While some banks may resist the requirement of such a certificate because of fear of injunction actions and the concomitant extension of the credit risk if the injunction is ultimately denied, most banks seem unlikely to be concerned by the requirement of one more certificate, and any additional credit risk from an injunction may be mitigated by a bond or other credit support as contemplated by U.C.C. section 5-109(b)(2) and comment 7, or by the civil procedure laws or rules of certain jurisdictions or by collateralization or bonding provisions in the reimbursement agreement. Still, despite all of these efforts, suspension of payment may be impossible in cross-border documentary credit transactions because frequently a foreign bank will have honored before the injunction can issue. Once one bank honors in good faith, the commitments along the chain all become firm and cannot be enjoined. See U.C.C. § 5-109 (2011).
[39] This section reflects the remedies provided in the FAR § 52.222.50 relative to combating trafficking in persons. Additionally, the clause adds an insecurity provision under U.C.C. section 2-609. The clause also clarifies that injunctive relief may be necessary. In addition, while Buyer may want to work with a Supplier toward full compliance, Buyer should be prepared to face waiver arguments. The timing of the exercise of remedies is sensitive and the exercise of remedies and any requests for damages may themselves have impacts on human rights. Therefore, this provision expressly recognizes that such careful consideration of the exercise of remedies by Buyer does not constitute a waiver of any rights. Further, with respect to removal of employees (section 5.3.c.), see infra note 48. Note also that the remedies provisions here (including sections 5.2 and 5.3.e. on suspension of payments) do not mention setoff, see 11 U.S.C. §§ 506(a)(1), 553 (2018) (setoff is a secured claim in bankruptcy), recoupment, clawback, or similar remedies; if those remedies are not already provided in the main agreement, counsel may wish to consider making such rights explicit in this clause.
[40] While Buyer in some industries may prefer to adopt a liquidated damages clause, U.C.C. section 2-718 generally prohibits penalties, including providing that “unreasonably large liquidated damages [are] void as a penalty.” The ultimate enforceability of these provisions will turn on whether the exercise of the remedy in the contractual clause was reasonable. Particular care should be exercised if Buyer includes the bracketed language that allows liquidated damages in addition to other damages.
[41] If no liquidated damages are included above for harm to reputation.
[42] Section 5.4 addresses monetary remedies, including consequential and special damages, recoverable in the event of a breach by Supplier. While measures such as diminished sales and harm to reputation are specifically included, Buyer may face challenges with respect to proving damages. This is common in claims for breach of contract, but Buyer may have special challenges with respect to the impact on its brand that results from violations of human rights policies. It is not clear that suppliers will agree to the inclusion of Buyer’s lost profits, real or imagined, as damages. Nor is it clear, however, that Supplier will have strong views on damages; Supplier may be judgment proof—for lack of assets or for procedural reasons—and damages may not be a realistic remedy in any case. The suggested text is presented as a starting place for discussions with respect to damages. An agreed liquidation amount may be an acceptable compromise.
[43] Donation of goods manufactured or otherwise delivered with the use of forced labor may not be permitted by the U.S. Customs and Border Protection, Cargo Security, Carriers and Restricted Merchandise Branch, Office of Trade. Buyer’s only option as an importer may be to return or export the goods. Other countries may have similar restrictions on the possession and ownership of merchandise mined, produced, or manufactured in any part with the use of a prohibited class of labor and such laws, which are beyond the scope of this document, must be examined before donations are made.
[44] See supra note 31.
[45] This section is drafted to address concerns that might be raised with respect to the U.C.C. section 1-305 mandate to place the aggrieved party in the position of its expectation, without award of consequential or penal damages unless specifically allowed, particularly with respect to minimizing damages. See also U.C.C. § 2-715 (2011) (consequential damages cannot be recovered if they could have been prevented). With an understanding that mitigation applies and may be non-waivable, particularly with respect to claims of consequential damages, an attempt by Buyer to avoid mitigation might be seen as a lack of good faith. Nevertheless, reselling the goods that are produced in violation of a human rights policy may be understood as increasing Buyer’s damages, rather than reducing them. Accordingly, Buyer should be entitled to discard, destroy, or donate to a charity any goods produced in violation of a human rights policy as an attempt toward mitigation, rather than against it.
[46] This disclaimer conflicts with the requirements of the FAR, 48 C.F.R. §§ 52.222–56, 22.1703(c) (2018) (requiring contractor certification (within threshold limits) that it will “monitor, detect, and terminate the contract with a subcontractor or agent engaging in prohibited activities”).
[47] Again, note the conflict with the FAR. See 48 C.F.R. §§ 52.222–56, 22.1703(c) (2018).
[48] Note supra section 5.3.c. This disclaimer is included to help negate claims of undertaking liability or liability under the peculiar risk doctrine. See Rahaman v. J.C. Penney Corp., No. N15C-07-174MMJ, 2016 WL 2616375, at *9 (Del. Super. Ct. May 4, 2016). This disclaimer could conflict with the section noted above, however, and counsel should consider whether it is better to have the power to require that its suppliers fire employees or other representatives or whether the disclaimer as to this factor (which relates to whether a supplier is an independent contractor) is more important. See also supra section 5.3.b.
[49] This provision emphasizes that Buyer is assuming no contractual duties to disclose although Buyer may have duties to disclose under other standards (legal or non-legal). For example, Buyer must determine if it provided false or misleading information to Customs and Border Protection and other officials in the event that goods are initially accepted and removed from the dock but are later determined to be tainted by forced labor. If the original information is false, a duty to amend may arise. See, e.g., 18 U.S.C. § 541 (2018); 19 C.F.R. § 12.42(b) (2018). As another example, under the FAR, contractors and subcontractors must disclose to the government contracting officer and agency inspector general “information sufficient to identify the nature and extent of an offense and the individuals responsible for the conduct.” 48 C.F.R. § 22.1703(d).
On September 28, 2018, California became the first US state to specifically regulate the security of connected devices (otherwise known as ”Internet of Things” or “IoT devices”).
The new laws aim at increasing the security of IoT devices, whose global use is growing rapidly. Statista has estimated that in 2018 there are over 23 billion IoT devices currently in use, and this number is expected to grow to over 26 billion in 2019 (Gartner has estimated 20 billion such devices will be online by 2020). Unfortunately many IoT devices remain dangerously unprotected from cybercriminals and vulnerable to malware as they enter the market with no passwords, default passwords (think ”123”, ”admin” or even worse, ”password”) or otherwise hard-coded passwords that cannot be modified or updated.
These concerns are not merely speculative. By way of ‘real life’ example, beginning September 2016, massive distributed denial of service (DDoS) attacks took down various US Internet infrastructure companies/DNS providers, leaving much of the Internet inaccessible on the east coast of the United States and incapacitating popular websites (including AirBnB, Amazon, Github, HBO, Netflix, Paypal, Reddit, the New York Times and Twitter, just to name a few). Originally created by three teenaged hackers, the Mirai malware responsible for the attack was specifically designed to target and infect susceptible IoT devices such as security cameras, home routers, air-quality monitors, digital video recorders and routers using a table of more than 60 common factory default usernames and passwords. These devices were turned into a network of remotely controlled bots that were used to launch the DDoS attacks which later spread globally, impacting such diverse organizations as OVH (a large European provider), Lonestar Cell (a Liberian Telecom Operator) and Deutsche Telekom. At its peak, Mirai infected over 600,000 vulnerable IoT devices.
These two new substantially similar IoT laws (California Senate Bill 327, chapter 886 and Assembly Bill No. 1906, “Security of Connected Devices” (2018 Cal. Legis. Serv. Ch. (S.B. 327)(to be codified at Cal. Civ. Code § 1798.91.04(a)) (collectively, the “IoT Laws”) require manufacturers of connected devices to equip the device with a ”reasonable” security feature or features that meet all of the following criteria: (i) appropriate to the nature of the device; (ii) appropriate to the information it may collect, contain, or transmit; and (iii) designed to protect the device and any information contained therein from unauthorized access, destruction, use, modification or disclosure. The IoT Laws broadly define a ‘connected device’ to mean any devices or other physical object that is capable of connecting to the Internet (directly or indirectly), and that is assigned an Internet Protocol address or Bluetooth address, meaning that consumer, industrial, and other IoT devices are covered.
Additionally, if the connected device is equipped with a means for authentication outside of a local area network, either of the following requirements must be met before it shall be deemed to possess a “reasonable security feature”: (i) it must have a preprogrammed password unique to each device manufactured; or (ii) the device must contain a security feature that requires a user to generate a new means of authentication before access is granted for the first time.
The IoT Laws broadly capture “manufacturers” to include the producers of the devices themselves and those who manufacture on behalf of such organizations, connected devices that are sold or offered for sale in California. However, manufacturers are not responsible for any unaffiliated third-party software or applications that a user chooses to add to the device. Contracts with organizations or persons involving the mere purchase of connected devices or purchasing and branding a connected device are excluded.
Manufacturers are obliged to allow users to have full control and/or access over connected devices, including the ability to modify the software or firmware running on the device at the user’s discretion. Additionally, no obligations or duties are imposed upon electronic stores, gateways, marketplaces or other means of purchasing software or applications to review or enforce compliance with these statutes.
The IoT Laws contain various exclusions and limitations. For example, they do not apply to manufacturers of connected devices that are already subject to security requirements under US federal law, regulations or the guidance of federal agencies (presumably FDA-regulated medical devices, for example). They do not prevent law enforcement agencies from continuing to obtain connected device information from a manufacturer as authorized by law or pursuant to a court of competent jurisdiction. They also do not apply to the activities of covered entities, providers of health care, business associates, health care service plans, contractors, employers, or other persons subject to the U.S. federal Health Insurance Portability and Accountability Act of 1996 (better known as HIPAA) or California’s Confidentiality of Medical Information Act.
Significantly, the IoT Laws do not provide individuals with a private right of action against non-compliant manufacturers. Only the Attorney General, a city attorney, a county counsel, or a district attorney has the authority to enforce these requirements.
The IoT Laws are scheduled to come into force on January 1, 2020.
The enactment of the IoT Laws was clearly motivated by the desire to improve the security of smart devices and mitigate security vulnerabilities that leave such devices open to cyber-attacks such as Mirai malware. By not mandating what security features are ”reasonable,” the legislation is effectively leaving it up to the manufacturer to determine whether its security features meet the three-prong test described above. Guidance from agencies such as the National Institutes for Standards and Technology (NIST) and other industry self-regulatory guidelines can help determine what will be reasonable under the circumstances (in fact NIST is currently seeking comments on its draft guidance document which includes recommendations for addressing security and privacy risks associated with IoT devices—see Draft NISTIR 8228, “Considerations for Managing Internet of Things (IoT) Cybersecurity and Privacy Risks”.)(“NIST Guidance”).
The new IoT Laws are not without their flaws and skeptics. Critics charge that certain aspects of the IoT Laws are vague and ambiguous given the lack of clear standards (what does “reasonable security feature or features” mean practically?) with no way to validate that the manufacturer actually designed to those standards. While the IoT Laws may address the security threats associated with hardcoded or default passwords that are easily guessable and may force manufacturers to in turn force consumers to change their passwords before using such devices (or otherwise install unique passwords), they do not address many other security concerns or truly enhance device security. These concerns include the failure of many manufacturers to routinely update the software/firmware accompanying many IoT devices (or otherwise compel consumers to update such software/firmware if patches/upgrades are actually available) to address security and other concerns. Other pre-market security means to enhance security are also ignored (device attestation, security audits for firmware from third party providers, improvements in device access, management, and monitoring, requirements to remove unnecessary insecure features, etc.). As the NIST Guidance has noted, an IoT device may be a black box that provides little or no information on its hardware, software, and firmware or may not offer any built-in capabilities to identify and report on known vulnerabilities. And users can still deploy terrible passwords.
However, while arguably incomplete from a security perspective, California is a large market and a standard setter for the U.S., and the IoT Laws may serve as an example for other jurisdictions to follow. Accordingly any manufacturer of an IoT device that intends to ship its products into California must start employing better security features that meet the requirements of the IoT Laws; as such the IoT Laws may be the catalyst required to nudge IoT-connected devices in the right direction to better security.
Blockchain technology (or as some commentators prefer, “distributed ledger technology”) is a major technological innovation that promises to significantly alter the way we do business in several fields. Those changes, in turn, will bring new legal challenges that our laws, courts, regulatory agencies, and other institutions must address. As promising as blockchain technology is, however, it is no panacea. It can offer concrete benefits over prior approaches, but it also comes with real costs that can limit or preclude its use in some applications. To better assess the legal challenges facing existing and new applications of blockchain technology, it is important to understand the benefits and costs of the technology; that, in turn, requires at least some level of understanding what blockchain technology is.
The starting point for the technology was Satoshi Nakamoto’s release in 2008 of the white paper, Bitcoin: A Peer-to-Peer Electronic Cash System (Nakamoto was a pseudonym for the real and still-unknown authors), in which Nakamoto introduced blockchain technology for the first time along with a fully conceived platform for its use to implement digital cash.
By the time Nakamoto released his white paper in 2008, digital signatures were a well-understood feature of the mathematical field of public-key cryptography. Participants generate a key pair composed of a public key and a related private key. The public key is distributed to all participants while the private key remains secret. The relationship between the two keys is such that a message encrypted with one of the keys can only be decrypted using the other key.
In this system, a participant, Alice, can digitally sign a message by encrypting it with her private key, which only she possesses. Anyone can read the message by decrypting it with Alice’s freely available public key, but the fact that the message can successfully be decrypted using Alice’s public key proves that Alice—and only Alice—digitally signed the text with her private key because only Alice possesses that key.
Like some others before him, Nakamoto began by defining a digital coin as a chain of digital signatures, but digital signatures alone could not prevent network participants from spending the same coins more than once by signing multiple but inconsistent spending transactions—the “double-spending” problem. To prevent double-spending, the system must have some way to determine whether the sender, Alice, owns a spendable coin that has not previously been sent to someone else. Prior electronic payment systems typically solved the double-spending problem by relying on a trusted central party to keep track of all transactions. In contrast to such a centralized system, Nakamoto sought a peer-to-peer system that did not assign trusted status to a special central party.
Nakamoto reasoned that a peer-to-peer system could work if each node possessed the means to evaluate for itself the validity of the transaction. Thus, each node would have to maintain its own ledger of all transactions. This ledger—with identical copies distributed to all notes—is the blockchain. All new transactions would be distributed in blocks to all nodes, which would add them to their ledgers.
With each node maintaining its own ledger, there arose a need to ensure that the separate ledgers would remain consistent. Thus, Nakamoto needed a mechanism to achieve consensus among the nodes as to which transactions should be included and in what order. Nakamoto decided to use “proof of work” to achieve consensus on the Bitcoin network. Certain nodes—miners—would validate transaction blocks by performing a time-consuming calculation, adding proof of the successful completion of the calculation to each validated block. Then, in the event a node received inconsistent blocks to add to the chain, Nakamoto specified that nodes should select the valid blocks representing the largest amount of computational work. A proof-of-work mechanism requires a lot of computation, but it is essential to the functioning of the Bitcoin consensus system. Therefore, the system provides miners an incentive payment in the form of newly created bitcoins and transaction fees offered by the sender.
People soon realized that blockchain technology could be adapted to uses beyond Bitcoin. The first such use was to create new cryptocurrencies. Today, there are thousands of “altcoins” using blockchain technology. Beyond cryptocurrencies, many other human activities are amenable to representation in a ledger system like the one underlying Bitcoin. One obvious example is a blockchain used to keep track of assets such as real property, inventory items, and government records. The blockchains in these use cases might operate similarly to the Bitcoin blockchain, but instead of coins, they would employ coin-like tokens linked to the underlying physical assets.
Taking blockchain technology beyond Bitcoin, other developers have implemented systems that offer the ability to execute user-specified programming code on the blockchain itself. For example, the Ethereum platform begun in 2013 allows users to create complex computer code linked to transactions on a blockchain. As a result, some users speak not of submitting transactions on Ethereum, but of creating “smart contracts” (also called distributed applications, or dApps), which run on the blockchain. The availability of smart contracts in a blockchain system makes it possible to envision autonomous, distributed functioning of a number of complex activities that cannot happen today without manual control and intervention, or a centralized bureaucracy.
Autonomous trading platforms. Smart-contract code automatically matches buyers and sellers and automatically performs trading on the blockchain in securities, commodities, or other assets.
Supply chains. Actors at each stage of a supply chain—purchasing, manufacturing, transportation, delivery, payment—enter secure transactions into a blockchain system, and smart code automatically tracks products, initiates new orders, and allocates appropriate resources at the next stage of the chain.
Peer-to-peer insurance. The pooling of risks, the events documenting the losses and claims, and the submission and payment of claims are represented by autonomous transactions on the blockchain.
Organizational decision making and voting. Participants in an organization vote for new policies, investments, or candidates by recording secure transactions on a blockchain, and smart-contract code automatically tallies the results and effectuates the election results.
Although blockchain technology confers many potential advantages, its nature poses potential costs as well. Not all centralized ledgers are better replaced by distributed blockchain technology. Some of the potential advantages and disadvantages are described below. The successful use cases will be ones with a favorable balance of factors.
Many business processes involve complex interactions among multiple individual or institutional intermediaries that are intended to serve as a check on one another. In a blockchain network, careful planning can allow cryptography and consensus mechanisms to take the place of human judgments about trust, just as they do in the Bitcoin network.
Transparency and immutability. The basic operation of a blockchain system is the creation and addition of validated blocks to a chain of prior blocks. These blocks provide a complete record of all transactions and operations processed by the system. Cryptography insures that blockchain records, once recorded, cannot be forged or altered.
Blockchains distribute the responsibility for storing and processing information across multiple nodes in a networked system. In doing so, they reduce the number of possible points of failure or points of attack.
Automatic rule enforcement. The nature of blockchain systems disallows certain kinds of errors and malfeasance that in other systems might require specialized code or human intervention.
User autonomy. Blockchain systems can allow users great autonomy in the control over their own transactions. In the Bitcoin network, for example, so long as the network continues to operate, there is no way to prevent a user from transferring bitcoins or to force an unwanted transfer without the user’s private keys.
Performance and scalability. The features that provide blockchain technology its advantages come with performance and resource costs. Even if a blockchain system does not use the proof-of-work system of Bitcoin, blockchains frequently require significant storage, computing power, and network bandwidth. As a general matter, blockchain-based systems use more computing resources and scale less efficiently than systems based on centralized ledgers.
Complexity, errors, and vulnerabilities. Blockchain systems can be highly complex and difficult to develop. Moreover, the design and programming of smart-contract systems utilizing blockchain systems is a separate source of complexity, and almost certain to produce significant bugs and vulnerabilities that can lead to execution flaws or vulnerabilities.
The blockchain contains a full and detailed record of every transaction processed using the system, and the consensus mechanism of the system ensures the replication of that full record across multiple nodes of the system. These risks do not necessarily prevent the use of blockchain technology for sensitive information, but they can add complication to the design of the system.
To practice law effectively, lawyers today need a basic understanding of modern technologies, which should include the fundamentals of blockchain technology.
In depositions and trials involving non-English-speaking parties and witnesses, clients represented by bilingual counsel have the clear upper hand. The advantage a bilingual attorney has over a nonbilingual attorney cannot always be offset by the services of an interpreter at deposition or trial, given that even the most skilled interpreter can make inadvertent mistakes and, more importantly, cannot comment on material credibility indicia of non-English-speaking witnesses, such as their intonation or sarcasm, while testifying. Consider these scenarios:
A plaintiff in a deposition testifies in Spanish, but neither the plaintiff’s nor the defendant’s attorneys speak Spanish. Out of necessity, both attorneys must rely on the interpreter’s translation of the plaintiff’s testimony (particularly if the proceeding is not videotaped), although neither attorney can be sure that the translation truly captured the meaning of the testimony the plaintiff gave in Spanish. Regardless, the interpreter’s translation stands without contest and becomes the official record of the deposition or trial. Clearly missing in an even accurate, verbatim translation of the testimony is an assessment of the witness’s credibility. Neither counsel will know whether the witness used certain words in a sarcastic or skeptical tone which, if known, would have prompted counsel to seek clarification or conduct follow-up questioning.
Consider another scenario, but one in which only one of the attorneys speaks the plaintiff’s native language. For this example, assume the bilingual attorney is defense counsel in the deposition of a Spanish-speaking plaintiff. Defense counsel, as the sole bilingual attorney in the proceeding, understands the plaintiff’s testimony in Spanish and understands the interpreter’s translations of counsel’s questions and plaintiff’s answers. In this scenario, the bilingual defense counsel has the ability to effectively challenge the accuracy and completeness of the interpreter’s translations during the deposition. Plaintiff’s counsel, the nonbilingual attorney, is at a clear disadvantage, unable to challenge defense counsel’s objections to the interpreter’s translations. Worse yet, the nonbilingual attorney may not be representing the client well if he or she fails to object to inaccurate translations defense counsel did not challenge. Besides the bilingual counsel’s ability to understand the Spanish testimony and translations, the bilingual counsel has another advantage. The Spanish-speaking witness may be more candid, cooperative, or feel less anxious if the witness knows the questioning attorney is bilingual.
The effectiveness of the legal representation a client receives in litigation involving non-English-speaking parties or critical witnesses often depends on the ability of a party’s counsel to understand the non-English-speaking party in his or her native language not only to ensure that the translations are correct, but more importantly, to assess witness credibility. Counsel at a deposition or trial should not rely on an interpreter for this purpose.
Just as court reporters in trials and depositions must transcribe testimony verbatim and without injecting subjective commentary, such as a witness’s intonation or sarcasm while responding to questions, interpreters in depositions and trials involving non-English-speaking witnesses must also act in neutral capacities. Interpreters can provide only verbatim translations of questions posed and answers given at depositions and trials. Interpreters may not add their own subjective commentary to translations, such as whether in a narrative response a witness used a particular word in a sarcastic, surprised, or skeptical tone. It is the responsibility of counsel to make important credibility assessments of witnesses—whether English-speaking or not—to effectively proceed with the interrogation or defense of a witness during a deposition or trial. It goes without saying that in addition to a witness’s substantive responses, a witness’s credibility involves an assessment of intonation, sarcasm, body language, and emphasis on certain words while testifying, particularly in harassment, discrimination, and other employment-related cases. The bilingual attorney who speaks the same language as the witness can pick up on important credibility subtleties and nuances (such as sarcasm, skepticism, fear, hesitation, etc.) that are not captured in interpreters’ translations and may be missed by counsel who are not bilingual. At a trial where jurors speak the same language as a witness, a bilingual attorney is in the best position to instantly gauge juror reaction to a witness’s intonation or emphasis of certain words while testifying and adjust trial strategy as necessary.
Aside from credibility assessment considerations, the bilingual attorney has other advantages. In the heat of trial or deposition, the bilingual attorney can quickly use his or her judgment in deciding whether to: pursue alternate questioning if a witness’s intonation while testifying indicates hesitation, discomfort, sarcasm, or skepticism; let awkwardly translated answers stand to avoid disrupting the flow of questioning or wasting limited time; forgo objections to certain translations of technical words or slang because they cannot be translated with precision; question a witness about foreign-language documents produced during a deposition; conclude that although testimony was not translated verbatim, an interpreter’s translation captures the essence of a witness’s testimony; call for a break upon detecting that an interpreter is becoming bored or tired as evidenced by labored or confusing translations of questions; or object to translated questions or testimony because the translations are inaccurate or incomplete.
Counsel may opt to videotape a deposition to capture a witness’s non-English testimony and an interpreter’s translations of same. Counsel should not count on using the videotape to challenge inaccurate translations after the deposition is concluded. Aside from possibly waiving such objections because they were not made during the deposition, it may not be feasible to reopen the deposition to conduct follow-up questioning based on the witness’s actual testimony. Moreover, the deponent may attempt to use the videotape to make substantive changes to the deposition transcript based on his or her responses as reflected in the videotaped deposition.
Large percentages of employment-related litigation in the United States are brought by non-English-speaking plaintiffs, particularly in states such as California where Latinos comprise almost 40 percent of the population. Given these demographic realities and to effectively represent their clients, counsel must be prepared to address the challenges presented in depositions and trials involving non-English-speaking witnesses.
In response to increasing public attention on the small percentage of women serving on corporate boards, the California Assembly passed Senate Bill 826 (the Act). The Act requires that all public companies headquartered in California have at least one female director and, beginning in 2021, a percentage of female directors based on the size of its board. Although championed by the National Association of Women Business Owners and other activists, the Act will face legal challenges to its implementation, and its overall impact may be muted.
Background and Requirements
California’s mandate is the most recent attempt in the growing movement to increase women on corporate boards across America. The first pages of the Act offer a litany of findings outlining the current state of affairs and the widespread historical exclusion of women from corporate leadership posts. The Act reads as follows:
For companies with a market capitalization of more than $10 billion, those with women directors on boards outperformed shares of comparable businesses with all-male boards by 26 percent. . . . As of June 2017, among the 446 publicly traded companies included in the Russell 3000 index and headquartered in California, representing nearly $5 trillion in market capitalization, women directors held 566 seats, or 15.5 percent of seats, while men held 3,089 seats, or 84.5 percent of seats. . . . More than one-quarter, numbering 117, or 26 percent, of the Russell 3000 companies based in California have NO women directors serving on their boards. . . . If measures are not taken to proactively increase the numbers of women serving on corporate boards, studies have shown that it will take decades, as many as 40 or 50 years, to achieve gender parity among directors.
The Act addresses these shortcomings through a two-pronged mandate. First, any publicly held domestic or foreign corporation whose principal executive office is in California (according to its 10-K) must have one female director on its board by December 31, 2019. Second, no later than December 31, 2021, those same corporations must have at least three female directors if there are six or more board seats, or two female directors if there are five board seats. The first violation of the Act (or a failure to file the mandated disclosure information) results in a $100,000 fine; each subsequent violation is $300,000.
Champions of the Act have realized the legal challenges to come (as discussed below), but viewed its passage and signing by Governor Jerry Brown as applying much-needed pressure to accelerate the elevation of women into corporate leadership positions. In his signing statement, Governor Brown expressed a desire for firm action despite the potential obstacles to implementation, stating: “There have been numerous objections to this bill and serious legal concerns have been raised. . . . Nevertheless, recent events in Washington, D.C.—and beyond—make it crystal clear that many are not getting the message.” After highlighting that corporations have been considered “persons” since at least 1886, well before women could even vote, Governor Brown further stated, “Given all the special privileges that corporations have enjoyed for so long, it’s high time corporate boards include the people who constitute more than half the ‘persons’ in America.”
Legal Objections
Beyond policy-based objections, critics have raised at least two legal arguments against the Act: (1) it violates equal protection by facially discriminating based on sex, and (2) because it applies to companies organized outside California, it violates the dormant commerce clause and the “internal affairs doctrine,” which requires that internal company affairs be under the regulatory purview of only one jurisdiction.
Taking these complaints in turn, the 14th Amendment equal protection argument is straightforward. Any law that discriminates based on sex must survive a heightened version of intermediate scrutiny. Per Justice Ginsburg’s 1996 majority opinion in United States v. Virginia, any sex-discriminatory law must have an “exceedingly persuasive justification” and be “substantially related” to an “important” state interest. Although remedying the long-standing exclusion of women from corporate leadership is no doubt an important state interest, California may struggle to show that its chosen means are a close fit with its legitimate end goals. The Act may apply both too narrowly (to the small subset of companies that are both publicly traded and headquartered in California) and too broadly (without consideration for whether a firm has previously engaged in discriminatory conduct or whether an industry may naturally attract more men or women) to survive scrutiny.
Second, by applying the mandate to companies organized outside California (so long as the executive offices are in California), the Act imposes a burden on foreign-organized corporations beyond California’s state interest and potentially requires companies to comply with incompatible mandates from competing jurisdictions. Due to these issues, the Act’s enforceability could be judicially limited to firms that are organized and located in California. If so, the Act would apply only to a small subset of local companies—one estimate puts the number at 72—and only one of the Fortune 500. See Joseph A. Grundfest, Mandating Gender Diversity in the Corporate Boardroom: The Inevitable Failure of California’s SB 826, Rock Center for Corporate Governance at Stanford University Working Paper No. 232 (Sept. 12, 2018).
Potential Impact on Board Composition and Governance
Although the number of companies directly impacted is relatively small (enforcement may well be limited to companies both chartered and located in California), the real value is in sending a signal that may prompt other states to begin pushing for and requiring more equitable board composition. The Act may also help to add momentum to diversity efforts undertaken by investors. Before the Act was passed, CalPERS sent a letter in 2017 to certain Russell 3000 companies asking each of them to “develop and disclose its corporate board diversity policy and implementation plan to address the lack of diversity.” State Street also attracted much attention for its diversity advocacy efforts when it installed “Fearless Girl” across from the “Charging Bull” in lower Manhattan at the center of the Financial District and announced that it would be engaging with companies about the importance of diversity. BlackRock likewise announced in 2017 that it would hold nominating and governance committees accountable if they do not achieve results. Passage of the Act keeps this issue at the forefront and may encourage other investors to follow suit.
California is blazing a new trail in the United States, but European countries began adopting quotas more than a decade ago when Norway adopted a 40-percent quota and France and Italy passed similar measures. Today, the composition of the boards of Norway’s public companies includes 41 percent women, a number well above that currently achieved in the United States. Whether the United States will be able to realize similar results will depend upon whether the Act and any other similar legislative efforts will be able to overcome legal challenges that are sure to make their way through the courts.
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