Recent Trends in Enforcement of Intercreditor Agreements and Agreements Among Lenders in Bankruptcy

Posted on January 16, 2018 by - Uncategorized

Over the last several decades, the enforcement of intercreditor agreements (ICAs) that purport to affect voting rights and the right to receive payments of cash or other property in respect of secured claims have played an increasingly prominent role in bankruptcy cases. Although the Bankruptcy Code provides that “subordination agreement[s]” are enforceable in bankruptcy to the same extent such agreements are enforceable under applicable nonbankruptcy law, the handling of creditor disputes regarding such agreements has been inconsistent.1

Both ICAs and agreements among lenders (AALs) purport to alter the rights of junior-lien creditors or subordinated creditors in a bankruptcy of their common debtors. For example, such agreements often include waivers of the right to object to bankruptcy sales, voting restrictions on plans of reorganization, and waivers of rights to object to debtor-in-possession financing and use of cash collateral. ICAs in secured transactions are generally among creditor groups that hold different tranches or classes of debt, each secured by separate but identical liens and acknowledged and agreed to by the applicable borrowers or issuers. AALs, by contrast, typically are agreements solely among the lenders under a single secured credit facility and its agent. The borrower is not party to the AAL and grants a single lien to the agent for the lenders to secure all of their obligations under the credit facility. The borrower discharges its obligations by paying required payments to the agent under the credit facility. The AAL then determines how those payments are divided among the lenders.

Bankruptcy courts have treated ICAs and AALs inconsistently. Some courts have enforced these agreements in accordance with their terms, others have invalidated provisions in these agreements,2 and still others have enforced agreements only to the extent that they provide the best outcome for the debtor’s estate. A recent trend in the case law has been to enforce ICA and AAL provisions altering creditors’ rights in bankruptcy only to the extent there is clear and unambiguous language in the agreement altering such rights. In this article, we examine three recent leading cases: Energy Future Holdings (EFH),3 Momentive,4 and RadioShack.5 These cases addressed whether the bankruptcy court was the proper forum for intercreditor disputes (including threshold jurisdictional issues for AALs), the ability of junior creditors to object to a sale supported by senior creditors, and whether an agreement providing only for lien subordination restricts a junior creditor’s ability to receive distributions under a plan of reorganization.

Proper Forum for Intercreditor Disputes

A threshold issue in cases involving ICAs or AALs is whether bankruptcy-related intercreditor disputes (including the right to approve or object to sales, cash collateral, and financing motions; vote on plans of reorganization; and receive and retain proceeds distributed by the debtor) should be decided by the bankruptcy court or another federal or state court. In both EFH and Momentive, intercreditor disputes originated in state court but were transferred to the respective bankruptcy courts administering the debtors’ cases. In both cases, the bankruptcy courts held that the intercreditor disputes were “core proceedings” relating to the administration of the debtors’ estates and were therefore within the scope of the bankruptcy court’s jurisdiction.

Energy Future Holdings is an electric utility company with its business operations divided into two silos: a regulated electrical utility (the so-called E side) and a nonregulated, electricity-generating and commodity risk-management and trading entity (TCEH, or the so called T side). The intercreditor dispute arose on the T side and was among T-side first-lien creditors regarding whether certain payments and distributions were subject to an application-of-payments provision governing sales or other dispositions of their collateral. TCEH’s first-lien debt included $1.8 billion in 11.5 percent senior secured notes (the holders of such notes, the Noteholders), approximately $22.6 billion of bank debt, and outstanding debt under certain swap and hedge agreements (the holders of bank, hedge, and swap debt together, the Non-Noteholders).6

The Noteholders initially filed suit to resolve a dispute over the allocation of certain adequate protection payments and eventual plan distributions in New York state court. The Non-Noteholders removed the case to the U.S. District Court for the Southern District of New York and moved to transfer the case to the Delaware bankruptcy court.7 The Noteholders sought to have the matter remanded back to state court. The district court granted the motion to transfer to the bankruptcy court, reasoning that the dispute would not exist but for the bankruptcy proceeding and cash collateral order providing for adequate protection payments, and that the dispute will affect the allocation of estate funds, which is a core bankruptcy function.

Momentive is a silicone and quartz manufacturer. At the time of its bankruptcy, its capital structure had first-, 1.5-, and second-lien secured debt, as well as additional unsecured debt.8 The lenders negotiated an ICA that provided lien subordination of the second-lien noteholders’ liens in the common collateral (as defined in the ICA). After Momentive declared bankruptcy, the second-lien creditors entered into a plan support agreement (PSA) with the debtors that provided the basis for the debtors’ proposed plan. Under the PSA, the first- and 1.5-lien noteholders would receive face value of their debt, but would not receive a make-whole premium, while approximately $1.3 billion in second-lien debt would be equitized.9 In the event that the first- and 1.5-lien noteholders voted to reject the plan of reorganization, they would receive new notes at below-market interest rates on account of their secured claims,10 whereas the second lien noteholders would receive new equity in the reorganized debtor.

Similar to the result in EFH, the first-lien and 1.5-lien noteholders filed suit in New York state court, and the second-lien noteholders removed the matter to the U.S. District Court for the Southern District of New York, which automatically referred the case to the bankruptcy court. The bankruptcy court denied the senior creditors’ motion to remand back to state court.

As demonstrated by these two cases, although dissenting creditors may prefer to initiate litigation in an alternate forum, these disputes are more likely than not to end up in bankruptcy courts if the disputes are viewed as core proceedings inextricably tied to the administration of the debtors’ cases.11

Interpreting Sale-Related AAL Provisions

RadioShack, by contrast, yielded more mixed results when it came to the bankruptcy court’s willingness to resolve AAL-related disputes. Nevertheless, this was the first case we are aware of where a bankruptcy court addressed, at least implicitly, the enforceability of AALs in bankruptcy.12 Although an AAL would likely be considered a subordination agreement for the purposes of section 510(a) of the Bankruptcy Code, debtors are not parties to AALs, which led to arguments that the AAL should be considered outside the scope of the property of the debtor’s estate as “an agreement that does not impact the debtors and [has] nothing to do with the debtors’ estates”13 and therefore is beyond the bankruptcy court’s jurisdiction.

RadioShack, a chain of electronics stores, had a complex capital structure at the time it filed for bankruptcy. RadioShack had two main groups of secured lenders: an asset-based, or ABL, lender group under a revolving credit facility, and a term loan lender group. The ABL and term loan had crossing liens and a split collateral structure, with lien subordination between the ABL and term loan governed by an ICA.14 The ABL and term loan were further divided into multiple tranches, with subordination among each of these tranches of debt governed by separate AALs. The ABL was divided into a first-out group, which was comprised of a number of hedge funds, and a last-out lender, which was an affiliate of Standard General L.P. (Standard General). For the term loan lender group, an affiliate of Cerberus Capital Management LP (Cerberus) was the first-out lender, and an affiliate of Salus Capital Partners LLC (Salus) was the last-out lender.

Standard General, acting as the stalking horse bidder, had offered to buy approximately half of RadioShack’s stores through a credit bid. Cerberus, the first-out term loan lender, initially objected to the sale but then withdrew its objection. Salus wanted to put in a competing credit bid and objected to the sale, an action Cerberus alleged was in violation of section 14(c) of the term loan AAL,15 which prevented last-out lenders from objecting to a sale on any grounds that could only be asserted by a secured creditor if the first-out lenders consented to the sale. Certain ABL lenders also objected to the sale for other reasons.

Judge Shannon of the Delaware bankruptcy court interpreted the provisions of the AAL in the RadioShack dispute, reasoning that the AAL pertained to the “treatment of a secured creditor” and, in doing so, implicitly recognized the enforceability of AALs in bankruptcy. Accordingly, the bankruptcy court allowed Cerberus to enforce the AAL to block Salus’s objections to the sale. This should provide some comfort to lenders party to AALs that their negotiated rights will be respected by bankruptcy courts to the same extent they would be under an ICA.

Plan Distributions and Lien Subordination Agreements

As mentioned above, ICAs and AALs can provide for either lien subordination or claim subordination. Under a lien subordination agreement, to the extent that there is value derived from agreed-upon collateral, the senior lender is paid first, up to the extent of its secured claim. If there are insufficient proceeds from this collateral, the senior lender would be entitled to a pro rata share of any remaining assets the borrower may have, along with other under-secured and unsecured creditors. Payment subordination, by contrast, is a more fundamental form of subordination where the senior lender’s right to payment is agreed to be superior to the junior creditor’s right to payment.

In Momentive and EFH, the courts were presented with subordination agreements that provided for lien subordination, rather than payment subordination. In both cases, these agreements were interpreted to not restrict plan distributions (e.g., equity of the reorganized debtor) because such distributions did not constitute common collateral or proceeds of collateral as defined in the applicable ICA.

In Momentive, the first- and 1.5-lien noteholders alleged that the second-lien noteholders had breached section 4.2 of the ICA, which provided the payment waterfall for the disposition of collateral or the proceeds of collateral, by retaining 100 percent of the common stock of the reorganized debtor when the more senior lien holders had not been paid in full. They argued that the stock of the reorganized debtor would be either common collateral or proceeds, as defined by section 9-102(a)(64) of the New York U.C.C.

The bankruptcy court concluded that the new equity of the reorganized debtor did not constitute “common collateral” as defined in the ICA because none of the lenders had “a lien on that stock” or the parent company’s current stock. In addition, the stock did not qualify as “proceeds” of the collateral as defined by section 9-102(a)(64) of the New York U.C.C. because the new equity is not something a current secured party’s existing lien would attach to—the new equity is distributed on account of the second-lien lenders’ secured claims, not the proceeds of the debtors’ assets. The court also noted that there had been no economic event to alter the nature of the assets, which is necessary to give rise to proceeds.

The issue in EFH was similar, namely whether adequate protection payments and plan distributions were distributions of collateral and/or proceeds of collateral such that the waterfall provisions of the ICA governed their allocation.16

The proposed plan of reorganization (the First Plan) called for first-lien creditors to receive common equity in the reorganized TCEH, cash, new TCEH debt, and certain other rights (the Plan Distributions), as well as the extinguishing of the first-lien creditor’s liens. The first-lien Non-Noteholders argued that Plan Distributions and adequate protection payments were not “collateral” or “proceeds” of collateral as defined in the ICA or security documents and, as a result, should be allocated on a pro rata basis as of the petition date among the first-lien creditors in accordance with the size of each class of creditors’ claims. In resolving this issue, the bankruptcy court built upon the reasoning set forth in Momentive.

In March 2016, Judge Sontchi of the Delaware bankruptcy court ruled in favor of the Non-Noteholders and held that the Petition Date Allocation Method advanced by the lower-interest-rate Non-Noteholders should be adopted. In his ruling, Judge Sontchi stressed that for the Noteholders to succeed in their proposed Post-petition Interest Allocation Method, they must show that each element of section 4.1 of the ICA, “Application of Proceeds,” is met. Otherwise, the ICA would be inapplicable to the scenario at hand.17

The court held that Plan Distributions and adequate protection payments did not constitute collateral or proceeds of collateral and, therefore, failed to meet the elements of section 4.1 of the ICA. Accordingly, because no other provision of the ICA applied to plan distributions and adequate protection payments, the court held that these payments should be allocated among the first-lien creditors on a pro rata basis based on the amounts owed as of the petition date.

The Noteholders asserted that the plan distributions constituted “collateral” because under the spin-off transaction contemplated by the plan, the first-lien creditors’ collateral would be “sold” to reorganized TCEH in exchange for reorganized common stock, along with other proceeds. However, the court did not find this argument persuasive and, adopting the reasoning in Momentive, held that the first-lien creditor did not have a lien on the new common stock issued as part of the debt-for-equity swap in the plan; therefore, to consider the new stock received under the plan as proceeds of collateral would improperly add to the first-lien creditors’ collateral. Specifically, in addressing whether the proposed spinoff transaction was a “sale or other disposition” of collateral, Judge Sontchi concluded in further reliance on Momentive that the plan gave no indication that reorganized TCEH was “purchasing” the collateral, nor that reorganized TCEH was a third-party purchaser, noting the absence of any “‘economic event’ that would create that sort of relationship.”

Alternatively, the Noteholders asserted that the Plan Distributions were proceeds of collateral. The court did not find this argument persuasive, noting that the language of the security agreement limited proceeds to (i) any consideration received from the sale/disposition of assets, (ii) value received by the debtor as a consequence of possessing the collateral, or (iii) insurance proceeds, none of which apply to the Plan Distributions.18 Further, the court held that adequate protection payments were not collateral as argued by the Noteholders, but rather constituted a protection against diminution in value of collateral.19

Ultimately, the First Plan did not go effective; accordingly, TCEH presented an amended plan (the New Plan), which was subsequently confirmed by the bankruptcy court and consummated in October 2016. Based on asserted distinctions between the First Plan and the subsequently confirmed New Plan, the Noteholders also asked the bankruptcy court to vacate portions of its prior ruling.

In denying the Noteholders’ motion to vacate, Judge Sontchi again adopted the reasoning in Momentive, ruling that the transactions contemplated by the New Plan were created “solely for tax purposes”20 and did not involve a sale or disposition of “collateral.” Accordingly, creditors receiving stock in a reorganized TCEH in exchange for their claims were not receiving their collateral or “proceeds of collateral.”21

Conclusion

Bankruptcy courts are increasingly willing to interpret ICAs and AALs and apply the plain language of these agreements to the facts of the case. Creditors should be cognizant of the fact that even if they may prefer to initiate litigation in an alternate forum, these disputes are typically viewed as core proceedings and will likely end up in bankruptcy court. This is especially notable because bankruptcy courts are courts of equity, and judges often take a pragmatic approach to these disputes. Moreover, senior creditors appear to continue to bear the risk of agreements that do not limit junior creditors’ rights in bankruptcy using clear and unambiguous language.

1     See 11 U.S.C. § 510(a).

2      For example, some courts have found assignments of a junior creditor’s right to vote on a chapter 11 plan of reorganization to be unenforceable. See, e.g., In re 203 N. LaSalle St. P’ship, 246 B.R. 325, 331 (Bankr. N.D. Ill. 2000) (“Subordination . . . affects the order of priority of payment of claims in bankruptcy, but not the transfer for voting rights.”); In re SW Hotel Venture LLC, 460 B.R. 4 (Bankr. D. Mass. 2011) (finding assignment voting rights in subordination agreement to be unenforceable), aff’d in part, rev’d in part, 479 B.R. 210 (B.A.P. 1st Cir. 2012), vacated on other grounds, 748 F.3d 393 (1st Cir. 2014).

3      In re Energy Future Holdings Corp., 546 B.R. 566 (Bankr. D. Del. 2016).

4      In re MPM Silicones, LLC, 518 B.R. 740 (Bankr. S.D.N.Y. 2014).

5      In re RadioShack Corp., Case No. 15-10197 (Bankr. D. Del.).

6      These obligations were secured by liens on substantially all of TCEH’s assets and proceeds thereof, and the relationship among the first-lien lenders with respect to the shared collateral was governed by an ICA.

7      Specifically, section 2.1 of the ICA provided that the scope and rank of the first-lien creditors’ property rights in the collateral and proceeds thereof was pari passu among the Noteholders and Non-Noteholders, “except as otherwise provided in Section 4.1.” In re Energy Future Holdings Corp., 546 B.R. 566, 571 (Bankr. D. Del. 2016). Section 4.1 set forth the waterfall for dispositions of collateral or proceeds of collateral received in connection with the sale or other disposition of such collateral or proceeds and contained a provision for payment of all amounts “then due and payable.” Id. at 572. In its simplest form, the dispute was whether the waterfall applied and, if so, whether post-petition interest at the contract rate was “due and payable.”

8      In re MPM Silicones, LLC, No. 7:14-cv-07471, slip op. at 3–6 (S.D.N.Y. May 4, 2015).

9      An additional $380 million in senior subordinated notes would be eliminated without receiving any distribution under the plan.

10     Under the so-called cramdown provisions of the bankruptcy code, the bankruptcy court determined that the treatment of the Noteholders’ claims complied with the code because such holders would retain their liens and receive an interest rate sufficient to provide for “deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property.” 11 U.S.C. § 1129(b)(2)(A)(i)–(ii).

11     But see In re TCI 2 Holdings, LLC, 428 B.R. 117 (Bankr. D. N.J. 2010) (confirming “cramdown” plan of reorganization proposed by second-lien creditors over objection of first-lien creditors despite allegations that plan violated proceeds of collateral and adequate protection provisions of ICA, and holding that even if violation occurred, it would not impede confirmation of plan that complied with bankruptcy code).

12    The parties in RadioShack consented to the bankruptcy court’s jurisdiction to hear their AAL dispute.

13     Hr’g Tr. at 64:8–9 (Mar. 26, 2015).

14    In this structure, the ABL lenders have a first lien on working capital assets and a second lien on fixed or long-term assets. The term lenders have a first lien on fixed or long-term assets and a second lien on working capital assets.

15    Specifically, section 14(c) of the term loan AAL provided that no last-out lender (i.e., Salus) “shall object to or oppose any such sale . . . on any grounds that only may be asserted by [a secured lender] if [Cerberus] . . . has consented to such sale.” See Exhibit A to Statement of Cerberus Lenders in Support of Sale to General Wireless, Inc., In re RadioShack Corp., Case No. 15-10197 (BLS), Docket No. 1551-1, at 16 (Bankr. D. Del. Mar. 26, 2015).

16    As background, among the first-lien creditors, the Noteholders had the highest interest rate and argued accordingly for the accrual of post-petition interest (the Post-petition Interest Allocation Method), regardless of whether such post-petition interest was allowed or allowable as part of their claim against the debtors, such that the Noteholders would have received a larger share of the payments. The Non-Noteholder disagreed, arguing that the distributions should be allocated on a pro rata basis based on the amounts owed as of the petition date (the Petition Date Allocation Method).

17    The Application of Proceeds elements were as follows: (i) Collateral or any proceeds of Collateral are to be distributed to the First Lien Creditors; (ii) the Collateral must be “received” by the Collateral Agent; (iii) the Collateral or the proceeds of Collateral must have resulted from a sale or other disposition of, or collection on, such Collateral; and (iv) the sale, disposition, or collection must have resulted from the exercise of remedies under the Security Documents. If any of these initial requirements were not met, the adequate protection payments and the plan distributions would be distributed outside of the ICA pursuant to the Bankruptcy Code, bankruptcy court orders, and the plan.

18     The security agreement’s definition of “proceeds” was limited as follows:

[as such] term defined in Article 9 of the UCC and, in any event, shall include with respect to any Grantor, any consideration received from the sale, exchange, license, lease or other disposition of any asset or property that constitutes Collateral, any value received as a consequence of the possession of any Collateral and any payment received from any insurer or other Person or entity as a result of the destruction, loss, theft, damage or other involuntary conversion of whatever nature of any asset or property that constitutes Collateral, and shall include (a) all cash and negotiable instruments received by or held on behalf of the Collateral Agent, (b) any claim of any Grantor against any third party for [claims dealing with Licenses, Trademarks, and Copyright] . . . and (c) any and all other amounts from time to time paid or payable under or in connection with any of the Collateral.

See In re Energy Future Holdings Corp., 546 B.R. at 580 (quoting Security Agreement, § 1(d)).

19     After the court’s March 2016 ruling, the Noteholders filed an appeal of the decisions.

20     In re Energy Future Holdings Corp., 566 B.R. 669, 684 (Bankr. D. Del. 2017).

21     Id. at 686–87. After the court’s April 2017 ruling, the Noteholders filed an appeal of the decisions, which has been consolidated with the Noteholders’ appeal of the March 2016 ruling, and the consolidated appeal is pending before the Delaware district court.

Federal Deregulation Opens the Door for State-Level Threats to Auto Finance

Posted on January 16, 2018 by - Uncategorized

A major legal transition is underway in the world of auto finance. As national regulators step back and federal law retreats, state regulators are stepping up. Changing market conditions are laying kindling for the regulatory and litigation fires to come. As a result, the auto finance industry may soon face serious legal threats from varied state regulators, particularly state attorneys general (AG individually or AGs collectively), many of whom appear poised to act.

These trends hearken back to the mortgage loan calamity triggered by bad credit and securitized loans. When millions of mortgages failed in 2008–2011, state regulators jumped to the fore, resulting in epic regulation and litigation. Although the conditions in the auto finance market appear considerably less severe than those that drove the mortgage meltdown, the latter’s history contains valuable lessons. Among the most important is one frequently forgotten: to beware of complacency founded on Washingtonian sound bites. As it has already done in other spheres, the federal government may indeed scale back its regulatory concern for the auto finance field. However, so long as state AGs stand ready to scrutinize or sue, every business’s net regulatory risk remains substantial. In, many AGs are already closely watching auto finance, sharpening their knives. To counter this looming threat, attorneys advising auto finance lawyers should help their clients embrace basic but proven methods to mitigate or even avoid regulatory attention if—or rather when—another financial bubble bursts.

I.  The Current Landscape

A. The Feds Retreat

Federal regulators and federal law are in retreat, as the recent travails of the Consumer Financial Protection Bureau (CFPB or Bureau) show.

On November 1, 2017, a resolution passed by Congress and signed by President Donald J. Trump officially revoked the CFPB’s arbitration rule. Proposed in July 2017, this rule would have banned class-action waivers in arbitration provisions for covered entities. Less than six months later, this prized initiative of the CFPB’s first director, Richard Cordray (Cordray), has been quashed by Washington’s new leadership.

A second setback came soon on its heels. On March 21, 2013, the Bureau issued Bulletin 2013-02, a nonbinding document that targeted dealer markups using “disparate impact” discrimination theories. Deemed advisory, the bulletin had nonetheless become a sore subject in the auto lending industry; many indirect lenders denounced as unfair the CFPB’s determination to penalize them for unintentional purported discrimination by auto dealers, while many questioned the methodology for determining disparate impact. In March 2017, Senator Pat Toomey (R-PA) asked the Government Accountability Office (GAO), Congress’s investigative wing, to determine whether the financial guidance issued in Bulletin 2013-02 qualified as a “rule.” On December 6, 2017, the GAO issued its findings in which it determined that the bulletin qualified as a rule subject to congressional review. This finding nullified the bulletin pending its submission to Congress.

Even before the GAO’s ruling, however, the CFPB appeared to be taking a step back from further dealing with indirect auto lending. At the end of 2016, the Bureau listed its fair-lending priorities, including redlining, mortgage and student loan servicing, and small-business lending, but said nothing regarding the automobile industry. The CFPB in another statement indicated that it would rely less on enforcement in pursuing its fair-lending goals. To many, this omission signaled the CFPB’s desire to reduce its attention to the auto finance industry.

The CFPB’s aggressive tactics endured perhaps its most dramatic setback when Director Cordray announced his early departure on November 15, 2017, and President Trump named Mick Mulvaney, director of the Office of Management and Budget, as the CFPB’s interim director. This appointment has not come without controversy, given that the Senate Democrats contend that the proper head of the Bureau is Leandra English, the deputy director appointed by Cordray. In recent weeks, a federal judge denied English’s request for a temporary restraining order preventing Mulvaney from taking the helm of the Bureau. The uncertainty surrounding the Bureau’s leadership could paralyze much of its operations.

A further sign that the Bureau may scale back its enforcement actions came near the end of the year when it announced that it was withdrawing its request to conduct a survey of individuals related to debt collection disclosures. Although the CFPB has long promised a new rule addressing debt collection, this move calls into question whether its new director wants to deprioritize the rule or even scrap rulemaking altogether.

As the CFPB’s regulatory reach has waned, so has that of the Federal Communications Commission (FCC). The auto finance industry has awaited over a year the result in ACA International v. Federal Communications Commission, currently pending before the United States Court of Appeals for the D.C. Circuit. The case centers on the FCC’s aggressive interpretation of the Telephone Consumer Protection Act (TCPA), a major thorn in the side of auto finance. The D.C. Circuit may strike down the FCC’s previous construction of the TCPA, one made by regulators appointed by President Obama. Regardless, under President Trump, commissioners with a deregulatory bent now control the FCC, as evidenced by the recent reversal of the net neutrality rule by the current majority. Considering this agency’s exclusive authority to issue rules under, and make definitive interpretations of, the TCPA, the FCC will likely take a step back in the years to come.

Although not all federal regulators have been quiet, as seen by the Federal Trade Commission’s recent settlements with auto dealers, federal deregulation is the unmistakable rule of the day.

B.  State Regulators’ Forward Momentum

1. New Plans and Old Patterns

State officials have essentially announced their intent to actively patrol the regulatory gaps created by the federal government’s pullback. Soon after President Trump’s election, Maria T. Vullo, superintendent of the New York State Department of Financial Services, reaffirmed her agency’s intent to oversee banks and other financial institutions. New Mexico’s AG, Hector H. Balderas, Jr., just as loudly directed his aides to identify areas where new federal policies enacted could harm New Mexico. Even where silence has reigned, much has been intimated. A former AG of Maryland has already referred to the “enhanced role in protecting consumers moving forward” likely to be assumed by state AGs. Chris Jankowski, a Republican strategist, agreed with this assessment and observed to the New York Times: “State attorneys general are now more permanent pieces on the chessboard of national policy development and implementation. And they are not mere pawns.” Even more AGs have privately revealed plans to redouble their efforts within the consumer protection arena, including the auto finance field.

Another sign of this increasing activity came on December 12, 2017, when a group of 17 state AGs issued a strongly worded letter to President Trump, promising “unwavering support for the mission of the Consumer Financial Protection Bureau” and efforts “to vigorously enforce consumer protection laws regardless of changes to the Bureau’s leadership or agenda.” Expressing concerns regarding President Trump’s appointment of Director Mick Mulvaney, the AGs noted that they “retain broad authority to investigate and prosecute those individuals or companies that deceive, scam, or otherwise harm consumers. If incoming CFPB leadership prevents the agency’s professional staff from aggressively pursuing consumer abuse and financial misconduct, we will redouble our efforts at the state level to root out such misconduct and hold those responsible to account.” Led by New York’s AG Eric Schneiderman, the coalition includes AGs from California, Connecticut, District of Columbia, Hawaii, Illinois, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Mexico, North Carolina, Oregon, Vermont, Virginia, and Washington.

The December 12th letter promises a new wave of state enforcement of consumer regulations following the election of President Trump. These states are taking advantage of a little-known provision of the 2010 Dodd-Frank law, which created the CFPB and gives state AGs the authority to enforce the agency’s rules and its broad ban on “unfair, deceptive and abusive” practices beyond state lines. For example, Pennsylvania’s AG Jack Shapiro has been quickly building up his own consumer finance unit since taking office in January. The Pennsylvania unit is staffed with more than a dozen attorneys and led by a former senior CFPB attorney. “We’re demonstrating a capacity to handle these big, complex, consumer financial protection cases,” Shapiro told Reuters, adding that AGs from both parties have asked how they can “mimic our efforts.”

In Washington, AG Bob Ferguson has similarly enlarged his consumer finance division to 27 attorneys, compared to 11 attorneys in place four years ago. Similarly, California’s AG Xavier Becerra has promised to “carry the torch and build on [former CFPB] Director Cordray’s good work to protect and empower consumers.” “Regardless of what President Trump and the CFPB do moving forward,” said Virginia AG Mark R. Herring, “my fellow attorneys general and I remain committed to fighting to protect consumers across the country, and we will not waver from that commitment.” Herring, like many of his counterparts across the country, has also reorganized and expanded his state consumer protection organization since the election of President Trump.

In addition, there have been open discussions in state AG meetings about the need to form a mortgage-crisis-like multistate taskforce to focus on the auto lending and servicing market, particularly the subprime market. A number of AGs often will come together to investigate a company for alleged violations of state law. These investigations originated in the mid-1990s when the states first joined forces to regulate the tobacco industry, not through legislation, but through investigation and regulatory enforcement. Although the federal government was not involved, the states effected significant change in the tobacco industry and its economics through a massive, industry-wide settlement. Multistate investigations usually involve a group of anywhere from a dozen states to a coalition of all U.S. jurisdictions, overseen by an executive committee comprised of the key states who constitute the driving force for that particular investigation. Although discussions between the AGs and their targets occasionally splinter into individualized litigation, the negotiation of a joint consent order or assurance of voluntary compliance, coupled with a monetary payment to the plaintiff states, more commonly occurs.

Multistates often lead to high-dollar, high-profile settlements, with states having collected many billions of dollars in the past few years. For instance, early 2017 saw a $586 million multistate settlement with Western Union to resolve allegations that the company permitted fraudulent transfers. New York has been especially active in the multistate space. In August 2016, it announced a $100 million multistate settlement with Barclays related to allegations that the bank artificially manipulated interest rates. Soon thereafter, New York AG Schneiderman announced a $714 million settlement with Bank of New York Mellon over fraudulent foreign exchange practices. The auto industry has not been immune to this force either, as varied state coalitions entered into settlements with Toyota for $29 million, as well as Hyundai and Kia for $41.2 million.

2. Examples

Four specific state actions may be harbingers of the future for auto finance.

In June 2017, Florida AG Pam Bondi announced a settlement with a Jacksonville car dealership, its financing arm, and its president regarding allegations that the dealership engaged in misleading business and sales practices. The consent agreement required the dealership to provide over $5 million in debt forgiveness to affected consumers.

In September 2017, Massachusetts AG Healey filed a complaint accusing JD Byrider, a used car dealership, of utilizing predatory practices in its sale of allegedly defective vehicles. According to the Commonwealth’s pleading, JD Byrider sold allegedly defective vehicles with high-cost loans to Massachusetts consumers under the “JD Byrider Program,” which bundled the vehicle sale, financing, and repair in one transaction. Healey’s office contended that JD Byrider failed to inform its customer that it priced its cars at more than double their retail value to force consumers to finance their purchase at an annual percentage rate of 19.95 percent, regardless of their credit qualifications.

Finally, New York’s AG Schneiderman announced two settlements with motor vehicle dealer groups in 2017. The settlements provided over $900,000 in restitution to approximately 6,400 consumers in the state and required the dealers to pay $135,000 in penalties and costs to the state itself for the unlawful sale of credit repair and identity-theft protection services to consumers who bought or leased vehicles. According to Schneiderman, the dealerships unlawfully sold “after-sale” credit repair and identity-theft protection services that considerably increased a vehicle’s purchase price. Consumers, Schneiderman asserted, unknowingly purchased these services, many having been led to believe that these services were free.

3. Tea Leaves

Despite Republican leadership in Washington, state AGs retain powerful tools at their disposal to help fill any void left by scaled-back federal enforcement: the ability to enforce rules previously promulgated by the CFPB; to enforce the federal Unfair, Deceptive and Abusive Acts and Practices (UDAAP) authority; and to use their own state Unfair and Deceptive Acts or Practices (UDAP) authority for consumer protection. In the legal sphere, they will continue to sue and seek individual settlements in the auto space, a sure fingerprint of their high degree of interest in and focus on the market, and will persist in considering the possibility of concerted investigations of purported violations of state consumer protection law by auto lenders.

All the while, AGs known for their regulatory activity will likely cultivate their longstanding connections with their state’s plaintiffs’ bar. As many consumer-facing companies know, state AG investigations often go hand-in-hand with class-action litigation and often concern the same claims. Many members of the plaintiffs’ bar watch for AG investigations; likewise, many members of state AG offices monitor significant consumer class action litigation.

A final portend came toward the year’s end. In October 2017, the National Consumer Law Center (NCLC) issued a report highlighting the mark-ups in add-on products during automobile sales, specifically GAP insurance and window etching. Because this report probably landed on the desks of every AG in the nation, its ripple effects could be felt for the next few years, both in consumer class litigation and investigatory actions.

This is the future that awaits the auto finance industry: increasingly active AGs, acting cooperatively, either triggering or building upon individual plaintiffs’ own suits.

II. Market Conditions

A. The Bubble Surfaces

The automobile holds a special place in this nation’s mythology and its people’s daily lives. This consumer good simultaneously serves as the primary means of transportation, essential to the survival and sustenance of countless U.S. families. Sales figures attest to its outsized role: after suffering dramatic declines during the Great Recession, U.S. vehicle sales have grown by greater increments for seven consecutive years and reached a record of $17.55 million in 2016.

The data as to the originations, outstanding balances, and delinquency rates of today’s auto loans tell the tale: as the total volume of auto loans has swelled, their terms have become longer and longer, and delinquencies have inched upwards. In terms of origination, auto loans to subprime borrowers, frequently defined as borrowers with credit scores of 660 or lower, nearly doubled from 2009 to 2014. Specifically, the percentage of used car loans that franchise auto dealers made to subprime borrowers increased from 17 percent to 25.4 percent, and new sales to subprime borrowers increased to 14 percent in 2014, comparable to prior highs in 2006 and 2007. Although lending to borrowers with lower credit scores did not expand in 2017, subprime auto lending, which all but vanished during the recession years, has now regained much of its market share.

During these years, the outstanding balances on all these loans have multiplied. In the third quarter of 2014, subprime borrowers held 39 percent, roughly $337 billion, of such loans compared to $304 billion and $255 billion in 2013 and 2012, respectively. A drop followed, but in the third quarter of 2017, auto loan balances once more increased by another $23 billion, with outstanding balances on subprime auto debt again nearing $300 billion. Holding a disproportionate share of subprime auto debt, auto finance companies currently hold more than $200 billion of such loans, double their 2011 holdings.

This upward trajectory has been matched by a noticeable ascent—if so far modest and manageable—in the general delinquency rate. For auto finance companies, this rate, already higher than the one enjoyed by conventional banks, has risen by more than two percentage points since 2004. In 2017’s first quarter, the percentage of auto loans that were over 90 days delinquent rose to 3.82 percent from 3.52 percent one year earlier, the highest level in four years. By November 2017, it reached four percent. Notably, the worsening in the delinquency rate of subprime auto loans appears most pronounced, as more than six million Americans were at least 90 days late on their auto loan repayment in 2016’s last quarter. Although the balances of subprime loans may be somewhat smaller on average, “the increased level of distress associated with subprime loan delinquencies,” the Federal Reserve Bank of New York has noted, “is of significant concern, and likely to have ongoing consequences for affected households.”

Finally, many investors are now “getting into auto loans because they have the money,” even as auto lenders have shown a revived willingness to assume greater risk. As both trends have accelerated, lenders have bundled more and more loans and created more and more securities marketed to investors and backed by the stream of payments owed by each loan’s original borrower (asset-backed securities or ABS). By late 2016, $97 billion in auto loans, with subprime loans constituting 41 percent of this total, had been securitized.

B. A Recent Parallel

One need not look too far back to find a parallel for this auto finance environment: the subprime mortgage market. Some contend that the mortgage crisis began in 2001 when the U.S. housing industry experienced an abrupt increase in the value of real estate assets to a point where consumer income to support the increase in value simply did not exist for many people. This so-called housing bubble was partly traceable to credit underwriting practices: with lenders looking beyond traditional measures of creditworthiness, a critical mass of loans went to subprime borrowers who proved unable to make their mortgage payments and subsequently defaulted on their loans. As these loans were securitized, the borrowers’ default led to massive losses in the value of the assets held by countless entities in national and international secondary markets. In 2008, the International Monetary Fund estimated that the subprime crisis led to losses totaling $945 billion in the United States alone.

On the heels of these steep losses, lenders, servicers, and owners faced a regulatory and litigation firestorm. Emblematic of the disaster was a $25 billion settlement reached in 2012 between state and federal regulators and the five largest mortgage servicers for alleged misdeeds in efforts to collect on those mortgages. Although the U.S. Department of Justice stood first in line, by all accounts the driving force of the settlement was the 49 state AGs who joined forces against the servicers.

III. Advising Clients to Plan Ahead

This is not to suggest that the situation facing the auto finance industry compares in terms of size and severity to that faced by the mortgage market in 2007 and 2008. The labor market shows low levels of unemployment, delinquency levels remain manageable, and the amount of credit outstanding is much smaller. However, historical parallels and recent state AG comments and common practices point to the distinct possibility that the auto finance industry will soon confront a mortgage-crisis-style legal environment in more than a handful of states. As a result, the question becomes how to best advise auto finance clients to minimize the risk.

Once a company finds itself in the regulatory crosshairs of a major multistate investigation, it is often too late to save money or face. The leverage and pressure that a multistate can bring to bear can make the facts and law secondary to the objectives of the state regulators. As such, the key to survival rests on one preventative action: avoid any invitation to the party in the first place. Well-known within their local communities if not the nation at large, the largest players live with a target on their back, which comes with the territory. Although the targets of a multistate can appear from the outside almost random, the reality reveals otherwise. Given clients’ mere size, their footprint, and presence, correlated to the likelihood of such scrutiny, attorneys for such entities must commit themselves to a single goal: advising any potentially impacted companies on how to establish a good reputation among regulators. Simply put, companies earn negative attention later by how they choose to act now, and a prepared attorney can steer his or her clients down a far less litigious (and expensive) path.

A four-point program, focusing on the basics, follows:

  1. Develop a plan. First, a smart company must plan to allay any risk of a potential firestorm. It should, for example, establish clear lines of authority for any decision making regarding a governmental inquiry, however minor, and ensure open communication (as well as encouraging cooperation) among key marketing, legal, and operations figures with actual, meaningful power, clearly demarcated. In short, no company should be unable to respond, confidently and knowingly, at a moment’s notice to a particular inquiry. Although omniscience cannot be expected, a piqued regulator or wary plaintiff should rarely encounter either persistent silence or bewildered mumbling.
  2. Build Regulatory Good Will with Respect and Responsiveness. History underscores the importance of positive relationships with state regulators. When such watchdogs come calling for routine examinations or to transmit a consumer complaint, a company must treat them with utmost respect and responsiveness to the extent consistent with any pendent legal concerns and dangers. Even if information must be withheld, such regard—and a good-faith explanation—may prompt a resolution or at least reduce possible acrimony. Most AGs are, after all, political actors who seek to provide dividends for their constituents and do not likely relish the prospect of open combat and uncertain rewards in the most common cases.
  3. Aggressively Resolve Complaints. History also teaches that a good way to avoid attention and to foster regulatory good will lies in an aggressive complaint management program. Many companies have written complaint management programs; lawyers can help develop policies for these programs targeted toward the achievement of aggressive resolution for most protests. Unresolved regulatory and consumer complaints remain likely to cause trouble. An unresolved complainant is a consumer who may be in search of a lawyer, and an unresolved complaint may cause a regulator to decide that the company cannot be trusted to police or manage itself.
  4. Focus on Key Areas of Technical Legal Compliance. Perhaps most importantly, the past reveals a central truth: the fundamental gripes of regulators often are not legal concerns. In the mortgage cases, for instance, regulators reacted to understandable consumer distress induced by unexpected foreclosures. Although it was not illegal to foreclose on a loan, regulators seized on technical noncompliance with one or more aspects of the myriad consumer protection laws, and used those errors as the casus belli—the formal stated reason for hostilities. To avoid this fate, a smart company must put in place the elements of compliance that a regulator would expect to see and scrub processes and documents for technical compliance, particularly those that are consumer facing.

No one can predict the future with 100-percent confidence. Regulatory trends may shift, and the economics of the auto finance industry can change without warning; however, those who fail to learn from history can be doomed to repeat it. The mortgage experience indicates that the worst can happen. Attorneys advising auto finance companies can do two things. First, message the risk internally and note the nature of the risk. Second, develop strategies to mitigate those risks. By understanding and anticipating the risks of state investigation, attorneys can prepare their clients to navigate the uncertain landscape facing auto finance companies.

Making Pass-Throughs Great Again

Posted on January 16, 2018 by - Uncategorized

In case you have been in a coma, major tax changes to the Internal Revenue Code were passed in December 2017 (see Pub. L. 115-97 (115th Cong., 1st Sess.)) (hereinafter H.R. 1). Those changes make it much more attractive (from a tax perspective) to arrange one’s affairs like a business owner.

Broadly speaking, the new tax law changed the landscape so that many business owners will now benefit from dramatically lower tax rates (e.g., the corporate rate has not been this low since 1939). Nevertheless, to take full advantage of the massive tax cuts, careful attention must be paid to match the appropriate entity type with the underlying business. In the professional services context, H.R. 1 may lead to some business reorganizations. When the stars align, one attractive entity type is the cooperative. Cooperative owners face fewer hurdles to obtaining a tax cut than every other business entity type, but governance challenges may outweigh the tax benefit.

What’s All This About a Pass-Through?

First, let us understand the changes. C corporations pay entity-level tax, whereas S corporations, partnerships, and other “pass-through” entities do not pay entity-level tax (at the federal level). In addition, for the last 30 years, individual income tax rates have generally been lower than corporate income tax rates. Therefore, there has been a strong incentive to use pass-through forms of business ownership to avoid two layers of tax and to pay a lower overall rate of tax. About 15 years ago, the introduction of a lower rate of tax on “qualified dividends” (which include many domestic corporate dividends) made corporate ownership less expensive, but did not eliminate the two layers of tax.

H.R. 1 dropped the corporate tax rate from 35 percent to 21 percent. Meanwhile, the highest rate for individuals is now 37 percent, down from 39.6 percent, with the qualified dividend rate at 15 percent for many taxpayers. Hence, the dual rates applied to corporate income combined (21 percent at the corporation level and 15 percent on the dividend to shareholders, for a total of 36 percent) are lower than the highest individual income tax rate. Does this mean that all those businesses that organized as pass-through entities (and settled for one layer of tax over two) are possibly worse off than they would be if they had organized as corporations?

H.R. 1 section 11011 creates new section 199A of the Internal Revenue Code, aimed at lowering the individual rate on pass-through income. Section 199A is 10 pages long, and it is complex. Nevertheless, section 199A is designed around an idea that is easy to understand—namely, to avoid incentivizing incorporation over other business forms, section 199A is meant to bring the pass-through rate down so that the total tax paid by a business owner is roughly the same whether the business is organized as a corporation or a pass-through.

A Few Details, Please

Next, let us look at the mechanics of the pass-through change. Section 199A is a “below the line” itemized deduction. That means section 199A will not reduce an individual’s adjusted gross income, but will reduce the amount of taxable income in a particular year. In addition, section 199A applies to taxpayers other than a C corporation. This means that an individual sole proprietor may take advantage of the “pass-through” deduction without forming a new entity.

Section 199A is designed to exempt 20 percent of ordinary income from a pass-through trade or business from income tax. Yet because it is a tax provision, it has to be more complex. So there are phase-ins and phase-outs; defined terms; calculations; reference to other sections in the Internal Revenue Code—basically a turkey with all the trimmings for a tax nerd (and an absolute nightmare for any normal person).

The absolute basics are as follows:

  1. For all single taxpayers with less than $157,000 in taxable income (or married taxpayers with less than $315,000 in taxable income): if the taxpayer quit his or her job, started Consulting LLC, and charged his or her old employer a consulting fee, the taxpayer would be able to exempt 20 percent of his or her income from federal income tax.
  2. For all single taxpayers with more than $207,000 in taxable income (or married taxpayers with more than $415,000 in taxable income): this trick continues to work only if the taxpayer’s trade is not on a list of “specified service trade or business” as defined in section 199A(d)(2). The list includes businesses generally characterized as professional service firms, such as doctors, law firms, accounting firms, financial services, and consulting firms. (Engineering and architecture firms are expressly excluded from the definition of a “specified service trade or business,” presumably because their lobbyists are betters than ours.)
  3. Where a taxpayer’s profession is a “specified service trade or business” and he or she makes more than $207,000 or $415,000 (if married): section 199A does not apply. That is, if you are a lawyer making over $415,000, you have the pleasure of paying a higher rate of tax than your architect or engineer clients.
  4. Unlike payments from other pass-through entities, “patronage dividends” from cooperative corporations are not subject to the restrictions and limitations discussed above. Hence, if our taxpayer forms a cooperative with his or her fellow colleagues instead of a single member LLC, the taxpayer may be able to exempt 20 percent of his or her income, regardless of profession or income amount.

Those basics are subject to some strong caveats, namely:

  1. The taxpayer cannot take a deduction for “the trade or business of performing services as an employee” under section 199A(d)(1)(B). Hence, the relationship between the taxpayer and his or her former employer must meaningfully change.
  2. The reduction in income tax will be partially offset by an increase in self-employment tax of 7.65 percent on the first $128,400 (in 2018). Other pre-tax employee benefits (such as health care) would now be paid post-tax by the self-employed taxpayer and subject to itemized deduction limitations.
  3. Existing state law and/or professional ethics rules may restrict the ability of professional services taxpayers to practice to certain entity types (e.g., California does not allow an LLC to render legal services, and laws governing cooperatives vary drastically from state to state).
  4. Judicial doctrines and factors employed by the IRS to look to the substance rather than the form of a situation may catch out even careful taxpayers.
  5. Section 199A is complex, and the summary above is a very simplified version. Consult a tax colleague in conjunction with any planning.

Give Me an Example or Four

With an understanding of the basic concepts, let us lastly consider four examples: a sole-proprietor barber, an associate attorney, a real estate executive, and an artist.

First, the barber. Suppose singleton Calvin the barber is a sole proprietor and has no employees. He leases a building and offsets his risk with insurance. He reports his income and expenses on Schedule C. After expenses, Calvin makes $50,000 per year. Good news for Calvin. Although his business has no employees and few assets, he is below the $157,500 threshold, and his services are not as an employee but as a barber. Assuming the barbershop is Calvin’s only source of income, he will get to exclude $10,000 from his taxable income (20 percent of the $50,000 business income).

Second, the associate attorney. Suppose engaged attorney Rachel intends to begin work at law firm Pearson Specter in New York with an annual salary of $180,000 on January 2, 2018. If Rachel works as an employee, her marginal income tax rate will top out at 32 percent, but if Rachel instead convinces Pearson Spector to hire Rachel LLC (her legal services entity) and Rachel otherwise avoids “employee” status, she will be able to take advantage of section 199A, although somewhat limited due to the phase out for “specified service trade or business” over $157,500 (the calculation is complicated, but in this example, Rachel would take a 45-percent section 199A deduction, which means she would exclude nine percent of her income (45% x 20%, or $16,200). If Rachel happens to marry a well-mannered prince with no income, she will be able to file a joint return, and the phase-out for “specified service trade or business” will not apply until the couple reaches $315,000 in taxable income. In that case, Rachel will exclude $36,000 from her taxable income (20 percent of the $180,000 LLC income).

Third, the real estate professional. Suppose real estate salesman Fred has been selling units of a building in SoHo for his employer. Fred, an employee, expects to make $450,000 from his employer this year. As an employee, his marginal income tax rate on $450,000 will top out at 35 percent, so Fred gets an idea. He offers to continue to sell units in SoHo as Fred LLC, rather than as an employee. Because real estate is not a “specified service trade or business,” Fred is entitled to the section 199A deduction. However, due to restrictions on the section 199A deduction, Fred will be limited to acquisition value of the LLC’s qualified property and to W-2 wages paid to employees.

Finally, consider the struggling artist. Artist Georgia is upset because artists are included in the definition of “specified service trade or business.” Hence, despite the fact that she has worked hard to build a successful business model around her art, she is unable to take advantage of section 199A because of the “specified service trade or business” provisions, but if Georgia were to form a cooperative corporation with her fellow artists and structure the payments so that she only received “patronage dividends,” Georgia would be able to fully take advantage of section 199A. This appears to be the case even if her income is above the threshold amounts, and even though her trade or business is a “specified service trade or business.” In exchange for a 20-percent tax break, Georgia must put up with one-member, one-vote governance and “patronage dividend” rules. Nevertheless, it might be worth the tax savings.

Conclusion

H.R. 1 brings with it many changes to the Internal Revenue Code. In general, this is legislation that benefits business owners. As many employees will find themselves paying lower taxes than their bosses, questions of equity cannot be far behind. If and when employees have an opportunity to negotiate with their employers, restructuring employment may be the next frontier. Forget fringe benefits; turning employees into an independent contractor relationship with an employee-owned pass-through is the biggest gift an employer can give. The employee gets to exempt 20 percent of income from federal tax; other than transaction costs, the employer is not seriously inconvenienced. Seems like a win-win-lose, where only Treasury loses out.

Effect of 2017 Tax Reform on Choice of Business Entity

Posted on January 16, 2018 by - Uncategorized

Tax reform enacted at the end of 2017 made C corporations much more attractive from the standpoint of annual income taxes than S corporations, partnerships, or sole proprietorships (collectively, pass-throughs). Or did it? And how about the consequences of transferring one’s business by sale to third parties or through estate planning tools?

C corporations now have a flat, 21-percent federal income tax rate. Even personal service corporations use the new low rate. This contrasts with the top federal income-tax bracket of 37 percent for pass-through income, which may be reduced to 29.6 percent by way of a 20-percent deduction for qualified business income—if and to the extent that one’s pass-through qualifies for the deduction. Partners and sole proprietors in lower income-tax brackets face 15.3-percent self-employment tax, and those in the highest brackets may pay 3.8-percent self-employment tax or net investment income tax. S corporation owners who work in the business must report compensation income to the extent of the lesser of cash they receive or “reasonable compensation,” and in 2017 the IRS explained to its agents how to keep taxpayers out of tax court when the IRS reclassifies distributions as compensation. Any amounts classified as wages are not eligible for the 20-percent deduction.

However, lower C corporation tax rates must be tempered by the taxation of distributions as dividends. A shareholder in the top bracket pays 23.8-percent federal income tax on qualified dividends, considering net investment income tax. Add state income tax, and the double taxation involved in declaring dividends each year can make C corporations unattractive.

If one lives in a state imposing five-percent income tax, here is a comparison of effective annual tax burdens, considering all of the above factors:

 

Individual in Top Bracket

Individual in Modest Bracket

Distributing 100% of Corporate Net Income After Income Tax

47.3%

40.8%

Distributing 50% of Corporate Net Income After Income Tax

36.7%

33.4%

Distributing None of Corporate Net Income After Income Tax

26.0%

26.0%

S Corporation, Partnership, or Sole Proprietorship

34.6%–45.8%

27.4%–46.2%

Although one can quibble over the assumptions used to generate the rates this chart uses, it demonstrates that a C corporation really produces superior annual income tax results only if it reinvests the lion’s share of its income.

Suppose, seeing this, one says, “I don’t care about taking annual distributions from the business. My goal is to build up the business by reinvesting earnings and selling it at some point.” Reinvested earnings add to the basis of one’s partnership interest or S corporation stock, but they do not add to the basis of one’s C corporation stock. Although one will not incur the annual tax pain of taking distributions, one will feel it on the back end when selling. However, some C corporation owners will be able to avoid the gain either by dying and getting a basis step-up, or by the IRC section 1202 exclusion. Generally, the IRC section 1202 exclusion applies to stock that the corporation issued to the taxpayer (or was issued to the donor or decedent who transferred the stock to the taxpayer) if the corporation was never an S corporation, and the corporations’ activities were always among those approved by IRC section 1202 (which does not include professionals).

Suppose a pass-through converts to a C corporation. If the entity used the cash method of accounting for tax purposes and averages over $25 million in gross receipts, it may be required to convert to the accrual method and pick up income on its accounts receivable, unless it qualifies for an exception. Furthermore, if an S corporation converts to a C corporation, it must wait five years before making an S election.

An S corporation that converts might consider taking steps to preserve the ability to distribute its accumulated adjustment account (AAA) (its reinvested earnings taxed to its shareholders that can be distributed tax-free):

  • Cash distributions made in the first C corporation taxable year after revoking the S election can use AAA instead of counting as dividends.
  • After that first year, some AAA may be able to be used if the shareholders are the same as when the S election was revoked.
  • If an S corporation converts to a C corporation, its AAA is wiped out and must start over if it later makes an S election. Before revoking the S election, consider undergoing a IRC section 368(a)(1)(F) tax-free reorganization in which a new parent takes on the existing corporation’s S status and AAA; then the existing corporation becomes a C corporation. If the old entity wants to revert to S corporation taxation, it can elect to be a qualified subchapter S subsidiary—an entity that is disregarding from its parent.

Suppose the political climate changes in Washington, D.C. again and corporate tax rates increase. After five years, the C corporation could make an S election. However, the conversion may be taxable:

  • Any assets with value in excess of basis that are sold within five years after making the S election are taxed at not only the shareholder level, but also the corporate level. If the C corporation uses the cash method, any accounts receivable would get hit with this double tax, so it might want to change to accrual before making the S election. The corporation might consider selling other assets before the conversion.
  • If the corporation uses LIFO inventory, recapture would be taxed.

Suppose the taxpayer decides to stay put as a pass-through. How does the new IRC section 199A deduction for qualified business income (QBI) work? It applies only to qualified income from a qualified trade or business. This has several components.

First, the business cannot be a specified service trade or business (SSB). An SSB is any trade or business other than certain businesses that (a) do not qualify for the IRC section 1202 exclusion from capital gain on the sale of C corporation stock, or (b) involve the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. The businesses mentioned in (a) are any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees (except that engineering and architecture are not blacklisted like the others are). The businesses mentioned in (a) are not blacklisted if the taxpayer’s taxable income is below certain limits.

Second, income as an employee of the qualified business, guaranteed payments that a partner receives for services rendered to the partnership, and similar payments do not qualify. A partner who receives only a distributive share of profits benefits more than an employee-shareholder of an S corporation. Suppose, before considering the owner’s compensation, a business has $300,000 of QBI, reasonable compensation is $200,000, and distributions to the owner are at least $200,000. If the business is an S corporation, then the $200,000 wages the S corporation pays its owner will reduce the QBI from $300,000 down to $100,000. If the owner were a sole proprietor or a partner paid only though his or her share of profits, QBI would be $300,000.

Third, the deduction is the lesser of (a) 20 percent of QBI, or (b) the greater of (i) 50 percent of wages paid or (ii) the sum of 25 percent of wages paid and 2.5 percent of the unadjusted basis of qualified property. The limitation in (ii) does not apply if the taxpayer’s taxable income is below certain limits. In addition, although adding the qualified property was intended to benefit real estate, note that real activity must qualify as a trade or business. Taxpayers receiving rent through triple-net leases should consider whether their rental activity qualifies as a trade or business.

As mentioned above, having taxable income below certain levels helps one avoid certain limitations to the QBI deduction. For a married person filing jointly, taxable income (ignoring the QBI deduction) no more than $315,000 obtains the full benefits, which phase out over that level until fully phased out at $415,000. For other taxpayers, the amounts are $157,500 and $207,500, respectively.

Moving beyond the QBI deduction, any type of business can benefit from bonus depreciation, which allows most tangible personal property (equipment, etc.) to be 100 percent written off in the year of purchase if placed in service after September 27, 2017, and before January 1, 2023.

Businesses should also consider their debt equity structure. Suppose an owner loans to his or her business (other than a sole proprietorship). A taxpayer in the top bracket would pay 40-percent federal tax (37 percent plus 3.8 percent net investment income tax) on interest income, whereas the business’ federal benefit would be only 21 percent if a C corporation or 29.6 percent for a pass-through with a full 20-percent QBI deduction. IRC section 163(j) also may limit deductions for business interest and applies to more businesses due to 2017 tax reforms.

This article attempts to highlight some of the many issues raised by 2017 tax reform. Feel free to e-mail the author for details supporting the statements made.

A Blueprint for Family Business Succession Planning

Posted on January 16, 2018 by - Uncategorized

When the owners of a family business ask their attorney to advise them with business succession planning, counsel should begin with an outline that summarizes the entire process but that divides it into distinct projects that progress toward construction of a comprehensive succession plan. With the clients’ help, counsel can then refine the outline to more accurately reflect their circumstances, needs, expectations, and vision. This “blueprint” for the succession planning process will make the process more efficient, more effective, less stressful, and more rewarding for the clients.

The Case for Family Business Succession Planning

The most recent PWC U.S. Family Business Survey (2016) concludes that inattention to succession planning is a substantial problem for many family businesses in the United States. The authors of the PWC Survey found that owners of 69 percent of the family businesses surveyed expected ownership of the business to continue in the next generation, but only 23 percent had a robust, documented business succession plan.

The authors of the PWC survey call this finding “worrisome” and contend that serious problems such as the following can arise if a family business does not have a formal succession plan in place when owners cease to maintain control:

  • next-generation family members may be reluctant, unprepared, or unable to lead;
  • family members and other stakeholders may not support the choice for successor leadership; and
  • the business may not have enough liquidity to support transition of ownership within the family.

The authors of the PWC survey correctly suggest that many succession problems can be avoided or mitigated if family businesses plan for succession, rather than wait until “the last minute, when options may be more limited.” “Regardless of when a business thinks a changing of the guard will take place,” they conclude, “it’s important to always have a plan ready for that eventuality, since unforeseen circumstances can cause a sudden need for new leadership.”

The PWC survey results and its authors’ conclusions will ring true for attorneys who have experience working with family businesses. The chronic failure of family businesses to engage in formal succession planning is at odds with their tendency to focus on long-term performance better than businesses that are not family owned. In the 2012 Harvard Business Review article, “What You Can Learn from Family Business”, authors Kachaner, Stalk, Jr., and Bloch assert that “[e]xecutives of family businesses often invest with a 10- or 20-year horizon, concentrating on what they can do now to benefit the next generation.” These same family businesses, however, often have no real plan for how the next generation will realize those benefits as successor owners and leaders.

To be fair, one reason why so many family businesses do not engage in proper succession planning is because it is difficult and complex. Family business succession planning must take account of countless unknown future circumstances and current facts that are continuously changing and interacting, including business factors like the economy, the regulatory environment, and the state of the market in which the business operates, as well as family factors like family dynamics and the changing skills, maturity, career objectives, economic needs, and health status of individual family members.

Under these circumstances of pervasive uncertainty and complexity, it is understandably difficult for family business owners to comprehend how they could construct a proper business succession plan. However, if their attorney can provide them with an organized, logical, step-by-step outline for succession planning, they may be much more likely to begin the process and eventually develop the kind of “robust, written” succession plan that the authors of the PWC survey and other family business advisors advocate.

The Blueprint for Family Business Succession Planning

Attorneys can use much of the text of this article to create their own outline for family business succession planning. The section on each project includes commentary that provides a description of the project and an explanation of legal concepts and other substantive factors that may affect how the clients make decisions about the project. Although the projects are arranged in sequential order, they should be considered concurrently. The substance of the projects are interrelated; therefore, the clients should make decisions about each project with a solid understanding of how they intend to address projects that appear later in the outline.

One important prefatory piece of business: For the purpose of this article, the term “clients” is used broadly to include collective decision makers for the business and family. However, for each family business succession planning engagement, it is important to establish an understanding, in writing, about which parties counsel represents (and which parties counsel does not represent). For example, the attorney might choose to represent the business (or more accurately, some or all of the companies owned by the family) and/or the senior generation of owners (or some of them). If the attorney represents more than one party, he or she should obtain conflict waivers and joint representation agreements as necessary. The attorney should also ensure that the parties the attorney does not represent understand that the attorney does not represent them and that they should consider obtaining the advice of independent counsel before signing documents that the attorney has drafted as part of the business succession plan.

1. Collecting Information

Before counsel begins to design a family business succession plan, counsel should review copies of current business governing documents, related party contracts, and estate planning documents that might affect governance, ownership, or succession of the business. The clients and their other advisors should help the attorney collect these documents. This process also offers clients an opportunity to get their personal and business records organized and establish procedures for keeping them organized and current. For a list of information to request, see the sidebar entitled “Due Diligence for Family Business Succession Planning.”

2. Valuation

Proper family business succession planning requires a reliable valuation of the stock of the family’s primary business entities and other important business assets when planning commences and throughout the term of family ownership. If the clients do not already have current opinions of value, counsel should help the clients obtain them. This can help the attorney and the clients avoid major mistakes in the planning process that the attorney might otherwise make if working on faulty assumptions of value.

Obtaining a current valuation can help the clients in other ways as well. The evaluation process can reveal information about the strengths and weaknesses of the clients’ business that the clients can use to improve operations and profitability. The valuation professional can also help counsel draft the most appropriate purchase price language in the clients’ buy-sell agreements. Finally, the clients can maintain their relationship with the valuation professional to obtain updated opinions on a regular basis (such as every two years) for the purposes of the clients’ buy-sell agreements and for transfers of ownership interests within the family to implement the succession plan.

3. Business Continuation Plan

If there are key family members who are particularly important to the operations or success of the family business, then early in the succession planning process, counsel should help the clients establish mechanisms to address the disruptions that would be caused by the sudden death or incapacity of one of those key family members. For example, the attorney should ensure that the controlling owner has updated powers of attorney appointing an appropriate person to vote clients’ interest if suddenly rendered incompetent; the attorney should ensure that the controlling owners’ stock designates an appropriate transfer-on-death beneficiary (such as their living trust) to avoid the delay of probate if they die during the succession planning process; and the attorney should ensure that the clients have a plan to replace the chief executive, at least on an interim basis, if he or she unexpectedly exits the business. These are temporary measures that will be replaced or supplemented by more permanent structures and procedures when the clients have made more progress on their succession plan.

4. Restructuring

After counsel reviews the existing business documents and obtains input regarding business valuation, counsel should work with the clients’ accountants to help the clients determine whether the business should be restructured or reorganized. It may be that making changes to the legal structure or tax treatment of the components of a clients’ business will facilitate succession planning. For example, it may be easier to plan transitions of ownership if the primary source of cash flow is taxed as a partnership rather than a C corporation, or if the real estate assets are held in entities that are separate from primary operations. The attorney should work with the clients’ accountants to ensure that any restructuring will be tax efficient (including income taxes and transfer taxes). Counsel must take into account other advantages of restructuring, such as limitations of liability, operational efficiencies, and diversifying ownership opportunities for family members. The attorney should include plans for how new ventures will be added to the structure in the future.

5. Governance and Buy-Sell Structures

Before updating the senior-generation owners’ estate plans with respect to the allocation of ownership among their beneficiaries, and before the senior-generation owners make additional lifetime transfers of ownership interests to members of the junior generation (or trusts for them), counsel should help the clients design the rules that will regulate governance, ownership, and owner exits after control has transitioned down from the senior generation. This includes four topics, which can be addressed in the business’s governing documents and agreements among the owners.

a. Unit Voting

The power to exercise owners’ voting rights primarily includes the power to appoint (or remove) board members and approve (or veto) major transactions. The clients should consider who should have the right to exercise owners’ voting rights. In some cases, voting units can be held in trust, to be voted by a fiduciary or a committee of fiduciaries, or the owners can sign agreements about how they will vote their units on particular issues. Governing documents can also be drafted to increase the scope of actions that require owner approval.

b. Governing Board

Members of a governing board, acting collectively, usually have the following powers: power to appoint and remove top executives and determine their compensation; power to issue dividends; and power to oversee budgets and long-range business planning, risk management, and strategic planning. The clients must decide how the board will be composed and how board members will be elected. Clients should consider the advantages of requiring an independent presence on the board, especially after members of the senior generation exit the business. Under most default rules, each board member is elected by plurality, but it may be desirable to “classify” the board so that each substantial owner can have one or two seats on the board. Governing documents can also be drafted to increase or decrease the amount of actions that the board can authorize without approval of the owners.

c. Executive Authority

Executives and officers have power and responsibility to run the day-to-day business, hire and terminate staff, develop budgets and plans for approval by the board, and sign checks and contracts, including loan agreements (within limits set by the board). While senior-generation owners are alive and competent, their status as patriarchs or matriarchs may naturally enable them to help their children and grandchildren make decisions about executive authority and compensation among family members, but after they are gone, the business’s owners and board must have a way to make decisions about the appointments, titles, duties, and compensation of family members that will be fair and will not disrupt family harmony.

d. Beneficial Ownership

Owners of business equity (which can be referred to as “beneficial owners” when considered apart from the power to vote the ownership interests (discussed above)) have the right to receive profits and appreciation from business operations. (Note: If the owners are also employees, they may receive most of their annual economic return in the form of compensation.) The clients should consider whether nonemployee family members should own shares and whether shares should be held in trust (primarily to protect them from estate taxes and claims of creditors or in the event of divorce). The clients should also decide upon mechanisms for owner exits that are fair to the exiting owners but are not disruptive to the business. The acquisition, ownership, and transfer of ownership interests, including redemptions triggered by retirement or other separation from employment at the business, should be drafted into updated governing documents.

It should be noted that although the business’s governing documents can provide the legal rules by which the business is governed and owned, the clients should also consider developing a family constitution, mission statements, and other policies that will guide decision makers when they apply the legal rules. The business’s legal documents cannot express the spirit and philosophy of the family as effectively as the principles that family members write in plain English and agree together to uphold.

6. Key Contracts

The attorney should help the clients negotiate restatements of key contracts with third parties that should (or must) be updated to be more consistent with business restructuring and anticipated changes of control or ownership. Such contracts include loan facilities and franchise/dealership agreements. The extent to which such contracts cannot be changed may affect decisions about how or when to implement other elements of the business succession plan.

The clients should also consider whether written contracts for related-party transactions would make the succession plan more effective. Such contracts may include the following: leases between the operating business and family-owned entities that hold real estate or equipment used by the operating business; debt instruments for loans from owners to the business; reimbursement/contribution agreements among the business and the owners who have personally guaranteed business debt; and employment agreements for family members who work for the business.

7. Update Senior-Generation Owners’ Estate Plans

The attorney should update the senior-generation owners’ estate planning documents, including wills and revocable trusts, consistent with business restructuring and decisions that the clients have made about future governance structures and ownership rights. Updates should address the following: specific allocation of stock/unit voting rights; specific allocation of beneficial interest in business equity; disposition of other important business and personal assets; specific use of life insurance proceeds; the source of funds needed to pay estate taxes; and the structure, funding, and amount of charitable bequests.

8. Plan for Senior-Generation Owners’ Retirement

Before the senior-generation owners transfer control and substantial equity interests to the junior generation, counsel should work with the senior generation and their financial advisors to help ensure that senior-generation members will have sufficient economic means to support them indefinitely in retirement (or in the event of disability). In particular, counsel must seek means of support, cash flow, and assets for retirement that are not dependent on the success of the next generation of owners of the family business. Although plans like unfunded deferred compensation, private annuities, or seller-financed redemptions may look good on paper, they may place disproportionate risk on members of the senior generation when they are no longer in a position to affect business outcomes.

9. Lifetime Transfers to the Next Generation

Ideally, the senior-generation owners will be able to oversee the transition of leadership and ownership of the family business to the next generation through lifetime transfers, rather than rely on post-mortem contingency planning. Counsel should work with the clients’ accountants to design lifetime transfers that are tax efficient, but the attorney should not sacrifice the financial well-being of the senior generation in a blind rush to redistribute wealth to avoid estate taxes. In most cases, a combination of diverse approaches to estate tax planning can give the clients time to implement a family business succession plan at a pace that makes business sense and is more likely to meet the long-term economic needs of the senior-generation owners and their successors.

Conclusion

Family business succession planning is complicated because it requires the clients to make many difficult decisions out of context. However, by providing the clients with an outline or blueprint of the entire process at the beginning of the representation, and by keeping that outline updated as decisions are made and projects are completed, counsel can make the process more effective, more efficient, and ultimately more successful.

Further, like a blueprint for building a house, the outline provides direction for original construction, but it does not foreclose the possibility of future modification, renovations, or improvements. As the authors of the PWC survey advise, “[O]nce a plan has been put into place, it shouldn’t be treated as a one-time event. Good succession planning involves a series of intentional, well-coordinated, strategic efforts, sustained over time . . . .”

Due Diligence for Family Business Succession Planning

At the start of a new representation with respect to family business succession planning, counsel should identify the clients’ key advisors, including accountants, financial advisors, and insurance agents. The attorney must ask the clients and their advisors for the following documents and information:

    1. Business Governing Documents. For the primary business entity and each, other family-owned entity, the following documents (including amendments):
      1. Articles of Incorporation/Organization
      2. Bylaws
      3. Shareholders’ Agreement/Operating Agreement
      4. Voting Agreements or Voting Trusts
      5. Table of current ownership
    2. Related-Party Contracts.
      1. Leases or other agreements between the business and any other family entity
      2. Any employment contracts with family members
      3. Any deferred compensation or other nonqualified retirement benefit contract between the business and a family member
      4. Any personal guarantees of the business debt
    3. Estate Planning Documents. For the senior-generation owners, the following documents:
      1. Wills
      2. Revocable Trust or Trusts
      3. Irrevocable Trust or Trusts (if any)
      4. Marital Property Agreement (if any)
      5. Powers of Attorney for Health Care
      6. Powers of Attorney for Financial Matters
    4. Business/Asset Valuation.
      1. Most recent formal or informal valuation of the business
      2. Most recent indication of value of business assets (and statement of balance of any mortgage debt)
      3. All substantial loan facilities for business debt and related security documents
    5. Senior-Generation Owner Financials.
      1. Statement of assets and liabilities
      2. Summaries of retirement plan assets and benefits, including Social Security, deferred compensation, and any pensions
      3. All contracts of insurance on the life of any senior-generation owner, including policy owner, beneficiary designations, pledges or assignments, and in-force illustrations
    6. Family Governance Documents.
      1. Family constitution, family mission statement, family employment policy, family counsel charter
      2. Family (charitable) foundation documents, donor advised fund contracts, or other collective charitable giving information

FINRA Delays Required Collateralization of TBAs and Other MBS Forwards

Posted on January 15, 2018 by - Uncategorized

On September 19, 2017, the Financial Industry Regulatory Authority, Inc. (FINRA) filed with the Securities and Exchange Commission (SEC) a proposed rule change to delay until June 2018 the implementation date of certain amendments to FINRA Rule 4210. When the amendments to Rule 4210 are implemented, they will require the collateralization of many forward transactions involving mortgage-backed securities (MBS). The proposed rule change  effectively pushes back the date for compliance with Rule 4210’s collateralization requirements from December 15, 2017, to June 25, 2018.

Before FINRA’s decision to delay the implementation of Rule 4210’s margining requirements, the impending effectiveness of those requirements led market participants to rush to update their documentation for their MBS forward transactions. In its proposed rule change, FINRA stated that industry participants had requested additional time to amend their contractual documentation and to make required systems changes as necessary to come into compliance with amended Rule 4210. FINRA noted that it had received questions regarding the implementation of Rule 4210’s collateralization requirements, had engaged in extensive discussions with industry participants and other regulators, and had made available a set of Frequently Asked Questions to facilitate market participants’ compliance efforts.

When revised Rule 4210 goes into effect, it will require margining of “Covered Agency Transactions,” a term that includes (i) “To Be Announced,” or TBA, transactions in certain securities where the parties agree that the seller will deliver to the buyer securities representing a pool or pools meeting certain criteria, but the specific securities to be delivered at settlement are not specified at the time of execution, for which the difference between the trade date and contractual settlement date is greater than one business day; (ii) “Specified Pool Transactions” in certain securities that are specified at the time of the execution, for which the difference between the trade date and contractual settlement date is greater than one business day; and (iii) transactions in certain collateralized mortgage obligations for which the difference between the trade date and contractual settlement date is greater than three business days.

Rule 4210, when its amendments are implemented, will require differing amounts of margin depending on the types of market participants that are parties to a transaction. For transactions between a FINRA member and an “exempt account,” such as a registered broker-dealer, Rule 4210 in many cases will require the member to collect margin corresponding to changes in mark-to-market value (that is, variation margin). In contrast, in relation to transactions between a FINRA member and other, “non-exempt” accounts, Rule 4210 in many cases will require the member to collect both margin based on changes in mark-to-market value and “maintenance margin,” generally defined as 2 percent of the contract value of the relevant net “long” or net “short” position. As amended, Rule 4210 will in each case place the obligation to collect margin solely on the FINRA member, although it will contain no prohibition on “two-way,” or reciprocal, margining for MBS forwards.

Most market participants have opted to update their documentation for MBS forwards by means of the Master Securities Forward Transaction Agreement published in December 2012 by the Securities Industry and Financial Markets Association. The Treasury Market Practices Group, an industry group sponsored by the Federal Reserve Bank of New York, helped to spur the move toward collateralizing such forward transactions starting in 2012, when it recommended margining such transactions to reduce counterparty and systemic risks.

Corporate Governance and Information Gaps: Importance of Internal Reporting for Board Oversight

Posted on January 15, 2018 by - Uncategorized

Introduction

The evolution of corporate governance and board of directors’ responsibilities continues. Recent years’ actions of shareowner activist groups and securities regulators—and reports of shareowner votes in corporate annual meetings thus far in 2017—provide many indications of ongoing growth in public expectations for the roles and performance of corporate boards of directors.

The existence and responsibilities of specialized committees on boards of directors have also continued to evolve. In addition to long-established types of board committees such as the audit, finance, compensation, risk management, and nominating and governance committees, we now see committees being formed to address such issues as science, technology and innovation, cybersecurity, health, safety and security, environment and sustainability, regulatory compliance and public policy, and other contemporary concerns. While these topics are all valid issues to consider in the oversight of today’s corporations, one wonders how many committees one board of directors can effectively administer and support. And how can numerous board committees successfully monitor corporate issues and developments and report on these matters in periodic board meetings?

In the face of growing expectations, further questions arise regarding whether boards today are receiving and utilizing adequate information and support to address their oversight responsibilities. It seems that nearly every week brings another news report about a breakdown in corporate ethics and controls as well as performance failures across a wide range of industries.

Recent events at Volkswagen and the public blowup at a well-known and seemingly successful “new economy” company, Uber, leading to the resignation of its co-founder and CEO, are two notable examples. The total fallout and remedies for these and other performance and governance failures are yet to be fully determined.

Upon reading about each new incident, one is prompted to ask, how could the directors in these companies not have been aware of serious problems? Did something go wrong in communications and information flows that let this happen?

Somehow, somewhere, it seems evident that there must have been some serious gaps in information supplied to the board, or possibly in board understanding and reactions to such information.

A deficiency in information supplied to boards calls into question whether boards today are in fact able to serve as an effective check and balance in the governance of public corporations.

Over the years, courts and eminent legal authorities have repeatedly emphasized the significant responsibilities of boards for oversight of the management of public companies. In the words of former Delaware Supreme Court Chief Justice E. Norman Veasey, stockholders should have the right to expect that “the board of directors will actually direct and monitor the management of the company, including strategic business and fundamental structural changes.”

Delaware Supreme Court Chancellor William B. Chandler also noted the significant oversight role of the board in his widely publicized opinion in the Disney Corporation Shareowner derivative suit concerning the hiring, compensation, and firing of Michael Ovitz. Chandler stated, “Delaware law is clear that the business and affairs of a corporation are managed by or under the direction of its board of directors. The business judgment rule serves to protect and promote the role of the board as the ultimate manager of the corporation.”

The “ultimate manager of the corporation”—those are very strong words. Some might debate the terminology, preferring instead a phrase like “the ultimate overseer of the corporation.” But whether one uses “ultimate manager” or “ultimate overseer” as a designation, it is clear that a board of directors has significant responsibilities for the welfare of the corporation and its stakeholders.

Serving as an “ultimate manager” or “ultimate overseer” requires appropriate information flows to support that role. While there are different types of information flows, this article will focus on financial information supplied to boards of directors. We will also discuss two types of information gaps —quantity and quality—that can make it difficult for board members to carry out their oversight responsibilities.

Quantity of Information—How much is the right amount? Who decides?

In considering quantity, we must first ask these questions: how much information is needed for an oversight body to perform its functions, especially for a board or a board committee with a critical role in ensuring the welfare of the corporation and the interests of its shareholders? How much information is it realistic to expect a part-time body composed mostly of people from a range of industries, institutions, and professions, that typically meets four to six times a year, to absorb and act upon?

Who decides what data elements will be in the directors’ regular information package supplied for the board’s periodic meetings? And who decides when special circumstances warrant additional information, and what that information should be? How involved are board members in determining and specifying how much information they will receive for various purposes, when, and in what form?

Commonly, when a company is established, the founders and sponsors will work with the initial senior management to lay out a proposed structure for its board, including the board committees that will exist therein and the charters for those committees. The company’s management will develop and offer up what they believe to be an appropriate information package for periodic board meetings. Then as time progresses, board members and board committees will ask for whatever else they think they need to carry out effective oversight.

Issues that may subsequently arise include situations in which different directors may have different views on the amount of information they should receive, creating a need for agenda management, customized information support, or other measures. And changing circumstances, special events, and unexpected conditions may suddenly create a change in the quantity of information needed—as in the case of an unexpected (and possibly unwelcome) tender offer for the company’s stock, or when an unexpected corporate crisis occurs.

A sizeable amount of routine and ongoing financial information to be supplied to boards is mandated by regulators of public companies such as the Securities and Exchange Commission and the stock exchanges. Beyond these mandates, the issue of optimum quantity and optimum design of board information is to be determined by each organization. In answering the question, board committees today often utilize the services of outside counsel and other advisors to identify the information that they should be requesting to support their oversight obligations. They may also use external service providers to assist in performing assessments of internal board processes on a periodic basis.

Quality of Information Supplied to the Board—Issues in Measuring Financial Performance

A next question is “what kind of information is needed?” In regard to quality of information, one must consider the nature of the information being supplied, what matters are covered, and how understandable the information is. The timeliness of information is also important. On one hand, board members will want to receive information sufficiently in advance of a meeting to review and absorb it properly. On the other hand, sometimes last-minute developments can affect information previously provided, and there will be a need to ensure that directors receive up-to-date information.

Common components of board information include information about an organization’s market and business strategy, risk management, measures of financial and operational performance, control structures, management processes, and human resources issues. All of these components of information are important. In particular, providing the right kind of financial information is an essential part of overseeing a company’s performance and prospects.

The design and use of financial and operational measures can be complex. For a publicly held company, a first obvious requirement for financial information to be supplied to the board is the company’s external financial statements and disclosures reported to investors, for which board review is mandated by securities regulators. These financial statements and disclosures are prepared in accordance with generally accepted accounting principles (GAAP) and supplemented by additional information required by regulators. The information mandated by GAAP and regulators is both voluminous and complex.

GAAP financial statements are widely used, important, and necessary, but they are not sufficient to oversee and manage a specific business effectively.

GAAP financial statements are the end product of elaborate and lengthy national and international standards-setting processes that are designed to achieve consensus among professional accountants, investors, and other stakeholders on how best to portray the value and performance of reporting entities across companies and industries. The resulting body of knowledge utilizes a very broad spectrum of concepts, principles, and rules.

GAAP accounting standards represent the eminent thinking and careful deliberation of many experts. The standards are important for broad cross-company use, as they seek to provide a uniform benchmark for external comparisons by investors. Yet despite the rigor underlying their preparation, GAAP financial statements are inadequate for understanding and running a particular business at a particular point in time, because they are static and often complex and inflexible.

Economic theory tells us that the division of labor is specific to an organization at a point in time. Similarly, corporate governance structures and processes, and operational needs and priorities, are specific to a firm at a point in time. The oversight responsibilities of boards of directors constitute an important check and balance in an organization’s ongoing governance structure and operational control system, and such a control system must consider more than GAAP financial statements. Boards require information that is relevant to addressing their oversight responsibilities, and information that is clear and understandable.

Boards regularly receive information provided to them by management. If this information primarily takes the form of GAAP financial data, it is likely that they are not obtaining a full picture of the business. In order to oversee, understand, and run a business effectively, one needs to look at performance measures in addition to GAAP. This need has led to custom-tailored internal financial reporting measures used by management and directors of an enterprise. Such internal reporting can be a flexible system, portraying not only standard recurring measures used by management but also selected aspects of operations of particular importance at one time or another. Internal reporting can make certain adjustments to results to consider unit-controllable results and thereby provide additional context and insight into the performance of both business units and the total company. Internal unit reporting may focus on actual versus budgeted cash flows more than unit gross profit or accounting net income.

Non-GAAP Measures in External Reporting

Because adjusted “Non-GAAP” results can be illuminating and useful to management and directors, some measures may be reported externally to the public and investors, as well as inside the business. However, Non-GAAP measures used in external reporting have at times been challenged by regulators as misleading to investors, on the basis that such measures were portraying only “good news” and/or were obscuring less favorable performance. There is a substantial body of information from the U.S. Securities and Exchange Commission providing guidance on proper use of Non-GAAP measures in external reporting and also describing SEC enforcement actions for misuse. On the international front, the International Organization of Securities Commissions, a worldwide body of securities regulators in both developed and emerging markets, has also issued pronouncements about Non-GAAP reporting. Entry of “Non-GAAP” in the search boxes on these organization’s websites, www.sec.gov and www.iosco.org, will bring up a host of documents providing guidance about what is and is not considered acceptable for public reporting of such measures.

This article will not attempt to cover the subject on Non-GAAP further beyond making these two statements: (1) Non-GAAP measures have a useful and legitimate place in reporting about a business, both internally and externally, but care must be taken so they do not mislead investors and other users. (2) A company’s board of directors would be well-advised to understand how a company’s Non-GAAP measures are developed and used, and why they are viewed as meaningful in assessing corporate performance. In particular, it is advisable for a board to understand any corporate use of measures that have been challenged by regulators, such as “free cash flow” or “net income excluding the effect of one-time charges,” when used in external reporting to investors. The latter has at times been challenged because the label “one-time” is debatable if such charges have occurred repeatedly, as is sometimes the case with restructuring charges.

Using Internal Reporting Design and Cash Flow Monitoring to Understand and Manage Effectively

Ideally, an organization’s internal reporting should identify and illuminate the relevant elements of financial and operational performance that are important to the company’s success. A good design for internal reporting can also be used to encourage the behaviors and actions that contribute to company success. However, there is an important caveat to be observed when using internal reporting for performance incentive purposes: a design for internal reporting and incentives that fails to consider risks that exist and controls that need to be present can have disastrous consequences.

The design of a company’s internal reporting system to managers and directors is inherently unique to each company. Guidance can be gleaned from benchmarking and understanding the approaches used in peer companies and others and from business publications, but ultimately each company must find its own best design to assess and understand performance. And a best design often needs revision over time, in light of changing needs and circumstances.

Cash Flow Monitoring—A Key Measure of Performance

An important part of performance measurement that sometimes receives insufficient attention in internal reporting to a company’s board of directors is cash flow monitoring. Cash flows are the lifeblood of a business. Not for nothing do we often hear the phrase “cash is king.”

Understanding how to interpret cash flows and monitoring cash closely is essential for overseeing and managing a business. Whether a business is a large, multinational, mega-billion-dollar corporation, a mid-size public or private company or partnership, or a small owner and founder-run enterprise, failure to track and manage cash flows effectively can seriously disrupt or even bankrupt a company. Cash flows can be effectively measured in a timely manner, and a comparison of budgeted to actual receipts and disbursements can often give a much clearer financial picture than reported revenues and expenses and net income on a GAAP income statement. Discussions on the causes of cash flow variances can uncover problems and opportunities without need for approximations or adjustments. The cash flows either did or did not occur within the particular time period.

Operational and capital cash flows are concrete results not easily subject to manipulation. Thus, they can serve as a safeguard against efforts to manipulate income through revisions in accruals or reclassifications of operating expenses to capital expenditures. They also can avoid misunderstanding of results that include unbudgeted one-time charges or have been adjusted to exclude such charges. Accurate cash flow information can also help to highlight possible weaknesses in controls and negative developments not readily apparent in income statement measures, as in a case where a strong corporate emphasis on customer sales growth, combined with a relaxing of the company’s product financing and credit-granting controls, may be increasing risk to an unacceptable level, for example.

Company CFOs, treasurers and controllers should work together to devise appropriate internal processes and teams for budgeting and measuring cash flows and analyzing anomalies – and for explaining cash flow information to the board in an understandable manner. Relevant board committees such as the Finance Committee, Audit Committee, and Nominating and Governance Committee will have a significant interest in receiving such information in their check-and-balance and governance roles. Internal audit and the external auditor may also provide input to enhance controls and accuracy.

Cash flow information can be very complex; for example, the Statement of Cash Flows that is presented in GAAP is viewed by some as arcane and difficult to understand. However, through effective internal measurement and reporting, companies can develop effective methods for presenting cash flow data and interpreting it for the board. For a more detailed discussion on cash flow monitoring and reporting, including a model for presenting such data, the reader is referred to an earlier article on this subject by one of the authors—see “Cash Flow Monitoring as a Governance Tool” in THE CORPORATE BOARD, March/April 2010.

Corporate and Director Obligations for Public Reporting and Disclosure

Since the passage of the Sarbanes-Oxley Act and the later Dodd-Frank Act, many obligations have been created for public company reporting to investors, and also for board of directors’ review of such reporting. Extensive and explicit documentation of such requirements exists in regulatory pronouncements and business and professional publications. Less explicitly defined are the requirements pertaining to board review of financial information that could influence an investor’s decision to buy or sell stock in a company—what is termed “material information” by the SEC and other regulators– as that information arises. For example, what are the obligations of a director who becomes aware of material information in board meeting discussions that the company’s executives do not feel is yet ready to be disclosed to the public? Consultation with corporate counsel may be needed in such situations.

Appropriate and timely reporting to investors is the direct obligation of a public company’s management. However, board oversight of this important obligation also requires a degree of knowledge about what should be done and when. A detailed discussion of this subject is beyond the scope of this article; however, it is a matter for which directors can request explanations from a company’s CFO, auditors, and general counsel.

Conclusion

Today’s boards of directors live in a time of growing oversight responsibilities and expectations. The likelihood of meeting these expectations can be enhanced if board members have a clear understanding of a company and its financial performance, cash flows, and prospects. Gaps in financial information can undermine a board’s ability to perform its role as an important check and balance in the governance and operation of the company. A well-designed internal reporting system for measuring and reporting financial performance, coupled with vigilant and active board interest, supports board effectiveness in carrying out oversight responsibilities. Well-designed internal financial reporting processes and cash-flow monitoring are important components of an effective board information system.

Spotlight on In re Fair Finance Co., 834 F.3d 651 (6th Cir. 2016)

Posted on January 15, 2018 by - Uncategorized

When the parties to a contract agree to alter the contract’s terms, the common law sometimes needs to classify the change as either an amendment or a novation, and this classification depends heavily on the intent of the parties. In this case, a trustee in bankruptcy convinced an appellate panel to indulge in unwarranted speculation about the parties’ possible intent to novate, thereby forcing a lender through a trial on the merits on whether its security interest should be avoided.

Textron Financial Corp. was the lender to Fair Finance Company, which turned out to be the operator of a Ponzi scheme. The lending transaction involved two sequential sets of loan documents: the first was executed in 2002, and the second—describing itself as an amendment and restatement of the first—was executed in 2004. During the interim, Textron had become aware of at least some of Fair Finance’s misdeeds, and after 2004 Textron was paid off in full. Later, as part of an involuntary bankruptcy proceeding, the trustee argued that the security interest provided by the 2004 loan documents was an actual fraudulent transfer. (The statute of limitations for a constructive fraudulent transfer cause of action had already passed, held the court, in a departure from other recent rulings.) To prevent the collateral from being held excluded from the UFTA’s definition of an “asset” that is subject to “transfer,” the trustee argued that the 2004 documents were a novation of the 2002 documents, rather than a mere amendment thereof, meaning that the collateral was not already encumbered by the lien of the 2002 documents. Textron moved to dismiss the trustee’s claim, and the district court (acting on a withdrawal of the reference) granted Textron’s motion, holding that the 2004 documents were an amendment rather than a novation as a matter of law. The Sixth Circuit reversed, finding a triable issue of fact on the parties’ intent to novate.

The grounds upon which the Sixth Circuit found this a triable issue of fact were weak. First, the 2004 documents provided that they constituted “the entire agreement of [the parties] relative to subject matter hereof.” This clause is a routine measure to prevent the undermining of the agreements by parol evidence, and accordingly should not be considered evidence of a terminating of the 2002 documents. Next, the 2004 documents included their own promissory note and personal guarantees rather than relying on the ones from 2002. But this appears to have been an instance of careful although duplicative documentation, engaged in to avoid interpretive questions that otherwise might have arisen about the continued efficacy of the 2002 note and guarantees. And third, and relatedly, the court found it potentially probative of novation that the 2004 documents were entered into on the very date that the 2002 documents expired. Yet this fact more readily supports – if anything – an intent to amend rather than an intent to novate: after all, with the 2002 documents coming to an end under their own terms, the parties had no need to terminate them.

The Sixth Circuit also faulted Textron’s lawyers for, in effect, not using both a belt and suspenders. The district court, in its opinion below, had found some support in a Florida case, In re TOUSA, Inc., 2011 WL 1627129 (S.D. Fla. March 4, 2011), in which a second set of documents had explicitly recited the parties’ intent that the lien of a first set would remain in full force and effect. By contrast, noted the Sixth Circuit here, the 2004 documents in this case had no such clause. It is troubling that the court found fault with the documentation for omitting this single clause (which concededly would have been a helpful inclusion), while at the same time misunderstanding the clauses that the documentation did carefully include. More fundamentally, avoidance-of-doubt clauses like the one in TOUSA are called “belt and suspenders” for a good reason: the extra clause, like the extra clothing device, is there to make sure that even if one or the other somehow doesn’t do its job, the pants will still stay up.

The point of a novation is typically to substitute one party for another. (For example, an obligee may agree to a novation in which an original obligor is discharged and a delegate commits to perform instead.) In this two-party setting there is no apparent reason why Textron, which clearly benefited from good legal advice and would have appreciated the importance of a continuing security interest, would have actually intended to novate rather than amend. Moreover, as a matter of sound jurisprudence, the distinction between novation and amendment should probably be ignored altogether on facts like these, for even if it is possible to conceptualize an instant of time elapsing between the discharge of one security interest and the attachment of the second, a technicality such as that is not a reason for judicially triggering momentous substantive consequences. Of course, the Sixth Circuit might have wanted to keep an arguably tainted lender from propping up a Ponzi scheme and then walking away from all of the losses; but other viable causes of action in this case, including civil conspiracy and equitable subordination, would have been much more appropriate vehicles for imposing losses on Textron. Perhaps, on remand, the district court would stick with its initial finding that the parties intended to amend rather than novate; but even in that event, this Sixth Circuit precedent will cast an unnecessary shadow over future perfectly sound transactions.

Why Blockchain Is More Important to Lawyers Than They Probably Understand

Posted on January 15, 2018 by - Uncategorized

Introduction

Laws in the United States have evolved to be technologically neutral, so that laws won’t dictate what technology to use, but rather mandate the attainment of a legal “end state.” In other words, laws will make clear that chain of custody, authenticity, completeness, immutability, veracity, privacy, and security are vital to compliance, but they won’t dictate how to attain it. That way, companies and individuals are free to buy or build whatever technology makes business sense and aren’t trapped into using a technology as it becomes obsolete. For example, the Health Insurance Portability and Accountability Act (HIPAA) Security Rule’s major goal “is to protect the privacy of individuals’ health information while allowing covered entities to adopt innovative technologies to improve the quality and efficiency of patient care.”

While laws won’t tell organizations what to buy, there are technologies that are worth exploring by lawyers because it helps attain authenticity, integrity, completeness, transparency, etc. One such technology is blockchain. Before I tell you why it holds so much promise for lawyers and others as well, it’s worth revisiting what it is and what it isn’t.

What is Blockchain?

For starters, blockchain is a technically complex system based on math, algorithms, and encryption. “The blockchain uses public key cryptography to create an append-only, immutable, timestamped chain of content.” (IEEE. A Case Study for Blockchain in Healthcare: “MedRec” prototype for electronic health records and medical research data. August 2016.) In contrast, the explanation that follows is simple and will likely make you want to learn more and at a deeper level. If you have heard about blockchain, it may be in the context of Bitcoin, but they are not synonymous. While blockchain is the technology behind many cryptocurrencies, like Bitcoin, blockchain technology holds promise for many other applications including real estate deals, portable secure health records, and financial transactions.

According to Gartner, technology analyst firm, “Blockchain is a type of distributed ledger in which value exchange transactions (in bitcoin or other token) are sequentially grouped into blocks. Each block is chained to the previous block and immutably recorded across a peer-to-peer network, using cryptographic trust and assurance mechanisms.”   

How Does Blockchain Technology Work?

Unlike a traditional clearinghouse, a blockchain implementation does not depend on just one entity to maintain the ledger of transactions. Blockchain depends on many independent third parties—miners—who compete to both verify each transaction and be the first to solve a math problem in exchange for payment. It is each miner’s responsibility to maintain an independent, often public memorialization of the transaction on the ledger of the chain (“block”) of transactions. The verified chain of transactions is derived when a majority of the thousands of anonymous, independent ledgers match. The use of distributed, anonymous, self-interested arrays of verifiers helps make bitcoin very hard to subvert. It would require collusion between 51 percent of miners, who likely don’t know each other, to perpetrate a fraud.

Transactions are executed within the blockchain environment and thereafter are aggregated in blocks, which are retained forever and are constantly revalidated with new transactions memorialized in new blocks. Similarly, there is a third-party retention of salient evidence of transactions, and validation of transactions. The chain of blocks, all verified, connected with hashes, and time-stamped accordingly, show the exact time the transaction took place, as well as the time of each subsequent verification. All this adds integrity to the blockchain process.

Like any technology, however, blockchain is not without its technical limitations. First, the database for “public” blockchain transactions, in which all transactions are stored, is public and not “owned” by an individual to the transaction. Private blockchains do exist but have limited personal use. When using a public blockchain, only the individuals involved in a transaction have access to all the information, including certain private information about the transaction, but the transaction and select information related to it is available to the public. Another issue is the need to rely on a third-party computer and entities to document transactions. Normally, business between two parties is limited to the systems controlled and used by the parties to the transaction. These uninterested, anonymous third parties have no stake in altering or hacking information; in fact, it is in their best interest to validate only real transactions in order to receive the transaction fee. Errors in effectuating and validating transactions will happen, though given the algorithmic nature of the process, they should be very limited.

Future Use That Should Matter to Lawyers

Blockchain is a transformative technology that is possibly revolutionizing various industries and business processes. Beyond its potential for securely transacting business and transferring money, there are many other business activities that would benefit from its use.

For example, “[t]he Pentagon and U.S. NATO allies have been moving discreetly but aggressively in recent months to develop military-related apps exploiting the capabilities of blockchain. NATO is considering the technology to improve efficiencies across such traditional processes as logistics, procurement and finance . . . if ‘significant portions of the [Defense Department] back-office infrastructure can be decentralized,’ DARPA wrote, “‘smart documents and contracts’ can be instantly and securely sent and received, thereby reducing exposure to hackers and reducing needless delays in DoD back-office correspondence” (Washington Times, 2017). The reason lawyers care is that the various uses of blockchain make better business evidence, promote the discovery process, and provide a risk-mitigated way to execute various types of business.

Help with Ownership

Blockchain can be useful for transactions involving proof and chain of title, ownership of property, or identity of a person. Because the ledger is an ongoing, validated, and secure log of all things that have happened, perhaps going all the way back, ownership can be known with exactitude.

Help with Secure Life-long Medical Records

Blockchain records similarly hold promise for the medical industry as Personal Identifiable Information that could be properly encrypted and securely stored in the Cloud for long-term access by authorized medical professionals and the patient alike. According to Brian Forde, editor of MIT Media Lab Digital Currency Initiative, “By putting your health records into a blockchain-managed system, you and your doctor should not only be able to update and review your medical information in real time, but also know it has been held securely.

A novel design feature of MedRec is the way records are validated and added to the blockchain. The miners for MedRec are medical researchers who are rewarded with access to census-level data of the medical records.”

Perhaps most intriguing is that Blockchain records can be securely stored, accessed, and shared over the lifetime of the patient with multiple providers. That allows medical records to have portability, longevity, and security that promotes care and treatment over the life of the patient.

Help with Disaster Recovery Backup

Blockchain could also be useful as a means to back up important information from an organization’s servers in much the same way as using a Cloud provider today, with differences related to its public facing and distributed technology design. With encryption, the content could be scrambled and securely stored in a third-party location that could be made available in the unlikely event of a disaster that requires information to be restored. In today’s information security environment, such protections may be more and more essential.

Help with Litigation Discovery

The litigation process could be greatly enhanced if ESI were blockchain records in that they would be “self-authenticating”; stored publicly, which would add to their integrity; and would be complete as they are captured real-time in total and validated as part of the blockchain process. Further, if managed in the blockchain environment overtime, chain of custody would be known and easier to demonstrate if challenged.

Help with Transactions Between Devices in the Internet of Things

With the exponential growth of transactions between smart devices, called the Internet of Things (IoT), traditional intermediaries like banks won’t be able to handle the volume of transactions. Here, too, Blockchain can execute and track such transactions. Many companies are testing out the utility of blockchain and IoT, from security to storage management.

Conclusion

Whether it’s secure real estate transactions, chain of custody, smart contract, multi-party agreements, or UCC filings, blockchain may be a gamechanger. According to the Harvard Business Review, “It can validate—and secure—almost anything. From voter authentication to government processes, health information, and proof of intellectual property, Blockchain can serve as a secure process to validate almost anything of value, and to keep it safe.”

While Bitcoin and other cryptocurrencies may wither away, blockchain is here to stay. U.S. law will likely never dictate that Blockchain be used, but, depending on the business being transacted, there are lots of reasons to see if it can make electronic business happen “faster, better and cheaper,” while being legally compliant.

Public Policy Prohibits Contractual Restrictions on an LLC’s Right to File Bankruptcy

Posted on January 15, 2018 by - Uncategorized

Generally, public policy prohibits attempts to contract away the right to file bankruptcy, and a string of recent decisions confirms this principle in the context of limited liability company (LLC) operating agreements. In September, the U.S. Bankruptcy Court for the Eastern District of Kentucky held that provisions of an LLC operating agreement that were added incidental to the closing of a commercial loan served no purpose other than to frustrate the LLC’s ability to commence a bankruptcy case, and were thus unenforceable. In re Lexington Hosp. Grp., LLC, 2017 WL 4118117 (Bankr. E.D. Ky. Sept. 15, 2017). In short, the applicable provisions gave the lender the ability to block a filing. Notwithstanding state law policy of freedom of contract in LLC agreements, the bankruptcy court observed that enforceability of bankruptcy restrictions is a matter of federal law. The court’s holding follows two other recent decisions similarly voiding restrictions on bankruptcy rights. See In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016); In re Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).

In Lexington Hospitality, the LLC’s original operating agreement contained no limitations on its manager’s and/or members’ ability to file bankruptcy on the LLC’s behalf. The LLC later executed an amended operating agreement (the Agreement) in connection with its acquisition of a hotel which granted the lender a 30 percent equity stake until the loan was fully repaid. The Agreement also provided for the appointment of an “Independent Manager” and vested the sole discretion to file bankruptcy on behalf of the LLC in that person: (i) “The Company may declare bankruptcy only so long as the Independent Manager authorizes such action” and (ii) “In order for the Company to declare Bankruptcy or dissolve and liquidate its assets, the Independent Manager must provide authorization, and then only upon a 75% vote of the Members.” 2017 WL 4118117 at *3. The Agreement set forth a list of nine requirements that attempted to preserve the Independent Manager’s independence. It then limited the Independent Manager’s ability to act, vote, or otherwise participate in any LLC matters other than to consent to file bankruptcy. The Independent Manager was instructed to consider the interests of the LLC in acting or otherwise voting, as well as the interests of creditors and the economic interests of a minority member that was controlled by the lender. The Agreement also eliminated any fiduciary duty or liability that the Independent Manager might have to other members or managers. And, the Independent Manager’s role terminated upon repayment of the loan.

An addendum to the Agreement contained a further restriction on the LLC’s right to file a bankruptcy petition: “[The LLC shall not file bankruptcy] without the advance, written affirmative vote of the Lender and all members of the Company.” That provision directly conflicted with the Independent Manager provisions, which required only a 75 percent vote of the members.

The LLC filed a petition for Chapter 11 relief signed by its manager pursuant to a corporate resolution authorizing such action. The resolution disclaimed any knowledge as to the contact information or whereabouts of the Independent Manager and did not indicate a member vote was taken. Three days later, the lender filed a motion to dismiss the bankruptcy case, arguing that the Agreement’s bankruptcy restrictions were not followed.

In analyzing the Agreement’s enforceability, the bankruptcy court first noted that “state law governs whether a business entity is authorized to file a bankruptcy petition.” Kentucky law permitted the LLC’s member to do so, absent the Agreement’s restrictions in favor of the lender. The court then turned to federal law and public policy to determine whether the restrictions were enforceable.

Federal Public Policy Against Bankruptcy Restrictions

 Parties to an operating agreement generally have the freedom to contract limited only by the parameters in the relevant articles of organization and statutory law. But there is a strong federal public policy in favor of allowing individuals and entities their right to a fresh start in bankruptcy. Thus, cases discussing bankruptcy restrictions in LLC operating agreements usually begin with the uncontested premise that entities, like individuals, cannot contract away access to bankruptcy relief. See, e.g., In re Squire Court Partners Ltd. P’ship, 2017 U.S. Dist. LEXIS 105032, at *9 (E.D. Ark. July 7, 2017); Lake Michigan Beach, 547 B.R. 899; Intervention Energy, 553 B.R. 258; In re Bay Club Partners 472, LLC, 2014 WL 1796688, at *1 (Bankr. D. Or. May 6, 2014); Continental Ins. Co. v. Thorpe Insulation Co., 671 F.3d 1011, 1026 (9th Cir. 2012) (“This prohibition of prepetition waiver has to be the law; otherwise, astute creditors would routinely require their debtors to waive.” (quotation and citation omitted)). As the Lexington Hosp. court noted, “[i]ndeed, since bankruptcy is designed to produce a system of reorganization and distribution different from what [sic] would obtain under nonbankruptcy law, it would defeat the purpose of the Code to allow parties to provide by contract that the provisions of the Code should not apply.” Lexington Hosp., 2017 WL 4118117 at *5 (citing In re 203 N. LaSalle St. P’ship, 246 B.R. 325, 331 (Bankr. N.D. Ill. 2000)). Based on those policy considerations, contractual provisions in operating agreements that effectively block the entity’s ability to file bankruptcy without a creditor’s consent have been held void. Id. (citing Intervention Energy Holdings, 553 B.R. at 263–64; Lake Michigan Beach, 547 B.R. at 913).

In Lake Michigan Beach, the LLC debtor defaulted on a debt and agreed to give the creditor “special member” status in exchange for a promise not to pursue the default. 547 B.R. at 903–04. The amended operating agreement made the creditor a member with the right to approve or disapprove a bankruptcy filing by the debtor. The creditor had no interest in the LLC’s profits or losses, no right to distributions, no tax consequences, and no obligation to make capital contributions to the LLC. The creditor “was kept separate and apart from the Debtor in all ways but for its authority to block the Debtor from petitioning for bankruptcy relief.”.

In Intervention Energy, the LLC debtor defaulted on its debt and agreed to make the creditor a common member in exchange for waiver of all defaults. The amended operating agreement required unanimous consent from members to file for bankruptcy. The effect of the amendment was to grant the creditor, holder of one membership unit out of 22 million, full veto power over a bankruptcy filing.

In Bay Club, the LLC debtor received a real estate purchase money loan secured by the property and the LLC’s related assets. 2014 Bankr. LEXIS 2051 at *1–3. The lender asked the debtor to add a bankruptcy waiver provision and other restrictive covenants to its operating agreement. The amended agreement provided that the debtor “shall not institute proceedings to be adjudicated bankrupt or insolvent” until “the indebtedness secured by that pledge is paid in full.”

The form that a contractual bankruptcy waiver may take is limited only by the resourcefulness of attorneys. Squire Court Partners, 2017 U.S. Dist. LEXIS 105032 at *11 (citing Intervention Energy 553 B.R. at 264). The bottom line, however, is that in all of the recent decisions, the provision amounted to a debtor agreeing to a prepetition waiver. Moreover, each case involved a creditor limiting a debtor’s right to seek bankruptcy relief as a condition of supplying credit. Each of these “blocking provisions” violated federal public policy.

Lexington Hospitality Group’s Amended LLC Agreement

In Lexington Hospitality Group, the court invalidated the bankruptcy restrictions in the amended LLC Agreement. First, the court found that the Independent Manager was “not a truly independent decision maker,” despite the existence of provisions that appeared to require independence. 2017 WL 4118117 at *6. The Independent Manager’s fiduciary duties to the company were abrogated by her contractual duties to creditors and the minority member controlled by the lender. The Independent Manager’s existence was also terminated upon payment of the debt; “this connection with the financing highlights the concern that the Independent Manager is not actually independent from the creditor who negotiated for her participation in a bankruptcy decision.”

In any event, even if those provisions were not enough to invalidate the restrictions, the court determined that the following provision “confirms that the Independent Manager is merely a pretense to suggest that the right to file bankruptcy is not unfairly restricted”—“In order for the Company to declare Bankruptcy or dissolve and liquidate its assets, the Independent Manager must provide authorization, and then only upon a 75% vote of the Members.” The 75 percent requirement, while purporting to reserve the LLC members’ bankruptcy rights, actually disguised the true impact of the restriction because, as part of the loan transaction, the LLC’s majority owner diluted its 100 percent ownership interest to give a 30 percent interest to an entity controlled by the lender. Thus, it was impossible for the LLC to achieve 75 percent without the lender’s consent.

Finally, the lender’s power to prohibit a bankruptcy filing was even more direct in the addendum to the Agreement, which gave the lender express veto power regardless of the members’ consent to a bankruptcy filing. For all of those reasons, the bankruptcy restrictions were deemed unenforceable.

“Acceptable” Bankruptcy Restrictions

Not all bankruptcy restrictions are unenforceable, however. Members of a business entity, even a non-fiduciary member or manager, may freely agree among themselves not to file bankruptcy. See, e.g., Lexington Hosp., 2017 WL 4118117 at *6. Thus, the issue is whether bankruptcy restrictions are imposed by a creditor to create an absolute waiver of the LLC debtor’s right to file bankruptcy. 2017 WL 4118117 at *6. With respect to such restrictions in favor of outside parties to an LLC—such as the appointment of an “independent director” with veto power over a bankruptcy filing—the rule is that “the director must be subject to normal director fiduciary duties and therefore in some circumstances vote in favor of a bankruptcy filing, even if it is not in the best interests of the creditor that they were chosen by.” Lake Michigan Beach, 547 B.R. at 913. Absent normal fiduciary duties, “allowing a creditor to contract for control of a debtor’s decision whether to file a bankruptcy petition would undermine the most fundamental purposes of the bankruptcy laws.” Squire Court Partners, 2017 U.S. Dist. LEXIS 105032 at *12 (citing Lake Michigan Beach, 547 B.R. at 914).

Conclusion

The key takeaway for parties considering restrictions on an LLC’s bankruptcy rights is that an independent decision maker installed by an outside creditor cannot exist simply to vote “no” to a bankruptcy filing, but must also have normal fiduciary duties. See Lexington Hosp., 2017 Bankr. LEXIS 3129, at *16 (citing Lake Michigan Beach, 547 B.R. at 911–13). This is consistent with the rule that upon insolvency (and in some states in the so-called “zone of insolvency”), fiduciary duties shift from equity holders to all creditors. Contractual provisions cannot alter existing common law and/or statutory fiduciary duties for the sole benefit of one creditor. Further, as the discussion in Lexington Hospitality makes clear, the purpose of a contractual restriction on bankruptcy and the factual circumstances surrounding its adoption may affect enforceability as much as the contract language itself.