On March 25, 2024, the National Association of Industrial Bankers (“NAIB”), American Financial Services Association (“AFSA”), and American Fintech Council (“AFC”) (collectively, “Trade Associations”) filed a complaint in the United States District Court for the District of Colorado on behalf of their members. The Trade Associations seek declaratory judgment and preliminary and permanent injunctive relief against the Colorado Attorney General and Administrator of the Colorado Uniform Consumer Credit Code. The complaint challenges Colo. Rev. Stat. § 5-13-106, which opts Colorado out of Section 521 of the Depository Institutions Deregulation and Monetary Control Act of 1980 (“DIDMCA”). Colorado’s DIDMCA opt-out is set to go into effect on July 1, 2024.
Sections 521–523 of DIDMCA granted federal authority to insured, state-chartered banks and credit unions, authorizing them to contract for the interest rate permitted by the state where the bank is located and export that interest rate into other states. In June 2023, Colorado signed into law legislation exercising its right under Section 525 to opt out of DIDMCA, which it believes will require state-chartered banks and credit unions to adhere to Colorado laws regarding interest rate and fee limitations.
The Trade Associations assert that Colorado’s DIDMCA opt-out violates the Supremacy Clause and the Commerce Clause of the United States Constitution. The Trade Associations claim that Colorado’s opt-out is overly broad and facially invalid because Colorado’s definition of where a loan is “made” for purposes of its DIDMCA opt-out goes “far beyond” what is permitted by federal law. The Trade Associations noted that Congress allowed states to opt out with respect to loans “made in” a particular state as defined under federal law, but it did not intend to permit each state to independently define that term and where a particular loan is “made.”
Under federal law and long-standing prudential regulator commentary, a loan is “made” in the state where all key functions associated with originating or “making” the loan occur. These include the following nonministerial functions of the bank: the decision to lend, the communication of loan approval, and the disbursement of loan proceeds. Colorado seeks to define a loan as one that is “made” in Colorado whenever the loan is made to a Colorado resident, regardless of where the nonministerial functions occur.
The Trade Associations outline a series of arguments:
Colorado’s DIDMCA opt-out is disregarding the plain terms of DIDMCA, usurping federal authority, and intruding on the ability of other states to regulate loans made within their borders.
The opt-out violates the Commerce Clause because it impedes the flow of interstate commerce by subjecting state-chartered banks to inconsistent obligations across different states and, as a result, creates a significant burden on interstate commerce.
Although intended to combat high-cost payday lending, the opt-out actually has the converse effect because Colorado consumers will be harmed by the decreased range and availability of credit products.
Members of the Trade Associations are not payday lenders but rather mainstream, household names that offer a wide variety of useful and familiar credit products such as installment loans, store-branded credit cards, and point-of-sale loans offered by retailers (i.e., buy now, pay later loans). These members often fill the gap for a population that cannot be served by a traditional bank model due to credit risk and other factors.
The intent of Colorado’s DIDMCA opt-out to prevent high-cost lending and protect consumers is undermined because the same types of products will still be available to Colorado consumers through the national banks, due to the inability of states to opt out of the National Bank Act. This outcome will have a negative effect on the very consumers Colorado insists it is trying to protect with the opt-out.
Since the complaint was filed, the Colorado Attorney General and Colorado Uniform Consumer Credit Code Administrator filed a responsive brief objecting to the Trade Associations’ motion for preliminary injunction. The Federal Deposit Insurance Corporation (“FDIC”) also filed an amicus curiae brief siding with Colorado’s interpretation of the DIDMCA opt-out. The FDIC asserts that its position is consistent with historical interpretations, while others assert that the brief appears to contradict the plain language of the FDIC’s longstanding positions regarding where loans are made in the context of federal rate exportation authority. The Trade Associations filed a reply in support of their motion, and the American Bankers Association (“ABA”) and the Consumer Bankers Association (“CBA”) submitted an amicus brief in support of the trade groups.
As more states have introduced and continue to introduce DIDMCA opt-out legislation, Colorado’s DIDMCA opt-out case will be significant in the regulatory landscape across the country for the financial services industry.
The Corporate Transparency Act (“CTA”) is a landmark piece of legislation that went into effect on January 1, 2024. Under the CTA, millions of corporations, limited liability companies, and other entities are required to disclose their beneficial owners to the U.S. Treasury Department’s criminal-enforcement bureau, the Financial Crimes Enforcement Network (“FinCEN”).
In National Small Business United v. Yellen, the plaintiffs—National Small Business United d/b/a the National Small Business Association (“NSBA”), a nonprofit organization that represents the interests of small businesses and entrepreneurs, and one its members, Isaac Winkles—brought suit against the U.S. Treasury, Janet Yellen as secretary of the Treasury, and Himamauli Das as acting director of FinCEN, challenging the constitutionality of the CTA. On March 1, 2024, the U.S. District Court for the Northern District of Alabama issued its ruling in the case, finding in favor of the plaintiffs and prohibiting FinCEN from enforcing the CTA against them.[1]
This article will examine the court’s ruling, its immediate impact on CTA reporting companies, and its broader implications for the CTA.
National Small Business United v. Yellen
In its ruling in National Small Business United, the court found that the CTA, as currently drafted, exceeds the authority granted to Congress under the Constitution as it relates to each of Congress’s powers (i) over foreign affairs and national security, (ii) under the Constitution’s Commerce Clause, and (iii) over taxes. However, having found that the CTA is not within Congress’s constitutional authority, the court declined to address the plaintiffs’ additional arguments—that is, that the CTA also violates the First, Fourth, and Fifth Amendments.
With respect to Congress’s powers over foreign affairs and national security, the defendants argued that the CTA is necessary in order to protect national security interests, by enabling law enforcement to counter money laundering, terrorist financing, and other illicit activities. The court rejected this argument, stating, among other things, that the congressional findings connecting the CTA to national security interests are not sufficient to conclude that “a regulation in the purely domestic arena of incorporation is . . . ‘derivative of, and in service to’ Congress’ foreign affairs powers, especially in light of the States’ historically exclusive governance of incorporation.”[2]
With respect to Congress’s powers under the Commerce Clause, the court found, in part, that the CTA is not a valid regulation of the “channels and instrumentalities” of interstate commerce, nor is it within Congress’s power to regulate activities that have a substantial effect on interstate commerce, because the CTA, on its face, does not regulate entities that have engaged in interstate commerce. Rather, the CTA regulates entities upon their formation or registration to do business, regardless of whether or not they will engage in interstate commerce, and the act of formation or registration in and of itself is not an economic activity that affects interstate commerce.
Lastly, with respect to Congress’s taxing power, the court rejected the defendants’ argument that the CTA is necessary and proper to ensure the proper reporting and collection of taxes, finding that the relationship between such purposes and the CTA’s disclosure requirements is too attenuated.
Impact on Reporting Companies
The ruling in National Small Business United does not actually allow most entities affected by the CTA to refrain from complying with its requirements. Rather, the ruling is narrow in scope and applies only to the plaintiffs in the case, namely Isaac Winkles, the NSBA, and the NSBA’s members as of March 1, 2024. As such, all other entities that are reporting companies under the CTA are still required to report their beneficial owners to FinCEN within the required deadlines (i.e., ninety days for entities formed or registered to do business in 2024, and thirty days for entities formed or registered thereafter), as affirmed by FinCEN in an alert published on its website shortly after the ruling.[3] However, as a practical matter, entities in existence prior to the effective date of the CTA (which have until January 1, 2025, to file initial beneficial ownership reports with FinCEN) may want to consider postponing their filings until closer to the deadline while the legal challenges to the CTA continue to play out.
Implications for the CTA
The defendants in National Small Business United filed a notice of appeal on March 11, 2024, appealing the district court’s ruling to the U.S. Court of Appeals for the Eleventh Circuit. The appeals process is currently ongoing, with oral arguments scheduled for the week of September 16, 2024. While the ultimate impact of the case is thus still to be determined, the ruling has already had an impact on other legal challenges to the CTA.
In another case challenging the constitutionality of the CTA, Robert J. Gargasz Co. v. Yellen, the government defendants moved to hold that case in abeyance pending the outcome of the appeal in National Small Business United, on the grounds that the underlying issues in both cases are similar, which the court granted.[4] Furthermore, following the ruling in National Small Business United, additional lawsuits have been filed challenging the constitutionality of the CTA; these cases include many of the same arguments that the court found persuasive in National Small Business United and piggyback off the plaintiffs’ success. In one such case, Small Business Ass’n of Michigan v. Yellen, filed on March 26, 2024, plaintiff Small Business Association of Michigan argues that “because the CTA is triggered by the mere fact that an entity has been formed under state or tribal law, it applies to entities merely by virtue of their existence, not because they have engaged in any sort of commerce—interstate or otherwise.”[5] As such, the plaintiff argues that the CTA is not within Congress’s power under the Commerce Clause and cites to National Small Business United as precedent for its argument.[6] Thus, although the outcome in each of these actions is still uncertain, the ruling in National Small Business United called into question the constitutionality of the CTA and, depending on the outcome of these cases, may turn out to be the first domino to have fallen.
Lastly, in addition to the lawsuits challenging the CTA, legislation was recently introduced by Senator Tommy Tuberville (R-AL) and Representative Warren Davidson (R-OH) to repeal the CTA, posing additional uncertainty to the fate of the CTA in the wake of the ruling in National Small Business United.[7]
Nat’l Small Bus. United v. Yellen, No. 5:22-cv-01448-LCB, 2024 WL 899372 (N.D. Ala. Mar. 1, 2024). ↑
In a Fireside Chat event on April 2, 2024, sponsored by the Uniform Commercial Code Committee of the ABA Business Law Section (UCC Committee) and organized by the Committee’s Tokenized Payments Instrument Task Force, Assistant U.S. Attorney for the Southern District of New York Thane Rehn shared reflections on and lessons learned from the high-profile trial of Sam Bankman-Fried (SBF), founder of crypto exchange FTX Trading Ltd. (FTX). In a discussion moderated by Jess Cheng, partner at Wilson Sonsini, Rehn provided insight into the investigation of FTX’s collapse, the prosecution’s trial strategy, and key facets of the case that enabled the prosecution team to move quickly. The event, which attracted news coverage,[1] was especially timely, as it occurred only five days after SBF was sentenced to twenty-five years in prison for misappropriating billions of dollars of customer funds and defrauding investors and lenders.
Timeline of the Fall of FTX and SBF Trial
The chain of events that led to FTX’s collapse began in early November 2022 with the leak of what purported to be a balance sheet of Alameda Research LLC (Alameda), a crypto trading firm and FTX affiliate. Among other things, the leaked document revealed that a significant portion of Alameda’s assets consisted of FTT, an illiquid exchange token issued by FTX. Within days, rival crypto exchange Binance.com announced it would sell off its FTT holdings and initially offered to acquire FTX, but shortly thereafter, it withdrew from the deal, citing reports of mishandling of customer funds and alleged federal investigations. On November 11, 2022, FTX filed for Chapter 11 bankruptcy protection.
On December 12, 2022, SBF was arrested in the Bahamas, and the following day, the U.S. Attorney’s Office for the Southern District of New York unsealed the indictment charging him with wire fraud, commodities fraud, securities fraud, and money laundering. In parallel, the Securities and Exchange Commission charged SBF with orchestrating a scheme to defraud equity investors in FTX in violation of federal securities laws, and the Commodity Futures Trading Commission charged SBF, FTX, and Alameda with fraud and material misrepresentations in violation of federal commodities laws.
On November 2, 2023, after about one month of trial proceedings, the jury found SBF guilty on all seven counts of fraud and conspiracy. The U.S. Department of Justice issued the following statement from Attorney General Merrick B. Garland on the guilty verdict:
Sam Bankman-Fried thought that he was above the law. Today’s verdict proves he was wrong. This case should send a clear message to anyone who tries to hide their crimes behind a shiny new thing they claim no one else is smart enough to understand: the Justice Department will hold you accountable. I am grateful to the U.S. Attorney’s Office for the Southern District of New York and the FBI for their outstanding work in bringing Mr. Bankman-Fried to justice.
On March 28, 2024, U.S. District Court Judge Lewis Kaplan sentenced SBF to twenty-five years in prison and three years of supervised release, and he ordered the defendant to pay $11 billion in forfeiture for his orchestration of multiple fraudulent schemes.
Reflections on and Lessons Learned from the Trial
During the UCC Committee event on April 2, Rehn provided key insights into the trial strategy based on his experience as part of the prosecuting team, including preparing for the trial, delivering the prosecution’s opening statements, and cross-examining witnesses.
Sharing colorful examples and compelling visuals used at trial, Rehn illustrated how cooperating witnesses played an important role in the trial and efforts leading up to it. He discussed how the specialized knowledge of certain members of SBF’s inner circle at FTX and Alameda helped prosecutors piece together the billion-dollar theft of customer funds and the fraud on investors and lenders, enabling the team to move quickly to trial.
Rehn also shared how he used the opening statements to help the jury understand the narrative of FTX’s collapse, explain core financial and crypto concepts, and more generally preview the structure of the prosecution’s arguments. Interestingly, the aspects of crypto that tend to be more challenging to grasp—namely, blockchain, distributed ledgers, and technological innovation—arose less often than one might expect. Rather, the focus tended to be on explaining FTX’s role as a crypto exchange and dispelling misconceptions about its fall, particularly in the context of a highly volatile crypto market.
The defense sought to argue that SBF acted in good faith and that FTX was “building the plane as they were flying it,” with SBF taking the stand during his trial. Rehn walked through how the wealth of SBF’s tweets, interviews, and other public statements belied his testimony and those arguments. Sharing anecdotes, Rehn discussed the prosecution team’s approach to illustrating how SBF’s statements under cross-examination directly contradicted his prior statements, such as his claims to investors and the public that FTX segregated customer funds.
Takeaways
The Fireside Chat was a unique opportunity to learn about the strategies behind and lessons from a high-profile trial, directly from a key member of the prosecution team. Although the fraud occurred in the context of an innovative and volatile industry, at its core the case is a reminder across all industries that there are serious consequences for defrauding customers, investors, and lenders.
The views expressed by the writers are the writers’ own and do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System, nor the views of Wilson Sonsini Goodrich & Rosati.
As global M&A activity faced significant headwinds throughout 2023, buyers and investors seeking opportunities in technology industries found refuge in critical technology subsectors—particularly artificial intelligence (“AI”). Despite global tech M&A volume falling roughly 50 percent in 2023 on a year-over-year basis, the aggregate value of global AI M&A transactions grew in 2023 by over 20 percent compared to the year prior. As fears of recession wane and expectations of interest rate decreases in 2024 grow, M&A activity in the AI sector is poised to continue its run with force.
In a variety of industries, organizations are rapidly investing in and acquiring AI software companies to enhance value and broaden their capabilities. AI companies offer notable advantages due to their ability to swiftly scale operations with minimal capital investment, ensuring operational efficiency. However, companies leveraging AI also present distinct challenges and unprecedented risks. These risks are particularly pronounced for AI companies employing cutting-edge technology or operating in highly regulated industries, such as FinTech, RegTech, biomedical solutions, digital health devices, or autonomous vehicles. Buyers, ranging from private equity funds to strategic and tech-savvy acquirers, must not only recognize these risks but also enlist the guidance of advisors experienced in acquiring companies with AI solutions (“AI companies”) to structure transactions in a manner that mitigates risk and maximizes value.
This article will highlight five key AI-specific issues to consider when acquiring an AI company and offer strategies to mitigate these risks. Screening for such AI-related concerns will supplement the standard considerations typical of ordinary acquisitions. As with any acquisition, buyers must thoroughly assess all aspects of the target company’s operations, encompassing employment practices, tax implications, commercial agreements, and any specific issues arising from the acquisition (e.g., regulatory scrutiny of the transaction).
1. Target Company IP Rights
In the realm of AI enterprises, having clear ownership or sufficient rights to utilize all critical intellectual property (“IP”) is imperative. IP forms the foundation of AI business activities. Without unequivocal ownership rights, a company faces the peril of third-party infringement assertions, posing existential threats to its business viability and profitability.
Buyers should initially identify the essential IP assets and AI solutions fundamental to the target company’s operations. Subsequently, they must ascertain whether the target holds exclusive ownership or possesses adequate rights to utilize the IP and AI solutions incorporated into its operations or offered in its products and services. This entails verifying that any entities involved in the development of the target company’s IP and AI—such as employees, contractors, service providers, or research institutions—have duly assigned and transferred all relevant rights to the target company. Buyers should meticulously scrutinize databases maintained by the relevant administrative bodies, such as the Canadian Intellectual Property Office, and conduct thorough IP searches. This diligence ensures that the target company is the rightful owner of any registered IP and that there are no encumbrances from third-party interests registered against the IP.
In instances where the target company does not possess outright ownership of the underlying IP, buyers must assess the extent of ownership and the terms governing the target company’s utilization of the IP. This includes evaluating any associated risks relating to potential IP infringement claims that could be levied against the target company.
In the context of AI companies utilizing employees or independent contractors to develop their AI solutions, it becomes imperative to ensure that the company has obtained waivers of moral rights and consents from these third-party contributors. Moral rights afford creators of original works that are protected under copyright laws specific rights to their creations, independent of formal registration. In Canada, moral rights cannot be transferred or licensed; rather, they must be explicitly waived.
Another consideration for buyers is whether the target company has incorporated open-source software into its AI solutions, which carries inherent risks. The use of open-source software can include obligations for the company to disclose, free of charge, the source code of any software or program integrating the open-source software. Given the substantial risks at hand, prospective buyers should contemplate enlisting a third-party evaluator to scrutinize the target company’s AI solution source code. Such an audit aids in comprehending any potential open-source challenges or infringements on third-party intellectual property associated with AI ventures.
2. Ownership and Voting Structure
During the launch and initial phases of growth, diverse investors may obtain equity in a company. Yet, early-stage enterprises often grapple with maintaining precise corporate records, which can pose challenges during the acquisition process. Hence, buyers must meticulously discern the identities of the target company’s shareholders and the attendant rights they hold, which could significantly influence the acquisition. These rights might encompass voting privileges or dissolution rights linked to specific share classes or investors.
Emerging and rapidly expanding firms frequently employ options or warrants to motivate both internal stakeholders (e.g., employees, board members, and contractors) and external counterparts (e.g., lenders, strategic allies, and key clients) to support their growth through investment endeavors. Consequently, buyers must scrutinize the terms and vesting schedules of any options, warrants, or convertible securities (if issued) by the target company, as these factors could impact future control and ownership.
The buyer must also ensure all appropriate shareholders approve of the share purchase transaction or agree to sell their shares (pursuant to the articles or shareholder’s agreement). A thorough examination of the target company’s minute books and relevant agreements, such as shareholder agreements, becomes imperative to grasp the company’s ownership and voting framework comprehensively. Additionally, scrutinizing the chain of share ownership is vital for buyers to ascertain the identity of each shareholder and confirm their authorization to transfer shares to the buyer.
3. Data Rights and Use of Personal Information
For AI companies, data and quantitative metrics often serve as pivotal value drivers. Prospective buyers must strive to gain a comprehensive understanding of how the target company leverages data and its corresponding data practices, with a particular focus on contractual obligations pertaining to data collection, usage, and transfer. This examination should encompass an assessment of the target company’s policies regarding personal information, ensuring adherence to relevant laws, including data protection and intellectual property regulations, and securing necessary consent for data transfer and utilization where applicable. Comprehensive scrutiny should extend to all privacy policies and internal data handling procedures employed by the target company. Verifying the adequacy of consents for data usage is essential in mitigating associated risks.
In scenarios where the target company’s data practices involve the handling and processing of personal data, buyers must ascertain the relevant legislation governing such activities and evaluate whether the target has established protocols that align with all applicable data protection and privacy laws, as well as any existing third-party agreements. Given the potential complexities and costs associated with rectifying data misuse issues, buyers must clearly comprehend the target company’s data practices. Noncompliance on the part of the target company could present significant challenges, potentially necessitating consent from relevant third parties to rectify.
In cases where the proposed transaction entails a transfer of data ownership, buyers must ensure that the target company possesses the requisite rights and consents for such transfer. Failure to secure appropriate consent could result in the target company breaching its contractual obligations and facing subsequent liability.
4. Regulatory Risk and Life Cycle Issues
During the initial phases of software development, AI companies typically concentrate on crafting products that fulfill specific functional criteria. However, in this pursuit, these entities may overlook the regulatory obligations that apply to them and their clientele. This oversight can occur when a solution initially tailored for a particular industry or jurisdiction is later offered to customers operating in different regulatory environments. Regulations are constantly evolving, and therefore products and services must be monitored and continually updated to reflect these changes to avoid regulatory offenses.
Buyers must verify that the target company’s AI aligns with the legal and regulatory requirements applicable to all involved parties, looking both to requirements regarding the technological aspects of the solution and to those related to the specific functions or industries it involves. Additionally, they should anticipate potential legal changes to ensure the longevity of the AI solution and prevent unforeseen regulatory breaches. Failure to meet regulatory standards could expose the target company to substantial liabilities from customers, third parties, and governmental entities.
Beyond regulatory compliance, the dynamic nature of disruptive AI solutions necessitates considering the life cycle of the target company’s AI solution. In conjunction with legal and financial due diligence, cyber diligence efforts should assess the scalability, functionalities, and growth potential of the AI solution slated for acquisition in the M&A transaction.
5. Cybersecurity
Ensuring data security is paramount in safeguarding an AI business’s assets and operations. A breach in data integrity can inflict severe damage on a company’s worth; unauthorized access to confidential business data or sensitive customer information has the potential to cause significant financial losses and tarnish the company’s reputation, thereby impacting credibility and revenue streams. Cybersecurity due diligence, commonly referred to as “cyber diligence,” serves as a proactive measure to mitigate the risk of future data breaches, regulatory penalties, and privacy infringement litigation.
Engaging in cyber diligence is advantageous for buyers because it allows for a comprehensive review of a target company’s cybersecurity practices, identification of potential vulnerabilities, and preemptive measures to address cybersecurity risks before they cause threats. Furthermore, cyber diligence should meticulously evaluate the sensitivity or value of stored data and monitor any gaps in data security protocols. Engaging cybersecurity experts may be necessary to assess the adequacy of security measures and identify vulnerabilities within the system. Buyers should also scrutinize the target company’s cybersecurity incident response plan to ascertain its readiness to manage, mitigate, or resolve cyber threats should they arise.
6. Addressing the Risks
Upon identifying issues, buyers should assess the feasibility of mitigating these risks and how they can be addressed. Depending on the gravity of the issue, the target company might have the capacity to rectify concerns before the closing of the deal. Buyers may opt to tackle identified issues pertaining to the AI solution through the representations and warranties outlined in the share purchase agreement.
In instances where issues cannot be rectified prior to closing, such as concerns surrounding the utilization of open-source software in the target company’s products or services, buyers are advised to negotiate a reduction in the purchase price to reflect the assumed risk and the anticipated cost of post-closing remedies. Additionally, buyers may contemplate securing a specific indemnity to address known issues or consider withholding a portion of the purchase price, which can be utilized to offset losses stemming from identified issues post-closing. The parties involved may also explore restructuring the transaction to alleviate associated risks.
Certain issues, such as significant infringement of third-party intellectual property or noncompliance with privacy laws, may not be possible to address prior to closing. Consequently, buyers must weigh the potential reputational risk of proceeding with the transaction without resolving such concerns.
Conclusion
The points discussed in this article are by no means an exhaustive list of all issues relating to M&A where the target has developed or incorporated AI solutions; the aim is to highlight certain unique challenges inherent in the AI landscape. The issues identified should be closely monitored and thoroughly assessed during the due diligence phase of any transaction. Based on the findings, issues may be able to be addressed in the purchase agreement. This will assist in protecting buyers and also in establishing a meaningful valuation for the target company, as the parties can seek to address the risk through a reduction in the purchase price.
Engagement of legal counsel well-versed in AI solutions and experienced in AI M&A transactions is crucial for both buyers and sellers. Such expertise ensures comprehensive protection of their respective interests throughout the transaction process.
An April 11, 2024, article in the Financial Times, “The inequity method of accounting: California family learns about private-equity hardball while selling supermarket chain,” has created a stir in the private equity deal community. The article details a dispute that arose between the prior owners of Save Mart, a California supermarket chain, and Kingswood Capital Management, a Los Angeles–based, lower-middle-market private equity firm. While the article is recent, the arbitration award detailed in the article was handed down on September 5, 2023, and confirmed by the Delaware Court of Chancery on February 28, 2024. Prior to the Financial Times article, the case received little attention. But the seeming harshness of the arbitration decision as detailed in the article (selling stockholders being required to pay the buyer approximately $70 million for the buyer to acquire the company), coupled with the Court of Chancery’s confirmation of it, has many in the deal community gobsmacked.
So, I decided to delve into it a bit more deeply and look at the actual provisions at issue to the extent obtainable. (Because the otherwise private arbitration ruling was posted by the Financial Times and is therefore publicly available, we have direct quotations from the purchase agreement to review.) What I have managed to learn from the available documents follows.
Save Mart Supermarkets, LLC operated over two hundred stores in California and Nevada. Save Mart also was a general partner in (and owned an equity interest of approximately 52 percent of) Super Store Industries (“SSI”), a separately run partnership with two other partners that operated a wholesale grocery distributor business. SSI had debt on its balance sheet of approximately $109 million. This debt was not on Save Mart’s balance sheet because SSI was an unconsolidated subsidiary, and Save Mart had elected to account for the SSI partnership using the equity investment method, meaning that Save Mart reflected on its balance sheet its net investment in SSI (SSI’s asset value less SSI’s debt, multiplied by Save Mart’s ownership interest). Save Mart’s latest balance sheet prior to its sale reflected its joint venture investment in SSI at a net $22.5 million. In other words, the SSI debt was well covered by the assets of SSI (and the SSI debt was current and had never been in default).
Kingswood Capital formed SM Buyer LLC (“Buyer”) to acquire Save Mart from its owners (“Sellers”). Buyer and Sellers entered into an Equity Purchase Agreement (“EPA”) on March 7, 2022. The deal was structured as a “cash free, debt free” deal, with an agreed “Base Value” of $245 million. Consistent with the “cash free” concept, the EPA permitted the Sellers to sweep all cash out of Save Mart prior to closing, and they in fact swept $205 million out of Save Mart prior to closing.
As is typical, the purchase price was determined by a formula that started with the base value and then subtracted closing date indebtedness and transaction expenses and added or subtracted other items, such as working capital excesses or deficiencies. The EPA contained a purchase price adjustment mechanism to address that calculation. It provided for (a) the Sellers to prepare an estimated closing statement a few days prior to closing (which the Buyer was entitled to comment upon and which provided the basis for the estimated purchase price to be paid at closing), (b) the Buyer to then, within ninety days after the closing, prepare its own closing statement consistent with the contractual guard rails, and (c) any dispute between the Sellers’ estimated and Buyer’s closing statements to be resolved by accountants or courts depending on the issue.
The definition of “Purchase Price” read as follows in the EPA (prior to an amendment that separated the sale of the SSI joint venture interest from the sale of the rest of Save Mart):
The aggregate consideration payable by Buyer in respect of the Company Membership Interests shall be an amount equal to (a) the Base Value, plus (b) the amount, if any, by which the Working Capital exceeds the Working Capital Target, minus (c) the amount, if any, by which the Working Capital Target exceeds the Working Capital, plus (d) the Closing Cash (which may be a negative number, in which case, Closing Cash shall reduce the Base Value), minus (e) Closing Date Indebtedness, minus (f) Transaction Expenses, minus (g) Deemed Accrual Amount (such resulting amount pursuant to clauses (a)-(g), and as such amount may be adjusted pursuant to the provisions of Section 1.4, the “Purchase Price”).
The key deduction from Base Value here was “Closing Date Indebtedness.” Closing Date Indebtedness was defined in the EPA as “the aggregate amount of all Indebtedness of the Group Companies as of the Adjustment Time.”
Indebtedness was defined very broadly to include:
among other things, “(i) the outstanding principal amount of and accrued or unpaid interest of (A) indebtedness of such Person or its Subsidiaries for borrowed money (including Debt Breakage Costs) and (B) indebtedness evidenced by notes, debentures, bonds or other similar instruments for the payment of which such Person or its Subsidiaries is responsible or liable,” and “(xi) all liabilities and obligations of the type referred to in clauses (i) – (x) of other Persons for the payment of which such Person or its Subsidiaries is responsible or liable, directly or indirectly, as obligor, guarantor or surety.”
Group Companies was defined to include Save Mart and its “Operating Subsidiaries.” Operating Subsidiaries was defined to include “all direct and indirect Subsidiaries of the Company [listed on Section 3.4(b) of the Company Disclosure Schedule].” SSI was in fact listed as an Operating Subsidiary on Schedule 3.4(b). Adjustment Time was defined as 11:59 p.m. PT on March 27, 2022, which was the day before the closing at 8:00 a.m. PT on March 28, 2022.
However absurd it may seem given the balance sheet accounting treatment of the SSI investment (net equity value), the strict language of the definition of Closing Date Indebtedness appears to cause all of the SSI debt (a revolver and a real estate loan, totaling $109 million) to be included.
At some point, the Buyer’s financing sources had apparently expressed concern about the potential for a creditor of SSI to directly sue Save Mart as a general partner of SSI. As a result, the Buyer asked the Sellers to restructure the deal so that Save Mart was no longer a direct partner of SSI immediately prior to the closing. They did this by amending the EPA (the “EPA Amendment”) to provide that immediately prior to the closing, Save Mart’s partnership interest in SSI would be distributed to the Sellers, who would then contribute that partnership interest to a newly formed entity (“SSI Holdco”). The Sellers would then sell the equity in SSI Holdco to a newly formed affiliate of the Buyer (“Topco”) for a fixed purchase price (not subject to any adjustment) of $90 million. As a result of the proposed pre-closing SSI spinoff required by the EPA Amendment, as of the closing date (a) Save Mart would no longer be a general partner of SSI, and (b) SSI would no longer be an Operating Subsidiary of Save Mart.
In the Amended EPA, the definition of Purchase Price was changed to read as follows (changes in bold):
The aggregate consideration payable by Buyer in respect of the Company Membership Interests shall be an amount equal to (a) the Base Value, plus (b) the amount, if any, by which the Working Capital exceeds the Working Capital Target, minus (c) the amount, if any, by which the Working Capital Target exceeds the Working Capital, plus (d) the Closing Cash (which may be a negative number, in which case, Closing Cash shall reduce the Base Value), minus (e) Closing Date Indebtedness, minus (f) Transaction Expenses, minus (g) Deemed Accrual Amount, minus (h) the SSI Purchase Price (such resulting amount pursuant to clauses (a)-(h), and as such amount may be adjusted pursuant to the provisions of Section 1.4, the “Purchase Price”), and the aggregate consideration payable by Topco in respect of the SSI Holdco Membership Interests shall be an amount equal to $90,000,000 (“SSI Purchase Price”).
But the definitions of Group Companies, Indebtedness, Closing Date Indebtedness, and Operating Subsidiary all remained unchanged. And notably, Schedule 3.4(b) continued to list SSI as an Operating Subsidiary, which was accurate pre-closing, but not post-closing when it mattered. Including all SSI debt in Closing Date Indebtedness made little sense before the SSI spinoff given the accounting treatment on Save Mart’s balance sheet, but it made no sense following the SSI spinoff because, post-closing, SSI was no longer a Group Company of Save Mart.
As required by the EPA, the Sellers prepared an estimated closing statement three days prior to the closing. The Buyer made several comments, and the Sellers made revisions to accommodate the Buyer’s comments. Notably, the Sellers did not include the SSI debt in the Closing Date Indebtedness for purposes of computing the estimated purchase price, and the Buyer did not object to the Sellers’ failure to do so. The estimated closing statement prepared by the Sellers reflected a purchase price to be paid by the Buyer to Sellers for Save Mart of approximately $39.5 million, of which approximately $7 million was to be deposited into an escrow account. The closing was then consummated based upon that estimated closing statement.
Pursuant to the terms of the EPA, the Buyer then prepared its own closing statement within ninety days after the closing; in that statement, the Buyer included the $109 million of SSI debt as a deduction from the Base Value for the purposes of determining the final purchase price. The provision in the EPA detailing how the Buyer was supposed to prepare its closing statement is set forth below in relevant part (emphasis added):
Closing Statement. No later than ninety (90) days after the Closing Date, Buyer shall cause to be prepared in good faith and delivered to Seller a statement (the “Closing Statement”) setting forth Buyer’s calculation of the Purchase Price (the “Closing Date Purchase Price”). The Closing Statement shall be prepared in a manner consistent with the definitions of the terms Working Capital, Closing Cash, Closing Date Indebtedness, Transaction Expenses, including, as applicable, the Accounting Rules (including as reflected on Exhibit A). The Parties agree that the purpose of preparing the Closing Statement and determining the Working Capital, Closing Cash, Closing Date Indebtedness, and Transaction Expenses is to measure the amount of the Working Capital, Closing Cash, Closing Date Indebtedness, and Transaction Expenses and such processes are not intended to (x) permit the introduction of accounting methods, policies, principles, practices, procedures, classifications or estimation methodologies for the purpose of determining the Working Capital, Closing Cash, Closing Date Indebtedness, or Transaction Expenses that are different than the Accounting Rules or (y) adjust for errors or omissions that may be found with respect to the Company Financial Statements or any inconsistencies between the Company Financial Statements and GAAP (except to the extent resulting from the application of the Accounting Rules in accordance with this Agreement).
There were disputes beyond whether the $109 million should have been included as part of Closing Date Indebtedness, and those disputes were referred to an accounting referee for resolution. But for reasons that are unknown (and must now be regretted by the Sellers), the parties agreed to submit the SSI debt inclusion dispute to binding arbitration before a retired former vice chancellor of the Delaware Court of Chancery (the “Arbitrator”), as opposed to litigating the dispute in court.
In the final arbitration award, the Arbitrator appears to concede that all of the extrinsic evidence suggests that the SSI debt was never intended to be a deduction to the purchase price. However, based upon Delaware’s strong contractarianism, he concludes early on that:
As explained below, the issues as framed by the parties distill down to a choice between two arguably unsatisfying outcomes: apply the clear and unambiguous terms of the operative contract and reach a result that is in tension with the extrinsic evidence; or follow that extrinsic evidence to a result that cannot be squared with the clear and unambiguous contract as written. That the resolution of the dispute, either way, will effect a material shift in the deal dynamics makes the choice between these outcomes all the more unsatisfying. But the choice, ultimately, is not difficult. The parties contractually invoked Delaware law and that election is consequential. Delaware law is more contractarian than most, and Delaware courts will enforce the letter of the parties’ contract without regard for whether they have struck a good deal or bad deal. Absent a contractual ambiguity, extrinsic evidence is inadmissible to construe the contract. The purchase agreement is not ambiguous. And the buyer has proffered the only reasonable construction of the contract’s operative provisions. Delaware law accordingly mandates that I adopt the buyer’s interpretation and ignore the extrinsic evidence.
The Sellers valiantly attempted to find places in the agreement (which after all must be read as a whole) to suggest that Buyer’s interpretation was not in fact the only reasonable interpretation, and that there was a perfectly valid interpretation that supported the Sellers’ view of the meaning of the term Closing Date Indebtedness in context of these other provisions (without necessarily relying on extrinsic evidence). Among those other provisions were the references to Accounting Rules and the fact that the EPA expressly forbade the “introduction of accounting methods, policies, principles, practices, procedures, classifications or estimation methodologies for the purpose of determining the Working Capital, Closing Cash, Closing Date Indebtedness, or Transaction Expenses that are different than the Accounting Rules.” The argument was that since the SSI debt had always been recorded under the net equity method of accounting, treating the entire SSI debt as if it were Indebtedness would be violating this provision. But after extensive analysis, the Arbitrator concluded that the Accounting Rules largely pertained to the calculation of Working Capital and could not overcome the clear definition of Closing Date Indebtedness. It is important to note here that the comparison was not to alternative balance sheets and differing methods of accounting for the debt, where the prohibition of changing methods of accounting may have had some applicability; instead this was a simple calculation of defined debt (which never mentioned applying accounting methods to determine the components of that defined debt).
There were other arguments based on isolated provisions of the EPA, including the fact that the SSI debt was listed as an Undisclosed Liability in the representations and warranties section of the EPA and, in context, Undisclosed Liabilities were stated as being in addition to Indebtedness that was otherwise included in calculation of the Purchase Price (emphasis added):
Undisclosed Liabilities. Except as set forth on Section 3.6 of the Company Disclosure Schedule [which listed the SSI debt only], neither the Company nor any of the Operating Subsidiaries have any material Liabilities, other than (a) as disclosed in, set forth on, or reflected and adequately reserved against in the Balance Sheet, (b) those incurred in the Ordinary Course of Business since the Balance Sheet Date (none of which arises from or relates to any violation of Law, tort, breach of Contract, environmental, health or safety matter or infringement or violation of Law or misappropriation or is otherwise material), and (c) those Transaction Expenses, Indebtedness, Working Capital and unpaid credit card processor’s fees, costs and expense items fully included in the calculation of the Closing Payments.
The argument was that if the scheduled SSI debt was intended to be included in the Indebtedness that was a part of the Closing Date Indebtedness deducted in determining the Purchase Price, then there was no reason to schedule it as an Undisclosed Liability in the first place. Again, the Arbitrator made short work of this argument (even though I kind of liked it) by simply noting that disclosures against representations and warranties are often broader than strictly necessary, and they don’t override the actual defined terms for purposes of calculating the Purchase Price.
The Sellers also tried to argue that SSI was not an Operating Subsidiary as of the Adjustment Time because the spinoff was supposed to happen one business day before the closing, which would have been prior to 11:59 PM PT on March 27, 2022. But the actual spinoff occurred immediately prior to the closing, which by definition was after the Adjustment Time. And the Sellers conceded at the arbitration hearing that the SSI spinoff, “without a novation from [the SSI lenders,] would not by itself discharge Save Mart’s theoretical general partner liability” on the SSI debt. With that concession, the Arbitrator was able to conclude that even if the SSI debt was not Indebtedness of an Operating Subsidiary as of the Adjustment Time, it could still qualify as Indebtedness for which Save Mart was otherwise liable (as a former general partner presumably) pursuant to clause (xi) of the definition of Indebtedness. If the spinoff did not eliminate the risk of the SSI lenders pursuing claims against Save Mart for the SSI debt, the Buyer’s financing sources must have been concerned about ongoing creditors other than the known SSI debt. In other words, the risk of Save Mart having to answer for the SSI debt directly did not appear to have been a driving concern for the Buyer or its financing sources, and there was no reason to expect that getting the benefit of a credit of $109 million against the Purchase Price (and the resulting payment of approximately $70 million to the Buyer by the Sellers) was going to result in the Buyer using that money to actually pay the SSI debt.
The Sellers also sought to reform the EPA based on unilateral or mutual mistake. Unfortunately, to prevail on these arguments, the Sellers were required to show “that the parties came to a specific prior understanding that differed materially from the written agreement.” And in this case the Arbitrator found that:
Seller fails to support this critical element. It has not produced clear and convincing evidence of a pre-existing agreement between the parties to exclude the SSI Debt from the definition of Indebtedness. To be sure, Kingswood’s original letter of intent did not include any SSI Debt in its sample Indebtedness calculation. But there is no evidence, never mind clear and convincing evidence, that the sample Indebtedness calculation caused the parties to reach a “specific prior understanding that differed materially from the written agreement.” In fact, witnesses from both sides repeatedly testified that the two sides simply never discussed the treatment of the SSI Debt in the Acquisition. This mutual silence is a far cry from the sort of clear and convincing evidence that could support a claim for reformation based on a mistake. Delaware law is clear that claims for mistake are not supported by “poor contract drafting” and “cannot save a party from its agreement to unambiguous contract provisions that later prove disadvantageous.”
The Sellers also argued that the “forthright negotiator principle” should result in a finding in favor of the Sellers. Application of the forthright negotiator principle, however, requires that there be an ambiguity in the contractual language that cannot be resolved by extrinsic evidence that leads “to a single, commonly held understanding of the contract’s meaning,” the Arbitrator noted. In such cases, “the court, in considering alternative reasonable interpretations of contract language, [may] resort to evidence of what one side in fact believed the obligation to be, coupled with evidence showing that the other party knew or should have known of such belief.” But here, according to the Arbitrator, “Buyer’s alleged lack of forthright negotiation [is] irrelevant because the EPA is unambiguous.”
Following the issuance of the final arbitration award in favor of the Buyer, the Buyer immediately sought to confirm the award in the Delaware Court of Chancery. Vice Chancellor J. Travis Laster, on February 28, 2024, in SM Buyer LLC v. RMP Seller Holdings, LLC, 2024 WL 8652024 (Del. Ch. (Trial Order) Feb. 28, 2024), granted the Buyer’s motion for summary judgment confirming the final arbitration award. In his order, Vice Chancellor Laster noted that “review of an arbitration award is one of the narrowest standards of judicial review in all of American jurisprudence.” To do so based on “manifest disregard of the law,” which was the ground asserted by the Sellers, requires “that the arbitrator (1) knew of the relevant legal principle, (2) appreciated that this principle controlled the outcome of the disputed issue, and (3) nonetheless willfully flouted the governing law by refusing to apply it.” Applying this standard, Vice Chancellor Laster concluded that:
[T]he Arbitrator strictly applied the literal words of the definition of Closing Date Indebtedness. The Arbitrator analyzed the Agreement as a whole and interpreted its language consistent with recent trends in Delaware law towards a highly contractarian jurisprudence. Given this record, it is not possible to find that the Arbitrator manifestly disregarded the law. He diligently applied the law.
But then Vice Chancellor Laster noted that even though he had to confirm the Arbitrator’s arbitration award in favor of the Buyer, he believed that “the outcome that the Buyer achieved in this case was . . . economically divorced from the intended transaction,” and that he “would have ruled differently than the Arbitrator” because:
I think the agreed-upon accounting principles and the mandate to prepare the reference statement and the final statement consistently meant that the Buyer’s adjustment was contrary to the plain meaning of the Agreement. At a minimum, I think the Agreement, read in conjunction with the Amendment and the separate treatment of the GP Interest [SSI], rendered the parties’ treatment of Closing Debt Indebtedness ambiguous.
Had the Sellers not agreed to submit this dispute to binding arbitration, they may still have had an appeal to the Delaware Supreme Court to right this apparent wrong, without the almost impossible burden of undoing the binding arbitration award. The appeal that is presumably in progress to the Delaware Supreme Court in the face of the final arbitration award is a much heavier lift than would have been the case had the final arbitration award simply been an opinion of the Delaware Court of Chancery.
This case raises some serious questions about deal-making ethics depending on who understood what and when about the potential inclusion of the SSI debt as a deduction to the Purchase Price. During my career I was once faced with a client pursuing a course of action that I believed was legally correct, but morally wrong, and my response was to refuse to represent them in the resulting dispute. Typically, sharp business practices will catch up with you eventually.
The obvious fix here, of course, was to amend the definition of Indebtedness to expressly exclude the SSI debt (and there were in fact a healthy list of exclusions to the definition of Indebtedness). That clearly should have happened. Another mitigating provision, which is often found in deals involving a private-equity-backed seller (which Save Mart was not), is to put a cap on any purchase price adjustment equal to the agreed escrow (which here was $7 million)—at least that would have resulted in a smaller ouch.
Deal lawyers tend to like Delaware’s strict contractarianism—it provides certainty that the documented deal is the deal. But that certainty can sometimes come at a cost in situations like this, particularly once an arbitrator applies that strict contractarianism.
In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996) was a landmark decision from the Delaware Court of Chancery holding that a corporate board’s failure to assure a reasonable information and reporting system is an act of bad faith and in breach of the board members’ duty of loyalty.
Caremark articulated a two-prong standard for board member liability as follows:
The board must have utterly failed to implement any reporting information protocols over key corporate actions; and
even where such restrictions or controls are implemented, liability could nevertheless attach if the board failed to monitor or oversee relevant corporate operations.
These Caremark duties remain good law in Delaware and continue to provide shareholders with a powerful remedy in bringing derivative actions against a board, albeit one that many commentators and jurists have asserted is possibly the most difficult theory in corporate law upon which such plaintiffs might hope to win a judgment. That being said, there have been a few recent examples where plaintiffs have survived a motion to dismiss and a large derivative settlement followed.
Perhaps the most notorious of these instances resulted from In re The Boeing Company Deriv. Litig., No. 2019-0907-MTZ, 2021 WL 4059934 (Del. Ch. Sept. 7, 2021). The derivative litigation there flowed from two fatal crashes involving Boeing 737 Max aircraft. In denying the motion to dismiss, the court held that aircraft safety was a “mission critical” board oversight responsibility and that the Boeing board failed to satisfy the Caremark standards. Ultimately, the litigation settled for $237.5 million, one of the largest derivative settlements in history.
Boeing’s product safety issues remain the subject of almost daily commentary in the legal and business press. Indeed, Boeing and certain of its executives were sued earlier this year in a putative class action involving a different version of the 737 aircraft and issues apparently not related to the earlier 737 Max litigation. Without being privy to the scope of the releases the Boeing board may have obtained when the 2021 shareholder litigation was settled, it remains an open question to what extent Boeing’s current issues with 737 and other aircraft may become the subject of a new Caremark suit. To date there has been no such derivative suit.
Nonetheless, the Boeing derivative suit and a few others where board defendants were unable to prevail upon a motion to dismiss give support to the notion that Caremark theories may not be as difficult for plaintiffs as they once were. Although the success rate is still well below 50 percent, the authors estimate it is at about 30 percent. To use a baseball analogy, a .300 hitter is not considered to be a shabby foe.
It behooves a board to take cognizance of what may be the mission-critical activities of the corporation and take steps to implement and enforce protocols to ensure that those activities are properly monitored through use of executive committees or other mechanisms.
The authors, along with two other co-authors, have written in greater detail on these corporate governance issues in Corporate Governance: Understanding the Board-Management Relationship, recently published by the Business Law Section of the American Bar Association. The book provides an analysis of corporate management and the legal liability of directors and officers, and it examines how the corporate board has evolved and changed. It provides expansive discussion of shareholder derivative litigation against officers and board members at Boeing and McDonald’s Corporation, as well as other recent high-profile litigation in Delaware.
The preface of the book by Dave Gilfillan, chief claims officer at CRC Group, states, “The authors have provided a unique and focused lens in which to evaluate and understand the actions of directors and officers and their implications for corporate executives, legal counsel, business managers, stockholders, and consumers. CorporateGovernance offers a textural perspective of a complicated subject that is often misunderstood by both professionals and the public.”
Following Gilfillan’s comments, the book takes the reader into the fundamental issues of governance, oversight, and management. Chapter by chapter, it addresses economic fundamentals underlying organization governance; stress testing your organization governance structure; the evolution from tone at the top to checks and balances; why a company should consider using an executive committee of its board of directors; organization governance and information gaps: importance of internal reporting and internal information for board oversight; monitoring cash flows: the board, the CLO, and the CFO; the board, management, and the organization’s intellectual capital; and board member selection and board interaction.
Even though tender offers and other business combination transactions may involve only non-U.S. companies, such transactions may nonetheless be subject to various U.S. laws and regulations, including U.S. federal securities laws and regulations. The application of U.S. federal securities laws and regulations generally depends on how the transaction is structured, whether any of the companies is subject to U.S. securities law and reporting obligations, and whether any of the companies’ security holders are located or resident in the United States. U.S. federal securities laws and regulations are applicable to cross-border tender offers and other business combination transactions involving, in the case of a tender offer, a “target,” or, in the case of a business combination transaction not involving a tender offer, a “subject company” that is organized in a jurisdiction outside the United States.
“Tender offer” refers generally to an offer by a bidder to acquire shares of another company, whether for cash or securities or a combination of the two, that is made directly to security holders of the target company and may or may not be supported by management of the target company. References to a “business combination transaction” mean a combination of two entities’ businesses by means of a tender offer or otherwise.
A fundamental goal of the U.S. securities laws is the protection of U.S. investors. The SEC has historically taken the view that U.S. securities laws potentially apply to any transaction that is conducted in the United States or that employs U.S. jurisdictional means. Specifically, U.S. securities laws may be implicated as follows:
The general anti-fraud provisions of the U.S. Securities Exchange Act of 1934, as amended, may be violated where fraudulent conduct occurs in the United States or where the effects of the fraudulent conduct are felt in the United States.
If a tender offer is made for securities of a class that is registered under the Exchange Act, it is generally necessary for the bidder to comply with the tender offer provisions of the Exchange Act, subject to available exemptions, if any.
Even where the target company does not have a class of securities registered under the Exchange Act, the Exchange Act proscribes certain “fraudulent, deceptive, or manipulative” acts or practices in connection with tender offers that are potentially applicable.
If securities are to be offered to persons in the United States, it may be necessary to register such securities pursuant to the U.S. Securities Act of 1933, as amended, or to confirm the availability of an exemption from registration.
U.S. federal securities laws apply to a tender offer or other business combination transaction notwithstanding the nationality of the bidder or target or the protections afforded by their respective home market regulators if extended to holders in the United States. This approach contrasts with the approach taken in many European jurisdictions, where the jurisdiction of the organization of the target or the jurisdiction of its primary listing, rather than the residency of the investors or the means by which the offer is made, will determine the regulatory implications of the transaction. For instance, the United Kingdom’s City Code on Takeovers and Mergers applies to offers for all public companies, whether listed or unlisted, resident in the United Kingdom, the Channel Islands, or the Isle of Man; South African takeover regulations apply to companies that are deemed to be resident in South Africa; and in France, the rules relating to tender offers generally apply only where the target company is a French entity listed in France—the residency of the shareholders of the target is irrelevant.
Rule 802 is an exemption for the issuance of shares in an exchange offer. To qualify, the target must be a foreign private issuer with a U.S. shareholding of less than 10 percent. There are also exemptions for Canadian companies in the Multi-Jurisdictional Disclosure System. Section 3(a)(10) of the Securities Act provides an exemption for the issuance of shares in connection with a business combination pursuant to a court order.
There are two tiers of cross-border exemptions to U.S. tender offer rules. Tier I applies in the following circumstances:
The transaction is a tender offer for the equity securities of a target company that is a foreign private issuer.[1]
Fewer than 10 percent of the target company’s shares are held by U.S. residents.
In the case of a Tier I offer, the bidder is exempt from the following procedural requirements:
the rules governing the duration of the tender offer and extensions;
the prompt payment requirement;
restrictions on purchases outside of the tender offer; and
the rules governing the response of the target company.
Tier II applies in the following circumstances:
The offer is a tender offer for the equity securities of a target company that is a foreign private issuer.
More than 10 percent but less than 40 percent of the target company’s shares are held by U.S. residents.
In the case of a Tier II offer, the bidder is exempt from the following procedural requirements:
the rules governing notice of extensions;
the prompt payment requirement;
the prohibition on early termination of the tender offer period; and
the prohibition on purchases outside of the offer.
The 2023 Merger Guidelines (“2023 Guidelines”)[1] jointly issued by the Antitrust Division of the Department of Justice (“DOJ”) and the Federal Trade Commission (“FTC”) (collectively, the “Agencies”) represent the latest iteration of a fluctuating interpretation over time of section 7 of the Clayton Act of 1914, which prohibits mergers the effect of which “may be substantially to lessen competition” in any section of the country.[2] The Merger Guidelines serve the goals of transparency in merger enforcement by discussing the legal and economic analytical approaches adopted by the Agencies. They do, however, tend to change direction with the political winds (i.e., which administration is in office at the time they are amended). Even taking those huffs and puffs into account, the latest iteration, finalized in December 2023, has significantly raised eyebrows because it constitutes a marked retrenchment to long-discarded approaches and legal positions that have been rejected by the courts over the years.
The Merger Guidelines do not, by themselves, have the force of law. Nevertheless courts have occasionally cited to them as persuasive authority. From a practical transactional standpoint, moreover, the antitrust enforcement policies and proclivities of the Agencies are often essential knowledge for structuring mergers and acquisitions (“M&A”) transactions. While this article cannot delve into the Merger Guidelines in depth, it will summarize their evolution and some significant aspects of the Agencies’ current approach.
A Brief History of the Merger Guidelines
1968 Guidelines
First issued (by DOJ alone) in 1968 during the Johnson administration, the Merger Guidelines’ distinctive characteristic was general hostility toward mergers between substantial companies, largely because such mergers—which, almost by definition, tend to increase concentration—would lessen the possibility of achieving a deconcentrated market in the future. For example, the 1968 Guidelines took a dim view of mergers involving firms with 5 percent or more of the market, even where that market was unconcentrated (i.e., below 1,000 on the Herfindahl-Hirschman Index (“HHI”)[3] scale),[4] and in a market displaying a significant trend toward concentration, the larger competitors would not have been permitted to acquire any firm with a market share of 2 percent or more.[5]
1982 and 1984 Guidelines
Quite a different philosophical approach permeated the first two revisions of the Merger Guidelines, which took place during the deregulatory Reagan era and regarded many mergers as either competitively beneficial or neutral. Conspicuously absent was any discussion of a “trend toward concentration.”[6]
The 1982 Guidelines and the successor 1984 Guidelines also rejected ad hoc market definition and instead defined a market as a group of products and a geographic area where a hypothetical firm that is the only seller of those products in that area would possess monopoly power and could profitably restrict output or raise prices. Such power could not be exercised, however, if it would result in buyers switching to other products sold in the same geographic market or to products sold in other areas or would induce out-of-market firms to enter the market and begin selling competing products. Any firms selling competing products or substitutes to which consumers would switch[7] in response to the hypothetical firm’s attempt to impose, in the 1982 and 1984 Guidelines’ terminology, a “small but significant and nontransitory price increase” (“SSNPI”), would make that price increase unprofitable, would prevent the exercise of market power,[8] and ought therefore to be included in the defined market. The methodology of the 1982 and 1984 Guidelines was then to expand the market definition to include these additional products and areas up to the point at which it would be profitable for a hypothetical firm that was the only seller of a product or group of products in that area to impose an SSNPI. At that point, that group of products and area would be considered to be a market.
Having defined the market, the 1982 and 1984 Guidelines’ next task was an assessment of the likely effects of a proposed merger on competitive behavior in that market. Even if those effects were “significantly adverse,” however, that was not the end of the analysis, for there could well be significant mitigating factors, such as ease of entry[9] or the proximity and similarity of next-best substitutes.[10]
1992 Guidelines
Emphasis under the 1992 Guidelines (which, for the first time, was a joint issuance of DOJ and the FTC) shifted slightly from the purely theoretical to the more practical. For example, in assessing likely conduct by consumers or by other producers, the 1992 Guidelines purported to eschew overreliance on polls of customers or competitors in favor of the more pragmatic inquiry into the parties’ incentives: “whether consumers or producers ‘likely would’ take certain actions, that is, whether the action is in the actor’s economic interest.”[11] Similarly, consumer reaction would now be measured with respect to an SSNPI lasting for the “foreseeable future,” instead of the one-year formulation of the 1984 Guidelines.[12]
The 1992 Guidelines were concerned with two broad categories of competitive effects: “coordinated effects” and “unilateral effects.” Coordinated effects had been a traditional target of antitrust enforcement and were characterized as being “profitable for each of the [colluding firms] only as a result of the accommodating reactions of the others.”[13] For coordinated action to be successful, the firms must be able (A) to arrive at “terms of agreement that are profitable to the firms involved” and (B) “to detect and punish deviations that would undermine the coordinated interaction.”[14] Unilateral effects were deemed to be of concern where the survivor of a merger “may find it profitable to alter [its] behavior unilaterally following the acquisition by elevating price and suppressing output.”[15]
As compared with the 1984 version, the 1992 Guidelines substantially expanded entry analysis. In light of some unfavorable litigation results during the 1980s,[16] DOJ began to repudiate reliance on structural conditions of entry in favor of a more fluid approach that took into account the likelihood of entry (not whether entry “could” occur but whether it “would”) and its timeliness and likely sufficiency. Judicial reliance on the entry language of the 1984 Guidelines had undercut the effectiveness of this position[17] and suggested that those provisions would have to be substantially revised, rather than merely fine-tuned.
One of the most significant changes in the 1992 Guidelines was the introduction into both market definition and entry analysis of the concept of “sunk costs.”[18] This concept relates to the question of whether another producer will enter the market and is used to distinguish between two categories of potential competitors: “uncommitted entrants” and “committed entrants.” The “uncommitted entrants” category constitutes firms not currently producing the product (or not currently competing in the relevant geographic market) that, in response to an SSNPI, “likely would” commence production of the relevant product within one year; “committed entrants,” by contrast, must incur significant sunk costs of entry and exit in order to commence timely production of the relevant product.[19] Such firms were not treated as market participants but were instead analyzed in a separate step to determine whether they would meet the entry tests of (A) timeliness (within two years),[20] (B) likelihood (based on profitability—at premerger prices),[21] and (C) sufficiency (in terms of whether the magnitude, character, and scope of the entry would be adequate to return prices to premerger levels)[22] and thus would likely deter anticompetitive mergers or deter or counteract the competitive effects of concern.[23] The 1992 Guidelines treated uncommitted entrants as incumbent, in-market producers of the relevant product—even though they were not currently producing that product or were not doing so in that geographic market—because of their putative flexible and timely competitive response without significant commitment to the relevant market.[24]
1997 and 2010 Guidelines
The Agencies made some minor tweaks to the Merger Guidelines in 1997 and again in 2010. Both versions focused on horizontal mergers. The 2010 Guidelines, however, de-emphasized market shares and market concentration vis-à-vis earlier versions. For example, the 2010 Guidelines rejected the mechanical, somewhat lockstep approach of the 1992 Guidelines—that is, (1) market definition and concentration, (2) competitive effects, (3) entry, (4) efficiencies, and (5) failing firm defense.
2020 Guidelines
The 2020 Guidelines focused on vertical mergers. In 2021, however, the FTC backed away from its endorsement of the 2020 Guidelines, based on the assertion that the guidance documents included “unsound economic theories that are unsupported by the law or market realities.”[25] The FTC reaffirmed its commitment to continue to work with DOJ on the Merger Guidelines but, by a vote of 3–2, withdrew its approval of the 2020 Guidelines as representing a flawed approach.
Lead-Up to the 2023 Guidelines
Under the Biden administration, there has been a marked policy shift in favor of more vigorous antitrust enforcement in the M&A sphere.[26] In July 2021, President Biden issued an executive order that “encouraged” the attorney general and the chair of the FTC “to review the horizontal and vertical merger guidelines and consider whether to revise those guidelines.”[27] Contemporaneously, the Agencies issued a joint statement that they would take a “hard look” at both sets of guidelines.[28]
Reacting to perceived increases in concentration across many industries, along with more than a doubling of merger filings in 2020 and 2021, DOJ and the FTC then launched a joint public inquiry aimed at strengthening enforcement against “illegal” mergers and sought public comment on how they could “modernize” antitrust enforcement with respect to mergers, acquisitions, joint ventures, and “other structural realignments of firms.”[29] Posing 165 specific questions grouped into fifteen areas of inquiry, the Agencies sought comment on (i) how advances in firm and market behavior in the modern economy should inform any revisions to the 2020 Guidelines; and (ii) areas underemphasized or neglected in the 2020 Guidelines, such as labor market effects and nonprice elements of competition like innovation, quality, potential competition, and trends toward concentration.[30] That the winds of change were particularly blustery was made clear by questions such as, “Does the guidelines’ framework suggest limiting enforcement to a subset of the mergers that are illegal under controlling case law?”[31]
The 2023 Proposal to Revise the Merger Guidelines
On July 19, 2023, DOJ and the FTC proposed a significant revision of the Merger Guidelines (the “Proposal”).[32] The Proposal represented a considerable degree of retrogression over the 2010 Guidelines and portended much more intense antitrust scrutiny of merger transactions (both horizontal and vertical).
Diverging from earlier incarnations of the Merger Guidelines in a number of significant ways, the Proposal, rather than setting forth separate guidelines for horizontal and vertical mergers, sought to instantiate their enforcement “wish list” in one far-reaching set of thirteen guidelines. This set was consolidated into eleven guidelines in the final version of the 2023 Guidelines, as summarized below.
There were a number of very noticeable departures from prior Merger Guidelines. The apparent goal of these alterations was to provide the Agencies with maximum flexibility to challenge transactions that they view as anticompetitive without running the risk of being hoist with their own petard by having their own Merger Guidelines cited against them. Significant departures from prior Merger Guidelines included:
the absence of any “safe harbors” or identification of any category of transaction characterized as unlikely to raise competitive concerns, even in unconcentrated markets;
extensive citations to case law, including case law that is anachronistic and no longer representative of judicial thinking about the Clayton Act and its standards;
reduced thresholds for when the Agencies will presume that a horizontal merger is anticompetitive;
creating a novel presumption of illegality for certain vertical mergers;
adding provisions relating to serial acquisitions and acquisitions of potential competitors;
discounting certain defenses to antitrust liability; and
explicitly addressing, for the very first time, the effects of transactions on labor markets—a factor not traditionally a focus of U.S. merger review but one commonly encountered in European Union merger analysis.[33]
Final Version of the 2023 Guidelines
The Proposal met with some harsh criticism from practitioners and industry commenters. Some of the more prominent critiques included the following:
The outdated precedent critique. Many commented that the Proposal did not constitute a practical and easily applied analytical framework but set forth, instead, a set of formulaic rules based on outdated antitrust precedent,[34] without acknowledgment of the role of economic analysis in modern merger analysis.
The structural presumptions critique. Commenters questioned the validity of the notion that a threshold of 30 percent should serve as a basis for concluding that a transaction could extend or entrench dominance, as well as the rigidity of the presumption that a vertical merger involving 50 percent market foreclosure would be incompatible with the antitrust laws.
As finally promulgated, the 2023 Guidelines are structured around principles animating “frameworks” the Agencies will use to assess whether a merger may violate section 7 of the Clayton Act. The Agencies explicated their augmented theories of merger enforcement and their highly skeptical attitude about mitigating circumstances such as efficiencies and failing firm defenses. The analysis was consolidated into eleven guidelines, summarized as follows:
Market concentration is often a useful indicator of a merger’s likely effects on competition. A presumption of illegality arises when a merger significantly increases concentration in an already highly concentrated market. This presumption may be rebutted by adequate evidence to the contrary.
The Agencies examine whether competition between the merging parties is substantial, because it is axiomatic that any merger or similar business combination will eliminate existing competition between them.
The Agencies examine whether a merger increases the risk of anticompetitive coordination. A market that is highly concentrated or has seen prior anticompetitive coordination is inherently vulnerable, and the Agencies likely will presume—subject to the opportunity to present evidence in rebuttal—that the merger may substantially lessen competition. If a market is not highly concentrated, the Agencies investigate whether the facts surrounding the transaction suggest a greater risk of coordination than does market structure alone.
Mergers can violate the Clayton Act when they eliminate a potential entrant in a concentrated market. The Agencies therefore assess whether, in a concentrated market, a merger would (a) eliminate a potential entrant or (b) eliminate current competitive pressure from a perceived potential entrant.
Mergers are problematic when they create a firm that may limit access to products or services that its rivals use to compete. The Agencies examine the extent to which the merger creates a risk that the merged firm would limit rivals’ access, gain or increase access to competitively sensitive information, or deter rivals from investing in the market.
Mergers that entrench or extend a dominant position can violate the Clayton Act. The Agencies analyze whether one of the merging firms already has a dominant position that the merger may reinforce, thereby tending to create a monopoly. They also examine whether the merger may extend that dominant position to substantially lessen competition or tend to create a monopoly in another market.
Industries experiencing a trend toward consolidation may heighten the risk a merger may substantially lessen competition or tend to create a monopoly. The Agencies consider such evidence carefully when applying the frameworks in guidelines 1–6.
When a merger is part of a series of acquisitions, the Agencies may examine the whole series. Where a merger is part of a firm’s pattern or strategy of multiple acquisitions, the Agencies consider the cumulative effect of the pattern or strategy when applying the frameworks in guidelines 1–6.
When applying the frameworks in guidelines 1–6 with respect to a merger that involves a multisided platform, the Agencies consider the distinctive characteristics of multisided platforms that can exacerbate or accelerate competition problems, including competition between platforms, on a platform, or to displace a platform.
When a merger involves competing buyers, the Agencies examine whether it may substantially lessen competition for workers, creators, suppliers, or other providers. The Agencies assess whether a merger between buyers, including employers, may substantially lessen competition or tend to create a monopoly.
Even when an acquisition is less than the entirety (i.e., involves partial ownership or control or minority interests), the Agencies examine its impact on competition under the frameworks in guidelines 1–6.
The Agencies eliminated from the final document a catchall provision (former guideline 13 in the Proposal) in favor of an assertion that the 2023 Guidelines are “not exhaustive” and that “a wide range of evidence can show that a merger may lessen competition or tend to create a monopoly. Whatever the sources of evidence, the Agencies look to the facts and the law in each case.”[35] In this regard, the document identified three categories of situations the Agencies have previously encountered that could substantially lessen competition via mechanisms other than those addressed specifically in the 2023 Guidelines:
a merger that would enable firms to avoid a regulatory constraint because that constraint was applicable to only one of the merging firms;
a merger that would enable firms to exploit a unique procurement process that favors the bids of a particular competitor who would be acquired in the merger; or
in a concentrated market, a merger that would dampen the acquired firm’s incentive or ability to compete due to the structure of the acquisition or the acquirer.[36]
Other Noteworthy Items
Here are some other noteworthy items that the Agencies reworked from the Proposal in the final version:
Rebuttal Evidence
Section IV of the Proposal contained an extensive discussion of rebuttal evidence that would demonstrate that a merger did not result in a substantial lessening of competition. Several categories of such rebuttal evidence were identified: (1) “Failing Firms,” (2) “Entry and Repositioning,” (3) “Procompetitive Efficiencies,” and (4) “Structural Barriers to Coordination Unique to the Industry.”[37] This separate section on rebuttal evidence and its categories has been recast in the final version of the 2023 Guidelines as Section III, though this time the fourth category (“Structural Barriers to Coordination Unique to the Industry”) has been omitted from that discussion and rearranged as part of the discussion under guideline 3.
Interspersed throughout the 2023 Guidelines, there is language acknowledging that parties to a transaction may offer evidence to rebut the presumption that a deal is anticompetitive. Nevertheless, the Agencies will have the benefit of a presumption that a transaction that lessens competition violates the antitrust laws, and therefore the rebuttal evidence must be very convincing. Furthermore, the Agencies have specified the most common sources of evidence that the Agencies draw on in a merger investigation.[38]
Trends Toward Concentration
Portions of what appeared in the Proposal as guideline 6 and guideline 8 have been combined to form what is now guideline 7 in the final version. The draft version of guideline 8 had established structural thresholds for challenging a merger that advances a trend toward concentration. Now, guideline 7 focuses on industries trending toward consolidation, including multiple mergers in succession by various players in the industry. The Agencies’ chief economists, in an article describing the 2023 Guidelines for the Stigler Center at the University of Chicago’s Booth School of Business, quote the rationale for guideline 7 and characterize it as an “intuitive idea”: “The recent history and likely trajectory of an industry can be an important consideration when assessing whether a merger presents a threat to competition.”[39] According to that article, guideline 7 clarifies that the Agencies will “closely examine industry consolidation trends in applying the frameworks” in guidelines 1–6.[40] The Agencies’ chief economists do, however, clarify that guideline 7 is a “plus factor” when analytically appropriate and does not constitute a basis for a challenge on its own or a separate structural presumption.[41]
Entrenching or Extending a Dominant Position; “Ecosystems”
In the final version’s guideline 6, the Agencies assert that a merger may substantially lessen competition or tend to create a monopoly if it entrenches or extends the position of an already dominant firm. The Agencies enjoy substantial discretion to deem a firm to be “dominant” and, consequently, to subject any transaction involving that firm to heightened scrutiny.
The Agencies also sandwiched into the discussion under this guideline some brand-new language concerning the elimination of nascent competitive threats, specifically by reference to the concept of “ecosystem competition.” That term refers to an incumbent firm that offers a wide array of products and services finding itself “partially constrained by other combinations of products and services from one or more providers, even if the business model of those competing services is different.”[42] The notion is that a firm operating in several related markets may have the ability to inflict competitive injury upon another firm competing in only one of those markets.
This “ecosystem” concept has acquired some traction with competition authorities in the European Union (“EU”) and the United Kingdom (“U.K.”). Though there is no clear definition of what such an ecosystem is, European authorities seem to have some sensitivity to strong links among different markets with one central hub, even where there are no clear horizontal or vertical business relations.
For example, on September 25, 2023, the European Commission (“Commission”) blocked the proposed merger between Booking Holdings (which operates the hotel reservation platform Booking.com) and Flugo Group Holdings AB (which operates the flight booking platform “eTraveli”). This decision was significant not merely because it was an apparent departure from the Commission’s published merger guidelines but because this was the first time EU merger authorities had prohibited a transaction because of ecosystem concerns. The Commission’s rationale was that Booking’s dominant position in the market for online hotel travel agencies in the European Economic Area would have been strengthened were the deal to go forward.[43] The EU authorities concluded that the transaction would have channeled eTraveli customers to Booking.com, allowing the latter to expand its travel services ecosystem business and strengthen its position in the market for online travel agencies. Although Booking Holdings offered as a remedy to shunt internet customers for air tickets to a screen with multiple hotel offers from competing hotel travel agents online, the Commission deemed the remedy inadequate to address the novel aspects of those online travel businesses. The decision reflects an unprecedented aggressiveness in blocking mergers on nonhorizontal grounds and may have far-reaching implications for transactions involving rapidly evolving high-tech industries (including, of course, financial services).
Interestingly, the U.K. Competition and Markets Authority (“Authority”) had cleared that same transaction a year earlier, having concluded that internet travel customers do not necessarily purchase distinct travel services from the selfsame provider.[44] In another instance, however—Microsoft’s acquisition of Activision—the Authority arrived at a different conclusion based on an assessment of Microsoft’s “ecosystem.”[45] After the transaction was restructured, however, the Authority cleared it.[46]
Reviewing the same transaction in the United States, the FTC brought an antitrust challenge. That effort was ultimately unsuccessful, as the U.S. district court did not share the FTC’s narrow view of the proposed remedy.[47]
Using this “ecosystem competition” approach in the United States would allow antitrust regulators to assess not only the acquisition of a direct competitor but also the addition of a niche or partially overlapping service to a company’s ecosystem of services. This is a novel approach to merger enforcement in the United States—one that may threaten to expand antitrust scrutiny even where competitive overlap between parties to a transaction is limited. Given the congeries of products and services offered by many business organizations and their affiliates, close attention needs to be paid, when planning a transaction, to “ecosystem” hurdles.
Conclusion
Overall, the 2023 Guidelines are a mixed bag of the innovative and the anachronistic—the latter including heavy reliance placed on court decisions fifty to sixty years old and doctrines (such as potential competition) that not only are in desuetude but also have not in recent memory achieved notable success for the Agencies. It remains to be seen how this current iteration of the Merger Guidelines will fare in litigation involving antitrust challenges to M&A transactions.
U.S. Dep’t of Just. & Fed. Trade Comm’n, Merger Guidelines (Dec. 18, 2023). The merger guidelines in general will be referred to as the “Merger Guidelines.” Versions of the Merger Guidelines will be referred to by their year of issuance. The current version will therefore be referred to as the “2023 Guidelines.” All versions are available on the website of the DOJ Antitrust Division. ↑
The HHI is a mathematical expression of the level of concentration in terms of the sum of the squares of each firm’s market share. The index approaches zero (in theory, at least) when a market is totally unconcentrated and is supplied by a large number of firms of relatively equal size, increases both as the number of firms in the market decreases and as the disparities in size among market participants increase, and reaches a maximum of 10,000 in the case of a 100 percent concentration level (i.e., the market is supplied by only a single firm). ↑
Indeed, trip wires for mergers in unconcentrated, moderately concentrated, and highly concentrated markets remained the same whether or not the market displayed any trend toward concentration. ↑
The time frame for production substitution was six months. U.S. Dep’t of Just., 1982 Merger Guidelines § II.B.l (1982). ↑
Market power is “the ability of a firm (or a group of firms acting jointly) to raise price above the competitive level without losing so many sales so rapidly that the price increase is unprofitable and must be rescinded.” William M. Landes & Richard A. Posner, Market Power in Antitrust Cases, 94 Harv. L. Rev. 937, 937 (1981). Perhaps the most trenchant observation in this area is Professor Areeda’s aphorism that “the best indication of market power is that it has been exercised.” Philip E. Areeda, Market Definition and Horizontal Restraints, 52 Antitrust L.J. 553, 554 (1983). ↑
The 1982 Guidelines acknowledged that “the Department is unlikely to challenge mergers” in markets in which entry “is so easy that existing competitors could not succeed in raising price for any significant period of time.” 1982 Guidelines, § III.B. ↑
The 1984 Guidelines recognized the implausibility of inferring adverse competitive effects solely from structural indices where there are close substitutes outside the market, i.e., where there is only a small “gap” at the edge of the market. U.S. Dep’t of Just., 1984 Merger Guidelines § 3.412 (1984). ↑
Id. § 1.11. Nevertheless, one-year time frames were retained with reference to business decisions made by competitors or potential competitors. Id. § 1.32. ↑
See, e.g., United States v. Baker Hughes, Inc., 908 F.2d 981 (D.C. Cir. 1990); United States v. Syufy Enters., 903 E.2d 659 (9th Cir. 1990); United States v. Waste Mgmt., Inc., 743 F.2d 976 (2d Cir. 1984); United States v. Archer-Daniels-Midland Co., 781 F. Supp. 1400 (S.D. Iowa 1991); United States v. Country Lake Foods, Inc., 754 F. Supp. 669 (D. Minn. 1990); United States v. Calmar Inc., 612 F. Supp. 1298 (D.N.J. 1985). ↑
For example, in United States v. Baker Hughes, Inc., DOJ’s argument that entry had to be “quick and effective” in order to rebut a prima facie case based on high concentration was rejected by then Circuit Judge Clarence Thomas as “novel and unduly onerous.” 908 F.2d 981, 987 (D.C. Cir. 1990). ↑
“Sunk costs” were defined as “the acquisition costs of tangible and intangible assets that cannot be recovered through the redeployment of these assets outside the relevant market, i.e., costs uniquely incurred to supply the relevant product and geographic market.” 1992 Guidelines, § 1.32. Sunk costs were deemed significant if they “would not be recouped within one year of the commencement of the supply response, assuming a[n SSNPI].” Id.↑
Note that firms that had already committed to entering the market prior to the merger under review would generally be included as in-market participants during the “market definition” stage. Id. § 3.2 n.27. ↑
Id. § 3.3. The Agencies were only interested in entry that would counteract any anticompetitive effects of the merger, which meant restoring premerger price levels. Accordingly, in assessing likelihood in terms of long-term profitability (taking into account an appropriate return on capital given that entry could fail) and the loss of sunk costs, a committed entrant’s in-market operations had to be viable at premerger prices. Id. ↑
Id. § 1.32. Nevertheless, “[i]f a firm has the technological capability to achieve such an uncommitted supply response, but likely would not (e.g., because difficulties in achieving product acceptance, distribution, or production would render such a response unprofitable), that firm will not be considered to be a market participant.” Id. (emphasis added). ↑
This is also evident from the FTC’s major expansion of the Hart-Scott-Rodino (HSR) Premerger Notification regime—for the first time in its forty-five years of existence. Press Release, Fed. Trade Comm’n, FTC and DOJ Propose Changes to HSR Form for More Effective, Efficient Merger Review (June 27, 2023). Among the many, extensive additions to the premerger filing are information about nonhorizontal acquisitions, “serial” or sequential acquisitions, private equity acquisitions, harm to nascent competition, harm to labor markets, and interlocking directorates. ↑
The draft of the new HSR form that the FTC recently released reflects this increased attention to calling for information from merging parties about labor markets as part of their premerger filing. See Fed. Trade Comm’n, Premerger Notification; Reporting and Waiting Period Requirements, 88 Fed. Reg. 42,178, 42,197–198 (June 29, 2023). ↑
E.g., United States v. E. I. du Pont de Nemours & Co., 353 U.S. 586 (1957); Brown Shoe Co. v. United States, 370 U.S. 294 (1962); United States v. Phila. Nat’l Bank, 374 U.S. 321 (1963); United States v. First Nat’l Bank & Trust Co. of Lexington, 376 U.S. 665 (1964); United States v. Penn-Olin Chem. Co., 378 U.S. 158 (1964); United States v. Pabst Brewing, 384 U.S. 546 (1966); United States v. Grinnell Corp., 384 U.S. 563 (1966); Fed. Trade Comm’n v. Procter & Gamble Co., 386 U.S. 568 (1967); Denver & Rio Grande W.R.R. Co. v. United States, 387 U.S. 485 (1967); Ford Motor Co. v. United States, 405 U.S. 562, 587 (1972); United States v. Falstaff Brewing Corp., 410 U.S. 526 (1973); United States v. Gen. Dynamics Corp., 415 U.S. 486 (1974). ↑
“Turbulence in world affairs presents unique challenges to commercial partnerships. Russia’s invasion of Ukraine and resultant sanctions have impeded the flow of goods, sparked product shortages and cost increases, and sent shudders through existing distribution networks. Escalations in the U.S.-China trade war, tariffs and the great powers’ move toward economic decoupling have similarly shaken established supply chains. Climate change and pandemic-related events create additional disruptions and uncertainty.”[1]
Instability in the business environment has led to increased disputes, clogging courts still coping with pre-pandemic backlogs, which are further exacerbated by the additional court closures during the pandemic. Although these court closures initially stifled claim filings, the pace of civil filing has steadily increased over the last year and a half. And, of course, this adversarial battling takes place in an environment of ballooning costs. In 2022, it was estimated that for every $1 billion in revenue, corporations spent $1.7 million on legal fees and costs.[2]
In sum, there are too many disputes inflicting too much disruption to corporate purpose. Litigation is notoriously slow, costly, and relationally ruinous, and even more streamlined alternatives like arbitration and mediation impose costs, direct and indirect. Wouldn’t it be better if mechanisms existed to prevent disputes in the first place?
Well, they do. Dispute prevention mechanisms have gained traction and adherents in the construction and labor-management sectors, and now, those mechanisms can even be deployed in the commercial sector, to great advantage.
Dispute prevention should not be confused with early dispute resolution (EDR). EDR programs, which are related to but distinct from dispute prevention, are designed to enable companies to evaluate disputes soon after they become evident. A thoughtful EDR program includes a strong early case assessment (ECA) protocol to review relevant facts and law in the dispute. ECAs help companies to assess the likelihood of liability and the range of potential damages. This review can be undertaken by in-house counsel, outside counsel, or both.
But before a company needs to turn to using mediation—and even before EDR and an honest ECA protocol come into play—a dispute prevention program can bring extraordinary value to companies. That is because, if it works, you don’t need to get to early assessment or resolution; the seeds of the conflict have been addressed.
Parties can incorporate prevention into their projects in many different ways. In any case, these efforts should mesh with the types of businesses and cultures involved.
Perhaps the most obvious approach is to introduce a “standing neutral” (or “relationship facilitator”) into the relationship. Parties should use a standing neutral in any relationship that involves a significant investment, or one of strategic importance. The neutral’s role is to ensure that the parties surface issues promptly, have a forum for addressing them, and resolve disputes efficiently.
A “standing” relationship facilitator can be designated in the contract to participate in regular, periodic reviews for the contract. The relationship facilitator has two jobs in regular periodic reviews: (1) observe and track the dynamics of the relationship and specific issues, and (2) identify topics of conflict and surface for party discussion. A party may be reluctant to highlight potential conflict, but the facilitator’s job is to make sure that folks do not turn their heads for too long.
Some arbitral institutions are further embracing and even formalizing these tools, to assist parties in developing dispute prevention mechanisms. For example, the International Institute for Conflict Prevention and Resolution (“CPR”) recently released Rules for Administered Dispute Prevention and Management Boards for Commercial Transactions. The rules are intended for parties that desire an accelerated, streamlined early dispute avoidance and mitigation process designed to result in consensual resolution of unanticipated issues and disputes, and, if unsuccessful, then the delivery of a decision within a short, specified period during the progress of a long-term commercial endeavor.[3]
CPR also provides model clauses for parties wishing to draft dispute prevention mechanisms or to incorporate their Dispute Prevention and Management rules. Of course, parties may also draft their own agreements. Dispute prevention agreements should include several important elements. First, the parties should acknowledge the importance of maintaining a strong ongoing relationship and that open channels of communication are critical to success. Ongoing communication needs to focus on how the collaboration is working and what circumstances must be addressed to avoid serious problems. Second, parties need to designate empowered, appropriate representatives to monitor performance, oversee the business relationship, and identify any potential or current issue that could result in a disagreement—or worse.
After the early identification of a problem, if the parties are unable to resolve it following escalation to appropriately chosen senior executives and to the neutral, the parties can go through a more traditional mediation process utilizing the neutral. Often, the mere presence of the neutral dramatically increases the likelihood that the parties will avoid disagreements.
Many lawyers in various fields use dispute prevention as part of their ongoing practices, whether they call it that or not. It is fundamentally an approach to design and use processes for identifying and engaging with conflicts early to find solutions, rather than default to litigation or arbitration. Understanding the tools and opportunities for dispute prevention enables lawyers who are looking for better solutions, or some new methods, to add dispute prevention to their own tool kit in serving as a trusted advisor.
This article is related to a CLE program titled “Throwing Water on the Fire – Techniques for Addressing and Preventing Disputes Before They Arise in The Modern World” that took place during the ABA Business Law Section’s 2023 Fall Meeting. To learn more about this topic, listen to a recording of the program, free for members.
The rules are interspersed with suggested guidance on their use, as well as a procedural flowchart. Additional information is available by visiting “Dispute Prevention & Management Board Rules,” CPR Dispute Resolution, accessed May 8, 2024. ↑
The “revolving door” is not just a department store– or hotel-entry challenge for the unwary. The phrase is also a metaphor for the shuttling of lawyers back and forth between government service and the private sector, which has long captured the attention of courts[1] and commentators.[2] The rules that have been adopted seek to balance various interests. On the one hand, where a lawyer’s successive clients are a government entity and a private client, there is a risk that the power vested in public authority might be co-opted for the special benefit of a private client, allowing the latter to secure an unfair advantage because of access (through the lawyer) to confidential information about an adversary obtainable only by dint of the lawyer’s government service. On the other hand, rules governing lawyers currently or previously employed by a government agency should not be so restrictive as to inhibit changing employment, lest the government’s ability to attract qualified lawyers be adversely affected.[3]
Among the provisions of the Model Rules of Professional Conduct (“Model Rules”) dealing with conflicts of interest, Model Rule 1.11 has garnered the least attention. Seeking to redress that situation, a recent ABA ethics opinion, ABA Formal Opinion 509 (“Formal Op. 509”), provides some useful discussion of the Rule.[4]
Under the old Model Code of Professional Responsibility (“Model Code”), DR 9-109(B)(1) forbade a lawyer from “accept[ing] private employment in a matter in which he had substantial responsibility while he was a public employee.”[5] That ukase now inhabits Model Rule 1.11(a), which prohibits a former government lawyer from representing “a private client in connection with a matter in which the lawyer participated personally and substantially” while in government employ. Note that one court has held that the prohibition applies even when the lawyer takes the same position in private practice as during government service: “[T]he prohibitions of Rule 1.11 are not limited to side-switching. . . .”[6]
As an earlier ethics opinion concluded, Model Rule 1.11(a) supersedes the general “former client” conflict provisions of Model Rule 1.9(a) when it comes to former government lawyers.[7] When a lawyer is disqualified under paragraph (a), paragraph (b) extends the prohibition to others in the same firm unless the disqualified lawyer is screened[8] from the matter, the disqualified lawyer receives no part of the fees, and written notice is given to the appropriate government office in order to ascertain compliance.
Model Rule 1.11 goes even further, however, and, like its Model Code predecessor (DR 9-109(B)(2)), articulates the conflict of interest principles applicable to a former government lawyer who, even though not having substantial responsibility in the course of that employment for a matter involving a person adverse to a client the lawyer (now in private practice) is representing, did acquire confidential information about that person. These principles are contained in Model Rule 1.11(c), and are the subject of the recent Formal Op. 509.
It is, of course, axiomatic in legal ethics that a lawyer who has gained important information about a person (natural or juridical) in the course of a representation (whether in government service, private practice, or otherwise) should not use that information against that person if the lawyer should change sides. Barring an exception, Model Rules 1.6(a) (confidentiality of information relating to representation of a client), 1.8(b) (specific applications of conflicts relating to current clients), and 1.9(c) (duties to former clients) prohibit a lawyer, without the client’s informed consent, from revealing or using to the client’s detriment any information obtained during the course of the representation.
Model Rule 1.11(c): Confidential Government Information
Model Rule 1.11 addresses the potential for misuse of “confidential government information.” That phrase is defined in the middle of Model Rule 1.11(c) as “information that has been obtained under governmental authority and which, at the time this Rule is applied, the government is prohibited by law from disclosing to the public or has a legal privilege not to disclose and which is not otherwise available to the public.” The remaining—substantive—part of that paragraph provides:
Except as law may otherwise expressly permit, a lawyer having information that the lawyer knows is confidential government information about a person acquired when the lawyer was a public officer or employee, may not represent a private client whose interests are adverse to that person in a matter in which the information could be used to the material disadvantage of that person. . . . A firm with which that lawyer is associated may undertake or continue representation in the matter only if the disqualified lawyer is timely screened from any participation in the matter and is apportioned no part of the fee therefrom.
Several things about this language are noteworthy:
First, unlike paragraphs (a) and (b) of Model Rule 1.11, which apply only to lawyers who have “formerly” served as a public officer or government employee (and subject them to the requirements of Model Rule 1.9(c)), paragraph (c) does not have that qualification and thus sweeps more broadly. In that regard, as Formal Op. 509 notes, paragraph (d) of the rule applies only to current government officers and employees and subjects them to the conflict regimes of Model Rules 1.7 (conflicts relating to current clients) and 1.9 (duties to former clients), as well as additional restrictions on participation in a matter and negotiation for private employment.
Second, the lawyer must “know” the information is “confidential government information.” Recall that Model Rule 1.0, the Terminology section of the Model Rules, defines know to mean only “actual knowledge.”[9] However, Model Rule 1.11(c)’s prohibition encompasses information that “could be” used to the detriment of the person to whom it pertains.[10]
Third, paragraph (c) proscribes use of information that could be a “material disadvantage.”[11] Contrast this with the language of Model Rule 1.8(b), which forbids using information relating to the representation of a client to the “disadvantage”—not “material disadvantage”—of the client. Formal Op. 509 does not explore this distinction.
Fourth, as the opinion points out, conflicts under paragraph (c), in contrast to the other paragraphs of Model Rule 1.11, are not waivable by client consent.[12] This statement is not based on anything in the plain language of paragraph (c) but, presumably, arises by negative inference from the express acknowledgment in Model Rules 1.6, 1.7, 1.8, and 1.9 of waiver by client consent and the absence of such language in Model Rule 1.11(c).
Finally, unlike confidential government information, the term private client is undefined either in Model Rule 1.11 itself or in the Terminology section of the Model Rules. As discussed further below, Formal Op. 509 undertook to define this term.
The breadth of the Model Rule’s prohibition is betokened by the phrase acquired when the lawyer was a public officer or employee, which suggests that the rule applies regardless of whether a lawyer in public service worked in a representational capacity when acquiring the information.[13] In other words, confidential government information reaches much more information than confidential information within the meaning of Model Rule 1.6; the latter applies only to information a lawyer obtains while representing a client, but the former can encompass information obtained from a variety of sources, including law enforcement.
Nevertheless, Model Rule 1.11(c) does not apply to all government information, and not even to all government information that would normally be considered confidential, but only to
information “obtained under governmental authority,” which would include information pursuant to grand jury subpoena, an agency subpoena, a search warrant, etc.;
information covered by a legal nondisclosure privilege or subject to an express legal prohibition against disclosure, in both cases as of the moment the rule is applied; and
information that is “not otherwise available to the public” (which implies that information disclosable—but not yet disclosed—pursuant to a federal or state Freedom of Information Act or similar statute would be exempt).[14]
Key Takeaways from Formal Op. 509
Formal Op. 509 seeks to clarify several points under Model Rule 1.11.
To begin with, the opinion considers whether paragraph (c) applies to former government employees (including lawyers previously employed by the government but in a nonrepresentational capacity), current employees, or both. The conclusion that both categories are covered emerges from a straightforward textual comparison of the various paragraphs of the rule. Paragraphs (a) and (b) apply to former government lawyers, while paragraph (d) applies only to current government lawyers. In contrast, paragraph (c) is not specific but simply focuses generally on “a lawyer having information that the lawyer knows is confidential government information.” That lack of specification, the opinion concludes, means that paragraph (c) applies to both current and former government lawyers. Furthermore, from a policy perspective, the need to protect against misuse of confidential government information is equally compelling with respect to both former and current government lawyers.
Moreover, according to Formal Op. 509, whether information is considered available to the public (hence, outside the definition of confidential government information) and whether it could be used to a person’s material disadvantage are questions of fact specific to each situation.
Finally, Formal Op. 509 endeavors to define the term private client as used in the rule. The term is ambiguous, in that the word private could refer to (A) any client of a lawyer in private practice, regardless of whether the client is a private or public person or entity; (B) a client that is a private person or entity; or (C) both (A) and (B). Relying on a 1970s ethics opinion interpreting the predecessor DR 9-109,[15] the opinion concludes that option (A) must be true, so the question boils down to whether option (B) is also true. Finding that it is, Formal Op. 509 concludes that option (C) is correct: private client includes not only clients that are private persons/entities and private persons/entities a lawyer represents in private practice but also public persons/entities a lawyer represents in private practice,[16] except in the situation where the public entity is legally entitled to use the confidential information, in which event applying the strictures of the rule would make no sense.[17]
See, e.g., Woods v. Covington Cty. Bank, 537 F.2d 804 (5th Cir. 1976). ↑
See, e.g., Irving R. Kaufman, The Former Government Attorney and the Canons of Professional Ethics, 70 Harv. L. Rev. 657 (1957); H. Richard Uviller, The Virtuous Prosecutor in Quest of an Ethical Standard: Guidance from the ABA, 71 Mich. L. Rev. 1145 (1973); Developments in the Law: Conflicts of Interest in the Legal Profession, 94 Harv. L. Rev. 1244 (1981); Douglas R. Richmond, As the Revolving Door Turns: Government Lawyers Entering or Returning to Private Practice and Conflicts of Interest, 65 St. Louis U. L.J. 325, 350 (2021). ↑
See Barnes ex rel. Est. of Barnes v. Dist. of Columbia, 266 F. Supp. 2d 138, 141 (D.D.C. 2003). ↑
ABA Comm. on Ethics & Pro. Responsibility, Formal Op. 509 (2024) [hereinafter Formal Op. 509]. ↑
Cf. Canons of Professional Ethics, Canon 36 (Am. Bar Ass’n 1908) (“A lawyer, having once held public office or having been in the public employ, should not after his retirement accept employment in connection with any matter which he has investigated or passed upon while in such office or employ.”). ↑
See ABA Comm. on Ethics & Pro. Responsibility, Formal Op. 409 (1997). ↑
Screen[ing] is defined in the Terminology section of the Model Rules as “isolation of a lawyer from any participation in a matter through the timely imposition of procedures within a firm that are reasonably adequate under the circumstances to protect information that the isolated lawyer is obligated to protect under these Rules or other law.” Model Rules of Pro. Conduct r. 1.0(k) (Am. Bar Ass’n 2024). ↑
Id. r. 1.0(f) (emphasis added); see id. r. 1.11, cmt. [8] (emphasis added). ↑
Formal Op. 509 provides this example: A lawyer who is also a police officer is a “public officer” within the meaning of Model Rule 1.11(c). Id. at 2. ↑
Cited as an analogy in Formal Op. 509 is the definition of nonpublic information in 5 C.F.R. § 2635.703(b): information that an employee obtains due to federal employment and that he knows or reasonably should know “(1) Is routinely exempt from disclosure under 5 U.S.C. 552 or is protected from disclosure by statute, Executive order or regulation; (2) Is designated as confidential by an agency; or (3) has not actually been disseminated to the general public and is not authorized to be made available to the public on request.” Formal Op. 509, supra note 4, at 4 n.13. ↑
ABA Comm. on Ethics & Pro. Responsibility, Formal Op. 342 (1975) (concluding that the term private employment in DR 9-109(B) refers to employment as a private practitioner). ↑
Formal Op. 509, supra note 4, at 9 (citing Gen. Motors Corp. v. City of New York, 501 F.2d 639 (2d Cir. 1974) (holding that a former Antitrust Division lawyer in private practice who had worked on an antitrust suit against General Motors (“GM”) was ineligible to represent New York City in litigation against GM)). ↑
