Asset-Based Lending Credit Facilities: The Borrower’s Perspective

Posted on February 16, 2017 by - Uncategorized

When negotiating a credit agreement, several factors, including the borrower’s risk profile or credit ratings, impact the breadth of the affirmative, negative, and financial covenants imposed on the borrower. Some of the most burdensome credit agreements are asset based-lending (ABL) credit agreements. The heart and soul of ABL lending is the collateral; thus, ABL credit agreements often provide for intense lender monitoring and supervision because the borrowing base is tied to “eligible” assets. Under such a strict regime and without good advice from counsel, it is not uncommon for borrowers to trip an unintended default. The purpose of this article is to provide an overview of ABL credit agreements and lay out several best practices when negotiating ABL credit facilities on behalf of borrowers to help avoid unintended “foot fault” defaults.

What Is an ABL Credit Facility?

ABL literally means asset-based loan; thus, it is no surprise that the foundation of any ABL facility is the assets supporting the borrowing base. Unlike a cash-flow facility, where the lenders look to the borrower’s future cash flow, availability of the loan in an ABL facility is driven by the quality and value of the “borrowing base assets,” typically eligible inventory and eligible receivables (and sometimes eligible equipment). In these type of facilities, lenders tend to be keenly interested in ensuring that the assets against which it is lending are, in the case of inventory, of good quality and easily accessible and, in the case of receivables, likely to be collected. This focus can lead to detailed reporting requirements, both as to scope and frequency. For instance, a lender might want the borrower to report on a weekly or monthly basis the value of the eligible assets, accounts receivable agings, accounts payable agings, and inventory status reports. These requirements are burdensome for borrowers, many of whom have treasury staff stretched too thin. There are certain ways, however, for lawyers to help their clients build a culture of compliance to help avoid defaults. These techniques can be employed at the term sheet phase, during credit agreement negotiations, and throughout the life of the loan.

Term Sheet Considerations

Counsel to borrowers should advise their clients on potential compliance issues from the earliest stages of the financing—ideally when the company is negotiating a term sheet for a proposed credit facility. Term sheets typically list in summary fashion eligibility requirements, representations, notices, financial covenants, negative covenants, and events of default that a borrower can expect to see included in its ABL credit agreement. It is critical, therefore, that counsel focus a client’s attention on key operational issues when negotiating a term sheet, especially when those restrictions likely are to be in place for the next four or five years. Counsel should suggest clients clearly define terms to be used in the calculation of availability, eligible receivables, eligible inventory, reserves, and other key provisions. Further, as may be expected, ABL facilities typically provide little flexibility for disposing of assets other than in the ordinary course of business. If the borrower has any asset sales reflected in its business plan, counsel should advise that these dispositions be expressly permitted in the term sheet. By discussing material business issues up front when negotiating the term sheet instead of after lender’s counsel has drafted the credit agreement, the lender will have a clearer understanding of the borrower’s key business drivers affecting the transaction terms, thereby making the processes of marketing the transaction and agreeing to the definitive documents much smoother. Because participating lenders in multi-lender facilities may not even see the full credit agreement until a few days before closing, it is critical to ensure linchpin business issues are vetted at the initial phase of negotiations to avoid credit approval issues popping up at the eleventh hour.

Avoid Defaults Going Forward

Although we often hear business people try to distinguish between “technical” and “real” defaults, as lawyers we know that any event of default—from a late notice to a breach of a financial covenant—gives rise to a lender’s rights and remedies under the contract. Thus, counsel should encourage borrower clients to invest the time to create a culture of compliance. Defaults give lenders leverage, enabling them to renegotiate pricing and terms more favorable to them, and waivers and amendments are distracting, time consuming, and often costly.

Given that ABL facilities often contain detailed reporting requirements, a borrower should tie any notice requirements to a monthly or quarterly financial report. For instance, instead of requiring ten days prior written notice of a new collateral location, counsel could revise the covenant to require that the borrower provide notice of all new collateral locations with the monthly or quarterly financials/compliance certificate. Even better, add a materiality threshold to the notice requirement so that only locations with collateral over a material amount need to be disclosed. That way, the officer responsible for completing the monthly reporting package will be prompted to disclose all new material collateral locations. If counsel structures the ABL credit agreement this way, the borrower is less likely to forget to provide the required notice. This same approach can be used with other notices too (i.e., notices of new bank accounts, commercial tort claims, and intellectual property).

ABL credit agreements also tend to have events of default that a borrower might not see in other types of credit facilities. Keeping with the theme of collateral is key; a lender may include events of default tied to an important customer contract or a material amount of orders cancelled or receivables not collected. As counsel to the borrower, try to remove these provisions because these types of events would inevitably affect the borrowing base. If not, then counsel should try to negotiate the highest thresholds it can to avoid tripping a default. It is one thing for a lost customer to cause a decline in borrowing base availability, but another to have that loss cause an event of default under the ABL credit agreement.

This may seem obvious, but do not overlook the security agreement. Even though business people typically do not focus on the security agreement, there may be a myriad of issues hidden in an ABL security agreement. Oftentimes, lenders bury notice requirements and different, more burdensome covenants in the security agreement, especially related to receivables. For instance, a security agreement may prohibit the borrower from adjusting, forgiving, or amending any receivables. For many borrowers, that standard is too strict to work for their business. To increase compliance success, move all of the reporting requirements to the notice section in the credit agreement and ensure that the documents work together.

After the deal closes, create a compliance checklist for the borrower that summarizes in layman’s terms what the borrower can and cannot do to remain in compliance with its ABL credit agreement. Include regular and occurrence-based reporting requirements as well as operating negative covenants. Including these requirements can be a valuable tool for borrowers as they navigate the sometimes overwhelming number of obligations contained in ABL credit documents. Further, counsel should consider maintaining a running list of compliance issues raised by clients. This list would be helpful to have before any amendment or refinancing to address any common or recurring compliance concerns.

On a final note, it can be helpful for counsel to emphasize to clients the value of building and maintaining strong relationships with their lenders. If the borrower forecasts a potential compliance issue under its credit facility, the borrower should consider alerting its primary banking relationship, such as the administrative agent on its facility. Doing so builds trust and, in the face of a default or other adverse developments, lenders are more likely to work with a company if they are not caught off guard.

Other Areas of Focus

Although we have provided an overview of best practices for counsel in negotiating ABL credit facilities, there are several other unique features of ABL credit facilities that merit additional scrutiny by counsel.

  • Reserves. Lenders can institute reserves against availability to fence credit risk in many situations. For instance, a lender might institute a rent reserve equal to three months’ rent if inventory is located at a location where the lender does not have a collateral access agreement with the landlord. In other words, the value of the inventory located at that location is reduced by the amount of the rent reserve, thereby reducing the available borrowing amount. As counsel to the borrower, it is critical to expressly state the amount of, or methodology for calculating, the reserves and the situations in which they can be used.
  • Reasonable Credit Judgment. This can be a helpful standard to incorporate into a company’s ABL credit agreement. As mentioned above, lenders oftentimes include the right to institute reserves on borrowing availability or make other decisions that affect borrowing availability. By holding the lender to an objective, “reasonable credit judgment” standard, you are helping ensure that your client will be treated by the lender in a similar manner as that lender treats other similarly situated borrowers. An example definition might read as follows: “Reasonable Credit Judgment” means, with respect to any Person, a determination or judgment made by such Person in the exercise of reasonable (in the business of secured asset-based lending) credit or business judgment and in good faith.
  • Eligible Inventory and Eligible Receivables. Many ABL credit agreements define these terms in the negative, listing everything that is not eligible. When dealing with eligible receivables, lenders typically limit the amount of receivables due from one customer (i.e., “concentration” limits) and exclude receivables due from affiliates of the borrower. If the borrower has any international customers, the lender may cap the receivables from those customers unless additional security (for instance, a letter of credit) or steps to perfect in collateral located abroad is provided. Counsel should study these definitions carefully to ensure they do not exclude assets that the borrower does not intend to be excluded. To that end, it can be very helpful for the borrower to submit to the lender a sample borrowing base calculation before closing to ensure that the business teams are using the same calculations in determining eligibility and the borrowing base.
  • Cash Management. It is typical in an ABL credit facility for the lender to require the borrower to maintain its cash management functions with the lender. Certain institutions further insist on “full dominion and control” over the borrower’s bank accounts, giving lenders the ability to sweep the cash in the borrower’s operating account on a daily basis to pay down borrowings on the line of credit. The borrower then funds disbursements using proceeds of the revolving loans, and the cycle starts over again. Further, to the extent that the borrower maintains bank accounts with other banks, it will be required to enter into a tri-party deposit account control agreement with the depository bank and the lender. As counsel to the borrower, it is important to understand what types of bank accounts a borrower has, at which institutions those accounts are maintained, over which accounts a lender is seeking liens, and whether the lender’s proposed control agreement is a full dominion agreement (i.e., the borrower cannot access the account) or a “springing” agreement (i.e., the lender cannot block access until after an event of default). Note that it is common to exempt from control agreements petty cash, payroll accounts, health care reimbursement, and other employee benefit accounts.

Sidebar: Key ABL Credit Agreement Compliance Takeaways for Counsel

1. Ensure that the credit agreement and security documents work together.

2. Move all notice obligations to one place in the credit agreement.

3. Tie reporting requirements to monthly/quarterly financial reporting.

4. Create a checklist of key compliance terms.

5. Encourage clients to maintain an open dialogue with their relationship bankers—it builds trust.

When the Last Thing You Need Is Another Headache: Auditors in Internal Investigations

Posted on February 16, 2017 by - Uncategorized

For every general counsel or public company audit committee member, much of the response to allegations of corporate wrongdoing is familiar: preserve evidence, consider whether to retain outside counsel, inform necessary constituencies inside the company, and scope out the investigation. One disclosure that might be required is to the company’s outside auditor, and this disclosure may lead to a frequently overlooked consideration of the internal investigation: What does the outside auditor need to accept the results of the investigation? In many cases, the inquiries of the outside auditor may appear to constitute unnecessary second-guessing and a revisiting of issues and work, including expensive and time-consuming electronic discovery, that already were deemed resolved.

From the perspective of the outside auditor, however, the depth of some of its inquiries is essential, and, unless satisfied, the auditor will not sign off on the company’s financials. Consequently, the company—ordinarily through its outside counsel—must anticipate and address the auditor’s concerns from the outset and understand how to successfully push back on the auditor’s requests.

Understanding the Auditor’s Obligation: GAAS and Section 10A

Auditors’ obligations with respect to possible illegal acts are dictated by both Generally Accepted Auditing Standards (GAAS) and Section 10A of the Securities Exchange Act of 1934 (Section 10A), 15 U.S.C. § 78j–1, which was enacted in 1995 as part of the Private Securities Litigation Reform Act. Where an auditor becomes aware that an illegal act has or may have occurred at a client, Section 10A requires the auditor to determine the likelihood that an illegal act has in fact occurred, and assess the potential impact of the act on the client’s financial statements. Section 10A’s application is expansive. It defines “illegal act” broadly as “an act or omission that violates any law, or any rule or regulation having the force of law.” Section 10A’s requirements also are triggered regardless of the materiality of the possible illegal act. Section 10A imposes reporting requirements on the auditor—specifically, to inform management of the possible illegal act and to ensure that the audit committee and/or board of directors are “adequately informed” of it. These reporting requirements are triggered unless the act is “clearly inconsequential.”

To assess the impact of a possible illegal act, the auditor must consider both the quantitative and qualitative materiality of the act under the Auditing Standard 2405 Illegal Acts by Clients ¶¶ 12–16, 19–20 (AS 2405) and the SEC Staff Accounting Bulletin No. 99—Materiality. The auditor must evaluate the impact of the illegal act on certain amounts presented in the financial statements, such as loss contingencies, and consider the adequacy of disclosures related to the illegal act. Apart from financial statement impact, the auditor must determine whether the illegal act impacts the audit itself by impairing the reliability of representations made by management. This requirement is critical in investigations where the members of management making representations to the auditor are in any way implicated in the possible illegal act. For this reason, auditors usually expect that outside counsel, and not members of the company’s office of the general counsel, will conduct the investigation because in-house counsel may have pre-existing relationships with members of management under investigation, or knowledge of the facts at issue, that could call their objectivity into question. Similarly, auditors routinely inquire of outside counsel the extent and nature of prior engagements to assess whether outside counsel is sufficiently independent.

The auditor’s ability to fulfill these obligations ultimately impacts its ability to issue an unqualified opinion. If the auditor concludes that it has not received sufficient evidence to evaluate the materiality of an illegal act’s impact on the financial statements, the auditor can disclaim an opinion on the financial statements. In certain circumstances, such a disclaimer could result in the auditor’s withdrawal from the engagement.

In addition to assessing the impact of an illegal act on the financial statements and audit under AS 2405, Section 10A also requires the auditor to assess management’s response to the illegal act. If the auditor concludes that appropriate remedial action has not been taken to address an illegal act materially impacting the financial statements, and the auditor issues a nonstandard opinion or withdraws as a result thereof, the auditor must report those conclusions to the client’s board of directors. The client’s board of directors then has one business day to report the auditor’s findings to the SEC.

In sum, the auditor ultimately has four obligations with respect to possible illegal acts:

  • determine whether an illegal act occurred;
  • understand the quantitative and qualitative impact of the illegal act on the client’s financial statements and on the audit itself;
  • determine whether management has taken sufficient remedial action to address the illegal act; and
  • make required reporting to the client’s management, board of directors, and audit committee.

The procedures performed by the auditor in response to the detection of a possible illegal act should be geared toward fulfilling these obligations.

Understanding the Lawyer’s Obligation: Privilege in Internal Investigations

Given the auditor’s obligations under GAAS and Section 10A, it is unquestionably in the auditor’s best interest to seek as much information as possible when conducting procedures in response to a potential illegal act. It is axiomatic that the more information and evidence the auditor has, the more informed the auditor believes its ultimate conclusions will be. However, the auditor’s interest in information is at odds with counsel’s obligations to protect the client from overreaching inquiries and to preserve the attorney-client privilege.

Both the attorney-client privilege and work-product doctrine apply in the context of internal investigations. The attorney-client privilege, which protects confidential communications between attorney and client for the purpose of securing legal advice, undoubtedly applies to internal investigations. Upjohn Co. v. United States, 449 U.S. 383, 389, 396–97 (1981). Under Upjohn, this privilege protects disclosure of communications, not disclosure of the facts underlying them. It is also subject to waiver, and external auditors are not privileged parties under federal law. See, e.g., Couch v. United States, 409 U.S. 322, 335–36 (1973). Disclosure of attorney-client privileged communications to auditors constitutes a subject matter privilege waiver. See e.g., Chevron Corp. v. Pennzoil Co., 974 F.2d 1156, 1162 (9th Cir. 1992); In re John Doe Corp., 675 F.2d 482, 488–89 (2d Cir. 1982). Essential to this analysis is whom the attorney represents. In virtually all cases, counsel should inform witnesses that the client is the company, board of directors, or the board committee, not the witness, and that no privilege attaches to the information the witness provides. Accordingly, the focus of counsel’s concerns relating to privilege will be on communications with the client—the company, board, or board committee—and counsel’s mental impressions, as opposed to the factual information witnesses provide.

The work-product doctrine protects materials prepared by an attorney in anticipation of litigation under Fed. R. Civ. P. 26(b)(3). The work-product privilege generally is understood to apply in the internal investigation context, although case law addressing this question is not uniform. See e.g., In re Grand Jury Investigation, 599 F.2d 1224, 1229 (3d Cir. 1979). Unlike the attorney-client privilege, most courts have held that work-product privilege is not waived by disclosure to auditors. See e.g., United States v. Deloitte, 610 F.3d 129, 139 (D.C. Cir. 2010); Merrill Lynch & Co, Inc. v. Allegheny Energy, Inc., 229 F.R.D. 441, 445–49 (S.D.N.Y. 2004). However, disclosure should be avoided whenever possible because some courts have held that disclosure of work product to an auditor waives work-product privilege. See e.g., United States v. Hatfield, No. 06-CR-0550 (JS), 2010 WL 183522, at *3 (E.D.N.Y. Jan. 8, 2010).

Mutual Understanding and Informed Communication

On their face, the obligations of attorneys and auditors appear incompatible. Auditors require sufficient information to satisfy their obligations under GAAS and Section 10A, whereas counsel must satisfy their own obligation to preserve privilege. The key to striking the appropriate balance between these competing interests is informed communication. To achieve informed communication, each party must consider the legal obligations driving the other, and the parties must communicate early and often. This section provides some practical tips for maintaining informed communication throughout the various stages of an investigation.

Planning and Scope

Counsel should involve the client’s auditor from the beginning of the investigation. Consulting with the auditor at the outset sets the tone for the relationship between the parties throughout the investigation. The initial meeting should cover the scope of the investigation, including all planned procedures. When designing those procedures, counsel should consider the auditor’s obligations—namely, to understand the nature and potential impact of the illegal act. This is particularly the case with electronic data review and evidence preservation. Counsel should anticipate that the company’s outside auditors will apply rigorous review to whether and how electronic data is captured and processed, and which search terms are applied against that data. Audit firms, particularly large ones, often have their own forensic groups that are well versed in document preservation, collection, and review. It is not uncommon for the outside auditors to suggest additional procedures or search terms. On the other hand, mindful of the limited nature of the auditor’s review, counsel reasonably can resist expanding the scope of data and document review where the auditor’s suggestions are overbroad.

Engaging with the auditor at the planning stage also has the practical benefit of achieving consensus among the parties before any real work begins. This consensus diminishes the possibility that the attorney will have to perform additional, unplanned procedures later in the investigation.

Executing Planned Procedures

Virtually every investigation will involve document review and witness interviews. To be comfortable with counsel’s document review, the auditor must understand the completeness of the data reviewed and the effectiveness of the review procedures performed. Counsel should be prepared to discuss the technical details of the review with the auditor; auditors frequently test the rates at which search terms generate “hits.” Auditors also occasionally sample documents deemed to be nonresponsive to test the thoroughness of the review. Accordingly, counsel should anticipate these procedures by installing robust quality control over the document review both in order to improve the accuracy of the review and to add to its defensibility when dealing with the auditors.

Counsel should also bear the auditor’s obligations in mind when planning witness interviews. Specifically, counsel should consider the auditor’s need to assess the continued reliability of management assertions when determining which witnesses to interview and what questions to ask during an interview. After the interviews occur, auditors routinely request summaries of key interviews (not including counsel’s mental impressions or other privileged aspects of the interviews) and inquire about the questions asked and responses provided. Depending upon the nature of the investigation, counsel might consider whether to consult with the auditor prior to a witness interview to review whether the auditor (or more likely the auditor’s national office or office of the general counsel) is looking for responses to specific questions. Doing so may avoid duplicative work, such as reinterviewing witnesses to cover additional topics.

Communicating Results

The conclusion of the investigation presents the greatest risk to counsel in terms of waiver of privilege. Auditors frequently request complete access to written reports prepared by counsel, but regularly will accept less than the complete report presented to the client. As a result, counsel should take care in drafting the report (if one is drafted at all), particularly with respect to whether to state conclusions or recommendations in the text of any report, and should consider alternative methods to communicate the substance of the report, including through tailored presentations. Regardless of how the facts learned through the investigation are presented, counsel should expect to engage with the auditor with follow-up to that presentation. Here, in particular, the scope of the auditor’s review is critical. Although the auditor’s curiosity may, at times, seem limitless, the scope of information it actually needs to satisfy its obligations is narrow. This, therefore, is an area where the company readily can explore what information the auditor truly needs to satisfy its inquiry.

In sum, the tension between an investigating attorney and auditor can be alleviated through regular, informed communication throughout an investigation. Understanding the legal obligations of the other party is essential to achieve this result. Accordingly, attorneys conducting internal investigations should consider the obligations of the auditor when planning and executing investigation procedures. At the same time, attorneys should remember that the auditor’s obligations are not boundless, and should use their understanding of the limits of the auditor’s obligations to push back on auditor requests where necessary. Attorneys also should ensure that the auditor understands and considers counsel’s obligation to preserve privilege when requesting information or communications from counsel. Although the interests of auditors and attorneys in an internal investigation may never perfectly align, informed communication can help point them in a similar direction.

The Importance of Our Service As Mentors

Posted on February 16, 2017 by - Uncategorized

At the ABA Business Law Section Council Meeting held in West Palm Beach, Florida, on January 7, 2017, Justice (Ret.) Henry duPont Ridgely delivered the following remarks.

Good morning,

I am very honored to be asked to speak with you this morning as a Business Law Advisor. Often this becomes a time to recount some of the professional history that the Advisor may have. But in view of my recent interview in the December issue of Business Law Today I am not going to go over that again. What I want to talk to you about is, what I am worried about as a member of our profession, as a Judge in Delaware for more than 30 years and as a member of the Bar for 43 years. I am worried about young lawyers. And I want to talk to you about mentoring and the critical importance to our profession of our service as mentors.

It is our shared responsibility as senior members of the Bar to provide and improve guidance to young lawyers and law students as their mentors. Over my career, I have come to recognize that there are limits to what law schools can do. There just isn’t the time to do what a mentor traditionally does. I am worried about young lawyers who can be adrift in a large law firm, or even worse, young lawyers who cannot find jobs and who open a practice on their own without professional guidance.

Since my own admission to the Delaware Bar in 1974, I have seen many Delaware lawyers serve as mentors. We have institutionalized that role in Delaware. Every applicant for Bar Admission must have a preceptor and complete five months of clerkship requirements under the preceptor’s direct supervision and guidance. It’s a long list of things you have to do that essentially is an introduction to the practice of law under the oversight of an experienced Delaware lawyer. You have to have been a lawyer for at least 10 years to be a preceptor. Preceptors set the example of leadership, public service, and professionalism for the new lawyer. The best preceptors convey as mentors that the practice of law is a higher calling. They explain that professionalism means more than mere competence in legal skills and civility. We’ve heard before, and it’s worth saying again, Roscoe Pound’s classic definition of a profession:

The term profession refers to a group . . . pursing a learned art as a common calling in the spirit of public service—no less a public service—because it may incidentally be a means of livelihood. Pursuit of the learned art in the spirit of public service is the primary purpose.

U.S. Supreme Court Justice Robert H. Jackson provided a timeless description of the professional lawyer. That is a person

[who] loves [the] profession, [who] has a real sense of dedication to the administration of justice, [who] holds his [or her] head high as a lawyer, [who] renders and exacts courtesy, honor and straight forwardness at the Bar. [This lawyer] respects the judicial office deeply, demands the highest standards of competence and disinterestedness and dignity, despises all political use of or trifling with judicial power, and has an affectionate regard for every [person] who fills [the] exacting description of a just judge. The law [to this lawyer] is like a religion, and its practice is more than a means of support; it is a mission. [This lawyer] is not always popular in [the] community, but is respected. Unpopular minorities and individuals often found in [this lawyer] their only mediator and advocate. [This lawyer] is too independent to court the populace— [this lawyer] thinks of himself [or herself] as a leader and a lawgiver, not as a mouthpiece.

I recognize that our common calling to lead and to promote justice and public good has inspired members of the American Bar Association to give back by being involved in their communities, by working to improve the profession, and by volunteering for pro bono representation. We must teach young lawyers this responsibility as well. The need for pro bono service has never been greater than it is today.

I ask each of you to counsel young lawyers about their responsibilities. Discuss public service with your mentees. Explain to them, like my father explained to me, that professionalism is expected and that civility can actually help you win for your client. Give them examples of why the golden rule of lawyering—treat others as you would want to be treated—can benefit them and their clients. Explain to them the importance of their integrity and reputation and that word travels fast through the lawyer and judicial grapevine. And explain to them the personal rewards of pro bono service by helping others in need, that pro bono service will sharpen their legal skills and provide them experience they may not otherwise find. Tell them it will enhance the firm’s reputation and visibility with the courts, and draw attention of current and prospective paying clients to your firm’s commitment to the community.

This is not rocket science. Instead it is a matter of commitment and finding the time to do it. There are even books on it. Guidance to your mentees on how to practice law as a higher calling may be found in Judge Carl Horn’s excellent book called Lawyer Life Finding a Life and a Higher Calling in the Practice of Law (2003). Judge Horn provides practical advice in today’s context where economic and competitive pressures are strong. In summing up the message of his book on finding a life and a higher calling in the practice of law today he writes:

First, that law can and should be understood and practiced as something higher and nobler than just a way to make a good living—although it is certainly that, too, and there is undeniably (and properly) a business side to the practice of law. Second, that we should reconnect with the tradition Elihu Root and others represented: the counselor at law. About half the practice of a decent lawyer, Root once observed, consists in telling would be clients they are damned fools and should stop. True then, true now. Third, that as officers of the Court, lawyers should embrace ethics, principles, and values far exceeding the de minimis requirements of the various Codes of Professional Responsibility. Fourth, that lawyers should look for creative ways to make peace between potential disputants and provide more proactive counsel, regarding litigation as a last resort. And fifth, that the legal profession, from law school through retirement, should embrace balance and wholeness for the professional life of every lawyer.

This is advice consistent with the lessons taught to me by my own mentors. If our mentees follow this advice, they will find a life and a higher calling in the practice of law that will be both satisfying and make our communities even better places to live.

So I ask you, what will you do to be a better mentor? The future of our profession depends on our collective answers and commitment to teach young lawyers how to practice law with the integrity, professionalism and civility we expect, how to lead, and how to serve.

Finally, I want to commend our Chair Bill Johnston and this Council for its leadership on Diversity and Inclusion. I have been an eye-witness to the benefits of diversity and inclusion within our Delaware Judiciary. When I joined Superior Court—it was all white males. When the first female judge was appointed my colleagues wondered—some even worried—about how our Court and our collegiality would change. The facts are that with new ideas and new perspectives our Court became progressively stronger as it became more diverse. In 2000, while I was President Judge—our Court was ranked number one among the 50 states by the U.S. Chamber of Commerce. There is no doubt in my mind that the great strength of this Section and the ABA will grow with its diversity and inclusion initiative.

Thank you for listening.

Lessons from Aetna/Humana: What Do Health Care Mergers Face Today?

Posted on February 16, 2017 by - Uncategorized

Aetna Inc.’s $37 billion deal to buy rival insurer Humana Inc. was blocked recently by a federal judge, thwarting one of two large mergers that would reshape the U.S. health-care landscape.

Judge John D. Bates of the U.S. District Court for the District of Columbia held January 23 that the Department of Justice can likely prove its case that Aetna and Humana’s merger would harm competition in Medicare Advantage markets in 364 counties in 21 states. Judge Bates also said that the merger will likely harm competition in at least three public exchange markets under the Affordable Care Act (ACA), even though Aetna pulled out of those markets during the merger challenge in a bid to undermine the government’s case.

About two weeks later, on February 8, Judge Amy Berman Jackson also blocked Anthem Inc.’s proposed $48 billion takeover of Cigna Corp., but her opinion explaining the decision is currently sealed. Even without benefit of Judge Jackson’s take on these megamergers, Judge Bates’s reasoning provides several lessons that other merging parties, particularly in health care, should consider.

What Efficiencies?

Efficiencies arguments based on cost weren’t successful in Aetna’s case. The proffered efficiencies are not cognizable under the law, and even if they are, the parties aren’t likely to pass any savings on to consumers, Judge Bates said.

Judge Bates’s opinion fits into a longer chain of decisions that support federal antitrust enforcers’ skeptical view of procompetitive merger efficiencies. The lessons of those decisions—and Judge Bates’s in particular—may resonate with Judge Jackson.

Parties face an uphill battle in proving any efficiencies defense in health-care mergers since the Federal Trade Commission successfully challenged a merger between the Saltzer Medical Group and St. Luke’s Health System, St. Alphonsus Med. Ctr.–Nampa Inc. v. St. Luke’s Health Sys., Ltd., 778 F.3d 775 (9th Cir. 2015).

In St. Alphonsus, the district court ordered St. Luke’s to divest Saltzer because the combined entity could raise prices for insurers. Although the parties argued that the combined entity would significantly improve patient outcomes, the court concluded that the proposed efficiencies were not “merger specific,” because they could be achieved by less restrictive means.

The U.S. Court of Appeals for the Ninth Circuit affirmed the order unraveling the deal, saying it remained “skeptical about the efficiencies defense in general and about its scope in particular.”

Though there have been glimmers of success for efficiencies defenses at the district court level since St. Alphonsus, appellate courts have rejected proffered efficiencies in challenged health-care mergers.

Based on the Ninth Circuit’s precedent, any efficiencies defense faces a high bar. The parties have to “clearly demonstrate” that the challenged deal produces “extraordinary efficiencies” in order to rebut the government’s prima facie case under Clayton Act §7. Particularly, merger efficiencies based on improvements in quality of care, as opposed to cost of services, are difficult to quantify and prove in court.

As more cases pile up rejecting different efficiencies defenses in health-care mergers, the mountain a successful defense must climb grows steeper. If merging parties believe they have substantial efficiencies or consumer benefits from a merger, proving them to the agency during negotiation is key. If the parties fail to convince the agency, convincing a court after a challenge is filed is onerous.

Something’s Gotta Give

The Aetna opinion also may signal that rapid consolidation in health care is reaching a competitive limit.

The relationship between providers and insurers has been described as an “arms race” to improve bargaining position. Regulators have challenged hospital deals by arguing that, when providers gain negotiating leverage, the result will be higher prices for consumers. Regulators alleged confidently that any increase in price will be passed through to consumers by health insurers on the losing side of the bargaining table.

In the Aetna decision, however, the court agreed with the DOJ that the opposite isn’t necessarily true. It is not evident that when insurers win in negotiating with providers, any price reductions they secure will wind up in consumers’ pockets, the court said.

In their approach to health-care mergers, the agencies seem to be signaling that each side of the health-care “arms race” has consolidated enough and neither should be allowed to gain a sizable advantage that way.

The Aetna opinion seems to embrace a view that consumers are not benefiting from this contest. Even if leviathan hospital groups and insurance companies extract better prices from one another, reduced competition on each side of the table means each side has less incentive to pass any savings on to consumers. Regardless of which side wins, consumers lose if both sides do not face robust competition.

Given that consumers are the most visible constituency protected by the antitrust laws, merging parties should expect to provide explicit proof of likely consumer benefit behind arguments about efficiencies based on scale and bargaining power.

Efficiencies arguments based on cost were not successful in Aetna’s case. Parties should watch how the court views the alleged cost advantages of the Anthem/Cigna deal, as well. In that case, the parties argued the merger would reduce costs because they can extract lower prices from providers.

Transparency

Another takeaway from Judge Bates’s decision: strong-arm tactics and gamesmanship are a dangerous route when dealing with the government.

The court found that Aetna threatened to leave ACA exchanges if the government challenged the Humana merger. Aetna then, as a litigation tactic, pulled out of those exchanges the government identified as competitively impacted. Aetna argued that doing so was a business decision, and that the merger wouldn’t reduce competition in those markets because Aetna would no longer compete in those exchanges anyway.

That argument failed. The court agreed with the DOJ that litigation posturing is not business as usual and found that Aetna was likely to return to the most profitable ACA markets when the threat of litigation passed.

Many companies divest assets or leave markets to ease a settlement with the merger authorities—that is standard procedure in contested mergers. Aetna’s tactic was treated differently because Judge Bates found that Aetna tried to hide its motivations for leaving the ACA markets and undermine the government’s case against the merger, rather than making actual business decisions or divesting in good faith.

If a company is large enough to threaten damage to specific markets, merger authorities are less likely to approve a merger that enhances that company’s market power. Throwing weight around is not ultimately a good strategy for merger review.

Layers of Review

There is substantial uncertainty about the priorities for a Trump administration in antitrust enforcement. But the Aetna case highlights another consideration for lawyers involved in health care mergers regardless of what happens at the top of the agencies for the next few years.

Eight states and the District of Columbia joined the court challenge to the Aetna-Humana merger; 11 states and the District of Columbia sued with the federal government to halt the Anthem-Cigna deal. Health-care entities, highly regulated at both the state and federal level, are accustomed to balancing their regulatory approach to take both into account. It is important to remember that the complementary regulatory role of federal and state authorities extends to merger review.

Every state in which a company operates might be concerned about consumer and competitive impacts of a proposed merger. States also work together through the National Association of Attorneys General (NAAG) to investigate and challenge anticompetitive conduct. Even with federal approval, merging parties might have to accommodate state concerns or battle resistance to their tie-up in court.

Furthermore, although Republican administrations are generally viewed as more “business friendly” and less likely to block mergers that fall on the margin of anticompetitive impact, the staff who evaluate mergers within the DOJ and FTC stays from administration to administration. Expect a level of continuity in how mergers are reviewed and what actions are recommended to any new personnel at the top of the agencies.

What’s Next?

Judge Bates’s opinion is well-reasoned and relies on copious record citations. His result rests on two independent grounds in two separate markets. It therefore has the markings of an opinion that will hold up on appeal. Aetna has said it is still weighing its options on whether to seek review in the D.C. Circuit.

The bottom line: according to data from Bloomberg Law Litigation Analytics, both judges are upheld on appeal more than 70 percent of the time, though neither has had many antitrust cases go to trial.

For More Information

Text of the court’s decision is at http://src.bna.com/lSl.

What Lawyers Should Know about Taxes, Constructive Receipt, and Structured Fees

Posted on February 16, 2017 by - Uncategorized

Constructive receipt is a fundamental tax concept that can have a broad and frightening impact. According to the IRS, you have income for tax purposes when you have an unqualified, vested right to receive it. Asking for payment later does not change that. Childs v. Comm’r, 103 T.C. 634, 654 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996). The idea is to prevent taxpayers from deliberately manipulating their income. The classic example is a bonus check available in December that an employee asks to be withheld until January 1. Normal cash accounting suggests that the bonus is not income until paid; however, the employer tried to pay the bonus in December and made the check available, making it income in December even though it is not collected until January.

Cash v. Accrual Accounting

Constructive receipt is an issue only for cash method taxpayers like individuals. Constructive receipt is built into the accrual method (used by most large corporations), under which you have income when all events occur that fix your right, if the amount can be determined with reasonable accuracy. Treas. Reg. §§ 1.446-1(c)(1)(ii), 1.451-1(a). Thus, you book income in accrual accounting when you send out an invoice, not when you collect it. Rev. Rul. 84-31, 1984-1 C.B. 127. For cash method taxpayers, however, the IRS worries about “pay me later” shenanigans. The tax regulations provide that a taxpayer has constructive receipt when income is credited to the taxpayer’s account, set apart, or otherwise made available to be drawn upon. See Treas. Reg. § 1.451-2.

Effect of Restrictions

On the other hand, there is no constructive receipt if your control is subject to substantial limitations or restrictions. There is considerable debate over what substantial limitations or restrictions prevent constructive receipt. For example, what if an employer cuts a check on December 31 but tells its employee to either drive 60 miles to pick it up or wait for its arrival in the mail? The employer may book this as a December payment (and issue a Form W-2 or 1099 that way), but the employee may have a legitimate position that it is not income until received. Such mismatches occur frequently, and there is little to suggest that there is manipulation going on.

Legal Rights

Whether they know it or not, lawyers deal with constructive receipt issues frequently. Suppose a client agrees orally to settle a case in December, but specifies that the settlement be paid in January. When is the amount taxable? In January. The mere fact that the client could have agreed to take the settlement in Year 1 does not mean the client has constructive receipt.

The client holds legal rights and is free to condition his or her agreement (and the execution of a settlement agreement) on the payment in Year 2. The key is what the settlement provided before it was signed. If you sign the settlement agreement and condition the settlement on payment next year, there is no constructive receipt. On the other hand, if you sign first and then ask for a delayed payment, you have constructive receipt. In much the same way, you are free to sell your house and to insist on receiving installment payments, even though the buyer is willing to pay cash. However, if your purchase agreement specifies you are to receive cash, then it is too late to change the deal and say you want payments over time. The legal rights in the documents are important.

Lawyer Trust Accounts

If a case settles and funds are paid to the plaintiff’s lawyer trust account, it usually is too late to structure the plaintiff’s payments. Even though the plaintiff may not have actually received the money, the lawyer has. For tax purposes, a lawyer is the agent of his or her client, so there is constructive (if not actual) receipt.

Consider the impact of disputes between lawyer and client. Suppose that Larry Lawyer and Claudia Client have a contingent-fee agreement calling for Larry to represent Claudia in a contract dispute. If Larry succeeds and collects, the fee agreement provides that Claudia receives two-thirds, and Larry retains one-third as his fee. Before effecting the one-third/two-thirds split, however, costs are to be deducted from the gross recovery.

Suppose that Larry and Claudia succeed in recovering $1 million in September of 2016. Before receiving that money, however, Larry and Claudia become embroiled in a dispute over the costs ($50,000) and the appropriate fee. Larry and Claudia agree that $25,000 in costs should first be deducted, but Claudia claims that the other $25,000 in costs is unreasonable and should be borne solely by Larry. Furthermore, Claudia asserts that a one-third fee is unreasonable, and that the most she is willing to pay is 20 percent. Larry and Claudia try to resolve their differences but cannot do so by the end of 2016. In January 2017, the $1 million remains in Larry’s law firm trust account. What income must Larry and Claudia report in 2016?

Undisputed Amounts

Arguably, there is a great deal that is not disputed. Larry and Claudia have agreed that $25,000 in costs can be recouped and that Larry is entitled to at least a 20-percent fee, although it is not yet clear if that 20-percent fee should be computed on $950,000 or on $975,000. Nevertheless, Larry is entitled to at least $25,000 in costs and to at least a $190,000 fee, for a total income of $215,000. Although it is not yet clear how much Claudia will net from the case, the minimum she will get is specified in the provisions in the fee agreement. Thus, taking the $50,000 as costs, Claudia should receive two-thirds of $950,000, or $633,270. Even under Larry’s reading of the fee agreement, this is the amount to which Claudia is entitled, although she might receive more if her arguments prevail.

How much should Larry and Claudia report as income? You might think that you do not have enough information to make that decision, and you would probably be right. After all, you do not really know whether Larry and Claudia have agreed that partial distributions can be made, or if they are taking the position that they will not agree to anything unless the entire matter is resolved. However, that does not appear to be so. Indeed, the positions of the parties seem clear that each is already entitled to some money. That gives rise to income, regardless of whether they actually receive the cash. If they have a legal right to the money and could withdraw it, then that is constructive receipt, if not actual receipt.

Any talk of withdrawal should invite discussion of restrictions and partial agreements. For example, what if you add to the fact pattern that, although these are the negotiating positions of Larry and Claudia, neither of them will agree to any distributions, treating the entire amount as disputed. Does that mean neither has any income in 2016? Does it matter what documents are prepared? The answer to the latter question is surely “yes.” Good documentation always goes a long way to helping to achieve tax goals.

For example, an escrow agreement acknowledging that all of the money is in dispute and prohibiting any withdrawal until the parties agree might contraindicate income. A document each party signs agreeing that they disagree and that no party can withdraw any amount until they both agree in writing should be pretty convincing. Even so, I am not sure it is dispositive to the IRS. It may be hard to argue with the fact that the parties’ positions speak for themselves, and that some portions of the funds are undisputed. Besides, there is a strong sentiment that a lawyer is merely the client’s agent. Presumptively, settlement monies in the hands of the lawyer are already received by the client for tax purposes.

Consider the defendant in this example. The defendant paid the $1 million in 2016. Depending on the nature of the payment, it seems reasonable to assume that the defendant will deduct it in 2016. It will likely issue one or more IRS Forms 1099, too, probably to both Larry and Claudia in the full amount of $1 million each. How will Larry and Claudia treat those Forms 1099? There may be a variety of possibilities. Assuming both Larry and Claudia argue the entire amount is in dispute, one approach is to footnote Form 1040, line 21 (the “other income” line), showing the $1 million payment. Then, they might subtract the $1 million payment as disputed and in escrow and therefore not income, netting zero on line 21. There is probably no perfect way to do this.

Escrows and Qualified Settlement Funds

Apart from mere escrows, qualified settlement funds (sometimes called QSFs or a 468B trusts) are also increasingly common. A QSF typically is established by a court order and remains subject to the court’s continuing jurisdiction. Treas. Reg. § 1.468B-1(c)(1). If the fund is a QSF, the defendant would be entitled to its tax deduction, yet neither Larry nor Claudia would be taxed on the fund’s earnings. The fund itself would be taxed, but only on the earnings on the $1 million, not the $1 million itself.

In our example, there is no court supervision, so it seems unlikely that the escrow could be a QSF. If the fund is merely an escrow, either Larry or Claudia should be taxed on the earnings in the fund, but not on the principal until the dispute is resolved and the disputed amount is distributed. Unlike a QSF, escrow accounts typically are not separately taxable, so one of the parties must be taxed on the earnings. See Treas. Reg. §§ 1.468B-6, 1.468B-7.

Normally, the escrow’s earnings would be taxable to the beneficial owner of the funds held in escrow. Rev. Rul. 77-85, 1977-1 C.B. 12 (IRB 1977), modified on other grounds, IRS Announcement 77-102 (1977). Either Larry or Claudia (or both) could be viewed as beneficial owners. Therefore, an agreement specifying who will be taxed on the disputed funds while held in escrow would be wise.

Structured Settlements and Structured Legal Fees

Some clients prefer structured settlements that pay them (through the use of annuities) over time rather than in a lump sum. In a similar way, contingent-fee lawyers who expect to receive a contingent fee are allowed to “structure” their fees over time, but if they receive the funds in their trust account, it is too late to structure. In fact, it is too late to structure fees if the settlement agreement is signed and the fees are payable. A lawyer who wants to structure legal fees must put the documents in place before the settlement agreement is signed. Just as in the case of the plaintiff, legal rights are at stake. In general, a contingent-fee lawyer is entitled to condition his or her agreement on a payment over time.

In reality, of course, it is the client of the plaintiff’s lawyer that has the legal rights and is signing the settlement agreement. That is why a lawyer who wants to structure fees must build that concept into the settlement agreement. Like structured settlements for plaintiffs, legal fee structures usually are not installment payments by the defendant. Rather, the settlement agreement will specify the stream of payments and call for the contingent fee to be paid to a third party that makes those arrangements. As you might expect, it is important for each element of the legal fee structure to be done carefully to avoid the lawyer being taxed before he or she receives installments, but the entire concept of structured legal fees must be mindful of the constructive receipt doctrine.

Understandably, cash method taxpayers do not want to be taxed on monies before they actually receive them; however, the constructive receipt doctrine can upset this expectation. Constructive receipt often can be avoided through careful planning and proper documentation.

More About Qualified Settlement Funds

The rules pertaining to constructive receipt seem to be thrown out the window when using this important and innovative settlement device. A QSF typically is set up as a case is resolved. The IRS provides that a fund is a “qualified settlement fund” if it satisfies each of the following:

  • It is established pursuant to an order of, or is approved by, specified governmental entities (including courts) and is subject to the continuing jurisdiction of that entity;
  • It is established to resolve or satisfy one or more claims that have resulted or may result from an event that has occurred and that has given rise to at least one claim asserting certain liabilities; and
  • The fund, account, or trust must be a trust under applicable state law, or its assets must otherwise be segregated from other assets of the transferor. Treas. Reg. § 1.468B-1(c).

Section 468B trusts allow defendants to pay money into the trust and be entirely released from liability in a case, yet the plaintiffs and their counsel do not have income until the money comes out. The 468B trust is a kind of holding pattern where no one is (yet) taxed on the principal or corpus of the trust. Even so, the defendant can deduct the payment for tax purposes. Any interest earned on the monies in the QSF is taxed to the trust itself. There are many nuances to observe about the use of QSFs.

However, QSFs can be a kind of safety valve from the constructive receipt doctrine. In appropriate cases, QSFs can provide lawyers and clients with additional time to sort out who is entitled to what, to resolve liens, and to arrange for structured settlements and structured legal fees. A QSF allows plaintiffs and their lawyers to resolve such issues after the defendant(s) have paid the settlement or judgment but before the plaintiffs and their lawyers have receipt.

Conclusion

Constructive receipt is a fundamental, yet widely confused, tax doctrine. It applies when you have an unrestricted right to income but you do not accept it. Consequently, lawyers and their clients may encounter constructive receipt concerns if they sign legal releases or are otherwise entitled to payments that they then try to delay. Be careful. A good rule of thumb is not to sign a settlement agreement unless: (1) you are clear on what the timing of the payments will be; and (2) this timing is acceptable to you. Once you (or your client) signs and is entitled to payment, it may be too late to change it. In some litigation, one way to build in payment flexibility can be by using a QSF that holds the funds. A QSF can be especially appropriate in complex cases with multiple parties involving disputes over payment amounts and timing. However you address these issues, no one wants to be taxed on money they have not even received!

Supreme Court Confirms Broad Reach of Insider Trading Liability

Posted on January 19, 2017 by - Uncategorized

On December 6, 2016, the Supreme Court issued its decision in Salman v. United States, clarifying the personal benefit standard of insider trading under the federal securities laws. In resolving what it called a “narrow” issue, the court reaffirmed the long-standing “guiding principle” of Dirks v. SEC that disclosing nonpublic material information to a “trading relative or friend,” even without any showing of pecuniary or tangible gain to the tipper, can give rise to criminal insider trading liability. In such situations, the court concluded, giving is as good as receiving, “the commonsense point . . . made in Dirks.” That is, the “tip and trade resemble trading by the insider followed by a gift of the profits to the recipient.” Salman thus underscores that market participants should continue to exercise vigilance when disseminating or receiving any material nonpublic information.

The court’s decision resolves a brewing dispute among the lower courts concerning the scope of tipper-tippee liability in insider trading cases. In particular, the Supreme Court took up Salman to decide whether a tipper had received a personal benefit for purposes of insider trading liability when he or she makes a gift of material nonpublic information to a relative who thereafter trades on that information. The Supreme Court answered in the affirmative, overturning some lower courts, including the Second Circuit, which had previously held that a tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for the tip.

The disagreement among federal courts over the definition of personal benefit, which has caused uncertainty among regulated professionals and their business networks and social contacts, stems from the Supreme Court’s last ruling on this issue, made more than three decades ago in 1983. In Dirks v. SEC, the Court explained that an unlawful personal benefit could be either a benefit that was effectively a cash equivalent, such as “pecuniary gain or a reputational benefit that will translate into future earnings” or, alternatively, “mak[ing] a gift of confidential information to a trading relative or friend.”

In 2014, the Second Circuit in United States v. Newman held that a corporate insider who made a gift of confidential information could not be held criminally liable unless the insider also received a personal benefit that “represent[ed] at least a potential gain of a pecuniary or similarly valuable nature.” In the 2015 United States v. Salman decision, however, the Ninth Circuit rejected the Second Circuit’s limited reading of Dirks and affirmed an insider trading conviction on the basis of an insider who had simply “ma[de] a gift of confidential information to a trading relative or friend.” In its December 16 decision, The Supreme Court affirmed the Ninth Circuit’s decision and thereby overruled the Second Circuit’s more limited reading of insider trading liability.

The Salman Decision

Salman centered on the relationship, and exchange of insider information, between two brothers, one of whom worked at a large investment bank. For more than two years, Maher Kara, who was the banker and the defendant’s brother-in-law, “regularly disclosed” to his brother, Michael Kara, information about upcoming mergers and acquisitions of and by the bank’s clients. Michael traded on that information and also passed it along to Bassam Salman, the defendant. Salman in turn gave the information to another relative, Karim Bayyouk. Salman and Bayyouk, the downstream tippees, then traded on the information and netted over $1.5 million in profits.

The Ninth Circuit found that Maher had disclosed the confidential information knowing that Michael intended to trade on it. According to the Ninth Circuit, the government had met its burden under Dirks because Maher had testified that, by providing Michael with inside information, Maher intended to benefit his brother and to fulfill whatever needs he had. On one occasion, for example, after Michael requested a favor because he “owe[d] somebody” but turned down Maher’s offer of money, “Maher gave him a tip about an upcoming acquisition instead.” To the Ninth Circuit, this was “precisely the ‘gift of confidential information to a trading relative’ that Dirks envisioned.”

The Supreme Court agreed, concluding that, under the long–standing rule set forth in Dirks, an insider effectively receives a concrete personal benefit where the disclosure of confidential information is made to a “trading relative or friend.” The court explained that when a tipper gives inside information to a trading relative or friend “the tipper benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.” In Salman, the corporate insider, Maher, “would have breached his duty had he personally traded on the information . . . himself [and] then given the proceeds as a gift to his brother.” By disclosing the information to his brother and allowing him to trade on it, “Maher effectively achieved the same result.” The court also overturned Newman to the extent it “held the tipper must receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends.”

Notably, however, the court’s Salman narrow ruling is limited to tips made to friends and family. It leaves open the possibility that tips made to acquaintances may be subject to a different standard and may, for example, still require the exchange of something “pecuniary or similarly valuable” to result in insider trading liability. And it leaves undisturbed the requirement that the government show that a trading defendant knew that a corporate insider received a personal benefit in exchange for the tip.

Implications

Salman makes clear that the Court’s decades–old Dirks decision set forth the correct standard for the definition of personal benefit. Under the right circumstances, as exemplified by Salman, the government may prosecute tippers and tippees where the insider conferred gifts or profits to a relative or friend. Thus, in Salman’s wake, government regulators will likely pursue insider trading cases with increased vigor. Absent a need to show that a corporate tipper disclosed confidential information for a tangible benefit or pecuniary gain, the government will likely launch more investigations and litigate more cases involving exchanges with only social or reputational benefits to the tipper. In particular, arrangements in Salman’s mold, where a corporate insider disseminates confidential information to a family member in order to obtain private advantage, may attract increased scrutiny from the government. All told, Salman may make it easier for the government to go after downstream tippees, including those who are multiple levels removed from the corporate insider, as long as they possess knowledge of the initial exchange that was made for direct or indirect personal benefit.

After Salman, corporate professionals are advised to trade with at least the same diligence and care as they have always undertaken. Legal and compliance departments are encouraged to continue monitoring trading activity and encouraging an open dialogue with employees regarding the dissemination and receipt of material nonpublic information. That said, the personal benefit test is a legal issue that need not influence trading decisions. Regulators will likely assess whether there was a personal benefit only after the government has issued a subpoena or otherwise initiated an investigation. But in the meantime, government enforcement activities carry the risk of reputational harm to the business, distraction from core business concerns, and added legal fees and expenses.

Model Business Corporation Act (2016 Revision) Launches

Posted on January 19, 2017 by - Uncategorized

Model Business Corporation Act (2016 Revision) Launches

Model Business Corporation Act (2016 Revision): Official Text with Official Comment & Statutory Cross-References was published in December by the Business Law Section’s Corporate Laws Committee. The book is available to order at the Section member price of $329.95 here.

***

Sixty-six years ago the Corporate Laws Committee (the “Committee”) of the American Bar Association’s Business Law Section published the Model Business Corporation Act (the “Act” or the “Model Act”). Now substantially adopted by a majority of the states, the Act has strongly influenced the law governing U.S. corporations and is an important and often cited reference for courts, lawyers and scholars. Just as corporate law has evolved over time, so has the Act. The Committee approved a substantial revision of the Act in 1969, less than 20 years after its initial publication, and just 15 years later, in 1984, the Committee adopted what was then called the Revised Model Business Corporation Act, a top to bottom revision of the original Act.

Through periodic amendments, the Act has continued to evolve in significant ways since 1984, as further described below. Until recently, however, the Committee had not undertaken another comprehensive revision of the Act that would facilitate adoption by state legislatures by capturing all of the changes to the Act since 1984. Nor had there been any systematic attempt to revise the Act to eliminate inconsistent terminology and adjust provisions that had become outdated over the more than three decades since the 1984 Revision.

As a result, beginning in 2010, the Committee undertook a thorough review and revision of the Act and its Official Comment. This effort has resulted in the recent publication of the Model Business Corporation Act (2016 Revision) (the “2016 Revision”).

The 2016 Revision, which is based on the 1984 version of the Model Act, incorporates all of the changes to the Act since 1984, provides consistency among provisions, and includes a streamlining and updating of the Official Comment. It also is designed to accommodate the Uniform Law Commission’s Uniform Business Organizations Code for those states that choose to follow a “hub and spoke” business entity statutory approach, as well as serving as a model for those states that wish to continue with a standalone corporation statute.

Most of the substantive changes included in the 2016 Revision have been previously adopted through the regular process for amending the Model Act, in which the Committee publishes for comment a notice of proposed amendments in The Business Lawyer and adopts the amendments after review of any comments received. A June 2016 Exposure Draft of the proposed 2016 Revision was posted on the Committee’s website along with an invitation for comment, particularly regarding matters that were not previously published for comment and adopted as amendments to the Act. After consideration of the comments received, the Committee approved the 2016 Revision at its meeting in September 2016 and published the 2016 Revision in December 2016.

Model Act Innovations

The Model Act, over the years, has made a number of important innovations to corporate statutory law. The following are a few of those made in prior years:

* streamlining the capital provisions by eliminating the concepts of par value, stated capital and treasury shares, permitting the consideration for shares to consist of any tangible or intangible benefit to the corporation, and eliminating the distinction among classes of shares and between classes and series;

* modernizing statutory financial provisions by establishing clearer tests for determining the legality of all types of distributions to shareholders;

* separating director standards of conduct from standards of liability and providing standards of conduct for officers;

* authorizing a provision in the articles of incorporation exculpating directors from liability for monetary damages to the corporation and its shareholders;

* creating a new approach with greater certainty for dealing with director’s conflicting interest transactions;

* adding a safe harbor for dealing with director and officer business opportunities;* requiring universal demand for bringing shareholder derivative actions and establishing certain independent determinations as a basis for dismissal of a derivative action;* permitting adoption of a bylaw for majority vote for the election of directors;* requiring shareholder approval for issuance of shares, other than for cash, that will result in an increase of more than 20 percent of the voting power of the outstanding shares;* authorizing statutory share exchanges, permitting mergers and share exchanges between a corporation and a non-corporate entity, and adopting uniform voting rules for all fundamental changes, including rules regarding separate group voting;

* clarifying when shareholder approval is required for disposition of significant corporate assets by establishing a test of whether the disposition will leave the corporation without a significant continuing business activity and providing as a safe harbor retention of 25% of total assets and 25 percent of income or revenue from continuing operations;

* introducing the concept of domestication to change the state of incorporation and conversion to change the form of entity;

* modernizing the appraisal remedy for dissenting shareholders, including by reintroducing the “market out” provision for non-interested transactions; and

* adding flexibility for non-public corporations, including by authorizing shareholders to establish their own governance rules in unanimous shareholder agreements.

Highlights of Recent Changes

Revisions to the Statutory Provisions. The following are examples of some of the more significant changes in the 2016 Revision since the Act’s prior publication in 2010:

1. Changes Related to the Uniform Business Organizations Code

Many of the amendments reflected in the 2016 Revision stem from the 2011 adoption of Article 1 of the Uniform Business Organizations Code (“UBOC”) by the Uniform Law Commission (“ULC”). That uniform legislation contemplates what is commonly described as a “hub and spoke” form of business entity legislation in which a “hub” contains provisions generally applicable to all forms of business entities and a “spoke” contains the substantive provisions for each form of entity. The Committee is now preparing a “spoke” version of the Act governing business corporations for use by jurisdictions that adopt the UBOC. That version will be drawn from the standalone 2016 Revision, which has been framed so as to make it compatible with the terminology and concepts used in the UBOC.

This adaptation of the 2016 Revision to the “hub and spoke” form of entity legislation accounts for many of the changes in the chapters on domestication and conversion, mergers and share exchanges, and foreign corporations, as well as corresponding changes in pertinent definitions. In particular, the provisions on domestication and conversion have been thoroughly revised, with the separate subchapters in the prior version of the Act for nonprofit conversion, foreign nonprofit domestication and conversion, and entity conversion now combined into the general conversion provisions. For foreign corporations, the most notable change is the elimination of the concept of qualification to do business, and the substitution of foreign corporation registration as a prerequisite to doing business within the state.

2. New Statutory Provisions

The 2016 Revision includes a number of amendments to the Act since its prior publication in 2010 which reflect recent corporate law developments. They include the following:

* new provisions permitting the ratification of defective corporate actions, including actions in connection with the issuance of shares;

* amendments that permit corporations to include in their articles of incorporation a provision that limits or eliminates a director’s or an officer’s duty to present a business opportunity to the corporation;

* addition of a provision permitting the articles of incorporation or the bylaws to specify the forum or forums for litigation of internal corporate claims;

* amendments clarifying the scope and operation of qualifications for nomination and election as directors;

* amendments that eliminate the requirement that a director or officer seeking

advancement of expenses provide a written affirmation that he or she has met the applicable standards for indemnification under the Act or, in the case of a director, that the proceeding involves conduct for which liability has been eliminated under the articles of incorporation;

* amendments permitting the merger of corporations without a shareholder vote

following a tender offer if certain conditions are met; and

* amendments that address the obligations of corporations to make financial statements available to shareholders, the maintenance of corporate records, and the inspection rights of shareholders and directors of corporations.

3. Procedures for Approving Fundamental Changes

The Act has long prescribed similar procedural steps for approval of mergers, share exchanges, amendments of the articles of incorporation, disposition of assets not in the ordinary course of business, dissolution, domestication and conversion. Despite this substantive similarity, the statutory language of the Act varied depending on the form of the transaction. The 2016 Revision amends the fundamental change provisions so that there is uniform language for the procedural steps for approval of these matters.

4. Distributions in Liquidation

The Act did not clearly articulate the treatment of distributions to shareholders made in the course of liquidation after dissolution of the corporation. Accordingly, the 2016 Revision reflects several changes that clarify the establishment of a record date for determining shareholders entitled to receive a distribution in liquidation after dissolution.

5. Corporation Voting its Own Shares

The Act historically has disenfranchised shares held by majority-owned subsidiaries (direct and indirect) of the corporation. The 2016 Revision more clearly prescribes disenfranchisement for shares in which the corporation has the economic interest, including shares owned by or belonging to the corporation indirectly through entities (corporate or non-corporate) that are controlled by the corporation.

6. Director Duties and Eliminating the Term “Public Corporation”

As a result of amendments adopted in 2005, the Act prescribed “oversight duties” for directors of “public corporations.” The Committee concluded that such a sharp demarcation of duties between directors of “public corporations” and other corporations has become increasingly artificial, especially in view of recent federal legislation permitting a greater number of shareholders before a corporation must become an SEC registrant and the evolution of trading of shares of such non-SEC registrants in alternative, secondary securities markets. Accordingly, the 2016 Revision deletes from the Act the specification of particular oversight duties for directors of “public corporations” and places discussion of those duties in the Official Comment as an elaboration on the more general articulation in the Act of the managerial and oversight responsibility of boards of directors. The 2016 Revision also deletes the definition of “public corporation.”

Consistent with the deletion of the definition of “public corporation,” a shareholders’ agreement no longer automatically ceases to be effective when the corporation becomes a “public corporation.” Nonetheless, the Act’s requirement of unanimous shareholder approval will likely make such shareholders’ agreements unavailable to public corporations as a practical matter, and in any event such agreements can still be drafted to effect automatic termination upon occurrence of a specific event such as an initial public offering. Similarly, the Act no longer limits use of a bylaw requiring a majority vote for election of directors to public companies.

7. Effective Date

The Committee found that the Act’s provisions defining when filings and transactions become effective were not internally consistent. The 2016 Revision makes those provisions more uniform and adopts a definition of “effective date” for filed documents that applies throughout the Act. That definition provides definitive rules for when a filing with the secretary of state becomes effective and has been revised to improve its clarity.

Changes Not Intended to Have Substantive Effect. Many of the changes in the statutory provisions of the Act included in the 2016 Revision are stylistic; others are intended to promote internal consistency with the Act’s provisions. The Committee does not intend for any of these changes to have substantive effect, through negative implication or otherwise. For example, the Committee added a provision that a shareholder does not have a vested property right resulting from any provision in the bylaws. This addition aligns with the provision that disavows the vested rights concept in relation to the articles of incorporation. There should be no implication from adoption of that amendment that the vested rights concept had any force in relation to bylaws that were in place before the amendment.

Revisions to the Official Comment. The Committee extensively revised the Official Comment to the Act so that the commentary functions solely as a guide to interpretation of the statutory provisions. Thus, the 2016 Revision:

* eliminates language in the Official Comment that merely restates operative

statutory language;

* eliminates comparisons with prior versions of the Act or with state corporation statutes; and

* eliminates discussion of case law and law review articles.

Conclusion

The Committee hopes that the 2016 Revision of the Act will encourage state legislatures—in states that have already adopted much or all of the Act and in other states as well—to consider adopting the 2016 Revision in full and thereby bring their corporate statutes into line with the most recent developments in corporate law. The 2016 Revision, as a comprehensive and updated Act, affords states the opportunity to modernize their corporation statutes, and in so doing, to enhance the business climate and revenue generating opportunities in their state. In addition, the greater the uniformity among states, the more likely a useful body of law can develop that will increase the certainty and efficiency of corporate actions and corporate transactions.

The Committee stands ready to assist states in this effort and to work with members of the Business Law Section and other groups to help make this happen. The Committee therefore welcomes inquiries about how the newly revised Act might be tailored for adoption in a particular jurisdiction.

New Publication: Model Asset Purchase Agreement for Bankruptcy Sales

Posted on January 19, 2017 by - Uncategorized

New Publication: Model Asset Purchase Agreement for Bankruptcy Sales

Using the Negotiated Acquisitions Committee’s 2001 Model Asset Purchase Agreement as a guide, the Business Bankruptcy Committee created a Model Asset Purchase Agreement for bankruptcy sales. Bankruptcy sales differ in many respects from a non-bankruptcy sale. This publication highlights the differences, includes commentary as a teaching mechanism, and provides ancillary documents and appendices.

This new publication is not a stand-alone asset purchase agreement. Instead, it highlights how certain terms and provisions may vary between a bankruptcy and a non-bankruptcy sale and, in some circumstances, provides commentary and case law to explain the reasoning underlying those variations. This publication about bankruptcy asset purchase agreements (and sales generally) does not include provisions that do not vary between a sale that would be consummated in bankruptcy and one that would be consummated outside of bankruptcy. For example, a definition for “Assets” is not included in this publication as it is generally identical in a bankruptcy and non-bankruptcy asset purchase agreement.

In addition, sample provisions and language not typically in non-bankruptcy asset purchase agreement are included—provisions concerning bid procedures, credit bidding rights, and executory contracts, for example. This publication should be used in conjunction with another asset purchase agreement and, in particular, the Negotiated Acquisitions Committee’s 2001 Model Asset Purchase Agreement. Such an approach will provide you with a comprehensive and flexible agreement for bankruptcy sales as well as a deep understanding of the purposes underlying each provision.

Section members can order the book at the price of $199.95 here.

Testing The Waters of the Safe Harbor

Posted on January 19, 2017 by - Uncategorized

Introduction

Payments made under supply-of-goods contracts, or contracts for the sale of goods, are often the subject of bankruptcy avoidance actions. Sections 546(e) and (g) of the Bankruptcy Code (11 U.S.C. § 546(e) and (g)) prohibit the avoidance and recovery of preferential and constructively fraudulent transfers made in connection with forward contracts and swap agreements. Specifically, section 546(e) protects settlement payments made to a forward contract merchant in connection with a forward contract, whereas section 546(g) protects transfers made to a swap participant in connection with a swap agreement.

At first blush, sections 546(e) and (g) seemingly apply exclusively to forward contracts and swap agreements relating to financial markets. Indeed, in amending several of the safe-harbor provisions in 1982, Congress explained that, “the amendments are intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.” H.R. Rep. No. 97-420, at 1 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583. Yet, despite Congress’s intentions, the terms “forward contract,” “forward contract merchant,” “settlement payment,” and “swap agreement” are so broadly defined that they arguably encompass transfers made in connection with ordinary supply-of-goods contracts. This article explores the Bankruptcy Code’s safe harbors and the ambiguities that can arise when dealing with such contracts.

Section 546(e) and Forward Contracts

Except for actual fraudulent transfers, section 546(e) prevents a bankruptcy trustee from avoiding and recovering: (1) a transfer that is a settlement payment made by or to (or for the benefit of) a forward contract merchant; or (2) a transfer made by or to (or for the benefit of) a forward contract merchant in connection with a forward contract that is made before the commencement of the case. Thus, to establish a section 546(e) defense, a defendant must show that: (1) the underlying agreement between the parties is a forward contract; (2) one of the parties to the agreement is a forward contract merchant; and (3) the transfers at issue constitute settlement payments.

Establishing the Existence of a Forward Contract

A party must first establish the existence of a forward contract to invoke section 546(e). The Bankruptcy Code defines a “forward contract,” in relevant part, as a contract for the sale of a commodity that is presently or in the future becomes the subject of dealing in the forward contract trade with a maturity date more than two days after the date into which the contract is entered. In defining “forward contract,” Congress stated that the “primary purpose of a forward contract is to hedge against possible fluctuations in the price of a commodity. This purpose is financial and risk-shifting in nature, as opposed to the primary purpose of an ordinary commodity contract, which is to arrange for the purchase and sale of the commodity.” H.R. Rep. No. 101-484, at 4 (1990), reprinted in 1990 U.S.C.C.A.N. 223, 226. Although legislative history relating to forward contracts indicates otherwise, the Bankruptcy Code’s definition arguably is broad enough to encompass ordinary supply-of-goods contracts so long as the contract: (1) is for the purchase, sale, or transfer of a commodity or any similar good that is presently or in the future becomes the subject of dealing in the forward contract trade; and (2) has a maturity date more than two days after the date into which the contract is entered.

The broad scope of the term “forward contract” can be limited only by its elements. As for the first element, the Bankruptcy Code specifically defines a “commodity” as wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats, oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, frozen concentrated orange juice, and all other goods and articles in which contracts for future delivery are presently or in the future dealt in. Given this broad, and circular, definition of “commodity,” nearly any and all goods and articles will fall within its scope.

However, the term “commodity” must be “the subject of dealing in the forward contract trade” to fall within the scope of a forward contract. The Bankruptcy Code does not define the term “forward contract trade.” In the context of an ordinary supply-of-goods contract, a litigator could introduce expert testimony to establish that such a contract does not involve a commodity involved in the forward contract trade. Still, the litigator likely will face an uphill battle, as numerous goods and articles are the subject of dealing in the forward contract trade.

As for the second element of a forward contract, the Bankruptcy Code does not define the term “maturity date.” Courts have reached differing conclusions on the term’s meaning. For instance, some courts have held that the maturity date is the date of delivery, while others have held that it is “the future date at which the commodity must be bought or sold.” McKittrick v. Gavilon, LLC (In re Cascade Grain Prods., LLC), 465 B.R. 570, 575 (Bankr. D. Or. 2011).

This lack of consensus is ripe for a savvy litigator to explore. For example, a typical supply-of-goods relationship involves a purchase order for certain goods, delivery of the goods, and payment in full 30 days after delivery. It is unclear at what point the maturity date occurs in such a relationship, if one occurs at all. A litigator could argue that the contract fully matures when the purchase order is issued, when the goods are delivered, or when payment is received. A litigator could even argue that the contract lacks a maturity date, as once the purchase order is issued and accepted, the parties’ obligations have matured. Finally, a litigator could introduce expert testimony to limit the scope of the term “maturity date” to its traditional meaning in the financial markets.

The Forward Contract Merchant Requirement

Having established the existence of a forward contract, one of the parties to the contract must be a forward contract merchant to invoke section 546(e). The Bankruptcy Code defines in section 101(26) a “forward contract merchant” in relevant part as “an entity the business of which consists in whole or in part of entering into forward contracts as or with merchants in a commodity or any similar good . . . which is presently or in the future becomes the subject of dealing in the forward contract trade.” Courts and commentators alike have interpreted this definition broadly and narrowly. For instance, Collier on Bankruptcy ¶ 556.03[2] (Alan N. Resnick & Henry J. Sommer eds., 16th ed.) provides that “[t]he language ‘in whole or in part’ in th[e] definition substantially broadens its coverage to include any person that enters into forward contracts as or with merchants in a commodity business context.” At least one bankruptcy court has followed Collier’s broad definition, which arguably would apply to supply-of-goods contracts.

Other courts, however, have followed a narrower definition espoused by Judge Dennis M. Lynn in Mirant Americas Energy Marketing, L.P. v. Kern Oil & Refining Co. (In re Mirant Corp.), 310 B.R. 548 (Bankr. N.D. Tex. 2004). In that case, Judge Lynn focused on the undefined terms “business” and “merchant” within the term “forward contract merchant” and found that the definition is limited in scope. Specifically, Judge Lynn defined “merchant” as “one that is not acting as either an end-user or a producer. Rather, a merchant is one that buys, sells, or trades in a market.” Judge Lynn further defined “business” as “something one engages in to generate a profit.” Accordingly, the court defined a forward contract merchant to be “a person that, in order to profit, engages in the forward contract trade as a merchant or with merchants,” with “merchant” meaning an individual or entity that is not acting as either an end-user or a producer. This construction gives effect to all parts of the definition because “[w]ithout references to ‘business’ and ‘merchant,’ the definition of ‘forward contract merchant’ could as easily have been ‘a person that enters into forward contracts.’” Most courts have adopted this interpretation over Collier’s construction.

Judge Lynn’s interpretation, if followed, might preclude the application of section 546(e) to an ordinary supply-of-goods contract. In such a context, a buyer simply purchases goods from a supplier. The buyer is an end-user and the supplier is a producer. To fall within the definition’s scope, a merchant would have to buy, sell, or trade the underlying contract in a financial market. This interpretation is not only logical, but also gives effect to Congress’s overall intentions in enacting section 546(e).

Transfers as Settlement Payments

Once the existence of a forward contract and forward contract merchant are established, a defendant must finally show that the transfers at issue constitute settlement payments. The Bankruptcy Code at section 101(51A) defines a “settlement payment” as, “for purposes of the forward contract provisions of this title, a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, a net settlement payment, or any other similar payment commonly used in the forward contract trade.” Although tautological, courts have held that a commodity settlement payment must, at a minimum, be some kind of payment on a commodity forward contract. Therefore, any payment on account of a forward contract likely falls within the definition, making this element easily met.

As the foregoing discussion demonstrates, the requirements to enter the safe harbor are seemingly straightforward, but the definitional issues may make section 546(e) much broader than Congress intended.

Section 546(g) and Swap Agreements

If unable to meet any of the elements contained in section 546(e), a party may seek protection under section 546(g). Except for actual fraudulent transfers, section 546(g) prohibits a bankruptcy trustee from avoiding a transfer made by or to (or for the benefit of) a swap participant or financial participant, under or in connection with any swap agreement that is made before the commencement of the case. To establish a section 546(g) defense, a defendant must show that: (1) the parties entered into a “swap agreement”; (2) one of the parties to the swap agreement is a “swap participant” or “financial participant”; and (3) the transfer was made “under or in connection with” the swap agreement. The second and third elements rarely are litigated because the essential element is whether a swap agreement exists. If a swap agreement exists, section 546(g) undoubtedly will be satisfied because the transfer sought to be avoided will be in connection with a swap agreement to a “swap participant,” which is defined as an entity that, at any time before the filing of the petition, has an outstanding swap agreement with the debtor.

Establishing the Existence of a Swap Agreement

The Bankruptcy Code defines a “swap agreement” broadly as, in relevant part, a commodity index or a commodity swap, option, future, or forward agreement. Although the Bankruptcy Code defines a “forward contract,” it does not define a “commodity forward agreement.” The leading and only authoritative case on the term “commodity forward agreement” is the Fourth Circuit’s decision in Hutson v. E.I. du Pont de Nemours & Co. (In re National Gas Distributors, LLC), 556 F.3d 247, 259–60 (4th Cir. 2009). In that case, the Fourth Circuit held that a commodity forward agreement exists when the following are present: (1) the subject of the agreement must be a commodity; (2) the agreement must require a payment for the commodity at a price fixed at the time of contracting for delivery more than two days after the date into which the contract is entered; (3) the quantity and time elements of the agreement must be fixed at the time of contracting; and (4) the agreement must have a relationship with the financial markets (although it need not be traded on an exchange or be assignable).

Subject to the previous discussion regarding section 546(e), the first three elements for a swap agreement likely will be met in the context of an ordinary supply-of-goods contract. Yet, the contract must also have a relationship with the financial markets. Whether this is the case depends on the terms of the contract. For instance, a purchase order for oil could have a relationship to the financial markets if the price of the oil depends on the overall market price for oil. On the other hand, a purchase order for corn at a fixed price likely lacks a relationship with the financial markets. Again, a litigator could use expert testimony to determine whether the agreement has such a relationship.

To be fair, Hutson’s interpretation of “commodity forward agreement” is problematic because it nullifies the forward contract merchant requirement that exists in section 546(e). In other words, a contract that does not meet the definition of “forward contract” for purposes of section 546(e) may meet the requirements of a forward agreement for purposes of section 546(g). In reaching its decision, the court in Hutson determined that the term “agreement” is broader than the term “contract”: “As Black’s states, the term ‘agreement,’ although frequently used as synonymous with the word ‘contract,’ is really an expression of greater breadth of meaning and less technicality. Every contract is an agreement; but not every agreement is a contract.” Using Hutson’s definition, any party to a commodity forward agreement can invoke the safe-harbor protections, even if neither party is a forward contract merchant.

Whether this was Congress’s intention is unclear. On the one hand, Congress seemingly intended a broad definition by stating that “[t]he use of the term ‘forward’ in the definition of ‘swap agreement’ is not intended to refer only to transactions that fall within the definition of ‘forward contract.’ Instead, a ‘forward’ transaction could be a ‘swap agreement’ even if not a ‘forward contract.’” H.R. Rep. No. 109-31, at 122 (2005), reprinted in 2005 U.S.C.C.A.N. 88, 184. On the other hand, Congress also stated that “[t]he definition of ‘swap agreement’ . . . should not be interpreted to permit parties to document non-swaps as swap transactions. Traditional commercial arrangements, such as supply agreements . . . cannot be treated as ‘swaps’ under . . . the Bankruptcy Code because the parties purport to document or label the transactions as ‘swap agreements.’”

As of now, the Hutson elements, if followed, would protect any commodity forward agreement that has a relationship with the financial markets, even if neither party is a forward contract merchant. Similar to section 546(e), the definitional issues of section 546(g) may render section 546(g) broad enough to encompass supply-of-goods contracts.

Conclusion

Congress’s adoption of sections 546(e) and 546(g) has created unintended results. Although clearly seeking to protect transfers made in connection with forward contracts and swap agreements relating to financial markets, Congress may have inadvertently protected transfers made in connection with ordinary supply-of-goods contracts. If the legislative history surrounding the safe-harbor provisions accurately reflects Congress’s intentions, the provisions should be amended to expressly exclude supply-of-goods contracts. As it currently stands, litigators that prosecute or defend bankruptcy avoidance actions should familiarize themselves with the safe-harbor provisions because their ambiguities may present unanticipated curveballs in what normally are considered straightforward avoidance actions.

When It Comes to the FBAR, You Cannot Afford to Stick Your Head in the Sand

Posted on January 19, 2017 by - Uncategorized

Do you have a financial interest in or signature authority over a foreign nest egg that is worth over $10,000 on any day of the year? Then you cannot afford to hide your head in the sand and ignore the annual Report of Foreign Bank and Financial Accounts (FBAR) filing and recordkeeping requirements. In addition to negligence or fraud penalties, steep civil and/or criminal penalties may apply if you fail to file the FBAR. What can happen, you ask? Consider the creator of Beanie Babies, H. Ty Warner, as an example. In 2008, he paid $53.6 million (i.e., 50 percent of the maximum balance of his foreign account), one of the largest FBAR penalties the United States has collected to date. United States v. Warner, 792 F.3d 847 (2015). Enough to make anyone’s feathers ruffle!

The United States requires its citizens, residents, and domestic entities to file FBARs because foreign financial institutions (unlike domestic ones) are not under U.S. jurisdiction and, therefore, are not subject to U.S. reporting obligations and to the power of the U.S. district courts to enforce the Internal Revenue Service’s (IRS) summons authority. The United States has several foreign asset filing requirements (see Chart 1). However, the FBAR is unique in that, unlike the IRS forms and schedules depicted in Chart 1, the FBAR is not a tax return protected under the taxpayer confidentiality rule, found in IRC (Internal Revenue Code) section 6103. Rather, it is a required yearly report, regardless of whether income is earned. It assists the United States with ferreting out secret foreign accounts used to fund international terrorist activities, launder money, hide income, and other illegal acts. Accordingly, it is freely shared among a network of law enforcement agencies.

Additionally, the FBAR, or the Financial Crimes Enforcement Network (FinCEN) Form 114 (formerly TD F 90-22.1), is not filed with the IRS but electronically through the FinCEN BSA E-filing system (no paper filing as of July 2013). Beginning in 2017, the FBAR due date will be moved from June 30 to April 15, and a maximum six-month extension to October 15 will be allowed (as a result of the enactment of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015). Thus, this new due date will coincide with that of tax return filings.

Since the Bank Secrecy Act’s (BSA) enactment, the FBAR has been around for over forty-five years, and is codified in Title 31 of the U.S. Code. Then why all the recent attention? Because the United States has stepped up FBAR enforcement efforts.

During the late 1990s, there were few FBAR indictments. In response to the tragic events of September 11, 2001, however, the United States made several efforts to improve the tracking of foreign funds. In April 2003, through a Memorandum of Agreement, FinCEN delegated full civil investigatory and enforcement authority to the IRS, giving the IRS power to assess and collect penalties, investigate civil violations, employ the summons power, issue administrative rulings, and take any reasonably necessary enforcement actions. The advent of the American Jobs Creation Act of 2004 (Jobs Act) created more stringent civil penalties for noncompliance. In 2008, the Department of Justice launched a crackdown into secret overseas assets, starting with Swiss Bank UBS, one of Europe’s largest financial institutions. In February 2009, UBS entered into a deferred prosecution agreement, agreeing to pay a settlement of $780 million to the United States as well as to identify over 4,000 U.S. taxpayers with hidden Swiss accounts. Finally, in March 2010 came a momentous change in the detection of offshore tax evasion: Congress passed the Foreign Account Tax Compliance Act (FATCA). FATCA enhanced the enforcement of the FBAR through mandatory disclosures by both foreign financial institutions (FFIs) and U.S. taxpayers. As IRS Commissioner John Koskinen commented in a March 15, 2016 IRS News Release, “Taxpayers here and abroad need to take their offshore tax and filing obligations seriously.”

This article focuses on the elements triggering a mandatory FBAR filing (with a skeletal flowchart) and concludes with a short overview of the possible outcomes for noncompliance.

Do You Need to File an FBAR?

To make the determination whether you are obligated to file an FBAR, ask yourself the four questions presented in Flowchart 1. Certain IRS forms and schedules also direct you to a possible FBAR filing requirement, if you check the box “Yes” as to having a financial interest or signature authority over a foreign financial account (see Item 5 of Chart 1).

Question 1: Is the Filer a U.S. Person?

Under the BSA, U.S. persons include: (1) U.S. citizens; (2) U.S. residents; and (3) entities formed within the United States. For FBAR purposes, the United States includes the 50 states, the District of Columbia, the territories and insular U.S. possessions (i.e., American Samoa, the Commonwealth of the Northern Mariana Islands, the Commonwealth of Puerto Rico, Guam, and the U.S. Virgin Islands), and the Indian lands as defined in the Indian Gaming Regulatory Act. Children are also included in the definition of U.S. persons, although their parents or guardians may file on their behalf. Let us look at these terms in more detail:

(1) Citizens. U.S. citizens are those with a U.S. birth certificate or naturalization papers.

(2) Residents. Residents are individuals who meet one of the following tests: (1) the green card test (i.e., a green-card holder who has entered the United States); (2) the substantial presence test (i.e., physically present in the United States for at least 183 days out of the current year, or at least 31 days during the current year and the sum of the number of days as calculated in IRC section 7701(b)(3) ); and (3) the resident alien election (i.e., filing a first-year election to be treated as a U.S. resident alien under IRC section 7701(b)(4)).

(3) Entities. Domestic entities may be corporations, partnerships, LLCs, estates, or trusts. The key to determining whether an entity is required to file an FBAR is the law under which it was created (e.g., state certificate of incorporation). A foreign entity that has elected to be treated as a U.S. entity for U.S. tax purposes and a foreign subsidiary do not need to file an FBAR. However, a domestic parent (or U.S. individual) may be obligated to file an FBAR if it has a financial interest in a foreign subsidiary that owns an offshore account.

The entity’s tax exemption and disregarded federal tax status are irrelevant for FBAR reporting purposes. For example, a domestic charitable organization, IRC under section 501(c)(3) and a single-member LLC may be obligated to file an FBAR (in conjunction with his or her owner), despite their tax situation.

Domestic subsidiaries may be exempt from filing an FBAR, however, if their parent entities name them in a consolidated FBAR. A parent may file a consolidated FBAR on behalf of itself and its subsidiary if it is formed under U.S. law, owns a greater than 50-percent interest in its subsidiary, and files an FBAR (which includes its financial and other information as well as its subsidiary’s). Thus, Subsidiaries O2, a California corporation, and O3, a Nevada corporation, do not need to file an FBAR when Parent O1, a Delaware corporation, files a consolidated FBAR (identifying all reportable accounts, itself, and its subsidiaries; see Part V of FinCEN Form 114).

Question 2: Does the Filer Have a Financial Interest in a Foreign Financial Account?

This question involves three special terms, namely, “foreign,” “financial account,” and “financial interest.” First, what does “foreign” mean, for FBAR purposes? It does not refer to the financial institution’s nationality, but to its geographical location outside the United States, District of Columbia, the Indian lands, and the territories and insular possessions of the United States. So, an account in a branch of a French bank that is located in New York is not a reportable account. By contrast, an account in a branch of a U.S. bank that is located in France is a reportable account.

What about “financial account”? This includes but is not limited to the following:

  1. bank account, or an account maintained with a person engaged in the business of banking, such as a checking account;
  2. securities account, or an account with a person engaged in the business of buying, selling, holding, or trading stock or other securities, for example a brokerage account;
  3. commodity futures or options account;
  4. insurance or annuity policy with a cash value, such as a whole life policy;
  5. mutual fund or similar pooled fund, meaning a fund that issues shares to the general public that have a regular net asset value determination and regular redemption (foreign hedge funds and private equity funds are excluded); and
  6. any account with a person that is in the business of accepting deposits as a financial agency. See 31 C.F.R. (Code of Federal Regulations)

§1010.350.

Let us examine a couple of financial account examples. In a 2016 case, the district court ruled that a U.K. poker fund, used for the exclusive purpose of facilitating poker playing, was not a financial account. Similarly, a credit card is generally not an account. However, the IRS posited, in I.R.S.  Legal Memorandum 2006-03-026 (Jan. 20, 2006), that a credit card may constitute an account if the cardholder was making advance payments and using the card like a debit card or checking account. Likewise, a safe deposit box is customarily not an account; however, if it is used in ways similar to an account, such as holding and issuing cash to the owner and facilitating the transmission of funds or extension of credit, then the IRS may argue that it is an account (IRS’s expressed position at the June 12, 2009 ABA Section of International Law’s Committee on International Taxation).

Finally, what does “financial interest” mean? The regulations define it as a U.S. person being the foreign account’s owner of record or having ownership or control over the owner of record, which rises to a level of having a financial interest. Generally, it can be any one of these possibilities: (1) an owner of record; (2) an agent; or (3) a U.S. person with greater than a 50-percent interest in an entity (either directly or indirectly) that owns a foreign account. Let us examine each of these situations in more detail:

Owner of record (or legal-title holder). A U.S. person has a financial interest if he or she is the legal owner or titleholder of a foreign account, regardless of whether he or she benefits from the account. This is true even if the account is used for the benefit of a non-U.S. person. If there are multiple U.S. persons who share ownership or title to the account, then each of them has a financial interest and a separate FBAR obligation (e.g., each U.S. co-trustee of a trust with an offshore account).

An exception exists for a married couple that jointly owns a foreign account(s). In that case, the couple may file a joint FBAR as well as complete and sign FinCEN 114a, Record of Authorization to Electronically File FBARs. Nevertheless, to prevent the risk of joint FBAR liability due to a noncompliant spouse, each spouse may file his or her own separate FBAR. If one spouse has signature authority and/or separately owns other offshore account(s), then each spouse should separately report his or her FBAR, including those jointly held account(s).

Agent, nominee, attorney, or a person acting on behalf of a U.S. account beneficiary. A U.S. person has a financial interest in an account if he or she uses an agent (or other person acting on his or her behalf) to acquire account benefits. For example, if U.S. citizen Oscar opens a foreign account in the name of his brother Ollie, who maintains it for Oscar’s benefit, such as in paying Oscar’s bills, then Oscar has a financial interest. If Ollie is a U.S. citizen or resident, then Ollie also has an FBAR reporting requirement.

Note: Financial interest encompasses those U.S. persons who may desire to avoid an FBAR obligation with a non-U.S. agent or nominee who obtains account benefits on their behalf (i.e., FBAR responsibilities follow economic reality). Thus, if a U.S. individual structures a foreign entity (e.g., trust or corporation) to own his or her overseas accounts, that individual still has a financial interest in the offshore accounts. The regulations’ anti-avoidance provision captures situations in which U.S. individuals create entities for the purpose of evading their FBAR obligations.

Person with a direct or indirect interest (e.g., voting power or equity interest) that is greater than 50 percent in an entity (e.g., corporation or trust) that is the record owner or titleholder of a foreign account. This situation may take on various scenarios, but we will focus on corporations and partnerships. If a domestic or foreign corporation directly or indirectly owns an overseas account, then a U.S. person who owns more than half of the total value of the corporate shares of stock or voting power of all shares of stock has an FBAR reporting obligation. Similarly, if a domestic or foreign partnership owns an offshore account, then a U.S. person who directly or indirectly owns more than half the partnership’s profits or capital has an FBAR reporting requirement.

To illustrate, U.S. resident Odell owns 75 percent of a California parent corporation that, in turn, owns 100 percent of a foreign subsidiary that has a foreign account. Both Odell and the California parent must file an FBAR because they are both U.S. persons with a majority financial interest in the total value of shares of the foreign subsidiary’s stock (even though Odell’s interest is indirect).

In contrast, if Odell owns only 40 percent of the California parent corporation while each of his children own 20 percent, none of the family members have an FBAR financial interest (unless, as described above, the anti-avoidance rule applies). Nevertheless, they may still have an FBAR reporting requirement if they have signatory authority over the offshore account.

Question 3: Does the Filer Have Signature or Other Authority Over the Foreign Account?

Signature or other authority is defined as an individual (either alone or in conjunction with another) who can control the disposition of account assets (e.g., withdrawing funds) by directly communicating (e.g., in writing or by oral mandate) with the person in charge of maintaining the account. 31 C.F.R. § 1010.350(f)(1). In other words, “signature or other authority” means that a financial institution will act upon a person’s direction (although more than one individual’s communication is required), regardless of whether the power is exercised.

Generally, a person who can control the deposits and withdrawal of bank funds has signature or other authority. The mere ability to control the investment of funds does not constitute such authority. Likewise, there is no such authority when an individual is an intermediary in the chain of command regarding the disbursement of account property. However, if the intermediary were introduced for the purpose of evading FBAR reporting, then the IRS can impose a higher FBAR penalty for a willful violation.

Let us look at an example: Omar opened an Australian account and hired an Australian attorney for the purpose of serving as the power of attorney over the account. Omar gave his partner the authority to make the account’s investment decisions and to instruct the attorney, but not the bank. Here, Omar has a financial interest because he is the owner of the account.  Additionally, his attorney has signature authority allowing him to control the disposition of account funds by directly communicating with the bank representative who maintains the account. However, Omar’s partner has no such authority because he can control only the investment of account funds and is unable to control any transmission of these funds.

FBAR reporting exceptions apply to the following officers and employees who have signature or other authority but no financial interest: (1) certain financial institutions; (2) certain authorized service providers; or (3) certain entities whose security is listed on any national security exchange or registered under section 12(g) of the Security Exchange Act. See 31 C.F.R. § 1010.350(f)(2).

For all other officers and employees who have signature or other authority but no financial interest, the regulations impose a duty to file an FBAR. However, the IRS has granted several extensions (from May 31, 2011 to December 8, 2015) and a new filing due date of April 15, 2017. See FinCEN Notice 2015-1. On March 1, 2016, FinCEN proposed to modify the regulations by exempting certain officers, employees, and agents of domestic entities with signature or other authority but no financial interest, provided that the FBAR is otherwise reported by the entities and that the entities maintain records regarding these individuals for at least five years.

Question 4: Is the Aggregate Value of All the Foreign Financial Account(s) Greater Than $10,000 at Any Time during the Calendar Year?

Now it is time to dust off your calculators! Aggregate value refers to the highest total amount of all those offshore accounts (in which you have either a financial interest or signature or other authority) at any time from January 1 to December 31.

You may rely on periodic quarterly or more frequently issued statements so long as they reasonably reflect the maximum account balance during the year. So, if you make several-thousand-dollar deposits in one month and withdraw all those monies before the end of the monthly statement, then your statement will not fairly reflect the largest account balance.

To determine your maximum account balance, you must value each account’s largest amount separately. Based on the Treasury Reporting Rates of Exchange’s (https://www.fiscal.treasury.gov/) end-of-year conversion rates, each account’s local currency value is transformed into U.S. dollars. You then add the maximum values of all your foreign accounts to see if you exceed the threshold of $10,000. Make sure that you do not double count the same monies transferred from one account to another.

For example, Oliver opened three Swiss bank accounts: A ($3,000 balance), B ($3,000 balance), and C ($2,000 balance). Presently, Oliver need not file an FBAR because the total account value of his overseas accounts is below $10,000. Suppose, however, that he closes bank account C and transfers the entire amount to account D. Suppose further that the value of each of his accounts increased by $1,000 during the following year. In that case, although none of the accounts (A, B, or D) individually exceed the threshold amount, their aggregate value does, so Oliver has an FBAR obligation. Note also that the transferred monies from account C to account D are counted only once.

What Are the Rules for U.S. Persons With a Financial Interest in or Signature or Other Authority for 25+ Foreign Financial Accounts?

Currently, the regulations provide that, if a U.S. person has a financial interest in 25 or more accounts, then that person may provide certain basic information regarding these accounts. A similar rule applies to those with signature or other authority over 25 or more accounts. See 31 C.F.R. § 1010.350(g). However, detailed information should be available upon the request of either the IRS or FinCEN (i.e., recordkeeping is still mandatory). On March 1, 2016, FinCEN proposed to make detailed information about all such offshore accounts mandatory, despite their numerousness.

Conclusion

In summary, the FBAR is a yearly, mandatory report on offshore accounts that helps the government to combat tax evasion, money laundering, and other illegal activity. As can be seen from the above FBAR requirements, there can be multiple filers for one account, such as joint owners and account co-signers. Accordingly, each filer may be subject to a penalty for noncompliance.

Civil penalties range from $10,000 for a non-willful violation (i.e., good-faith inadvertence, mistake, or negligence) to the greater of $100,000 or 50 percent of the amount of the transaction or account balance at the time of the willful violation (e.g., an intentional violation or a conscious effort to avoid learning about the FBAR reporting and recordkeeping requirements). Both criminal and civil penalties may be imposed simultaneously, as well as non-FBAR penalties (e.g., an accuracy-related penalty). However, the IRS may apply mitigation measures, provided that certain conditions are met. In addition, there is penalty relief if the violation was: (1) due to reasonable cause (i.e., a violation despite an exercise of ordinary business care and prudence); and (2) the amount of the transaction or the balance of the account at the time of the transaction was properly reported.

If you believe you have an FBAR filing requirement (or may be a delinquent FBAR filer), you should consult with your tax professional. Quietly disclosing your late FBAR may open you to risks (e.g., filing an amended return and past-due FBAR without reasonable cause and enrollment in an FBAR amnesty program). There are different options for delinquent FBAR filers; for example, the streamlined program for a non-willful violation and the offshore volunteer disclosure program (OVDP) for a willful violation, which may be better than paying the full penalty. Of course, it is best to avoid all penalties by timely filing; therefore, remember that, when it comes to the FBAR, do not be an ostrich!