On August 24, 2018, in a rare, 73-page decision interpreting the Foreign Corrupt Practices Act (“FCPA”), the Second Circuit in United States v. Hoskins[1] largely rejected a Department of Justice (“DOJ”) interlocutory appeal and limited the FCPA’s reach, holding that foreign nationals who cannot be convicted as principals under the FCPA also cannot be held liable for conspiring to violate or aiding and abetting a violation of the statute. The decision, written by Judge Pooler (joined by Chief Judge Katzmann and Judge Lynch, who also wrote a concurring opinion), concluded that, due to affirmative legislative policy and extraterritoriality concerns, the FCPA’s application was limited to the three specific categories of individuals and entities identified in the statute, namely, U.S. issuers and U.S. “domestic concerns” (and their officers, employees, and agents, even if foreign), and anyone who engages in any act in furtherance of a corrupt payment while in U.S. territory. To the extent that Hoskins, a U.K. citizen working for a French company, did not fall within any of these three categories, the Court stated that he could not be charged as a co-conspirator of, or with aiding and abetting, someone who did.[2]
In reversing the district court’s opinion in part, the Court reiterated, however, that any individual (including a foreign national) who does fall within one of those three enumerated categories can be charged with conspiracy to commit a FCPA violation, since neither the affirmative legislative policy exception nor extraterritoriality bases of its decision would apply.[3] As a result, the Court ultimately reinstated the conspiracy charge in keeping with the government’s assertion that it could prove that Hoskins acted as an agent of a domestic concern.[4] Thus, while Hoskins certainly has implications for the government’s enforcement of the FCPA against foreign nationals, given the breadth of the FCPA’s jurisdiction and the agency doctrine that the DOJ relied upon in seeking reinstatement of its conspiracy charge, the practical impact of the decision is likely to be fairly limited.
Factual Background
As noted, the FCPA prohibits corrupt conduct involving three categories of individuals or entities:
(1) issuers of securities registered under the Securities Exchange Act, or any officer, director, employer, or agent thereof, or any stockholder acting on behalf of the issuer, (2) any U.S. “domestic concern” – a U.S. citizen, resident, or company, or any officer, director, employer, or agent thereof, and (3) any foreign person or business that commits an act in furtherance of a corrupt payment while in the United States.[5]
In Hoskins, the government alleged that defendant Hoskins, a foreign national employed by the U.K. subsidiary of Alstom, S.A. and working in France, approved and authorized payments to two consultants retained by Alstom’s U.S.-based subsidiary, Alstom Power, knowing that a portion of these payments would be used to bribe Indonesian officials.[6] The government alleged not only that Alstom Power was a U.S. domestic concern, but that certain acts in furtherance of the scheme occurred in the United States, including through U.S. executives who discussed the scheme in person, by phone, and electronically while in the United States, and that certain of the funds used for bribes were held in accounts in the United States.[7] However, while Hoskins was allegedly in communication with U.S.-based Alstom employees about the bribery scheme, the government conceded that he never committed any act in furtherance of the scheme while in the United States.[8]
The government charged Hoskins in Count One of the Indictment with a two-object conspiracy to violate the FCPA’s anti-bribery provisions, with the first object a violation of the prohibition on domestic concerns or their agents from violating the FCPA, and the second object a violation on the prohibition on foreign nationals from engaging in any acts relating to a bribery scheme while present in the United States.[9] Hoskins was also charged with six counts of substantive violations of the FCPA’s anti-bribery provisions, both as an agent of a domestic concern (Alstom Power), and with aiding and abetting that domestic concern.[10]
Procedural History
Hoskins moved in the district court to dismiss the government’s conspiracy count because “it charged that he was liable even if he did not fit into one of the statute’s categories” of relevant individuals, which Hoskins argued was an impermissible attempt by the government to bypass the “narrowly-circumscribed groups of people” for whom “the FCPA prescribes liability.”[11] The government cross-moved in limine as to the substantive counts, arguing that, even if Hoskins did not himself fall within one of those enumerated categories, Hoskins could still be liable for conspiring to violate, or aiding and abetting others who violated, the FCPA, to the extent others with whom he participated in the offense fell within one of the three categories, and Hoskins should be precluded from arguing otherwise.[12]
The district court denied the government’s motion in limine and granted Hoskins’ motion to the extent the government failed to allege that Hoskins fell within one of the three categories of individuals or entities to whom the FCPA applied. In so holding, the court reasoned that Congress had not intended “to impose accomplice liability on non-resident foreign nationals who were not subject to direct liability” under the FCPA.[13] However, the court denied Hoskins’ motion to the extent that the government charged him with conspiring to violate, or aiding and abetting a violation of, the FCPA as an agent of Alstom’s U.S. subsidiary, since he would then be expressly covered by one of the enumerated categories of individuals covered by the FCPA.[14] In light of its rulings, the district court dismissed the first object of the conspiracy count except to the extent the government could prove Hoskins was an agent of a U.S. domestic concern, and the second object in its entirety because Hoskins had not committed any act within the United States.[15]
The Second Circuit Decision
On appeal, the Second Circuit affirmed in part and reversed in part the lower court’s decision.[16] In so ruling, the Court focused on whether “a person [can] be guilty as an accomplice or a co-conspirator for an FCPA crime that he or she is incapable of committing as a principal.”[17] The Second Circuit concluded that a defendant could not be, based on concerns relating to (1) the “affirmative legislative policy” exception and (2) the presumption against extraterritoriality.
Affirmative Legislative Policy Exception
The Court explained that “the firm baseline rule” of conspiracy and complicity law is that individuals can be found liable for offenses they did not (or even could not) commit themselves as a principal, either as an accomplice who aided or abetted the commission of the offense or for the separate crime of conspiring to commit the offense.[18] However, there is a “narrowly circumscribed” exception to this rule: the “affirmative legislative policy exception,” which is triggered where “it is clear from the structure of a legislative scheme that the lawmaker must have intended that accomplice liability not extend to certain persons whose conduct might otherwise fall within the general common-law or statutory definition of complicity.”[19]
The Court then examined two leading cases that define the contours of the affirmative legislative policy exception in the Second Circuit: Gebardi v. United States[20] and United States v. Amen.[21] In Gebardi, which contemplated violations of the Mann Act (prohibiting the interstate transportation of women for purposes of prostitution), the Supreme Court held that Congress did not intend for women who simply agree to be transported to be liable under the statute, and “a necessary implication of that policy” was to limit their liability for a conspiracy charge under the statute.[22] In Amen, the Second Circuit applied Gebardi’s reasoning to find that the continuing criminal enterprise statute similarly evinces an affirmative legislative policy to limit conspiracy or accomplice liability to the “kingpin” individuals who Congress intended as targets of the statute, and not third parties.[23]
Applying Gebardi and Amen, the Court examined the FCPA’s text, structure, and legislative history to determine whether “an affirmative legislative policy [could] be discerned.”[24] The Court found that each of these, and in particular the FCPA’s extensive legislative history, reflected Congress’s intent to limit liability to the statute’s enumerated categories of defendants.[25] As a result, “the government may not override that policy using the conspiracy and complicity rules” to find Hoskins liable for conspiring to violate the FCPA if he does not fall within one of the categories of individuals covered by the FCPA.[26]
In reaching this holding, the Court rejected the government’s narrower reading of Gebardi, as well as its more expansive reading of the jurisdictional reach Congress intended to afford the FCPA.[27] (Notably, the government’s position was consistent with the guidance it provides to companies and individuals in its FCPA Resource Guide, which has now been expressly refuted by the Second Circuit.) The Court pointed out that the government’s position “would transform the FCPA into a law that purports to rule the world,” and that would ignore Congress’s “desire[] that the statute not overreach in its prohibitions against foreign persons.”[28]
Presumption Against Extraterritoriality
The Court separately held that even if no affirmative legislative policy existed, the presumption against extraterritoriality still prohibits Hoskins’ conspiracy or complicity liability to the extent he falls outside of the categories of defendants covered by the FCPA.[29] Specifically, the Court explained that there is a presumption against the extraterritorial application of domestic law to individuals and entities outside of the United States. When a U.S. statute nonetheless is intended to apply extraterritorially, the presumption “operates to limit that provision to its terms.”[30] As a result, the presumption works to limit the FCPA “to its terms” by restricting extraterritorial liability under the FCPA to the statute’s specifically enumerated categories of defendants, unless the government could demonstrate congressional intent otherwise.[31] Because “the extraterritorial reach of an ancillary offense like aiding and abetting or conspiracy is coterminous with that of the underlying criminal statute” and because the legislative history demonstrated Congress’s intent to keep the FCPA’s reach circumscribed, the Court noted that the presumption therefore narrowed conspiracy and complicity liability under the FCPA to the specific provisions of the statute.[32] Accordingly, the Court held that the presumption provided an independent basis to conclude that Hoskins could not be charged with conspiracy and accomplice liability except to the extent he could be charged as a principal.[33]
Reinstating the Second Object of the Conspiracy
While the Second Circuit affirmed the district court’s conclusion regarding the general limitations on charging conspiracy and aiding and abetting liability under the FCPA, it reversed the lower court’s decision dismissing the second object of the conspiracy, in which Hoskins was charged with conspiring with foreign nationals who engaged in proscribed conduct while in the U.S. but had not himself committed any act on U.S. territory.[34] The Court noted that the government argued that it could prove that Hoskins had acted as an agent of a “domestic concern” – Alstom Power – in violating the FCPA.[35] The Court explained that, assuming the government was able to prove that, Hoskins fell within one of the three enumerated categories of individuals to whom the statute applied, and neither the affirmative legislative policy exception nor the presumption against extraterritoriality would be offended if Hoskins was also prosecuted for a conspiracy whose object was to violate the FCPA with foreign nationals who acted within the United States, even if he did not do so himself.[36]
Concurring Opinion
Judge Lynch issued a concurring opinion in which he largely agreed with Judge Pooler’s reasoning, but explained that he viewed the case as a close one, in which the “important purposes” of the FCPA had to be balanced against an “intru[sion] into foreign sovereignty” due to the “novel” nature of the FCPA’s already expansive jurisdiction.[37] Judge Lynch noted that it was unlikely that Congress had anticipated a scenario like Hoskins, in which a senior official of a French company could potentially escape liability for directing an American subsidiary and its employees to undertake certain acts in furtherance of a bribery scheme, and that this potentially led to a “perverse” result where lower level employees and others who were agents of that U.S. company could be charged but not Hoskins.[38] That said, Judge Lynch concluded that the legislative history of the FCPA combined with the presumption against extraterritoriality led him to conclude that the Court had reached the right result.[39]
Conclusion
Although the Second Circuit’s decision limits the government’s ability to prosecute foreign nationals for conspiring to commit or aiding and abetting a violation of the FCPA, the practical implications of the decision seem limited. It applies only to a small class of foreign nationals and entities – those who engaged in a bribery scheme in which there is otherwise jurisdiction under the FCPA, but who are not themselves U.S. nationals or residents, or agents, employees, or officers of either a U.S. issuer or domestic concern, and who have not acted within the United States. That said, the ruling is significant as one of the few cases limiting the FCPA’s jurisdiction due to the statute’s unique, extraterritorial nature, which may encourage charged defendants in other cases to challenge the DOJ’s broad interpretation of its jurisdiction.
[16] The Court concluded that it had jurisdiction to review the lower court’s decision pursuant to 18 U.S.C. § 3731, which permits interlocutory appeal in criminal cases when there has been a dismissal of a count – even a partial dismissal, as was the case here. Hoskins, 2018 WL 4038192, at *12. Interlocutory appeal is justified in such instances, the Court noted, because a potential ground for conviction has been lost. Id. at *14-17.
For the past year the #MeToo movement has altered the landscape of corporate conduct and accountability, not only for senior management but for corporate boards as well, as evidenced by the recent controversy surrounding CBS’s former Chairman and CEO Moonves. Since the disclosures last October regarding Harvey Weinstein’s conduct, over 100 senior executives, across a variety of industries, resigned or were fired as a result of allegations regarding sexual misconduct. Workplace sexual harassment is prevalent, and until the #MeToo movement, largely silent.
In announcing its Strategic Enforcement Plan for FY2017-2021, the U.S. Equal Employment Opportunity Commission (EEOC) indicated that preventing systemic harassment was one of its top six priorities. In its recent release of preliminary sexual harassment data for FY2018, the EEOC noted a 50 percent increase in the number of sexual harassment lawsuits filed from FY2017.
Though the majority of publicity surrounding the #MeToo movement focused on the media and entertainment industries, the legal industry should consider this a wake-up call as it is certainly not immune from scrutiny nor potential litigation, as evidenced by the gender bias lawsuits filed this year.
Recently, the American Bar Association and the Minority Corporate Counsel Association released a study, “You Can’t Change What You Can’t See: Interpreting Bias in the Legal Profession”. A survey of over 2800 in-house and law firm attorneys found that 25 percent of the women respondents reported some form of unwelcome sexual harassment at work and more than 70 percent of all respondents encountered sexist comments or jokes.
Recently, Aon reviewed the employment practices liability (EPL) claims filed against its law firm clients from 2005-2017 and found that a total of 1,315 charges of wrongful conduct were filed during that period. The most frequently filed charges included retaliation, wrongful termination and discrimination based on disability, gender, age and race. On these claims, law firms and their insurers paid a total of $91,101,674 in judgements and settlements, and in excess of $44 million in defense costs, the latter of which Aon believes were underreported due to self-representation by law firms. The primary EPL offenders—75 percent—were male lawyers.
EPL should be a priority for all law firms if for no other reason than the sheer economic opportunity cost of misconduct. As a risk mitigation strategy, firms should consider adopting the following best practices as an integral component of their enterprise risk management program:
Institute a Code of Conduct if one does not already exist. The Code is the firm’s blueprint for the rules of engagement and is a reflection of the tone at the top and the firm’s ethical and organizational culture. While policies and procedures are tactical, the Code should set forth the firm’s mission, corporate values, and at a minimum, include the following: a) a zero tolerance stance regarding workplace misconduct and b) a clear non-retaliation policy, particularly given that retaliation was the most common EEOC claim filed in FY2017, representing 48.8 percent of the total charges filed. Similarly, retaliation was the most frequently cited of Aon’s EPL claims as well.
Routinely review, update, and follow firm policies and procedures with respect to workplace conduct. The firm’s policies and procedures are the means by which the Code of Conduct is implemented; having policies, however, is not sufficient. In fact, in reviewing selected gender bias lawsuits against law firms, there is a marked propensity to ignore and or fail to follow internal policies. To do so suggests that compliance is not taken seriously, that policies are merely a formality, and/or that management is irresponsible.
Take training and discipline for infractions seriously. In the wake of #MeToo, the expectation is that employers will offer anti-sexual harassment training, and in some states, it is legally mandated. Requirements vary by state, with multiple nuances. For example, while the Commonwealth of Pennsylvania currently has a limited policy that requires that Commonwealth employees are “educated in sexual harassment issues,” in the state of Delaware, House Bill 360, which is scheduled to take effect January 1, 2019, requires all employers with more than 50 employees to conduct anti-sexual harassment training every two years. Bottom line, law firms need to know the sexual harassment training requirements of the jurisdictions in which they operate in order to be compliant.
Further, training on the firm’s workplace policies and procedures should not stop at on-boarding orientation. To be effective, it needs to me mandatory, ongoing, conducted annually (regardless of the legislative mandates, some of which only require bi-annual training), and, preferably, interactive. This is not an optional exercise and should be applied consistently, regardless of status within the firm. No one gets a pass. Just as important, the disciplinary measures need to be applied consistently as well, which conveys the message that status does not proffer immunity.
Understand how far liability extends under state legislation. As with training, coverage protections vary by state. Under the proposed Delaware law, sexual harassment protections extend not only to employees (including those placed by employment agencies), but also to unpaid interns, employment applicants and apprentices. Other jurisdictions such as New York are even more comprehensive, holding employers liable for instances of sexual harassment involving non-employees, including contractors, sub-contractors, vendors and consultants, provided the employer knew or should have known that the non-employee was subjected to sexual harassment in the employer’s workplace.
Combining these best practices will mitigate, though not totally eliminate, the risk of sexual harassment and other employment practice liability claims. Further, taking these steps demonstrates the firm’s commitment to a respectful and non-toxic workplace–a responsibility that employees will continue to hold law firms accountable for well into the future.
The growing wave of sexual harassment cases against high-profile figures has revealed that the use of nondisclosure or confidentiality provisions in settlement agreements has forced many women to keep their sexual harassment allegations private, which, in some respects, may allow harassers to continue their misconduct. When confidentiality is made a term of a settlement agreement, the parties are generally prohibited from disclosing not only settlement terms, but also facts relating to the underlying dispute. The controversy over settlement agreements that include confidentiality provisions reached a fever pitch when it came to light that dozens of women and girls who accused former USA Gymnastics team doctor Larry Nassar of abusing them had signed such agreements. Other well-known individuals accused of harassment or abuse who have been protected by confidentiality clauses under similar circumstances include Harvey Weinstein, Kevin Spacey, Bill O’Reilly, and Bill Cosby. The inclusion of confidentiality or nondisclosure provisions in settlement agreements for employment-related cases, including sexual harassment and discrimination claims, has long been standard practice. However, the recent news stories, along with the outpouring of sexual harassment allegations from the #MeToo movement, has reignited the debate over whether confidentiality requirements should be enforceable in sexual harassment or abuse cases.
Critics of confidentiality agreements argue that such agreements enable abusers by silencing victims and allowing harassers to continue their misbehavior, assuming, as was alleged in the USA Gymnastics scandal, that those with power and potential oversight over the abuser did nothing to stop the conduct. The abuser may be undeterred and even emboldened knowing that the public may never learn of the misconduct. On the other hand, other victims may feel isolated and fail to come forward for fear of not being believed.[1] In most cases, nondisclosure agreements impose steep financial costs in the event the accuser discloses at a later time. For instance, Olympic champion gymnast McKayla Maroney had entered a nondisclosure agreement with USA Gymnastics that, if enforced, would have resulted in a $100,000 penalty if she spoke about her abuse by Dr. Nassar or the settlement. USA Gymnastics later said they would not enforce the nondisclosure agreement. Opponents of confidentiality provisions in settlement agreements argue that the greatest benefit of banning such provisions means that serial harassers would lose the ability to buy the silence of their victims.
The inclusion of confidentiality provisions in settlement agreements for sexual harassment and discrimination claims has historically been a standard practice. A chief reason for an employer to settle a sexual harassment or discrimination claim is to avoid the possibility of a public trial and prevent any negative publicity. Moreover, confidential settlements prevent plaintiff’s attorneys who represent employees from creating a standard rate for settlements against a specific employer. Because trials can be costly, time consuming, and risky, barring nondisclosure provisions altogether for sexual harassment and discrimination claims could discourage employers from settling cases; this may result in plaintiff’s attorneys taking fewer sexual harassment cases, which could prove detrimental to victims. In addition, nondisclosure agreements can provide some benefit to accusers who do not want to be identified. Absent a confidentiality provision, victims may fear that a vindictive former boss will publicly smear them or hurt their efforts to find new employment.
Against the backdrop of the mounting criticism of nondisclosure agreements, there has been a growing trend by lawmakers at both the federal and state levels to prohibit confidentiality agreements for sexual harassment claims. One notable change in recent months at the federal level is a change to the tax treatment of settlements in claims of sexual harassment and discrimination. Specifically, 26 U.S.C. § 162(q) of the new tax law that took effect in 2018 eliminates tax deductions for settlements, payouts, and attorney’s fees in cases related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement. Under the new law, employers may no longer deduct attorney’s fees or settlement payments if a nondisclosure provision is used in a case related to sexual harassment or abuse. Congress is also exploring changes to allow for more transparency. For example, a bill was recently introduced entitled the Sunlight in Workplace Harassment Act which seeks to require companies to publicly report sexual harassment data. Under the proposed law, companies would be required to report payments for settlements related to sexual harassment and discrimination. Moreover, companies would be required to disclose the average length of time it took to resolve a sexual harassment complaint. There has been noteworthy change occurring at the state level as well. In 2016, California became the first state to bar nondisclosure agreements in civil cases that could be prosecuted as felony sex crimes. In July of 2018, a budget bill signed into law by New York Governor Andrew Cuomo will prohibit mandatory arbitration clauses and ban nondisclosure clauses in settlements, agreements, or other resolutions of sexual harassment claims, unless the condition of confidentiality is the complainant’s preference. State legislatures in Pennsylvania, New Jersey, and several other states have considered similar bills with the intent of banning the use of confidentiality provisions in sexual harassment and other employment-related cases.
In closing, the changing legal landscape regarding confidentiality agreements for sexual harassment and discrimination claims underscores the fact that employers must be mindful of possible changes in the future as well as recently implemented changes, such as the federal tax law. Employers should meaningfully consider the pros and cons of including nondisclosure agreements that relate to sexual harassment and discrimination claims in their employment-related agreements. Employers should certainly weigh the negative publicity and potential fallout that could result from attempting to enforce such provisions. Finally, even though there is no legal requirement to change existing agreements, employers should at least consider proactively reexamining their current agreements. A number of companies have taken such action. Most significantly, Microsoft announced in December of 2017 that it was waiving the contractual requirement for the arbitration of sexual harassment claims in its arbitration agreements for the limited number of employees who had this requirement.
[1]See Juliana Batista, Behind Closed Doors: The Advantages and Disadvantages to Mediating Sexual Harassment Complaints, 70 Disp. Resol. J., 87, 89 (2015) (explaining that the settlement of sexual harassment cases often means that the “public is denied the settlement information and [is] consequently unable to develop a deep understanding of patterns, trends, and common practices that should be used to resolve sexual harassment cases”).
Uncertainty is bad for business. The interpretation by the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) of “an instrumentality of a foreign government” under the Foreign Corrupt Practice Act (FCPA) might discourage business between U.S. and Colombian companies. The compliance programs of American companies can turn into lengthy procedures with long chains of people involved, making business decisions expensive and time-consuming because they could involve hiring foreign attorneys, mitigating a broad category of risks, and hiring employees that understand the Colombian political situation and its laws.
The FCPA prohibits bribing a foreign official for the purposes of influencing any act or decision of the foreign official in his or her official capacity. 15 U.S.C. § 78dd-2(a)(1)(A)(i). A “foreign official” under the FCPA, among other factors, is any officer or employee of a foreign government, or any department, agency, or instrumentality of a foreign government. 15 U.S.C. § 78dd-2(h)(2). However, Congress has not defined what constitutes an “instrumentality of a foreign government.” Rather, courts have filled the gap by defining an instrumentality as a company controlled by a foreign government that performs a function the foreign government treats as its own. For example, in United States v. Esquenazi, 752 F.3d 917, 925 (11th Cir. 2014), the Eleventh Circuit held that there is a two-pronged test to determine whether a company is an instrumentality of a foreign government. The first element is that there must be control from the foreign government over the state-owned company. For the Esquenazi court, “control” existed when the formal designation of the company was public, the government had a majority interest in the company, and the government had the ability to hire and fire the company’s principals, among other factors of control. The second element of the test is that the state-owned company must perform a function the government treats as its own. The Esquenazi court found a government function when the company has a monopoly over the activity that it carries out, when the government subsidizes the costs of the services, when the company provides services to a large population, and when the foreign country perceives the company is performing a governmental function. These factors are not an exhaustive list of all the factors courts can consider to determine what is an instrumentality of a foreign government, however.
The DOJ and the SEC have jurisdiction to investigate actions that violate the FCPA and adopted the Esquenazi factors in their for companies which adds other elements from cases to determine what an instrumentality is, Crim. Div. of the U.S. Dep’t of Just. & the Enf’t Div. of the U.S. Sec. and Exch. Comm’n, A Resource Guide to the U.S. Foreign Corrupt Practices Act, (p 20) (2015). In addition to their investigatory function, the DOJ and the SEC enforce the FCPA, applying the various factors listed in the guide. Deputy Attorney General Rosenstein has stated that the U.S. government will enforce the FCPA against foreign and domestic companies. In addition, Attorney General Jeff Sessions stated that the DOJ “will continue to strongly enforce the FCPA and other anti-corruption laws.”
Unfortunately, neither the DOJ nor the SEC has explained how the factors relate to each other, or how many factors are required to conclude that a foreign company is an instrumentality of a foreign government. When the courts, the DOJ, or the SEC conclude that a foreign company is an instrumentality of a foreign government, all of its employees become government officials under the FCPA. Nevertheless, this conclusion may conflict with the foreign country’s laws. For example, in Colombia, the distinction between a government official and a private employee is blurred when state-owned companies are involved because not all the employees of a state-owned company are government officials. Thus, American companies could risk sanctions by the DOJ or the SEC because Colombian laws are not clear on this subject.
The Colombian government owns stock in several companies, from one percent to 99 percent of the companies’ stock. Nevertheless, to know whether employees of a state-owned company are government officials requires a case-by-case analysis according to Colombian Constitutional Court. Corte Constitucional [C.C.] [Constitutional Court], mayo 4, 2011, M.P: Gabriel Eduardo Mendoza Martelo, Sentencia C-338/11, Gaceta de la Corte Constitucional [G.C.C.] (p. 22) (Colom). If the Colombian government owns more than 90 percent of the stock, there is little room for debate as to whether the company is an instrumentality of the government because Colombian law expressly provides that conclusion. Id. at 24. However, if the Colombian government owns less than 90 percent, the line is blurred between a government official and private employee. For example, the Colombian Constitutional Court held that Ecopetrol, a company of which the Colombian government owns 88.49 percent of stock, is part of the government’s structure, and its employees are government officials despite the fact that Ecopetrol’s bylaws provide that its employees are private. Corte Constitucional [C.C.] [Constitutional Court], septiembre 12, 2007, M.P: Clara Inés Vargas Hernández, Sentencia C-722/07, Gaceta de la Corte Constitucional [G.C.C.] (p. 54) (Colom). Another example is Interconexión Eléctrica S.A. E.S.P. (ISA), where the Colombian government owns 51 percent of the stock and the courts considered ISA an instrumentality of the Colombian government. Consejo de Estado [C.E.], Sala de Consulta y Servicio Civil septiembre 20, 2007 M.P: José Enrique Arboleda Perdomo, Radicación 1.840 (p.5) (Colom).
If the Esquenazi factors are applied to Colombian state-owned companies, where the distinction between a government official and private employee is not clear, is possible to obtain a contradictory conclusion. For example, the Colombian government owns 32.5 percent of the stock of Colombia Telecomunicaciones (Telefoníca), a cable, phone, and internet company. Due to the stock ownership, the Colombian government has one seat on the board of directors. The Colombian government and the public perceive Telefoníca as a private company, although Telefoníca is part of the government. Nevertheless, Colombian courts have not yet ruled whether Telefoníca is part of the government or if its employees are government officials. In Telefoníca’s case, the Esquenazi factors support two contradictory conclusions: that Telefoníca is an instrumentality of the Colombian government because it is part of the government, and that Telefoníca is not an instrumentality because the public and the government perceive that Telefoníca does not perform a government function. Consequently, the Esquenazi factors are not clear enough to apply to the hard cases and may promote decisions against the laws of foreign countries.
Another example of the lack of clarity of application of the Esquenazi factors is the special obligation that Colombian state-owned companies owe to Comptroller General of the Republic (CGR) investigations. The CGR, Colombia’s equivalent to the U.S. Government Accountability Office, annually conducts an internal investigation in state-owned companies to protect public money. The companies must answer all the requests made by the CGR and are subject to an annual report that includes an assessment of the company’s administration. Only the companies that have government participation (over 100 state-owned companies) are specially obligated to allow the CGR’s investigation.
Under the broad application of the instrumentality definition, any Colombian company subject to the CGR’s investigations could be considered an instrumentality of the Colombian government. According to the DOJ and SEC guides, a state-owned company is an instrumentality of a foreign government when the state-owned company has special obligations. The Colombian state-owned companies have the obligation to allow the CGR’s investigations, answer its questions, and submit reports to the CGR. Therefore, the DOJ and the SEC may conclude that any state-owned company is an instrumentality of the Colombian government because the company has special obligations and provides services to the public at large, and the company is performing a governmental function. However, for the Colombian government, not all the state-owned companies are instrumentalities of the government. Consequently, American companies’ compliance programs must take into consideration the risk that if they are dealing with any Colombian state-owned company, the DOJ and the SEC might conclude that the Colombian company is an instrumentality of the Colombian government.
American companies’ compliance programs must mitigate a broad category of risks, and is a proper way to avoid sanctions from the DOJ or the SEC. Another way American companies can avoid sanctions is to avoid making any payment to a foreign employee or official, although in business some payments are allowed. Nowadays, the legal denominations of a Colombian company—LLC., Inc., or Co.—is not enough to determine whether it is an instrumentality of the government. American companies must know whether the Colombian government owns stock in the Colombian company, directly or through another company. In addition, American companies must know whether the Colombian company is subject to the CGR’s investigations.
The lack of clarity as to what is “an instrumentality of a foreign government” increases the possibility that the DOJ or the SEC will open an investigation against a company. In Colombia, state-owned companies are a risk to American companies because the DOJ and the SEC may start an administrative procedure alleging that the American company is dealing with a Colombian government official when in reality it is a private employee. Hence, companies’ compliance programs must mitigate a broad category of risks, including the possibility of dealing with a private employee who could be considered a government official.
To mitigate such risks, American companies must have qualified employees that understand Colombia’s political situation and its laws, which could include hiring attorneys in Colombia. Given lack of clarity as to what constitutes an instrumentality, the company may seek the DOJ’s opinion about the Colombian company’s status, and that could take time. Before an American company engages in a negotiation with a Colombian company, the American company should take steps to determine whether the Colombian company is considered an instrumentality of the government under the Colombian law or under the broad interpretation of the DOJ and the SEC. However, compliance programs can turn into costly and lengthy procedures, with long chains of people involved, making decisions expensive and time-consuming. Finally, the combination of Esquinazi factors and the eagerness of the DOJ and the SEC to enforce the FCPA could affect U.S.-Colombian business, discouraging investment in oil, energy, banking, telecommunications, transportation, agriculture, and health because the American companies are at risk of investigation if the Colombian companies are dealing with a foreign official.
On October 3, 2018, the United States Supreme Court held oral argument for New Prime Inc. v. Oliveira, No. 17-340, a case concerning Section 1 of the Federal Arbitration Act (“FAA”). Section 1 of the Federal Arbitration Act (“FAA”) provides that the FAA does not apply “to contracts of employment of seamen, railroad employees, or any other class of workers engaged in foreign or interstate commerce.” 9 U.S.C. § 1. Specifically, the Court is addressing two issues: (1) whether a court or an arbitrator must determine the applicability of Section 1; and (2) whether Section 1 of the FAA’s exemption for contracts of employment includes, as a matter of law, independent contractor agreements. The underlying dispute arises from an independent contractor agreement between the parties pursuant to which Oliveira’s trucking company,located in Missouri, provided services to New Prime, a national trucking company. The underlying agreement specifically stated that there was no employer/employee relationship created between the parties and that any disputes would be resolved through arbitration. Subsequent to entry into the agreement, a dispute over the rate of payment arose and Oliveira joined in a class action under, inter alia, the Fair Labor Standards Act. New Prime sought to compel arbitration and Oliveira opposed, contending, among other things, that the FAA barred arbitration because it was a contract of employment. The Fifth Circuit affirmed the district court’s decision that the court, not the arbitrator, was to decide whether Section 1 of the FAA was applicable and that independent contractor agreements fell within the purview of the FAA’s Section 1 exemption.
On appeal, New Prime argued that courts must give deference to arbitration clauses under the FAA and uphold prior court precedent creating a “presumption of arbitrability.” As such, arbitrators should be able to decide this threshold jurisdictional issue. Oliveira’s response to this argument—that this question in the first instance should be decided by the court and not the arbitrator—was adopted by the lower courts. Oliveira contends that while parties may delegate some threshold issues to the arbitrators, arbitrability covers which issues have been submitted to arbitration, but not all potential threshold issues, such as the application of the FAA.
With respect to the second issue, whether Section 1 of the FAA’s exemption for contracts of employment includes, as a matter of law, independent contractor agreements, New Prime argues the applicability of the FAA to an independent contractor agreement is outside the scope of the exemption provided by Section 1. New Prime advances a narrow reading of this exemption and points to the underlying purpose of the FAA, which was to balance judicial hostility to arbitration agreements in general. For purposes of comparison, New Prime identifies other statutes in which the ADR-related provisions governing employment-related disputes did not include independent contractor agreements. New Prime presents an interesting analysis of the literal meaning of employment agreement terms, including, but not limited to, citations to Black’s Law Dictionary, which defines an employment contract as one between an employer and employee, and does not include independent contractor agreements. In response, Oliveira argued that the FAA does not define the term “employment contract” and that the plain meaning should be utilized in rendering any determination. Further, Oliveira points to language from other Supreme Court cases where the term contracts of employment were found to include independent contractor agreements. Moreover, Oliveira refers to other statutes enacted contemporaneously with the FAA, wherein similar interpretations, or definitions, support this proposition.
Additional parties have filed amicus briefs, such as the Customized Logistics and Delivery Association—they raise a concern that excluding independent contractors from using arbitration will impact other sectors of the transportation industry and may result in significant cost increases in the transportation industry. The Chamber of Commerce and the Society for Human Resource Management also submitted amicus briefs supporting New Prime, and cautioned that consumers will bear the brunt of any increase in costs due to the unavailability of arbitration as an option to resolve certain disputes.
Follow up next month for the decision of the Court, as well as for additional information on the second case slated for oral argument on October 29, 2018, Lamps Plus, Inc. v. Varela, No. 17-988.
The recent popularity of cryptocurrencies and blockchain-based tokens among investors has raised implications under U.S. securities laws, including whether these tokens are securities.
Legal issues aside, as a simplified illustration, a blockchain is a “shared digital ledger, also called a distributed ledger, for storing and tracking transactions,” with each peer user of the ledger holding a unique digital key to the ledger.[1] Blockchains and, more broadly, distributed digital ledgers[2] are often touted as having an revolutionary effect on how transactions can be conducted and how people can interact with each other by eliminating intermediaries.[3] Numerous variations of such digital ledgers currently exist on the market; they were mostly developed by different consortiums that consist of technology companies and/or financial institutions.[4]
The digital assets that move across a blockchain or a distributed ledger are termed “tokens,” “coins,” or “cryptocurrencies.” Among the most common existing coins are bitcoin (originated on the original blockchain) and ether (originated on the well-known ethereum ledger), which can be easily exchanged for fiat currencies (e.g., U.S. dollars) in the open market and used to purchase other digital (and even nondigital) products, thus bearing a strong resemblance to the traditional concept of currency.[5]
Technology companies and even traditional business entities have come to realize the potential of blockchain’s commercial use and are using it in a number of ways. One of those ways is an initial coin offering (ICO) that is expected to lead to the completion of blockchain-based projects. An ICO is an event in which a blockchain-based project or entity raises capital by issuing tokens to purchasers in exchange for a contribution of value in the form of either fiat currency or digital currencies.[6]
The rest of this article will explain why ICOs and digital assets in general implicate the U.S. securities laws. Part II gives an overview of the orders, actions, and statements by the Securities and Exchange Commission (SEC) leading up to Director Hinman’s speech (the Hinman Speech),[7] including the famous “The DAO Report” and the SEC’s cease-and-desist order against Munchee Inc. (Munchee Order).[8] Part III points to alternatives to ICOs that are less likely to run afoul of the securities laws and SEC regulations. The purpose of this article is two-fold: (1) to analyze how the SEC applies old laws to emerging issues and develops its jurisprudence, and (2) to provide some guidance to counsels and practitioners who are or will be structuring a transaction involving digital assets.
II. The SEC’s Developing View on Digital Assets
Like bitcoin or ether, digital assets sold today can function as a medium of exchange, unit of account, or store of value.[9] Increasingly, however, these tokens begin to represent other rights, such as a right to participate in the developer’s profit distribution or a right to access the blockchain-based platform once it is placed into commercial production. Depending on the circumstances, these other rights could cause digital assets to fall in the definition of “securities” under the Securities Act of 1933 and the Securities Exchange Act of 1934 (collectively, the Securities Laws).[10]
Under the Securities Laws, all securities offered and sold in the United States must be registered with the SEC or must qualify for an exemption from the registration requirements. In addition, any entity or person engaging in the activities of an exchange must register as a national securities exchange or operate pursuant to an exemption from such registration. Thus, whether a token is a security becomes crucial for token issuers and people who facilitate the promotion and issuance of tokens. As discussed below, the SEC evaluates whether tokens are securities by considering whether they are “investment contracts,”[11] which must satisfy the Howey test: The instrument is (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the entrepreneurial or managerial efforts of others.[12]
1. Pre-Munchee Order SEC Actions and The DAO Report
Before ICOs heated up in the latter half of 2017,[13] the SEC brought sporadic actions against security intermediaries alleging fraudulent behaviors. However, in those administrative proceedings or cases, bitcoins or digital tokens were only tangential ingredients that were not the focus of the SEC’s analyses.[14]
The DAO Report published in July 2017 represented the first instance in which the SEC truly opined on the nature of digital tokens.[15] The blockchain company Slock.it created and sold DAO tokens to the public in exchange for ether. DAO tokens granted token holders certain voting and ownership rights.[16] According to the company’s promotional materials, DAO token holders would share in the anticipated earnings from projects funded by their investment in DAO tokens and would have the ability to make a profit by reselling DAO tokens in a secondary market.[17]
In evaluating whether DAO tokens are securities, the SEC did not hesitate to apply the Howey test: “[A] security includes ‘an investment contract’ . . . . This definition embodies a ‘flexible rather than a static principle’ [and] in analyzing whether something is a security ‘form should be disregarded for substance.’”[18]
Observing that “‘money’ need not take the form of cash” and that DAO token holders gave something of value (i.e., ether), the SEC quickly concluded that the first prong is met.[19] Next, given that ether contributed by DAO token holders was pooled and made available to the DAO platform to fund projects, the returns on which would be shared by holders, purchasers of DAO tokens invested in a common enterprise and reasonably expected profits in the form of “increased value of investment.”[20]
Most ink was spilled on the last prong that the profit is to be derived from “the entrepreneurial or managerial efforts of others.” The trick, compared to the facts that made the first three prongs an easy pass, is that DAO token holders did have some voting right to decide what business projects to be deployed. The question was whether the managerial efforts of Slock.it were nonetheless the significant ones driving the value of The DAO in light of DAO token holder’s decision-making power as to projects. The SEC answered in the affirmative because: (1) Slock.it and its co-founders held themselves out as experts in the ethereum network and led investors to believe they could be relied on to make The DAO a success; (2) Slock.it and its co-founders actively monitored, operated, and safeguarded The DAO and investor funds; (3) DAO token holders could vote only on proposals filtered by Slock.it and its co-founders using limited information provided to the holders and had no role in negotiating terms of the contracts; and (4) there was no practical way for DAO token holders to consolidate their votes into powerful blocs.[21] In other words, “the voting DAO Token holders [had were] akin to those of a corporate shareholder.”[22] Because DAO token holders were unable to assert actual control over the business, they necessarily relied on the managerial and entrepreneurial efforts of Slock.it and its co-founders.
Through The DAO Report, the SEC spoke directly to digital token issuers for the first time. In a certain sense, the message conveyed in The DAO Report was a mild, friendly warning given that the SEC decided not to pursue any enforcement action, and a considerable portion of the report reiterated the Securities Laws, which in retrospect might be unfortunate because practitioners and businesses mistook it for an opportunity to test the regulator’s limit. Another aspect of The DAO Report that tends to be downplayed is the SEC’s reminder that a marketplace meeting the definition of an “exchange” under the Exchange Act on which securities (including digital assets that are securities) transactions take place must register with the SEC pursuant to the Securities Laws and regulations. This “afterthought” that was squeezed in to the end of The DAO Report turned out to be crucial in the SEC’s more recent enforcement activities, as discussed below.
2. The Munchee Order
Many think The DAO is not even a close case; after all, except that the instruments were called “tokens,” not “shares,” DAO tokens shared many of the attributes of a traditional equity stock.[23] Creative people predictably would not allow their tokens to be pigeonholed to the type of “security tokens” created by The DAO.
The thinking prompted the burgeoning of the so-called utility tokens, which replaced the profit-sharing attribute of DAO tokens (or the like) with a certain consumer utility attribute. In fact, token issuers can customize the terms of the tokens in whatever way they see fit, typically in an informational “white paper” document from which prospective purchasers know to what features of the tokens they are subscribing. Utility tokens represent a right to use the issuer company’s products or services instead of any interest in the company itself. After The DAO Report, an increasing number of companies began issuing utility tokens to raise funds for the development of its products or services to which prospective token holders will have access.
On December 11, 2017, the SEC issued a cease-and-desist order against Munchee Inc., a California company that created an iPhone app for reviewing restaurants, for offering and selling unregistered tokens, which in the SEC’s view was a security. Notably, the Munchee Order was the first SEC enforcement action against an ICO that made no fraud allegations.[24] The tokens sold by Munchee (MUN tokens) were utility tokens allowing holders to purchase goods or services in the to-be-improved “ecosystem” of the app.[25] The SEC found that Munchee indicated that it would take steps to increase the value of the tokens, which made purchasers of MUN tokens to have a reasonable expectation of obtaining future profits predominantly from the efforts of Munchee and its agents.[26] Accordingly, the SEC found that MUN tokens were securities, and the offering and sale of MUN tokens was subject to the Securities Laws.
Applying the same Howey test, the Munchee Order focused on the third prong: a “reasonable expectation of profits.” This is a sensible approach because when people buy a garden-variety merchandise, they are paying for the utility offered by the merchandise, not its potential to appreciate in value; even though it is plausible that certain consumer goods could increase in value over time, this alone usually is not what motivated consumers to make the purchase in the first place.[27] By building in MUN tokens a feature that would allow holders to engage in various activities in the new app ecosystem (i.e., consumer utility), Munchee was pulling MUN tokens out of the investment instrument basket and putting them into the consumer goods basket. The implication was that purchasers of MUN tokens probably did not have a reasonable expectation of profits.
The SEC took issue with Munchee’s strategy, and the Munchee Order on the whole exemplified how the SEC interpreted “form should be disregarded for substance.” Not limited by Munchee’s self-labeling, the SEC looked at facts evidencing a reasonable expectation of profits among MUN token purchasers, including: (1) although Munchee told potential purchasers MUN tokens could be exchanged for goods or services after Munchee created an ecosystem, no one was able to buy any good or service with MUN tokens before the ecosystem became operational;[28] (2) on Munchee’s website and in its white paper, Munchee indicated that “MUN tokens would increase in value”;[29] (3) in public appearances, Munchee and its agents primed purchasers’ expectation of profit through statements and endorsements of others’ statements that MUN tokens would increase in value and that purchasers would receive a significant return by buying MUN tokens early;[30] (4) Munchee specifically targeted potential purchasers interested in investing in cryptocurrencies, not its app users or restaurants, by promoting MUN tokens in digital asset investment forums where prospective investors gather and paying third parties to publish promotional statements in those forums;[31] and (5) Munchee intended that MUN tokens would trade in a secondary market, and Munchee represented that it would buy or sell MUN tokens using its retained holdings in order to ensure a liquid secondary market.[32] Munchee did much more than a garden-variety retailer would do to promote its merchandise but at the same time neglected what a retailer should do—to market the good to people who find it most useful. Taken together, these facts support the SEC’s conclusion that Munchee was priming prospective purchasers’ expectation of profits.
The Munchee Order tells us that whether a token is called an investment token or a consumer good, the inquiry does not stop there. The Munchee Order went so far as to say, “Even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security.”[33] It is unnecessary for the SEC to make statements on facts that were not present in the instant case; perhaps the SEC wanted to show its strong determination that the economic-reality analysis would be applied in each and every case involving ICOs and to deter issuers who would try evading scrutiny by introducing the slightest variation to its digital assets.
3. Post-Munchee Order SEC Actions
On the same day that the Munchee Order was issued, SEC Chairman Jay Clayton released a statement to both main street investors and securities market professionals who play a role in ICOs.[34] Predictably, the statement picked on utility tokens: “Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.”[35] Chairman Clayton, however, left it open to structuring an ICO not involving the offering of securities. He noted that, “a participation interest in a book-of-the-month club may not implicate [] securities laws,” whereas “many [utility] token offerings appear[ed] to have gone beyond this construct and [were] more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come.” It is yet to be seen what kind of utility tokens is (or is not) akin to a participation interest in a book club that is already built and running.[36] All we know is that no lines will be drawn, and the same case-by-case factual analysis will continue to apply.
The Munchee Order set in motion a series of efforts targeting the ICO market in a broader scope. The Clayton statement not only cautioned investors against investing in cryptocurrencies or ICOs without making adequate inquiry into the specifics of an offering, but also called on market professionals (e.g., broker-dealers, investment advisers, exchanges, and lawyers) to focus on “the protection of our Main Street investors” by ensuring that offerings of securities be accompanied by important disclosures, and the Securities Laws be complied with in all respects. This message echoes The DAO Report’s warning that a marketplace where trading of securities occurs must register as a national exchange or, if certain conditions are met, a broker-dealer. Lastly, the Clayton Statement “promised” that “the SEC’s Division of Enforcement [would] continue to police this area vigorously.”
In the same vein as the Munchee Order and the Clayton statement, the SEC continued to closely monitor ICO-related activities,[39] but the SEC’s post-Munchee Order focus seemed to be shifting from token issuers to market professionals who facilitated ICOs. In January this year, Chairman Clayton sent additional warning signals to securities professionals, especially lawyers, that when the ICOs had many of the key features of a securities offering they should counsel clients that the product being promoted was likely a security.[40] The chairman observed that “federal securities laws apply regardless of whether the offered security . . . is labeled a ‘coin’ or ‘utility token,’” and that the SEC was “disturbed” by “form-based arguments” made by lawyers, trading venues, and financial services firms that “depriv[ed] investors of mandatory protections.”[41]
On February 21, 2018, the SEC filed a complaint against a bitcoin-denominated platform and its founder for, among other things, operating an unregistered securities exchange.[42] An SEC official stressed that “[p]latforms that engage in the activity of a national securities exchange, regardless of whether that activity involves digital assets, tokens, or coins, must register with the SEC or operate pursuant to an exemption.”[43] As already reminded in The DAO Report, a system meeting the definition of an “exchange” is “any organization, association or group of persons . . . which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities”[44] and must register as a national securities exchange or operate pursuant to an appropriate exemption, one such frequently used exemption being an alternative trade system (ATS) that can register as a broker-dealer and comply with only Regulation ATS.[45] In any event, for an entity operating a digital token system or considering to operate one, as well as lawyers advising such an entity, it is worth reading the Regulation ATS adopting release and studying the illustrations in that release.[46]
4. The Hinman Speech
Half a year after the Munchee Order, the Hinman Speech marks another milestone in the SEC’s public dialogue in the digital assets field. Perhaps most interesting to the digital asset industry is the much-anticipated reassurance that ether is not a security.[47] From the perspective of the Securities Laws, the Hinman Speech repeats and continues The DAO Report and the Munchee Order: (1) how the instrument is labeled bears no significance on the Howey analysis;[48] (2) the prong analyzing investor’s reliance on a third-party promoter should be given primary consideration when applying the Howey test to digital assets;[49] and (3) whether the creation of a digital asset has a consumer purpose and whether people purchase it out of consumptive motivation will be evaluated based on various objective factors.[50] Whether a digital asset is a security does not inhere to the instrument; rather, the real question is whether the manner in which it is offered and sold creates a reasonable expectation of profits to be derived predominantly from the promoter’s efforts. This explains why simply restyling a digital asset as a “utility token” is doomed to fail.
Apart from crystalizing the entire Howey test into the last two prongs in the context of applying the Securities Laws to digital assets, Hinman implicitly made a pragmatic argument when addressing why ether and bitcoin should not be securities:
The disclosures required under the federal securities laws nicely complement the Howey investment contract element about the efforts of others. As an investor, the success of the enterprise . . . turns on the efforts of the third party. . . . Without a regulatory framework that promotes disclosure of what the third party alone knows of these topics and the risks associated with the venture, investors will be uninformed and are at risk. . . . [I]f the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede.[51]
Because both bitcoin’s and ether’s operation and their respective networks are so decentralized that basically every user is on the same page and no central third party determines the fate of the network, “applying the disclosure regime of the federal securities laws to the offer and resale of [bitcoin and ether] . . . would add little value.”[52] In other words, protection under the Securities Laws will be meaningless because there will not be a promoter to be sued and be held accountable in the event bad things happen.
Hinman noted that most of the ICOs he has seen have touted promoters’ ability to create an innovative application of the distributed ledger technology and targeted passive investors, and the lack of a clear business model often left purchasers no choice but to rely on the efforts of the promoters to build the network. Therefore, even though digital assets offered in those ICOs are not technically securities themselves, just like orange groves in Howey, “[a]t that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”[53] Hinman indicated, however, that the network on which certain digital assets operate may eventually mature, and at some point those digital assets would become the new “ether” to which the application of the Securities Laws would add little value.
III. Alternatives to Noncompliant ICOs
If a network could achieve the same degree of decentralization as the bitcoin network or the ethereum network, then it would probably be blessed by the SEC. Outside bitcoin and ether, however, regulatory uncertainty still accompanies each and every coin offering in the United States, and it is rare, if ever possible, for a network to begin in a sufficiently decentralized form. As suggested by Hinman, one way around this is to begin fundraising through traditional equity or debt offering, and once the network is up and running, distribute blockchain-based digital assets to potential users. Nevertheless, this route may not be desirable or executable for all digital asset issuers, and separating fundraising from token sale may deprive some crypto-enthusiasts’ opportunity to participate in the early stage of developing a perhaps groundbreaking project. The rest of this Part III briefly outlines three options for structuring legally compliant ICOs: Regulation D, Regulation S, and Regulation A.
Citing Regulation D, Chairman Clayton acknowledged that “[i]t is possible to conduct an ICO without triggering the SEC’s registration requirements,” which provides a private placement exemption.[54] The private placement exemption, Rule 506(c), allows an issuer to raise an unlimited amount of capital so long as there are no more than 35 purchasers who are not “accredited investors”[55] (AI), and the non-AI purchasers, either alone or with their representatives, possess a certain level of financial sophistication.[56]
Similar to what people can do in other unregistered offerings, an ICO can be structured to comply with Regulation S such that the digital assets will be deemed to be offered and sold outside the United States and not subject to the SEC’s jurisdiction.[57] Regulation S requires that each offer or sale of securities by an issuer be made outside the United States: (1) in an “offshore transaction,”[58] (2) with no direct selling efforts in the United States, and (3) be subject to any additional conditions as determined by the category of the securities being offered or sold.[59]
The third alternative is Regulation A, which as amended by the JOBS Act in 2015, allows a qualified issuer[60] to raise up to $50 million from the public without complying with the full SEC registration process. However, the issuer may only sell to non-AIs if the purchase price paid by such non-AIs does not exceed 10 percent of the greater of their annual income or net worth (for natural persons) or 10 percent of the greater of its revenue or net assets (for entities).[61] The issuer must file an offering statement, and the SEC must qualify it before the issuer can start to sell the securities.[62]
There are, however, obvious tradeoffs associated with the exempted offerings discussed above, including restrictions on publicity, investor qualifications, and limited resales, which may in some cases decrease the appeal of an ICO as a means of raising capital. For example, under Regulation D, general solicitation is disallowed if the digital assets, assuming they are securities, end up being sold to non-AIs.[63] In addition, digital assets offered pursuant to Regulation D and Regulation S are not freely transferrable in a secondary market.[64] From the perspective of a prospective purchaser, digital assets offered pursuant to these exemptions might be less desirable because the investor verification process (i.e., to verify the AI status for Regulation D offerings, and for Regulation S offerings to verify the non-U.S. person status) goes against the pseudonymous principle of most distributed ledgers. Regulation A, on the other hand, seems to have fewer publicity and resale limitations, but the $50 million cap may not satisfy ambitious entrepreneurs’ capital need (or expectation).[65]
IV. Conclusion
At the end of 2017, the SEC began to send subpoenas and information requests to technology companies and, remarkably, to their advisors and lawyers as well.[66] “[T]he wave of subpoenas includes demands for information about the structure for sales and pre-sales of the ICOs”—the “most concrete sign of the SEC’s intention to crack down on the sudden emergence of coin offerings.”[67]
Before any congressional action to carve out a special regulatory regime for blockchain and cryptocurrency, the 1946 Howey test will continue to guide the SEC’s analysis and perhaps the courts’ analysis as well. As the SEC becomes impatient with token issuers and their advisors, it is difficult to make more creative arguments without confronting the SEC head on,[68] and it is probably more prudent to seek the SEC’s view before proceeding with any definitive offering plan. According to Director Hinman, “[the SEC is] happy to help promoters and their counsel work through these issues. We stand prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.”[69]
What all this means for lawyers is that when clients seek advice in connection with ICOs, which clients may include token issuers, ICO promoters who played a similar role to underwriters, and trading platforms that may be viewed as unregistered exchanges, lawyers should ask whether the proposed action will compromise the purpose of investor protection laws and regulations, the lens through which the SEC is determined to scrutinize the markets for digital assets.
Of course, none of the above is relevant to fraudulent ICOs. Any fraud, not just fraudulent ICOs, deserves to be hit as hard as possible.
*I am grateful to Rebecca Simmons for her helpful guidance and comments. All views expressed in this article are my own.
[1] Tawnya Plumb, Blockchain: What’s in It for Lawyers?, 41 Wy. Law., Feb. 2018, at 50. The decentralized feature of blockchains is thought to make a blockchain more immune to hacking than a centralized database. Id.
[2] For the rest of the article, blockchain and digital or distributed ledger will be used interchangeably.
[3] For a general overview of what distributed ledger technology can do for the business community, see Bryce Suzuki, Todd Taylor & Gary Marchant, Blockchain, 54 Az. Atty. 12, 14–17. (Feb. 2018).
[5]See Arjun Kharpal, All You Need to Know About the Top 5 Cryptocurrencies, CNBC, Dec. 14, 2017 (showing that, as of the end of 2017, market cap of bitcoin was $275.1 billion and that of ether was $71.1 billion); Elise Moreau, 13 Major Retailers and Services That Accept Bitcoin, Lifewire, Mar. 7, 2018 (listing major consumer vendors that accept bitcoins as payment method). Bitcoin, ether, and other coins having similar attributes to real-world currency are sometimes called “cryptocurrencies.” Cryptocurrencies and other types of tokens are generally referred to as “digital assets” in this article.
[6]See SEC Investor Bulletin: Initial Coin Offerings (July 25, 2017) [hereinafter SEC Investor Bulletin] (noting that developers, businesses and individuals are using token sales to raise money for developing digital platforms). In fact, an ICO turned out to be an astounding device for raising money. As an example, the initial offering of “Basic Attention Tokens,” which allows holders to access a blockchain-based publishing and advertising platform, raised $35 million in 24 seconds. Becker Goldstein et al., Basic Attention Token (BAT) Token Launch Research Report (Oct. 30, 2017).
[11]Id. (“The term ‘security’ means any note, stock . . . investment contract . . . or warrant or right to subscribe to or purchase, any of the foregoing.”).
[12]United Hous. Found., Inc. v. Forman, 421 U.S. 837, 852 (1975); SEC v. Howey, 328 U.S. 293, 301 (1946).
[14]Cyber Enforcement Actions (last updated Sept. 26, 2018) [hereinafter SEC Enforcement Actions] (listing up-to-date enforcement actions with respect to digital currency/ICOs). In these cases, the SEC alleges fraudulent behavior of certain broker dealers and exchange platforms, but none of these concerns the question of whether the tokens are unregistered securities.
[15] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207 (July 25, 2017) [hereinafter The DAO Report] (concluding that The DAO tokens, a digital asset, were securities).
[23] The Supreme Court identified the characteristics associated with common stock to be: (1) the right to receive dividends contingent upon an apportionment of profits; (2) negotiability; (3) the ability to be pledged or hypothecated; (4) the conferring of voting rights in proportion to the number of shares owned; and (5) the capacity to appreciate in value. Landreth Timber Co. v. Landreth, 471 U.S. 681, 686 (1985).
[24] Since The DAO Report, the SEC filed a complaint on September 29, 2017, against Recoin Group Foundation, LLC; DRC World Inc. a/k/a/ Diamond Reserve Club; and Maksim Zaslavskiy, alleging that a businessman and two companies defrauded investors in a pair of ICOs purportedly backed by investments in real estate and diamonds, and the SEC filed complaint in December 2017 against Plexcorps (a/k/a and d/b/a Plexcoin and Sidepay.Ca), Dominic Lacroix, and Sabrina Paradis-Royer halting an ICO-based fraud that had raised up to $15 million from thousands of investors since August by falsely promising a 13-fold return in less than one month’s time. SEC Enforcement Actions, supra note 15.
[27] In the context of applying the Howey test, the Supreme Court drew the line between the motivation of a consumer and that of an investor, and only the presence of an investing motivation is relevant to the question whether the instrument is a security: “[W]hen a purchaser is motivated by a desire to use or consume the item purchased . . . the securities laws do not apply.” United Hous. Found., Inc. v. Forman, 421 U.S. 837, 854–53 (1975).
[34]Public Statement, SEC Chairman Jay Clayton Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017) [hereinafter Clayton Statement]. The Clayton statement is not formal SEC guidance or a statement of the SEC, but is instead an informal statement by the chairman.
[36] The chairman suggested that all (or almost all) of the token offerings he had seen as of his statement involved the offer or sale of securities. The SEC has yet to bring another enforcement action against a nonfraudulent ICO after the Munchee Order.
[39] To date, the SEC brought seven enforcement actions involving ICOs or digital assets since the Munchee Order, but none involved analysis of whether the token being offered is a security. SEC Enforcement Actions, supra note 15.
[42]Press Release 2018-23, Security Exchange Commission, SEC Charges Former Bitcoin-Denominated Exchange and Operator with Fraud (Feb. 21, 2018).
[43]Id. See also 15 U.S.C. § 78e (making it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security or to report any such transaction unless the exchange is registered as a national securities exchange or is exempted from such registration).
[44] 15 U.S.C. § 78c(a)(1). The SEC Rule 3b-16(a) further refines the definition into a two-part test that the organization must: (1) bring together the orders for securities of multiple buyers and sellers; and (2) use established, nondiscretionary methods under which such orders interact with each other, and the buyers and sellers entering such orders must agree to the terms of the trade. 17 C.F.R. § 240.3b-16(a).
[47] The SEC leadership has previously indirectly conceded that bitcoin is not a security. See,e.g., Clayton Statement, supra note 35, at n.2 (stating that bitcoin is a commodity and is subject to the regulations of the Commodities Futures Trading Commission). Ether is the second largest virtual currency by market cap (the largest being bitcoin) that can be held and transferred on blockchains, function as a medium of exchange for other goods or services, and be used to create decentralized applications on the ethereum network, making it a much more versatile digital asset than bitcoin. Therefore, considerable legal consequences and commercial disruptions would follow if the SEC declared ether a security.
[48] Hinman analogized digital assets, which are essentially computer codes, to orange groves in Howey. Neither digital assets nor orange groves are securities by nature, but if promoters offer and sell digital assets in the same way the Howey company sold orange groves (i.e., to cause prospective purchasers to believe that profit can be derived solely from the efforts of promoters), then the offer and sale of computer codes becomes an offer and sale of securities. See Hinman Speech, supra note 8.
[49] Hinman cited a nonexhaustive list of factors to assess whether a third party—a person, entity, or coordinated group of actors—drives the expectation of a return on the digital asset. Id.
[50]Id. (listing nonexclusive factors to consider how digital assets can be structured like a consumer item).
[54] Clayton Statement, supra note 35. Notably, Kodak and its partner filed an SEC notice to offer rights to purchase KODAKCoins in future sales pursuant to Rule 506(c). JD Alois, KODAKCoin to Issue SAFT, Seeks $176.5 Million ICO, Crowdfund Insider, Mar. 19, 2018.
[55] In the case of an individual, to qualify as an AI, the investor must meet certain thresholds concerning its net worth and annual income. See 17 C.F.R. § 230.215.
[58] “Offshore transaction” means (1) the offer is not made to a person in the United States, and (2) the buyer is outside the United States or the transaction is executed outside the United States. 17 C.F.R. § 230.902(h).
[59] Regulation S divides securities into three categories. Category 1 securities include those issued by “foreign private issuers” as defined in SEC Rule 405. Among other alternatives that are irrelevant here, an offering or sale of Category 1 securities complies with Regulation S if there is no “substantial U.S. market interest” as defined under Regulation S or, if there is substantial U.S. market interest in the securities, the offering or sale is directed to a single country other than the United States in accordance with local laws. Categories 2 and 3 securities consist of securities offered by foreign reporting issuers and U.S. domestic issuers. Regulation S imposes more onerous conditions on these two categories of securities which include, among other things, placing legends on marketing materials, additional undertakings by distributors to comply with Regulation S, and a distribution compliance period during which offer or sale cannot be made to U.S. persons other than distributors. 17 C.F.R. § 230.903.
[60] One of the qualifications is that the issuer is a nonreporting company organized under the laws of the United States of Canada. 17 C.F.R. § 230.251(b)(1), (2).
[62] The offering statement consists of two parts: (1) notification and (2) an offering circular. 17 C.F.R. § 230.252(a). An offering circular is an abridged version of the traditional disclosure document. Some blockchain companies have filed Form 1-A with the SEC (i.e., the form for Regulation A offerings), but we have yet to see one qualified by the SEC.
[64] Securities offered pursuant to Rule 506 are “restricted securities,” and any resale must comply with Rule 144 to avoid being viewed as a distribution and, thus, the reseller an underwriter. 17 C.F.R. § 230.202(d). For purpose of Regulation S, a resale transaction will be deemed to occur outside the United States if it is made in an offshore transaction without directed selling efforts in the United States. 17 C.F.R. § 230.904.
[65] Funderbeam, Initial Coin Offerings Funding Report (Oct. 2017), at 11 (showing that funds raised for the top 10 ICOs in 2017 all exceed $50 million); id. at 4 (average size of ICOs increasing rapidly).
[68] As an example, the so-called Simple Agreement for Future Tokens (SAFT) is structured as a sale of the right to purchase utility tokens that will be released in the future; although such rights are admittedly securities and to be offered to AIs only, people using SAFT contemplate that once the investors exercise their right to purchase the utility tokens, the securities (i.e., the rights) disappear and all that is left is the utility tokens, which are pure nonsecurities. Predictably, there is indication that the SEC had SAFT in mind when sending out the waves of subpoenas. See Brady Dale, What If the SEC Is Going After the SAFT?, Coindesk, Mar. 6, 2018.
[69] Interestingly, Hinman called out SAFT specifically. He warned against applying the opinion expressed in the Hinman Speech to a hypothetical SAFT in the abstract. Instead, he encouraged people with questions on a particular SAFT to consult with securities counsel or the SEC directly. Hinman Speech, supra note 8, at n.15.
Subject to court approval, Tesla will appoint two additional new independent directors in connection with its settlement of fraud charges brought against Tesla CEO Elon Musk and settlement of other charges against the company.
Tesla at present has nine directors. One is Musk, who will step down as chairman of Tesla for at least three years as part of the SEC settlement; one is Musk’s brother; and the other seven directors are independent under NASDAQ independence standards, according to Tesla’s most recent proxy statement.
Of those seven independent directors, however, three have ties to SpaceX, the private rocketry company also founded by Musk. Accordingly, five of nine Tesla directors are either Musk family members or have connections to other Musk projects beyond Tesla Board of Directors membership. The board may, technically, have a majority of directors who are independent, but it also has a majority of directors with actual or potential conflicts of interest.
Director independence in any company is not valuable for its own sake. Independence is a proxy for what investors actually need: decision makers with integrity, whose judgments on behalf of the company and its shareholders are rendered after thoughtful and fair consideration of the salient facts, untainted by favoritism, or undue deference to management.
In Tesla’s circumstances, regardless of whether specific exchange standards for independence are met, it is fair to consider whether any director can truly be independent.
After all, Musk’s vision, personality and history of business success have driven the company. Musk has a unique ability to bring capital, engineering talent, and a grasp of an emerging market into a package that investors will value. Tesla lists its dependence upon Musk as a Risk Factor in its Form 10-K. And Musk owns more than 20% of the company.
Can any board really be expected to fire Musk as CEO, or take disciplinary steps that might cause him to leave the company? And if a board doesn’t have that level of freedom in its oversight of CEO, is the board truly independent?
The short answer: maybe.
Compared to CEOs at other companies, who lack Musk’s celebrity and wealth and who are not visionary genius founders with a huge stock position, Musk has more leverage in negotiating with the Tesla Board of Directors over matters such as business strategy, personnel, pay, and similar issues.
However, it is possible that at this point in Tesla’s development, Musk is no longer an indispensable figure. The market for electric vehicles is proven, and key technologies have been developed. If Tesla’s remaining business issues are dealing with supply chain and financial questions, while maintaining cutting edge research and engineering into the future, genius may be less important than execution.
If Musk’s chief contribution to the company now is the ability to use his celebrity to generate publicity that Tesla doesn’t have to pay for, the board may have greater freedom, and success, in demanding that Musk meet the standards for CEO behavior that apply to everyone else.
At a minimum, the Tesla Board of Directors needs to ensure that the company has a succession plan in place and an organizational structure that permits Tesla to survive the departure of Musk, with or without a continuing relationship. Such business planning, as a question of sustainability, would be part of planning against a sudden death of visionary founder anyway. Anything that is in Musk’s head and hasn’t already been reduced to paper, or that is kept as trade secret, needs to be made available to the next generation of leaders.
Other tech companies with visionary founders have transitioned to operating without them. HP continued beyond Hewlett and Packard. Microsoft weathered Bill Gates’ departure from an operational role. Apple survived the first departure of Steve Jobs in the 1990s, and then after his return survived his death.
Two independent directors, by themselves, do not ensure that Musk will no longer engage in the behavior that gave rise to the SEC charges in the first place. The board acts as a group, and no individual director can act alone to rein in a CEO whose behavior is, at a minimum, erratic regardless of whether it rises to the level of fraud.
Tesla’s need for capital, more than the independence of its directors, may provide the board the upper hand. Musk didn’t build a company by himself. To be realized, his vision needed engineers, designers, marketing personnel—and, most of all, investors. As Tesla’s recent stock price in the public market has shown, regardless of whether the board is willing or able to hold Musk accountable, investors don’t like reckless behavior.
The SEC brought serious charges against Musk: securities fraud, specifically, sending out knowingly false Twitter comments whose purpose seemed to be inflicting economic punishment on Tesla short sellers. Musk’s behavior not only generated a combined $40 million in SEC fines for him and the company, it also exposed Tesla to economic damage from private securities claims.
A board cannot allow dishonest or illegal behavior by an executive to go without consequences, regardless of whether the SEC steps in. An oversight body that ignores erratic executive behavior or tolerates executive dishonesty has failed in its duties. That means Musk’s next misstep will not be just a problem for him, it will be a problem for the board.
Which might be enough to keep them truly independent.
The Eleventh Circuit recently found in favor of Blue Bell Creameries, Inc. by rejecting its own earlier dicta and explicitly expanding the preference payment defense known as “new value.” This provides additional protection for companies doing business with a debtor in the 90 days prior to bankruptcy.
The Scoop: Bruno’s v. Blue Bell
In 2008, Blue Bell Creameries (Blue Bell) was a steady supplier of ice cream to Bruno’s Supermarkets, LLC (Bruno’s). In the 90 days before Bruno’s bankruptcy filing, Bruno’s paid Blue Bell approximately $560,000. Meanwhile, during those 90 days, Blue Bell delivered approximately $435,000 in products to Bruno’s, only some of which was paid for.
Bruno’s filed for bankruptcy and then sued Blue Bell, claiming that the entire $560,000 was a “preference.” A “preference” in bankruptcy vernacular is any transfer of an interest of the debtor in property to or for the benefit of a creditor, based on an antecedent debt, made while the debtor was insolvent, and made within 90 days of the bankruptcy, that provides the creditor with more than it would receive in a chapter 7 liquidation. See 11 U.S.C. § 547(b). A common example of a preference applicable here is when a debtor seeks to claw back payments it made within 90 days before the bankruptcy to an unsecured supplier, despite the debtor having received the goods or services related to such payments. Although this may seem inherently unfair to the supplier, the underlying bankruptcy policy is that equally situated creditors should be treated equally—no one creditor should be “preferred,” or receive payment leading up to bankruptcy, while others do not.
Chocolate or Vanilla?: Eleventh Circuit Dicta Conflates Unavoidable and Unpaid
Here, the $560,000 was admittedly a preference on its face. However, Blue Bell asserted the statutory defense known as “new value.” Basically, a trustee may not avoid a preference to the extent that, after such transfer, such creditor gave new value to the debtor. The wrinkle is that such new value must not have been satisfied by an “otherwise unavoidable transfer . . . .” 11 U.S.C. § 547(c)(4)(B) (emphasis added). The Eleventh Circuit previously stated that this phrase had “generally been read to require . . . that the new value must remain unpaid.” Charisma Inv. Co. v. Airport Sys., Inc. (In re Jet Florida Sys., Inc.), 841 F.2d 1082, 1083 (11th Cir. 1988) (emphasis added). Blue Bell challenged the “unpaid” language of Jet Florida, arguing that it should be able to utilize all new value delivered during the 90-day preference period, whether paid for or not, to shield that same dollar amount from being clawed back.
The bankruptcy court, relying on the “unpaid” language in Jet Florida, gave Blue Bell credit only for amounts that were unpaid, and ultimately held that the trustee could avoid about $440,000 of the over $560,000.
Dessert Is Served: Paid New Value Still Counts
On appeal, the Eleventh Circuit disagreed with the bankruptcy court. The Circuit Court rejected its own Jet Florida language as nonbinding dicta and joined the Fourth, Fifth, Eighth, and Ninth Circuits in holding that new value need not remain unpaid for the creditor to use the new value defense. Three factors swayed the court.
First, the plain language of the statute reads “unavoidable,” not “unpaid.” As both parties agreed, the transfers were preferences and therefore avoidable by the trustee, thus satisfying the “not . . . otherwise unavoidable” requirement of the statute. Second, although the predecessor statute to section 547(c)(4) required new value to remain unpaid, the current statute abandoned that language. One can reasonably conclude that Congress intentionally removed the unpaid limitation to the new value defense by removing the explicit language. Finally, policy considerations indicated that new value need not remain unpaid. If courts decided otherwise, then creditors such as Blue Bell would be hesitant to extend credit to distressed businesses such as Bruno’s in their run up to bankruptcy. This would thwart a key purpose of chapter 11 bankruptcy, which is to reorganize a debtor’s business so that it may pay creditors and regain profitability in the future. In addition, encouraging short-term creditors such as Blue Bell to extend credit to distressed businesses such as Bruno’s will help longer-term creditors. This extension of credit will therefore help distressed businesses from entering bankruptcy in the first place—a better result for all involved.
On August 13, 2018, President Donald Trump signed into law the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) as part of the John S. McCain National Defense Authorization Act for Fiscal Year 2019. FIRRMA amends section 721 of the Defense Production Act of 1950, the statute that governs the operations and powers of the Committee on Foreign Investment in the United States (CFIUS, or the Committee).
Prior to FIRRMA, CFIUS had jurisdiction to review a transaction by or with any foreign person that could result in control of a U.S. business by a foreign person. Although “control” for purposes of CFIUS jurisdiction is a flexible concept that can reach a large number of minority investments, the legislative sponsors of FIRRMA were concerned that there were a number of foreign investment transactions that did not qualify as involving the acquisition of “control,” or did not involve an investment in a U.S. business, but that still presented threats to national security that needed to be addressed. One of the central concerns of the sponsors was that foreign government-sponsored investment could be used as part of a strategy to neutralize or surpass the United States’ advantages in technology by gaining access to technologies with potential military applications such as robotics, artificial intelligence and automation through non-control investments. In addition to expanding CFIUS’s jurisdiction, FIRRMA also reforms certain elements of the CFIUS review process that will have impacts on all transactions that are subject to CFIUS jurisdiction.
FIRRMA will have a significant impact on structuring considerations and the parties’ assessment of deal risk where foreign parties are involved in a transaction, and especially foreign governments or foreign government-controlled parties. As a result of the jurisdictional expansions pursuant to FIRRMA (although not yet effective, pending regulations to be issued by CFIUS), transactions involving foreign parties are significantly more likely to be subject to CFIUS review than they have been in the past.
Jurisdictional Expansions
New Categories of “Covered Transactions”
FIRRMA expands CFIUS’s jurisdiction to include as “covered transactions” subject to CFIUS review four new types of transactions that would not result in control of a U.S. business by a foreign person:
Real Estate Transactions. The purchase or lease by a foreign person of, or a concession offered to a foreign person with respect to, real estate located in the United States that is a part of an air or maritime port or is in “close proximity” to a U.S. military installation or another United States Government facility or property that is sensitive for reasons relating to national security, could reasonably provide the foreign person with the ability to collect intelligence on activities at such a installation, facility or property, or otherwise could expose national security activities at such an installation, facility or property to the risk of foreign surveillance has been made subject to CFIUS jurisdiction, even if the purchase, lease or concession does not relate to a U.S. business. Real estate transactions involving a single “housing unit” or real estate in “urbanized areas” are excepted, subject to regulations that CFIUS may adopt in consultation with the Department of Defense that may reduce the scope of these exceptions.
Non-controlling Investments in Companies that Deal in Critical Technology, Critical Infrastructure and Personal Data of U.S. Citizens. FIRRMA provides CFIUS with jurisdiction to review any “other investment” by a foreign person in any unaffiliated U.S. business that (i) owns, operates, manufacturers, supplies or services critical infrastructure, (ii) produces, designs, tests, manufactures, fabricates or develops one or more critical technologies, or (iii) maintains or collects sensitive personal data of U.S. citizens that may be exploited in a manner that threatens national security.
For purposes of FIRRMA, “other investment” means any non-controlling investment (meaning an acquisition of equity interest, including contingent equity interests), direct or indirect and regardless of size, that affords the foreign person (1) access to any material nonpublic technical information relating to critical infrastructure or critical technologies in the possession of the U.S. business; (2) membership or observer rights on the board or equivalent governing body of the U.S. business or the right to nominate an individual to a position on the board of directors or equivalent governing body; or (3) any involvement (other than through voting of shares) in substantive decision-making regarding critical infrastructure, critical technologies or sensitive personal data of U.S. citizens. CFIUS will prescribe regulations providing guidance on the types of transactions that the Committee considers to be “other investments.”
Changes in Rights of a Foreign Person with Respect to its Investment in a U.S. Business. Any change in the rights that a foreign person has with respect to a U.S. business in which the foreign person has an investment, if that change could result in foreign control of the U.S. business or an “other investment.”
Transactions Structured To Evade CFIUS Review. Any other transaction, transfer, agreement or arrangement the structure of which is designed or intended to evade or circumvent the application of the covered transaction definition, subject to regulations prescribed by the Committee.
Potential Expansion of Target Businesses Subject to CFIUS Jurisdiction
Another potentially significant jurisdictional expansion relates to the definition of “U.S. business.” FIRRMA defines “U.S. business” to mean “a person engaged in interstate commerce in the United States.” In contrast, the current definition in CFIUS regulations includes a limiting clause “but only to the extent of its activities in interstate commerce.” Without this limiting clause from the current CFIUS regulations, FIRRMA appears to have the potential to provide CFIUS with jurisdiction to review elements of a transaction affecting an entity that provides goods or services in the United States without limiting that review to the entity’s U.S.-based activities. Depending on the regulations that are promulgated by the Committee under FIRRMA, this definition of “U.S. business” could entail oversight over transactions with much less of a U.S. nexus than is currently the case.
Clarification of “Other Investment” for Investment Fund Investments
FIRRMA clarifies and limits CFIUS’s jurisdiction over investments by U.S.-controlled investment funds that may receive capital contributions from foreign limited partners or the equivalent. Subject to regulations prescribed by the Committee, FIRRMA provides that an indirect investment by a foreign person through an investment fund in a U.S. critical infrastructure, critical technology or personal data business that affords the foreign person (or a designee of the foreign person) membership as a limited partner or equivalent on an advisory board or committee of the fund will not be considered an “other investment” as long as (i) the fund is managed exclusively by a general partner or equivalent that is not a foreign person; (ii) the advisory board does not have the ability to approve, disapprove or otherwise control investment decisions of the fund or decisions made by the general partner or equivalent related to entities in which the fund is invested; (iii) the foreign investor does not otherwise have the ability to control the fund, including the authority to approve, disapprove or otherwise control investment decisions of the fund or decisions made by the general partner or equivalent related to entities in which the fund is invested, or to unilaterally dismiss, prevent the dismissal of, select or determine the compensation of the general partner or equivalent; and (iv) the foreign person does not have access to material nonpublic technical information relating to critical infrastructure or critical technologies in the possession of the U.S. business as a result of its participation on the advisory board or committee.
Accordingly, investments in the types of sensitive businesses identified by FIRRMA by U.S.-controlled investment funds with foreign limited partners will not necessarily be subject to CFIUS review. These provisions will have potentially significant implications for U.S.-controlled investment funds that receive investments from foreign investors, and both U.S.-controlled funds and foreign investors already invested or who are seeking to invest in such funds will need to understand and consider the implications of these rules with respect to fund governance and other limited partner rights afforded to foreign investors.
Although the clarification of how to treat indirect investment through U.S. investment funds was included to clarify the circumstances in which a limited partner’s governance or other rights in a U.S.-controlled fund could give rise to jurisdiction as an “other investment,” it is not unreasonable to expect that CFIUS may use such indicia by analogy in considering whether investment by a foreign-controlled investment fund whose general partner is located in one foreign country poses a greater threat because of foreign limited partners from one or more other foreign countries than if such limited partners had no such rights. For example, in assessing the potential threat posed by an investment by an investment fund with a general partner located in the United Kingdom or Canada (which would be jurisdictionally covered as a transaction that gives a foreign person control of a U.S. business), CFIUS might apply the four criteria in assessing the significance and potential threats posed by Chinese limited partners in that fund.
Effectiveness of Jurisdictional Expansions
The jurisdictional expansions discussed above are not immediately effective. According to the U.S. Department of Treasury’s FIRRMA FAQs, CFIUS will provide further guidance as to the timing for the effectiveness of these provisions. FIRRMA also authorizes CFIUS to conduct pilot programs to implement any provisions of FIRRMA that are not immediately effective. The FIRRMA FAQs indicate that the scope and procedures of any such pilot program will be published in the Federal Register. Although FIRRMA’s jurisdictional expansions will take effect only upon the Committee’s issuance of regulations or the implementation of one or more pilot programs, as a matter of prudence, parties should evaluate potential transactions under the expanded jurisdictional provisions.
Process Reforms
Additional Time for CFIUS Review
Under the prior version of the statute, the CFIUS review process consisted of a 30-day review period, potentially followed by a 45-day investigation period. Although parties to a transaction may in certain cases withdraw and refile the notice at the end of the investigation period, and thus start a new sequence of review and investigation periods, the core CFIUS review process under the old statute lasted for up to 75 days.
FIRRMA extends the initial review period to 45 days and authorizes CFIUS to extend the subsequent investigation period by an additional 15 days in “extraordinary circumstances,” to be defined by CFIUS regulations. With these modifications, the core CFIUS review process has been extended to 90 days, and the CFIUS review process could take as long as 105 days before taking account for any time related to the pre-filing process and before accounting for any withdrawals and resubmissions of the written notice.
Timing for Review of Draft Filings and Acceptance of Filings
FIRRMA requires that CFIUS provide comments on draft notices submitted by the parties to a transaction in advance of a formal filing within 10 business days, and further requires CFIUS to accept formal filings — and thus start the review period “clock” — within 10 business days following submission. If CFIUS determines that the submission is incomplete, it must explain to the parties why the filing is incomplete. In order for the 10-day deadlines to apply, the parties must stipulate that the transaction is a “covered transaction” subject to CFIUS jurisdiction.
Declarations and Mandatory Declarations
FIRRMA establishes a new form of “light” filing, called a “declaration,” that contains basic information regarding the transaction and generally would not exceed five pages in length. FIRRMA directs CFIUS to prescribe regulations establishing specific requirements for declarations, and the provisions relating to declarations are not yet effective.
FIRRMA provides that, upon receiving a declaration, CFIUS may request that the parties to the transaction file a written notice, initiate a unilateral review of the transaction, notify the parties in writing that the Committee has completed all action with respect to the transaction or inform the parties that the Committee is unable to complete action with respect to the transaction on the basis of the declaration alone and invite the parties to the transaction to file a written notice with complete responses to all the items that CFIUS expects to be included in a filing. FIRRMA requires the Committee to take action in respect of a declaration within 30 days following receipt.
FIRRMA provides that a declaration (or, at the election of the parties, a written notice in lieu of a mandatory declaration) is mandatory in respect of certain transactions that would result in the direct or indirect acquisition of a substantial interest in a United States business by a foreign person in which a foreign government has a direct or indirect substantial interest. The transactions at issue include those that involve investment in a U.S. business that is the target of the “other investment” provision described above – U.S. businesses in critical infrastructure, critical technology or with personal data of U.S. citizens that may be exploited in a manner that threatens national security. FIRRMA authorizes CFIUS to identify through regulations other categories of transactions that involve critical technologies (but not critical infrastructure or sensitive data on U.S. citizens) beyond those that involve a substantial interest in a United States business by a foreign person in which a foreign government has a direct or indirect substantial interest for which declarations will be mandatory.
For purposes of the mandatory declaration, the term “substantial interest” will be defined by CFIUS regulations. In developing those regulations, the Committee is required to consider the means by which a foreign government could influence the actions of the foreign person, including through board membership, ownership interest or shareholder rights. However, FIRRMA specifies that an interest that is excluded from the term “other investment” or that is less than a 10-percent voting interest will not be considered a “substantial interest.” Mandatory declarations also will not be required for investment funds that are structured consistent with the clarification of “other investment” in the investment fund context, as discussed above. FIRRMA also authorizes CFIUS to waive, with respect to a foreign person, the requirement to submit a mandatory declaration if the Committee determines that the foreign person has demonstrated that the investments of the foreign person are not directed by a foreign government and that the foreign person has a history of cooperation with the Committee. This waiver provision could potentially benefit government-sponsored pension funds that have a long history of investment in the United States.
Under FIRRMA, CFIUS may not require mandatory declarations to be submitted more than 45 days before the completion of the transaction, and FIRRMA provides CFIUS with authority to impose civil penalties on any party that fails to comply with a mandatory declaration requirement. CFIUS may not request or recommend that a mandatory declaration be withdrawn and refiled, except to permit the parties to correct material errors or omissions. This means that CFIUS will have to make the decision to do one of the following: (1) request that the parties to the transaction file a written notice; (2) initiate a unilateral review of the transaction; (3) notify the parties in writing that the Committee has completed all action with respect to the transaction; or (4) inform the parties that the Committee is unable to complete action with respect to the transaction on the basis of the declaration alone and invite the parties to the transaction to file a written notice with complete responses to all of the items that CFIUS expects to be included in a filing. CFIUS is required to make such decision within 30 days after it receives a mandatory declaration, but if CFIUS decides that a written notice is necessary, then a full review and investigation period could be required.
Filing Fee
Under the prior version of the statute, there was no filing fee associated with any notification to CFIUS. FIRRMA authorizes CFIUS to impose a fee of no more than one percent of the value of the transaction or $300,000 (adjusted annually for inflation pursuant to regulations prescribed by the Committee), whichever is less. CFIUS has not yet taken steps to impose this fee, and will do so by regulation at a later date.
In addition, FIRRMA establishes a fund to be administered by the CFIUS chairperson and authorizes $20 million in appropriations to this fund for each of fiscal years 2019 through 2023 to enable the Committee to perform its functions.
Implications
Parties will need to consider carefully both the statutory and regulatory definitions and examples of key terms such as “critical technology,” “critical infrastructure,” “sensitive personal data” and “U.S. business” to determine whether the nature of the U.S. business brings any particular transaction within CFIUS’s purview. Real estate transactions that previously were not subject to CFIUS review because they did not involve a U.S. business will potentially be subject to CFIUS jurisdiction. Parties to transactions will need to analyze whether a foreign government has a “substantial interest” in any foreign party to the transaction, as well as whether that foreign party is acquiring a substantial interest in a U.S. business involved in one of the specified categories, to determine whether a declaration of the transaction to CFIUS is mandatory.
Investment fund managers will need to consider carefully the implications of the structure of their funds and the rights given to foreign limited partners. U.S.-based investment fund managers that provide governance and informational rights to foreign limited partners will need to be aware that those rights may give rise to CFIUS jurisdiction in respect of the fund’s investments, so that any acquisition by that fund of U.S. businesses involved in critical infrastructure, critical technology or personal data of U.S. citizens could potentially be subject to CFIUS jurisdiction. Foreign-based investment fund managers will also need to consider the rights they give to limited partners located in foreign countries that are generally deemed to present greater national security threats, such as China, because those rights could affect how CFIUS views the potential threat posed by a proposed acquisition by that investment fund.
Certain provisions, such as the introduction of declarations as a form of “light” filing or the specification of a time period during which CFIUS must comment on draft notices or accept certain formal notices, may serve to reduce the length of the CFIUS review process for parties to certain transactions. However, FIRRMA’s extension of the initial review period to 45 days and introduction of the possibility that parties’ submission of a declaration may be followed by a request from the Committee for a full notice filing means that in other cases parties will certainly face a longer review process than they would have under prior law.
In addition, since FIRRMA leaves many details to be prescribed by Committee regulations, the full implications of the CFIUS reform affected by FIRRMA will not be known for many months. However, parties will have substantial opportunities to engage with the Committee throughout the rulemaking process and to provide the Committee with valuable insight into essential aspects of transactions involving foreign investment in the United States.
The law regarding sandbagging (which refers to a buyer that brings a claim for misrepresentation post-closing even though the buyer knew the representation was false before closing)[1] in Delaware seemed clear to many practitioners. Vice Chancellor Laster stated in a 2015 oral ruling that “Delaware is what is affectionately known as a ‘sandbagging’ state.”[2] In addition, then-Vice Chancellor Strine held that a buyer need not establish justifiable reliance in order to bring a breach of contract claim arising out of an acquisition agreement,[3] and given that the reliance element is what creates a problem for a buyer attempting to sandbag, this decision is often interpreted as a pro-sandbagging holding. Additionally, the 2017 ABA Deal Point study seems to confirm that practitioners have this view by finding that 51 percent of deals were silent on the point.[4] After all, many buyers reason that if Delaware is a pro-sandbagging state, why use negotiating capital to get a clause that is unnecessary?
However, this approach is dangerous after the May 24, 2018 Delaware Supreme Court’s decision in Eagle Force Holdings, LLC v. Stanley Campbell.[5] In a footnote, the majority opinion explained that there is a debate about whether a buyer can recover for a breach-of-warranty claim when the buyer knew at signing that the representation was not true. Although the majority observed that most states follow New York’s CBS Inc. v. Ziff-Davis Publishing Co.[6] (which held that traditional reliance is not required, and that the only “reliance” required is that the express warranty is part of the bargain of the parties), the majority did not decide this “interesting issue” because the claims were not before the court. Similarly, the dissent did not determine how this issue should be decided but emphasized Delaware’s anti-sandbagging jurisprudence.[7]
How Did Delaware Law Get Here?
To understand why the law is unclear on the sandbagging issue, it is helpful to discuss the path of the law. Early on, courts did not consider mere representations to be promises. Consequently, a buyer could not sue a seller for a breach of representation in a contract dispute because the representation was effectively not part of the contract. [8] To provide a buyer relief for being lied to, however, courts allowed the buyer to make a tort claim for misrepresentation, and one element of such a claim is reliance. Thus, under the traditional tort-based framework, a buyer must prove that it relied on the misrepresentation. Under the modern view, however, representations are actionable under contract law, and given that reliance is not part of contract law, the buyer need not show reliance.[9] It is this history of the importation of tort law to fill a gap in contract law (which gap, by the way, no longer exists) that has created uncertainty.
As a side note, this history of tort law and contract law is part of the reason acquisition agreements refer to “representations and warranties.” The representation refers to a tort concept and the warranty to a contract concept. As the debate about these near synonyms has been discussed in prior years in this publication, we will not relitigate the issue.[10]
Returning back to Delaware sandbagging case law, in the 1910s the Delaware Superior Court held that reliance was a necessary requirement of a breach-of-warranty claim.[11] This was reaffirmed in 2002.[12] However, in 2005, the Superior Court shifted and held that reliance was not an element of a claim for breach.[13] Shortly thereafter, the Chancery Court came out in favor of sandbagging in the often-cited Cobalt Operating, LLC v. James Crystal Enterprises case.[14] This is one of the cases mentioned in the introduction, but the Cobalt case might not be as strong as it first appears because the contract in Cobalt contained a clause that representations would not be affected by due diligence, and the court found that the Cobalt defendant intentionally obscured its fraud and gave misleading explanations when the plaintiff inquired about inconsistencies that arose in due diligence. These two facts can make it easy for a court to distinguish the case, and in fact, Delaware courts continued to have decisions that were inconsistent regarding sandbagging. The Delaware Supreme Court had not ruled on this issue[15]—that is, until the dicta comments in Eagle Force.
Conclusion
Although the majority and dissent in Eagle Force leave some clues as to how they might rule on the sandbagging issue, it is not productive to speculate about the outcome. Instead, buyers are best advised to include a pro-sandbagging clause (which is commonly referred to as a knowledge savings clause) in the purchase agreement. The following is an example of such a clause:
The post-Closing indemnification rights of the parties pursuant to Article [●] (Indemnification) shall not be affected by any waiver of condition set forth in Article [●] (Conditions to Closing) or any knowledge, obtained from any source at or before the execution hereof or at or before the Closing, of any breach of representation, warranty, covenant or agreement, and the parties shall be deemed to have reasonably relied upon the representation, warranty, covenant and agreement notwithstanding such knowledge.
Eagle Force has put buyers on notice that they might need to update their approach to sandbagging. To be silent is to leave the matter ambiguous.
This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content herein does not reflect the views of Sidley Austin LLP.
[1] The term “sandbagging” dates back to the 19th century when street gangs would craft a homemade weapon by pouring sand into socks. Although the sock looked innocuous enough, when swung at an enemy, the concealed lump of sand could inflict substantial damage. The term has evolved to represent concealing or misrepresenting with the purpose of deceiving another. See Glenn West & Kim Shah, Debunking the Myth of the Sandbagging Buyer, M&A Lawyer, Jan. 2007, at 3.
[2]See NASDI Holdings v. North Am. Leasing, No. 10540-VCL, slip op. at 57 (Del. Ch. Oct. 23, 2015).
[3]See Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff’d without op., 945 A.2d 594 (Del. 2008).
[4]See ABA M&A Mkt. Trends Subcomm., Private Target Mergers & Acquisitions Deal Points Study 66 (Jessica C. Pearlman ed., 2017).
[5]See Eagle Force Holdings, LLC v. Campbell, C.A. No. 10803-VCMR at 47, n.185 (Del. May 24, 2018).
[6]See CBS Inc. v. Ziff-Davis Publ’g Co., 553 N.E.2d 997 (N.Y. 1990). It is interesting that the majority opinion did not did not discuss the subsequent case law that has significantly narrowed Ziff-Davis’s impact.
[7]See Eagle Force, No. 10803-VCMR at 10 (Strine, J. & Vaughn, J., dissenting) (“[T]o the extent Kay is seeking damages because Campbell supposedly made promises that were false, there is doubt that he can turn around and sue because what he knew to be false remained so. Venerable Delaware law casts doubt on Kay’s ability to do so . . . .”).
[9]See Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, Del. J. Corp. L. 1081, 1084–86.
[10]See Kenneth A. Adams, A lesson in drafting contracts: What’s up with “representations and warranties”?, Bus. L. Today, Nov.-Dec. 2005; Tina L. Stark, Nonbinding Opinion: Another view on reps and warranties, Bus. L. Today, Jan.–Feb. 2006. Interestingly, the footnote in the majority opinion in Eagle Force cites to Professor Stark’s article (but for a different proposition).
[11]See Clough v. Cook, 87 A. 1017, 1018 (Del. Ch. 1913); Loper v. Lingo, 97 A. 585, 586 (Del. Super. Ct. 1916). The dissent in Eagle Force cited the Clough case for the proposition that a party who signs a contract with knowledge that a representation is false may not later claim reliance on it. See Eagle Force, No. 10803-VCMR at 10 n.39 (Strine, J. & Vaughn, J., dissenting).
[12]See Kelly v. McKesson HBOC, Inc., 2002 WL 88939, at *8 (Del. Super. Ct. Jan. 17, 2002) (“According to sound Delaware law, a plaintiff must establish reliance as a prerequisite for a breach of warranty claim.”).
[13]See Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513, 548 (Del. Super. Ct. 2005). The court also noted that “the extent or quality of plaintiffs’ due diligence is not relevant to the determination of whether [defendant] breached its representations and warranties in the Agreement. . . . [P]laintiffs were entitled to rely upon the accuracy of the representation irregardless [sic] of what their due diligence may have or should have revealed.” Id.
[14]See Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff’d without op., 945 A.2d 594 (Del. 2008).
[15] The Delaware Supreme Court did affirm Cobalt, but it did so without a written opinion. James Crystal Enters. v. Cobalt Operating, LLC, 945 A.2d 594 (Del. 2008).
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