Editors

Michael Pastore

Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.
One Financial Center,
Boston, MA 02111
+1.617.239.8427
[email protected]

Steve Ganis

Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.
One Financial Center,
Boston, MA 02111
+1.617.348.1672
[email protected]

§ 1.1 Introduction

The volumes of final judicial and enforcement actions decreased somewhat in 2020 due to disruptions associated with the global coronavirus pandemic.  As in previous years, a significant amount of financial institutions’ enforcement litigation that established important precedents was settled, due in part to the difficulties associated with disputing cases brought by one’s regulator.  Still, there were some very important cases, including enforcement actions imposing record monetary penalties.  Key themes of 2020’s financial institutions’ litigation include cases arising in alleged failures by all types of financial institutions to address suspicious activities by institutional and retail customers.  We summarize instances in which a banking official, broker-dealers, a futures commission merchant, and a cryptocurrency money transmitter all allegedly failed to detect and report suspicious activity and agreed to significant fines.  Another case holds an institutional broker-dealer responsible for providing direct market access to other broker-dealers that operated alternative trading systems and allegedly conducted a wide range of market manipulation schemes.  We also discuss the continuation in 2020 of sales practice-related cases centering on special investor protection issues for more complex retail investment products like variable annuities and unit investment trusts.  We hope you find this summary of key cases on financial institutions’ legal and regulatory requirements helpful and welcome any feedback.

§ 1.2 Banking Institutions

In the Matter of Michael LaFontaine, 2020-01, U.S. Department of the Treasury Financial Crimes Enforcement Network (Feb. 26, 2020)

Michael LaFontaine, the former Chief Operational Risk Officer at U.S. Bank National Association (“U.S. Bank”), accepted a fine from the Financial Crime Enforcement Network (“FinCEN”) in the amount of $450,000 in connection with his role in anti-money laundering (“AML”) violations committed by U.S. Bank.  FinCEN found that, while Mr. LaFontaine was in charge of U.S. Bank’s AML compliance function, the bank improperly capped the number of alerts generated by its automated transaction monitoring system and failed to adequately staff the Bank Secrecy Act (“BSA”) compliance function.  This matter is of interest because FinCEN placed weight on the fact that a separate institution, Wachovia Bank, had previously been fined by FinCEN for similar conduct, and Mr. LaFontaine “should have known based on his position the relevance of the Wachovia action to U.S. Bank’s practices or conducted further diligence to make an appropriate determination.”  In essence, individuals responsible for AML compliance must be aware of regulatory actions generally in the industry.  Further, the targeting of the individual executive starkly reminds the industry that AML suspicious activity monitoring parameters must be set based on actual AML risks, not arbitrary volume limits, and that suspicious transaction volumes, not desired resource expenditure levels, must dictate the amount of suspicious activity monitoring and investigation a financial institution conducts.  Mr. LaFontaine admitted to all facts in consenting to the $450,000 penalty.

In the Matter of TD Bank, N.A. (“TD Bank”), CFPB Administrative Proceeding No. 2020-BCFP-0007 (August 20, 2020)

TD Bank consented to an order by the CFPB relating to the marketing and sale of its optional overdraft service, without admitting or denying the findings.  According to the CFPB, TD Bank’s general practice was not to present new customers with a written overdraft notice until the end of the account-opening process, and without having provided written disclosures.  The overdraft service forms were pre-filled by TD Bank, and CFPB viewed these practices as amounting to an “opt-out” procedure as opposed to the “opt-in” procedure for overdraft services as mandated by Regulation E, and were deceptive acts or practices.  According to the CFPB, TD Bank’s practices also violated the Electronic Fund Transfer Act (“EFTA”) and Regulation E by charging consumers overdraft fees for ATM and one-time debit card transactions without obtaining their affirmative consent.  TD Bank agreed to pay restitution in the amount of $97,000,000 and a civil monetary penalty in the amount of $25,000,000.

In the Matter of Citibank (“Citi”), National Association, OCC Case AA-EC-2020-65 (October 2, 2020)

Without admitting or denying the allegations, Citi settled an Office of the Comptroller of the Currency (“OCC”) enforcement action alleging that it failed to implement and maintain an enterprise-wide risk management and compliance risk management program, internal controls, or a data governance program commensurate with the Bank’s size, complexity, and risk profile.  The OCC found Citi violated 12 C.F.R. Part 30, Appendix D, “OCC Guidelines Establishing Heightened Standards for Certain Large Insured National Banks, Insured Federal Savings Associations, and Insured Federal Branches,” and conducted unsafe or unsound practices with respect to the Bank’s enterprise-wide risk management and compliance risk management program.  Deficiencies the OCC found included: (a) failure to establish effective front-line units and independent risk management; (b) failure to establish an effective risk governance framework; (c) failure of the Bank’s enterprise-wide risk management policies, standards, and frameworks to adequately identify, measure, monitor, and control risks; and (d) failure of compensation and performance management programs to incentivize effective risk management.  The OCC further found Citi lacked clearly defined roles and responsibilities, resulting in noncompliance with multiple laws and regulations and unsafe or unsound practices with respect to the Bank’s data quality and data governance, including risk data aggregation and management and regulatory reporting.  The OCC alleged that these enterprise risk management failures contributed to separate violations of: the Fair Housing Act, 42 U.S.C. § 3601—19, and its implementing regulation, 24 C.F.R. Part 100; the holding period for other real estate owned, 12 U.S.C. § 29 and 12 C.F.R. § 34.82; and the Flood Disaster Protection Act, as amended, 42 U.S.C. § 4012a(f), and its implementing regulations, specifically 12 C.F.R. § 22.7(a).  The OCC noted Citi has begun taking corrective action and has committed to taking all necessary and appropriate steps to remedy the deficiencies identified by the OCC.  Citi agreed to pay a civil monetary penalty of $400,000,000.  The case is an important example of how federal banking regulators will aggregate various risk, control, and governance issues to impose large fines under the stricter enterprise risk management requirements specifically imposed on large institutions by the Dodd-Frank Wall Street Reform and Consumer Protection Act and related guidance issued by federal banking regulators.

§ 1.3 Securities Institutions

In the Matter of Department of Enforcement vs. Wilson-Davis & Co., Inc., James C. Snow, and Byron B. Barkley, FINRA Case No. 2012032731802 (Dec. 19, 2019)

The National Adjudicatory Council affirmed the Decision of a FINRA Hearing Panel finding that the Respondents (1) engaged in short selling in violation of Regulation SHO of the Securities Exchange Act of 1934 (“Reg SHO”), (2) failed to supervise registered representatives generally, including failure to supervise instant message communications, and (3) failed to establish and implement AML policies and procedures and conduct adequate AML training.  These findings also triggered violations of NASD Rule 3010 and FINRA Rule 2010.  Mr. Snow and Mr. Barkley were two of the three principals of Wilson-Davis.  According to FINRA, the short sales were designed to carry out a speculative trading strategy, and not as “bona fide market making activities.”  FINRA also found that the written supervisory procedures “did not provide procedures, processes, tests, or guidance that would permit an evaluation by supervisors at the firm of whether the particular facts of a short sale transaction established that a sale was made in connection with bona-fide market making activity … [and that] the firm did not even have procedures for locating or borrowing securities for its short sales because the firm considered all trading to be bona-fide market making.”  Wilson-Davis was fined $350,000 and ordered to disgorge $51,624 plus prejudgment interest for the violations of Reg SHO.  The firm was fined an additional $750,000 and directed to retain an independent consultant for its failures to supervise and implement adequate AML procedures.  Mr. Snow was fined $77,000 and suspended for one year as a principal and supervisor (including three months in all capacities) for AML violations.  Mr. Barkley was fined $52,000 and suspended for one year as a principal and supervisor (including three months in all capacities) for short sale violations.

Robinhood Financial, LLC (“Robinhood”), AWC No. 2017056224001, FINRA (December 20, 2019)

Without admitting or denying the findings, Robinhood agreed to a settlement of an enforcement action alleging violations of FINRA Rule 5310 (“Best Execution”) relating to equity orders, and related supervisory failures.  For a period of more than a year, Robinhood routed non-directed equity orders to four separate broker-dealers, each of whom paid back Robinhood for the order flow.  Best Execution requires that firms use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.  This obligation can be satisfied by either reviewing order-by-order, or conducting what is known as “a regular and rigorous review.”  According to FINRA, Robinhood failed to do either, and did not have written supervisory procedures for Best Execution outside of merely reciting the regulatory requirements.  The result was hundreds of thousands of orders a month falling outside of a compliant review process.  In addition to accepting a censure and retaining an independent consultant, the firm paid a fine in the amount of $1,250,000.

Credit Suisse Securities (USA) LLC (“Credit Suisse”), AWC No. 2012034734501, FINRA (December 23, 2019)

Without admitting or denying the findings, Credit Suisse agreed to a settlement of an enforcement action alleging violations of Exchange Act Rule 15c3-5 (the “Market Access Rule”).  Over a four-year period, Credit Suisse offered clients direct market access (“DMA”) to a number of exchanges and alternative trading systems (“ATSs”), generating in excess of $300 million in revenue.  In addition to accepting a censure and retaining an independent consultant, the firm paid a fine in the amount of $1,250,000.  FINRA alleged that, despite this large revenue figure, Credit Suisse failed to implement reasonable supervisory procedures to detect manipulative activity by its DMA clients.  This failure resulted in more than 50,000 alerts at FINRA and multiple exchanges for potential manipulation, including spoofing, layering, wash sales, and pre-arranged trading that Credit Suisse allegedly allowed to continue unabated.  In addition to a censure, Credit Suisse agreed to update its supervisory policies and procedures with respect to DMA clients, and pay a fine of $6,500,000.

Prudential Investment Management Services LLC (“PIMS”), AWC No. 2015047966801, FINRA (January 2, 2020)

Without admitting or denying the findings, PIMS settled an enforcement action with FINRA relating to the allegedly inaccurate information it provided with respect to group variable annuities (“Group VAs”).  According to FINRA, PIMS provided inaccurate expense ratio and historical performance information to employer sponsors and employee participants over a period of seven years, in violation of FINRA’s advertising content rules.  Additionally, for a period of 15 years, PIMS allegedly provided performance data for money market funds available as investment options in retirement plans without providing the seven-day yield information required by SEC Rule 482.  The result of this failure was that plan participants using the communications did not have up-to-date yield information when making investment decisions, as required by the Rule.  In addition to a censure, PIMS agreed to retain an independent consultant and pay a fine of $1,000,000.

Virtu Americas LLC (“Virtu”), AWC No. 2015045441001, FINRA (February 2, 2020)

Without admitting or denying the findings, Virtu agreed to settle an enforcement action relating to its trading of over-the-counter (“OTC”) securities.  According to FINRA, Virtu failed to immediately execute, route, or display 156 customer limit orders in OTC securities in violation of FINRA Rule 6460 and to timely report nearly 500 transactions in Trade Reporting and Compliance Engine (“TRACE”)-Eligible Securities in violation of FINRA Rule 6730.  Virtu also allegedly violated FINRA Rule 6437 (the “Locked/Crossed Rule”) by failing to implement policies designed to avoid displaying locking or crossing quotations in any OTC Equity Security.  Virtu agreed to a censure and a fine of $250,000.  This fine included $100,000 for the Locked/Crossed Rule violations and $40,000 for TRACE-related violations.

In the Matter of the Application of Newport Coast Securities, Inc. (“Newport”), SEC Admin. Proc. File No. 3-185555 (April 3, 2020)

The SEC upheld a FINRA decision (1) expelling Newport from FINRA membership; (2) imposing a $403,000 fine; and (3) ordering payment of more than $900,000 in restitution and costs.  FINRA imposed these sanctions upon a finding that Newport’s registered representatives engaged in a five-year pattern of excessive trading, churning, and qualitatively unsuitable recommendations.  According to FINRA, Newport abdicated its responsibility to supervise those representatives.  Newport did not contest liability or the fines assessed.  Rather, Newport argued that the proceedings were constitutionally and procedurally defective and that the order of expulsion was excessive and oppressive.  Specifically, Newport argued that the expulsion was punitive because the firm was no longer doing business, was an undue burden on competition, and was disproportionate to the claimed supervisory failures.  The SEC disagreed, finding that “Newport abused its customers’ trust and confidence by excessively trading and churning their accounts and by making qualitatively unsuitable recommendations.  These were not isolated incidents; rather, they were repeated, years-long securities law violations committed against more than twenty customers by multiple representatives and across multiple offices.”  The SEC also found that there was no evidence of any procedural or constitutional abnormalities and that FINRA did not single out Newport unfairly.  The SEC sustained FINRA’s findings of violations and imposition of sanctions in their entirety.

SagePoint Financial, Inc. (“SagePoint”), AWC No. 2018056858101, FINRA (June 10, 2020)

Without admitting or denying the findings, SagePoint agreed to settle a FINRA enforcement action alleging failure to supervise its registered representatives’ recommendations to customers for early rollovers of Unit Investment Trusts (“UIT”), an area where both the SEC and FINRA have had increasing focus over the past few years.  A UIT is a type of registered investment company offering a fixed (unmanaged) portfolio of securities having a definite life.  The common maturity date of a UIT is between 15 and 24 months from initial offering, and at maturity, the investor will usually receive the proceeds of the value of the investment, accept a rollover of the investment into a new UIT, or receive an in-kind transfer of the UIT’s underlying portfolio securities.  According to regulators, UITs are generally not suitable for short-term holds because of their fee structure.  The early liquidation of a UIT accompanied by the rollover of investor positions into another UIT is particularly problematic for regulators due to the attendant sales charges generated for the broker.  FINRA found that SagePoint executed more than $895 million in UIT transactions during a four-year period that generated more than $17.2 million in sales charges.  This included $203.7 million in proceeds for early rollovers and $65.8 million in proceeds for trades where the UIT is rolled over to purchase a subsequent series in the same UIT (known as “series-to-series rollovers”).  SagePoint agreed to a censure, a fine of $300,000 and restitution in the amount of $1,315,373.01.

In the Matter of Department of Enforcement vs. Sandlapper Securities, LLC, (“Sandlapper”) Trevor Lee Gordon, and Jack Charles Bixler, FINRA Case No. 2012032731802 (June 23, 2020)

The National Adjudicatory Council affirmed the Decision of a FINRA Hearing Panel finding that (1) the respondents defrauded investors; (2) Mr. Gordon and Mr. Bixler caused Sandlapper to be an unregistered broker-dealer; and (3) Sandlapper and Mr. Gordon failed to reasonably supervise investment sales.  These findings amounted to willful violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Exchange Act Rule 10b-5, and FINRA Rules 2010 and 2020.  The underlying scheme involved the purchase of fractional interests in saltwater disposal wells from a well operator, and reselling those interests to investors.  Over a three-year period, more than $12 million was raised from 170 investors to fund this endeavor.  According to FINRA, the sales of the fractional interests were fraudulent, and investors were overcharged by $8 million through excessive markups.  Additionally, despite the fact that Mr. Gordon and Mr. Bixler claimed the investments were not securities, FINRA found otherwise.  Therefore the failure to register Sandlapper as a broker-dealer was another violation.  The NAC upheld the sanctions in their entirety, including expulsion of Sandlapper, a permanent bar for Mr. Gordon and Mr. Bixler, and restitution totaling $7.1 million.

Frederick Scott Levine, AWC No. 2018057247201, FINRA (July 21, 2020)

Without admitting or denying the findings, Mr. Levine agreed to settle a FINRA enforcement action alleging “an unsuitable pattern of short-term trading of [UITs] in customer accounts.”  This enforcement action continues FINRA’s apparent interest in early rollovers of UITs (see Sagepoint case summary above), and shows that FINRA is targeting individuals as well as firms.  According to FINRA, Mr. Levine recommended early rollovers to customers on approximately 950 occasions, 600 of which were series-to-series rollovers.  FINRA found that these recommendations “caused his customers to incur unnecessary sales charges and were unsuitable in view of the frequency and cost of the transaction.”  Mr. Levine agreed to a three-month suspension and a $5,000 fine.

Morgan Stanley Smith Barney LLC (“MSSB”), AWC No. 2019063917801, FINRA (August 12, 2020)

Without admitting or denying the findings, MSSB agreed to a settlement of an enforcement action alleging failure to supervise a registered representative in recommending trades without a reasonable basis for doing so.  During a period of five years, the registered representative engaged in a practice of recommending the purchase of corporate bonds or preferred securities, only to then recommend the sale of the same investments shortly thereafter.  According to FINRA, this practice resulted in losses to the customers, while at the same time generating increased sales charges for the representative.  MSSB’s automated system generated multiple alerts relating to this activity, and the compliance department conducted a review concluding that the representative’s recommendations were “generating high costs/commissions and the products/investment strategies were costing the clients more money than they are making the client.”  Despite these facts, MSSB did not take action sufficient to address the representative’s practices, resulting in more than $900,000 in customer losses over the relevant period.  MSSB consented to a censure, a fine of $175,000, and restitution in the amount of $774,574.08, plus interest.  In a related action, the registered representative received a permanent bar from associating with any FINRA member firm.  This matter reflects an ongoing trend of FINRA levying fines on firms for failure to supervise excessive short-term trading, not just in equities, but also as here in fixed income securities.

Jose A. Yniguez, AWC No. 2018060543701, FINRA (August 25, 2020)

Without admitting or denying the findings, Mr. Yniguez agreed to settle a FINRA enforcement action relating to failing to disclose an Outside Business Activity (“OBA”) and participating in a private securities transaction.  The actual allegations here are not extensive relative to other enforcement actions: Mr. Yniguez only received $5,000 from his OBA, and the total investment of individuals he referred to the private securities transaction amounted to $99,000, while his undisclosed investment was $4,300 (Mr. Yniguez also received $1,600 in referral compensation).  What is notable, however, is that while the fine and disgorgement totaled $14,000, the representative was suspended for 14 months – a considerable period of time in light of the allegations.

§ 1.4 Derivatives Institutions

United States Commodity Futures Trading Commission vs. Peter Szatmari, Civil Action No. 19-00544, United States District Court for the District of Hawaii (July 28, 2020)

The CFTC secured a default judgment against Peter Szatmari in the amount of $13,800,000 for fraudulently soliciting U.S. residents to open binary options trading accounts.  Mr. Szatmari engaged in “affiliate marketing,” a form of performance-based marketing promoting third-party products or services, such as binary options trading.  This activity is typically conducted by email or internet postings.  According to the CFTC, Mr. Szatmari intentionally defrauded customers by sending marketing solicitations that “(1) misrepresented that trading binary options would generate guaranteed profits while minimizing or disclaiming any risks; (2) claimed trading software was tested and produced profits when software had not been tested; (3) used actors or fake personalities as real owners of the trading software; and (4) depicted fictitious trading results as real.”  The Court found that Mr. Szatmari “intentionally committed fraud in connection with his binary options which qualify as a ‘swap’ under Section 1a(47)(A), 7 U.S.C. § 1a(47)(A).”  The judgment includes $6,258,250 in restitution, $1,899,837 in disgorgement, and a civil monetary penalty of $5,700,000.

In the Matter of JPMorgan Chase & Co., JPMorgan Chase Bank, N.A., and J.P. Morgan Securities LLC (together, “JPMorgan”), CFTC Docket No. 20-69 (Sept. 29, 2020)

The CFTC settled charges against JPMorgan alleging manipulative and deceptive conduct and spoofing with respect to precious metals and U.S. Treasury futures over an eight-year period.  This settlement is significant because JPMorgan agreed to a payment of $920,203,609, representing the largest amount of monetary relief ever imposed by the CFTC.  According to the stipulated findings, “[JPMorgan] traders placed hundreds of thousands of orders to buy or sell futures contracts with the intent to cancel them before execution, intentionally sending false signals of supply or demand designed to deceive market participants into executing against other orders they wanted filled.”  The CFTC noted JPMorgan’s cooperation in the early stages of the investigation was “unsatisfactory[,]” but that it was cooperative in the later stages of the investigation.  According to the CFTC, JPMorgan benefitted from the scheme in the amount of $172,034,790, which was the total amount of disgorgement under the settlement.  Restitution was in the amount of $311,737,008 and the civil monetary penalty was $436,431,811.

In the Matter of Interactive Brokers LLC (“Interactive Brokers”), SEC File No. 3-19907 (Aug. 10, 2020)

Interactive Brokers, AWC No. 2015047770301, FINRA (Aug. 10, 2020)

In the Matter of Interactive Brokers, CFTC Docket No. 20-25 (Aug. 10. 2020)

Interactive Brokers settled with three separate regulatory entities for a total of $38 million, without admitting or denying the findings.  According to the SEC, Interactive Brokers failed to file at least 150 SARs in connection with the potential manipulation of microcap securities in its customers’ accounts, leading to $11,500,000 in fines.  The same alleged activity constituted violations of AML rules resulting in $15,000,000 in fines payable to FINRA and $12,000,000 million to the CFTC.  Some of the activity cited by the SEC that should have resulted in SARs filings included:

• Interactive Brokers’ customers deposited large blocks of microcap securities followed by sales of those securities and the rapid withdrawals of the proceeds from the customers’ accounts.
• Customer sales accounted for a significant portion of the daily trading volume in certain U.S. microcap securities issuers.
• Interactive Brokers failed to review at least 14 deposits of U.S. microcap securities where the security at issue had been the subject of an SEC trading suspension.

With respect to the AML violations, FINRA and the CFTC determined that:

• Interactive Brokers’ customers wired hundreds of millions of dollars, including to countries recognized as “high risk,” without being surveilled for money laundering concerns.
• Interactive Brokers lacked sufficient personnel and a reasonably designed case management system to investigate suspicious activity, despite being warned of such deficiencies by a compliance manager.
• Interactive Brokers failed to establish and implement policies, procedures, and internal controls reasonably designed to cause the reporting of suspicious transactions as required by the Bank Secrecy Act (“BSA”).
• Even where Interactive Brokers maintained written policies, it did not commit adequate resources to monitor, detect, escalate, and report suspicious activity in practice, commensurate with the size and scope of its business.

The FINRA and CFTC settlements carried with them the additional penalty that Interactive Brokers must retain an independent compliance consultant and disgorge $700,000 in profits.  These matters highlight that AML compliance was singled out as a 2020 examination priority of both the SEC and FINRA.

§ 1.5 Money Services Businesses

In the Matter of Larry Dean Harmon d/b/a Helix, 2020-2, U.S. Department of the Treasury Financial Crimes Enforcement Network (Oct. 19, 2020)

In its authority pursuant to the Bank Secrecy Act (“BSA”), FinCEN assessed a civil monetary penalty against Larry Dean Harmon as the primary operator of Helix and as CEO and primary operator of Coin Ninja LLC (“Coin Ninja”) in the amount of $60,000,000.  During the relevant time period, Mr. Harmon and Coin Ninja were doing business as “money transmitters” as defined by 31 C.F.R. § 1010.100(ff)(5) in their capacity as exchangers of convertible virtual currencies, accepting and transmitting bitcoin.  Over the course of a five-year period, Harmon (1) failed to register as a money services business on behalf of himself and Coin Ninja; (2) failed to implement an effective AML program; and (3) failed to report certain suspicious activity.  With respect to the unreported suspicious activity, FinCEN identified at least 2,464 instances in which Mr. Harmon failed to file a SAR for transactions involving Helix.  Helix was also involved in $39,074,476.47 in bitcoin transactions with darknet and other illicit marketplace-associated addresses.  FinCEN determined that a maximum penalty would have been $209,144,554, but ultimately settled on the $60,000,000 fine.  The reasons for the reduced fine are not expressly detailed in the Order, but FinCEN noted that Helix agreed to two statute of limitations tolling agreements.

The requirement of non-financial reporting. Financial market regulators and stock exchanges across the world have issued guidance and/or requirements on non-financial reporting for listed companies.  An increasing number of jurisdictions, however, are changing non-financial reporting from a voluntary element of CSR to a legal requirement, often with extra-territorial reach. Non-financial reporting is a company’s formal disclosure of certain information not traditionally related to finances, including environmental, social and governance (ESG) factors. Such reporting elevates Corporate Social Responsibility (CSR) and sustainability to the next level.  The resultant transparency is intended to help organizations, investors and other stakeholders identify and measure the biggest non-financial challenges facing business today: climate change, diversity, equity and inclusion, and human rights impacts. 

Given the different regulatory regimes across the globe governing ESG disclosure[i] and discrepancy within industry norms, companies that previously enjoyed a degree of latitude in the context of non-financial reporting are under increasing pressure.  Companies are now expected to gather accurate data to ensure that their disclosures in non-financial reports are comprehensive and reliable.  Banks and investors alike are looking for company-specific information that identifies impacts, risks and opportunities within ESG categories. On January 19, 2021, together with the Principles for Responsible Investment (PRI), the European Leveraged Finance Association (ELFA) and the London-based Loan Market Association (LMA) jointly published a Guide for Company Advisers on ESG Disclosure in Leveraged Finance Transactions (Guide).  The Guide addresses considerations for including ESG-specific contractual obligations in documentation such as credit agreements.  Such provisions would require quarterly and/or annual reporting with respect to ESG factors, ESG-compliance certificates, and third party verification (optional). As ESG metrics become more prevalent, the Guide anticipates covenant protections may be elaborated to refer to pre-determined performance thresholds or metrics, akin to a financial covenant.[ii]  And a series of recent announcements by the U.S. Securities and Exchange Commission (SEC) underscores the agency’s commitment – and allocation of resources – to a heightened focus on ESG disclosures and related litigation.[iii]

More importantly, ESG issues are increasingly recognized as yet another aspect of corporate risk management included in expected financial reporting.  As more ESG issues are rightly included in regulatory and financial reporting requirements, companies will be expected to provide specific data rather than broad statements and assurances with respect to their policies. 

How MCCs 2.0 can help. The ABA Business Law Section’s UCC Committee Working Group to Draft Model Contract Clauses to Protect Human Rights in International Supply Chains (Working Group) recently published its 2021 Report and Model Contract Clauses (MCCs) for International Supply Chains, Version 2.0 which can be found here.  The Working Group’s 2021 Report and the MCCs Version 2.0 are the culmination of more than four years’ research and consultation with international companies, trade associations, NGOs and civil societies.  The MCCs offer modular terms companies can use in contracting and operational practice, and can significantly assist companies with complex international supply chains in satisfying non-financial reporting obligations.  The MCCs can help a company accurately “tell its ESG story.”[iv]

Section 1.1(b) of the MCCs Version 2.0 requires timely sharing throughout the supply chain of all relevant information relating to human rights threats in the supply chain by providing:

“[Buyer and Supplier each] [Supplier] shall and shall cause each of its [shareholders/partners, officers, directors, employees,] agents and all subcontractors, consultants and any other person providing staffing for Goods or services required by this Agreement (collectively, such party’s “Representatives”) to disclose information on all matters relevant to the human rights due diligence process in a timely and accurate fashion to [the other party] [Buyer].” (Emphasis added)

Section 1.4 requires the creation of a functioning grievance mechanism and self-reporting cooperation with regular reports as to OLGM use and success as follows:

“Operational-Level Grievance Mechanism. During the term of this Agreement, Supplier shall maintain an adequately funded and governed non-judicial Operational Level Grievance Mechanism (“OLGM”) in order to effectively address, prevent, and remedy any adverse human rights impacts that may occur in connection with this Agreement. Supplier shall ensure that the OLGM is legitimate, accessible, predictable, equitable, transparent, rights-compatible, a source of continuous learning, and based on engagement and dialogue with affected stakeholders, including workers. Supplier shall maintain open channels of communication with those individuals or groups of stakeholders that are likely to be adversely impacted by potential or actual human rights violations so that the occurrence or likelihood of adverse impacts may be reported without fear of retaliation.  Supplier shall demonstrate that the OLGM is functioning by providing [monthly] [quarterly] [semi-annual] written reports to Buyer on the OLGM’s activities, describing, at a minimum, the number of grievances received and processed over the reporting period, documentary evidence of consultations with affected stakeholders, and all actions taken to address such grievances.” (Emphasis added)

Section 1.4 is immediately followed by Article 2, which addresses remediating adverse human rights impacts linked to contractual activity. Section 2.1(a) requires Supplier to prepare and provide a detailed summary of the human rights threat and how it was addressed stating:

“Within _____days of (i) Supplier having reason to believe there is any potential or actual violation of Schedule P (a “Schedule P Breach”), or (ii) receipt of any oral or written notice of any potential or actual Schedule P Breach, Supplier shall provide to Buyer a detailed summary of (1) the factual circumstances surrounding such violation; (2) the specific provisions of Schedule P implicated; (3) the investigation and remediation that has been conducted and/or that is planned as informed by implementation of the OLGM process set forth in Section 1.4; and (4) support for Supplier’s determination that the investigation and remediation has been or will be effective, adequate, and proportionate to the violation.” (Emphasis added)

To ensure the contractually required sharing of all relevant information relating to a discovered human rights abuse or likely abuse without vulnerability to the argument that there has been a waiver of the attorney-client privilege or other barrier to a defense in the event of a dispute, Section 2.2(b) addresses the parties’ respective concerns with the following text:

“Each party shall provide the other with a report on the results of any investigation carried out under this Section; provided that any such cooperation in the investigation does not require Buyer or Supplier to waive attorney-client privilege, nor does it limit the defenses Supplier or Buyer may raise.” (Emphasis added)

And, turning to the implementation of a specific remediation plan, Section 2.3(d) insists upon proof of execution and stakeholder satisfaction by noting:

“Supplier shall provide [reasonably satisfactory] evidence to Buyer of the implementation of the Remediation Plan and shall demonstrate that participating affected stakeholders and/or their representatives are being regularly consulted. Before the Remediation Plan can be deemed fully implemented, evidence shall be provided to show that affected stakeholders and/or their representatives have participated in determining that the Remediation Plan has met the standards developed under this Section.” (Emphasis added)

MCCs 2.0 are a practical, business-minded tool to meet legal and financial obligations and replace outmoded “check the box” routines.  MCCs 2.0 are not another guide to nonfinancial ESG reporting.[v]  They are instead a practical tool for gathering essential information at every tier of the supply chain.  This information is crucial to any board committed to satisfying its active oversight and subsequent monitoring obligations under In re Caremark International, Inc. Derivative Litigation[vi] and its progeny.[vii]  Data collected as a result of regular enforcement of the MCCs would also be sufficient to complete a questionnaire presented by a governmental unit, regulatory agency, stock exchange, fund manager, or lending source that is insisting on greater ESG transparency.

In the current risk landscape, contract provisions that continue to focus only on supplier representations and warranties with respect to the absence of human rights abuses such as forced labor, child labor and dangerous working conditions are simply insufficient to address human rights impacts in a company’s supply chain.  It is important to operate with the assumption that the chain is vulnerable to human rights abuse compromises which make the representations and warranties ineffective if not meaningless the moment a supply contract including such empty promises is signed.  It is essential that we change the focus of supply chain contract provisions to assess, clearly identify and address human rights abuses upon detection and add provisions that allow buyers and suppliers to acquire accurate data for required ESG disclosures.  Take a look; the MCCs Version 2.0 can help.   

[i] Recent examples of instruments include the Nasdaq Reporting Guide 2.0 (https://www.nasdaq.com/docs/2019-ESG-Reporting -Guide.pdf) (2019), the B3 State-Owned Enterprises Governance Program (http://www.b3.com.br/data/files/F3/B4/1E/4F/C1B2F510ACF0EOF5790D8AA8/State-Owned-Enterprises-Governance-Program11.05.17.pdf) (2017) and the Singapore Stock Exchange Listing Rules (http://rulebook.sgx.com/net_file_store/new_rulebooks/s/g/SGX_Mainboard_Practice_Note_7.6_July_20_2016.pdf (2016) which requires every listed issuer to prepare an annual sustainability report on a “comply or explain” basis.    For example, EU Directive 2014/95/EU (https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32014L0095) set out rules on disclosure of non-financial and diversity information from large businesses with more than 500 employees. Covered companies must publish reports on the policies they implement in relation to environmental protection, social responsibility and treatment of employees, respect for human rights, anti-corruption and bribery, and diversity on company boards. In June 2017, the European Commission published its guidelines to help business with this information (https://ec.europa.eu/info/publications/170626-non-financial-reporting-guidelines_en) but, under Directive 2014/95/EU businesses are given significant flexibility to disclose relevant information in the way they consider most useful using international, European or national frameworks to produce their statements.  They can reply on the UN Global Compact (https://unglobalcompact.org/), the UN Guiding Principles on Business and Human Rights (https://www.chchr.org/Documents/Publications/GuidlingPrinciplesBusinessHR_EN.pdf), or the OECD Guidelines for Multinational Enterprises (https://www.iso.org/iso/hone/standards/iso26000.htm).  Draft Directive (EU) 2021/338 of the European Parliament and of the Council of 16 February 2021 (EU 2021) intends to amend Directive 2014/65/EU as regards information requirements, product governance and position limits, and also contemplates revisions to Directives 2013/36/EU and (EU) 2019/878 as regards their application to investment firms.  Another example is the French Duty of Vigilance Law (2017), applicable to certain large French businesses headquartered in and outside France, which requires the development, implementation and publication of annual vigilance plans detailing the steps taken or to be taken to detect human rights risks and prevent serious violation, the health and safety of persons and the environment resulting from the activities of the business, its subsidiaries, suppliers and subcontractors.

[ii] See OECD Guidance on Due Diligence for Responsible Corporate Lending and Securities Underwriting and the Dutch Banking Sector Agreement, both of which involve a multi-stakeholder approach including banks, CSOs and governments.  In December 2019, GLS Bank and Pax-Bank called for a legal duty of care for human rights and the environment.  In February 2020, the New York-based Loan Syndications and Trading Association (LSTA) published a template ESG Diligence Questionnaire applicable to borrowers across all industries to facilitate due diligence reviews of the ESG profile of borrowers.  In April 2020, a statement, led by the Investor Alliance for Human Rights and signed by 105 international investors representing over US $5 trillion in assets under management called on governments to require companies to conduct human rights due diligence and, during the UN Forum in November 2020, BMO Asset Management explicitly supported mandatory human rights due diligence during a panel on the topic.    See the BankTrack Human Rights Benchmark (https://www.banktrack.org/) which evaluates 50 of the largest private sector commercial banks globally against a set of 14 criteria based on the requirements of the UN Guiding Principles by looking at four aspects of banks’ implementation of the Guiding Principles: their policy commitment, human rights due diligence (HRDD) process, reporting on human rights and their approach to access to remedy.  For investors, there are resources which attempt to quantify the social and environmental factors that can contribute to the value of the investment but are not included in its financial reports such as the ESG Index and the Israeli Maala Index.  The Corporate Human Rights Benchmark (https://corporatebenchmark.org/) is an investor-backed initiative which assesses 101 of the largest publically traded companies in the world on 100 human rights indicators including transparency.

[iii] In the United States, the standard for disclosure in financial reports is “materiality” as defined by the United States Supreme Court and the SEC.  This definition is based on what is deemed to be likely to significantly affect the total mix of information a reasonable investor considers in making an investment decision.  While ESG considerations are not currently required to be part of US public companies’ financial statements, the SEC requires companies to include non-financial information and metrics in their regulatory filings, effective for the upcoming proxy season in 2021.  Stepping up its focus on ESG reporting, the SEC announced on March 4, 2021 the creation of a Climate and ESG Task Force in the Division of Enforcement (https://www.sec.gov/news/press-release/2021-42) which will focus on identifying “material gaps or misstatements in issuers ‘disclosure of climate risks under existing rules,” examining “disclosure and compliance issues related to investment advisers’ and funds’ ESG strategies,” and evaluating whistleblower complaints related to ESG issues.  The previous day, on March 3, 2021, the SEC’s Division of Examinations announced its 2021 examination priorities with enhanced “focus on climate and ESG-related risks by examining proxy voting policies and practices to ensure voting aligns with investors ‘best interest and expectations,’” noting that investment advisors are “increasingly offering investment strategies that focus on ESG factors” (https://www.sec.gov/news/press-release/2021-39).

[iv] Proper implementation of the MCCs would also assist a company responding to a Customs and Border Protection investigation which might otherwise result in a Withhold Release Order and provide for the regular collection of data as indicia of satisfaction of mandatory human rights due diligence very likely to be soon imposed by Germany and EU 2021.  

[v] See the UN Guiding Principles Reporting Framework (https://www.ungpreporting.org/) developed by Shift and Mazars, a tool to assist businesses in reporting on how they respect human rights; the GRI Sustainability Reporting Standards (GRI Standards) (https://globalreporting.org/standards/), which provides a framework for businesses to report on the broad spectrum of sustainability issues, including human rights (https://www.globalreporting.org/standards/work-program-and-standards-review/review-of human-rights-related-gri-standards/); the International Integrated Reporting Framework, which aims at encouraging better corporate reporting, taking into account financial and non-financial performance; and the UN Global Compact Communication on Progress (https://www.unglobalcompact.org/docs/communication_on_progress/Tools_and_Publications/COP_Basic_Guide.pdf).

[vi] 698 A.2d 959 (Del. Ch. 1996) finding that the directors violated their fiduciary duties when the corporation’s information and reporting system in concept and design is “adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations…”  Id. at 970.

[vii] See, Stone v. Ritter, 911 A.2d 362 (Del. 2006) and Caremark at the Quarter-Century Watershed: Modern-Day Compliance Realities Frame Corporate Directors’ Duty of Good Faith Oversight, Providing New Dynamics for Respecting Chancellor Allen’s 1996 Caremark Landmark, E. Norman Veasey and Randy J. Holland, The Business Lawyer, Winter 2020-2021, Vol. 76, Issue 1, page 1.

Editor

Stanley S. Jutkowitz

Seyfarth Shaw LLP
975 F Street, N.W.
Washington, D.C. 20004
(202) 828-3568 phone
[email protected]

Contributors

Jeremy Schachter

Seyfarth Shaw LLP
620 8th Avenue
32nd Floor
New York, NY 10018
(212) 218-5292 phone
[email protected]

Avrohom Colev Posen

Seyfarth Shaw LLP
620 8th Avenue
32nd Floor
New York, NY 10018
(212) 218-4649
[email protected]

Stanley S. Jutkowitz

Seyfarth Shaw LLP
975 F Street, N.W.
Washington, D.C. 20004
(202) 828-3568 phone
[email protected]

§ 1.1 Introduction

Laws and regulations relating to cannabis and the cannabis industry continue to evolve at a rapid pace.  In order to put current developments in context, it is important to understand the current state of the law regarding marijuana and hemp.

The starting point is the Controlled Substances Act, 21 U.S.C. § 801 et. seq. (“CSA”), passed in 1970 to regulate the manufacture, use, and distribution of certain controlled substances for medical, scientific and industrial purposes and to prevent these substances from being used for illegal purposes.  The CSA classified various drugs and chemicals into five categories, or schedules.  Marijuana, along with heroin, cocaine, LSD, and other substances, was placed on the most restrictive schedule, Schedule 1.  The CSA prohibits the manufacture, distribution, sale possession, or use of marijuana.  Also, the CSA operates to prohibit the transportation of marijuana across state lines, even between states that have passed laws legalizing marijuana, as well as international borders.

Despite the existence of the CSA, as of today, thirty six states plus the District of Columbia, Guam, Puerto Rico, and the U.S. Virgin Islands have laws legalizing marijuana for medical use, and fifteen of those states, plus D.C., and Guam a have legalized marijuana for recreational use, as well.  Legislation to legalize marijuana is currently working its way through other state legislatures.  Since the CSA is the law of the land, how states can “legalize” marijuana consistent with the preemption doctrine is complicated. _____.

The laws relating to marijuana and hemp became very complicated at the end of 2018, with the passage of the Agricultural Improvement Act of 2018, the Farm Bill.  It is important to understand that both hemp and marijuana come from the same species of plant, Cannabis sativa L., and both were included in the definition of marijuana in the CSA.  Both marijuana and hemp contain a number of chemical compounds, the two most known of which are THC (the psychoactive compound) and CBD.  The legal difference is that hemp contains less than three percent THC.  Part of the confusion revolves around the other chemical compound, CBD, which is extremely popular and ubiquitous in the market place.  CBD comes from both hemp and marijuana.  Further complicating the situation is that there is no standard for measuring THC content in a cannabis plant, so what might be classified as hemp by one state might be classified as marijuana by a different state.

While hemp is technically legal under federal law, the Food and Drug Administration maintains jurisdiction over hemp (and therefore CBD) to the extent it is marketed as a food or dietary supplement or as a drug.  Also, the state statutory and regulatory framework for hemp and CBD derived from hemp remains very confusing and is rapidly evolving.

This section will focus on recent developments in cannabis law.

§ 1.2 Tax Issues for the Cannabis Industry

Richmond Patients Group v. Commissioner of Internal Revenue, T.C. Memo 2020-52

Date: May 4, 2020

Facts: Plaintiff operated a medical marijuana dispensary.  It purchased for resale bulk marijuana and inspected, sent out for testing, trimmed, dried, packaged, and labeled the marijuana it purchased.  It did not grow marijuana or sell live plants, clones, or seeds.  Plaintiff took business expense deductions for compensation to officers, salaries and wages, repairs and maintenance, rents, taxes, and license fee.  Plaintiff argued that it was a producer, not a reseller and therefore should be able to include in cost of goods sold (COGS) certain indirect inventory costs pursuant to regulations issued under Internal Revenue Code (Code) section 471.

Held: Plaintiff was a reseller, not a producer and therefore not able to deduct certain indirect inventory costs included in COGS and plaintiff was not able to deduct certain business expenses.

Reasoning: The plaintiff argued that it was a producer for purposes of sections 471 and 263A of the Code and should be entitled to deduct or include in COGS certain indirect inventory costs.  The Court analyzed the definition of what it means to produce and found that constructing, building, installing, manufacturing, developing, improving, creating, raising, or growing were activities of production.  Plaintiff did none of those things and was therefore a reseller, not a producer.

In denying a deduction by the Plaintiff for certain business expenses, the Court cited Code section 280E which denies a deduction of any business expenses related to a business consisting of trafficking in a controlled substance.  A marijuana dispensary is such a business.  The Court then analyzed whether such business expenses could be included in COGS.  The Court noted that Section 263A includes in COGS only business expenses that are otherwise deductible and since 280E prohibits these expenses from being deductible they could not be included in COGS.  This case is one of a long line of cases in which the Internal Revenue Service has successfully argued against taxpayers seeking to plan around section 280E.

Wakefield v. Department of Revenue, State of Oregon (unpublished) 2020 WL 905739 (Or. Tax Magistrate Div.)

Date: February 25, 2020

Facts: Plaintiff operated a medical marijuana business in Oregon.  Plaintiff filed its 2014 and 2015 Oregon income tax returns reporting certain business expenses.  The Oregon Department of Revenue disallowed Plaintiff’s business expenses citing Code section 280E.  The issues was whether the Plaintiff could deduct its business expenses due to Code section 280E since Oregon income tax law generally follows federal tax law.

Held: Plaintiff was not eligible to deduct certain business expenses in 2014 but was able to do so in 2015 based on a state measure, Measure 91, that was approved in 2015 that made Code section 280E inapplicable to computation of state income taxes.

Reasoning: Plaintiff argued that Measure 91 which became effective on July 1, 2015 for tax years beginning on January 1, 2015, should be retroactively applied to the 2014 tax year.  The version of the statute that implemented Measure 91 was modified and the earlier version of that statute was deleted and Plaintiff argued that this rendered the effective date ambiguous.  The Oregon Tax Magistrate Division ruled that based on the Oregon constitution, statutes, and case law the effect of deleting a statute that was superceded by an amended version of the same statute did not have the effect of altering the effective date.  Accordingly, the Plaintiff could not take business deductions prohibited under 280E prior to the date it was decoupled from Oregon law.  This case illustrates the complexities of dealing with the impact of section 280E under federal and state tax law.  A careful analysis of the impact of Code section 280E on a cannabis business is essential both for ongoing business planning as well as for an M&A transaction.

§ 1.3 Trademarks

Kiva Health Brands LLC v. Kiva Brands Inc., 439 F. Supp.3d 1185 (N.D. Cal. 2020)

Date: February 14, 2020

Facts: Plaintiff started using KIVA trademark in connection with natural foods starting in 2013 and obtained a registration in 2014.  Defendant started using KIVA trademark in connection with cannabis infused chocolates starting in 2010.  Plaintiff allegedly first learned of Defendant’s use of the same mark in June 2015.  Plaintiff brought suit for trademark infringement in 2018.  Among other things, Defendant asserted laches and prior use as affirmative defenses to infringement.  Both parties moved for summary judgment on these defenses.

Held: Summary judgment against laches defense denied.  Summary judgment against prior use defense granted.

Reasoning: Laches defense.  The principle behind laches is that a court should not help a plaintiff who sleeps on its rights.  To establish laches, a defendant needs to show unreasonable delay and prejudice.  A plaintiff’s delay is the time between: (a) the date it knew, or in the exercise of reasonable diligence, should have known about its potential cause of action; and (b) the date it brings suit against the defendant.  A delay cannot be reasonable if it is longer than the analogous statute of limitations, which in this case, the court held was four years.  Here, Plaintiff brought suit in 2018, claiming to have first learned of Defendant’s use of the KIVA mark in 2015 (within the statute of limitations period).  Defendant, however, showed evidence of its use online, including on its website and on Facebook as early as 2013 (outside the statute of limitations period).  Thus, summary judgment was denied because there was a genuine dispute as to the period of Plaintiff’s delay and whether it was even capable of being deemed reasonable.

Prior use defense.  In a prior decision on a motion for preliminary injunction, the court held that Defendant’s prior use defense was not likely to succeed under the Lanham Act, 15 U.S.C. § 1115(b)(5) because its use—in connection with cannabis infused chocolates—was illegal under federal law.  The court restated its reasoning from that opinion in this one: “To hold that [Defendant’s] prior use of the KIVA mark on a product that is illegal under federal law is a legitimate defense to [Plaintiff’s] federal trademark would put the government in the anomalous position of extending the benefits of trademark protection to a seller based upon actions the seller took in violation of that government’s own laws.” (citation and internal quotation marks omitted).  (Author’s view: The court’s reasoning is questionable for multiple reasons, including because it denied summary judgment on the laches defense.  If the federal illegality of Defendant’s use would bar a prior use defense, there is no reason why it would not also bar a laches defense.) 

Given the court’s earlier decision denying prior use as a defense under Section 1115(b)(5), Defendant this time relied on Section 1065 of the Lanham Act, which expressly provides for a prior use defense based on trademark rights established under state law.  The court did not dispute Defendant’s interpretation of Section 1065’s language or suggest that Defendant’s prior use defense would not be available thereunder.  But the court dismissed Defendant’s position as inapposite because Section 1065 concerns “incontestable” marks, which Plaintiff’s mark is not, and granted summary judgment to Plaintiff on Defendant’s prior use defense.  (Author’s view: The court’s reasoning is questionable.  Marks that have obtained incontestable status are afforded even greater protections under the Lanham Act than marks that have not.  See 15 U.S.C. § 1115(b).  By seemingly making prior use of cannabis marks a viable defense to incontestable marks but not contestable marks, the court gave greater protections to contestable marks.  That does not square with the Lanham Act.)

BBK Tobacco & Foods LLP v. Skunk Inc., No. CV-18-02332-PHX-JAT, 2020 WL 1285837 (D. Ariz. March 18, 2020)

Date: March 18, 2020

Facts: Plaintiff brought suit against Defendant for infringing certain federally registered SKUNK-formative marks.  Defendant counterclaimed seeking to cancel Plaintiff’s SKUNK registration for “herbs for smoking” on the grounds that SKUNK is generic for cannabis, which is an herb for smoking.  Plaintiff moved to dismiss the counterclaim.

Held: Motion to dismiss counterclaim granted.

Reasoning: The court found that the USPTO’s policy is to refuse registration of marks used for unlawful goods, such as cannabis, and noted the USPTO’s refusal of several registrations for cannabis-based goods.  The court therefore concluded that the “herbs for smoking” identified in Plaintiff’s SKUNK registration could not have been a reference to cannabis.  The court also noted that “a trademark registration is not susceptible to a genericness challenge simply because it is the generic name for something; rather, it must be the generic name for the particular goods listed in the trademark registration.”  Here, even if skunk is generic for cannabis, cannabis is not one of the goods listed in Plaintiff’s registration.  Accordingly, Defendant’s counterclaim seeking dismissal of SKUNK on the basis that skunk is generic for cannabis failed to state a claim upon which relief could be granted.

Clint Eastwood v. Sera Labs, Inc., et al., Case No. 2:20-cv-06503-RGK-JDE, 2020 WL 5440564 (C.D. Cal. July 28, 2020)

Date: July 28, 2020

Facts: Advertising claimed that Defendant’s CBD product was put out by Clint Eastwood.  Advertising included fabricated interviews with Mr. Eastwood.  Eastwood sought a TRO and preliminary injunction based on false advertising, violation of common law right of publicity, false endorsement under the Lanham Act, and various other related claims.

Held: TRO granted.

Reasoning: Defendants had zero relationship with Clint Eastwood.  All advertising was completely fabricated. Defendant Sera Labs submitted a declaration explaining that the advertising was created and disseminated by others without approval from Sera Labs.  On that basis, the court agreed to exclude Sera Labs from the TRO, but acknowledged that such a finding would not preclude its potential liability.

§ 1.4 False Advertising

Snyder v. Green Roads of Florida LLC, 430 F. Supp.3d 1297 (S.D. Fla. January 3, 2020)

Date: January 3, 2020

Facts: Defendant sells various CBD products.  Plaintiff sues for false advertising and related laws on the theory that labels overstate the CBD content.  Defendant moved to stay under the primary jurisdiction doctrine.

Held: Motion to stay granted.

Reasoning: Courts consider four factors when applying the primary jurisdiction doctrine: (1) the need to resolve an issue that (2) has been placed by Congress within the jurisdiction of an administrative body having regulatory authority (3) pursuant to a statute that subjects an industry activity to a comprehensive regulatory scheme that (4) requires expertise or uniformity in administration.  Courts also consider and rely heavily on a fifth factor implicating FDA jurisdiction: whether the FDA has shown any interest in the issues presented by the litigants.  Here, the court determined that the primary jurisdiction doctrine was applicable because there is a need for consistent guidance on CBD labeling standards, Congress has placed the authority with the FDA via the Farm Bill, and the FDA, which has expertise and will ensure uniformity in administration, is in the midst of working on the issue.

Potter v. Potenetwork Holdings, Civil Action No. 19-24017-Civ-Scola, 2020 WL 1516518 (S.D. Fla. March 30, 2020)

Date: March 30, 2020

Facts: Defendant sells various CBD products.  Plaintiff sues for false advertising and related laws on the theory that labels overstate the CBD content.  Defendant moved to stay under the primary jurisdiction doctrine.

Held: Motion to stay denied.

Reasoning: The court determined that the primary jurisdiction doctrine was not applicable here because the FDA’s forthcoming guidance and regulations on the labeling of CBD products is unlikely to affect the outcome of a case concerning the truth or falsity of the content claim at issue.

Colette et al. v. CV Sciences, Inc., 2:19-cv-10227-VAP-JEM(x), 2020 WL 2739861 (C.D. Cal. May 22, 2020)

Date: May 22, 2020

Facts: Defendant sells various CBD products.  Plaintiff sues for false advertising and related laws on the theory that she would not have purchased the products if she had known they were not legally sold in the U.S.  Defendant moved to stay under the primary jurisdiction doctrine.

Held: Motion to stay granted.

Reasoning: The court determined that the primary jurisdiction doctrine was applicable in this case because the FDA is in the process of regulating the products at issue and there is uncertainty with respect to how the products will be classified, the types of labelling that will be required, etc.  The court was also concerned that because there are multiple similar litigations pending, proceeding in any of them without the benefit of the FDA’s ultimate guidance likely would result in inconsistent rulings.  The court also distinguished this case from others where FDA guidance would not affect the outcome, and there was no danger of inconsistent rulings.

Glass v. Global Widget, LLC d/b/a Hemp Bombs, No. 2:19-cv-01906-MCE-KJN, 2020 WL 3174688 (E.D. Cal. June 15, 2020)

Date: June 15, 2020

Facts: Defendant sells CBD-infused edibles, capsules, oils, and vape products.  Defendant’s advertising represented that its products were legal and, according to Plaintiff, that they contain between seven and 82% more CBD than is actually present in the products.  Plaintiff brought suit for false advertising and related claims.  Defendant, among other things, moved to stay based on the primary jurisdiction doctrine.

Held: Motion to stay granted.

Reasoning: Piggybacking on Collette case, the court held that the FDA’s activities in clarifying its position on CBD warranted a stay.

Ahumada v. Global Widget, Case No. 19-cv-120005-ADB, 2020 WL 5669032 (D. Mass. August 11, 2020)

Date: August 11, 2020

Facts: Defendant sells various CBD products.  Plaintiff sues for false advertising and related laws on the theory that labels overstate the CBD content and falsely convey legality.  Defendant moved to stay under the primary jurisdiction doctrine.

Held: Motion to stay granted.

Reasoning: The court determined that the primary jurisdiction doctrine was applicable in this case because the FDA is in the process of regulating the products at issue and there is uncertainty with respect to how the products will be classified, the types of labelling that will be required, etc.  The court was also concerned that because there are multiple similar litigations pending, proceeding in any of them without the benefit of the FDA’s ultimate guidance likely would result in inconsistent rulings.

Ballard v. Bhang Corp., Case No. EDCV 19-2329 JGB (KKx), 2020 WL 6018939 (C.D. Cal. Sept. 25, 2020)

Date: September 25, 2020

Facts: Defendant sells “medicinal chocolate,” which claims to have certain amounts of THC and CBD.  Plaintiff’s independent lab testing revealed that Defendant’s chocolate did not contain the amount of CBD advertised.  Plaintiff therefore filed a class action lawsuit for false advertising and related claims.  Among other things, Defendant moved to stay based on the primary jurisdiction doctrine, and dismiss based on preemption.

Held: Motion to stay based on primary jurisdiction denied.  Motion to dismiss based on preemption denied

Reasoning: Motion to stay.  Defendant argued that FDA regulations concerning CBD safety, including how to measure and label cannabinoid content, was forthcoming, and that the court should therefore defer consideration of the CBD claim until after such guidance was issued under the primary jurisdiction doctrine.  The court denied the motion because FDA guidance would not clarify the straightforward issue of whether the amount of advertised CBD was true or false.  The court distinguished other cases that had granted stays pending FDA guidance on the theory that such guidance would clarify an issue, such as the legality of CBD, or the meaning of “hemp extract.”  The court reasoned that no such clarity was needed here, as this was not a case that involved a “definitional agreement” or required “the FDA’s technical expertise.”

Motion to dismiss.  Defendant’s motion to dismiss was based, in part, on its argument that the 2018 Farm Bill granting the FDA authority to regulate cannabinoids in food products preempted Plaintiff’s stated false advertising claims.  The court denied the motion because nothing in the Farm Bill purports to preempt state tort laws, and state false advertising laws do not conflict with or impede the 2018 Farm Bill.  The court, however, ultimately granted Defendant’s motion to dismiss, with leave to amend, because Plaintiff’s complaint failed to identify basic information, including the specific chocolates he bought, when he bought them, how they were advertised, and how they fell short of that advertisement.

§ 1.5 Bankruptcy

In re Malul, 614 B.R. 699 (Bankr. D. Colo. 2020)

Facts: Several years after the debtor’s Chapter 7 case was closed, the debtor filed a motion to reopen the case in order to disclose her interests in what was then a non-operational medical marijuana company and pending state court lawsuit against the company’s principal.  The motion was granted and after entry of order reopening the case, the debtor filed an amended schedule of assets and a motion to compel abandonment of her interests in the company and the lawsuit.  The Chapter 7 trustee filed a motion to settle the debtor’s claim in the state court action.  The United States Trustee filed a motion to vacate the order conditionally reopening the case and to return the parties to the status quo ante.

Held: The Bankruptcy Court granted the motion to vacate, vacated the Order reopening the case, and then denied the Motion to Reopen.  It also directed the parties to take all actions necessary to re-establish the status quo ante.

Reasoning: The Bankruptcy Court reasoned that under the Controlled Substances Act (CSA), which preempted state law in this instance, it was illegal to use, sell or cultivate marijuana.  Any contract relating to the sale, use, or cultivation of marijuana was in contravention of public policy and therefore void and unenforceable.  The Court pointed out that any such contract was also illegal and unenforceable under Colorado law.

The debtor argued that the company had no assets and operations and was therefore no longer a marijuana business.  The Court found, however, that despite the fact that the company had no assets or operations, the debtor’s interest in the marijuana company was illegal ab initio and ownership of an interest in the company constituted an ongoing violation of the CSA.  Furthermore, the Court found that the lawsuit involved a loss of profits from an illegal business.  Following a long line of bankruptcy cases, the Court found that reopening the case would require the Court to deal with an illegal asset in violation of Federal laws.  In rendering its decision the Court noted that “participants in the marijuana industry will continue to experience difficulty and uncertainty in predicting the outcome of any song marijuana-related bankruptcy case unless and until Congress provides a legislative solution to the divergent federal and state drug laws.”  The Court may enjoy the opera, but anxiously awaits the fat lady’s song.

§ 1.6 Real Estate

§ 1.6.1 Zoning

SEVEN HILLS, LLC, et al., Appellants, v. CHELAN COUNTY, Respondent, Case No. 36439-9-III, Unpublished Opinion Filed April 23, 2020.

Facts: Washington State voters approved Initiative 501 in 2012 to decriminalize most marijuana production and use in the state.  Chelan County passed a moratorium on the siting of marijuana facilities in September 2015, and in February 2016, banned marijuana production and processing permanently in Chelan County.  Appellant received four citations in September 2016, for manufacturing marijuana in violation of the local Chelan County ban on cannabis production and for operating without proper permits.  Chelan County, in March 2017, then ordered Appellant to cease marijuana production and processing, and to remove all plants, growing structures, and propane tanks from the premises.  Appellant alleged that they had a vested right to produce marijuana because they began operating legally prior to the enacted moratorium.  They challenged the citations and the order to the county hearing examiner, who affirmed, and to the Chelan Superior Court, which did the same.  Seven Hills then appealed to the Court of Appeals of Washington, Division 3.

Held: The Court of Appeals affirmed the decisions of the county hearing examiner and the Chelan Superior Court, ruling that Appellant did not establish that it had a valid nonconforming use, as it was not legally operating its production business prior to the moratorium established in September 2015.

Reasoning: While the appeal to the Court of Appeals raised two primary areas of challenge, the Court found Appellant’s arguments regarding the burden of proof at the administrative hearing and deficiencies regarding the county hearing examiner’s lack of legal citations to be without merit.  When addressing the issue concerning Appellant’s alleged nonconforming use of the property, the Court analyzed the timeline of Appellant’s activities.  In order to establish a nonconforming use despite local zoning ordinances, the use must lawfully exist, and continuously be maintained, prior to enactment of the regulation restricting such use.  Here, the Court found that Appellant’s actions prior to the passing of the moratorium in September 2015 were not sufficient to establish a legal nonconforming use.  Appellant claimed that the applications filed and permits obtained from the Chelan County officials in advance of the moratorium were in pursuit of the development and construction of marijuana production and processing facilities.  However, the Washington State Liquor and Cannabis Board (WSLCB) first issued a license to Seven Hills to produce and process marijuana on January 26, 2016, two weeks prior to the passing of the permanent ban, but nearly four months following the temporary moratorium.  The Court found that marijuana production remains illegal in Washington State absent permission from WSLCB to produce it.  Therefore, Appellants actions prior to the issuance of the WSLCB permit could not sufficiently establish a legal nonconforming use of the property once the moratorium was enacted.

§ 1.6.2 Geographical Restrictions

TOP CAT ENTERPRISES, LLC, Appellant, v. CITY OF ARLINGTON, et al., Respondents, Case No. 79224-5-I, Opinion Filed: January 6, 2020. 11 Wash.App.2d 754 (Court of Appeals of Washington, Division 1).

Facts: The Washington State Liquor and Cannabis Board (WSLCB) was the agency tasked with awarding the retail licenses in Washington State following the approval of Initiative 501 in 2012.  Licenses were initially granted using a lottery system and were assigned to specific jurisdictions.  In 2015, with the passing of the Cannabis Patient Protection Act (CPPA), the number of available licenses increased by 222, but were awarded to applicants using a priority rating system (based on skill, experience, and qualifications in the marijuana industry).  The CPPA also allowed certain previously awarded lottery licenses with jurisdictional limitations to transfer to other jurisdictions, but only once their WSLCB licensing approval process was complete and if an open spot remained in their desired target jurisdiction.  Top Cat was a lottery winner that was unable to open in its initial jurisdiction due to a local moratorium.  On December 8, 2015, 172nd Street Cannabis received its initial CPPA designation and sought the last available retail license in Arlington for a retail location.  They sought to operate at a leased property located at 5200 172nd St., in Arlington, which was identified as lot 500B on the larger Arlington Municipal Airport property.  On January 29, 2016, Top Cat applied to move its license to Arlington, but WSLCB then subsequently approved and issued the only available license to 172nd Street, before completing a final inspection of Top Cat’s application.  Top Cat requested an administrative hearing before an Administrative Law Judge (ALJ) alleging that the 172nd’s leased property violated the CPPA requirement prohibiting marijuana retail locations within 1,000 feet of “the perimeter of the grounds of” a school, since Weston High School leases lot 301 from the Airport as well.  The ALJ concluded that the measurement of 1,000 feet was to be calculated from the edge of the leased premises, not the larger Airport parcel.  The Snohomish County Superior Court then affirmed the order and Top Cat appealed to the Court of Appeals of Washington, Division 1.

Held: The Court of Appeals agreed with the conclusions of the ALJ and WSLCB, finding that the ordinary meaning of “property line” should apply, which in this case was interpreted to mean that the distance should be measured from the line separating a lot from other adjoining lots or streets, not the edge of the larger parcel containing the lot.

Reasoning: The Court of Appeals of Washington stated that they interpret agency regulations as if they were statutes, but reviews an agency’s legal determinations de novo (but with substantial weight to an agency’s interpretation of statutes and regulations within its area of expertise).  Under I-502, the WSLCB is prohibited from issuing “a license for any premises within one thousand feet of the perimeter of the grounds of any elementary or secondary school.” In the WSLCB regulations, the language included additional text providing that “The distance shall be measured as the shortest straight line distance from the property line of the proposed building/business location to the property line of” the prohibiting entity.  Top Cat argued that “property line” should be understood as a legal description from a deed setting forth the boundaries of real property for the lot overall, which, they alleged, put the 172nd Street Cannabis’s location only 120 feet from the school property (because the Airport property is immediately diagonal from the proposed retail store).  However, the Court of Appeals of Washington, agreeing with the prior decisions, confirmed that the 1,000 foot separation requirement must follow the plain meaning and should use the leased lot lines when calculating the distance.  They concluded that the WSLCB’s measurement finding a 1,600 foot separation between the retail location and the school was consistent with the statute, the legislative intent and the plain meaning, thereby affirming the approval of 172nd Street Cannabis’ license.

The Mendes Hershman Student Writing Contest is a highly regarded legal writing competition that encourages and rewards law students for their outstanding writing on business law topics. Papers are judged on research and analysis, choice of topic, writing style, originality, and contribution to the literature available on the topic. The distinguished and highly-regarded former Business Law Section Chair, Mendes Hershman (1974-1975) lends his name to this legacy. See the abstract of this year’s third place winner, Kristen Kelbon of the Villanova University Charles Widger School of Law, Class of 2021, below.

The effects of the novel coronavirus pandemic (“COVID-19”) altered operations, financial performance, and market predictions for a vast majority of companies and industries in virtually a matter of weeks. In January 2020, the Senate held a private briefing where senators learned of classified information pertaining to COVID-19. Four U.S. senators subsequently dumped their stocks—just days before the market plummeted. The senators faced intense disparagement and accusations of potential insider trading, thus, the overarching question was whether these senators actually violated insider trading laws.

Prior to 2012, the conventional insider trading laws arguably did not apply to
 Congress. However, in 2012, Congress passed the Stop Trading on Congressional Knowledge Act (“STOCK Act”) into law, expressly prohibiting members of Congress from trading on material, nonpublic information they gleaned on Capitol Hill. The STOCK Act attempted to clarify whether members of Congress are subject to prohibitions on insider trading. However, it remains unclear whether the Securities and Exchange Commission or Department of Justice can successfully pursue civil and criminal actions against members of Congress under the current securities laws. Indeed, the STOCK Act has some deficiencies making it difficult to successfully prosecute congressional insider trading, and the coronavirus controversy renewed concerns about its effectiveness as a deterrent.

The recent insider trading scandal illustrates that the STOCK Act and preexisting insider trading statutes are not sufficient to prevent corruption and financial conflicts of interest. As such, high- profile stock transactions during the country’s worst pandemic, and accompanying economic crisis, should provide a sufficient impetus for a new Congress to revisit the issue of congressional insider trading and take appropriate action.

On March 31, 2021, the Consumer Financial Protection Bureau (“Bureau” or “CFPB”) announced the rescissions of a range of policy statements issued under the leadership of former Director Kathleen L. Kraninger.  These rescissions rolled back one policy statement regarding communications between institutions subject to CFPB supervision and their examiners, and seven policy statements issued in the early days of the COVID-19 pandemic to provide regulatory relief to affected institutions.  Below, we describe the state of play prior to these rescissions, the effect of each rescission, and what these developments tell us about the CFPB under new leadership.

Discontinuation of Supervisory Recommendations

From September 2018 until the March 2021 announcement, CFPB Bulletin 2018-01 provided the rules of the road regarding the CFPB’s communication of its supervisory expectations.  Under the Bulletin, the CFPB could include in examination reports and supervisory letters two distinct categories of findings to convey supervisory expectations: 

• First, the CFPB could issue Matters Requiring Attention (“MRAs”), which were tied to a violation of federal consumer financial law and would provide directions for correcting the violation, remediating affected consumers, and addressing relevant weaknesses in the institution’s compliance management system (“CMS”). Covered persons receiving an MRA would be required to provide periodic reporting to the Bureau regarding the status of corrective actions, as well as the timeframes for completing such corrective actions. 
• Second, the CFPB could provide Supervisory Recommendations (“SRs”), which would recommend action in light of supervisory concerns related to CMS. Unlike MRAs, SRs would arise from perceived weaknesses in CMS, rather than actual violations of federal consumer financial law.

On March 31, 2021, the Bureau rescinded CFPB Bulletin 2018-01 and replaced it with CFPB Bulletin 2021-01.  The new Bulletin ends the use of SRs outright, instead instructing examiners to “continue to rely on [MRAs] to convey supervisory expectations” in examination reports and supervisory letters.  Under the new CFPB Bulletin 2021-01, MRAs no longer must be tied to a violation of federal consumer financial law, but may also result from “risk of such violations or compliance management system (CMS) deficiencies.” In effect, the function of SRs under Bulletin 2018-01 has been merged into the function of MRAs under Bulletin 2021-01.

The rescission represents a sudden and significant alteration to the supervisory relationship between the CFPB and the industry.  As a practical matter, the change limits examiners’ ability to give feedback to institutions in a constructive, non-adversarial manner.  SRs provided examiners with a middle ground between informal feedback and MRAs that could convey concrete recommendations to institutions, without legal sanction, while inviting further dialogue on achieving compliance goals.  The gravity accompanying MRAs raises the stakes for institutions subject to CFPB examinations, and institutions may lose the ability to pursue innovative compliance approaches because MRAs impose specific, prescriptive remedial actions.  Further, the Bureau’s statement that it may now issue MRAs even without a finding that an institution has violated the law could foreshadow operational micromanagement by examiners, requiring changes in CMS even when an institution has not deviated from the requirements of applicable laws.

Reversing Industry-Focused Pandemic Relief

Following the onset of the COVID-19 pandemic in the United States in early 2020, the CFPB (under the leadership of former Director Kraninger) issued a number of policy statements to offer relief to the financial industry, which was grappling with the practical realities of the pandemic.  These industry-relief measures included the suspension of certain filing deadlines, relaxing of timeframes for certain responses to consumers, and the consideration of pandemic-rooted staffing changes in supervisory and enforcement determinations.  Last month’s action by the Bureau included the rescission of seven statements that provided such industry-relief measures:

• Statement on Bureau Supervisory and Enforcement Response to COVID-19 Pandemic: This statement had provided that the CFPB would take pandemic-related disruption into account in supervisory and enforcement activities, and encouraged the industry to pursue “prudent efforts undertaken in good faith that are designed to meet the exigent needs of financial institutions’ borrowers and other customers.”  In rescinding this policy statement, the Bureau also withdrew from the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus and the Interagency Statement on Appraisals and Evaluations for Real Estate Related Financial Transactions Affected by the Coronavirus.
• Statement on Supervisory and Enforcement Practices Regarding Quarterly Reporting Under the Home Mortgage Disclosure Act: Under this statement, the CFPB had indicated that it would not initiate supervisory or enforcement action for an institution’s failure to timely submit quarterly HMDA data.  The Bureau’s rescission instructs institutions required to submit HMDA data quarterly to do so beginning with data for first quarter 2021, due by May 31, 2021.
• Statement on Supervisory and Enforcement Practices Regarding Bureau Information Collections for Credit Card and Prepaid Account Issuers: This policy statement had provided that the CFPB would not initiate supervisory or enforcement action based on an institution’s failure to timely submit certain information relating to credit card and prepaid account products required under the Truth in Lending Act (“TILA”), Regulation Z, and Regulation E.  The rescission instructs institutions to resume this reporting, generally imposing an April 30, 2021 submission deadline.
• Statement on Supervisory and Enforcement Practices Regarding the Fair Credit Reporting Act and Regulation V in Light of the CARES Act: Under this policy statement, the CFPB had described the responsibilities of furnishers under the CARES Act, stated that it would not take supervisory or enforcement action based on a consumer reporting agency or furnisher’s failure to timely resolve consumer reporting disputes so long as the institution “mak[es] good faith efforts to investigate disputes as quickly as possible,” and encouraged institutions to provide payment relief options to consumers.  The Bureau’s rescission undoes much of the policy statement’s regulatory relief and flexibility for conduct after March 31, 2021, stating the CFPB’s “intent to exercise its supervisory and enforcement authority consistent with the Dodd-Frank Act and FCRA and with the full authority afforded by Congress consistent with the statutory purpose and objectives of the Bureau.”  However, the rescission leaves intact provisions that encourage voluntary payment relief efforts and that provide that the CFPB will not take supervisory or enforcement action against an institution that furnishes information accurately reflecting such relief.
• Statement on Supervisory and Enforcement Practices Regarding Certain Filing Requirements Under the Interstate Land Sales Full Disclosure Act and Regulation J: This statement had indicated that the CFPB would not initiate supervisory or enforcement action based on a land developer’s failure to timely submit annual reports and financial statements required under the Interstate Land Sales Full Disclosure Act and Regulation J.  The Bureau’s rescission instructs covered land developers to resume regular reporting and submit any delayed submissions by April 30, 2021.
• Statement on Supervisory and Enforcement Practices Regarding Regulation Z Billing Error Resolution Timeframes in Light of the COVID-19 Pandemic: This statement had provided that the CFPB would not take supervisory or enforcement action against a creditor that failed to timely resolve a billing error notice under Regulation Z, so long as the creditor complied with all other applicable requirements and made a good faith effort to obtain the necessary information and make a determination as quickly as possible.  The Bureau’s rescission lifts this regulatory relief effective April 1, 2021, stating that the CFPB “intends to exercise its supervisory and enforcement authority consistent with the Dodd-Frank Act and with the full authority afforded by Congress consistent with the statutory purpose and objectives of the Bureau.”
• Statement on Supervisory and Enforcement Practices Regarding Electronic Credit Card Disclosures in Light of the COVID-19 Pandemic: This statement had provided flexibility from requirements under the Truth in Lending Act and Regulation Z that lenders obtain certain consumer consents in writing before providing required disclosures electronically.  The rescission states that the Bureau will exercise its full supervisory and enforcement authority for violations of the written consent requirements of TILA and Regulation Z occurring after April 30, 2021.

These seven rescissions show a clear shift in focus from the pandemic response of the Bureau under Director Kraninger.  The initial policy statements targeted the effects of the pandemic on the financial industry, such as the need to shift to remote work in light of stay-at-home orders.  While the Bureau encouraged institutions to work with consumers facing hardship as a result of the pandemic, such encouragement was voluntary only.

In contrast, the rescissions pivot the CFPB’s efforts towards ameliorating the effects of the pandemic on consumers through robust supervision and enforcement.  In doing so, the Bureau points to changed circumstances for the industry in the time since the policy statements were issued, such as the successful transition to remote work, the ability to resume in-person work in certain limited capacities, and the lifting of stay-at-home orders in some jurisdictions.  The CFPB portrays different circumstances for consumers than those in effect at the time the statements were issued: Acting Director David Uejio, in announcing the rescissions, opined that “[t]he virus has affected industry as well as consumers, but individuals and families have been hardest-hit by the pandemic’s health and economic impacts.”

Lessons from the Rescissions

The rescissions of these policy statements illustrate a number of changes at the Bureau under the direction of Acting Director Uejio.  The undoing of the pandemic-centered regulatory relief aligns with an increased focus on consumers experiencing financial distress as a result of the pandemic.  Acting Director Uejio has described this as a top priority of the CFPB since his first days on the job, and the Bureau has demonstrated a focus on housing insecurity amid the pandemic through a proposed rulemaking, a joint statement, and a research report.

More generally, these rescissions mark a conscious change in direction—in supervision, enforcement, regulation, and general tone from the top—from that of the CFPB under Director Kraninger.  Much like the Bureau’s March 11, 2021 rescission of a Kraninger-era policy statement setting parameters around the Dodd-Frank prohibition on abusive acts or practices, these shifts send the message that the CFPB is acting to dissolve Kraninger-era roadblocks on its discretion to interpret and enforce the law.  Taken together, these actions suggest that the Bureau under Acting Director Uejio (and, if confirmed, Director Rohit Chopra) will move forward with a far-reaching approach to consumer protection, even at the cost of reduced clarity for the industry.

Introduction

A human resources department now culls through resumes using an Artificial Intelligence (AI) tool. No human eyes see the candidates’ credentials until the pool of job seekers is culled down to a manageable number. Elsewhere, an online insurance company has a very quick turnaround and low cost of client acquisition when selling life insurance. Prospective clients provide minimal personal information into a web interface and thereafter the company’s AI application crunches the provided information with various relevant databases to automate underwriting and make a go, no-go decision within hours, not days or weeks. Somewhere, a financial organization uses chatbots to securely process banking transactions for customers. Another firm uses facial recognition to allow employees to enter the building and to gain access to the company’s technology systems and data. Healthcare professionals use AI to improve accuracy and efficiency in diagnostics, treatments, and predictions. And a widget manufacturer does quality control and visual inspection with the aid of Machine Learning so that human verification of its products is no longer necessary.  

All of this makes business better, cheaper, and happen faster. But the changes that come with new processes require lawyers, business folks, and information and technology professionals (at a minimum) to play a new role in managing the informational output of the processes to deliver compliance with laws and regulations, and to manage risk and cost. This article explores how AI creates information that must be proactively managed and who is needed to get such management done right.

Will AI Be Coming to Your Company?

There are numerous predictions about the growth and impact of AI, Machine Learning (teaching a tool by using known parameters) and Deep Learning (neural networks that behave like a human brain), and it appears that these technologies will continue to be transformative. The corporate pressure to use AI makes it almost impossible to avoid if your corporation wants to stay competitive. According to the International Data Corporation (IDC), the AI hardware and software market is predicted to be $156 Billion in 2021. What this means in practical terms is that many businesses are committing to using these powerful tools to transform all kinds of business processes. But as AI changes the way businesses function, there is still a need for regulatory compliance, and to have evidence of business activities and operations.   

AI isn’t just about “running faster,” as the implementation of AI tools creates unique, information issues (e.g. ownership, bias, privacy, retention), which must be addressed by the company using the AI. An example may help make this point clear.    

Building a Better Widget: A Business Case

Company manufactures and sells widgets around the world. While they produce high quality widgets, ABC Company is always striving to better the process, predict errors, advance new innovations, and cut costs. The head of manufacturing entertains various proposals each year to help manufacture a better widget. So how can ABC Company automate more of the manufacturing process and make AI robots do the heavy lifting? How can the manufacturing process attain better product consistency and reduce variables in the manufacturing process across the globe, in the various plants?

Just about every proposal advanced in 2021 to better the manufacture of the widget involves the application of technology in various aspects of the manufacturing process (sometimes referred to as Digital Transformation[1] or applying new technologies to radically change processes, customer experience, and value). So,  ABCCompany decides to begin producing widgets by using robots, and inspecting them with the aid of AI tools. ABC Company’s R&D team decide to make the widgets “smart,” such that the widgets now send information back to ABC Company.

Every time technology is brought to bear on the design and development of the widget, there is new information output that needs to be addressed. In other words, the company has to deal with issues like information access, ownership, control, lifecycle, etc. for each new process that bettered the manufacturing process of the widgets. And unless these issues are addressed up front from legal, information and records, technical and business perspectives, there will be many downstream legal issues that are more thorny to unwind.

So, for example, because ABC Company’s widget became “smart” and sends information back to the company, there are now privacy, liability, ownership and other previously unaccounted for challenges. And because ABC Company’s widget is now produced by robots and inspected with the aid of AI tools, there is information output which must be managed. The remainder of this article provides an approach to taking on these new information issues.

Let the Past Be Your Guide

As AI technology is introduced into your business processes, it may make sense to use the old rules that you developed in the past as a guide and morph them for today’s technology realities, rather than starting from scratch in your approach to managing the information that is generated because of AI. Let’s say your company is using AI tools to cull through engineers’ resumes, in order to find skilled resources to help build the new manufacturing lines; the engineers’ experience will be vital to reworking the manufacturing process. If your company previously kept the resumes for workers that you did not hire, then it may be worth keeping the resumes reviewed by the AI tool as well. Perhaps the resumes rejected by the AI tool will be useful if you wish to interview the candidates in the future, such as for a position different from the candidate’s original application. Or perhaps the resumes were kept in the past to address claims of discriminatory hiring – in this case, keeping not only the resumes reviewed but also the method the AI tool used to cull through the resumes seems logical. In any event, it is essential to consider what existing laws and regulations say about retaining the information in the relevant jurisdictions.

Does the Information Document a New Process or System?

When the implementation of AI technology to a business process creates a whole new way of doing things, you will need to consider how the technology functions; what information is used in or created by the process; how the process and AI technology is set up and what the output of the process is.

Setup

Let’s say ABC Company wants to do a better job of quality control on their widgets while also phasing out inspection operators on the assembly line. Instead of using humans to review the quality of the widgets during production, the new process will use AI tools. Images of the widget will be taken and compared to the images that were used to train the AI tool to determine which widgets conform to quality standards and which widgets don’t meet specifications. Machine Learning techniques (or something similar) will be required to get the system to assess which widgets pass the minimum quality standards without human intervention. If done correctly, the AI or Machine Learning application will be far faster and more consistent at reviewing the quality of the manufactured product.  

To get this process right, the following questions regarding information  retention should be considered:

• Should information related to the development, sourcing and implementation of the AI software and any hardware to run the AI or Machine Learning process be retained, and for how long?
• Should the company keep information related to the decision-making process during which it was determined where AI would be applied in the business or manufacturing process?
• Should the company retain information related to the AI technology in use (both hardware and software), and if so, what information should be kept?
• What decisions regarding implementation of the AI technology should be documented for future reference?
• Should the company retain documentation related to the AI functionality?
• What information regarding training and testing (Machine Learning) should be retained?
• What does the law of the relevant jurisdictions say about retaining these various types of information?

Machine Learning and the Need to Understand Training Records

Back to the earlier example, if the company is seeking to replace human inspection with AI tools, a “learning” or “training” process will be needed to teach the system what good widgets look like, and what defective parts should be flagged or discarded. Many training examples will be needed to “educate” the AI system on what to look for and how to determine if a part is good or bad. Can an algorithmic equation be used effectively to unearth defective parts? Yes! And AI and Machine Learning are doing a whole lot more to increase efficiency in areas beyond manufacturing as well.

So, what should ABC Company do with the training examples after the AI system has been trained? To the extent that the system will need to be retrained in the future, the training examples should be kept. Also, if they are needed to keep the AI system running (if the system needs to refer to good and bad samples for comparisons, i.e.), the training examples should be retained as well.

If a regulator wants to review how the system functions, you will want to be able to show how the system was trained and why you know it is doing the job it was trained to do. In the HR context, if an AI tool is assisting in the resume culling process to find the right candidate, the way in which the system was trained could be the focus of a discrimination claim. The company will want both the training examples and evidence of the process used to demonstrate that the system doesn’t discriminate.[2]

What Happens when Information Volumes Grow?

The AI and Machine Learning processes sometimes create huge volumes of information as part of the process. But does all that information need to be retained? When you are determining what – if any – of the AI process’s informational output should be retained and for how long (two complicated questions), you need to assess the business utility of the content as well as any legal obligation to retain the information. This requires an upfront analysis of the business need for the information and what laws dictate that a record of the process is retained. In that regard, not all information output must be considered a “Record” for long term retention. In the case of the widgets, if multiple images are obtained to ensure the parts in production have passed, an analysis of business needs could become critical in weighing the cost of retaining every image obtained. 

So, part of the informational output of the AI or Machine Learning process may be records while other output will not rise to the level of a record requiring retention. Usually, the company can decide what records of the business process they want to retain, but that too can be a complicated question. In any event, it is likely not necessary to retain all information as a record of the new business process. Getting a handle on this issue will require working through the various business and legal issues with the lawyers, business folks and IT professionals. Again, a team approach will get the company to the full-bodied right answer.

Consider Ownership

Whenever technology creates new information, the company should consider if there are any information ownership issues. Say for example, as part of the manufacturing line renovation project, ABC Company plans on installing smart monitoring tools to manage electricity utilization, and smart line vibration technology that will seek to maximize the stability of the manufacturing line so that the end-product remains consistently produced over time. Each of the monitoring devices are an Internet of Things (IoT), which means that they will be connected to the network and send data in real time to a centralized server. Many times, this IoT will be a cloud-based service. Assuming the server or service is owned by the maker of the monitoring equipment company, will ABC Company have access to the information (beyond its immediate use in adjusting equipment, etc.)? Perhaps more importantly, who owns the data that came from the manufacturing line monitoring tools? Who will get to use that information and how can they use it? Can the monitoring equipment company sell the data that came from ABC Company’s factory? Can they use it to improve the quality of the monitoring tools they might provide to other widget companies? You get the point. For every new stream of information, the company needs to understand who owns the information, what the access is, and the use your company will have of the information. Waiting until the process is up and running is too late to address ownership of information issues. Negotiate ownership, access, use and privacy issues up front in the contract for a more predictable and less painful result.

Consider Privacy and Information Security

Like all business processes that create or store information, consideration should be given to ensuring private information remains private, securing and locking down information as needed, and protecting company intellectual property and trade secrets. It is important to avoid unintended and unaccounted for data collection. For example, if a camera is capturing images of a manufacturing process, will it also capture images of a human operator? Are there additional data privacy considerations that need to be made? Also be aware that every time a new piece of technology or network connected device is added to a business process, that may be another way for your company systems to be hacked, exposed, exploited, and pilfered.  

Conclusion

For every technology applied to a business process, there is information output that must be managed. And for all informational output that requires management, there are questions that need lawyers, business leaders, and technology and information professionals to weigh in. In that sense AI, Machine Learning, IoT and the application of any new technology is a team sport.  

[1] IDC. “Digital Transformation (DX).” https://www.idc.com/itexecutive/research/dx

[2] Randolph A. Kahn, Niki Nolan, James Beckmann. “When Algorithms Inherited the Earth, How They Learned to Discriminate and What You Can Do About It.” April 17 2020. https://businesslawtoday.org/2020/04/algorithms-inherited-earth-learned-discriminate-can/

Definitions of the term “Material Adverse Effect” (“MAE”) in business combination agreements typically contain exceptions from the definition for events arising from certain systematic risks.[1] Common exceptions pertain to general changes in business or economic conditions, changes in financial or securities markets, and changes in the industries in which the target operates. Other common exceptions pertain to force majeure events or changes in law or generally accepted accounting principles (“GAAP”). Such exceptions have figured prominently in the MAE cases arising from the COVID-19 pandemic, such as AB Stable[2] and KCake[3] in Delaware and Fairstone[4] in Canada. Indeed, these cases have revealed a latent ambiguity in the typical MAE definition: sometimes the causal background of a material adverse effect on the target is complex, with an earlier event E₁ (such as a pandemic) causing a later event E₂ (such as governmental lockdown orders) and the later event E₂ (the lockdown orders) causing the material adverse effect on the target. If the MAE definition allocates the risk of both events to the same party, then clearly that party bears the risk of the material adverse effect, but what happens if the definition allocates the risk of one event to one party and the risk of the other event to the other party? If the target bore the risk of a pandemic but the acquirer bore the risk of lockdown orders (under an exception related to changes in law), has there been a Material Adverse Effect or not?

Albeit only in dicta, the courts in AB Stable[5] and KCake[6] both resolved this particular problem by saying that there would be no Material Adverse Effect. The court in Fairstone reached a similar conclusion.[7] Further complicating the problem, the court in KCake also considered the effect of language in the MAE definition introducing the exceptions and expanding their scope to include not only events falling into the exceptions but also events “arising from” or “related to” such events. The problems that these cases raise thus involve the meaning of the language in the exceptions, the relation of the exceptions to the main part of the MAE definition and to each other, and the effect of the language introducing the exceptions.

Starting with First Principles

In a new article on Pandemic Risk and the Interpretation of Exceptions in MAE Clauses^[8] forthcoming in the Journal of Corporation Law, I argue that, to make sense of these issues, we should begin by taking a step back and reflect on the general structure of a typical MAE definition. In my view, there are two aspects of that definition that are critically important in this context. First, in MAE definitions, the (capitalized) term “Material Adverse Effect” is defined to mean any event that has or would reasonably be expected to have (the exact language varies) an (uncapitalized) material adverse effect on the target. The definition thus involves two separate things, an event and a material adverse effect that the event causes, which are related as cause to effect. It is counterintuitive but nevertheless apparent from the face of the definition that a (capitalized) Material Adverse Effect is not an (uncapitalized) material adverse effect. Rather, a Material Adverse Effect is an event that causes (i.e., “has or would reasonably be expected to have”) a material adverse effect.

Of course, good transactional lawyers know all this, but they nevertheless often speak imprecisely, running together Material Adverse Effects and material adverse effects, an infelicitous habit that is greatly facilitated by the fact that the three-letter abbreviation “MAE” is used indiscriminately for both concepts. Confusions of Material Adverse Effects with material adverse effects crop up in ordinary speech when someone says that a company “has suffered a Material Adverse Effect”; if anything, the company suffered a material adverse effect because some event occurred that was a Material Adverse Effect. Some confusions even appear in the text of merger agreements negotiated by expert counsel, as when a representation is required to be true except for “inaccuracies that would not have a Material Adverse Effect”; if anything, the inaccuracies just are a Material Adverse Effect because they are facts or events that would reasonably be expected to have a material adverse effect on the company. Because, as we shall see, such confusions are not always harmless, I shall distinguish in this article clearly and consistently between Material Adverse Effects and the material adverse effects that they cause.

The second feature of MAE definitions I want to emphasize concerns how they allocate risk between the parties. In particular, such definitions allocate risk on the basis of events causing material adverse effects, not on the basis of material adverse effects arising from such events. That is, the definition takes the universe of all possible events and divides these events into two classes—events the risk of which is allocated to the target, and events the risk of which is allocated to the acquirer. In particular, MAE definitions effect this division by saying all events causing a material adverse effect are Material Adverse Effects, except for events falling into one of the exceptions enumerated in the definition. Hence, the risk of an event causing a material adverse effect is allocated to the target, unless the event falls into an exception, in which case the risk of that event is allocated to the acquirer. Exceptions in the MAE definition apply to events, and whether the risk of an event is allocated to the acquirer or the target depends on whether the event falls into an exception or not.

What Is Included with an Allocated Risk

The fact that Material Adverse Effects are not material adverse effects but events causing material adverse effects, and the fact that MAE definitions allocate risks on the basis of events not effects are both evident from the plain language of the typical MAE definition. For this reason, I think both are well-nigh indisputable. There is another key point about the typical MAE definition, however, that is implicit in the definition and so not immediately evident from the text. This point concerns exactly which risks are allocated when an MAE definition allocates to one party or another the risk that a certain event will occur. To grasp this point, notice that MAE definitions allocate the risks that certain events may occur not because the parties care about those events in and of themselves; MAE definitions allocate the risks that certain events may occur because those events may have a material adverse effect on the target. That is why MAE definitions define Material Adverse Effects in terms of their effects—that is, they define an event to be a Material Adverse Effect in terms of the event’s having, or being reasonably expected to have, a material adverse effect on the target. Therefore, when an MAE definition allocates to one party or the other the risk that a certain event may occur, what is being allocated is the risk that the event occurs along with all of the event’s reasonably-expected consequences, up to and including any reasonably-expected material adverse effect on the target.

 To see just what that means, reflect that events rarely have material adverse effects on a company immediately and directly. On the contrary, events typically result in material adverse effects, if at all, only through generally predictable causal pathways. Indeed, parties single out certain kinds of events and specifically allocate the risks of those events precisely because the parties know that such events tend to set in motion a sequence of events that often lead to a material adverse effect. For example, suppose the MAE definition allocates to one party or the other the risk of “a change in interest rates,” and after the agreement is signed the Federal Reserve’s Federal Open Market Committee (the “FOMC”) announces that it has decided to increase its target Federal Funds Rate. This decision is a “change in interest rates,” and the risk of any material adverse effect reasonably expected to follow from that change is allocated to the party that bears the risk of such change. But any adverse effect on the target resulting from this decision by the FOMC would come about only through a long and complicated, but nevertheless reasonably-expected, sequence of events. In particular, the FOMC’s decision to increase the target Federal Funds Rate will result in the Trading Desk at the New York Federal Reserve Bank making certain purchases of securities in the open market, and this, via the decisions of bond traders and commercial bankers, will likely result in a change in the effective Federal Funds Rate, which is an average of the rates depository institutions actually charge each other for overnight loans of banking reserves. That change, via the trading decisions of innumerable market participants, will filter through the credit markets, eventually increasing the yield on long-term Treasury bonds, which will (under accepted principles of corporate finance) increase the company’s cost of equity capital, thus reducing the present value of its future cashflows. When the parties allocate the risk of a change in interest rates, they do so precisely because they understand that changes in interest rates tend to have such consequences, up to and including a reduction in the value of the target when the present value of its future cashflows is reduced in the manner stated. It would subvert the intention of the parties were someone to later argue that, because the causal sequence from the decision by the FOMC to the reduction in the present value of the company’s future cashflows runs through a great many other events, the material adverse effect on the target should be attributed not the decision by the FOMC but to some intermediate event in the causal sequence, such as the decisions of bonders traders reacting to the FOMC’s decision. On the contrary, in allocating the risk of a change in interest rates, the parties are allocating the risks of all events that would reasonably be expected to follow from a change in interest rates, up to and including any reasonably-expected material adverse effect on the company. More generally, when an MAE definition allocates the risk of a certain event, it allocates the risk of all other events reasonably expected to follow from that event. Indeed, the whole point of allocating the risk of the event is to allocate the risk of the reasonably-expected consequences of the event, again, up to and including any material adverse effect on the company.[9]

How to Apply MAE Definitions in Causally Complex Cases

Such considerations show us how we should apply MAE definitions when the causal background of a material adverse effect runs through multiple events and the definition allocates the risks of different events to different parties. Thus, suppose that a first event E₁ (say a pandemic) causes a second event E₂ (such as governmental lockdown orders) and the second event E₂ (the lockdown orders) causes a material adverse effect on the company (because the orders curtail its operations), and suppose further that the MAE definition allocates the risk of E₁ (the pandemic) to the target and the risk of E₂ (the lockdown orders, under an exception for changes in law) to the acquirer. In such cases, when event E₁ (the pandemic) occurs, the relevant question under the MAE definition is whether that event would reasonably be expected to have a material adverse effect on the target. If so, since the target bore the risk that event E₁ (the pandemic) would occur, E₁ is a Material Adverse Effect. This is true even though the causal pathway from E₁ (the pandemic) to the material adverse effect runs through another event E₂ (the lockdown orders) that is of a kind that, generally speaking, falls into an exception, which would shift the risk of such an event to the acquirer. The reason is that, in allocating to the target the risk of a pandemic, the MAE definition allocated to the target everything that is reasonably expected to follow from a pandemic, and if a pandemic actually occurs and is such that it would reasonably be expected to result in certain lockdown orders, then the risk of such orders was included with the risk of the pandemic. As a matter of contract interpretation, the specific governs over the general, and even if the risk of changes in law was generally allocated to the acquirer, nevertheless in allocating the risk of a pandemic to the target, the MAE definition also allocated to the target the specific risk of lockdown orders reasonably-expected to follow from a pandemic. This is the reasonable way of giving effect to both allocations of risk made by the MAE definition.

Now, although in allocating the risk of a pandemic to the target the MAE definition also allocated the risk of all events reasonably expected to follow from a pandemic, including any reasonably-expected lockdown orders, nevertheless the acquirer could concede arguendo that the risk of lockdown orders resulting from a pandemic was allocated to it under the exception for changes in law and yet still succeed in showing that there had been a Material Adverse Effect. The reason is that, in situations like this, where the risk of the more remote event E₁ (here the pandemic) is allocated to the target and the risk of the more proximate event E₂ (here the lockdown orders) is allocated to the acquirer, there is an even stronger argument available to the acquirer, an argument that does not require the acquirer to rely on the fact that, in allocating a risk, an MAE definition allocates the risk of everything reasonably expected to follow from that risk. That is, the acquirer can argue that, if the more remote event E₁ (the pandemic) occurs and would reasonably be expected to have a material adverse effect on the target, then that event is a Material Adverse Effect under the express terms of the MAE definition. It may well be perfectly true, the acquirer may say, that some other event E₂ (the lockdown orders) is not a Material Adverse Effect because the risk of such an event was allocated to the acquirer. But the fact that some other event is not a Material Adverse Effect in no way changes the fact that E₁ (the pandemic), the risk of which was allocated to the target, is a Material Adverse Effect. The acquirer will say that, in arguing that the risk of a change in law was allocated to the acquirer and so cannot be a Material Adverse Effect, the target is like the defendant who, charged with the murder of Jones, proves he did not kill Smith.

Now, what is good for the goose is good for the gander, or, more accurately, MAE definitions treat all events in the same way, whether the risk of the event is allocated to the target or to the acquirer. Thus, suppose again that a first event E₁ (a pandemic) causes a second event E₂ (lockdown orders), with event E₂ (the lockdown orders) causing a material adverse effect on the company, but this time suppose that that the MAE definition allocates the risk of event E₁ (the pandemic) to the acquirer and the risk of event E₂ (the lockdown orders) to the target (because there is no exception for changes in law). If a pandemic occurs and is such that it would reasonably be expected to have a material adverse effect on the target, then that risk has been allocated to the acquirer, and so the pandemic is not Material Adverse Effect. If the acquirer says that it bore the risk of a pandemic but not the risk of changes in law, and the material adverse effect on the target resulted from governmental lockdown orders (albeit ones that themselves resulted from the pandemic), the answer is that in allocating the risk of a pandemic to the acquirer, the MAE definition also allocated to the acquirer the risk of all events reasonably expected to follow from the pandemic up to and including any material adverse effect on the target. Hence, if the pandemic results in lockdown orders of a kind reasonably expected to follow from the pandemic, and those orders have a material adverse effect on the target, the risk of such orders was allocated to the acquirer along with the risk of the pandemic itself. It does not matter that, in general, the MAE definition allocated the risks of changes in law to the target. In this specific case (and the specific governs over the general), the risk of these changes in law (the lockdown orders reasonably to be expected to follow from the pandemic) were specifically allocated to the acquirer when the acquirer agreed to bear the risk of a pandemic and, by implication, everything reasonably to be expected to follow from any pandemic that actually occurs.

It is important to understand, however, that the target cannot concede arguendo that the risk of the change in law was allocated to it and still claim it is entitled to prevail in the way the acquirer could when the roles were reversed and the target bore the risk of the more remote event E₁ (the pandemic) and the acquirer bore the risk of the more proximate event E₂ (the lockdown orders). The acquirer could make this concession and still prevail because it could argue that the more remote event, E₁ (the pandemic), the risk of which was allocated to the target, was still a Material Adverse Effect even if some other event, such as E₂ (the lockdown orders), was not a Material Adverse Effect because that other event fell into an exception. The target cannot make an analogous argument because such an argument would amount to saying that, since the more remote event E₁ (the pandemic) is not a Material Adverse Effect (because the risk of such an event was allocated to the acquirer), it does not matter that the more proximate event E₂ (the lockdown orders), the risk of which was allocated to the target, is a Material Adverse Effect. Clearly, such an argument does nothing to help the target, for it most certainly would matter that there was another event that was a Material Adverse Effect. Indeed, such a point would be decisive. This form of the argument (as long as one event is a Material Adverse Effect, it does not matter that some other event is not) is available to the acquirer while the analogous form of argument (as long as one event is not a Material Adverse Effect, it does not matter than some other event is) is not available to the target because of the fundamental asymmetry between acquirers and targets in relation to MAE clauses. That is, for the acquirer to prevail, there need be only one event that is a Material Adverse Effect, and so the acquirer can shrug off the existence of events that are not Material Adverse Effects; but for the target to prevail, there need be no events that are Material Adverse Effects, and so the target cannot shrug off events that are Material Adverse Effects.

This asymmetry puts the target at a disadvantage in cases where the risk of the more remote event E₁ is allocated to the acquirer and the risk of the more proximate event E₂ at least appears to be allocated to the target in the sense that it is not expressly covered by an exception from the MAE definition. As explained above, under the correct interpretation of the MAE definition, the allocation of the risk of event E₁ includes the allocation of the risk of all events reasonably expected to follow from event E₁, including event E₂ (assuming E₂ really would reasonably be expected to follow from E₁). The target is at a disadvantage, however, because, unlike the acquirer, it cannot make the kind of argument explained above but would have to argue that, in allocating the risk of the more remote event E₁ (the pandemic) to the acquirer, the MAE definition also allocated the risk of all events reasonably expected to follow from E₁, which would include event E₂ (the lockdown orders). This argument is perfectly sound, but the target would still have to make it, which puts the target at a disadvantage relative to the acquirer in the analogous situation. There is, however, a simple drafting solution to this problem: the MAE definition can make explicit what is already implied by expressly providing that, when the risk of a certain event is allocated to the acquirer under an MAE exception, allocated along with that risk are the risks of all events reasonably to be expected to follow from that event. And, in fact, the language introducing the exceptions in the MAE definition typically does exactly this by expressly stating that excepted from the definition are not only events falling into the exceptions but also all events “arising from” events falling into the exceptions. This language thus restores a certain parity between the target and the acquirer by ensuring that the risks of events allocated to them are treated in the same way.

Why the Courts Have Misread the Exceptions in MAE Definitions

If all this correct, then the courts that have thus far confronted these issues have been misreading the exceptions in the MAE definitions before them in rather serious ways. Take AB Stable, by far the best-reasoned of these cases. Albeit only in dicta,[10] the court in that case suggested that, even if the target had borne the risk of a pandemic, exceptions in the MAE definition for changes in business conditions, changes in industry conditions, and changes in law would each have applied, with the result that there was no Material Adverse Effect.[11] Now, the court’s argument for that conclusion has three main steps. In the first, the court stated that the various exceptions to the MAE definition are to be read independently of each other in the sense that whether an event falls into an exception depends on the language in that exception and is independent of whether the event would fall also into some other exception.[12] That proposition, I think, is entirely correct.

In the second step, however, the court said that whether an event falls into an exception is also independent of whether any event causing that event falls into an exception, and thus, for example, governmental lockdown orders would fall into an exception related to changes in law even if the orders resulted from a pandemic and the pandemic was not excepted.[13] Although I myself once argued for exactly that proposition[14] (and the court cited one of my working papers in reaching that conclusion),[15] for the reasons given above I now think that this is mistaken. The better view is that, when the MAE definition allocates the risk of an event, it allocates along with that risk the risk of all the reasonably-expected consequences of the event. Hence, if a pandemic is such that it would reasonably be expected to result in lockdown orders, then the risk of those orders is allocated along with the risk of the pandemic. It was a mistake for the court to treat events reasonably expected to follow from the pandemic as being separate events under the MAE definition.

But even making this mistake, the AB Stable court could still have reached the right result, for it was still open to the acquirer to argue that, although the lockdown orders were not a Material Adverse Effect (because they fall into the exception for changes in law), nevertheless the pandemic, a quite different event, was a Material Adverse Effect, for it did not fall into any exception and would reasonably be expected to have a material adverse effect on the target. As explained above, this reasoning is perfectly sound, and although it is not clear whether the acquirer made this argument, it is clear that the court would have rejected it because of an additional and even more serious mistake in the third and final step of the court’s argument. That step is left mostly implicit, but from what the court says explicitly elsewhere in the opinion, we know that the court thinks that if “the cause of the [material adverse] effect fell within an exception to the MAE Definition,” then “the effect could not constitute a Material Adverse Effect.”[16]

This innocuous-sounding sentence conflates material adverse effects and Material Adverse Effects and leads to a near reversal of the internal logic of the MAE definition. That is, in the situation that the court is considering, an event causing a material adverse effect falls within an exception. What follows from this is that this event is not a Material Adverse Effect. What the court thinks follows from this is that the material adverse effect caused by the event is not a Material Adverse Effect. But this latter conclusion is nonsense, for it is events causing material adverse effects that are Material Adverse Effects (if the event is not excepted) or not Material Adverse Effects (if the event is excepted); material adverse effects themselves cannot be Material Adverse Effects. Thinking they could be is a category mistake. Moreover, confusing material adverse effects with Material Adverse Effects in this context leads the court to the erroneous view that exceptions in the MAE definition apply to material adverse effects in the sense that, if an excepted event causes a material adverse effect, then not only is that event itself excepted but the material adverse effect it causes is excepted too, and so any other event causing that material adverse effect is treated as if it were excepted as well, even if it is plainly not excepted. That is why, in the court’s view, if the lockdown orders (an excepted event) cause a material adverse effect, the pandemic that caused the same material adverse effect (via the lockdown orders) is not a Material Adverse Effect: on the court’s view, the pandemic is not a Material Adverse Effect because the material adverse effect it causes has been “excepted” since it was also caused by an excepted event (the lockdown orders). This is all quite wrong, of course, because the exceptions in an MAE definition plainly apply to events causing material adverse effects and not to material adverse effects themselves, and the fact that one event is not a Material Adverse Effect does not generally imply that some other event is not a Material Adverse Effect.

Now, as I argued above, on the correct reading of the MAE definition, acquirers enjoy a certain natural advantage in MAE disputes. That is, the acquirer prevails if there is even one Material Adverse Effect, that is, even one unexcepted event that would reasonably be expected to have a material adverse effect. The existence of other events that are not Material Adverse Effects is irrelevant. By contrast, the target prevails only if every event is not a Material Adverse Effect, that is, every event is either excepted or would not reasonably be expected to have a material adverse effect. The court’s reading of the MAE definition negates this natural advantage enjoyed by the acquirer and confers an analogous advantage on the target. Under the court’s reading, if there is even one excepted event that would reasonably be expected to have a material adverse effect, then that material adverse effect is excepted, and no event, excepted or unexcepted, causing that effect is a Material Adverse Effect. Hence, for the acquirer to prevail, every event causing a material adverse effect must be unexcepted, and if there is even one excepted event causing that material adverse effect, the target wins. Put yet another way, if there are many events causing a material adverse effect, under the proper reading of the MAE definition, the acquirer wins if even one of them is unexcepted; under the court’s reading, the acquirer wins only if every one of them is unexcepted. By making the MAE exceptions apply to material adverse effects rather than the events causing them, the court’s reading has negated the natural advantage of the acquirer and conferred an analogous advantage on the target.

Furthermore, recall that, when the risk of a remote event E₁ (such as a pandemic) was allocated to the acquirer and the risk of a proximate event E₂ (such as lockdown orders) was allocated to the target, the acquirer’s natural advantage under the proper reading of the MAE definition (it takes only one unexcepted event having a material adverse effect for there to be a Material Adverse Effect) creates the possibility that the acquirer may ignore the principle that for purposes of the MAE definition an event includes all its reasonably-expected consequences and argue speciously that, even if the remote event E₁ (the pandemic) was not a Material Adverse Effect, the proximate event E₂ (the lockdown orders) resulting from E₁ was a Material Adverse Effect. Recall, too, that such specious arguments can be blocked by language in the MAE definition introducing the exceptions and providing that events arising from excepted events are excepted. The court in AB Stable, by treating exceptions in the MAE definition as if they applied to material adverse effects rather than events causing material adverse effects, has not only negated the acquirer’s natural advantage under the MAE definition and conferred an analogous advantage on the target, but it has also created the possibility of the target making analogously specious arguments against the acquirer. That is, when the risk of a pandemic is allocated to the target, but the risk of changes in law is allocated to the acquirer, the target ought not be permitted to distinguish between the pandemic and any lockdown orders reasonably expected to arise from it. To block such a move, there is a drafting solution analogous to the language introducing the exceptions and providing that events arising from excepted events are excepted: such a solution would involve having the MAE definition provide that events arising from non-excepted events are not excepted.

Unsurprisingly, therefore, the court in AB Stable pointed out that its interpretation of the MAE exceptions could be blocked if the language in the exceptions included a proviso to the effect that otherwise excepted events would not be excepted after all if they arose from unexcepted causes.[17] Of course, such a proviso should be doubly unnecessary. It is unnecessary in the first instance because, in allocating the risk of an event to the target, the MAE definition allocates as well the risk of any event reasonably expected to follow from the event. It is unnecessary a second time because, if exceptions are understood to apply to events causing material adverse effects and not to material adverse effects themselves, even if an event arising from an unexcepted event is excepted and so not a Material Adverse Effect, nevertheless the unexcepted event from which the excepted event arises may be a Material Adverse Effect in its own right, which is all the acquirer needs to prevail. Hence, the fact that the court noted that parties could add a proviso to the MAE definition to make events arising from unexcepted events unexcepted shows again that the court had reversed the basic logical structure of that definition.

In sum, there are two problems with the reasoning in AB Stable. The first and less serious is a failure to appreciate that, in allocating the risk that a certain event will occur, the MAE definition also allocates the risk of all events reasonably expected to follow from the event, up to and including any reasonably-expected material adverse effect on the target. The second and more serious is that, by conflating Material Adverse Effects with material adverse effects at a critical point in the argument, the court has made exceptions in MAE definitions apply to material adverse effects rather than Material Adverse Effects,[18] which largely reverses the internal logic of the MAE definition.

The Origin of the Confusion in AB Stable

Now, as I mentioned above, even the most expert and experienced transactional lawyers sometimes conflate Material Adverse Effects and material adverse effects, which suggests that the AB Stable court ought not be judged harshly for falling into this mistake at a critical point in the argument. In fact, however, the particular form of the confusion in AB Stable, making exceptions in MAE definitions apply to material adverse effects instead of events causing them, is not the court’s fault at all. If anyone is responsible for this mistake, I am. The mistake existed in both scholarly and practitioner literature for years before AB Stable, but the earliest example of this mistake that I have found is in one of my own law review articles from 2009.^[19] There, I said, “When … exceptions are present [in an MAE definition], adverse changes to the company resulting from such causes are not MACs within the meaning of the definition.”^[20] Replace the word “changes” with “effects” and the abbreviation “MAC” with “MAE,” and what I said in 2009 is exactly what the court in AB Stable said in 2020: if an event causing a material adverse effect falls into an exception, the material adverse effect that the event causes is not a Material Adverse Effect, which makes the exceptions apply to material adverse effects rather than the events causing them, and so entails all the erroneous consequences exposed and deprecated above. The confusion I condemn here is thus one that I myself invented. Whether everyone who has fallen into this mistake has done so under the influence of my writings is doubtful; because of the pervasive confusion of Material Adverse Effects with material adverse effects, this was a mistake waiting to happen. But given the unpleasant choice, I would rather accept the whole blame and be accused of grandiosity in appropriating the responsibility to myself than blame others for making the mistake independently and be accused of shirking the responsibility for the mistake.

The Effect of the Language Introducing the Exceptions

There remains one final point about the language introducing the exceptions in the MAE definition. A new article by Professor Guhan Subramanian (Harvard University) and Caley Petrucci (Wachtell, Lipton, Rosen & Katz)[21] forthcoming in the Columbia Law Review includes an impressive empirical study of MAE definitions in public-company merger agreements and reports that the language introducing the exceptions in an MAE definition tends to come in one of two forms. Sometimes, as discussed above, the language introducing the exceptions provides that, besides events falling into the exceptions, events “arising from” excepted events are excepted; in other cases, the language provides that, besides events falling into the exceptions, events “related to” excepted events are excepted.[22] The authors suggest that the latter language is broader than the former, that is, would result in more events being excepted.[23]

To make sense of this, I think it helps to take a step back and recall that, in the simplest case, the language introducing the exceptions would say only that no event falling into an exception “is” or “shall constitute” a Material Adverse Effect. That is, if we understand the exceptions as listing certain kinds of events the risk of which are being allocated to the acquirer, the introductory language need only say that no event falling into an exception will count as a Material Adverse Effect even if the event, should it occur, would have or would reasonably be expected to have a material adverse effect on the target. Moving to more complex cases, we see that the introductory language can expand the set of excepted events to include as well events “arising from” events falling into the exceptions. Given the discussion above, the purpose of such language is clear: when an MAE definition allocates the risk of an event, by implication it allocates as well the risk of all events reasonably expected to follow from the event up to and including any material adverse effect on the target. But this is by implication, and adding the “arising from” language to the introduction of the exceptions makes this explicit. That is particularly important for the target, because, as explained above, given the logical structure of the MAE definition, the acquirer enjoys a natural advantage in that, under a proper reading of the definition, all events are non-excepted events (unless they happen to fall into an exception), and so in particular events arising from non-excepted events are non-excepted events (unless they happen to fall into an exception). To restore some form of parity between events the risk of which are allocated to the target and events the risk of which are allocated to the acquirer, parties can agree to language introducing the exceptions that provides that events arising from events falling into exceptions are also excepted.[24]

But what if the language introducing the exceptions excepts not just events arising from excepted events but also events merely “related” to excepted events? Wouldn’t this, as Subramanian and Petrucci say, greatly expand the scope of the exceptions? I don’t think so. In fact, reading this language expansively—i.e., reading “related” to mean “related in any way whatsoever”—would make nonsense of the definition and play havoc with the allocation of risks that the parties intend. Indeed, reading the language in this way would mean that an event that (a) causes a material adverse effect on the target, and (b) does not itself fall into an exception, would nevertheless not count as a Material Adverse Effect, if the event (c) was “related” in any way whatsoever to any other event that did fall into an exception. That would make the set of excepted events extremely large. For example, in Akorn,[25] the emergence of new competitors had a material adverse effect on the target, and this event—the emergence of the new competitors—did not fall into an exception. Suppose that, while the new competitors were emerging, the economy slipped into recession. The recession would be a general change in economic conditions and so would fall within an exception covering such changes. Had the Fresenius-Akorn merger agreement used the “related” language rather than the “arising from” language, would the emergence of the new competitors, which caused a material adverse effect on Akorn, not have counted as a Material Adverse Effect because the emergence of the competitors occurred simultaneously with (and thus in a sense was “related to”) the recession, an excepted event, even though the recession had no causal connection either with the emergence of the new competitors or with the material adverse effect on the company? Reading the “related” language in this unrestricted manner implies that the emergence of the new competitors would no longer count as a Material Adverse Effect, but I cannot see how such an interpretation of the contract would serve any rational purpose. Sophisticated commercial parties would attribute no importance to the occurrence of events “related” to the event causing the material adverse effect if such events were not themselves causally related to either the material adverse effect or the event causing it.

Furthermore, if the phrase “related to” in the language introducing the exceptions meant “related to in any way whatsoever,” then there would almost certainly never be a Material Adverse Effect. For, whenever a non-excepted event caused a material adverse effect, we could always find some excepted event—some change in business, economic, market or industry conditions, some change in law or GAAP, some force majeure event—that was “related,” in some way or other, to the event causing the material adverse effect, which would mean that this event would not count as a Material Adverse Effect. Thus, when the language introducing the exceptions includes events “related” to excepted events, the meaning cannot be that the related events are related to the excepted events in just any way whatsoever, such as occurring simultaneously or being discussed in the same edition of The Wall Street Journal. The meaning has to be more restricted. The obvious way of restricting the meaning is to say that “related to” means “related to as effect to cause.” This interpretation has the virtue of making the resulting allocations of risk rational and consistent with the rest of the MAE definition, but it also makes “related to” equivalent to “arising from” and thus deprives the phrase “related to” of any independent meaning.

In KCake, the only Delaware case ever to consider the import of the language introducing the MAE exceptions, the court stated in dicta that the phrase “arising from or related to” “is broad in scope under Delaware law,” and the court clearly implied that “arising from” and “related to” have different meanings.[26] Beyond that, however, the court did further construe either phrase, and on the facts it was clear that the events “arising from or related to” the excepted events had arisen from the excepted events as effects from causes. The problem remains, then, whether the “related to” language can have some meaning beyond that of “arising from” but still not be so expansive as to amount to “related to in any way whatsoever.” One possibility would be to construe “related to” as meaning “correlated with.” In that case, an event would be “related to” an excepted event if the related event either arose from the excepted event or else both the related event and the excepted event arose from the same cause. This sounds promising, but the first possibility reduces to “arising from,” and the second possibility, which is doing all the work of giving “related to” some independent meaning, seems to produce anomalous results. That is, interpreted in this manner, the “related to” language would imply that there could be an event that (a) would reasonably be expected to have a material adverse effect on the target, and (b) does not itself fall into an exception, and yet (c) would not count as a Material Adverse Effect merely because it (d) arose from some event that also caused an event that did fall into an exception.

It is difficult even to construct a plausible example, but imagine that the President of the United States takes some highly controversial action, such as moving the American embassy in Israel from Tel Aviv to Jerusalem or declaring Turkish atrocities against the Armenians during World War I an act of genocide. As a result, the target company’s chief executive officer, who is deeply offended by the President’s decision, demands that the company cease doing business with the government of the United States, and when the board of directors refuses, he abruptly resigns. The resignation is not excepted under the MAE definition, and it results in a material adverse effect on the company. Meanwhile, the President’s decision also spurs various terrorist attacks against Americans around the world, but these events have no effect at all on the company. Terrorist attacks, however, are excepted events under the MAE definition. Now, the departure of the chief executive officer is both not excepted and reasonably expected to have a material adverse effect on the company. It would thus seem to be a Material Adverse Effect. Would anyone say that since the departure and the terrorist attacks, which had no effect on the company, arose from the same cause, and since the terrorist attacks were excepted, the departure should also be excepted because it was “related” to the terrorist attacks in the sense that both events arose from the same cause? It is hard to see why sophisticated commercial parties would attribute any importance to this fact. There would seem to be no economic rationale for treating the risk of the chief executive abruptly resigning merely because the cause prompting him to resign also resulted in terrorist attacks that had no effect on the company.

For such reasons, it is difficult to see what independent meaning, distinct from the meaning of “arising from,” can plausibly be ascribed to the phrase “related to” in the language introducing the exceptions in the MAE definition. Perhaps the best view is to construe “arising from or related to” as a legal doublet like “null and void” or “cease and desist” and limit the meaning to the causal interpretation.[27] If that is right, then it makes no difference whether the language introducing the exceptions excepts events “arising from” or “related to” events falling into such exceptions. Although transactional lawyers may sometimes argue about this issue as if it mattered,[28] the case may be analogous to distinctions between the various kinds of efforts clauses, about which transactional lawyers also argue about but among which the Delaware courts have been unable to meaningfully distinguish.[29]

[1] Professor of Law at the University of Iowa College of Law and Fellow and Program Affiliated Scholar at the Classical Liberal Institute at New York University Law School. This article is an expanded version of How Much Do Exceptions in MAE Definitions Except? 26.2 Deal Points 10 (Spring 2021), and it draws on material from Robert T. Miller, Pandemic Risk and the Interpretation of Exceptions in MAE Clauses, 46 J. Corp. L. __ (forthcoming, 2021).

[2] AB Stable VIII LLC v. Maps Hotels & Resorts One LLC, No. 2020-0310-JTL, 2020 WL 7024929 (Del. Ch. Nov. 30, 2020).

[3] Snow Phipps Group, LLC v. KCake Acquisition, Inc., No. 2020-0282-KSJM, 2021 WL 1714202 (Del. Ch. April 30, 2021).

[4] Fairstone Fin. Holdings Inc. v. Duo Bank of Can., 2020 CanLII 7397 (Can. Ont. Super. Ct. J.).

[5] AB Stable VIII LLC, No. 2020-0310, at *55-56.

[6] KCake Acquisition, Inc., No. 2020-0282, at *35.

[7] Fairstone Fin. Holdings Inc., 2020 CanLII 7397, at paras. 105-108.

[8] Robert T. Miller, Pandemic Risk and the Interpretation of Exceptions in MAE Clauses, 46 J. Corp. L. __ (forthcoming, 2021).

[9] Notice that, when we ask what is reasonably expected to follow from an event, we ask what is reasonably expected to follow from the actual event that occurs, not what is reasonably expected to follow from an “average” or “typical” event of the relevant kind. In the example in the text, what matters is what is reasonably expected to follow from the actual decision by the FOMC in the actual circumstances in which the decision was made. Thus, what is reasonably expected to follow from an increase in the target Federal Funds Rate of 25 basis points is not what is reasonably expected to follow from an increase in that rate of 500 basis points. Similarly, if one party bears the risk of a pandemic and a pandemic occurs, we ask what is reasonably expected to follow from the actual pandemic that has occurred, which will depend on the nature of the actual pandemic occurring. Some pandemics are much worse than others (compare the H1N1 pandemic of 2009 with the COVID-19 pandemic of 2020), and so what would reasonably be expected to follow from one particular pandemic might not reasonably be expected to follow from another particular pandemic. In asking what would reasonably expected to follow from an event, we are asking what would reasonably be expected to follow from the actual event that has occurred, in all its existential particularity. The reason for this is that the MAE definition expressly speaks of events and what is reasonably expected to follow from them, not of kinds or types of events or of “average” or “typical” events of certain kinds.

[10] The court ultimately held that the acquirer bore the risk of a pandemic because an exception in the MAE definition included the terms “natural disaster” and “calamity,” and the COVID-19 pandemic was both of these. AB Stable VIII LLC, No. 2020-0310, at *57-59. Hence, the court’s discussion of whether other exceptions in the MAE definition would have applied if the target had borne the risk of a pandemic is dicta.

[11] Id. at *55-57.

[12] Id. at *56. Court also says about root cause, but we can let that pass. “each exception applies on its face, not based on its relationship to any other exception or some other root cause

[13] Id. at *56-57.

[14] Robert T. Miller, Material Adverse Effect Clauses and the COVID-19 Pandemic (Univ. Iowa Legal Stud., Rsch. Paper No. 2020-21), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3603055 [https://perma.cc/NHA6-EXL7] [hereinafter Miller, Covid-19 Pandemic], at 25-26.

[15] AB Stable VIII LLC, No. 2020-0310, at *55 n. 204.

[16] AB Stable VIII LLC, No. 2020-0310, at *48 (emphasis added).

[17] AB Stable VIII LLC, No. 2020-0310, at *56.

[18] The court in KCake makes exactly the same mistake. In that case, the acquirer had pointedly refused to agree that “pandemics” would be excepted events, thus allocating the risk of a pandemic to the target, KCake Acquisition, Inc., No. 2020-0282, at *6-7, but the parties had agreed that general changes in the economy, id., and changes in law would be excepted, id. at *35, and thus that the risk of such changes would be allocated to the acquirer. The court held that the target had not suffered a material adverse effect, which suffices to dispose of the case, but it then went to say in dicta that that “revenue declines arising from or related to changes in law fall outside of the definition of an MAE, regardless of whether COVID-19 prompted those changes in the law.” Id. As in AB Stable, this confuses events causing material adverse effects with the material adverse effects they cause. Perhaps “changes in law” and “revenue declines” are excepted events and so not Material Adverse Effects, but that does not prevent COVID-19, which caused the revenue declines, from being a Material Adverse Effect, unless the declines are treated as a material adverse effect, and this effect is deemed excepted because the court was applying the exceptions to effects rather than events. As in AB Stable, if a material adverse effect arises from an excepted event, then no event causing that material adverse effect can be a Material Adverse Effect.

[19] Robert T. Miller, The Economics of Deal Risk: Allocating Risk Through MAC Clauses in Business Combination Agreements, 50 Wm. & Mary L. Rev. 2007 (2009).

[20] Id., at 2047.

[21] Guhan Subramanian & Caley Petrucci, Deals in the Time of a Pandemic, __ Columb. L. Rev. __ (2021), https://papers.ssrn.com/sol3/abstract_id=3799191.

[22] Id. at 50. The authors state that only 47% of the agreements in their sample use the causal “arising from” (or similar) language, while 53% use the non-causal “related to” (or similar) language. Id. It turns out, however, that the authors counted such expressions as “impact of,” “resulting directly or indirectly,” and “arising in connection with” as non-causal. Id. at 37 n. 211. These expressions seem plainly causal to me. Accordingly, I doubt whether Subramanian and Petrucci’s breakdown of 47% (causal language) and 53% (relational language) is correct.

[23] Id. at 50.

[24] Note that, to accomplish this goal, the phrase “arising from” in the language introducing the exceptions must be construed in the same way as the phrase “reasonably expected” in the base part of the definition. The “reasonably expected” language suggests the concept of proximate causation commonly used throughout the law. The “arising from” language certain can suggest the same concept, but it can also suggest the notion of but-for causation, which is also commonly used throughout the law. I think the two expressions should be read as having the same meaning, and that the meaning should be the proximate-causation meaning of the base part of the definition. That is, if the language in the base part of the definition speaks in terms of events “reasonably expected” to have a material adverse effect on the target, then any “arising from” language introducing the exceptions should be read as meaning “reasonably expected to arise from.” If the “arising from” language were read in terms of but-for causation, the results would be unpredictable and often irrational because the but-for effects of an event are multifarious, extremely far-reaching, and highly unpredictable. It is difficult to imagine that sophisticated commercial parties would allocate risks in such a haphazard manner.

[25] Akorn, Inc. v. Fresenius Kabi, AG, No. 2018-0300, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018)

[26] KCake Acquisition, Inc., No. 2020-0282, at *35.

[27] This insightful point was suggested to me by Glenn West.

[28] Subramanian & Petrucci, supra note 24, at 53.

[29] Akorn, Inc., 2018 WL 4719347, at *86­87; Williams Cos. v. Energy Transfer Equity, L.P., 159 A.3d 264, 272 (Del. 2017).

Editors

Rebecca L. Butcher

Landis Rath & Cobb LLP
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Tyler O’Connell

Morris James LLP
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Authors

Samuel E. Bashman

Morris James LLP
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Albert J. Carroll

Morris James LLP
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Clarkson Collins, Jr.

Morris James LLP
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Damon B. Ferrara

Morris James LLP
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Eric Hacker

Morris James LLP
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Lewis H. Lazarus

Morris James LLP
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Matthew F. Lintner

Morris James LLP
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Albert H. Manwaring, IV

Morris James LLP
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Ian D. McCauley

Morris James LLP
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Kathleen A. Murphy

Morris James LLP
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Kuhu Parasrampuria

Morris James LLP
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Benjamin M. Potts

Wilson Sonsini Goodrich & Rosati LLP
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Jonathan G. Strauss

Morris James LLP
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Bryan Townsend

Morris James LLP
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Patricia A. Winston

Morris James LLP
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Kirsten A. Zeberkiewicz

Morris James LLP
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§ 1.1 Introduction

The year 2020 saw numerous significant corporate law decisions from the Delaware courts.  Stockholders’ requests for non-public information under Section 220 of the Delaware General Corporation Law continued to be litigated, with both the Delaware Supreme Court and Court of Chancery issuing decisions clarifying the stockholder’s relatively low burden of proof in this area.  See § 15.2, infra.  The Delaware courts also issued important corporate governance decisions addressing disclosure obligations among fellow directors, conflicting decisions of board committees, and the permissible extent of forum selection provisions in the organizational documents of Delaware corporations.  See §15.3, infra.  In the M&A context, the issues of whether a transaction involves a controlling stockholder or control group continued to be a subject of significant litigation, including whether adequate procedural protections were employed to permit deferential review of controlling stockholder transactions under the business judgment rule.  The Delaware Court of Chancery also considered whether the current COVID-19 circumstances give rise to a “material adverse effect” within the intendment of an acquisition agreement.  See § 15.4, infra.  Appraisal litigation in the public company context continued to address deference to market indicators, with notable rulings including a decision affirming reliance upon a corporation’s unaffected trading price.  See § 15.5, infra.  On the regulatory front, Nasdaq recently proposed to the U.S. Securities and Exchange Commission new requirements mandating disclosures concerning corporate boards’ inclusion and diversity policies and practices.  See § 15.8, infra.  These developments, as well as demand futility decisions (§ 15.6) and advancement decisions (§ 15.7) are discussed herein.

§ 1.2 Books and Records

§ 1.2.1

AmerisourceBergen Corp. v. Lebanon Cty. Employees’ Ret. Fund, __ A.3d __, 2020 WL 7266362 (Del. Dec. 10, 2020).  In this decision, the Delaware Supreme Court held that a stockholder who has a “credible basis” to investigate potential wrongdoing or mismanagement need not identify a specific intended use or “end” for the information requested.  In addition, the Court clarified that a stockholder need not show, as a matter of law, that the potential wrongdoing is actionable.  Rather, a “credible basis” to suspect possible wrongdoing or mismanagement is sufficient.

By brief background, stockholders of AmerisourceBergen Corporation (the “Company”), one of the nation’s largest distributors of prescription opioids, sought to inspect its books and records pursuant to 8 Del. C. § 220.  The stockholder-plaintiffs wished to investigate potential wrongdoing or mismanagement relating to the Company’s alleged significant role in the opioid epidemic.  Reports of government investigations and pending lawsuits alleged that the Company failed to comply with federal regulations by, inter alia, continuing to do business with suspicious pharmacies and failing to report suspicious orders to regulators.  Over 1,500 civil lawsuits were then pending against the Company, with defense costs totaling over $1 billion, and the plaintiffs in those actions having rejected a $10 billion settlement offer.  Analysts predicted that the Company may have to pay $100 billion to reach a global settlement.

The stockholder-plaintiffs sought books and records, with their demand letter (“Demand”) indicating purposes of investigating potential wrongdoing or mismanagement to “consider any remedies that may be sought” and to “evaluate litigation or other corrective measures[.]”  Before the Court of Chancery, the Company argued that the stockholder-plaintiffs failed to sustain their burden to show a “proper purpose” because the Demand failed to specify the ultimate intended use of the documents or information sought.  The Company also argued that a stockholder seeking to investigate potential wrongdoing must identify actionable wrongdoing, which the Company argued they could not do because their potential claims would be time-barred and because the Company’s directors were independent and would be entitled to exculpation.  After a trial on a paper record, the Court of Chancery ruled for the stockholder-plaintiffs and rejected the Company’s arguments that they lacked a proper purpose.

Addressing the matter en banc, the Delaware Supreme Court affirmed the Court of Chancery’s decision.  The Court first confirmed that a stockholder seeking to investigate potential wrongdoing or mismanagement need not specify the intended uses of any documents requested in her demand.  The Supreme Court reasoned that a rule requiring disclosure of intended use made sense in the context of a request for stocklist materials, where it was necessary to assess the propriety of the purpose.  Such a rule was inapt when the purpose is to investigate potential wrongdoing, where precedent recognizes that permitting an inspection upon the requisite showing of a “credible basis” serves the interests of all stockholders.  Defendant-corporations remain able to inquire into the stockholder’s purposes and any intended use, and the Court of Chancery remains able to find the facts concerning such issues – all of which may inform the “proper purpose” inquiry.  A stockholder, however, need not know the specific “ends” of the inspection, provided that she has a “credible basis” to suspect possible wrongdoing.

Regarding the Company’s alternative argument – that a stockholder must identify a basis to suspect “actionable wrongdoing” that may be remedied by litigation – the Delaware Supreme Court reasoned that the Demand properly asserted non-litigation purposes, which rendered it unnecessary to address the issue.  But, to provide clarity in this area, the Supreme Court further explained: “we have stated that a stockholder is not required to prove that wrongdoing occurred, only that there is possible mismanagement that would warrant further investigation.”  The Court reasoned that this approach struck the appropriate “balance” between stockholders’ informational rights and the rights of directors to manage the corporation without undue interference.  It also was consistent with the intended “summary” nature of books and records proceedings to avoid evaluating merits-based defenses over the conduct stockholders seek to investigate.  On the other hand, the Delaware Supreme Court reasoned that, in the rare case where bringing litigation is the sole purpose for a demand and such litigation would be barred due to an “insurmountable procedural hurdle,” the Court of Chancery remains able to deny an inspection.  However, courts applying Section 220 generally should “defer the consideration of defenses that do not directly bear on the stockholder’s inspection rights, but only on the likelihood that the stockholder might prevail in another action.”  The Delaware Supreme Court accordingly held “[t]o obtain books and records, a stockholder must show, by a preponderance of the evidence, a credible basis from which the Court of Chancery can infer there is possible mismanagement or wrongdoing warranting further investigation.  The stockholder need not demonstrate that the alleged mismanagement or wrongdoing is actionable.”

§ 1.2.2

Juul Labs Inc. v. Grove, 2020 WL 4691916 (Del. Ch. Aug. 13, 2020).  This decision holds that, pursuant to the internal affairs doctrine, inspection rights for a stockholder of a Delaware corporation are governed exclusively by Delaware law, not by laws of other jurisdictions, regardless of where a company’s principal place of business is located.

JUUL Labs is a privately held Delaware corporation with a principal place of business in California.  After a JUUL Labs stockholder based his demand on California state law and threatened to bring suit in California state court to enforce his inspection rights, JUUL Labs sought declaratory relief in the Court of Chancery.  JUUL Labs argued that the stockholder waived his inspection rights under certain form agreements; that in any event, Grove’s default statutory inspection rights were governed by Section 220 of the Delaware General Corporation Law (“DGCL”), not under Section 1601 of the California Corporations Code; and that the Court of Chancery had exclusive jurisdiction due to a forum-selection provision in JUUL Labs’ certificate of incorporation.  Each side moved for judgment on the pleadings.

The Court first held that JUUL Labs failed to show that the stockholder was a party to an agreement reflecting the clear and affirmative language necessary to waive statutory rights.  While some language purported to waive rights under Section 220 of the DGCL, none expressly referenced the California Corporations Code.  Accordingly, it was necessary to determine what, if any, inspection rights the stockholder had under California law.

In this regard, the Court reasoned that stockholders’ statutory inspection rights are a core matter of the internal affairs of a Delaware corporation.  Precedent from the U.S. Supreme Court and the Delaware Supreme Court requires that, where the laws of the state of incorporation differ from those of another state, the former govern matters relating to the corporation’s internal affairs.  This is necessary as a matter of due process to provide certainty over which state’s laws apply.  Reviewing California law in detail, the Court concluded that, while California’s books and records statutes were not “radically different” than Delaware’s, “California’s balancing of the competing interests between stockholders and the corporation differs from Delaware’s.”  And California was not alone in granting inspection rights to stockholders of foreign corporations, creating a risk that “a Delaware corporation could be subjected to different provisions and standards in jurisdictions around the country.”  Therefore, under the internal affairs doctrine, Delaware law applied.  Relatedly, the terms of a Delaware exclusive forum provision in JUUL Labs’ certificate of incorporation applied, and the stockholder was required to bring any claim to enforce inspection rights in the Court of Chancery.

The Court granted JUUL Labs judgment on the pleadings.  In doing so, the Court noted it was not deciding whether purported waivers of the stockholder’s statutory inspection rights under Section 220 in JUUL Labs’ form agreements would be enforceable.  While some Delaware cases have not respected such waivers when located in a corporation’s constituent documents, waivers in a separate agreement might be viewed differently.  Because the stockholder’s demands were not made under Section 220, the Court was not required to decide such issues.

§ 1.2.3

MaD Investors GRMD, LLC v. GR Cos., Inc., 2020 WL 6306028 (Del. Ch. Oct. 28, 2020).  This decision confirmed that a stockholder plaintiff’s five business days under Section 220 between demand and suit does not expire until midnight on the fifth business day.  The Court further held that the stockholder plaintiffs’ standing to pursue remedies under Section 220 that had been eliminated by merger between the filing and dismissal of its Section 220 action could not be revived under the Court’s equitable powers.

At 5:03 p.m., on the fifth day after serving a Section 220 demand (the “Demand”) on GR Companies, Inc. (the “Company”), MaD Investors GRMD, LLC and MaD Investors GRPA, LLC (together, “Plaintiffs”), filed a complaint to compel inspection of books and records pursuant to 8 Del. C. § 220 (the “Complaint”).  The Company filed a motion to dismiss, asserting that Plaintiffs had filed the Complaint prematurely.  Plaintiffs filed a cross-motion for leave to amend the Complaint (the “Leave Motion”).

Section 220(c) provides that stockholders may not file a books and records action until the company (1) refuses a demand to provide books and records, or (2) has not replied “within 5 business days after the demand has been made.”  Here, the Demand was made on July 9 and the Complaint was filed at 5:03 p.m. on July 16.  Because the Company never responded to the Demand, it argued that Plaintiffs could not file the Complaint prior to 12:00 a.m. on July 17.  In response, Plaintiffs argued that they complied with the deadline because (1) the Company “refused” the Demand by requesting an extension to respond on July 15, and (2) the response period ended at 5:00 p.m. (the Court’s filing deadline) on the fifth business day following service of the Demand.  In rejecting these arguments, the Court found that, because the request for an extension was not alleged in the Complaint, it was not properly before the Court and, in any event, this request did not constitute a refusal under Section 220.  The Court also found that Section 220 refers to “business day” not “business hours,” and the commonly accepted meaning of a “business day” is “a twenty-four hour day other than weekends and holidays.”

Having found that the Plaintiffs had filed the Complaint prematurely, the Court held that it did not have jurisdiction over the Complaint or any request to supplement it.  Furthermore, the Court held that, despite the fact that Plaintiffs no longer had standing as stockholders that would allow them to file a curative demand (due to the subsequent closing of a merger), there was no “equitable safe harbor” excusing the premature filing of the Complaint.

For the foregoing reasons, the Court dismissed the Complaint with prejudice and denied the Leave Motion.

§ 1.2.4

Pettry v. Gilead Sciences, Inc., 2020 WL 6870461 (Del. Ch. Nov. 24, 2020).  This case illustrates that a Court applying Delaware law may award a stockholder attorneys fees and expenses as a means of addressing the overly aggressive defense of a books and records action.  Section 220 of the Delaware General Corporation Law permits a stockholder plaintiff who has a “credible basis” to suspect wrongdoing by officers and directors to demand inspection of books and records relating to that misconduct.  In this case, plaintiff-stockholders of Gilead Sciences, Inc. (“Gilead”) sought to inspect Gilead’s books and records to investigate misconduct.  Gilead was subject to numerous lawsuits and government investigations arising out of alleged anticompetitive conduct, mass torts, breach of patents, and false claims relating to the development and marketing of its HIV drugs.  The plaintiffs sought books and records about Gilead’s (1) anticompetitive agreements, (2) policies and procedures, (3) senior management materials, (4) communications with the government, and (5) director questionnaires.  Gilead refused to produce any documents, even though the plaintiffs had a credible basis to suspect wrongdoing and the records they sought related directly to the misconduct.  The Court of Chancery found that “Gilead exemplified the trend of overly aggressive litigation strategies by blocking legitimate discovery, misrepresenting the record, and taking positions for no apparent purpose other than obstructing the exercise of Plaintiffs’ statutory rights.”  The Court, therefore, granted plaintiffs leave to move for fee shifting.

§ 1.2.5

Alexandria Venture Investments, LLC v. Verseau Therapeutics, Inc., 2020 WL 7422068 (Del. Ch. Dec. 18, 2020).  In a dispute over a stockholder’s request for books and records, the Court held that the stockholder plaintiffs only needed to provide a credible basis for the court to infer wrongdoing, they did not need to state that the conduct to be investigated was actionable.  The Court limited the stockholders’ inspection to the materials necessary to investigate the claims of wrongdoing and would not allow broad inquiry into the company’s financial condition.

Verseau Therapeutics, Inc. (the “Company”) is a company that is developing immunotherapies to treat certain cancers.  Alexandria Venture Investments, LLC and Alexandria Equities No. 7, LLC (“Alexandria”) are stockholders in the Company.  In 2020, the Company was seeking additional financing due to the likelihood it would run out of operating funds by early 2021.  Alexandria made a financing proposal to the Company that included restrictions on cash payments to directors and Alexandria approval of related party transactions.  The Company’s board rejected the financing proposal at an early June meeting.  At that meeting, one of the directors indicated that his firm was working on an alternative bridge financing proposal that he believed would be more attractive to the Company.  The Company’s board considered the Alexandria financing proposal again at a late June meeting and rejected the proposal.

On July 1, Alexandria made a books and records demand on the Company to investigate whether the board had breached its fiduciary duties in rejecting Alexandria’s proposed financing.  Alexandria was unaware at the time of the demand of the June 29 board meeting.  Alexandria then made a supplemental demand on July 9 related to the second rejection of its financing proposal.  The Company did not respond to the second demand and Alexandria filed suit in the Court of Chancery on July 17.

The Company did not challenge whether Alexandria was a stockholder or had met Section 220’s technical requirements.  It only challenged whether Alexandria had stated a proper purpose.  Alexandria raised concerns with the Board’s ability to make an unbiased decision on the proposed financing due to the conflicts of interest of several board members.  The Company argued that this could not be a proper purpose because the challenged decision had been approved by a majority of the disinterested members of the Company’s board.  A fact that was unchallenged by Alexandria’s petition.

The Court rejected the Company’s argument citing the Supreme Court’s decision in AmeriSource Bergen Corp. v. Lebanon County Employees Retirement Fund and held that the appropriate inquiry on a books and records demand is whether the stockholder has alleged a credible basis from which the court can infer mismanagement.  The stockholder is not required to allege an actionable claim to merit inspection.  The court held that Alexandria’s allegations of conflict were sufficiently detailed and material to merit inspection of the books and records related to the June board meetings.

The Company did not press its claim that Alexandria had an ulterior motive for its inspection request, therefore the Court did not rule on that issue.  Finally, the Court limited Alexandria’s inspection rights to the materials necessary to determine whether a breach had occurred.  The Court allowed inspection of the formal board materials related to the June meetings and directed the parties to meet and confer on the extent that the Company’s board informally considered Alexandria’s proposal via text or email and submit a proposed order on additional production.

§ 1.3 Corporate Governance 

§ 1.3.1

Blackrock Credit Allocation Income Tr., et al. v. Saba Capital Master Fund, Ltd., 224 A.3d 964 (Del. 2020).  The Delaware Supreme Court reversed the Court of Chancery’s decision requiring two closed-end trusts (together, the “Trusts”) to count the votes of Saba Capital Master Fund, Ltd’s (“Saba”) slate of dissident nominees at the Trusts’ respective annual meetings.  The Supreme Court ruled that Saba’s nominations were ineligible because Saba had failed to respond to the Trusts’ request for supplemental information within the clear and unambiguous five day compliance deadline in the Trusts’ advance notice bylaws (the “Bylaws”).

In response to Saba’s notice that it planned to present a slate of dissident nominees at the Trusts’ annual meetings, the Trusts sent out supplemental questionnaires (the “Questionnaires”) requesting more information about the slate.  Saba failed to make any response to the request within the five business day compliance deadline, and the Trusts declared the nomination notice invalid.  In the proxy contest that followed, the Trusts urged stockholders not to return proxy cards sent by Saba.

Saba filed suit and asked the Court of Chancery to enjoin the Trusts from interfering with its attempt to present a slate of nominees.  On “a highly expedited and pre-discovery record,” the Court granted Saba’s request and required the Trusts to count the votes for Saba’s nominees.  While the Court agreed that the Trusts could request supplemental information from Saba pursuant to the Bylaws, it held that the Questionnaires “went too far” because the information was not “reasonably requested” or “necessary” as required by the Bylaws.  The Trusts appealed.

The Supreme Court held that, although the Court of Chancery interpreted the Bylaws correctly, it erred in granting injunctive relief because Saba failed to meet the Bylaws’ clear and unambiguous five day compliance deadline.  The Court noted that while concerns about the breadth of the Questionnaires could be valid, Saba should have raised those concerns before the expiration of the deadline.  The Court “was reluctant to hold that it is acceptable to simply let pass a clear and unambiguous deadline in an advance-notice bylaw, particularly one that had been adopted on a ‘clear day.’”  The Court further noted that “encouraging [] after-the-fact factual inquiries into missed deadlines could potentially frustrate the purpose of advance notice bylaws”—to permit orderly meetings and proxy contests and provide fair warning to the corporation.  Thus, the Court found Saba’s nominations to be ineligible and remanded the case to the Court of Chancery for further proceedings. 

§ 1.3.2

Salzberg v. Sciabacucchi, 227 A.3d 102 (Del. 2020).  Reversing the Court of Chancery, the Delaware Supreme Court concluded that federal forum selection clauses, requiring that litigation under the Securities Act of 1933 (“‘33 Act”) only be filed in federal courts, are allowable provisions in a Delaware corporation’s certificate of incorporation or bylaws.

Under recent U.S. Supreme Court precedent, private plaintiffs may bring ‘33 Act claims in either federal or state court.  A wave of securities class actions filings in state courts inspired corporations to consider limiting such actions to federal courts through charter or bylaw provisions.  A stockholder-plaintiff sued seeking a declaration that provisions designed to limit a plaintiff’s choice of forum for an action arising under the ‘33 Act to federal courts were invalid under Delaware law.  The Court of Chancery agreed with the plaintiff, holding that Section 102(b)(1) of the Delaware General Corporation Law (“DGCL”) prohibited a corporate charter from “bind[ing] a plaintiff to a particular forum when the claim does not involve rights or relationships that were established by or under Delaware’s corporate law.”

Specifically, under DGCL Section 102(b)(1), a corporate charter may contain (1) “any provision for the management of the business and for the conduct of the affairs of the corporation” and (2) “any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders, or any class of the stockholders, … if such provisions are not contrary to the laws of this State.”  Citing Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), the Court of Chancery held that Section 102(b)(1) endowed the corporation only with the power to govern claims arising under the internal affairs of the corporation – in this case, claims addressing “the rights and powers of the plaintiff-stockholder as a stockholder.”  A federal securities claim involves a claim of fraud in connection with the sale of securities; the fact that the company involved might be incorporated in Delaware is “incidental” to the claim.  Instead, the corporate charter must defer to the rights granted pursuant to the external federal statute, which allows for state and federal jurisdiction.

The Delaware Supreme Court reversed, finding that Section 102(b)(1) endowed Delaware charters with broad powers, and that the statute “bars only charter provisions that would achieve a result forbidden by settled rules of public policy.”  The Court reasoned that “corporate charters are contracts among a corporation’s stockholders, … and that, Delaware’s legislative policy is to look to the will of the stockholders in these areas.”  The Court agreed that Section 102(b)(1) precluded a charter from purporting to govern the location of filings of actions arising under a corporation’s external affairs, but held that federal securities laws were “Intra-Corporate Affairs” – an area that comprised a band of claims between truly external affairs (such as tort claims) and a corporation’s “internal affairs” (such as stockholder derivative actions).  A ‘33 Act claim could be brought by an existing stockholder purchasing more shares, and such a claim would seem to fit within the language in Section 102(b)(1) allowing for provisions “creating, defining, limiting and regulating the powers of the … the stockholders, or any class of the stockholders.”  As such, it could not be said that in all cases such provisions were invalid.  The Supreme Court also held that corporate bylaws may similarly include such forum selection clauses.

§ 1.3.3

Cty. of Ft. Myers Gen. Employees Ret. Fund v. Haley, 235 A.3d 702 (Del. 2020).  The decision is significant for articulating the standard applicable to evaluating director disclosure to fellow directors and what facts are necessary to plead that the business judgment rule does not apply when the plaintiff attacks the interest of only one officer and director.

This case involved a merger of equals, Willis Group Holdings Plc (“Willis”) and Towers Watson & Co. (“Towers”).  When the parties announced the deal, market reaction was negative for the Towers stockholders.  Analysts noted, for example, that the Towers stockholders’ shares in the exchange ratio were valued at 9% below the unaffected trading price even though the financial performance metrics for Towers were much stronger than those of Willis.  In this atmosphere of uncertainty over deal consummation, a representative of Value Act, a large stockholder of Willis, proposed a compensation package (“the Proposal”) to the CEO of Towers, John Haley, who was to serve as the CEO of the combined entity.  The Proposal would have significantly increased the upside potential over three years from Haley’s existing compensation plan of $24 million to $140 million.  When the parties issued their joint proxy, they did not mention the Proposal, the extent of the post-signing discussions or Value Act’s role in the executive compensation discussions with Haley.

The market reaction was so negative that Towers adjourned its stockholder meeting when it had received only about 43% stockholder approval.  Thereafter, the Towers board met to discuss potential revisions to the merger agreement.  Haley did not disclose the Proposal at that meeting.  The board agreed to increase a special dividend from $4.87 to $10 per share.  Plaintiff alleged that, because of his interest in the undisclosed Proposal, this increase reflected the bare minimum necessary to assuage the Towers stockholders.  The Towers stockholders later approved the revised deal at a reconvened stockholder meeting.

In the litigation that followed, the Court of Chancery held that plaintiff had failed to allege that the non-disclosure of the Proposal was material because the Towers board knew that Haley was going to be the CEO of the combined entity and that his compensation would be greater because the entity would be larger.  Second, the Court held the Proposal was not binding and reflected upside potential only for pie-in-the-sky circumstances.  The Court thus held Plaintiffs had not overcome the business judgment rule and dismissed the complaint.

In reversing, the Supreme Court reaffirmed that to state a claim in these circumstances, a plaintiff would have to allege that a director was materially self-interested; that the director failed to disclose his interest to the board; and that a reasonable board member would find the director’s material self-interest a significant fact in their evaluation of the proposed transaction.  The Court defined “materiality” as “relevant and of a magnitude to be important to directors in carrying out their fiduciary duty of care in decision-making.”  Applying that standard, the Supreme Court held that “Plaintiffs are entitled to an inference that the prospect of the undisclosed enhanced compensation proposal was a motivating factor in Haley’s conduct on the renegotiations to the detriment of Towers stockholders.”  The Court noted that the fact that the compensation package ultimately approved post-closing had even greater upside reward led to the reasonable inference that the board and Haley believed the milestones were attainable.  The Court also found that Plaintiffs adequately alleged that Haley did not disclose the Proposal to the Towers board.  Finally, the Court also found that testimony from a disinterested director who served as Chair of the Compensation Committee that he would have wanted to know about the Proposal indicated that a reasonable director would have viewed the Value Act Proposal as a significant fact in the evaluation of the transaction.

§ 1.3.4

Palisades Growth Capital II, L.P. v. Bäcker, 2020 WL 1503218 (Del. Ch. Mar. 26, 2020).  In this case, the Delaware Court of Chancery held that it may void an action by a board of directors – even where the action is not otherwise in violation of the corporate charter or the Delaware General Corporation Law (“DGCL”) – when equity so requires.

Defendant Alex Bäcker (“Bäcker”) was the co-founder and former CEO of the nominal defendant corporation, QLess, Inc., as well as one of its five directors.  Following internal employee reports that his leadership was threatening the stability of the corporation, however, the board voted to remove him as the CEO.  After initially protesting the decision, Bäcker appeared to approve of the replacement CEO, and likewise appeared to agree with the board’s plans to create a sixth board seat for the newly appointed CEO to occupy.  The board therefore scheduled a meeting in November 2019, at which the new CEO board seat would be created and filled by the new CEO.

Prior to the board meeting, all five board seats were occupied: Bäcker and his father held two seats; Palisades Growth Capital (“Palisades”), the majority holder of Series A shares, held one seat; the non-party majority holder of the Series A-1 shares held a fourth seat; and an independent director held a fifth seat.  Shortly before the board meeting, however, the non-party preferred shareholder and the independent director both unexpectedly resigned their respective seats, leaving only three directors on the board in advance of the meeting.  Believing that he held a 2-1 majority, Bäcker allegedly “seized the moment by scheming with [his co-defendant director] (and counsel) to take control of the Company in advance of the November 15 meeting.”  At the meeting, the defendants prevented the expected resolutions from being adopted.  The defendants instead, with their two to one majority, voted to terminate the newly appointed CEO, to reappoint Bäcker as the CEO (allowing him to occupy the newly-created CEO director seat), and to appoint a new director to fill Bäcker’s newly-vacant director seat.

In response, Palisades brought a Section 225 action against Bäcker and his father, seeking a declaratory judgment that the defendants’ actions during the meeting were invalid for a multitude of reasons.  Palisades’ availing argument was that the defendants’ actions were inequitable, and therefore invalid, because the defendants lured the Palisades director to the meeting under the false pretense of planning to vote to appoint the new CEO as a sixth director and to appoint a replacement for the newly-vacant preferred shareholder seat.

While the Court found that the defendants did not violate any specific provisions of the corporate charter, bylaws, or the DGCL, the Court nevertheless noted “[i]t is bedrock doctrine that this Court will not sanction inequitable action by corporate fiduciaries simply because the act is legally authorized.”  The Court clarified that, before equity may be invoked in a case such as this, the defendants (acting as fiduciaries) must be shown to have actually affirmatively deceived the plaintiffs.  Here, the defendants represented their intentions to vote the new CEO into a director seat, and even suggested that they believed the new CEO already effectively occupied a director position.  In light of this affirmative deception, the Court rendered a decision voiding “all actions taken at the contested November 15 meeting.”

§ 1.3.5

In re WeWork Litig., 2020 WL 7346681 (Del. Ch. Dec. 14, 2020).  In this case the Delaware Court of Chancery assessed the claims of competing board committees to authorize and to revoke authorization for litigation against the company’s controlling stockholders and determined that a modified Zapata standard is appropriately used to review such committee decisions.

In this case, the board of directors of The We Company (“Company”) created a special committee (“Special Committee”) to negotiate a multi-step transaction (“MTA”) that would resolve the company’s liquidity crisis as well as transfer majority ownership of the Company from Adam Neumann to SoftBank Group Corp. (“SBG”) and SoftBank Vision Fund (AIV MI) L.P. (“Vision Fund”).  Part of the MTA was a tender offer.  The tender offer opened, but was terminated by SBG and Vision Fund before it could close.  The Special Committee initiated litigation before the Court of Chancery against SBG and Vision Fund for breach of the MTA for failing to make best efforts to complete the tender offer (“Litigation”).

SBG and Vision Fund immediately protested the filing of the Litigation to the Company’s management and board.  After receiving these complaints, the board of directors approved the appointment of two new directors to form a committee (“New Committee”) to review the authority for and propriety of the Special Committee’s Litigation.  The New Committee subsequently issued a report stating that the Special Committee was not authorized to initiate the Litigation and that the Litigation was not in the best interests of the Company.  The New Committee then brought a 41(a) motion to dismiss the Litigation initiated by the Special Committee.

The parties presented multiple standards under which the New Committee’s decision to terminate the Litigation should be evaluated.  These ranged from business judgment to entire fairness.  The New Committee while advocating that the most stringent standard for evaluating its decision would be business judgment, allowed that the Court could apply the Zapata  analysis for evaluating a committee’s decision to dismiss derivative litigation with prejudice.  The Court found that a modified Zapata standard of review made the most sense under the circumstances.

In so holding, the Court stated that Zapata was the most analogous standard because the Company was seeking to dismiss litigation through use of a board committee in a scenario with the potential for abuse.  The business judgment rule was too lenient and the entire fairness test did not fit the circumstance of action taken by a properly authorized board committee.  Under the first prong of Zapata, the Court stated that the Company was required to establish that the New Committee was independent and acted reasonably and in good faith.  The Court found that the New Committee was unquestionably independent.  But, the Court found that the New Committee did not act reasonably.  The Court performed a detailed analysis of the conclusions reached by the New Committee and found that the conclusions reached regarding the authority of the Special Committee to initiate the Litigation and whether the Litigation was in the best interests of the Company were not reasonable.  Therefore, the Court denied the motion to dismiss under the first Zapata prong.

The Court recognized that the second Zapata prong allowed the Court to exercise its own judgment in determining whether the Litigation should be dismissed.  The Court concluded that given the merits of the underlying breach of the MTA claim, the proximity of trial and the unlikelihood that the stockholders could pursue an alternate remedy to remediate SBG’s and Vision Fund’s alleged failure to use best efforts to close the tender offer that the motion to dismiss should be denied.  The Court recognized that the Special Committee was not without conflict but in balancing the overall harm to the minority stockholders from dismissing the litigation with the potential for conflict, the Court held that the Litigation should be allowed to proceed.

§ 1.3.6

Pascal v. Czerwinski, 2020 WL 7383107 (Del. Ch. Dec. 16, 2020).  This decision affirms that a direct claim for failure to disclose against a board of directors must meet a materiality threshold before it will provide a basis for relief.  The plaintiff stockholder’s failure to allege that material information had been withheld was the basis for the court’s dismissal of the direct disclosure claim.

Plaintiff stockholder asserted direct and derivative claims against the board of directors of Columbia Financial, Inc. (“Columbia”) for breach of fiduciary duties related to the approval of bonuses for the directors.  The derivative claims are not addressed in the opinion.  The direct claim alleged a breach of duty due to failure of the board to adequately disclose material information related to the equity incentive plan when seeking stockholder approval.  The stockholder requested that the entire equity incentive plan be voided for this failure to disclose.

Directors have a common law duty to disclose material information to stockholders when seeking their approval for corporate action.  Information is material if, from the perspective of a reasonable stockholder, the information is substantially likely to significantly alter the total mix of information.  Here the plaintiff stockholder alleged that the directors’ disclosure of the equity incentive plan indicated that it was to be an incentive for future performance.  Plaintiff alleged that the equity incentive plan as adopted was actually intended to reward the directors for past efforts in taking Columbia public.  As the Court framed it, the issue to be decided was whether the directors’ disclosure of the intent to compensate themselves generally as opposed to specific disclosure that compensation was for past performance related to taking Columbia public was material to stockholder approval of the equity incentive plan.

The Court analyzed the plaintiff’s two allegations of omission of material information.  In reviewing the proxy statement, the Court held that it was clear that the board intended the awards to compensate the board for past performance.  While the proxy statement did not specifically discuss the going public transaction, the Court held the failure to identify the specific event was not material.  The plaintiff stockholder additionally complained of the failure to disclose the peer group of going public transactions on which compensation under the equity incentive plan would be modeled.  The court found that adequate disclosure of the peer group that formed the basis for the plan was made in the proxy statement.

The Court dismissed the direct stockholder claim for breach of duty in failing to make adequate disclosures because the complaint did not allege any material undisclosed information that would have been likely to affect the stockholder approval of the equity incentive plan.  The Court reserved the questions on the fairness of the equity incentive plan approved for consideration as part of the derivative breach of fiduciary duty claims.

§ 1.4 Mergers & Acquisitions 

§ 1.4.1 

In re Tesla Motors, Inc. S’holder Litig., 2020 WL 553902 (Del. Ch. Feb. 4, 2020).  The Delaware Court of Chancery denied plaintiffs’ and defendants’ (including Elon Musk’s) motions for summary judgment on the grounds that genuine issues of material fact still remain to be determined at trial.  The plaintiffs brought the action based on the allegation that Musk improperly influenced the Tesla board of directors to approve Tesla’s acquisition of SolarCity, another entity owned partially by Musk that was purportedly on the verge of insolvency.

The defendants asserted that the acquisition of SolarCity was approved by a fully informed and uncoerced vote of the minority stockholders, and therefore subject to business judgment review under Corwin.  After discovery, defendants argued that there was no evidence that Musk, who controlled only a minority (22.1%) of Tesla’s voting power, had actually coerced Tesla’s other stockholders into approving the transaction, and on that basis sought summary judgment.  The Court reasoned, however, that if Musk was found to be a controller and had the ability to exercise control over the vote, regardless of whether he actually did so, the transaction would remain subject to entire fairness review.  In that regard, the Court explained that Delaware law recognizes that a controller can exert “inherent” coercion over shareholders facing a vote to approve a transaction.  As articulated by the Court: “That conflicted controller transactions are inherently coercive … is a fixture of our law endorsed by our highest court and re-emphasized in numerous decisions of this Court.”

The Court acknowledged that leading Delaware jurists, through scholarly articles, have questioned why concerns about “inherent coercion” should justify imposing entire fairness review upon a transaction that rational investors have approved by a fully informed vote.  Yet the Court also reasoned that Delaware Supreme Court precedent recognized the doctrine, which was dispositive.  Accordingly, if Musk were a controller at the time of this acquisition, his status as such would result in a presumption of “inherent coercion” that prevents Corwin from securing business judgment review.

The Court found it could not, on the current record, determine whether Musk was a controller. Nor could it determine whether or not the stockholder vote was fully informed, or whether a majority of the board was independent when it approved the acquisition.  Accordingly, the case will continue to trial, and should Musk be determined to be a controller, the transaction will be reviewed under an entire fairness standard.

§ 1.4.2

Voigt v. Metcalf, 2020 WL 614999 (Del. Ch. Feb. 10, 2020).  This decision contains an instructive review of the factors the Court of Chancery will examine to determine whether a minority stockholder may in fact be a controlling stockholder in the circumstances of a specific transaction.

In July 2018, NCI Building Systems, Inc. (the “Company”) acquired Ply Gem Parent, LLC.  At the time, a private equity firm (“CD&R”) owned 34.8% of the Company and had four designees on the Company’s twelve-member board.  CD&R also owned 70% of the Ply Gem Parent.  Company stockholders sued, alleging that three months before the transaction Ply Gem Parent was valued at roughly half the merger price, and accordingly that CD&R and various directors breached their fiduciary duties.

Addressing the defendants’ motion to dismiss, the Court analyzed a number of factors supporting a pleadings-stage inference that CD&R controlled the Company.  Among other things, the Court examined the detailed rights CD&R obtained via a stockholders’ agreement, including consent (or veto) rights over matters that otherwise would be board-level decisions.  CD&R also had other avenues of board influence, including a right to proportionate representation on committees.  In addition to appointing four CD&R insiders to the board, CDR also had longstanding ties to two others, whom it had repeatedly appointed to boards paying significant directors’ fees.  The Company’s public filings also indicated that, subject to their fiduciary duties, those two directors’ appointment furthered CD&R’s ability to exercise control at the board level.  CD&R also had influence over two more directors by virtue of their employment as officers and, for one, an anticipated promotion in the post-transaction company.  Although a special committee was used, it chose a financial advisor with a current relationship with CD&R without interviewing other candidates.  The committee also chose not to interview or hire its own counsel, opting instead to proceed with Company counsel.

Of particular note is the Court’s discussion of how a non-majority equity stake factors into the control analysis.  The Court observed that “simple mathematics” shows that “a relatively larger block size should make an inference of actual control more likely.”  Even a “large stockholder with less than a majority of the voting power retains considerable flexibility to take action at a meeting” because “stockholders who oppose the blockholder’s position can only prevail by polling votes at supermajority rates.”  The Court explained that a 35% blockholder like CD&R will win any vote so long as just one out of every seven other shares votes similarly, whereas opponents need to win over 90% of the unaffiliated votes.  Thus, even though CD&R held less than a majority, its 35% position lent itself to a pleadings-stage inference of control.

As to the breach of fiduciary duty claim against the directors, the Court concluded that four of the directors were exculpated under a Section 102(b)(7) provision in the Company’s certificate of incorporation, because there were no properly plead allegations that they engaged in intentional wrongdoing – i.e., bad faith.  Otherwise, the Court rejected a call by the CD&R-designated directors to dismiss them because they abstained from voting on the transaction.  At the pleadings stage, the Court could not conclude that they did not participate in the negotiation or approval of the transaction, so the claim survived.

§ 1.4.3

DLO Enterprises, Inc. v. Innovative Chem. Prods. Grp., 2020 WL 2844497 (Del. Ch. Jun. 1, 2020). Defendants/Counterclaim Plaintiffs (“Buyers”) acquired substantially all of the assets of Arizona Polymer Flooring, Inc., later renamed DLO Enterprises, Inc. (“Sellers”).  Sellers filed this action disputing who was financially responsible for certain defective products.  During discovery, Sellers produced several pre-closing communications with their counsel that were redacted in part to protect the privilege.  Buyers filed a motion to compel unredacted copies of the documents.

In denying Buyers’ motion, the Court found that the right to waive privilege over these documents did not pass to Buyers either by law or contract.  The Court of Chancery has held that, in the merger context, the privilege over all pre-merger communications passes to the surviving corporation under Delaware statutory law (i.e., 8 Del. C. § 259) unless there is an express carve out in the merger agreement.  See Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP, 80 A.3d 155 (Del. Ch. 2013).  The Court, however, reasoned that the same default rule does not apply when there is an asset purchase rather than a merger.  In an asset purchase, the seller still exists and holds any assets and related privileges that were not explicitly purchased under the asset purchase agreement.  Under the Purchase Agreement between Buyers and Sellers here, Buyers did not contract for the right to assert or waive privilege over Sellers’ communications about the transaction; therefore, that right remained with the Sellers.

The Court requested supplemental briefing on the issue of Sellers’ communications with counsel that were in Buyers’ possession because the email accounts were transferred to Buyers in the transaction.  The Court noted, however, that upon realizing that they had potentially privileged documents, Buyers’ counsel should not have reviewed the content of those documents and should have segregated them pending resolution of the dispute.  The Court held that, should any of those documents be found to be privileged, Sellers’ counsel may file a letter outlining any relief that they deem to be appropriate for Buyers’ review of such documents.

§ 1.4.4

Morrison v. Berry, 2020 WL 2843514 (Del. Ch. Jun. 1, 2020).  This decision held that even if fiduciary duty of care claims against a target company’s board of directors are exculpated, an aiding-and-abetting claim against a financial advisor to the board may survive a motion to dismiss when the advisor is alleged to have knowingly misled the board and prevented the board from running a reasonable sales process.

The Apollo group of equity investors sought to acquire the Fresh Market grocery store chain in a going-private transaction in conjunction with other large equity holders.  Fresh Market relied on its financial advisor, J.P. Morgan Securities, LLC (“J.P. Morgan”), which during its negotiations with Apollo generated downward adjustments to management projections and adjustments to its discounted cash flow analysis that resulted in a lower valuation range for Fresh Market.  Apollo had paid J.P. Morgan $116 million in fees in the two years preceding the transaction.  Throughout the sales process, Apollo allegedly communicated with its “client executive” at J.P. Morgan to solicit inside information about the bid process and negotiating dynamics.  J.P. Morgan’s conflict of interest disclosures to Fresh Market’s board of directors indicated its “senior deal team members” were not currently “providing services” for the members of J.P. Morgan’s Apollo coverage team.  The Court agreed with the plaintiffs that one could reasonably infer this disclosure was “artfully drafted” to omit the backchannel communications with Apollo.  The Court found it reasonably inferable that Apollo outlasted other potential buyers and was able to acquire Fresh Market due to J.P. Morgan’s assistance.

The Court of Chancery thus held that at the pleadings stage, the plaintiff’s aiding-and-abetting claim against J.P. Morgan was legally sufficient.  The Court reasoned that where a conflicted financial advisor has prevented the board from conducting a reasonable sales process, the advisor may be liable for aiding and abetting the board’s breach of fiduciary duties even if the individual directors are exculpated from liability for their breach.  The Court explained that while Fresh Market’s directors were exculpated from their alleged duty of care breach of failing to comprehend J.P. Morgan’s conflict of interest, J.P. Morgan could nevertheless still be liable for aiding and abetting their breach of the duty of care based on its misleading statements, which prevented the board from conducting a reasonable sales process.

§ 1.4.5

In re Homefed Corp. S’holder Litig., 2020 WL 3960335 (Del. Ch. Jul. 13, 2020).  This case illustrates that a Court applying Delaware law will apply the entire fairness standard to review a squeeze-out merger by a controller, if the controller engages in substantive economic discussions before the company has enacted the procedural protections outlined in Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”) that would permit business judgment review. 

In this case, Jefferies Financial Group Inc. (“Jefferies” or the “Controller”), which owned 70% of HomeFed Corporation (“HomeFed”), acquired the remaining shares of HomeFed in a share exchange in which each HomeFed minority shareholder received two Jefferies shares in exchange for one of its HomeFed shares (the “Transaction”).  A HomeFed director originally proposed the 2:1 share exchange to Jefferies in September 2017, and Jefferies subsequently discussed the share exchange with HomeFed’s second largest shareholder Beck, Mack and Oliver, LLC (“BMO”).  In December 2017, HomeFed’s board of directors (the “Board”) formed a special committee (the “Special Committee”) that had the exclusive power to evaluate and negotiate a potential transaction.  When the parties were unable to agree to merger terms, the Special Committee “paused” its process in March 2018.  Despite pausing the Special Committee, Jefferies continued to discuss a potential transaction with BMO for the next year.

In early February 2019, BMO encouraged Jefferies to pursue the Transaction and indicated that it and another significant shareholder would vote for the Transaction.  Jefferies announced the proposed 2:1 share exchange on February 19, 2019 (the “February 2019 Offer”) and the Board then reauthorized the Special Committee.  During the Special Committee’s negotiations, Jefferies’ CEO reached out to BMO without the authorization of the Committee and implied that the 2:1 share exchange was a “take it or leave it” offer.  The Special Committee and a majority of the minority shareholders approved the Transaction in May and June 2019, respectively.

The plaintiffs, who are former shareholders of HomeFed, claimed that the HomeFed directors and the Controller breached their fiduciary duties.  In response, the defendants requested the Court of Chancery dismiss the case because the Transaction is subject to the business judgment rule under MFW.  In MFW, the Delaware Supreme Court held that the business judgment rule applies to a squeeze-out merger by a controller “where the merger is conditioned ab initio upon both the approval of an independent, adequately-empowered Special Committee that fulfills its duty of care and the uncoerced, informed vote of a majority of the minority stockholders.”

The Court of Chancery denied the motion to dismiss because it found that the plaintiffs adequately pled that Jefferies did not impose the MFW conditions ab initio.  This was because, among other things, the Board never dissolved the Special Committee, Jefferies had substantive economic discussions about a potential transaction when the Special Committee was paused, even though the Special Committee had the exclusive power to negotiate a transaction, and BMO consented to the Transaction before the Special Committee even began its negotiations.  The Court held that it was reasonably conceivable that the February 2019 Offer was part of the same process that commenced in December 2017.  The process failed to comply with MFW because Jefferies did not agree to the MFW protections before the December 2017 process began.  Additionally, the Court explained that, even if the February 2019 Offer was part of a new process, the new process also failed to comply with MFW because Jefferies had substantive economic discussions with BMO and obtained the support of BMO and another crucial shareholder in early February 2019, before the Special Committee was reauthorized near the end of February 2019 and before HomeFed publicly announced that any transaction would be subject to MFW’s requirements.  Jefferies’ discussions were contrary to the ab initio requirement, which bars the controller from having substantive economic discussions with the minority shareholders, and instead requires that the controller negotiate exclusively with a special committee acting on behalf of the minority shareholders.  The Court explained that a controller cannot satisfy the MFW conditions if it undermines the Special Committee by engaging in substantive discussions with minority stockholders before the Special Committee is authorized to act.  The Court, therefore, denied the defendants’ motion to dismiss.

§ 1.4.6

In re Baker Hughes, Inc. Merger Litig., 2020 WL 6281427 (Del. Ch. Oct. 27, 2020).  This decision arose out of a merger involving Baker Hughes and the oil and gas segment of General Electric (GE).  Stockholders of Baker Hughes brought post-closing breach of fiduciary duty claims against certain officers of Baker Hughes and aiding and abetting claims against GE, with the allegations focused on certain financial statements provided by GE in connection with the merger.  GE did not maintain separate statements for its oil and gas business line in the ordinary course.  The parties accounted for this by having GE prepare unaudited financial statements for that business line and conditioning closing obligations on GE providing audited financial statements that did not differ materially in an adverse manner.

In the ensuing lawsuit, the Court of Chancery dismissed the aiding abetting claim against GE for lack of a predicate breach of fiduciary duty by the Baker Hughes’ board, but upheld a claim for breach of fiduciary duty against the Baker Hughes’ CEO.  Among the relevant rulings, the Court rejected the stockholder-plaintiffs’ theory that GE caused the disinterested and independent board of Baker Hughes to breach its fiduciary duties by creating an informational vacuum that induced the board to strike an allegedly bad deal based on the unaudited financial statements.  Applying Revlon enhanced scrutiny, and citing, in part, the protections Baker Hughes secured in the merger agreement, the Court found that the Baker Hughes’ board acted reasonably in the circumstances of GE’s consolidated reporting practices.  The Court also distinguished the “informational vacuum” decisions advanced by plaintiff (i.e., Rural Metro, PLX, KCG, and TIBCO).  Unlike the arms’ length circumstances of this action, each of those cases “involved a player – privy to the internal deliberations or process of a target board that had conflicting financial interests – who deliberately withheld material information from the board, thus casting doubt on the integrity of a sale process.”

The Court, however, upheld a claim against Baker Hughes’ CEO for allegedly breaching his fiduciary duties in connection with the company’s proxy statement.  The Court found that the omission of the unaudited financial statements from the proxy in the circumstances was an omission of material information supporting a disclosure violation.  This was true even though the information contained in those statements was publicly available in GE’s SEC filings because, as the Court explained, Delaware law “does not impose a duty on stockholders to rummage through a company’s prior public filings” to obtain potentially material information.  This disclosure violation prevented the stockholder vote approving the deal from invoking business judgment review under Corwin and supported a claim against the CEO, who was involved in the negotiations, signed the proxy, and conceivably may be liable for breaching his duty of care. 

§ 1.4.7

AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, 2020 WL 7024929 (Del. Ch. Nov. 30, 2020).  Parties to a sale and purchase agreement (“SPA”) had planned to close a deal to sell fifteen luxury hotels for $5.8 billion.  As the COVID-19 pandemic spread across the globe in early 2020 and battered the hotel industry, the buyer terminated the SPA.  Seller sought specific performance in the Court of Chancery.  After trial, the Court denied seller’s request for relief.

The Court first noted that the buyer did not have the right to terminate the SPA under its provision for a Material Adverse Effect (“MAE”) simply because a pandemic was ravaging the hotel industry.  Seller asserted that the consequences of the COVID-19 pandemic fell within an exception to the definition of an MAE for effects resulting from “natural disasters and calamities.”  Though the exception did not explicitly include the term “pandemic,” the Court pointed out that pandemics were included in the dictionary definition of “calamity.”  The Court rejected buyer’s argument that a “calamity” had to constitute an MAE under the SPA unless—unlike COVID-19—it was similar to a natural disaster that is a sudden, single event that threatens direct damage to physical property.  The Court reasoned that the plain meaning of “calamity” encompassed a pandemic.  Surveying case law and commentary concerning MAE clauses, the Court reasoned that this result was consistent with the MAE clause in general, which was relatively seller-friendly.  The parties’ competing expert witness analyses of MAE clauses in precedent transactions similarly did not show that sophisticated parties likely would have used the more specific word “pandemic,” as buyer contended.  Thus COVID-19 fell within the SPA’s exception to an MAE.  Consequently, the Court concluded that the business of the seller did not suffer an MAE as defined in the SPA.

The Court subsequently held, however, that the buyer was entitled to terminate the SPA because the seller failed to comply with its covenants between signing and closing.  Seller’s covenants included a commitment that the business of seller would be conducted only in the ordinary course of business, consistent with past practices in all material respects.  The Court explained that changes in response to a global pandemic and governmental guidelines did not control over the terms of the SPA.  Buyer proved that due to the COVID-19 pandemic, the seller had made extensive operational changes to its hotels’ past-routine business practices.  The Court reasoned that “[a] reasonable buyer would have found them to have significantly altered the operation of the business.”  The test was not what reasonable managers would do in response to a pandemic.  Therefore, the Court found that the seller failed to comply with the “ordinary course of business” covenant, relieving buyer of its obligation to close the deal.  There were also complex factual issues involving a fraudulent scheme, title insurance, and the Delaware Rapid Arbitration Act, which also relieved buyer of its obligation to close.

Having concluded that the buyer was permitted to terminate the SPA, the Court denied seller’s request for specific performance.  Under the plain language of the SPA, the Court awarded the buyer its $582 million transaction deposit with interest, its attorneys’ fees, and $3.685 million in transaction-related expenses.

§ 1.5 Appraisal

§ 1.5.1

Fir Tree Master Fund, L.P. v. Jarden Corp., 236 A.3d 313 (Del. 2020).  Adding to its appraisal jurisprudence, the Supreme Court of Delaware affirmed the use of the unaffected trading price of a public corporation’s stock to determine its “fair value” in the circumstances presented, while clarifying that “it is not often that a corporation’s unaffected market price alone could support fair value.”

After the CEO and co-founder of the respondent corporation negotiated a sale of the company for $59.21 per share, several stockholders refused to accept the sale price and pursued their appraisal rights.  Of the valuation methodologies presented at trial, the Court of Chancery determined that only the $48.31 unaffected market price reliably determined fair value.  Because of a flawed sale process, a lack of comparable companies to assess, and wildly divergent discounted cash flow analyses, all other valuation methods received little to no weight.  

On appeal, the Supreme Court rejected the petitioners’ argument that the Court’s earlier decision in Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., 210 A.3d 128 (Del. 2019) foreclosed, as a matter of law, using the unaffected market price to support fair value The Court surveyed its more recent appraisal opinions in DFC Global Corp., Dell and Aruba.  The Court explained that the DFC Global decision took issue with the Court of Chancery’s rejection of the deal price as relevant to fair value and specifically noted that the pre-transaction price of a public company may be relevant to a fair value analysis.  In Dell, the Court of Chancery was reversed for assigning no weight to market value or deal price, which the Supreme Court found had substantial probative value in the circumstances of that case.  Aruba discussed the considerable weight to be afforded the deal price absent deficiencies in the deal process, because a buyer possessing material non-public information about the seller is better positioned to value the seller when negotiating the purchase price.  The Aruba Court further opined that when there were indications that the market was “informationally efficient” – i.e., that it digested and assessed all of the publicly available information such that it was quickly impounded into the stock price – then the market price may be indicative of fair value.  The notable “takeaway” from these opinions – which the Supreme Court indicated the court-below got “exactly right” – is the requirement that the Court of Chancery explain its fair value calculation in a manner that is based upon the evidence presented.

Turning to the valuation methodologies presented to the Court of Chancery and its conclusions, the Supreme Court reasoned that the Court of Chancery did not abuse its discretion in rejecting those calculations, in arriving at factual conclusions reached in making that determination and in ultimately relying upon the unaffected market price.  The court-below had a basis in the record to conclude that the market did not lack material information about the corporation’s prospects.  The record supported the Court’s finding that the divergence of management’s and analysts’ projections was attributable to a difference of opinion, not a material difference in available information.  The Supreme Court also declined to find fault with the Court of Chancery’s decision not to rely upon the deal price as a floor for its fair value analysis.  The petitioners had attacked the sale process and the deal price it yielded as unreliable and argued to the court-below that synergies were only relevant if the deal price was reliable.  After noting this differed from the petitioners’ argument below, the Supreme Court held that the Court of Chancery did not err in reasoning that, based on the record, the deal price included significant synergies.  In any event, the trial court did not err in declining to give the deal price weight.  The Supreme Court similarly affirmed the court-below’s decision to find certain market evidence more reliable, including the price of share issuances and repurchases occurring near in time, and to find certain other evidence as less reliable, such as certain analysts’ targets or certain results-oriented valuations in the record.  Lastly, the Supreme Court held that the Court of Chancery did not abuse its discretion in calculating a terminal investment rate for its DCF model, a method the court used only as a check on the market price, based on convergence theory (also known as the McKinsey formula), as the Court of Chancery has done in certain other recent matters.

§ 1.5.2

Kruse v. Synapse Wireless, Inc., 2020 WL 3969396 (Del. Ch. Jul. 14, 2020).  This case illustrates how appraisal works outside of the public market context when a lack of data hinders a reliable valuation.  Here, stockholder William Richard Kruse (“Kruse”) sought appraisal of his shares of SynapseWireless, Inc. (“Synapse”), a privately-owned corporation.  McWane Inc. (“McWane”) acquired Synapse in two rounds of investments: McWane, first, acquired a controlling interest in 2012, and, then, acquired the remaining Synapse shares in 2016 in a cash-out merger (the “Merger”).  As part of the 2012 transaction, McWane gained the right to purchase newly issued Synapse shares at a price set by the 2012 acquisition.  Synapse had disappointing performance after the 2012 merger, posting less than half of the projected revenues used to calculate the 2012 merger price.  To mitigate Synapse’s poor performance, McWane provided loans and purchased Synapse shares at the price set by the 2012 merger.  For example, in 2014, McWane bought $31 million of shares at $4.99 per share to keep Synapse afloat, and to increase McWane’s ownership of Synapse to realize tax benefits.

McWane bought the remaining Synapse shares in the 2016 Merger at $0.43 per share, but Kruse refused McWane’s offer and filed this appraisal action in the Court of Chancery.  At trial, Kruse’s expert valued Synapse at $4.19 per share as of 2016, while Synapse’s expert calculated a value between $0.06 and $0.11 per share.  Both experts used three valuation methods: (i) a Prior Company Transaction analysis; (ii) a Comparable Transactions analysis, and (iii) a Discounted Cash Flow (DCF) analysis.  The Court of Chancery eschewed the first two valuation methods as unreliable, but adopted Synapse’s DCF analysis with minor adjustments.  Accordingly, the Court appraised Synapse at $0.23 per share.

In assessing the parties’ contentions, the Court found that, because there was no market check or competitive sales process, there was no contemporaneous market evidence to aid the Court in determining fair value.  The Court also ignored a report on Synapse’s value from an investment bank because no employee of the investment bank testified at the trial and hence was not subject to cross-examination.

In lieu of market data, the Court first considered the parties’ Prior Company Transaction analyses.  These analyses derived the value of Synapse from the price McWane paid for Synapse shares in prior transactions.  Because Synapse had dramatically underperformed the revenue projections used to calculate the 2012 merger price, the 2012 merger price was “stale as of the 2016 Merger.”  Additionally, McWane’s purchases of Synapse stock in 2014 were at a price contractually agreed-upon at the time of the 2012 merger, and for that reason did not reflect fair value as of 2016.

The Court next considered the parties’ Comparable Transactions analyses, which estimated the value of Synapse by comparison with other transactions within a similar timeframe, industry and company size.  The Court held that neither party had carried its burden to show that its Comparable Transactions analysis reflected Synapse’s fair value.  This was because the experts each made thoughtful objections to the other’s analyses, including the comparability of the transactions, and neither expert successfully rebutted the other’s objections.

Finally, the Court evaluated the parties’ DCF analyses.  According to the Delaware Supreme Court, a DCF analysis is “widely considered the best tool for valuing companies when there is no credible market information and no market check . . . .”  The DCF measures a company’s value by projecting its future cash flows, and then discounting the projections to present value.  The Court found Synapse’s DCF calculation more reliable because it better accounted for Synapse’s poor performance, and so adopted the calculation with minor adjustments, finding the fair value on the date of the Merger to be $0.23 per share.

§ 1.5.3

Manti Holdings, LLC v. Authentix Acquisition Co., 2020 WL 4596838 (Del. Ch. Aug. 11, 2020).  This decision from the Court of Chancery clarifies the ability of corporate constituents to modify by agreement the rights associated with the statutory appraisal remedy, 8 Del. C. § 262.  In a previous decision in the case, the Court denied a stockholder’s appraisal petition holding that an advance waiver of statutory appraisal rights in a stockholder agreement is permitted under Delaware law as long as the relevant contractual provisions are clear and unambiguous.  Manti Holdings, LLC v. Authentix Acquisition Co., 2019 WL 3814453 (Del. Ch. Aug. 14, 2019).  In its latest decision, the Court ruled that a prevailing party fee-shifting provision in the stockholder agreement did not contravene Delaware law and was likewise enforceable.

In connection with a prior merger of a previous company into the defendant Authentix Acquisition Company, Inc. (“Authentix”), petitioners entered into a Stockholders Agreement with the new stockholders as a condition of that merger.  Under the Stockholders Agreement, petitioners agreed that “in the event that … a Company Sale is approved by the Board” they would “consent to and raise no objection against such transaction … and … refrain from the exercise of appraisal rights with respect to such transaction.”  Petitioners also agreed to a prevailing party fee-shifting provision “[i]n the event of any litigation or other legal proceedings involving the interpretation of this [Stockholders] Agreement or enforcement of the rights or obligations of the Parties…”

In 2017, the Authentix board of directors approved a merger agreement with a third party. Petitioners refused to consent to the merger, sent appraisal demands, refused to withdraw their demands and filed an action seeking appraisal under 8 Del. C. § 262.  After a grant of summary judgment in favor of the surviving corporation because petitioners had validly waived their appraisal rights in the Stockholders Agreement, the surviving corporation sought, and the Court granted, enforcement of the prevailing party fee provision to recover its attorney’s fees.

Acknowledging the contractual fee-shifting provision, the petitioners argued that it was unenforceable for reasons of statutory procedure, public policy and equity.  The Court first addressed petitioners’ argument that the Delaware legislature’s enactment of 2015 amendments to §§ 102(f) and 109(b) of the Delaware General Corporation Law (“DGCL”) to proscribe fee-shifting provisions in corporate charters and bylaws for intracorporate litigation, established statutory norms that lower order documents such as stockholder agreements could not contravene.  The Court rejected this argument because: (i) neither statutory provision specifically addressed stockholder agreements, and (ii) the legislative history evidenced an intent to carve-out stockholder agreements from the fee-shifting prohibitions.  The Court reasoned that the amendment addressed the concern that corporate charters and bylaws, to the extent contractual, are analogous to contracts of adhesion.  In contrast, stockholder agreements “signed by the stockholder against whom the provision is to be enforced” fall outside the intended prohibition of the section 102(f) and 109(b) amendments to the DGCL.

Further, the Court observed that the animating concern of the statutory amendments prohibiting fee-shifting was the perverse chilling effect of such provisions on stockholders’ ability to assert and enforce breach of fiduciary duty claims.  Noting that breach of fiduciary duty claims were not before him in the appraisal litigation, the court cited the difference between limiting fiduciary duties and waiving statutory appraisal rights as an additional justification for upholding the fee-shifting provision when only appraisal rights are at stake.

§ 1.6 Demand

§ 1.6.1

McElrath v. Kalanick, 224 A.3d 982 (Del. 2020).  In this decision the Supreme Court upheld a Court of Chancery dismissal for failure to adequately allege demand excusal.  This case exemplifies the Delaware courts’ approach to examining demand futility.

In 2016, Uber Technologies, Inc. (“Uber”) acquired Ottomotto LLC (“Otto”), a company started by a contingent of employees from Google’s autonomous vehicles group, in order for Uber to gain expertise in developing autonomous vehicles.  The shareholder-plaintiff brought a claim, on behalf of Uber, against some of Uber’s directors.  The plaintiff alleged that Uber’s directors ignored the risks presented by Otto’s alleged theft of Google’s intellectual property, which eventually led to Uber paying a settlement of $245 million to Google and terminating its employment agreement with Otto’s founder.

The plaintiff argued that the directors should have informed themselves of the results of a report prepared by a forensic investigative firm hired by Uber to conduct due diligence on Otto.  The report uncovered that Otto employees had misappropriated Google’s intellectual property.  More specifically, the plaintiff contended that the directors were on notice to review the report.  The directors should not have relied on the representations of then-CEO Travis Kalanick to acquire Otto because Mr. Kalanick had repeatedly flaunted laws applicable to Uber.  Plaintiff also alleged that the directors were on notice because of unusual indemnification provisions in the merger agreement between Uber and Otto that protected Otto from liability for some of its disclosed bad acts and misstatements.  Finally, the plaintiff claimed that the directors had notice to inquire about the results of the report because they were aware that Uber had requested the forensic investigative firm to prepare the report.

The Delaware Supreme Court affirmed the Court of Chancery’s dismissal of the plaintiff’s complaint because the plaintiff had failed to allege that a majority of Uber’s directors was not disinterested or independent.  The Supreme Court held that the mere fact that Kalanick had appointed a director in a control dispute to the Uber board did not lead, without more, to the inference that that director was interested or not independent of Kalanick.  In addition, Uber has an exculpatory charter provision, which shields its directors from liability for breaches of the duty of care, meaning that the otherwise disinterested and independent directors could be liable only for intentional misconduct.  The plaintiff’s complaint and documents incorporated by reference reflected that the directors discussed the diligence prepared by the forensic accounting firm, were told that the diligence was “OK,” and noted the possibility of litigation with Google.  The Supreme Court also found that the directors could have reasonably relied on Mr. Kalanick’s representations because Uber’s alleged past violations of laws under his leadership did not involve intellectual property, and Mr. Kalanick did not have a history of lying to the board.  The Supreme Court therefore held that “[a]though there might have been reason to dig deeper into Kalanick’s representations about the transaction, the board’s failure to investigate further cannot be characterized fairly as an ‘intentional dereliction’ of its responsibilities.”

§ 1.6.2

Hughes v. Hu, 2020 WL 1987029 (Del. Ch. Apr. 27, 2020).  This decision denied the directors’ motion to dismiss finding that plaintiff had adequately pled demand futility.

According to Plaintiff, for several years Defendants exercised no meaningful oversight over the company’s financial reporting and auditing.  This alleged lack of oversight lead to, inter alia, failures to understand and disclose related-party transactions, company funds being held in directors’ personal accounts, and inaccurate financial and tax reporting.  Although the company promised to correct these deficiencies in 2014, the problems persisted virtually unabated for three more years.  For example, the company continued using problematic auditors, who while purportedly “independent” had no other clients, and the board’s audit committee typically met for less than one hour just once per year.  Plaintiff asserted that demand would have been futile because four of the Defendants comprised a majority of the six-member board that would have considered the demand.  And some of those same members had also been on the audit committee.

Before turning to the specifics of the case, the Court provided a thorough exposition of the observation that the Court and legal commentators have made for years: the two tests used to evaluate demand futility “ultimately focus on the same inquiry.”  The Court began with a casebook-worthy history of the two tests, Aronson and Rales.  The earlier Aronson framework applies when the directors who committed the alleged wrong are the same directors who would consider a plaintiff’s litigation demand.  Under Aronson, a plaintiff must plead facts which create a reasonable doubt that the directors are disinterested and independent and that the board’s action was a valid exercise of business judgment.  The broader Rales framework applies to all situations not addressed by Aronson, such as when the board failed to act or when the board’s membership changed.  Rales requires a plaintiff to plead that a majority of directors are “either interested in the alleged wrongdoing or not independent of someone who is.” disinterested and independent and that the board’s action was a valid exercise of business judgment. 

As the Court explains it, “[c]onceptually … the Aronson test is a special application of Rales” even though Rales came later.  Rales asks generally “whether a director could be interested in the outcome of a demand because the director would face a substantial risk of liability if litigation were pursued” whereas Aronson examines a specific subset when the threat of liability comes from a transaction that the same directors approved.

Using this discussion as a springboard, the Court observed that the case illustrated the overlap between Rales and Aronson.  Technically, Aronson would apply because a majority of directors considering the demand were same directors who allegedly failed to provide financial oversight.  But because Plaintiff challenged an alleged failure of oversight — i.e., a Caremark claim — rather than a specific board act, the Court determined that the broader Rales standard would typically apply.

The Court concluded that, because the well-pled facts showed a majority of the board faced a substantial risk of liability under Caremark and its progeny, Plaintiff pleaded sufficient facts to establish demand futility.  First, the Court concluded that the chronic deficiencies in financial oversight supported a pleadings-stage inference that the board (acting through its audit committee) failed to provide financial oversight or to install a system of financial controls.  Defendants attempted to rely upon the fact that the company did have some financial controls – e.g., an audit committee.  But Plaintiff had made a pre-suit inspection demand under 8 Del. C. § 220, and obtained books and records showing the board’s activities in this area over the pertinent time period, as well as a certification affirming that the production was complete with respect to its subject matter.  The Court criticized the board and audit committee’s general lack of activity despite known problems with financial controls and obtaining transparency into related-party transactions.  The Court concluded that the audit committee likely did not fulfill its obligations under its charter.  Because of such deficiencies, four of the six board members faced a substantial likelihood of liability for breaching their duty of loyalty, and thus, the board lacked an independent, disinterested majority to consider a demand.  The Court denied Defendants’ motion.

§ 1.6.3

Utd. Food and Comm. Workers v. Zuckerberg, 2020 WL 6266162 (Del. Ch. Aug. 24, 2020).  The Court of Chancery discussed the legal tests to demonstrate demand futility in derivative actions under the seminal cases of Aronson and Rales.  Reconciling longstanding and recent case law, the Court ruled that demand futility turns on whether at the time of filing of the complaint, the majority of a board of directors is disinterested, independent, and capable of impartially evaluating a litigation demand to bring suit on behalf of a company.

This derivative suit followed prior litigation that challenged a proposed, board-approved reclassification of Facebook stock that would have enabled Mark Zuckerberg to sell significant quantities of his stock without attendant stockholder voting rights to maintain his present level of control over Facebook.  On the eve of trial in the reclassification litigation, Zuckerberg asked the Facebook board to withdraw the proposed reclassification.  The plaintiff then filed derivative claims for breach of fiduciary duties, seeking damages in connection with the board’s approval of the stock reclassification.

The Court held that plaintiff failed to adequately plead demand futility under Court of Chancery Rule 23.1.  Conducting a director-by-director analysis of the Facebook board, the Court found that the nine-member board could impartially consider a litigation demand if at least a majority, or five members, could exercise independent and disinterested judgment regarding a litigation demand.  Two members were outside directors, who had joined the board after the proposed reclassification had been approved, and plaintiff had failed to plead non-conclusory allegations that called into question their disinterest or independence.  For three other members, their alleged business relationships with Facebook or personal relationships with Zuckerberg did not support any inference that they were unable to independently consider a litigation demand.  Nor did plaintiff plead any facts that would support a pleading-stage inference that they had received personal benefits from the proposed reclassification or committed a non-exculpated breach of fiduciary duty, and thus could face personal liability in the derivative litigation, as a result of voting to approve the reclassification.

In sum, the Court found that demand was not excused because a majority of the Facebook board was disinterested, independent, and capable of impartially considering a litigation demand regarding the board’s approval of the stock reclassification.  Accordingly, the Court dismissed the complaint based on plaintiff’s failure to plead demand futility. 

§ 1.7 Advancement and Indemnification

§ 1.7.1

Int’l Rail P’tners v. Am. Rail P’tners, 2020 WL 6882105 (Del. Ch. Nov. 24, 2020).  This case considered whether an indemnification provision in a limited liability company agreement covered losses stemming from so-called “first-party” claims (i.e., claims between the parties to the contract, as opposed to so-called “third-party” claims brought by non-parties).  The Court of Chancery interpreted the plain language of the provision against a background of advancement and indemnification case law, and distinguished this context from interpretive principles that apply to general indemnification provisions found in commercial contracts.

The individual plaintiff (“Plaintiff”), an officer of the defendant LLC (“Defendant” or the “Company”), brought an action in the Court of Chancery to enforce his rights to advancement under the Company’s LLC agreement.  The advancement action arose out of an underlying dispute between the Company and Plaintiff, in which the Company alleged that Plaintiff mismanaged the Company and enriched himself to the detriment of the Company.  Based on those allegations, the Company brought an action in the Delaware Superior Court seeking damages against Plaintiff (the “Superior Court Action”).  Defendant responded to Plaintiff’s advancement action by arguing that Plaintiff was not entitled to advancement because Plaintiff was defending the Superior Court Action against the Company itself.  According to Defendant, the Company’s LLC agreement did not provide for advancement where the claims were brought by or on behalf of the Company against the covered person (which Defendant referred to as “first-party claims”).  In reaching this conclusion, Defendant reasoned that the LLC agreement did not expressly address first-party claims and, therefore, no advancement for such claims was allowed—even though the terms of the agreement provided for advancement and indemnification for expenses “arising from any and all claims” against a covered person (as Defendant conceded Plaintiff to be).

The Court rejected Defendant’s arguments, however, and granted judgment on the pleadings to Plaintiff.  The Court reasoned that “[i]f Defendant’s position is to be accepted, an LLC Agreement that uses the precise language of the statute to provide for indemnification and advancement to all of its members, managers, and other specified persons as to ‘any and all claims whatsoever’ does not mean what it says.”  The Court came to this conclusion despite Defendant’s reliance on Delaware case law relating to indemnification agreements in the bilateral commercial contract context.  Those cases suggested that an indemnification provision in a bilateral commercial contract does not operate to shift fees in a claim between parties unless the contract explicitly addresses the issue.  The Court noted that the leading Delaware case on this issue was TranSched Sys. Ltd. v. Versyss Transit Solutions, LLC, 2012 WL 1415466 (Del. Super. Mar. 29, 2012).  The Court reasoned, however, that TranSched was inapplicable in the LLC indemnification context (under 6 Del. C. §18-108) because TranSched interpreted a standard indemnity clause in a bilateral commercial purchase agreement and was decided in the context of an arms-length transaction between two commercial entities.  The TranSched Court reasoned that, if it interpreted such a standard indemnity agreement as shifting attorneys’ fees in a claim between the parties, the American Rule in Delaware would be eviscerated.

As such, the Court found that TranSched did not create a presumption that advancement for first-party claims was disallowed in the Section 18-108 context.  Instead, the Court found that LLC indemnification agreements must expressly preclude first-party claims—if the parties wished to do so—reasoning that “[g]iven the statutory framework, the broad language of the LLC Agreement’s indemnification provision, and the strong public policy in favor of indemnification and advancement, … I decline to elevate an interpretive presumption applied to commercial contracts above the strong public policy of advancement and indemnification, particularly in light of the ‘capacious and generous standard’ articulated in the American Rail LLC Agreement.”  The Court accordingly ordered the Company to the advance the Plaintiff CEO’s reasonable attorneys’ fees and expenses in defending against the Superior Court Action.

§ 1.7.2

Perryman v. Stimwave Tech., Inc., 2020 WL 7240715 (Del. Ch. Dec. 9, 2020).  The Court upheld a charter amendment requiring that advancement agreements for executives be approved by the Series D shareholders.  One of the plaintiffs’ advancement agreements was upheld despite the charter amendment, the other was denied as postdating and failing to comply with the charter amendment.

Plaintiffs Laura and John Perryman were directors of Stimwave Technologies Incorporated (“Company”) since 2010 and 2013, respectively.  Laura Perryman also served as the Company’s chief executive officer through November 2019.  The Company’s original charter adopted in 2010 provided that it would not be amended to change any advancement or indemnification provisions after the initiation of an investigation of any act or omission.  The Company’s bylaws further provided that the corporation shall indemnify its officers and directors to the fullest extent permitted by Delaware law.

These provisions remained in place undisturbed until 2018 when the Company solicited additional investors.  In connection with a $5 million investment in April 2018, the Company created a new series of preferred shares, Series D.  In addition, the Company adopted a charter amendment that stated that the Company would not enter any agreements with its executives except with the approval of 68% of the outstanding Series D shares.  A further revision in July 2018 provided that any unapproved agreements with executives were void ab initio.

In October 2019, the Department of Justice initiated a False Claims Act against the Company.  In November 2019, Laura Perryman resigned as CEO.  Around the time of her resignation she provided the Company with an advancement and indemnification agreement between her and the Company dated January 2018.  Pursuant to the terms of the agreement, the Company began advancing fees to Ms. Perryman.  In December 2019, the Company initiated a breach of fiduciary duty claim against Ms. Perryman with various allegations of financial misfeasance.  The complaint was later amended to include a claim for breach of fiduciary duty against Mr. Perryman as well.  Mr. Perryman submitted a claim for advancement to the Company and provided an advancement and indemnification agreement dated January 2015.

There was significant dispute and conflicting evidence about the date Ms. Perryman’s and Mr. Perryman’s advancement and indemnification agreements had been executed.  The Court concluded after trial that Mr. Perryman’s agreement had been executed in April 2018 around the time the Company’s board approved entry into such agreement with the directors.  The Court further concluded that Ms. Perryman’s agreement had not been executed until November 2019. 

The court held that Mr. Perryman’s agreement was not subject to the approval requirements of the charter amendment because he was not an executive.  In addition, Mr. Perryman’s agreement was executed while Ms. Perryman was still CEO, therefore it was a valid agreement with and binding on the Company.  Mr. Perryman was awarded advancement of his attorneys’ fees and expenses.

Ms. Perryman’s indemnification agreement was executed after the charter amendment, was not approved by the Series D shareholders as a contract with an executive and was not enforceable.  In denying Ms. Perryman advancement, the Court further noted that the charter’s provision directing indemnification of the Company’s officers and directors was of no import because advancement and indemnification were separate considerations.  Without a valid advancement agreement, the Company had no obligation to advance Ms. Perryman’s legal fees.

§ 1.8 SEC Developments 

2020 was a busy year at the Securities Exchange Commission (“SEC”), both in terms of new rulemaking and enforcement actions.  But the most material development in terms of its potential effect on Delaware corporate law is a recent proposal Nasdaq submitted to the SEC regarding disclosures related to board diversity and inclusion.  Although this proposal potentially raises difficult Delaware corporate law questions, it encouragingly signifies broader institutional support of board diversity initiatives and requirements.

According to Nasdaq, “[i]f approved by the SEC, the new listing rules would require all companies listed on Nasdaq’s U.S. exchange to publicly disclose consistent, transparent diversity statistics regarding their board of directors.  Additionally, the rules would require most Nasdaq-listed companies to have, or explain why they do not have, at least two diverse directors, including one who self-identifies as female and one who self-identifies as either an underrepresented minority or LGBTQ+.”[1]  Nasdaq’s proposal states that it is proposing the new listing rules because, “[w]hile gender diversity has improved among U.S. company boards in recent years, the pace of change has been gradual, and the U.S. still lags behind other jurisdictions that have imposed requirements related to board diversity.  Moreover, progress toward bringing underrepresented racial and ethnic groups into the boardroom has been even slower.”[2]

If Nasdaq’s proposed listing rule passes, Delaware corporate law could be implicated in at least a couple of ways.  First, the passage of the listing rule may increase support and momentum for Delaware’s legislature to create statutory board diversity requirements applicable to Delaware corporations—an issue on which the legislature has been silent to date.  Second, the rule’s passage may result in litigation that forces Delaware courts to address the contours of the internal affairs doctrine as it relates to non-Delaware-law-based mandates for diversity on the boards of Delaware corporations.  Some have forcefully argued that other states’ statutes cannot mandate Delaware corporations’ board diversity.[3]  While the proposed listing rule is not a state statute, and may not be viewed as a mandate (given its “adopt or explain” structure), the possibility remains that challenges to the rule under the internal affairs doctrine may arise.

Whatever the outcome of these potential Delaware legislative or judicial endeavors, it is clear that business institutions are moving in the direction of better supporting gender and racial diversity on corporate boards.  In addition to the Nasdaq proposal, institutional giants ISS and Glass Lewis have recently improved their policies related to board diversity.[4]  Whether these developments prove to encounter resistance when stacked up against Delaware law, or instead harmonize nicely, remains to be seen.  In any event, the likelihood that the advancement of board diversity initiatives and requirements will soon require Delaware corporate law to break its silence on the issue is increasing, and fast.

[1] Press Release, Nasdaq to Advance Diversity through New Proposed Listing Requirements Dec. 1, 2020) (available at https://www.nasdaq.com/press-release/nasdaq-to-advance-diversity-through-new-proposed-listing-requirements-2020-12-01).

[2] Nasdaq Stock Market LLC, Form 19b-4 (Dec. 1, 2020) at 8 (available at https://listingcenter.nasdaq.com/assets/rulebook/nasdaq/filings/SR-NASDAQ-2020-081.pdf).

[3] See, e.g., Joseph A. Grundfest, Mandating Gender Diversity in the Corporate Boardroom: The Inevitable Failure of California’s SB 826, Rock Center for Corporate Governance (Sept. 12, 2018) (available at https://www.law.berkeley.edu/wp-content/uploads/2019/10/SSRN-id3248791_3561624_1.pdf).

[4] See ISS, United States Proxy Voting Guidelines Benchmark Policy Recommendations (Nov. 19, 2020)  at 61; Glass Lewis, 2021 Proxy Paper Guidelines:  An Overview of the Glass Lewis Approach to Proxy Advice, at 26-27.

The UN Guiding Principles on Business and Human Rights require companies to embed their commitment to fulfill their responsibilities to respect human rights in the operational policies and procedures that apply throughout the business enterprise.[1]  Embedding has been described as creating the right “macro-level” environment for the company’s human rights policies to be effective in practice through training, performance, and accountability structures, the tone at the top from the board and senior management, and a sense of shared responsibility for meeting the company’s human rights commitments.[2]  There is no universal standard for embedding human rights in a company’s operations and organizational culture.  However, there does appear to be a consensus that companies should begin the process with the full-scale assessment of human rights impacts, relying on both internal resources and external assistance, and then use the information collected during the assessment process to develop a human rights strategy with commitments and performance targets.  Subsequent steps would typically include developing processes and procedures to integrate human rights throughout the organization, including extensive training, and monitoring and measuring progress toward the performance targets; setting up a framework for reporting on human rights activities and performance and other communications to stakeholders relating to human rights; and ensuring that the initiatives relating to human rights are regularly reviewed and that appropriate changes are made to continuously improve performance.[3]

Governance and Management

Research has found that corporate social responsibility (“CSR”) initiatives are most effective when CSR principles have been integrated into the company’s governance and management processes and its organizational culture.  CSR governance begins at the top of the organization with the board of directors, which has been charged by emerging corporate governance guidelines and stakeholder expectations with responsibility for oversight of the environmental and social impacts of the company’s operations.  The directors and members of the senior executive team must proactively respond to the serious challenges confronting business, and society in general, resulting from neglect of important environmental and social issues.  The UN Guiding Principles explicitly call on businesses to demonstrate the commitment of senior management to the due diligence process from the very beginning.  One of the first steps that should be taken is to design and implement appropriate high-level governance arrangements that have been publicly endorsed by the board of directors and senior management.[4] 

CSR and human rights are like any other important management initiatives and require proactive leadership from the top of the organization.  It is clear that the “tone at the top” is an important factor in the success or failure of any effort to embed and integrate human rights into a company’s operations and business relationships.  The directors and senior managers of the company are uniquely positioned to act as internal champions of this process, and they should proactively communicate with everyone in the organization on a daily basis about the steps they believe are necessary to effectively manage the company’s human rights impacts.  The directors and senior managers must also commit to investing the time and effort necessary to explain the company’s human rights initiatives to customers and other stakeholders and must develop and implement metrics for tracking and reporting progress.  While social responsibility certainly extends “beyond the law,” directors and officers must be mindful of their fiduciary duties and understand how laws, regulations, and standard contract provisions are rapidly evolving to incorporate standards for respecting human rights.

Operations

Even in large organizations, concern for human rights due diligence may begin with just one person or a small group of persons with a passion for the subject.  However, like any other important project, due diligence requires project management skills, structures and widespread participation and support.  Companies should form a human rights steering or working group, either as a totally new entity or perhaps by extending the charter of an existing group working on related issues such as ethics.  The working group should include senior managers from all relevant areas of the organization including social , legal, environmental and/or sustainability, human resources, worker/trade union representatives, operations/production, compliance and ethics, procurement (including supply chain and business relationships), sales and marketing, community development, external affairs/reporting, risk management, mergers and acquisitions, and audit.  It is important for the working group to be cross-functional in order to avoid a “siloed” approach and ensure that input is solicited and obtained from stakeholders across all of the levels and functions within the organization.  The specific composition of the working group will depend on the activities and size of the company and the specific risks it faces.  

One important issue to consider when attempting to organize and manage a cross-functional initiative is ensuring that each of the functions and departments involved in the process understands why the company is undertaking human rights due diligence, their specific role in the process, how due diligence will impact their day-to-day activities, and how their performance will be assessed by senior management and others throughout the organization.  Each function or department will have its own set of salient human rights issues based on its specific activities (e.g., human resources will be concerned with industrial relations and working conditions while the information technology group will be focused on privacy).  Leaders of a function or department may be concerned about the effect that human rights due diligence will have on their limited resources and the changes that might have to be made in historical practices in order to accommodate the requirements of due diligence.  While critics of corporate efforts to act responsibly complain when it appears that a decision to “do the right thing” turns on an attractive business case, the reality is that many managers will be more motivated when they are shown how addressing human rights risks will improve their traditional financial-based bottom line. However, the responsibility to carry out human rights due diligence applies regardless of any business case argument.[5] 

Strategy

Once the assessment of the company’s human rights impacts has been completed and the company has identified and prioritized its own unique set of salient human rights issues and actions, attention needs to turn to:

• developing a human rights strategy, a process which includes building support among the directors, senior management and employees;
• researching what others are doing, and assessing the value of recognized voluntary human rights initiatives and instruments;
• preparing a matrix of proposed actions; developing ideas for proceeding and the business case for them; and
• deciding on direction, approach, boundaries, and focus areas.[6] 

As with any other strategic initiative, human rights activities must be institutionalized in the organization in order to be sustainable and thus it is essential that respect for human rights be seen to be inherent in the organizational culture and adopted as part of the company’s long term strategy and decision-making rather than being seen as an “add on” that can be discarded when circumstances change (e.g., when an economic downturn creates pressures to divert resources away from sustainability initiatives).[7]  Like any other strategy, a human rights strategy reflects decisions among multiple potential projects and provides a path for implementation, assigns roles and responsibilities throughout the organization, establishes timetables for completion of various tasks, and incorporates metrics to measure progress and performance.  The strategy should also be aligned with the company’s core values and standards. 

The strategy itself should include a mission statement, goals and commitments, policies and procedures, key performance indicators, a clear allocation of responsibilities for the implementation of the strategy, procedures for reporting on progress, and regular evaluation of the strategy.  As the strategy moves toward finalization, it should circulated to key stakeholders for their input, a step that not only improves the strategy but creates a sense of participation among stakeholders that will help to ultimately garner their support.[8]  Once the company is actively engaged in implementing the strategy, it is essential to measure and assure performance, engage stakeholders, and report on performance, both internally and externally. The human rights working group described elsewhere in this article must evaluate performance, identify opportunities for improvement, and engage with stakeholders on implementing changes.

Commitments

Once the human rights strategy has been completed, it is time to move forward with developing and implementing human rights commitments.  Developing those commitments involves doing a scan of existing commitments relating to human rights issues; holding discussions with major stakeholders; creating a working group to develop the commitments; preparing a preliminary draft of the commitments; and consulting with the affected stakeholders.  In order to implement the commitments, steps must be taken to develop an integrated decision-making structure; prepare and implement a strategic plan; set measurable targets and identify performance measures; engage employees and others to whom the commitments apply; design and conduct training; establish mechanisms for addressing problematic behavior; create internal and external communications plans; and make commitments public. 

Commitments should address human rights-related targets for each of the company’s key stakeholders and institutionalize associated processes such as stakeholder engagement, collaborations with value chain partners, and sustainability reporting and communications.  The commitments should be closely aligned to the list of salient human rights issues created earlier in the assessment and implementation process.  Alignment makes it easier for the company to focus its attention on a relatively short list of commitments that are easily to describe, such as the following:[9]

• Employee health and safety: Ensuring that employees work in a safe environment which meets or exceeds relevant regulatory expectations, addresses health and safety concerns as they arise, and mitigates opportunities for reoccurrence of incidents.
• Product quality and safety to customers: Choosing materials from quality sources, complying with current “good manufacturing practice,” and delivering fit-for-purpose, safe products to customers that adhere to or exceed strict regulatory standards in all jurisdictions served by the company.
• Corruption and bribery: Business must be conducted with transparency and free from unethical persuasion in every aspect of the company’s business from identifying product sources, through development of new products, transactions with regulatory bodies, and sale to customers.
• Ethical purchasing and human rights in the supply chain: Responsibility to partners to ensure our product line is free from human rights concerns such as forced labor and trafficking, unsafe labor standards, and unfair treatment.
• Compliance: Responsibility to drive compliance with legal and regulatory requirements applicable to our global business including training programs, continuous improvement, and striving for best practices.
• Resource use and waste management: Reducing the environmental impact of the company’s operational activities by managing energy usage during manufacture and logistics, water usage, and waste as a by-product of manufacture.
• Employee development: Offering employees the opportunity to develop their professional skills mentoring, technical training, and continuing education programs.
• Making maximum use of new technology: Developing and acquiring new technologies to improve productivity and operational efficiency in an environmentally and socially responsible manner.

Human rights commitments are generally formalized in a separate commitment statement that is made available to all stakeholders for viewing on the company’s website along with other documents and instruments pertaining to the company’s governance and operational guidelines.  Statements regarding human rights commitments are accompanied by principles and policies, including a code of corporate conduct that covers legal compliance, financial responsibility, fair competition, prohibitions on bribery and corruption, conflicts of interest, customer relationships, supply chain relationships, workplace conditions and employee wellbeing, environmental responsibility, and community relations; environmental policies; human resources policies; and principles of responsible purchasing.[10]

Performance Targets

Once the human rights commitments have been selected, the company needs to define the target level for its performance with respect to each of the commitments.  When setting the targets, consideration should be given to both effectively managing material risks to the business and rights holders and meeting expectations of key stakeholders.  The initial target level depends on the current status of the company’s activities, and companies should expect to periodically review and, as appropriate, reset the targets.  At a minimum, companies need to comply with all laws and regulations applicable to their business operations. However, a serious effort goes beyond minimum compliance to include both surpassing the requirements of laws and regulations and making and keeping voluntary commitments selected by the company that are related to the company’s key human rights impacts.  The next level is meeting the expectations of markets and stakeholders, which inevitably exceeds legal and regulatory compliance and can be understood only through a process of extensive engagement with investors and other key stakeholders.  Finally, some companies may progress to the point where they become recognized as being among the leaders of best practices with respect to human rights due diligence.[11]

Processes and Procedures

Companies need to establish processes and procedures to support the implementation of their human rights strategies that span the full scope of their business activities and functions.  Among other things, the company needs to implement processes for identifying its human rights-related risks and opportunities, such as the matrix approach described above, and understanding business, cultural, economic, and political conditions in each of the geographic locations in which it is currently operating or intends to operate in the future.  It is particularly important for companies to establish control systems for managing the human rights-related aspects of their business.  Common approaches include incorporating social and environmental criteria into every assessment of a new project; a supplier qualification process that considers compliance criteria along with other factors such as cost, speed, quality, and innovation; mandatory reviews of prospective customers’ human rights record and processes; codes of conduct; checklists and instructions for business operations in sensitive areas including scheduled and unscheduled inspections; supplier guidelines, including requirements for independent audits and certification in accordance with internationally-recognized standards and sector-specific initiatives; and mandatory requirements relating to human rights due diligence in standard contracts for common business relationships.[12]

Communications and Reporting

Companies should be prepared to communicate with stakeholders regarding their human rights strategies, policies, procedures, and performance using a variety of internal and external communications and reporting tools, including codes of conduct, the company’s website, company publications, annual reports, and notice boards.  Information should be presented in local languages and stakeholders, particularly employees, should be able to understand the performance indicators that the company is using to track its human rights initiatives in order to influence behaviors and guide decision-making during day-to-day operational activities.  Information should be readily accessible and should be presented in a format that can be readily understood by all affected stakeholders.  Planning for communications should also include developing and publicizing tools for stakeholders to safely pose questions and raise concerns regarding the company’s human rights performance.  Companies should engage regularly with key stakeholders to discuss issues relating to the relationship between them including dissemination of information and the effectiveness of consultation processes.  Formal reporting, either in a free-standing document or as part of the company’s annual report, should not only conform to applicable legal requirements but also use an effective reporting format that addresses the company’s key stakeholders and provides them with a full and transparent picture of the impact of the company’s operations on human rights and the steps that the company is taking to prevent adverse impacts.[13]

Reviewing and Improving

Effective performance relating to social responsibility and respect for human rights depends on commitment, careful oversight, evaluation, and review of the activities undertaken, progress made, achievement of identified objectives, resources used, and other aspects of the company’s efforts.  Regular monitoring and review of human rights performance ensures that the company understands whether its strategies and programs are proceeding as intended and allows the company to identify problems and issues and to take remedial actions including changes in programs and shifts in the human rights issues that are given the greatest attention.  While many of the monitoring and review activities are internal—tracking metrics on progress toward human rights-related goals tied to operational matters—consideration must also be given to the opinions and insights available from external stakeholders.  Companies must continuously review changing conditions or expectations, legal or regulatory developments affecting social responsibility, and new opportunities for enhancing their efforts on social responsibility.[14]  One of the most important tools with respect to review and improvement is the grievance mechanisms that should be established as part of the human rights due diligence process, mechanisms which not only provide stakeholders with an easily accessible means for providing feedback on the company’s human rights performance but also enable the company to identify situations that require additional attention and perhaps changes in policies and practices.

This article is an excerpt from the author’s new book, Business and Human Rights: Advising Clients on Respecting and Fulfilling Human Rights, published by the ABA Section of Business Law.  More information on the book is available here.

[1] Alan S. Gutterman is a business counselor and prolific author of practical guidance and tools for legal and financial professionals, managers, entrepreneurs and investors on topics including sustainable entrepreneurship, leadership and management, business law and transactions, international law and business and technology management.  He is the co-editor and contributing author of several books published by the ABA Business Law Section including The Lawyer’s Corporate Social Responsibility Deskbook, Emerging Companies Guide (3^rd Edition) and Business and Human Rights: A Practitioner’s Guide for Legal Professionals.  More information about Alan and his work is available at his personal website at www.alangutterman.com.

[2] Doing business with respect for human rights: A guidance tool for companies (Global Compact Network Netherlands, Oxfam, and Shift, 2016), 40.

[3] For discussion of an effective enterprise-wide culture relating to respect for human rights, including schematic diagrams attempting to capture the spectrum of diverse corporate cultures in this context, see S. Maslow, Business and Ethical Challenges: Human Rights Requirements, Due Diligence, Remediation and Brand Protection (Business Law Today, November 4, 2019).  The article suggests the following spectrum of corporate cultures: “good global citizen” (active anti-human rights violations policies and procedures), “rule follower” (some recognition of applicable law); “two-facer” (policies only); “eyes wide shut” (plausible deniability); “negligent actor” (“benign” neglect); and “bad actor” (endorsement).  Each of these cultures has a unique approach to managing involvement in human rights harm and preventing violations.

[4] Background Note: “Corporate human rights due diligence—Identifying and leveraging emerging practice” (UN Working Group on Business and Human Rights, April 2018), 4-5.

[5] The report of the Working Group on the issue of human rights and transnational corporations and other business enterprises (UN Working Group on Business and Human Rights, July 16, 2018), 6. 

[6] P. Hohnen (Author) and J. Potts (Editor), Corporate Social Responsibility: An Implementation Guide for Business (Winnipeg CAN: International Institute for Sustainable Development, 2007), 68.

[7] F. Maon, V. Swaen and A. Lindgreen, Mainstreaming the Corporate Responsibility Agenda: A Change Model Grounded in Theory and Practice (IAG- Louvain School of Management Working Paper, 2008), 37.

[8] CSR Self-Assessment Handbook for Companies (Vilnius, Lithuania: UAB “Baltijos kopija” (Financed by the European Union and United Nations Development Programme), 2010), 13-14.

[9] Based on Mayne Pharma Group Limited Sustainability Report 2016, 12, https://www.maynepharma.com/media/1896/myx_2016_sustainability_report.pdf.

[10] Finnish Textile & Fashion Corporate Responsibility Manual (Helsinki: Finnish Textile & Fashion, 2016), 12.

[11] Id.

[12] A Guide for Integrating Human Rights into Business Management (Business Leaders Initiative on Human Rights, United Global Compact and Office of the High Commissioner for Human Rights, 2004), 24-27.  The Guide encouraged companies to tap into the resources of sector-specific initiatives with expertise in human rights codes and procedures including the Ethical Trading Initiative, Fair Labor Association, Social Accountability 8000, the Voluntary Principles on Security and Human Rights, the Extractive Industries Transparency Initiative, the Equator Principles and the Electronic Industry Code of Conduct.  Id. at 27.

[13] Id. at 28-30, 36.

[14] ISO 26000 Guidance on Social Responsibility (Geneva: International Organization for Standardization, 2010), 81.