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Fall 2021 Cover

Alainna Nichols — Wed, 27 Oct 2021 15:44:37 GMT

NEW – LIBOR Floor Provisions: Market Trends 2020/2021

sheika — Wed, 18 Aug 2021 09:53:18 GMT

This practice note discusses LIBOR floor provisions, including current market trends in publicly filed credit agreements and commitment letters from the second half of 2020 and first half of 2021. Lenders tended to increase LIBOR floor percentages in 2020 during the height of COVID-19 in response to the dropping LIBOR benchmark rate. With a stabilizing market in 2021 and the end of LIBOR as a benchmark rate in sight, lenders have not focused on LIBOR floors in recent transactions and LIBOR floor rates have fallen back closer to the norm of 0% in the first half of 2021.

The following analysis is based on 123 publicly filed credit agreements that included a LIBOR floor from the second and third quarters of 2020 and 186 publicly filed credit agreements that included a LIBOR floor from the fourth quarter of 2020 and the first quarter of 2021. The data analyzed in this practice note was obtained using Market Standards, the searchable database from Practical Guidance of publicly filed credit agreements and commitment letters that enables users to search, compare, and analyze over 2300 credit agreements using approximately 90 detailed deal points and over 370 commitment letters using approximately 70 deal points to filter search results. For more information on Market Standards, click here.

For more information on recent trends concerning LIBOR floors, see Interest Rate Provisions in Credit Agreements, SOFR Loan Documentation: 8 Things for Borrowers to Think About, The Client Asks: What Happens When LIBOR Ends?, and LIBOR Replacement Resource Kit.

LIBOR Floor Provisions

Countries sometimes attempt to stimulate their economies by reducing benchmark interest rates, including LIBOR. Benchmark rates have at times been reduced to zero or even been negative. Due to the potential for benchmark rates to be reduced, lenders often include a benchmark floor in their credit agreements, which commonly was 0% prior to COVID-19.

During the height of COVID-19 in the second and third quarters of 2020, the U.S. Federal Reserve lowered benchmark rates to near zero. Many lenders began to counteract such decline in benchmark rates by increasing the LIBOR floor in their transactions to percentages greater than zero, typically in the range of 0.5% to 1.25%. Due to optimism that the economy is recovering and as the LIBOR cessation date is approaching at the end of 2021, banks have become less focused on increasing LIBOR floors. In the last quarter of 2020 and into 2021, the number of transactions with a LIBOR floor above 0% has steadily declined.

Out of 123 credit agreements surveyed from the second and third quarters of 2020 that included LIBOR floors, 64 deals (52%) included a LIBOR floor greater than 0%, and 59 deals (48%) included a 0% LIBOR floor.

Visualization of LIBOR Floors Q2 2020 and Q3 2020

Source: Market Standards, date range 4/1/2020 to 9/30/2020

Of those 64 deals with a LIBOR floor greater than 0%, 57 deals had a LIBOR floor between 0.1% and 1%. Seven deals had a LIBOR floor greater than 1% ranging from 1.5% to 2%.

Out of 186 credit agreements surveyed from the fourth quarter of 2020 and the first quarter of 2021 that included a LIBOR floor, 50 (27%) deals included a LIBOR floor greater than 0% ranging from 0.25% to 1%. The remaining 136 (73%) deals had a LIBOR floor of 0%.

Visualization of LIBOR Floors Q4 2020 and Q1 2021

Source: Market Standards, date range 10/1/2020 to 3/31/2021

Examples of Publicly Filed Credit Agreements in Lexis Market Standards

Camping World Holdings, Inc.

Agreement Date	June 3, 2021
Agreement	Credit Agreement
Company	CWGS Group, LLC
Administrative Agent	Goldman Sachs Bank USA
Facility Size/Type	$1.1 billion initial term loan commitment $65 million initial revolving commitment
Industry	Retail—Auto Dealers and Gasoline Stations
Applicable Interest Rate Margin	Ranges from 2.25% to 2.50% for Eurocurrency loans depending on borrower's total net leverage ratio Ranges from 1.25% to 1.50% for ABR loans depending on borrower's total net leverage ratio
LIBOR Floor	The LIBO Screen Rate will be deemed to be 0%, if such rate would otherwise be determined to be less than 0% Solely with respect to the initial term loans, the LIBO Screen Rate will be deemed to be 0.75%, if such rate would otherwise be less than 0.75%

Stitch Fix, Inc.

Agreement Date	June 2, 2021
Agreement	Amended and Restated Credit Agreement
Company	Stitch Fix, Inc.
Administrative Agent	Silicon Valley Bank
Facility Size/Type	$100 million revolving commitment
Industry	Retail—Catalog and Mail-Order
Applicable Interest Rate Margin	25% for Eurodollar loans 1.25% for ABR loans
LIBOR Floor	Eurodollar base rate shall not be less than 0%

MSA Safety Inc.

Agreement Date	May 24, 2021
Agreement	Fourth Amended and Restated Credit Agreement
Company	MSA Safety Incorporated, et al.
Administrative Agent	PNC Bank, National Association
Facility Size/Type	$900 million revolving credit facility
Industry	Orthopedic, Prosthetic and Surgical Appliances, and Supplies
Applicable Interest Rate Margin	Ranges from 0.875% to 1.750% for LIBOR rate loans depending on borrower's net leverage ratio Ranges from 0.000% to 0.750% for base rate loans depending on borrower's net leverage ratio
LIBOR Floor	Benchmark rate floor applicable to the LIBOR rate, if not otherwise specified, is 0%

Chipotle Mexican Grill, Inc.

Agreement Date	April 13, 2021
Agreement	Revolving Credit Agreement
Company	Chipotle Mexican Grill, Inc.
Administrative Agent	JPMorgan Chase Bank, N.A.
Facility Size/Type	$500 million revolving commitment
Industry	Retail—Eating Places
Applicable Interest Rate Margin	Ranges from 1.375% to 2.125% for Eurodollar loans depending on borrower's total leverage ratio Ranges from 0.375% to 1.125% for ABR loans depending on borrower's total leverage ratio
LIBOR Floor	If the LIBO Screen Rate is less than 0%, then such rate shall be deemed to be 0% for purposes of the credit agreement

Petiq, LLC

Agreement Date	April 13, 2021
Agreement	Term Credit and Guaranty Agreement
Company	Petiq, LLC
Administrative Agent	Jefferies Finance LLC
Facility Size/Type	$500 million revolving commitment
Industry	Wholesale—Drugs, Drug Proprietaries, and Druggists' Sundries
Applicable Interest Rate Margin	25% for Eurodollar rate loans 3.25% for base rate loans
LIBOR Floor	Adjusted Eurodollar rate shall at no time be less than 0.50%

American Electric Power Company, Inc.

Agreement Date	March 31, 2021
Agreement	Credit Agreement
Company	American Electric Power Company, Inc.
Administrative Agent	Wells Fargo Bank, National Association
Facility Size/Type	$1 billion revolving commitment
Industry	Electric Services
Applicable Interest Rate Margin	Ranges from 1.000% to 1.750% for Eurodollar rate advances depending on borrower's credit rating level Ranges from 0.000% to 0.750% for base rate advances depending on borrower's credit rating level
LIBOR Floor	If the Eurodollar rate is less than 0%, it shall be deemed to be 0% for purposes of the credit agreement

Community Healthcare Trust Inc.

Agreement Date	March 19, 2021
Agreement	Third Amended and Restated Credit Agreement
Company	Community Healthcare Trust Incorporated
Administrative Agent	Truist Bank
Facility Size/Type	$400 million revolving and term commitments
Industry	Real Estate Investment Trusts
Applicable Interest Rate Margin	Eurodollar Rate: Ranges from 0.775% to 1.45% for revolving Eurodollar rate loans depending on borrower's credit ratings Ranges from 1.15% to 1.70% for A-2 term Eurodollar rate loans depending on borrower's credit ratings Ranges from 1.35% to 1.90% for A-3/A-4 term Eurodollar rate loans depending on borrower's credit ratings Base Rate: Ranges from 0.00% to 0.45% for revolving base rate loans depending on borrower's credit ratings Ranges from 0.15% to 0.70% for A-2 term base rate loans depending on borrower's credit ratings Ranges from 0.35% to 0.90% for A-3/A-4 term base rate loans depending on borrower's credit ratings
LIBOR Floor	If the LIBOR rate is less than 0%, such rate is deemed to be 0%

Brightsphere Investment Group Inc.

Agreement Date	February 23, 2021
Agreement	Amended and Restated Revolving Credit Agreement
Company	Acadian Asset Management LLC, as assignee of Brightsphere Investment Group Inc.
Administrative Agent	Citibank, N.A.
Facility Size/Type	$125 million revolving commitment
Industry	Investment Advice
Applicable Interest Rate Margin	Ranges from 1.50% to 2.00% for Eurodollar loans Ranges from 0.50% to 1.00% for ABR loans
LIBOR Floor	If the LIBO Screen Rate is less than zero, such rate shall be deemed to be 0% for purposes of the credit agreement

PPG Industries, Inc.

Agreement Date	February 19, 2021
Agreement	Term Loan Credit Agreement
Company	PPG Industries, Inc.
Administrative Agent	PNB Paribas
Facility Size/Type	$2 billion term loan commitment
Industry	Paints, Varnishes, Lacquers, Enamels, and Allied Products
Applicable Interest Rate Margin	Ranges from 0.750% to 1.250% for Eurocurrency rate loans depending on borrower's credit ratings Ranges from 0.000% to 0.250% for base rate loans depending on borrower's credit ratings
LIBOR Floor	If the LIBO rate is less than 0%, such rate shall be deemed to be 0% for purposes of the credit agreement

Credit Acceptance Corp.

Agreement Date	January 29, 2021
Agreement	Loan and Security Agreement
Company	Credit Acceptance Funding LLC 2021-1
Administrative Agent	Fifth Third Bank
Facility Size/Type	$100 million term commitment
Industry	Personal Credit Institutions
Applicable Interest Rate Margin	0% for prime rate or Fed funds rate loans N/A for benchmark rate loans calculated using the LIBOR rate
LIBOR Floor	In the event that the LIBOR rate is less than 0%, such rate shall be deemed to be 0% for purposes of the credit agreement

Express, LLC

Agreement Date	January 13, 2021
Agreement	Asset-Based Term Loan Agreement
Company	Express, LLC
Administrative Agent	Wells Fargo Bank, National Association
Facility Size/Type	$90 million term loan commitment $50 million delayed draw term loan commitment
Industry	Retail—Apparel & Accessory Stores
Applicable Interest Rate Margin	Ranges from 7.00% to 8.25% for LIBO rate loans depending on borrower's level of EBITDA Ranges from 6.00% to 7.25% for base rate loans depending on borrower's level of EBITDA
LIBOR Floor	If at any time the published LIBO rate is below 0%, then the LIBO rate determined for the credit agreement shall be deemed to be 0%

AssetMark Financial Holdings, Inc.

Agreement Date	December 30, 2020
Agreement	Credit Agreement
Company	AssetMark Financial Holdings, Inc.
Administrative Agent	Bank of Montreal
Facility Size/Type	$250 million revolving commitment
Industry	Investment Advice
Applicable Interest Rate Margin	Ranges from 2.000% to 3.625% for Eurodollar loans depending on borrower's total leverage ratio for the applicable pricing date Ranges from 1.000% to 2.625% for base rate loans depending on borrower's total leverage ratio for the applicable pricing date
LIBOR Floor	If LIBOR as determined is less than 0%, LIBOR will be deemed to be 0% for purposes of the credit agreement

Matrix Service Company

Agreement Date	November 2, 2020
Agreement	Fifth Amended and Restated Credit Agreement
Company	Matrix Service Company
Administrative Agent	JPMorgan Chase Bank, N.A.
Facility Size/Type	$200 million revolving commitment
Industry	Construction—Special Trade Contractors
Applicable Interest Rate Margin	Ranges from 2.00% to 3.00% for Eurocurrency, EURIBOR, and CDOR loans depending on borrower's leverage ratio Ranges from 1.00% to 2.00% for ABR loans depending on borrower's leverage ratio Ranges from 2.50% to 3.50% for Canadian prime rate loans depending on borrower's leverage ratio
LIBOR Floor	If any screen rate (including the LIBO rate) is less than 0%, such rate shall be deemed to be 0% for purposes of the credit agreement

DoubleVerify Holdings, Inc.

Agreement Date	October 1, 2020
Agreement	Amendment and Restatement Agreement
Company	DoubleVerify Inc.
Administrative Agent	Capital One, N.A.
Facility Size/Type	$150 million revolving commitment
Industry	Services—Computer Programming
Applicable Interest Rate Margin	Ranges from 2.00% to 2.75% for Eurodollar loans depending on borrower's total net leverage ratio Ranges from 1.00% to 1.75% for ABR loans depending on borrower's total net leverage ratio
LIBOR Floor	Eurodollar base rate shall not be deemed to be less than 0.75%

Purple Innovation, LLC

Agreement Date	September 3, 2020
Agreement	Credit Agreement
Company	Purple Innovation, LLC
Administrative Agent	KeyBank National Association
Facility Size/Type	$55 million revolving commitment $45 million term loan commitment
Industry	Household Furniture
Applicable Interest Rate Margin	Ranges from 3.00% to 3.75% for Eurodollar rate loans depending on borrower's consolidated net leverage ratio Ranges from 2.00% to 2.75% for base rate loans depending on borrower's consolidated net leverage ratio
LIBOR Floor	Adjusted Eurodollar rate is the greater of 0.50%, and LIBOR If benchmark replacement for adjusted Eurodollar rate is less than 0.50%, then such rate will be deemed to be 0.50% for purposes of the credit agreement

Pyxus International, Inc.

Agreement Date	August 24, 2020
Agreement	Exit Term Loan Credit Agreement
Company	Pyxus Holdings, Inc.; Pyxus International, Inc.; Pyxus Parent, Inc.
Administrative Agent	Alter Domus (US) LLC
Facility Size/Type	$213.42 million term commitment
Industry	Wholesale—Farm Product
Applicable Interest Rate Margin	00% for LIBO rate loans 00% for prime rate loans 0.50% for Fed funds rate loans
LIBOR Floor	In no event shall the LIBO rate be less than 1.5%

Doordash, Inc.

Agreement Date	August 7, 2020
Agreement	Amended and Restated Agreement
Company	Doordash, Inc.
Administrative Agent	JPMorgan Chase Bank, N.A.
Facility Size/Type	$300 million original revolving commitment $100 million incremental revolving commitment
Industry	Services—Business Services, Not Elsewhere Classified
Applicable Interest Rate Margin	00% for Eurodollar loans 0.00% for ABR loans
LIBOR Floor	If the LIBO Screen Rate as determined is less than 0%, the Screen Rate shall for all purposes of the credit agreement be 0%

Waste Management, Inc.

Agreement Date	July 28, 2020
Agreement	Credit Agreement
Company	Waste Management, Inc.
Administrative Agent	Mizuho Bank, Ltd.
Facility Size/Type	$3 billion revolving commitment
Industry	Refuse Systems
Applicable Interest Rate Margin	Ranges from 1.00% to 1.30% for Eurocurrency rate loans depending on borrower's credit ratings Ranges from 0.000% to 0.300% for base rate loans depending on borrower's credit ratings
LIBOR Floor	If the Eurocurrency rate is less than 0%, then such rate shall be deemed 0% for purposes of the credit agreement

Axogen, Inc.

Agreement Date	June 30, 2020
Agreement	Term Loan Agreement
Company	Axogen, Inc.
Administrative Agent	Argo SA LLC
Facility Size/Type	$75 million term loan commitment
Industry	Electromedical and Electrotherapeutic Apparatus
Applicable Interest Rate Margin	7.5% for LIBOR rate loans
LIBOR Floor	LIBOR floor is 2.0%

Carnival Corporation

Agreement Date	June 30, 2020
Agreement	Term Loan Agreement
Company	Carnival Corporation Carnival Finance LLC
Administrative Agent	JPMorgan Chase Bank, N.A.
Facility Size/Type	$1.86 billion term loan facility
Industry	Water Transportation
Applicable Interest Rate Margin	50% for base rate loans 50% for LIBOR rate loans 7.50% for EURIBOR rate loans
LIBOR Floor	If the LIBO Screen Rate is less than 0%, then such rate shall be deemed to be 0% for purposes of the credit agreement

Examples of Publicly Filed Commitment Letters in Lexis Market Standards

Oasis Petroleum Inc.

Commitment Date	May 3, 2021
Agreement	Commitment Letter
Company	Oasis Petroleum Inc.
Administrative Agent	JPMorgan Chase Bank, N.A.
Facility Size/Type	$500 million bridge commitment
Industry	Crude Petroleum and Natural Gas
Applicable Interest Rate Margin	6.50% increasing by 0.50% at the end of each three month period after closing for Eurodollar rate loans
LIBOR Floor	If the LIBO Screen Rate is less than 1.0%, such rate shall be deemed to be 1.0% for purposes of calculating such rate

Skyworks Solutions, Inc.

Commitment Date	April 22, 2021
Agreement	Project Mansfield US$2,500,000,000 Bridge Facility Commitment Letter
Company	Skyworks Solutions, Inc.
Administrative Agent	JPMorgan Chase Bank, N.A.
Facility Size/Type	$2.5 billion bridge facility commitment
Industry	Semiconductors and Related Devices
Applicable Interest Rate Margin	Ranges from 1.125% to 2.000% for LIBO rate loans depending on borrower's credit ratings Ranges from 0.125% to 1.000% for base rate loans depending on borrower's credit ratings
LIBOR Floor	If the LIBO Screen Rate is less than 0%, such rate shall be deemed to be 0%

Synnex Corporation

Commitment Date	March 22, 2021
Agreement	Project Spire Bridge Commitment Letter
Company	Synnex Corporation
Administrative Agent	Citibank, N.A.; Citicorp USA, Inc.; Citicorp North America, Inc.; Citigroup Global Markets Inc.
Facility Size/Type	$1.5 billion senior unsecured term bridge facility commitment $2.5 billion senior unsecured term bridge facility commitment $3.5 billion senior unsecured revolving credit facility commitment
Industry	Wholesale—Computers, Peripherals, and Software
Applicable Interest Rate Margin	Ranges from 1.125% to 1.750% for LIBOR loans depending on borrower's credit ratings Bridge unused fee ranges from 0.125% to 0.300% depending on borrower's credit ratings For ABR loans, margin is 1.00% less than margin for LIBOR loans but in any event not less than 0%
LIBOR Floor	Adjusted LIBOR is the greater of 0% and LIBOR as determined

Perspecta Inc.

Commitment Date	February 18, 2021
Agreement	Project Jagman Amended and Restated Commitment Letter
Company	Peraton Corp.; Peraton Inc.
Administrative Agent	JPMorgan Chase Bank, N.A.; Alter Domus (US) LLC
Facility Size/Type	$3,775,000 senior secured incremental term loan facility commitment $200 million incremental revolving commitment $1,340,000 incremental senior secured second lien term loan facility commitment
Industry	Services—Computer Processing and Data Preparation and Processing
Applicable Interest Rate Margin	For first lien incremental term facility, 4.25% for LIBOR loans and 3.25% for base rate loans with two 0.25% step downs depending on borrower's first lien leverage ratio Margin for incremental revolving facility is the same as for the existing revolving facility For second lien incremental term facility, 8.00% for LIBOR loans and 7.00% for base rate loans
LIBOR Floor	LIBOR for purposes of calculating interest on any loan under the second lien term facility shall be deemed to be not less than 0.75%

Vielo Bio, Inc.

Commitment Date	January 31, 2021
Agreement	Project Venus Commitment Letter
Company	Horizon Therapeutics USA Inc.
Administrative Agent	Citibank, N.A.
Facility Size/Type	$1.3 billion incremental term loan commitment
Industry	Pharmaceutical Preparations
Applicable Interest Rate Margin	25% for LIBO rate loans 25% for alternate base rate loans Rates step down 0.25% depending on borrower's total net leverage ratio
LIBOR Floor	In no event shall the LIBO rate applicable to the term loan facility be less than 0.50%

Seacor Holdings Inc.

Commitment Date	December 4, 2020
Agreement	Project Safari Commitment Letter
Company	Safari Parent, Inc.
Administrative Agent	HPS Investment Partners, LLC Ally Bank
Facility Size/Type	$395.60 million first lien term loan facility commitment $169.40 million first lien delayed draw facility commitment $100 million senior secured asset-based facility commitment
Industry	Deep Sea Foreign Transportation of Freight Establishments
Applicable Interest Rate Margin	For term loan facility: 6.75% for LIBOR rate loans, and 5.75% for ABR loans, with two step down adjustments of 0.25% each depending on borrower's total net leverage ratio For ABL loans: ○ Ranges from 2.00% to 2.50% for Eurodollar loans excluding supplemental amount and from 4.00% to 4.50% for supplemental amount, depending on average excess availability ○ Ranges from 1.00% to 1.50% for ABR loans excluding supplemental amount and from 3.00% to 3.50% for supplemental amount, depending on average excess availability
LIBOR Floor	Adjusted LIBOR in no event shall be less than 1.0%

Tuesday Morning Corp.

Commitment Date	November 2, 2020
Agreement	Commitment Letter
Company	Tuesday Morning, Inc.
Administrative Agent	JPMorgan Chase Bank, N.A.
Facility Size/Type	$110 million senior secured revolving credit facility commitment
Industry	Retail—Variety Stores
Applicable Interest Rate Margin	For the first 12 months after closing, 2.75% for Eurodollar rate loans and 1.75% for CB floating rate loans After the first 12 months, ranges from 2.25% to 2.75% for Eurodollar loans depending on excess availability After the first 12 months, ranges from 1.25% to 1.75% for CB floating rate loans depending on excess availability
LIBOR Floor	The adjusted LIBO rate shall have a floor of 0.50% at all times

Modivcare Inc.

Commitment Date	September 28, 2020
Agreement	Commitment Letter
Company	The Providence Service Corporation
Administrative Agent	Jefferies Finance LLC
Facility Size/Type	$30 million senior secured first lien revolving facility commitment $600 million senior unsecured bridge loan facility commitment
Industry	Transportation Services
Applicable Interest Rate Margin	For revolving credit loans, 4.00% for LIBOR loans and 3.00% for base rate loans For bridge loans, 5.25% for LIBOR loans with increases of 0.50% each three-month period after closing
LIBOR Floor	Three-month LIBOR shall in no event be less than 1.0%

Roper Technologies, Inc.

Commitment Date	August 12, 2020
Agreement	Bridge Facility Commitment Letter
Company	Roper Technologies, Inc.
Administrative Agent	Bank of America, N.A.
Facility Size/Type	$4 billion 364-day senior unsecured bridge facility commitment ($2.5 million tranche A and $1.5 million tranche B)
Industry	Industrial Instruments
Applicable Interest Rate Margin	Ranges from 1.00% to 1.75% for LIBOR loans depending on borrower's credit ratings Ranges from 0.00% to 0.75% for alternate base rate loans depending on borrower's credit ratings
LIBOR Floor	If the LIBOR rate (or the base rate) is less than 0%, such rate shall be deemed 0% for purposes of the bridge facility

California Resources Corporation

Commitment Date	July 15, 2020
Agreement	Senior Secured Superpriority Debtor-In-Possession Revolving Credit Facility Commitment Letter
Company	California Resources Corporation
Administrative Agent	JPMorgan Chase Bank, N.A.
Facility Size/Type	$483,010,655.62 senior secured superpriority debtor-in-possession revolving credit facility commitment
Industry	Crude Petroleum and Natural Gas
Applicable Interest Rate Margin	50% for LIBOR loans 3.50% for base rate loans
LIBOR Floor	1.00% LIBOR floor

To find this article in Lexis Practical Guidance, follow this research path:

RESEARCH PATH: Practical Guidance, Finance

Cannabidiol (CBD) Regulatory Landscape and Enforcement Risks

Alainna Nichols — Fri, 11 Jun 2021 15:44:53 GMT

By: Cori Annapolen Goldberg, Adam Brownrout, and Sung Park, Reed Smith LLP

This article provides an overview of the federal and state agencies regulating hemp and cannabidiol (CBD) products, as well as an overview of current federal and state regulations and requirements for the marketing and sale of CBD products.

Federal Legalization of Industrial Hemp and CBD

Prior to 2018, industrial hemp and industrial hemp-derived compounds, such as CBD, were considered marijuana under federal law. Until that time, marijuana compounds were identified as Schedule 1 substances under the Controlled Substances Act of 1970 (CSA).¹

The Agricultural Improvement Act of 2018 (2018 Farm Bill), which became U.S. law in December 2018, expressly removed hemp from the definition of marijuana under the CSA, thereby legalizing industrial hemp and industrial hemp-derived compounds. Under the 2018 Farm Bill, hemp was defined as “the plant Cannabis sativa L. and any part of that plant, including the seeds thereof and all derivatives, extracts, cannabinoids, isomers, acids, salts, and salts of isomers, whether growing or not, with a delta-9 tetrahydrocannabinol concentration of not more than 0.3% on a dry weight basis.”

Along with legalizing industrial hemp, the 2018 Farm Bill also assigned to the U.S. Department of Agriculture (USDA) federal regulatory authority for production of industrial hemp. Importantly, however, the 2018 Farm Bill also included a carve-out provision under which the U.S. Food and Drug Administration (FDA) retained its ability to regulate products subject to the federal Food, Drug and Cosmetic Act (FDCA).

USDA Oversight

The 2018 Farm Bill tasked the USDA with promulgating regulations and guidelines to establish and administer a program to encourage production of hemp in the United States. The USDA issued its final rule for hemp production on January 15, 2021. The USDA rule became effective on March 22, 2021. The final rule, which regulates the growth and production of hemp (but not CBD products), allows states and Indian tribes the option of either submitting to the USDA for approval of a proposed hemp regulation plan or agreeing to submit to the USDA’s general requirements. As of March 22, 2021, the USDA has approved the plans of 23 states, two U.S. territories, and 41 tribes. According to the USDA final rule, all state and tribe plans submitted to the USDA must include the following:

A description of the land used for hemp production
Sampling and testing procedures for the delta-9 tetrahydrocannabinol (THC) in the hemp crop
A plan for the disposal of hemp containing more than the allowable 0.3% THC
Procedures for the inspection of hemp producers and their hemp crop
Maintenance of a database including information on state hemp production, land use, and producer information

The USDA rule also notably prohibits states from interfering with the interstate transportation of industrial hemp grown pursuant to a USDA-approved state-hemp production plan. However, as mentioned, the USDA rule does not govern the marketing, sale, and production of CBD products. Oversight of the marketing, sale, and production of CBD products remains with the FDA.

FDA Oversight

While the 2018 Farm Bill provided the USDA with oversight of hemp production, it also left intact the FDA’s authority over certain hemp and hemp-derived products (cosmetics, dietary supplements, food, and drugs). The 2018 Farm Bill explicitly did not amend the FDCA, meaning that hemp and hemp products must be compliant with the FDCA and its related regulations.

The FDA’s regulation of CBD products varies depending on whether the product is a cosmetic, a drug, or a food or dietary supplement. The FDA is presently working on developing comprehensive guidance for companies manufacturing, selling, and marketing CBD products.

CBD Cosmetics

Section 201(i) of the FDCA² defines cosmetics as “articles intended to be rubbed, poured, sprinkled, or sprayed on or introduced into, or otherwise applied to the human body or any part thereof for cleansing, beautifying, promoting attractiveness, or altering the appearance.” Although certain ingredients are prohibited from inclusion in cosmetics under the FDCA, that is not the case for hemp or hemp-derived ingredients, including CBD. However, even though cosmetics may contain hemp or hemp-derived compounds, under FDA authority, these products must still comply with FDCA requirements—namely, products may not be adulterated or misbranded.

Under Section 601 of the FDCA,³ a cosmetic product is adulterated under the FDCA, if, among other reasons, “it contains any poisonous or deleterious substance which may render it injurious to users.” A cosmetic product is misbranded under Section 602 of the FDCA⁴ “if its labeling is false or misleading” or if it fails to comply with other regulatory requirements for labeling.

As discussed later in this article, the FDA has focused its enforcement efforts in the CBD space on products that bear claims that render the products misbranded or unapproved new drugs under the FDCA. That said, pursuant to the FDCA, hemp and hemp-derived compounds, such as CBD, may be legally marketed and sold as cosmetics under federal law if they comply with FDA regulations.

Food and Dietary Supplements

Unlike cosmetics, the FDA has repeatedly and explicitly stated that CBD may not be added to food and dietary supplements because under the FDCA, a food or dietary supplement may not contain ingredients that are also active ingredients in an FDA-approved drug product.

In 2018, the FDA approved CBD as the active pharmaceutical ingredient in Epidiolex, a seizure medication for children. This meant that under the FDCA, CBD could no longer be added to food or dietary supplements, absent additional guidance from the FDA. In fact, in a series of responses to frequently asked questions about CBD regulation, the FDA made its position even clearer that dietary supplements cannot lawfully contain CBD and that such products are regarded as unapproved new drugs. Specifically, FDA has indicated that CBD has not been approved as a food additive and does not meet the statutory definition of a dietary supplement.

However, in December 2018, the FDA determined that certain parts of the hemp plant (hulled hemp seed, hemp seed protein powder, and hemp seed oil) are Generally Recognized as Safe (GRAS) for human consumption and, thus, may be lawfully marketed in food products, so long as very specific criteria set forth in the GRAS Notification Letters are met. This criterion includes, but is not limited to, the specific types of food products to which the GRAS substances may be added as well as the technical requirements for processing the GRAS substances.

FDA Enforcement Actions

The FDA has issued several warning letters to companies manufacturing CBD products that the FDA deems misbranded or adulterated in violation of the FDCA. Typically, the FDA has sent these letters to companies selling products that the FDA considers misbranded based on the inclusion of unlawful health claims in marketing materials, including, most recently, statements related to CBD’s alleged treatment of aches or pain. For example, the FDA has questioned the following health claims:

“CBD has been demonstrated to have properties that counteract the growth of [and/or] spread of cancer.” July 22, 2019 Warning Letter to Curaleaf, Inc.
“[P]ossible uses for CBD include helping with skin problems such as acne, autism, ADHD, and even cancer. It’s often used in conjunction with traditional treatments to provide extra help. Children can use high amounts of CBD safely and without any risk.” October 10, 2019 Warning Letter to Rooted Apothecary LLC.
“CBD was administered after onset of clinical symptoms, and in both models of arthritis the treatment effectively blocked progression of arthritis.” March 28, 2019 Warning Letter to PotNework Holdings, Inc.
CBD “[m]ay reduce anxiety and depression.” December 22, 2020 Warning Letter to Bee Delightful.
“Importantly, CBD products also offer a viable alternative to opioids and other medications that carry strong side effects and the potential for addiction.” December 22, 2020 Warning Letter to New Leaf Pharmaceuticals, LLC.
“Our all natural plant-based ingredients, like organic menthol, are strong enough for even your toughest pain.” March 15, 2021 Warning Letter to Honest Globe, Inc.
“For temporary relief of occasional: . . . minor aches and pains . . . Stiffness of muscles, joints and tissues.” March 18, 2021 Warning Letter to BioLyte Laboratories, LLC.

Companies receiving warning letters from the FDA have 15 days from receipt to respond with evidence of how they will correct the violations. Failure to respond or correct the violations may result in further legal actions, including product seizure and injunction of sales.

FTC Oversight

Although the 2018 Farm Bill did not explicitly provide the Federal Trade Commission (FTC) with oversight of hemp and hemp-derived products, the FTC has remained active in monitoring and attempting to regulate the market because of its authority over advertisements. Under the FTC Act,⁵ it is unlawful to advertise that a product can prevent, treat, or cure human disease unless the claims are substantiated (at the time they are made) by reliable and competent scientific evidence. Therefore, pursuant to the FTC Act, the FTC has issued numerous warning letters (often jointly with the FDA) to CBD companies making various health claims without scientific evidence and clinical studies to support the claims. In December 2020, the FTC issued a press release announcing that it had begun issuing monetary fines for deceptive claims related to CBD products. According to the release, “companies made unsupported claims that their oils, balms, gummies, coffee, and other goods could treat serious diseases such as cancer and diabetes.” The orders settling the FTC’s complaints also bar the offending companies from similar deceptive advertising in the future and require that they have scientific evidence to support any health claims they make for CBD and other products.

State Regulation of Hemp and CBD

Although the USDA has provided guidance on hemp production and the FDA has provided some guidance on the use of CBD in FDA-regulated products, a comprehensive and uniform regulatory scheme for hemp products does not exist at the federal level.

In the absence of federal guidance, some states have developed their own requirements for the sale and marketing of CBD products, including rules for testing and labeling CBD products. Nearly half the states have developed such rules, while other states are either working to develop rules or have merely accepted the realities of an unregulated CBD market while awaiting further FDA guidance.

CBD companies doing business in a state—including selling or marketing CBD products—are subject to the requirements of that state. In most states, CBD product regulation is handled by the state’s Department of Agriculture or Department of Health.

CBD Product Labeling / Testing Requirements

In states where comprehensive regulatory schemes have been adopted (e.g., Utah, Florida, and Colorado), certain core requirements for CBD product labeling and testing requirements have been consistently included in the state regulatory schemes. State requirements typically include:

A requirement that all CBD products be registered with the state (this responsibility typically falls on the manufacturer, and not the retailer, of the CBD product)
A requirement that a certificate of analysis for the product’s source of hemp be available and include:
- The CBD and THC levels of the tested hemp plant by dry weight
- Test results indicating the presence of any solvents, pesticides, microbials, and heavy metals
- The hemp batch ID number
- The date the certificate of analysis was issued
- The testing laboratory’s method of analysis
A requirement that product labels conform with FDA regulations (e.g., no unsupported health claims)
A requirement that product labels contain a scannable bar code, QR code, or website containing a link to the certificate of analysis

Despite the lack of uniform testing and labeling requirements across the states, a company can generally lessen its risk of both state and federal enforcement actions by ensuring that CBD products are labeled and tested in compliance with the above requirements.

Companies should also ensure that there are no further state requirements, in addition to the above. As discussed below, state regulations are constantly shifting and, to mitigate risk and ensure compliance, companies should actively monitor and comply with state regulatory developments.

Alternative Hemp Derivatives (and Delta-8 THC)

Although CBD is the most well-known industrial hemp derivative, the market has seen an influx of alternative hemp derivatives. Of these alternative derivatives, Delta-8 tetrahydrocannabinol (Delta-8 THC) has gained the most attention and popularity. Delta-8 THC is a cannabinoid derived from the chemical conversion of hemp-derived CBD into Delta-8 THC. At first glance, Delta-8 would seemingly appear to be legal under the Farm Bill framework as it is derived from legal hemp-derived CBD. However, in August 2020, the DEA released an interim final rule on hemp, hemp-derived CBD, and alternative hemp-derived cannabinoids which stated in part, that, “[a]ll synthetically derived tetrahydrocannabinols remain schedule I controlled substances.” Neither the interim final rule nor any federal law, including the CSA, expressly defines “synthetically derived tetrahydrocannabinols.” By its plain meaning, a synthetic material is something produced by chemical or biochemical synthesis. Because Delta-8 THC is produced via chemical synthesis, albeit using legal CBD, and without further guidance from the DEA, the interim final rules suggest that the DEA may consider Delta-8 THC as a “synthetically derived tetrahydrocannabinol,” and thus, illegal.

State Regulation of CBD in Food

Although the FDA has explicitly held that CBD may not be added to food products in interstate commerce, some states (e.g., Utah, Maine, and Colorado) have, in direct contravention of FDA guidance, explicitly legalized the sale and marketing of CBD food products. Other states (e.g., California, Washington, and New York) have also explicitly stated that CBD food products are illegal until the FDA issues further guidance on the matter.

Despite its stance on CBD food products, it is possible that the FDA will defer to state regulations as it continues to develop a comprehensive regulatory scheme. However, the interstate transportation of CBD food products implicates federal law and thus, to avoid the risk of federal enforcement actions, CBD food products should be manufactured, produced, and sold only within the boundaries of the state where legal. Even then, the federal government is likely to find an interstate commerce hook based upon use of the internet, federal mail service, or components of the product. For example, if the paper used in the labeling of a product was made out of state or with ink from out of state, that is likely to be enough of a hook to constitute interstate commerce and subject a company to federal oversight and enforcement efforts.

Class Action Lawsuits

Companies must accurately market the amount of CBD in their products. Plaintiffs across the country have filed a spate of federal class actions claiming that companies are misrepresenting, and thus falsely advertising, the actual amount of CBD in their products. In most of these actions, plaintiffs claimed that companies have overstated the actual amount of CBD in their products. In one case, the plaintiff alleged that a company falsely claimed its products to be THC-free.⁶

In addition, companies must take care to monitor where they are selling their products and whether the products are legal in those jurisdictions. Several lawsuits filed in federal court in California by consumer-plaintiffs have stated that the plaintiffs would not have purchased the products if they understood them to be illegal in California at the time of purchase.⁷ Notably, a number of these cases have been indefinitely stayed by courts given the uncertainty in the CBD legal landscape. In Dasila, the court indefinitely stayed the action because it is “unclear how the Court can adjudicate Plaintiff’s claims given the lack of clarity as to which of Defendants’ CBD Products are drugs, dietary supplements, or food products, and what standards apply to those Products.” The court further opined that “[c]onsistent guidance and uniform administration are therefore needed in this area, particularly given potential safety concerns.” For now, some courts have decided to leave regulation of the cannabinoid products to the FDA prior to acting on a plaintiff’s claims.

Navigating the Patchwork of State and Federal Regulations

CBD regulations on both the state and federal levels are constantly evolving. It can therefore be incredibly difficult to properly assess and ensure that hemp and hemp-derived products are complying with all applicable regulatory requirements.

However, companies in this industry can substantially lower the risk of state and federal enforcement actions against them by taking the following steps:

Ensure that products comply with all applicable FDA regulations, including, but not limited to, refraining from making unlawful health claims about products containing CBD.
Avoid adding CBD products to food or dietary supplements. If companies choose to do so, they should ensure that production and sales are confined solely to a state in which such products are legal and, even then, should understand that there is still federal legal risk associated with such actions.
Review and follow all applicable state regulations concerning CBD products, including, but not limited to, complying with all labeling and testing requirements.
Ensure that all CBD products, and the hemp crop from which the CBD was derived, were tested by a reputable, independent laboratory. Additionally, maintain all certificates of analysis and documentation regarding the testing processes.
Ensure that claims set forth in all labeling, packaging, marketing, and advertising of CBD accurately reflect any test results and are otherwise fully substantiated before the claims are made.

Unless and until the FDA issues comprehensive regulations for the testing, labeling, and marketing of CBD products, companies producing, selling, and marketing CBD products will have to grapple with the patchwork of conflicting state and federal regulations and the risk of class action litigation. However, CBD companies can help avoid the pitfalls of these regulations and potential regulatory enforcement by reviewing and staying abreast of new developments in the ever-changing legal landscape.

Cori Annapolen Goldberg is a partner in Reed Smith’s Life Sciences Health Industry Group. She focuses her practice on FDA regulatory issues for the food, drug, medical device, and cosmetic industries across the supply chain, including companies investing in these industries. Cori has regulatory, transactional, and investigational expertise. Cori specializes in providing legal and strategic advice regarding communications with FDA; pre-submission meeting requests and product approval submissions to FDA; product labeling, advertising, and promotion; clinical research considerations across the product life cycle; and corporate compliance concerns. She assists clients during FDA inspections, in responding to FDA 483s and Warning Letters, and with recalls and market withdrawals of products. With the passage of the 2018 Farm Bill, Cori has advised product manufacturers, distributors, and retailers on FDA regulatory compliance considerations surrounding CBD products. Cori is a Board Member of the Life Sciences Advisory Board for Lexis Practical Guidance, and she is also a member of the New York State Bar Association’s Committee on Cannabis Law.

Adam Brownrout is an associate in Reed Smith’s Global Commercial Disputes practice, based in San Francisco. Adam’s practice focus is on commercial litigation including business disputes, product liability actions, and class action defense. Adam is also a member of Reed Smith’s Cannabis team, where he advises clients on cannabis and hemp regulatory solutions to ensure risk mitigation and compliance with complex federal and state statutory frameworks.

Sung Park is an associate in the Life Sciences Health Industry Group in the Washington, D.C. office of Reed Smith. Sung provides counsel to companies during both the pre-market and post-market phases of product life cycles. He guides companies in developing, distributing, and marketing FDA-regulated products and, when necessary, in responding to regulatory and administrative enforcement actions by federal and state agencies such as FDA, USDA, and state attorneys general offices.

To find this article in Lexis Practical Guidance, follow this research path:

RESEARCH PATH: Cannabidiol (CBD) Regulatory Landscape and Enforcement Risks in Practical Guidance.

Best Practices for Prevention and Defense of Negligent Hiring, Retention and Supervision Claims

sheika — Fri, 11 Jun 2021 15:40:52 GMT

By: Darryl G. McCallum, Shawe Rosenthal, LLP

This article addresses the potential for negligence liability that employers face when they hire and/or retain employees who end up causing injury to third parties or other employees.

UNDER MOST STATES’ LAWS, AN EMPLOYER HAS AN obligation to use reasonable care in selecting and retaining employees. An employer violates this duty when it hires or retains an employee that it knows or should know is unfit or incompetent to perform the work required.

Avoiding Liability for Negligent Hiring or Retention

It is important to advise employers to perform reasonable investigations of their employees upon hiring to ensure that each employee’s past does not indicate a tendency that would render the employee unsuitable for his or her position. The nature and responsibilities of the position, the thoroughness of the investigation, and the extent of prior conduct indicating relevant tendencies will often determine the employer’s liability when an employee harms a third party. Employers must be mindful that certain positions will require more thorough investigations based on the level of responsibility and potential for injury. Keeping in mind the employee’s level of responsibility and potential to injure others while performing his or her duties, the employer should take reasonable precautions to investigate an applicant’s background.

In cases about negligent hiring or retention, courts evaluate the adequacy of an employer’s investigations based on several factors, such as:

The risks associated with the position
The extent of the employer’s investigative measures
The discoverability of the employee’s past conduct or history that would indicate a tendency that would render the employee unsuitable for the position

You should advise an employer to be detailed and accurate in documenting its investigative practices and policies to demonstrate a record of consistently using reliable and adequate information in its hiring and retention decisions.

Prompt and consistent investigation of and discipline for employee misconduct can also help shield employers from liability for negligent hiring and retention. By taking prompt and consistent measures, the employer demonstrates its concern for hiring and retaining only qualified and competent employees.¹ Should an employer face a negligent hiring or retention claim, it could point to the record of its history of taking employee misconduct seriously and not retaining employees negligently.

#MeToo Movement

The #MeToo movement in social media based on highly publicized incidents of sexual harassment highlights the importance of a prompt and effective employer response in order to avoid liability not only for sexual harassment claims, but also for negligent hiring, retention, and supervision claims. For instance, in Clehm v. BAE Systems Ordinance Systems² the court held on summary judgment that a company that took prompt action in immediately launching an investigation and eventually terminating a male employee for harassing a female employee could not be held liable for negligent hiring and retention by a second female employee who claimed that the male employee also sexually assaulted her. Unlike her colleague, the second female employee “did not take advantage of BAE’s harassment reporting procedures, of which she was well aware . . . .”³ Having failed to report the alleged sexual assaults to a supervisor, member of management, human resources, or through the company’s ethics help line, the employee could not show that the company had actual or constructive knowledge of the alleged harasser’s misconduct, and thus her negligence claims failed as a matter of law.⁴

Elements of a Negligent Hiring Claim

Negligent hiring claims generally require the plaintiff to prove the following:

The employer did not exercise reasonable care in hiring the employee.
The employee had dangerous tendencies or was incompetent for the job in question.
The employee’s dangerous tendencies or incompetence would have been apparent to the employer had it exercised reasonable care.
As a result of the employer’s failure to exercise reasonable care, the employee or customer suffered injury.⁵

In short, courts hold employers liable for negligent hiring if they fail to conduct a reasonable level of pre-employment screening and consequently overlook evidence of an employee’s dangerous tendencies, so you must advise employers to always conduct good pre-employment screening.

As a general rule, employers have a duty to exercise reasonable care “to select employees competent and fit for the work assigned to them and to refrain from retaining the services of an unfit employee,” which extends to “members of the public who would reasonably be expected to come into contact” with the employee.⁶ The measure of reasonable care is what a person of ordinary prudence would do in view of the nature of the employment and the consequences of employing an incompetent or dangerous individual.

Negligent Retention

A claim of negligent retention requires essentially the same elements as a negligent hiring claim. The difference is the point at which the employer knew or should have known of an employee’s dangerous tendencies. The elements of a negligent retention claim include all of the following:

An employment relationship
Incompetence of the employee
Actual or constructive knowledge of the incompetence by the employer
An act or omission by the employee which caused the plaintiff’s injuries
Proximate causation (i.e., the employer’s negligent retention of the employee was the proximate cause of the plaintiff’s injuries)⁷

Negligent retention claims tend to focus on whether the employer knew or should have known that the employee was unfit for duty. Factors courts consider include the employee’s overall work record, any prior complaints the employer had received about the employee, whether any prior improper behavior by the employee was job-related, and whether any managers or supervisors witnessed any prior improper behavior by the employee. Moreover, in certain jurisdictions, such as Virginia, a plaintiff must allege serious and significant physical injury resulting from the employee’s actions in order to maintain a claim of negligent retention. A plaintiff who alleged emotional harm and physical symptoms such as headaches and nausea resulting from an employee’s alleged sexual harassment could not state a claim for negligent retention.⁸

In Anicich v. Home Depot U.S.A., Inc,⁹ the U.S. Court of Appeals for the Seventh Circuit reversed the dismissal of a complaint alleging negligent hiring, supervision, and retention of a manager whose sexual assault resulted in the death of an employee. The suit was brought by the estate of the deceased employee against Home Depot, and the complaint alleged that Home Depot employed a manager with a known history of sexually harassing, verbally abusing, and physically intimidating his female subordinates. In this instance, the manager allegedly verbally abused a female employee, threw things at her, and monitored her both during and outside her work hours.¹⁰ On one occasion, he required the employee to accompany him to an out-of-state family wedding, threatening to cut her hours or fire her if she refused. While on the trip, the manager allegedly killed the employee and raped the employee’s corpse after the wedding (the manager was eventually convicted of murder and sexual assault and sentenced to life imprisonment).¹¹ The Court of Appeals found that, based on the allegations in the complaint, the manager’s harassing, controlling, and aggressive behavior toward his female subordinates demonstrated that he was particularly unfit for his job and thus that the injury to the employee was foreseeable.¹² The employer argued that the violent attack on the employee was a radical break from the manager’s prior behavior, and thus that no reasonable employer could have foreseen that such violence would occur. The Court of Appeals found, however, that the magnitude of the harm inflicted upon the employee did not by itself render the harm unforeseeable.¹³ The issue of foreseeability was a question of fact, and, the Court reasoned, a reasonable jury could have found, based on the history of the manager’s harassing behavior, that it was foreseeable that he would take “the small further step to violence.”¹⁴

Negligent Supervision

A claim of negligent supervision requires essentially the same elements as a claim of negligent retention (or negligent hiring).¹⁵

These claims often arise where an employee injures a customer or other third party on the employer’s premises or using a vehicle or other property belonging to the employer. When the injury is to another of the employer’s employees, state workers’ compensation laws will normally bar a negligence claim. For more information, see the following section.

Workers’ Compensation Defense to Negligence Claims Brought by Employees

When representing an employer faced with a negligent hiring, retention, or supervision claim by an employee, you should always consider raising workers’ compensation as a defense.¹⁶ Where fellow employees (as opposed to customers or other third parties) bring negligence-based claims against the employer, it can assert a defense that workers’ compensation is the plaintiff’s exclusive remedy and precludes common law claims. An employer’s exclusive liability to an employee—and an employee’s exclusive remedy as against the employer—for negligence arises out of the workers’ compensation laws.¹⁷ This is so even in the context of a claim of negligence premised on alleged sexual harassment or sexual assaults.

However, if plaintiffs can show that their injuries resulted from the employer’s deliberate attempt to injure them, then workers’ compensation will not bar their claim.¹⁸ The conduct must be more than “gross, wanton, wil[l]ful or reckless negligence” to escape workers’ compensation exclusivity.¹⁹

In some jurisdictions, the nature of the injury (whether physical or nonphysical) will determine whether the injury is subject to the exclusivity provisions of workers’ compensation laws. For instance, in Reiber v. Mathew,²⁰ the U.S. District Court for the Northern District of Indiana denied a defendant employer’s motion to dismiss claims of negligent hiring and supervision. In that case, an employee alleged that she was forced to resign from her employment at a healthcare facility because of a doctor’s relentless sexual harassment. The alleged harassment included repeated and unwanted verbal and physical sexual advances toward the employee by the doctor.²¹ The incidents alleged in the complaint occurred in the course of the plaintiff’s employment, arose out of her employment, and resulted in an unexpected (i.e., accidental) injury; thus, such an injury would normally be subject to the exclusivity provisions of the workers’ compensation law.²² However, the court reasoned, the alleged injury sustained by the plaintiff was non-physical in nature.²³ While non-physical injuries may be subject to workers’ compensation exclusivity in some instances, the court reasoned that to be subject to workers’ compensation exclusivity, a disability or impairment must be “more than a refusal, or even emotional inability, to continue to work in a discriminatory and hostile environment . . . .”²⁴ The court noted that while the employee felt she could no longer work for the defendant, she remained fit for employment elsewhere and had in fact applied for numerous similar positions after leaving the employer.²⁵

Liability to Third Parties for Negligence

Unlike an employee, whose injuries are normally covered by workers’ compensation, an injured third party may be able to recover from the employer all damages that its employee’s conduct caused. If an employer does not look deeply enough into an employee’s background prior to hiring the employee, it could face liability to third parties who are injured by that employee’s conduct.

This does not mean that employers should use all means available to investigate job applicants. You must coach employers to walk a fine line when they screen job applicants, because an employer may face liability to applicants if it screens them based on certain impermissible factors, such as mental impairments or arrest (as opposed to conviction) records.

Where an employee is expected to come into contact with the public, the employer must make some reasonable inquiry before hiring or retaining the employee to ascertain his fitness, or the employer must otherwise have some basis for believing that he or she can rely on the employee. The nature and extent of the inquiry that is needed will naturally vary with the circumstances.²⁶

In Cramer v. Hous. Opportunities Comm’n of Montgomery Cty., a tenant of a housing project who was raped by an employee of the county housing commission sued the commission, alleging it was negligent in hiring the employee as a housing inspector. The court held that the tenant was clearly a person to whom the housing commission owed a duty of reasonable care in the hiring of a housing inspector. Yet the commission hired the housing inspector despite the fact that he did not complete portions of his application, including the part of the application that asked whether he had ever been dismissed or asked to resign from any previous job. The commission made no attempt to contact any of the employee’s prior employers or personal references, or to verify any of the information included in the application. As it turns out, the employee had earlier been convicted of robbery and assault, and at the time of his hiring, he was under indictment for rape and related offenses. In holding that a jury was entitled to consider whether there was a causal connection between the commission’s negligence and the tenant’s injury, the court stated:

[W]here the work involves a serious risk of harm if the employee is unfit . . . there is no presumption of competence and there may well exist a duty to conduct a criminal record investigation. Other factors must be considered, including the availability of such information; the cost, inconvenience, and delay in obtaining it; whether other sources, including a previous employment record in the same field, are sufficient to justify a finding of fitness; and whether unanswered questions, negative indicators, or other “red flags” have surfaced during routine investigation. No single factor is dispositive, and the trier of fact must consider all the circumstances to determine whether the failure to obtain a criminal history record constitutes a breach of duty in a given case.²⁷

Thus, an employer that does not make use of the methods available to it in checking into the background of an employee prior to making a hiring decision could face liability for negligence, as did the employer in Cramer.

In Denton v. Universal Can-Am, Ltd.,²⁸ a company was found liable for negligent hiring and retention based on a car accident caused by one of its truck drivers who had been convicted of nine traffic-related offenses in the seven years prior to his applying for a truck driver position with the company. Furthermore, the employer “retained [the truck driver] after he continued to violate its policies and specifically neglected to monitor [his] commercial driver’s license or motor vehicle record after he was hired. That failure resulted in [the truck driver] driving a truck on a suspended license when he hit [the victim].”²⁹ Based on these facts, the court upheld a jury’s $54 million verdict against the company in favor of the victim, who suffered from debilitating injuries as a result of the accident.30

The duty of an employer to control its employees and prevent harm to third parties is not absolute, however. For instance, in Pagayon v. Exxon Mobil Corp.,³¹ an employee got into a fistfight with another employee as well as the second employee’s father, resulting in the death of the father. The father’s family sued, alleging that the employer was negligent in supervising the first employee, and that it failed to take steps to prevent the fight from occurring. While the second employee, whose father was killed in the altercation, had previously complained about two minor incidents of alleged harassment by the first employee, the court held that the two incidents about which the second employee complained were insufficient to make it foreseeable that the first employee would become violent.³² The two alleged incidents involved (1) a lighthearted question about whether the second employee was involved in a sexual relationship with another employee and (2) an allegation that the employee wrongfully and intentionally put an “out of order” sign on the men’s bathroom. The court noted that these two complaints “cannot even arguably have given Exxon reason to think employee friction might injure store patrons.”³³The court further reasoned that “[t]o require every employer to intervene in all such circumstances and hold it liable for any result, however unlikely, would impose too great a burden on the employment relationship.”³⁴

Thus, unlike the Anicich v. Home Depot case discussed above, in which the employer was allegedly aware of prior verbal and physical outbursts by the alleged harasser toward female employees, the facts in Pagayon did not, according to the court, demonstrate that the employee’s violent behavior, which resulted in the death of another employee’s father, was foreseeable.

In Ledet v. Mills Van Lines, Inc.,³⁵ a Massachusetts appellate court held that even though a moving company had been negligent in failing to conduct a criminal background check on an employee who subsequently sexually assaulted a third party, the company could not be held liable for the assault. In Ledet, the employer failed to conduct a criminal background check on an employee at the time of hire, in violation of its own policies. In fact, the employee had an extensive criminal record, including more than 20 arrests, 10 felony convictions, and five incarcerations in three states, including for crimes such as inciting violence, threatening domestic violence, burglary, and aggravated theft.³⁶ The employer hired the employee as a rider-helper on the employer’s moving trucks. While off duty during one of his moving trips, the employee assaulted a woman he saw on the street (who was not a customer of the moving company). The employee ended up pleading guilty to kidnapping and assault and was sentenced to 10–13 years in prison.

The victim of the assault sued the employer for negligence, claiming that the employer’s failure to conduct a criminal background check on the employee was the proximate cause of her injuries. However, the court granted summary judgment to the employer. The court found that the employee’s criminal assault of the plaintiff was not a foreseeable consequence of its negligence in hiring him as a helper. While the employee was driving a moving truck when he saw the plaintiff, the truck was held not to be the instrumentality that led to the assault. The employee, who was off duty at the time, got out of the truck and assaulted the plaintiff, who was walking on the street. Accordingly, the court ruled, his employment did not furnish the means by which he committed a criminal act.³⁷ However, the result in this case might have been different had the plaintiff been a customer of the moving company, or if the employee had been on duty or had lured or dragged the plaintiff into the truck to assault her. Under such circumstances, it would have been easier for the plaintiff to establish that the employment furnished the means by which the employee criminally assaulted her.

Cases Involving Individuals Who Have Frequent Contact with Minors

Additionally, once an employee is hired, it is important for an employer to promptly investigate and respond to any allegations of inappropriate conduct by an employee toward their fellow employees, customers, or clients. This is especially true in the case of schoolteachers, or any other individuals who have frequent contact with minors. Two cases in Minnesota involving illicit sexual contact between a teacher and a minor student illustrate this point. In the first case, Jane Doe 175 v. Columbia Heights Sch. Dist. ,³⁸ the parents of a ninth-grade female student who was allegedly sexually abused by a football coach brought a lawsuit on the student’s behalf against the school district, alleging negligence and negligent supervision. The Minnesota Court of Appeals affirmed the lower court’s grant of summary judgment in favor of the school district. In so doing, the court noted that there was insufficient evidence that the school district was on notice of the football coach’s behavior toward the student, such that the alleged abuse of the student was reasonably foreseeable. The court noted that for purposes of a negligence claim, “there is no general duty to protect another from harm, but a duty to protect arises if there is a special relationship between the parties and the risk is foreseeable.”³⁹ In determining whether the danger is foreseeable, “‘courts look at whether the specific danger was objectively reasonable to expect, not simply whether it was within the realm of any conceivable possibility.’”⁴⁰

While the plaintiff in Jane Doe 175 noted that there were “red flags” that should have put the school district on notice of the coach’s behavior, the court found that the incidents cited by the plaintiff, including (1) one instance where she yelled “I love you” to the coach during a football practice, (2) one instance where she and the coach were seen talking in the school parking lot, (3) one instance where she used an office computer in the team’s weight room office, and (4) one instance where the coach was accompanied by a young girl in the weight room on a Saturday, were insufficient to raise a genuine issue as to whether the alleged sexual abuse was foreseeable.⁴¹ Significantly, the school had a policy in its employee handbook that explicitly stated that dating and sexual relationships between teachers and students were prohibited and directed employees to employ safeguards against any such improper relationships.⁴²

In a later case, the U.S. District Court for the District of Minnesota distinguished the holding in Jane Doe 175, finding that summary judgment for a boarding school was inappropriate where three students alleged sexual abuse by a former teacher, bringing claims against the school for negligence, negligent supervision, and negligent retention.⁴³ In Doe YZ, unlike in Jane Doe 145, the court found that several high-level employees at the school “received specific reports concerning [the former teacher’s] inappropriate sexual contact with students, many of which occurred prior to the abuse of these Plaintiffs.”⁴⁴ The inappropriate behavior that had previously been reported included the teacher’s holding naked dance parties, patting students’ buttocks, and having explicit sexual discussions with students. The court found that these behaviors “are objectively reasonable indicators of a potentially inappropriate relationship with students.”⁴⁵

Thus, based on these two cases, it is apparent that whether an employer will be held liable for negligence based on an employee’s misconduct toward third parties depends on whether there were red flags that should have put the employer on notice of the inappropriate behavior. Unlike the behavior in Doe YZ, the football coach’s behavior in Jane Doe 175 would not have led a reasonable person to believe that there could be inappropriate sexual contact happening between the coach and a female student. Employers should have policies in place that require the immediate reporting of any inappropriate behavior by employees in the workplace, especially in the area of sexual misconduct, so that they can promptly investigate such incidents and take appropriate remedial measures.

Liability of Employers that Perform Background Checks

While the employer has a duty to investigate potential hires thoroughly, it may face liability for digging too deep in certain areas. There are many steps an employer may take to check into an applicant’s background. Depending on the nature of the position in question, you should advise an employer to take some or all of the following steps for conducting appropriate background investigations. As discussed below, if the employer uses a third party to conduct some or all of these types of background investigations, the Fair Credit Reporting Act (FCRA), which covers a wide range of background checks in addition to credit checks, may apply.

Criminal Conviction Record

You should advise employers that the rules for using arrest history and actual convictions to screen job applicants are different. An employer may consider an applicant’s criminal conviction record in its hiring decision provided it is job-related and consistent with business necessity. With regard to convictions, the federal Equal Employment Opportunity Commission (EEOC) emphasizes in its Enforcement Guidance on Consideration of Arrest and Conviction Records in Employment Decisions under Title VII of the Civil Rights Act of 1964 (No. 915.002, Apr. 25, 2012) that employers must consider (1) the nature of the crime, (2) the time elapsed since the conviction, and (3) the nature of the job. The EEOC’s Guidance further suggests that employers should conduct an “individualized assessment” of each applicant to determine if the policy as applied is job-related and consistent with business necessity. It states that “individualized assessment” generally means that an employer informs the individual that he or she may be excluded because of past criminal conduct; provides an opportunity to the individual to demonstrate that the exclusion does not properly apply to him or her; and considers whether the individual’s additional information shows that the policy as applied is not job-related and consistent with business necessity. The individual’s showing may include information that he or she was not correctly identified in the criminal record, or that the record is otherwise inaccurate.⁴⁶

In Texas v. EEOC,⁴⁷ a lawsuit that the EEOC originally brought challenging the state’s ban on hiring felons in certain state agencies, the state questioned the EEOC’s authority to issue its 2012 Enforcement Guidance on Consideration of Arrest and Conviction Records. The U.S. Court of Appeals for the Fifth Circuit agreed with Texas that the Guidance was a substantive rulemaking that is subject to legally required notice and opportunity for public comment under the Administrative Procedures Act, with which the EEOC had not complied.⁴⁸ The Fifth Circuit barred the EEOC from enforcing its Guidance against Texas.⁴⁹ While this ruling prohibits the EEOC from enforcing its guidance against the State of Texas, it does not impact the analysis above about the need for employers to make an individualized assessment regarding the use of criminal conviction records in hiring decisions. Unless and until other courts take the same position as the Fifth Circuit, employers would be wise to continue observing the EEOC’s Guidance, especially because the principles embodied in the Guidance are derived from prior court decisions.

Arrest Record

In contrast, you should advise employers not to collect or use arrest history to screen job applicants. The EEOC has expressed concern regarding the potentially discriminatory impact of criminal background checks on certain minority populations. It asserts in its Guidance that it is never appropriate for employers to use arrest records to screen applicants because doing so may have a disparate impact on African Americans and other minorities.⁵⁰

An employer may require a job applicant to sign a release allowing the employer to access the applicant’s criminal record information for purposes of determining the applicant’s fitness for employment. Note, however, that some state and local laws prohibit an employer from conducting a criminal background check until the end of the first employment interview or even until after the employer makes a conditional offer of employment. Consult the laws in your jurisdiction before advising employers on this issue.

Driving Record

Advise employers to review the driving records of applicants for positions that require employees to use a company vehicle or include a significant amount of driving as a job responsibility. Employers should check these applicants’ driving records before making a job offer, and then periodically throughout employment. When checking an applicant’s driving record, employers should confirm that he or she has a valid driver’s license and review any driving violations, particularly those involving reckless driving and driving under the influence of alcohol.

While the Americans with Disabilities Act (ADA) treats alcoholism as a disability, the law does not protect the current use of alcohol or illegal drugs.⁵¹ Thus, employers have successfully defended against ADA claims where the employer took an adverse action against an employee whose license was suspended because of his or her alcohol or drug use.⁵²

Consumer Reports

You should advise employers that the FCRA imposes significant compliance requirements on employers who use consumer reports in making employment-related hiring, promotion, and termination decisions.⁵³ Failure to follow the FCRA’s requirements could result in liability for civil fines or damages and even criminal prosecution.

The FCRA defines the term “consumer report” broadly as any written, oral, or other communication from a consumer reporting agency bearing upon the consumer’s credit worthiness, credit standing, credit capacity, character, reputation, personal characteristics, or mode of living.⁵⁴ It includes, among other things, motor vehicle, criminal, medical, and credit history records that an employer uses “in whole or in part” to assess an individual’s qualifications for employment. The FCRA applies only to consumer reports that a consumer reporting agency generates. Generally, the FCRA does not apply to an employer’s activities to conduct its own reference checks by contacting former employers or checking public records or documents.

The following guidelines summarize some of the principal requirements the FCRA imposes when an employer uses a consumer report in making employment decisions. Advise an employer that before it obtains a consumer report for the purpose of screening potential employees or using one to make promotion, demotion, or discharge decisions about existing employees, it must first:

Have an employment purpose for obtaining the consumer report (that is, the employer intends to use the report to evaluate a consumer for employment, promotion, reassignment, or retention).⁵⁵
Give the affected individual written notice of the employer’s intention to obtain a consumer report in a document that consists solely of this notice.⁵⁶
Obtain from the affected individual written permission to procure a consumer report on that individual.⁵⁷
Certify to the consumer reporting agency that provided the consumer report that the employer has complied with all applicable FCRA provisions.⁵⁸

Taking Adverse Action Based on a Consumer Report

You should advise an employer that has decided to take an adverse action (such as declining to hire, promote, or retain an employee) based wholly or in part on information in a consumer report that, before taking the action, the employer must provide the affected individual a pre-adverse action disclosure. This disclosure consists of both:

A copy of the consumer report the employer relied upon
A copy of A Summary of Your Rights Under the Fair Credit Reporting Act (FCRA Summary of Employee Rights)⁵⁹

As of September 21, 2018, employers must begin using an updated copy of the summary of rights that includes notice to consumers that they may obtain a security freeze or place a fraud alert on their credit files.⁶⁰

After the employer takes the adverse action, you should make sure that it provides written notice to the affected individual of all of the following:

That the employer has taken the adverse action (e.g., declined to hire, retain, or promote the individual)
The name, address, and phone number—the toll-free number, if there is one—of the consumer reporting agency that provided the consumer report
That the consumer reporting agency that provided the report did not take the adverse action and cannot provide the individual with the specific reasons the adverse action was taken
That the individual has the right to receive a free copy of the consumer report in question from the consumer reporting agency that provided it to the employer if he or she requests it within 60 days from the date of the notice
That the individual has the right to dispute incomplete or inaccurate information in the report with the consumer reporting agency⁶¹

Oral and electronic notice are both acceptable alternatives, but you should encourage the employer to provide written notice instead because it constitutes documentation.

Credit Checks

Whether an employer may use credit scores to disqualify applicants for employment will depend on state and local law. For instance, Maryland’s Job Applicant Fairness Act prohibits employers from using an applicant’s or employee’s credit report or credit history to deny employment, terminate employment, or make decisions about compensation or other terms of employment, with certain limited exceptions.⁶² You must check the laws in your jurisdiction before advising an employer about using credit scores in hiring and other employment-related decisions.

You should advise employers in every U.S. jurisdiction that under the FCRA, if an employer relied on a credit score, in whole or in part, to make an adverse employment decision, then the employer must provide the affected individual with written or electronic disclosure of all of the following:

The credit score that it used
The range of possible credit scores under the credit scoring model used
The date that the credit score was created
The name of the entity that provided the credit score
A list of the key factors, in order of importance, that affected the individual’s credit score⁶³

^{Access to Applicants’ Social Media Accounts}

You must determine whether your jurisdiction has any laws restricting employers’ access to prospective employees’ social media accounts. While it is common for employers to search the Internet for publicly available social media information about prospective employees, many states are now banning employers from requiring job applicants to disclose their social media passwords. For instance, all Maryland employers are prohibited from requiring employees or applicants to turn over passwords needed to access private websites, including social media sites. Specifically, the Internet and Electronic Account Privacy Protection Act bars employers from requiring or even requesting that an applicant or employee divulge his or her “user name, password, or other means for accessing a personal account or service through an electronic communication device.”⁶⁴

Several other states, including New Jersey, Illinois, Arkansas, California, Colorado, Louisiana, Michigan, New Mexico, Nevada, Oregon, Utah, and Washington, have enacted similar laws. Thus, while obtaining social media information about prospective employees may be helpful in the screening process, you should caution employers against requiring applicants to disclose social media passwords.

Can Failure to Monitor an Employee’s Computer Use Result in Liability for the Employer?

At least one court has said yes to this question. In Doe v. XYC Corp.,⁶⁵ a mother brought a negligence action against her husband’s employer on behalf of her minor daughter, seeking to hold the employer liable for her husband’s use of a work computer to post nude photographs of the daughter to a child pornography site. A New Jersey appellate court found that the employer was on notice (based on its own investigation and reports from other employees) that the employee was viewing child pornography on his work computer, and the employer breached its duty to exercise reasonable care to report and/or take effective action to stop the employee’s unlawful activity. Thus, the employer could be held liable for the husband’s inappropriate use of his work computer.

You should advise employers to exercise caution in this area, as the law in most jurisdictions is unsettled. A claim like that in Doe would present a question of first impression in many courts.

Employers Must Take Appropriate Action

Advise employers that to avoid negligent retention and negligent supervision claims they should promptly investigate and take appropriate action to address an employee’s alleged improper activity as soon as they learn of it. Proactive steps that employers should take include:

Providing clear examples in the employee handbook of harassment and other conduct that is inappropriate
Implementing a substance abuse policy and testing program
Providing a clear and detailed complaint procedure in the handbook that allows employees to bypass their management chains
Promptly investigating any reports of workplace harassment, violence, or threats of violence
Providing appropriate training to all employees regarding harassment, workplace violence, and the company’s substance abuse policy

When an employer has to address any behavior by an employee that could negatively impact coworkers, customers, or other third parties, you can recommend actions including:

Disciplining the employee
Removing the employee from a position in which he or she could potentially harm other employees or members of the public
Increasing supervision of the employee
Discharging the employee

Advise employers to document the findings of any investigation into alleged employee misconduct and retain a record of the evidence management relied on to support its decision to act or not to act against the employee.

Impact of Marijuana Legalization Laws on Negligent Hiring and Retention Claims

There has been a wave of legislation throughout the United States legalizing the use of small doses of marijuana or marijuana-derived substances for medicinal or recreational use. While marijuana is still classified as a Schedule I illegal drug under federal law, most states and the District of Columbia have legalized the possession and use of marijuana for medical and/or recreational purposes. This can create a dilemma for employers in maintaining a safe workplace and avoiding liability for negligent hiring or retention. This is especially true in states where the law specifically protects users of medical marijuana from discrimination.

For instance, in a Delaware case decided in December 2018, Chance v. Kraft Heinz Foods Co.,⁶⁶ an employee was operating a shuttle wagon on railroad tracks when the wagon derailed. The employer requested that the employee undergo a drug test, which revealed the presence of marijuana. The employee informed the medical review officer he had a valid medical marijuana card, but the employer terminated the employee nonetheless. The court considered whether the Delaware Medical Marijuana Law (DMMA), which protects medical marijuana users from discrimination, gave an employee the ability to bring a lawsuit even though the DMMA was silent on this point. The court noted that Delaware was one of only nine states whose medical marijuana law expressly prohibits the failure to hire, discipline, or discharge an employee who uses medical marijuana outside of work and tests positive on a drug test. The court concluded that because the DMMA has a specific anti-discrimination provision, the Delaware legislature must have intended to permit the employee to sue under the DMMA.⁶⁷

As of March 30, 2021, the number of states with laws specifically protecting medical marijuana users from discrimination has increased to 16. In addition to Delaware, these states include Connecticut, Rhode Island, Arizona, Illinois, Maine, Nevada, New York, Minnesota, Arkansas, New Jersey, New Mexico, Oklahoma, Pennsylvania, South Dakota, and West Virginia.⁶⁸

Thus, while employers may still use drug tests to screen out employees who may cause harm to themselves and others through their use of marijuana and other drugs, employers in states where marijuana use has been legalized must be careful not to run afoul of state law in making employment decisions based on a positive drug test. The legalization of marijuana in some states for medicinal and/or recreational purposes has made maintaining a zero-tolerance policy more difficult. In those states that prohibit adverse action against employees who are authorized to use marijuana outside of work and test positive on a drug test, the employer will need additional evidence before taking adverse action against an employee. To maintain a safe workplace, a prudent employer would take adverse action against an employee if it appeared that the employee was indeed impaired on the job by his or her marijuana use.

For instance, in Whitmire v. Wal-Mart Stores, Inc.,⁶⁹ the U.S. District Court for the District of Arizona, interpreting Arizona’s Medical Marijuana Act, held that an employer could not rely on a positive drug screen alone to establish that an employee was impaired by marijuana on the job. In Whitmire, the employee suffered a workplace injury and was subsequently required to submit to a drug test, per standard company policy. At the time she took the drug test, the employee informed the drug clinic that she used medical marijuana. She subsequently provided a copy of her medical marijuana card to her employer. After the drug test came back positive for marijuana, the company suspended and ultimately terminated the employee. The employer’s personnel coordinator stated that the company terminated the employee because the coordinator believed that the positive drug test demonstrated that the employee was impaired on the job. The court concluded, however, that the employer had the burden of establishing that the level of metabolites present in the employee’s drug screen demonstrates that marijuana was present in her system “in a sufficient concentration to cause impairment.”⁷⁰ The court found that the employer could not meet that burden because the personnel coordinator was admittedly not qualified to opine as to whether the positive drug test result meant that the employee was actually impaired while on the job. The court ruled that the employer would have had to present expert testimony regarding the significance of the drug test results and the personnel coordinator was not an expert witness.

This ruling means that the employer could not simply rely on a positive test result to demonstrate that the employee was impaired at work. Notably absent from the evidence in this case was any testimony that demonstrated that the employee showed observable symptoms of being drug-impaired while at work. The employer in Whitmire simply attempted to rely on the personnel coordinator’s opinion as to impairment based on the drug test result itself, which the court held was insufficient absent expert testimony that would establish that the employee was impaired based on the test result. Interestingly, at this time, there does not appear to be any test developed that would definitively show impairment, rather than just the presence of marijuana in the system. In fact, according to the National Drug & Alcohol Screening Association, “[l]eading toxicologists worldwide generally agree that impairment testing for marijuana could potentially be decades away.”⁷¹ In addition, “[u]nlike blood-alcohol tests, which quantify the amount of alcohol present and translate it with scientific precision into predicted levels of impairment and risk, no such test exists for marijuana impairment.”⁷² Thus, employers in states that protect medical marijuana users from discrimination need to walk a fine line in attempting to navigate this legal landscape. Drug testing remains an important tool in maintaining a safe work environment and avoiding negligent hiring or retention lawsuits. However, legal protections for employees and applicants who use medical marijuana create potential liability for employers who attempt to rely solely on a positive drug test in making a termination decision.

Darryl G. McCallum is a partner at Shawe & Rosenthal LLP. He concentrates his practice in employment law matters, including the defense of race, sex, and other discrimination suits; sexual harassment claims; and claims involving wrongful discharge. He routinely advises employers on human resources issues. Immediately prior to joining Shawe & Rosenthal, Mr. McCallum was an associate litigation counsel with the Law and Public Policy Department of MCI in Washington, D.C. While at MCI, he provided advice to management on various employment law issues, and litigated employment matters before federal and state courts and enforcement agencies. After law school, Mr. McCallum served as a judicial clerk for the Honorable Robert N. Wilentz, former Chief Justice of the New Jersey Supreme Court. He then spent six years in the litigation group at Shaw Pittman in Washington, D.C., where he concentrated his practice in employment matters, appearing before courts in Maryland, the District of Columbia, and Virginia.

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Energy Policies Lead to Texas Power Crisis

Alainna Nichols — Fri, 11 Jun 2021 15:45:37 GMT

By: Cameron Kinvig, Practical Guidance

Extreme winter weather and poor statewide energy policies recently caused an enormous public health and safety crisis in Texas. This article analyzes what went wrong with Texas' energy infrastructure during Winter Storm Uri, including failures in natural gas generation, production, transportation, and storage; the failure of power producers to properly winterize natural gas, renewable, coal, and nuclear power generation equipment; and the integration failure that almost caused the complete collapse of the Texas power grid. These problems proved vast and dangerous during the recent winter storm, but they are solvable with responsible statewide regulation and oversight.

What Happened?

Beginning in early February, experts predicted that a set of winter storms would descend on Texas on or around February 12, bringing polar weather much colder than usually experienced in the state. Snow was predicted, and weather experts said Texans should expect sub-freezing temperatures for at least a week. People did what they usually do—stocked up on bread, milk, and eggs. Energy companies also did what they usually do to prepare for a winter storm in Texas—very little.

The first of the two storms that eventually hit the state—dubbed Winter Storm Uri—brought temperatures down to 100-year lows in some places. The storm brought significant snow and wind. A population used to temperate weather in February was faced with wind chills that reached -30 degrees Fahrenheit. Demand for both electricity and natural gas soared beyond what the Electric Reliability Council of Texas (ERCOT)—the state-controlled entity which manages Texas’ electric grid—forecast for an emergency winter storm.

By Monday, February 15, approximately 4.5 million Texas households were without power. Most of those were also without heat. Household and apartment water pipes had frozen and burst, causing an estimated $295 billion in damage. One hundred twenty-five people ultimately died. And the entire state was under a declared state of emergency.

As the week wore on, temperatures did not increase, and an additional winter storm brought more snow, ice, and misery. Water utilities began to feel the strain. Hundreds of water mains throughout the state froze and burst, and water treatment facilities began to cease operations due to frozen equipment. By Wednesday, February 17, it was estimated that over 50% of Texans did not have access to reliably clean water, with a large portion of that number having no access to running water at all. In short, it was the worst winter disaster ever faced by the state.

Politicians at the highest levels have begun investigating the situation. But, at its core, the explanation of what went wrong needs little forensic analysis and is relatively simple to understand. That’s because this has happened before—most recently in 2011. And unless the state’s energy policies change, it will undoubtedly happen again.

What Caused the Failures in Texas’ Electric Grid?

In the months and weeks leading up to the storms in question, ERCOT and others assured Texas legislators that the state’s electric grid was stable enough to withstand a severe winter storm. However, when Winter Storm Uri began on the evening of February 12, and temperatures plummeted to all-time lows, it immediately became clear that Texas’ energy infrastructure was far from stable.

Almost immediately, electricity generation capacity began to fall dramatically. Efforts to increase electricity generation were not successful, as more capacity fell out of the system than could be added. The entire electric grid became overloaded and unstable, as consumer demand for electricity and natural gas to heat homes far outstripped supplies of either. ERCOT was forced to ration electricity to keep the grid from incurring permanent damage, which could take weeks or months to fix. ERCOT’s senior leadership noted later that the Texas power grid was approximately five minutes away from a catastrophic failure that would have caused a statewide blackout when the decision was made to cut power to large portions of the state.

ERCOT has no ability to pick which businesses or communities will or will not receive electricity. It merely tells regional utility providers how much capacity they must remove from their local systems and leaves it to the utility providers to pick how rolling brownouts are allocated among consumers. It later became clear that these regional utility providers were not always able to allocate rolling brownouts equally, meaning as the weekend passed and the situation got worse, brownouts become permanent blackouts for many Texas residents. Many households experienced 96 hours or more without any electricity in sub-freezing weather and were forced to leave their homes to find warmth and shelter.

By Tuesday, February 16, approximately 46,000 megawatts of electricity generating capacity—or close to 50% of total winter generating capacity—would go offline. With temperatures hovering well below freezing for days, and electricity generating capacity so low, what started as an inconvenience turned into a public safety emergency.

Problems with Natural Gas Production and Storage

The low temperatures which accompanied Winter Storm Uri immediately began to cause widespread havoc with natural gas production and transportation. Natural gas—which often emerges from the ground with water vapor mixed in—began to freeze inside wellheads, natural gas pipelines, and in valves at natural gas processing plants. This occurrence—known as freeze-off—halved statewide natural gas production almost instantly and made transportation impossible. Other pipelines were unable to move processed natural gas to power plants because their pumps began to freeze. Adding insult to injury, some wells and pipelines that remained operational had their power turned off as part of the statewide rolling brownouts.

While natural gas-based electricity producers throughout the United States often utilize underground storage facilities near each plant to store excess natural gas, electricity generators in Texas rarely do this. With natural gas production so prevalent in Texas, it is less expensive for a power producer to transport natural gas directly from a treatment plant or well than it is to store natural gas and retrieve it when needed. It would have been extremely helpful for power plants to have some minimum volume of stored gas available for emergency generation, but there are no state or federal regulations requiring this. Because most power generators had no access to natural gas storage, when pipelines and wells froze, they simply had no fuel to use for power generation.

Problems with Wind Generation

Winter Storm Uri also affected wind and solar electricity generation efforts. Roughly half of the wind turbines in the state went offline because their blades accumulated too much snow and ice to move. As wind energy accounts for roughly 25% of the electricity produced in the state, this was a meaningful generation reduction.

Unlike wind facilities located in cold-weather climates, wind-generating facilities in Texas are not built to withstand extreme weather conditions. However, the technology exists to rectify and winterize these generating assets. It is simply not mandated at the state level at the current time.

Problems with Coal and Nuclear Plants

Coal-fired electricity generation makes up roughly 18% of the power produced in Texas at any given time. Nuclear power constitutes roughly 11% of the total. While coal-fired and nuclear power plants ran into fewer problems as a result of Winter Storm Uri, their winterization failures did cut production of what is considered base-load power to the Texas grid.

Both coal and nuclear plants operate by using heat to turn large amounts of water into steam, which in turn powers electricity-generating turbines. This water is drawn into the power plant’s boiler system via large feedwater pumps. These pumps are susceptible to cold weather and may freeze unless properly winterized, which is exactly what happened when Winter Storm Uri hit. Many of these plants are located in South Texas, and their equipment was simply not designed to withstand extremely cold weather.

Similar power plants in other states handle this by upgrading pumps to be freeze-resistant, and by installing anti-freeze technology in feedwater ponds. Unfortunately, Texas does not mandate any such measures, leaving these plants with design deficiencies susceptible to recurring winterization failures.

Problems with ERCOT and the Public Utility Commission

According to testimony given at public hearings, it now appears that ERCOT computer systems helped cause the same problems its leadership was trying to solve. As ERCOT employees sought to stabilize the electric grid by bringing dormant electric generation capacity online, ERCOT’s rate-setting computer misinterpreted this reserve generating capacity as excess and began shutting down natural gas plants that were more expensive to operate. So, despite ERCOT’s best efforts, electricity generation capacity in the state continued to fall as the storm grew worse.

This situation caused regulators at the Texas Public Utility Commission (PUC) to make a pricing decision that would ultimately cost Texas residents billions of dollars. After a six-minute phone conference, the PUC decided that the drop in power generation must be caused by the Texas electricity market setting wholesale energy prices too low. To spur additional electricity generation, it temporarily suspended the independent Texas electricity marketplace and raised power prices to the statutory maximum of $9,000 per megawatt hour. To put this into perspective, the average wholesale cost of a megawatt hour of electricity in Texas is approximately $26.00, so the PUC rate-setting move caused a rate increase of close to 35,000% over normal power prices. This translated into some individual household electric bills exceeding $1,000 per day.

The PUC’s pricing move did not work as intended. By then, power plants that were shut down could not generate electricity due to lack of fuel or frozen infrastructure, and others continued to be shuttered due to the ERCOT computer glitch. No additional power was generated as a result of higher prices. Instead of helping resolve the power crisis, the PUC pricing move cost Texans with variable-rate electric plans billions of dollars in additional charges for sporadic power. Notably, the PUC did not revert to market-based pricing until Friday, February 19.

ERCOT (Electric Reliability Council of Texas) Real-time Price, LCG Consulting Energyonline, http://www.energyonline.com/Data/GenericData.aspx?DataId=4 (last visited February 26, 2021)

Problems with the Grid in General

The 90% of the Texas electric grid controlled by ERCOT is largely independent of electric grids serving the remainder of the country and has been so since 1930. Texas does have a minimal connection with the East Coast electric grid and with the grid serving northern Mexico, but no connection with the West Coast electric grid at all.

The Texas grid is largely self-reliant to minimize exposure to brownouts facing California residents in the summer and residents of Eastern states in the winter. This self-reliance also stems from a desire to self-regulate, rather than subject the state’s utilities to regulation from the Federal Energy Regulatory Commission (FERC) and its delegate, the North American Electric Reliability Corporation (NERC). This lack of interconnectivity became a major problem once Winter Storm Uri hit Texas, because Texas could not draw power from unaffected states, and was left to solve for its own power deficiencies. While power from the East Coast grid was largely unavailable during Winter Storm Uri due to winter weather issues, the West Coast grid could have provided emergency power to Texas, had it been connected. This lack of interconnectivity should be rethought carefully by the Texas legislature. The foremost concern should be Texans’ safety, rather than grid or regulatory independence.

What Can Your Clients Expect as a Result of the Texas Power Crisis?

While the Texas power crisis is now over, the effects of that crisis are just beginning to be felt. Your clients should expect legislative and regulatory investigations, additional regulation at both the state and possibly federal levels, significant litigation, and possible criminal charges stemming from the Texas power crisis. A detailed discussion of each is included below.

Legislative and Regulatory Investigations

Legislative investigations into the Texas power crisis have already begun. The first public hearings were conducted by Texas House and Senate committees on February 25, 2021. The CEOs of power generation companies and ERCOT were called to testify, and the investigations will continue for an extended period. While there is certainly enough blame to go around, it is certain that ERCOT, PUC, and electricity generation providers will face significant scrutiny, additional regulation, and major oversight changes.

Additional Federal and State Regulation

As early as February 19, FERC chair Richard Glick called on Congress to allow FERC to regulate ERCOT and the Texas utility marketplace. By February 22, both FERC and NERC announced they would begin investigations into ERCOT’s conduct during the Texas power crisis. The results of those investigations may end the independence currently enjoyed by ERCOT and the Texas utility marketplace. Using the interstate commerce clause and Texas’ minimal connections to the East Coast power grid as a justification, Congress may decide to regulate Texas’ utility marketplace in the future. You should prepare your clients for this possibility.

Additionally, the Texas legislature is sure to place restrictions on some or all of these entities to ensure this does not happen again and in an effort to stave off federal regulation. If your clients include Texas electricity generators, you should tell them to expect additional regulation. They should work through you and/or lobbyists to help shape the coming regulations, rather than take a wait and see approach.

Litigation

The Texas power crisis has spurred significant litigation against all parties involved. Multiple class-action suits have already been filed against ERCOT, alleging it knew or should have known that the Texas electricity grid could not handle a winter storm of Uri’s magnitude, yet did nothing to prepare. Individual electricity providers have also been sued, with allegations that their allocation of days-long blackouts caused pain, suffering, and in some instances, death by hypothermia. Other utility providers—mainly those that offer variable-rate pricing tied to wholesale electricity rates—have been sued for over $1 billion for alleged price gouging by consumers that are facing utility bills approaching $10,000 each. Significant insurance litigation is likely on the horizon, as it is estimated that only a fraction of the total damage caused by the storm will ultimately be covered by insurance.

With an estimated $295 billion in damage statewide to fight over, and a major loss of life directly caused by power outages, significant litigation will continue for years to come. Utility providers, pump and other equipment manufacturers, natural gas producers, and pipeline operators all share some of the blame associated with damage from Winter Storm Uri. If you represent any of these entities, you should prepare your clients for possible class-action litigation that may seek billions of dollars in damages. You should also prepare your clients for denial of coverage by insurance companies that otherwise would have a duty to defend.

Possible Criminal Liability

The Travis County District Attorney’s office announced on February 23 that it opened a criminal investigation into whether any state entity, leader, or regulatory authority should face criminal charges because of the Texas power crisis. In addition, it, along with other county district attorneys’ offices, are investigating market manipulation, price gouging, and other financial crimes that may have occurred. If you have utility industry, power generation, or natural gas production clients, you should brief them on the possibility they may become involved in or be the target of a criminal investigation, as well as the possibility that any actions they took during the crisis may lead to criminal liability.

What Can be Done to Ensure This Does Not Happen Again?

While Winter Storm Uri has caused billions of dollars in freeze damage to residential and commercial plumbing, already spurred class-action lawsuits against ERCOT and public utility companies, and led to an unacceptable loss of life, the problems encountered by Texas’ electricity grid can be solved. Here are some ideas that have worked in cold-weather climates, and which should be adopted via mandatory regulation in Texas:

Require producers to winterize natural gas wells and pumps so they continue to operate in sub-zero temperatures, with annual inspections related to winterization steps and equipment
Require natural gas producers to have back-up generator systems available to power wellheads in case a brownout turns off electric power to a well
Require midstream gathering system operators and pipeline operators to winterize pipelines and pumps, with an annual inspection of winterization steps taken • Utilize glycol absorption to remove water from pumps and pipelines
- Utilize molecular sieve towers to remove water
- Inject methanol into pipelines, which works as an antifreeze to lower the freeze point of water vapor present with the natural gas
- Apply line heaters to pumps, control valves, and at-risk areas of pipeline
- Design pipelines with drip pots, liquid dumps, and/or offset filter dryers so that water and water vapor can be quickly and effectively removed before a pipeline or pipeline component freezes
Provide heat or other winterization solutions to critical pumping and other equipment at natural gas processing facilities
Mandate that power plants have emergency natural gas storage available for generation during winter months
Mandate that all new wind turbines be installed with cold weather packages which will keep ice accumulation on wind turbine blades to a minimum, including a combination of any of the following technologies
- Heated carbon fiber skins on each turbine blade
- Circulated hot air within each turbine blade
- Utilize cold-weather steel in turbine and blade design
- Utilize lubricants designed to stay at proper viscosity in cold weather
Mandate that all existing wind turbines must be retrofitted with cold weather packages within a five- year period and inspected to meet best practice cold weather standards for freeze protection
For coal and nuclear power plants, upgrade feedwater pumps (especially those located outdoors) to heated, weather-resistant models, or enclose the same in heated structures
Reevaluate Texas Energy Grid Independence
- Put new regulations in place that voluntarily meet FERC and NERC standards
- Create limited connectivity with outside power grids to draw emergency generating capacity when needed
- Mandate that ERCOT maintain minimum base-load power generation capacity at all times that is sufficient to provide power to the entire state on a rolling basis
- Provide incentives for creation of new base-load power generation

It is estimated that the cost of fully winterizing Texas power producers and the utility grid in general will be between $5 and $20 billion. Some estimate that consumers would only see an increase of approximately $10 per month on their utility bills if these costs were passed through to consumers. Many of these winterization steps were suggested by the FERC after a 2011 winter storm caused power outages for more than three million Texans. While ERCOT utilized some of the FERC guidance as part of its winterization best-practices suggestions to Texas utility providers, none became mandatory through state regulation. Ten years later, it is apparent that many of these best practices have largely been ignored, to the detriment of Texas residents and businesses. It is time for state authorities to use their regulatory powers to change things, protect Texas residents, and protect the integrity of the Texas power grid. With climate change causing increasingly harsh winters, the time to act is now.

Cameron Kinvig is a Content Manager for Practical Guidance, focusing on Energy & Utilities. Prior to developing content for Practical Guidance, Cameron was General Counsel and Chief Financial Officer for X-Subsea, a multi-national oil and gas services company focused on offshore dredging and excavation. Cameron also spent many years at Hunton Andrews Kurth, where he focused on energy law, corporate law, and real estate.

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FCA Announcement May Trigger LIBOR Cessation Benchmark

Alainna Nichols — Fri, 11 Jun 2021 15:45:19 GMT

By: The Practical Guidance Finance Team

The UK Financial Conduct Authority (FCA) has formally set the dates by which panel banks will no longer report on tenors of the London Interbank Offered Rate (LIBOR). These are the final dates the FCA will regulate LIBOR and the ICE Benchmark Administration (IBA) will publish LIBOR. If these dates remain unchanged, then all 35 tenors of LIBOR will cease after June 30, 2023. This could trigger a notice requirement under some credit agreements, as described below.¹

LIBOR (OFTEN REFERRED TO AS THE EURODOLLAR RATE IN credit agreements) has been the baseline pricing mechanism in loan agreements (and many other contractual arrangements, for that matter). The responsibility for overseeing and administering has rested with the IBA following the LIBOR manipulation scandal of 2012. The FCA, the regulator overseeing LIBOR, said that it would no longer require banks to provide LIBOR estimates at the end of 2021. However, the IBA subsequently said that only one-week and two-month USD LIBOR and, likely, Euro LIBOR and Swiss Franc LIBOR would cease on December 31, 2021, with the remaining tenors expiring on June 30, 2023. The Federal Reserve and the Alternative Reference Rate Committee (ARRC), a board comprising financial institutions and banks, trade associations (such as the Loan Syndication and Trading Association (LSTA)), and official sector members advising on the cessation of LIBOR in the United States, supported this announcement, as it provides some breathing room in the transition, but maintains clear targets.

Timing for LIBOR’s End

With its announcement, the FCA also supports the IBA’s timetable. Specifically, the FCA said that:

Publication of all seven euro LIBOR settings; all seven Swiss franc LIBOR settings; the Spot Next, 1-week, 2-month and 12-month Japanese yen LIBOR settings; the overnight, 1-week, 2-month and 12-month sterling LIBOR settings; and the 1-week and 2-month USD LIBOR settings will cease immediately after December 31, 2021.
Publication of the overnight and 12-month USD LIBOR settings will cease immediately after June 30, 2023. Previously, it had been noted that these will remain in effect to reduce disruption to a post-LIBOR benchmark rate (such as the Secured Overnight Financing Rate (SOFR))—specifically “in markets where it is unlikely to be feasible to convert certain outstanding contracts that reference LIBOR to alternative reference rates.” This includes commercial loan documents. Note that the extension relates only to legacy contracts, and new originations should not use LIBOR after 2021.

As with overnight and 12-month USD LIBOR, the FCA also said that it will consult on requiring the IBA to continue to publish the 1-month, 3-month, and 6-month Japanese yen LIBOR settings after end-2021 on a synthetic basis, for one additional year. The synthetic basis refers to the changed methodology by which the IBA will continue to provide rates after end-2021, reflecting the cessation of reporting by panel banks. These rates will not represent the underlying market and economy as the widely reported LIBOR rates had traditionally been (or supposed to be).

This goal of the extension, according to the FCA, “would be intended primarily to protect market integrity by allowing more time for transition away from Japanese yen LIBOR to complete.” Further, the FCA does not “envisage using our proposed powers to compel IBA to continue to publish any Japanese yen LIBOR settings after end-2022, and publication of these settings will consequently cease permanently immediately after a final publication on 30 December 2022.” However, the FCA left open the possibility of further extensions: “we will continue to consider the case for using these proposed powers also to require continued publication on a synthetic basis of the 1-month, 3-month and 6-month US dollar LIBOR settings for a further period after end-June 2023, taking into account views and evidence from the U.S. authorities and other stakeholders.”

Finally, the announcement also triggers an “Index Cessation Effective Date” under ISDA derivatives contracts. This means that the fallback spread adjustment has become fixed with the FCA’s announcement. The spread adjustment is added to SOFR to make the replacement rate representative.²

Impact Analysis

The main immediate impact of this announcement is that it could constitute a Benchmark Transition Event under a hardwired or amendment approach to transitioning away from LIBOR. These are standard-form clauses that address how the lenders and loan parties should proceed when LIBOR ceases being a benchmark interest rate. A Benchmark Transition Event is triggered when a regulator or administrator of LIBOR (such as the FCA) announces that the benchmark is no longer representative or that the administrator has ceased or will cease to provide the benchmark.

Right now, in most hardwired LIBOR transition clauses, this means that the administrative agent must notify the borrower and lenders of the event. Or, in a bilateral loan, the lender must notify the borrower. Such notice could begin the waiting period to amend a credit agreement to address a new benchmark rate in credit agreement using the amendment approach to LIBOR cessation. The LSTA has provided a draft notice based on the FCA’s announcement to members.³ Otherwise, the only other immediate impact is that a Benchmark Transition Event is a potential condition to a Benchmark Replacement Date, which would then be the date at which LIBOR will no longer be provided (i.e., the outside dates provided in the FCA’s announcement).

You should review your credit agreement to see if notice is required at this point, and if so, inform your client.

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Third Circuit Scuttles Triangular Setoff in Bankruptcy

Alainna Nichols — Fri, 11 Jun 2021 15:45:07 GMT

By: Charles M. Oellermann and Mark G. Douglas, Jones Day

This article discusses a recent decision in the U.S. Court of Appeals for the Third Circuit addressing whether triangular setoff is permissible in bankruptcy.

THE ABILITY OF A CREDITOR TO EXERCISE ITS CONTRACTUAL, common-law, or statutory rights under non-bankruptcy law to set off amounts owed to a debtor in bankruptcy against the debtor’s obligations to the creditor gives offsetting creditors an important advantage. Unlike many other creditors, creditors with setoff rights can receive preferential treatment in the form of full payment on their claims up to the amount of the setoff. However, a limitation on the exercise of setoff rights in bankruptcy is the Bankruptcy Code’s requirement that the debts involved must be mutual, a concept that is not well understood and sometimes disputed in the courts.

The Third Circuit recently addressed the meaning of mutuality in this context as a matter of first impression. In In re Orexigen Therapeutics, Inc.,¹ the Third Circuit affirmed lower court rulings that a triangular setoff does not satisfy the Bankruptcy Code’s mutuality requirement.

Setoff in Bankruptcy

Section 553 of the Bankruptcy Code provides, subject to certain exceptions, that the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case.”² Section 553 does not create setoff rights—it merely preserves certain setoff rights that otherwise would exist under contract or applicable non-bankruptcy law.³ As noted by the U.S. Supreme Court in Studley v. Boylston Nat. Bank,⁴ setoff avoids the “absurdity of making A pay B when B owes A.”

With certain exceptions for setoffs under safe-harbored financial contracts, a creditor is precluded by the automatic stay from exercising its setoff rights without bankruptcy court approval.⁵ However, if it applies, the automatic stay merely suspends the exercise of such a setoff pending an orderly examination of the respective rights of the debtor and the creditor by the court, which will generally permit the setoff if the requirements under applicable law are met, except under circumstances where it would be inequitable to do so.⁶

A creditor stayed from exercising a valid setoff right must be granted adequate protection⁷ against any diminution in the value of its interest caused by the debtor’s use of the creditor’s property.⁸

Setoff is expressly prohibited by Section 553 if (1) the creditor’s claim against the debtor is disallowed; (2) the creditor acquires its claim from an entity other than the debtor either (a) after the bankruptcy filing date or (b) after 90 days before the petition date while the debtor was insolvent (with certain exceptions); or (3) the debt owed to the debtor was incurred by the creditor (a) after 90 days before the petition date, (b) while the debtor was insolvent, and (c) for the purpose of asserting a right of setoff (with certain exceptions).⁹

Thus, for a creditor to be able to exercise a setoff right in bankruptcy, Section 553 requires on its face that (1) the creditor has a right of setoff under applicable non-bankruptcy law, (2) the debt and the claim are mutual, (3) both the debt and the claim arose prepetition, and (4) the setoff does not fall within one of the three prohibited categories specified in the provision. Although some courts have permitted the setoff of mutual postpetition debts¹⁰ the remedy is available in bankruptcy only “when the opposing obligations arise on the same side of the . . . bankruptcy petition date.”¹¹

Creditors typically rely on the remedy of setoff if the mutual debts arise from separate transactions, although the issue is murky.¹² By contrast, if mutual debts arise from the same transaction, the creditor may have a right of recoupment, which has been defined as “a deduction from a money claim through a process whereby cross demands arising out of the same transaction are allowed to compensate one another and the balance only to be recovered.”¹³ Unlike setoff, recoupment is not subject to the automatic stay¹⁴ and may involve both pre and postpetition obligations.¹⁵

Mutuality and Triangular Setoffs

The Bankruptcy Code does not define the term mutual debt. Debts are generally considered mutual when they are due to and from the same persons or entities in the same capacity, but there is some confusion among the courts on this point.¹⁶

For example, an exception to this strict mutuality requirement may exist in cases involving triangular setoff, the provenance of which is commonly traced (rightly or wrongly) to a 1964 ruling construing Section 68(a) of the former Bankruptcy Act of 1898 by the U.S. Court of Appeals for the Seventh Circuit in In re Berger Steel Co.¹⁷ In such a situation, A might have a business relationship with B and C, where B and C are related parties. Triangular setoff occurs when A owes B, and A attempts to set off that amount against amounts C owes to A. The validity of triangular setoff in the bankruptcy context, as distinguished from under state contract or common law, is subject to debate.

In In re SemCrude, L.P.,¹⁸ Bankruptcy Judge Brendan L. Shannon of the Delaware bankruptcy court ruled that triangular setoff is not permitted in bankruptcy due to the absence of mutuality. According to the court, “mutuality cannot be supplied by a multi-party agreement contemplating a triangular setoff.”¹⁹ The court rejected the contention that parties can contract around Section 553’s mutuality requirement. It also rejected Berger Steel as authority for the proposition that non-mutual setoff provisions in a contract can be enforced against a debtor.

In In re Lehman Bros.,²⁰ a New York bankruptcy court similarly ruled that triangular setoff does not satisfy the Bankruptcy Code’s mutuality requirement and that the Bankruptcy Code’s safe harbor provisions for financial contracts²¹ do not eliminate that requirement in connection with setoffs under such contracts.

Consistent with the rulings in SemCrude and Lehman, a Delaware bankruptcy court held in In re Am. Home Mortg. Holdings, Inc.,²² that (1) parties cannot contract around Section 553’s mutuality requirement; (2) the Bankruptcy Code’s safe harbor provisions for financial contracts “cannot be interpreted as implicitly removing the mutuality requirement for setoff”; and (3) without moving for relief from the stay, the nondebtor counterparty to a swap or repurchase agreement cannot exercise control over estate property by retaining funds via exercising alleged triangular setoff rights.²³

Other courts have also concluded that triangular setoff does not involve the mutuality required for setoff in bankruptcy.²⁴

Until recently, however, this issue had not been ruled upon at the court of appeals level. The Third Circuit considered this question in Orexigen.

Orexigen

In 2016, pharmaceutical company Orexigen Therapeutics, Inc. (OTI) entered into a distribution agreement with McKesson Corporation (McKesson) under which McKesson agreed to distribute weight management drugs manufactured by OTI to pharmacies. The distribution agreement included a setoff provision that allowed “each of [McKesson] and its affiliates . . . to set-off, recoup and apply any amounts owed by it to [OTI’s] affiliates against any [and] all amounts owed by [OTI] or its affiliates to any of [McKesson] or its affiliates.”²⁵

Later in 2016, OTI entered into a separate services agreement with McKesson subsidiary McKesson Patient Relationship Solutions (MPRS) under which MPRS managed a customer loyalty program for OTI whereby patients would receive price discounts from pharmacies. MPRS advanced funds to pharmacies selling OTI’s drugs, and OTI reimbursed MPRS for the advances. The distribution agreement and the services agreement did not reference, incorporate, or integrate one another.

OTI filed for Chapter 11 protection on March 12, 2018, in the District of Delaware. At that time, OTI owed MPRS approximately $9.1 million under the services agreement, and McKesson owed OTI approximately $6.9 million under the distribution agreement. Had there been a setoff under the distribution agreement prior to the petition date, OTI would have owed MPRS approximately $2.2 million, and McKesson would have owed OTI nothing.

In OTI’s bankruptcy, McKesson argued that it should be permitted to exercise the setoff, but later agreed to pay the $6.9 million it owed to OTI, which amount was segregated pending resolution of the dispute by the bankruptcy court. Bankruptcy Judge Kevin Gross denied McKesson’s request to exercise the setoff. He concluded that, although the setoff provision created an enforceable contractual right to effect a prepetition triangular setoff under state law, that relationship “does not supply the strict mutuality required in bankruptcy.”²⁶

Relying on SemCrude and Lehman, Judge Gross reasoned that contracts cannot transform non-mutual debts into debts satisfying the mutuality requirement of Section 553. He rejected McKesson’s argument that mutuality merely “identifies the state-law right that is thereby preserved unaffected in bankruptcy.”²⁷ Judge Gross also rejected the argument that MPRS’s alleged status as a third-party beneficiary of the distribution agreement created mutuality, characterizing those arguments as attempts to “contract around section 553(a)’s mutuality requirement.”²⁸

The district court affirmed on appeal, and McKesson appealed to the Third Circuit.²⁹

The Third Circuit’s Ruling

A three-judge panel of the Third Circuit also affirmed. Writing for the court, Circuit Judge Kent A. Jordan initially noted that “[t]he meaning of mutuality in [section 553] is a matter of first impression for us” and that, although “our sister circuits have opined on the importance of mutuality as a distinct limitation of § 553, they have not ruled on whether a contract can create an exception to the requirement of direct mutuality.”³⁰

Citing SemCrude and Lehman with approval, Judge Jordan rejected McKesson’s contention that both the general right to enforce a setoff and the required mutuality are defined by state law, and that Section 553 imposes “no independent mutuality limitation.” Specifically, McKesson argued that, because Section 553 includes three enumerated federal exceptions to the right to enforce a setoff in Section 553(a)(1)–(3) (as described above), lawmakers would have included an enumerated exception addressing mutuality if they “had intended that concept to serve as a limitation under federal law rather than a term simply descriptive of state law.” According to Judge Jordan, “McKesson’s reading of the provision would render the term ‘mutual’ redundant, as the phrase ‘any right . . . to offset’ provides adequate definitional scope to § 553.” Moreover, he explained, the text in Section 553(a) immediately following the mutuality requirement—which limits setoff to prepetition debts—has consistently been “viewed as a distinct limitation on the ability to assert a setoff right, and there is no persuasive reason to treat the requirement of mutuality any differently.”

Having determined that mutuality is a “distinct and limiting requirement of federal bankruptcy law,” the Third Circuit panel determined that triangular setoffs do not satisfy the requirement. Judge Jordan noted that setoff is inconsistent with the fundamental bankruptcy policy of equality of distribution among similarly situated creditors. For this reason, he explained, lawmakers’ intent to exclude contractual modifications purporting to establish mutuality for setoff purposes beyond simple, bilateral relationships is “not surprising.” According to Judge Jordan, the reasoning on this point articulated in SemCrude, Lehman, and other decisions rejecting triangular setoffs (including the lower courts in this case) was persuasive. In addition to serving the goal of the Bankruptcy Code to ensure that similarly situated creditors are treated fairly and enjoy equality of distribution absent compelling circumstances, he wrote, “a rule that excludes nonmutual debts from the setoff privilege of § 553 promotes predictability in credit transactions.”

Finally, the Third Circuit panel rejected McKesson’s argument that it actually asserted a direct claim against OTI under the setoff provision of the distribution agreement, noting that this position, which was also considered and rejected by the SemCrude court, “is nothing but a recasting of [McKesson’s] failed effort to defeat the purpose and meaning of § 553” based on a flawed interpretation of the definition of claim.

Outlook

With Orexigen, a federal court of appeals has now apparently for the first time unequivocally concluded that, even though triangular setoff may be enforceable under state law, it is not permitted in bankruptcy. This means that cross-affiliate setoff without mutuality continues to be impermissible at least in the two most popular business bankruptcy jurisdictions in the United States—the Southern District of New York and the District of Delaware—and likely most other jurisdictions. However, the Third Circuit indicated in dicta that alternative structures to contractual triangular setoff provisions, such as cross-collateralization, joint and several liability, or perfected security interests in receivables owed by or to affiliates, might be enforceable in bankruptcy.

Charles M. Oellermann is of counsel and oversees the Business Restructuring & Reorganization Practice in Jones Day’s Columbus, Ohio office. He has more than 25 years of experience representing clients in complex restructuring and bankruptcy matters. His practice focuses primarily on corporate restructuring, bankruptcy, and other insolvency-related matters. He plays leading roles in Jones Day’s representation of debtors, creditors’ committees, asset purchasers, and other parties in large corporate restructurings, both in court and out of court, across the country. Charlie also provides insolvency-related advice in litigation and transactional contexts. In addition, he counsels clients regularly on such matters as fraudulent conveyances, preferential transfers, secured financings, and distressed mergers and acquisitions.

Mark G. Douglas is the New York-based restructuring practice communications coordinator of Jones Day. He is the managing editor of the Jones Day Business Restructuring Review, a bimonthly newsletter discussing recent developments in bankruptcy, restructuring, distressed mergers and acquisitions, and related issues. He is also the managing editor of Jones Day’s EuroResource, a monthly newsletter discussing European distressed debt developments, and sits on the board of editors of Pratt’s Journal of Bankruptcy Law and The Bankruptcy Strategist.

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Cannabis Legalization and the Insurance Industry

Alainna Nichols — Fri, 11 Jun 2021 15:43:59 GMT

By: Christy Thiems, American Property Casualty Insurance Association

This article discusses the impact of cannabis legalization on the insurance industry. Disparate state laws on both medical and recreational use, federal issues such as classification/scheduling of cannabis and the evolving nature of federal enforcement of drug laws, and the conflicting interplay between state and federal cannabis laws are discussed, as well as the coverage requirements for the cannabis industry’s legitimate and complex business needs and insurance-specific concerns raised by developments such as increased accident frequency and coverage mandates.

WORKERS’ COMPENSATION INSURANCE ISSUES, SUCH as coverage for medical cannabis in work-related injury and illness claims, treatment concerns, and cannabis in the workplace are included with a review of drug-testing and impairment issues in the workplace and elsewhere and the wide-ranging impact that barriers to research continue to have on the cannabis industry’s nascent insurance protections.

In 2018, nearly 1,000 cannabis-related bills were introduced into state legislatures across the country. By 2019, 23 states had considered recreational cannabis legislation and 15 states had considered medical cannabis bills. As of Q1 2021, 36 states and the District of Columbia had approved the broad medical use of cannabis and 15 states and the District of Columbia had legalized recreational cannabis use. The federal government continues to classify cannabis as an illicit drug. CLICK HERE TO READ THE FULL ARTICLE IF YOU ARE A PRACTICAL GUIDANCE SUBSCRIBER

The Courts Have Spoken: Lessons of the Covid-19 Force Majeure Cases

sheika — Fri, 11 Jun 2021 15:42:51 GMT

By: Timothy Murray, Murray, Hogue and Lannis

The majestic New York State Supreme Court Building in Lower Manhattan has stood in regal watch over the tumult of the past century, a silent witness to every shade of humanity—from the disgraced movie mogul Harvey Weinstein, who was convicted there in 2020, to the revered jurist Benjamin Cardozo, who attended its dedication in 1927.

IT HAS BEEN A CRITICAL PLAYER IN COUNTLESS FILMS and television programs featuring characters that, just as in real life, span the spectrum of vice and virtue—from the mobster Barzini, who was shot on its steps in The Godfather, to Santa Claus himself, who stood trial there in the original Miracle on 34th Street. Courtroom 228 was the scene of the trial in the great morality play 12 Angry Men.

Lately, the grand old building is the epicenter of one of the greatest sagas in modern commercial jurisprudence, the COVID-19 force majeure cases—an avalanche of disputes over whether contractual performance should be excused due to the pandemic. Except this time, there are no villains or heroes, no morality plays, just tales of hapless folks trying “to negotiate a resolution that is painful but practical to insure that ‘on the other side’ there will be something left.”¹

Up in courtroom 432, Justice Arlene Bluth of the Supreme Court of New York County has become the unwitting face of the COVID-19 force majeure cases. She has handed down a staggering string of well-reasoned COVID force majeure, frustration of purpose, and impossibility decisions involving commercial real estate—always empathizing with tenants unable to pay the rent because of pandemic-spawned market downturns but equally mindful that the landlord has its own obligations.² When the parties themselves have not bothered to allocate the risk of a supervening event in their contract, the tenant is asking too much when it expects Justice Bluth to rewrite the contract because business is bad.³ In one case she cautioned a tenant raising the defense of frustration of purpose: “[I]magine a landlord who enters into a long-term lease, such as the one here, and then realizes a few years into the lease that the market rate for the leased premises far exceeds what the tenant is paying. Would that landlord be permitted to invoke the frustration of purpose doctrine? Of course not.”⁴ The same logic must prevail when the tenant suffers the market downturn, she said. Justice Bluth’s empathy evaporates when a party invokes the pandemic as a pretext to avoid its contractual obligations. In one case, she held that COVID-19 was not a valid excuse for failure to make payments under a settlement agreement since the failure predated the pandemic by almost a year. Her words were the judicial equivalent of an icy glare: “This Court can look at a calendar.”⁵ When another tenant “use[d] the pandemic as an excuse,” she said it was “an affront to the actual suffering of the many restaurants and businesses which were no longer able to pay their rent because of the pandemic.”⁶

Not all jurists bring such pointed clarity to these issues, but what the courts say in the COVID-19 force majeure cases is important. Courts tell us how to draft, and how to litigate in the COVID-19 force majeure landscape. The attorney who does not care what the courts say is like the pilot who refuses to learn about changes to the aircraft’s flight and navigation instruments—would you ride on that pilot’s plane?

For a much fuller discussion of these issues, see Corbin on Contracts: Force Majeure and Impossibility of Performance Resulting from COVID-19 (revised 2021 ed., pending publication at the time this article is being written). In this short article, I highlight some of the most important lessons of the COVID-19 force majeure cases.

Promises Generally Are Not Excused for Supervening Events

The first thing that every client who wants to declare force majeure due to COVID-19 needs to hear is that being excused of contractual obligations due to a force majeure event is the exception to the rule. That is not a feckless platitude—case after case attests that it is exceedingly difficult to be excused of contractual obligations, even in the worst pandemic in a century. “Generally, once a party to a contract has made a promise, that party must perform or respond in damages for its failure, even when unforeseen circumstances make performance burdensome . . . .”⁷

This means that force majeure should not be lightly invoked as a bargaining chip where it may not be applicable. If you declare force majeure on behalf of a client and it turns out that you were wrong, your client likely committed an anticipatory repudiation—a breach of contract that could subject your client to liability for damages and discharge the other party of its contractual obligations.⁸

Courts Honor Parties’ Allocation of the Risk of Supervening Events

To figure out if parties should be excused of their obligations due to a supervening event such as the pandemic, it is a mistake to start by looking to extra-contractual theories such as impossibility⁹ and frustration of purpose.¹⁰ You must start—and usually end—with the contract itself: did the parties somehow allocate the risk of the supervening event in their document? “[P]arties have broad discretion to allocate risks between them in a contract. . . . Only where there has been no contractual allocation of a risk should a court determine the allocation based on common law theories, such as impossibility and frustration of purpose.”¹¹

Sometimes, The Contract Explicitly Says Whether a Party May Be Excused

Some contracts squarely address the force majeure event. When a student sued a study abroad program for switching to online and distance learning classes due to the COVID-19 pandemic, the court dismissed the action because the contract specifically excused defendant of responsibility for loss “occasioned by or resulting from . . . force majeure, acts of government [ . . . ] epidemics or the threat thereof, [and] disease . . . .” Further, plaintiff agreed to “assume all risk of any such problems which could result from . . . perceived or actual epidemics” that could “delay, disrupt, interrupt or cancel programs.”¹²

In another case, Phillips, an art auction house, contracted with JN to take a painting on consignment and auction it in May 2020. The contract’s force majeure clause allowed Phillips to terminate for, inter alia, a “natural disaster.” When Phillips terminated the agreement due to the pandemic, JN sued for breach, but the court dismissed the action, explaining: “It cannot be seriously disputed that the COVID-19 pandemic is a natural disaster.”¹³

On the other hand, many contracts explicitly refuse to excuse parties of certain obligations due to supervening events. In one commercial lease, both the pandemic and the government shutdowns that followed were construed as force majeure events, but the court refused to excuse the tenant of its rent obligations because the lease also said that force majeure events do not excuse the tenant from paying rent. Since the contract allocated the risks, the court refused to consider the common law theories of impossibility and frustration of purpose.¹⁴ Similarly, a restaurant was not excused of its rent obligations even during a COVID-ordered shutdown since the lease said that tenant’s obligation to pay rent “shall in no wise be . . . excused because Owner is unable to fulfill any of its obligations under this lease . . . by reason of . . . government preemption or restrictions . . . .”¹⁵ The same was true in the cases involving a gym¹⁶ and a funeral home.¹⁷

Sometimes the decisions are difficult to reconcile. In In re CEC Entertainment, ¹⁸ CEC, an operator of Chuck E. Cheese venues, filed a motion to abate rent payments for leases affected by COVID-19 government restrictions that curtailed the restaurants’ operations by prohibiting arcade games and limiting patron capacity. In one of those leases, a force majeure provision excused performance that was “prevented or delayed” by “unusual governmental restriction,” but not for “inability to pay any sum of money due hereunder or the failure to perform any other obligation due to the lack of money . . . .” The court held that the tenant was not excused of its obligation to pay rent despite the government restrictions.

But in In re Hitz Rest. Grp., ¹⁹ a force majeure provision excused a restaurant tenant’s performance that was “prevented or delayed, retarded or hindered by . . . laws, governmental action or inaction, orders of government.” It also said that “[l]ack of money shall not be grounds for Force Majeure.” Unlike the CEC case, the court held that the force majeure clause was triggered by governor’s order suspending on-premises consumption at restaurants. The court rejected the landlord’s argument that the tenant’s excuse was merely “lack of money” (which would not be an adequate excuse). “Governor Pritzker’s executive order shutting down all ‘on-premises’ consumption of food and beverages in Illinois restaurants is the proximate cause of [tenant’s] inability to generate revenue and pay rent.”

Courts Interpret Contracts to Mean What They Say

CB Theater sought to be excused of its lease payment obligations during the time that theaters in Florida were under COVID-19 shutdown orders. Article 59 of the lease stated:

If either party to this Lease, as the result of any . . . (iv) acts of God, governmental action . . . or (v) other conditions similar to those enumerated in this Section beyond the reasonable control of the party obligated to perform (other than failure to timely pay monies required to be paid under this Lease), fails punctually to perform any obligation on its part to be performed under this Lease, then such failure shall be excused and not be a breach of this Lease by the party in question, but only to the extent occasioned by such event.

The court held that Article 59 excused CB Theater from operating during the shutdown. Importantly, the parenthetical “other than failure to timely pay monies” did not apply to the excuse regarding “acts of governmental action” since it “is part of romanette (v) - the ‘other conditions’ phrase.” ²⁰

In another case, MS Bank had an account with CBW Bank, and their agreement included this force majeure clause: “If a party is prevented, hindered, or unavoidably delayed from or in performing any of its obligations under this Agreement by an event beyond its reasonable control, such as compliance with a law or governmental order . . . , that party shall not be obliged to perform its obligations . . . .” The agreement also allowed CBW to terminate the agreement on 30 days’ notice, which is what CBW did. MS sought to enjoin termination, arguing that the COVID-19 pandemic made it difficult to find a replacement bank to perform the services it required. The court held that MS failed to point to any “obligation,” per the force majeure clause, that it was unable to perform. The court refused to expand what the parties themselves had agreed to.²¹

Since the goal of contract law is to give effect to the parties’ intentions,²² courts look to the entire contract, not just the force majeure clause, to figure out if the parties intended to allocate the risk of a supervening event. In one case, the parties entered into a court approved settlement that said Zapata “shall” pay Pinero $200,000.00 by April 1, 2020, with a built-in grace period allowing Zapata to pay by May 1, 2020, and to obtain refinancing on the properties by June 1, 2020. Failure to meet either obligation meant that Zapata would relinquish her interest in the properties to Pinero. Zapata claimed that the COVID-19 pandemic made timely performance impossible, and the trial court granted extensions. The appellate court reversed and held that the trial court improperly voided and rewrote the agreement. The contract set firm due dates with a single one-month extension without spelling out relief for force majeure events.²³

Conditions Precedent Are Not Lightly Inferred

In Shin v. Young Yoon, ²⁴ defendants moved to delay payments on a stipulated judgment for one year, claiming that economic hardship arising from COVID-19 made it impossible because they were not able to sell a certain hotel necessary to meet their obligation. The stipulated judgment stated that the sale of the hotel would fund a significant portion of their payments. The court refused to delay defendants’ payments, explaining that the sale of the hotel was not a condition precedent to defendants’ obligation to pay. Merely mentioning an intent to sell the hotel did not make it a condition precedent (a condition precedent is not lightly inferred), and defendants did not treat it as a condition precedent—they made some payments despite the failure to sell the hotel.

Clarity in Drafting Is Crucial

No judge has ever complained that a contract is too clear. In Gibson v. Lynn Univ., Inc.,²⁵ a student sued the university after it transitioned to remote learning due to the COVID-19 pandemic. The university filed a motion to dismiss, citing the force majeure clause in its University Policies that provided as follows: “There will be no refund of tuition, [or] fees ... in the event the operation of the University is suspended at any time as a result of an act of God, strike, riot, disruption or for any other reasons beyond the control of the University.” But the plaintiff pointed to a disclaimer stating that the University Policies “do[] not create an express or implied contract.” Since it was not clear whether the University Policies were contractual in nature, the court denied the motion.

In Rudolph v. United Airlines Holdings,²⁶ plaintiffs sued United Airlines seeking a refund (not just a credit) for fares after cancellation of flights in the wake of COVID-19. The conditions of carriage spelled out more than one type of involuntary cancellation: (1) “Force majeure” (where the passenger was not entitled to a refund): “Any condition beyond [the airline’s] control including, but not limited to . . . acts of God . . . .” (2) “Irregular operation” (where the passenger was entitled to a refund): This included cancellations “necessary or advisable by reason of . . . conditions beyond [United’s] control, (including, but not limited to acts of God, force majeure events . . . .).” The court denied, in part, United’s motion to dismiss because the agreement was ambiguous: irregular operation directly overlapped with force majeure—irregular operation included force majeure as part of its definition. The court explained: “Certainly, there must be some point where a Force Majeure Event ends, and . . . [an] Irregular Operation begins. And to the extent that boundary is unclear, the [conditions of carriage], drafted entirely by United, must be construed in Plaintiffs’ favor.ˮ

Subjective Inability to Perform (e.g., Financial Hardship) Does Not Excuse Performance

In case after case, businesses—often commercial tenants that service the public—have been economically devastated by COVID-19 market downturns. Contracts typically do not provide relief for the tenant when that happens, and where the contract has not allocated the risk, extra-contractual theories provide no defense for market downturns caused by the pandemic. Typical is RPH Hotels 51st St. Owner, LLC v. HJ Parking LLC,²⁷ where a parking garage in the heart of Times Square sought to be excused of the default judgment entered against it stemming from its failure to pay rent during the COVID-19 pandemic. Justice Arlene Bluth wrote: “If a business that was permitted to operate throughout the pandemic (as opposed to others, such as gyms, that were forced to close for months) can assert a frustration of purpose or impossibility defense, then nearly every struggling commercial tenant could seek relief from their leases.” Suffering is widespread in the pandemic, she wrote, but “[t]he solution is not for this Court to ignore an otherwise-valid contract to the severe detriment of one party.”

In another case, Justice Bluth explained that “both the landlord and the tenant have undoubtedly faced significant hardship” due to the pandemic, but the parties did not agree to place the risk of the pandemic on the landlord. “The Court declines to step in and unilaterally modify the parties’ contract and tell the landlord that it should not be able to enforce the agreement it signed with a tenant.”²⁸ There have been a plethora of such decisions in the past few months.²⁹

Performance Is Excused Only if the Non-Occurrence of the Supervening Event Was a Basic Assumption of the Parties

Both Parties Must Share the Basic Assumption

In deciding whether a supervening event excuses a party’s performance, “the central inquiry is whether the non-occurrence of the circumstance was a ‘basic assumption on which the contract was made.’”³⁰ In one case, Martorella agreed to purchase property and made a deposit that the agreement said he would lose if he failed to close. The contract said that Martorella “acknowledges that this Agreement contains no contingencies affecting [his] obligation to perform” (e.g., no financing contingency). Martorella did not tell the seller that he relied on his wife to help obtain financing. Before closing, Martorella’s wife contracted COVID-19 and became seriously ill, but the seller refused to delay the closing despite Martorella’s claims of impossibility. Martorella filed an action, which the court dismissed because Martorella had expressly assumed the risk of making the payment—there were no contingencies—and the health of Martorella’s wife was not a basic assumption on which the contract was made.³¹

Generic Leases Versus Leases Restricted to a Single Use

UMNV leased commercial space to Caffé Nero on condition that the premises could only be used to operate a “Caffé Nero themed café” and for no other purpose. When the governor banned restaurants from serving on-premises food or beverages due to COVID-19, Caffé Nero temporarily shut down its premises and stopped paying rent. UMNV terminated the lease and sued, inter alia, for back rent and for damages for the 12 years remaining on the lease. The court granted partial summary judgment in favor of Caffé Nero, concluding that Caffé Nero’s performance under the lease was temporarily excused due to frustration of purpose during the shutdown. Critical to the court’s holding was that “[t]he Lease provides that Caffé Nero could use the leased premises only to operate a café with a sit-down restaurant menu ‘and for no other purpose.’” A basic assumption of the lease was the non-occurrence of a government shutdown of restaurants.³²

Justice Bluth provided an astute analysis in 1140 Broadway LLC v. Bold Food, LLC.³³ A company that managed restaurants stopped paying rent when the COVID-19 shutdowns of the restaurants it serviced severely hurt its business. The landlord sued, and the court rejected the tenant’s frustration of purpose defense. The tenant’s problem was subjective: tenant had not been ordered to shut down, but it happened to use the space it leased for a particular business that was severely hurt by the pandemic. Justice Bluth wrote: “This was a generic office lease,” and it “is not a case . . . where a tenant rented a unique space for a specific purpose that can no longer serve that function.”

A decision that merits some attention is SVAP v. Coon Rapids,³⁴ where a landlord sued a gym for failing to pay rent when it was shut down due to COVID-19. The lease mandated that “Tenant shall use the Premises for only the operation of a fitness center and workout facility,” so the shutdown prevented the tenant from using the space for the sole purpose that the contract allowed, but the court refused to excuse the tenant from its contractual obligations based on frustration of purpose.

The court’s rationale to support this conclusion is not satisfying. It held that the possibility of closure was an “implied risk” that the tenant assumed, and it pointed to a generic lease provision requiring the tenant to “comply with any and all requirements of any public authority, and with the terms of any . . . law, statute or local ordinance or regulation applicable to Tenant for its use, safety, cleanliness or occupation of the Premises.” (The court italicized “any and all.”) No one questions a tenant’s obligation to comply with the law. But the fact that the tenant agreed—in a standard, non-specific, all-encompassing, boilerplate lease provision—to generally comply with all laws relating to its tenancy does not tell us whether the parties should “have foreseen as a real possibility”³⁵ the outright closure of gyms because of the worst pandemic in a century. It strains credulity to suggest that this garden variety provision—to quote another court—“allocate[d] to [tenant] the unforeseen risk that a global pandemic could lead to government orders that bar [tenant] from operating . . . on the leased premises.”³⁶

The court also noted that the lease “allows Tenant to seek Landlord’s consent to operate the Premises for some other purpose” and suggested that the tenant should have sought the landlord’s consent to do just that. This is a thin reed on which to rest the holding because parties always may modify their agreement and change its purpose regardless of whether the contract says so. That mere possibility does not alter the deal that the parties actually struck—in this case, the parties never agreed that the tenant would change its business to something other than a gym. Besides, it is wholly unrealistic to assume that the operator of a gym can, or should, simply wake up one day and launch an entirely new line of business. The court also said that tenant should have attempted “innovative measures” to generate income (e.g., virtual training, loans, fundraisers, and reallocation of funds between affiliated locations). But the tenant bargained to lease space to operate a gym—not to host a Zoom studio, launch a GoFundMe campaign, or sell cookies door-to-door to raise money.³⁷ In short, the facts suggest that, contrary to the court’s holding, the non-occurrence of a shutdown of gyms was a basic assumption of this lease.

Takeaways from the COVID-19 Force Majeure Cases

Contract disputes are often won and lost in the drafting phase. The pandemic presents a golden opportunity to rethink force majeure provisions going forward. In early 2020, it was unthinkable to many businesses that they would be shut down and otherwise restricted for extended periods of time. Many are intent on avoiding anything similar. The climate for negotiating deals has changed. “Tenants are getting anywhere from 10 to 75 percent off their contractual minimum rent rates. In addition, many landlords are agreeing to percentage rent deals, which prior to COVID-19 were unusual and rare.”³⁸ But “some landlords are requesting a landlord right of termination, which would allow the landlord to terminate the lease upon a certain number of days’ notice to the tenant.”³⁹

In drafting, keep the following in mind:

Spell out in the contract all occurrences that would make the bargain intolerable to your client (e.g., the loss of a sole source of supply). If your client’s performance depends on something happening, call that event a condition precedent to your client’s obligations.
If the force majeure clause lists contingencies, the canon expressio unius est exclusio alterius would exclude any item not specifically listed, so add a catch-all that is not limited to the same type of events as the listed items. Example: “. . . or any other events or circumstances not within the reasonable control of the party affected, whether similar or dissimilar to any of the foregoing.” Many courts hold that “[w]hen parties specify certain force majeure events, there is no need to show that the occurrence of such an event was unforeseeable.”⁴⁰ When the event is not specifically listed but a party seeks to rely on the catch-all provision of a force majeure provision (e.g., “any other cause not enumerated herein but which is beyond the reasonable control of the party whose performance is affected”)—the event that purportedly falls within the catch-all must be unforeseeable.⁴¹
Mention, inter alia, government action, calamity, natural disaster, viral outbreaks, and perceived or actual epidemics and pandemics.
Describe with clarity whether, and to what extent, a full or partial government shutdown of the business excuses performance obligations, and whether such shutdown overrides lack of money.
Spell out the necessity of providing prompt notice of the event and the duty to keep the non-affected party apprised.
Spell out how and when the non-affected party may treat the contract as ended after the other party has declared force majeure.

Timothy Murray, a partner in the Pittsburgh, PA law firm Murray, Hogue & Lannis, writes the biannual supplements to Corbin on Contracts, is author of Volume 1, Corbin on Contracts (rev. ed. 2018), and is co-author of the Corbin on Contracts Desk Edition (2017).

To find this article in Lexis Practical Guidance, follow this research path:

RESEARCH PATH: THE COURTS HAVE SPOKEN: THE LESSONS OF THE COVID-19 FORCE MAJEURE CASES IN PRACTICAL GUIDANCE.

U.S. Supreme Court Securities Litigation Decisions

sheika — Fri, 11 Jun 2021 15:41:54 GMT

By: Susan L. Saltzstein, Mollie Kornreich, and Kyle J. Schwartz Skadden, Arps, Slate, Meagher & Flom LLP

This article highlights a selection of U.S. Supreme Court decisions that touch on key aspects of the securities laws, including (1) liability for statements of opinion and belief; (2) the scope of liability under the Securities Exchange Act of 1934, as amended (Exchange Act); (3) disgorgement in Securities and Exchange Commission (SEC) enforcement actions; (4) issues relating to the Securities Litigation Uniform Standards Act of 1998; (5) limitation periods; and (6) the scope of liability under the Securities Act of 1933, as amended (Securities Act).

THE U.S. SUPREME COURT HAS SHAPED THE CONTOURS of litigation under the Securities Act and the Exchange Act and has been particularly attentive to issues arising under these statutes in recent years. This article discusses critical decisions on issues such as materiality, scienter, loss causation, reliance, extraterritoriality, and insider trading.

Liability for Statements of Opinion and Belief

The Supreme Court addressed what may constitute a false or misleading opinion for purposes of liability under Section 11 of the Securities Act in Omnicare, Inc. v. Laborers Distr. Council Constr. Indus. Pension Fund, 575 U.S. 175 (2015). Section 11 provides investors with a private right of action for false statements of material fact in a registration statement, or omission of a material fact necessary to render material in the registration statement not misleading.¹

At issue in Omnicare were two sentences in the issuer’s registration statement—each of which began, “We believe”— that expressed the company’s view of its compliance with legal requirements.² The Court, in an opinion by Justice Elena Kagan, declined to hold that an incorrect statement of opinion was necessarily false for purposes of Section 11 liability. Liability, however, may arise “if the speaker did not hold the belief she professed” or if the statement contained “embedded statements of fact” that were untrue.³ The Court also explained that a reasonable investor may, under certain circumstances, “understand an opinion statement to convey facts about how the speaker has formed the opinion,” and if contrary real facts are omitted, the opinion could be misleading.⁴ An opinion, however, is not necessarily misleading when an issuer does not disclose “some fact cutting the other way” because reasonable investors “understand that opinions sometimes rest on a weighing of competing facts.”⁵ An investor must identify particular and material facts underlying the opinion, the omission of which renders the opinion “misleading to a reasonable person reading the statement fairly and in context.”⁶ That, the Court recognized, “is no small task for an investor.”⁷

Remanding the case for consideration under the misleadingby-omission standard, the Court emphasized that the lower court should address whether the alleged omission would have been material to a reasonable investor, and whether it rendered Omnicare’s stated opinions misleading because the company “lacked the basis for making those statements that a reasonable investor would expect.”⁸ This analysis had to consider the opinion statements’ context. Because the statements at issue involved the company’s view of its compliance with legal requirements, the Court directed the lower court to “take account of whatever facts [the company] did provide about legal compliance, as well as any other hedges, disclaimers, or qualifications it included in its registration statement.”⁹

In the years since Omnicare was decided, courts have applied its standard to allegedly misleading statements or omissions outside the Section 11 context. The Second and Ninth Circuits, for example, have applied the Omnicare standard in cases involving Section 10(b) of the Exchange Act.¹⁰

Scope of Liability under the Exchange Act

Who May Be Liable for a Misstatement or Omission

Over the past few decades, the Court’s jurisprudence has significantly evolved on the issue of who private plaintiffs may hold liable for a material misstatement or omission under Section 10(b) of the Exchange Act.¹¹ Two key decisions in this area—Cent. Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), and Stoneridge Inv. Partners, LLC v. ScientificAtlanta, Inc., 552 U.S. 148 (2008)—concern aiding and abetting claims. In Central Bank, the Court held that there is no private right of action for aiding and abetting under Section 10(b).¹²

The Central Bank decision caused some, including then-SEC Chair Arthur Levitt, to lobby Congress to create an express cause of action for aiding and abetting in the Exchange Act.¹³ Congress did not do so; instead, in the Private Securities Litigation Reform Act of 1995 (PSLRA), it directed the SEC to prosecute aiders and abettors.¹⁴ Accordingly, in Stoneridge, the Court reaffirmed its Central Bank holding that liability under Section 10(b) “does not extend to aiders and abettors.”¹⁵ The Court reiterated that, to be actionable, “[t]he conduct of a secondary actor must satisfy each of the elements or preconditions for liability.”¹⁶

The Court built upon its decisions in Central Bank and Stoneridge in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), where it rejected plaintiff’s attempt to impose Section 10(b) liability upon registrants’ advisors and service providers. The Court held that “[f]or purposes of Rule 10b-5, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”¹⁷ “Without control,” the Court explained, “a person or entity can merely suggest what to say, not ‘make’ a statement in its own right.”¹⁸ The Court analogized to the relationship between a speechwriter and a speaker, noting that the speaker, not the speechwriter, is the one who takes the credit or blame for what is ultimately said.¹⁹

Eight years after the Court’s decision in Janus, which reaffirmed the somewhat narrow scope of liability under Section 10(b) and Rule 10b-5 first set out in Central Bank and Stoneridge, the Court arguably took a step in the opposite direction in Lorenzo v. SEC, 139 S. Ct. 1094 (2019). Rule 10b-5 makes it unlawful:

“(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact . . . or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit . . . in connection with the purchase or sale of any security.”²⁰

In Lorenzo, the Court held, in an opinion authored by Justice Stephen Breyer, that a person who did not “make” a false statement under Rule 10b-5(b) may still be liable under Rule 10b-5(a) or (c) for “disseminat[ing] false or misleading statements to potential investors with the intent to defraud.”²¹ Plaintiffs may now argue that Lorenzo expands potential liability under Rule 10b-5(a) and (c) for a defendant who disseminates purported misstatements by third parties.

Justice Clarence Thomas—who authored the Court’s opinion in Janus—penned a vigorous dissent, contending that the majority’s opinion in Lorenzo rendered Janus “a dead letter.”²² Justice Breyer—who dissented in Janus—rejected this argument, maintaining that “Janus would remain relevant (and preclude liability) where an individual neither makes nor disseminates false information—provided, of course, that the individual is not involved in some other form of fraud.”²³

Materiality

In TSC Indus. v. Northway, 426 U.S. 438 (1976), which involved claims under Section 14(a) of the Exchange Act²⁴ for an allegedly incomplete and materially misleading proxy statement, the Court defined materiality by stating that “[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.”²⁵ The Court later, in Basic Inc. v. Levinson, 485 U.S. 224 (1988), expressly adopted this definition of materiality for Section 10(b) and Rule 10b-5 as well.²⁶

Decades later, the Court referenced this definition again in Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27 (2011), when considering whether reports of adverse drug reactions were material and whether a drug company’s failure to disclose them was actionable under the Exchange Act. Defendants argued that the complaint was deficient because it did not “allege that Matrixx knew of a statistically significant number of adverse events requiring disclosure.”²⁷ The Court declined to draw a bright-line rule for materiality in this context, holding that plaintiffs had “alleged facts plausibly suggesting that reasonable investors would have viewed these particular reports as material.”²⁸

The Court considered the interplay between the materiality requirement and Rule 23’s prerequisites for class certification in Amgen Inc. v. Conn. Ret. Plans & Trust Funds, 568 U.S. 455 (2013). Specifically, the Court considered “whether district courts must require plaintiffs to prove, and must allow defendants to present evidence rebutting, the element of materiality before certifying a class action under § 10(b) and Rule 10b-5.”²⁹ The focus of the Court’s inquiry was Rule 23(b) (3)’s requirement that “questions of law or fact common to class members predominate over any questions affecting only individual members.”³⁰ The Court held that “proof of materiality is not required to establish that a proposed class is ‘sufficiently cohesive to warrant adjudication by representation’—the focus of the predominance inquiry under Rule 23(b)(3).”³¹ Responding to policy arguments that the Court’s decision would unduly pressure defendants to settle rather than incur the costs of defending a class action, the Court noted that Congress sought to address so-called in terrorem settlements in the PSLRA but chose not to “decree that securities-fraud plaintiffs prove each element of their claim before obtaining class certification.”³²

Scienter

The Supreme Court has long held that liability under Section 10(b) of the Exchange Act (and Rule 10b-5) requires a plaintiff to prove that the defendant acted with scienter, not mere negligence.³³ The SEC must also establish scienter as an element of a civil enforcement action to enjoin violations of Section 10(b) of the Exchange Act and Rule 10b 5.³⁴

The Court elaborated on the standard for pleading scienter in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), which followed enactment of the PSLRA. “Exacting pleading requirements [were] among the control measures Congress included in the PSLRA,” which was designed to curb “abusive litigation by private parties.”³⁵ But although the PSLRA requires plaintiffs to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind,”³⁶ Congress “left the key term ‘strong inference’ undefined, and Courts of Appeals [were] divided on its meaning.”³⁷

The Supreme Court held in Tellabs that “an inference of scienter must be more than merely plausible or reasonable—it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.”³⁸ This standard requires district courts to “take into account plausible opposing inferences” and consider how likely it is “that one conclusion, as compared to others, follows from the underlying facts.”³⁹ The inquiry is “inherently comparative” and “cannot be decided in a vacuum.”⁴⁰ The Court cautioned that “[a] complaint will survive . . . only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.”⁴¹ Tellabs therefore clarified that the PSLRA heightens plaintiffs’ pleading burden by requiring them to allege in their complaints particular facts sufficient to establish a cogent inference of scienter. When a complaint’s allegations insufficiently plead a defendant’s intent, the defendant may have a strong motion to dismiss.

“In Connection with” a Purchase or Sale

Section 10(b) may give rise to liability for misconduct “in connection with the purchase or sale of any security.” In Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), the Supreme Court held that only actual purchasers or sellers of securities could maintain a private action under Section 10(b) and Rule 10b-5—not, for example, potential purchasers of shares who decided not to invest because of a misrepresentation or omission. The Court relied, in part, on various “policy considerations” in reaching its decision, including potential problems that could arise if investors who neither bought nor sold could claim that they would have traded absent the alleged fraud.

The Court later examined the scope of the “in connection with” requirement in SEC v. Zandford, 535 U.S. 813 (2002). The Court held that a complaint alleging that a stockbroker “[sold] his customer’s securities and us[ed] the proceeds for his own benefit without the customer’s knowledge or consent” sufficiently alleged conduct “in connection with the purchase or sale of any security” within the meaning of Section 10(b).⁴² The Court explained that although not every fraud involving securities constitutes a Section 10(b) violation, a “scheme in which the securities transactions and breaches of fiduciary duty coincide” may give rise to liability under the statute.⁴³

Reliance

In Basic Inc. v. Levinson, the Supreme Court held that a plaintiff could satisfy Section 10(b)’s reliance requirement through a rebuttable presumption that a company’s stock price in an efficient market reflects all material public information, and any investor trading in that market presumptively relies on any material misstatements in that information. Reliance based on this “fraud-on-the-market” theory may only be presumed where a plaintiff demonstrates all of the following:

The defendant made public, material misrepresentations.
The shares were traded on an efficient market.
The plaintiff traded after the misrepresentations were made but before the truth was revealed.⁴⁴

Nevertheless, Basic provided plaintiffs with an invaluable mechanism for satisfying Section 10(b)’s reliance requirement, particularly as it could be applied on a classwide basis

Decades later, in 2014, the Supreme Court addressed the continued applicability and scope of this presumption in Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014) (Halliburton II). Though it declined to modify the presumption, the Court emphasized that, “[a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.”⁴⁵ And, critically, the Court held that “defendants must be afforded an opportunity before class certification to defeat the presumption through evidence that an alleged misrepresentation did not actually affect the market price of the stock.”⁴⁶ Because reliance in the absence of the presumption would need to be proven by investors on an individualized basis, this opportunity provides a useful tool to potentially defeat certification of an investor class.

The Supreme Court will have the opportunity to consider Basic’s reach once again in the next term. On August 21, 2020, a petition for a writ of certiorari was filed asking the Court to consider (1) “Whether a defendant in a securities class action may rebut the presumption of classwide reliance recognized in Basic Inc. v. Levinson by pointing to the generic nature of the alleged misstatements in showing that the statements had no impact on the price of the security, even though that evidence is also relevant to the substantive element of materiality,” and (2) “Whether a defendant seeking to rebut the Basic presumption has only a burden of production or also the ultimate burden of persuasion.” Petition for a Writ of Certiorari at I, Ark. Teacher Ret. Sys., No. 20-222 (U.S. Aug. 21, 2020). The Court granted the petition on December 11, 2020.

Loss Causation

In Dura Pharms., Inc. v. Broudo, 544 U.S. 336 (2005), the Supreme Court considered what a Section 10(b) plaintiff must plead and prove to establish that a defendant’s misstatements and omissions caused plaintiff’s losses. It held that a disparity between the price plaintiff paid for its shares and the shares’ true value at the time of purchase is insufficient to prove loss causation; an investor does not necessarily suffer loss by purchasing at an inflated rate, the Court reasoned, since upon purchase, the investor possesses a share of equivalent value—and could, for example, sell before the market corrects the price. And a subsequent drop in price may be attributable to changed economic circumstances, changed investor expectations, or a variety of factors. A plaintiff must therefore establish a causal connection between the alleged fraud and the loss.

The Court subsequently addressed whether a plaintiff is required to prove loss causation at the class certification stage in Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011) (Halliburton I). The Court reasoned that loss causation “has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory,” and the Court of Appeals therefore erred by requiring plaintiffs to establish loss causation as a condition of class certification on that ground.⁴⁷

Extraterritoriality

Prior to 2010, lower courts’ application of Section 10(b) to extraterritorial cases was often inconsistent. The Supreme Court took up the issue in Morrison v. Nat’l Australia Bank Ltd., 561 U.S. 247 (2010), in which Australian purchasers of stock in the National Bank of Australia—which is traded on the Australian stock exchange—sought to bring Section 10(b) claims in the United States based on misconduct that allegedly occurred in Florida. The Court held that the plaintiffs failed to state a claim because Section 10(b) only applies to securities listed on U.S. exchanges, or transactions that occur within the United States.⁴⁸ The Court’s decision in Morrison sharply curtailed plaintiffs’ ability to sue foreign issuers in the United States for losses incurred on transactions in foreign securities.

Insider Trading

In its landmark insider trading decision Chiarella v. United States, 445 U.S. 222 (1980), the Supreme Court laid out what it has since referred to as a traditional or classical theory of insider trading liability. Under this theory, Section 10(b) and Rule 10b-5 are violated “when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information.”₄₉ “Trading on such information qualifies as a ‘deceptive device’ under § 10(b) . . . because ‘a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation.’”⁵⁰

Further developing its insider trading jurisprudence, the Court addressed liability under Section 10(b) for those who receive “tips” of misappropriated, inside information in Dirks v. SEC, 463 U.S. 646 (1983). The Court held that “a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.”⁵¹ Whether the insider’s disclosure is a breach of duty depends largely on whether the disclosure is for personal advantage. The test is whether the insider personally benefits from the tip, either directly or indirectly. “Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.”⁵²

Subsequently, in United States v. O’Hagan, the Court held that Section 10(b) alternately allows the government to establish insider trading liability through a so-called “misappropriation theory.” Under this standard, “a person commits fraud ‘in connection with’ a securities transaction . . . when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”⁵³

The Court revisited the requirement that a tipper must personally benefit from making a tip for the conduct to fall within the scope of Section 10(b) and Rule 10b-5 in Salman v. United States, 137 S. Ct. 420 (2016). The defendant in Salman “received lucrative trading tips from an extended family member, who had received the information from [the defendant’s] brother-in-law.”⁵⁴ The Court held that “Dirks makes clear that a tipper breaches a fiduciary duty by making a gift of confidential information to ‘a trading relative.’”⁵⁵ Citing Dirks, the Court explained that “when a tipper gives inside information to ‘a trading relative or friend,’ the jury can infer that the tipper meant to provide the equivalent of a cash gift . . . In such situations, the tipper benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.”⁵⁶

The aforementioned cases concern insider trading under Section 10(b) of the Exchange Act, codified at Title 15 of the U.S. Code. In a recent Second Circuit case, United States v. Blaszczak, 947 F.3d 19 (2d Cir. 2019), the government sought to prosecute insider trading under Section 1348 of Title 18, which “was added to the criminal code by the SarbanesOxley Act of 2002 in large part to overcome the ‘technical legal requirements’ of the Title 15 fraud provisions.”⁵⁷ The Second Circuit held in Blaszczak that the personal-benefit test announced in Dirks “does not apply to the wire fraud and Title 18 securities fraud statutes,” potentially expanding the scope of criminal liability to insider trading cases where there is no evidence of direct or indirect personal benefit to the tipper.⁵⁸ On September 4, 2020, a petition for a writ of certiorari was filed asking the Supreme Court to consider, among other things, “Whether [the] Court’s holding in Dirks v. SEC, requiring proof of ‘personal benefit’ to establish insider-trading fraud, applies to Title 18 statutes that proscribe fraud in language virtually identical to the Title 15 anti-fraud provisions at issue in Dirks.” Petition for a Writ of Certiorari at i, Olan v. United States, No. 20-306 (U.S. Sept. 4, 2020).

Disgorgement in SEC Enforcement Actions

The Supreme Court has also recently addressed the remedies available in SEC enforcement actions. In a highly anticipated decision, Liu v. SEC, 140 S. Ct. 1936 (2020), the Court rejected the argument that the SEC lacked authority to seek disgorgement in a civil action. It held, however, that because such disgorgement is an equitable remedy rather than a punitive sanction, it is limited to net profits after legitimate business expenses are deducted.⁵⁹ The Court declined to reach the additional argument that the disgorgement award at issue was improper because, among other things, it failed to return funds to the victims, leaving that to the analysis on remand.⁶⁰

SLUSA

The Securities Litigation Uniform Standards Act of 1998 (SLUSA) has raised a variety of issues that have percolated up to the Supreme Court. SLUSA precludes certain state law class actions involving “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.”⁶¹ SLUSA defines “covered security” to include only securities traded on a national exchange or issued by investment companies.⁶²

In Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71 (2006), the Court held that SLUSA precludes covered state law claims where the alleged fraud dissuades a potential buyer from purchasing a security or prevents an investor from selling. The Court reasoned that “[t]he requisite showing . . . is deception in connection with the purchase or sale of any security, not deception of an identifiable purchaser or seller.”⁶³ In reaching its decision, the Court noted that a narrow reading of SLUSA would be contrary to its purpose, which was to prevent certain state securities class actions from frustrating the objectives of various restrictions imposed on federal securities class actions.⁶⁴ Class actions brought by holders (as opposed to purchasers or sellers) “pose a special risk of vexatious litigation,” and it would be “odd” if SLUSA did not preempt “that particularly troublesome subset of class actions.”⁶⁵

The Court subsequently considered whether SLUSA precludes state law class actions involving uncovered securities (e.g., certificates of deposit that are not traded on any national exchange) that were falsely represented as being backed by covered securities in Chadbourne & Parke LLP v. Troice, 571 U.S. 377 (2014). The Court held that SLUSA does not apply in such circumstances, explaining that “[a] fraudulent misrepresentation or omission is not made ‘in connection with’ such a ‘purchase or sale of a covered security’ unless it is material to a decision by one or more individuals (other than the fraudster) to buy or to sell a ‘covered security.’”⁶⁶ Because the plaintiffs did not “allege that the defendants’ misrepresentations led anyone to buy or to sell (or to maintain positions in) covered securities,” SLUSA did not apply.⁶⁷

In Cyan, Inc. v. Beaver Cty. Emples. Ret. Fund, 138 S. Ct. 1061 (2018), the Court held that SLUSA does not preclude state courts from hearing Securities Act claims because, “[b] y its terms,” SLUSA “does nothing to deprive state courts of their jurisdiction to decide class actions brought under the [Securities] Act.”⁶⁸ In the wake of Cyan, plaintiffs seeking to represent nationwide classes in Securities Act cases often file competing complaints in state and federal courts throughout the country. Defendants are grappling with the procedural challenges posed by this new landscape, which renders it more difficult to consolidate claims arising out of the same alleged conduct in a single forum.

Limitations Periods

The Supreme Court has also addressed certain statute of limitations issues that arise in securities cases. In Merck & Co. v. Reynolds, 559 U.S. 633 (2010), the Court addressed potential tolling of Section 10(b) claims and held that “the limitations period does not begin to run until the plaintiff thereafter discovers or a reasonably diligent plaintiff would have discovered ‘the facts constituting the violation,’ including scienter—irrespective of whether the actual plaintiff undertook a reasonably diligent investigation.”⁶⁹

In addition, in Credit Suisse Sec. (USA) LLC v. Simmonds, 566 U.S. 221 (2012), the Court addressed the two-year limitations period to bring suit under Section 16(b) of the Exchange Act, which imposes reporting requirements and trading restrictions on corporate insiders.⁷⁰ The Court rejected the argument that the limitations period is tolled until the insider files the requisite public report; instead, the “2-year clock starts from ‘the date [the] profit was realized.’”⁷¹ But the Court was divided four to four (Chief Justice John Roberts took no part in the consideration or decision of the case) as to whether Section 16(b) establishes a period of repose that is not subject to equitable tolling.⁷² The justices agreed, however, that even assuming the statute of limitations were subject to equitable tolling, such tolling would not continue beyond the time when a plaintiff becomes aware, or should have become aware, of facts underlying the disgorgement claim.⁷³

Scope of Liability under Section 12 of the Securities Act

The Supreme Court has also clarified who may be liable for claims under Section 12 of the Securities Act⁷⁴. In Pinter v. Dahl, 486 U.S. 622 (1988), the Court held that Section 12(a)(1), which imposes liability on anyone who offers or sells a security in violation of the registration requirements in Section 5 of the Securities Act, extends to the owner who passes title and to anyone who successfully solicits a purchase “motivated at least in part by a desire to serve his own financial interests or those of the securities owner.”⁷⁵ As a result of this decision, Section 12(a)(1) liability may extend to underwriters, broker-dealers, selling agents, and others, even if they never had title to the security.

Subsequently, in Gustafson v. Alloyd Co., 513 U.S. 561 (1995), the Court limited the scope of Section 12(a)(2) of the Securities Act, which creates liability when someone offers or sells a security “by means of a prospectus or oral communication” containing a material misstatement or omission.⁷⁶ In Gustafson, the Court held that the word “prospectus” as used in this provision “is a term of art referring to a document that describes a public offering of securities by an issuer or controlling shareholder.”⁷⁷ Accordingly, private contracts of sale—not held out to the public—are not covered.⁷⁸

Susan L. Saltzstein, a partner in Skadden’s New York office, is codeputy of Skadden’s nationwide Securities Litigation Group. Her sophisticated litigation practice focuses on the representation of U.S. and global financial institutions, corporations and individual clients embroiled in complex securities, and corporate and commercial litigation in federal and state courts. Her experience extends to class and derivative actions, investigations, and corporate control contests. Bet-the-company litigation is one of the mainstays of her renowned practice.

Mollie Kornreich, an associate in Skadden’s New York office, represents clients in complex commercial disputes at the trial and appellate levels and advises on related issues. She has represented plaintiffs and defendants across industries in a wide range of matters involving securities, breach of contract, False Claims Act, antitrust, intellectual property, and a variety of other claims.

Kyle J. Schwartz is a Complex Litigation and Trials associate in Skadden’s New York office. He is licensed to practice in New York and the District of Columbia. Previously, he served as a law clerk to the Hon. Thomas P. Griesa of the U.S. District Court for the Southern District of New York.

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Subchapter V Bankruptcy Cases: Recent Developments

sheika — Fri, 11 Jun 2021 15:39:17 GMT

By: Mark Haut, Practical Guidance

This article provides an update on several developments that have occurred since the Small Business Reorganization Act of 2019 (SBRA) became effective on February 19, 2020. The SBRA created a new bankruptcy option under Chapter 11, known as Subchapter V, which allows small business debtors to address their outstanding liabilities in a fast and efficient, modified Chapter 11 proceeding. The goal of the SBRA is to improve the reorganization process for small business Chapter 11 debtors.

THE SBRA BECAME EFFECTIVE JUST IN TIME TO ASSIST small business debtors in dealing with the COVID-19 pandemic. Since the SBRA effective date, new legislation has been enacted that temporarily amends Subchapter V. These amendments are intended to address the economic effect of the pandemic. This article provides an overview of Subchapter V and a summary of these legislative changes and the new body of case law interpreting Subchapter V.

Subchapter V Overview

The SBRA added Subchapter V to Chapter 11 of the Bankruptcy Code. The SBRA does not repeal existing Chapter 11 provisions regarding small business debtors, but instead creates an alternative procedure that small business debtors may elect to use (if eligible). Small business debtors now have the option of filing a Chapter 11 petition and proceeding under Subchapter V. The SBRA’s addition of Subchapter V, among other things, (1) provides for the appointment of a trustee to assist the Subchapter V debtor that remains in possession, (2) requires the debtor to pay its disposable income to unsecured creditors over three to five years, (3) protects secured creditors with the same cramdown protections as in traditional Chapter 11, and (4) allows the debtor to keep its business. CLICK HERE TO READ THE FULL ARTICLE IF YOU ARE A PRACTICAL GUIDANCE SUBSCRIBER

Receivership in Real Estate Transactions

sheika — Fri, 11 Jun 2021 15:38:46 GMT

By: Richard P. Ormond, Buchalter PC

This article provides an overview of receivership in real estate transactions. It discusses the legal basis for receivership, the role and powers of a receiver, the process of appointing a receiver, and the benefits of receivership over potential alternatives. It also includes guidance for lenders and secured creditors when seeking the appointment of a receiver and reviewing an appointment order.

Overview

What Is a Receiver?

A receiver is a court-appointed officer who acts as a neutral to manage assets (real property or personal property) or even manage businesses as going concerns when they are the subject of a legal dispute. A receiver can also be appointed to act as a liquidator of such assets or businesses. A receiver’s primary role is to efficiently preserve assets in trust for all creditors.

Receivership is a legal remedy that exists in federal and state courts and provides an aggrieved party the option of placing an asset or business into legal custody, meaning that the court dispossesses the party in control of that asset or business and puts it into the hands of a court-appointed agent—the receiver.

Technically, the receiver is an officer of the court whose authority is derived through the equitable powers of that court. In federal court, the appointment of a receiver is authorized by Fed. R. Civ. P. 66; in state court, it is authorized under both common law and statute. Receivers are, by the nature of their appointment orders, fiduciaries of the court much like a trustee in a bankruptcy context. As a result, actions taken by the receiver are seen as actions by the court.

In essence, the receiver is the arm of the court, taking action that a judge himself or herself cannot take without stepping down from the bench. In addition, the receiver is the eyes and ears of the court, and the receiver (and its agents) are neutral, transparent, and fully report all of their actions and decisions to the appointing court. Further, the receiver’s role as a court officer provides court oversight of the receiver’s actions and business decisions and provides a forum in which interested parties can challenge or support a receiver’s decision or action.

Why Appoint a Receiver?

In many circumstances, there are clear advantages to seeking the appointment of a receiver—usually, a situation in which a receiver will be able to preserve a disputed asset or business and maximize its value in the marketplace. For example, it is very common to seek a receiver on behalf of an unpaid lender whose borrower is in default and there is valuable collateral to preserve while litigating the dispute.

While receivership may be considered an extreme remedy under the law, in the fractured world of litigation and business, many circumstances do arise where a court will simply remove management (or an owner-operator) and replace it with a receiver. Receivers can be a helpful tool, by supplanting bad managers with a transparent neutral agent of the court. The receiver is often appointed to look after the best interest of creditors and other aggrieved third parties, not just equity holders. It is also an effective legal remedy if you are a significant creditor or claimant and the circumstances warrant divesting an operator or owner from their business operations.

Once appointed, receivers have broad equitable powers and can operate a business, sell assets, or unwind a business, simply depending on what is best for all of the parties involved. An experienced receiver will be able, through a well-crafted court order, to stabilize the day-to-day operations of a business, provide transparency to lenders, identify specialized third-party asset managers to operate any on-site facilities, manage in-flow and outflow of monies or goods, identify claimants, or resolve or reduce those claims.

The neutrality and transparency of the receiver alone provide a tremendous advantage to the court, lenders, and creditors, and allow the parties to accurately evaluate how best to restructure or dispose of collateral and estate property.

A receiver also has other advantages including what is known as quasi-judicial immunity, meaning that a receiver typically cannot be sued for undertaking his or her duties under court supervision or court order. For example, if a receiver sells real property, the sale will be consummated by the entry of a court order selling those properties “as is, where is” with no representations or warranties—all blessed by that court. This eliminates the risk of third-party claims against the receiver or the assets in the estate subject to that sale. Conversely, if a foreclosing party (or its agent) were to sell the property, the selling party would bear the burden of the liability, consumer protection regulations, and many more representations and warranties related to the sale.

As an inherent feature, the appointment of a receiver provides insulation to lenders and creditors from claims and liabilities arising from certain responsibilities. Those responsibilities are, instead, shifted to the court through the receiver, who can present equitable solutions to the court. From the sale of inventory to the more complex task of resolving creditor claims, the receiver can be granted the authority to resolve issues and eliminate hurdles prior to a disposition of the disputed property. This saves the litigants the burden of liability, known or unknown, that may arise.

A receiver’s appointment can be short or may last many years, all depending on the circumstances warranted by each case and how best to maximize the estate’s assets’ values.

Creditor Considerations

When a business is put into receivership, it certainly should raise concern for its creditors, suppliers, and customers. Seeking legal guidance is always helpful and direct communication with the receiver (or its agents) is key. Receivers, by law, are required to be transparent and file reports with the appointing court, but it is a legal process and not always easy for parties to navigate. When a party is in receivership, the receiver is usually the best source of information about the status of claims, receivables, payments, and operations.

Knowing the nature of the receivership is critical. Is it a liquidating receiver, there to simply sell off assets and wind down the operations? Or is it a restructure, where the receiver will sort through claims and streamline operations? Or is it something else entirely, such as babysitting a business while warring partners work out their differences? Each has different implications for outside parties and litigants.

Finally, receivers are also used in creative ways to effectuate workouts and turnarounds as an alternative to bankruptcy. In most instances, a receivership is less costly than a Chapter 11 bankruptcy, and it is more flexible, as it is not overburdened by the highly complex Bankruptcy Code. Receivership is an established alternative to bankruptcy when implemented smartly.

Legal Basis for Receivership

The appointment of a receiver is an equitable procedure that a court uses when it believes that a party to an action is not in a position (or, in some circumstances, refuses) to comply with the desires of the court. Appointment of a receiver is also a provisional remedy that allows courts to preserve and/or maintain assets, so that waste does not occur and the value of an asset in dispute can be preserved pending final adjudication. This concept of waste in recent times has given receivers broad authority to maximize the value of businesses, receivables, and other assets through effective management and sale.

Article III, Section 2

As a matter of constitutional law, the United States traces its equitable courts to U.S. Const. Art. III, § 2, which established the judicial power of the federal government to all cases “at law and in equity.” The U.S. Supreme Court, in Heckers v. Fowler, 69 U.S. 123, 128–29 (1864), held that the administration of insolvent enterprises, investigations into the reasonableness of public utility rates, and the performance of other judicial functions often require the special services of masters in chancery, referees, auditors, and other special aids.

In Heckers, the Court held the practice of referring pending actions to a referee to be coequal with the organization of the federal courts under Article III. The leading case of Ex parte Peterson, 253 U.S. 300 (1920), centered on a U.S. district court’s appointment of an auditor with power to compel the attendance of witnesses and the production of testimony.

In Peterson, the district court authorized the auditor to conduct a preliminary investigation of facts and file a report on them to simplify the issues for the jury. This action was neither authorized nor prohibited by statute, but rather emanated from the court’s equitable powers. In sustaining the action of the district judge, Justice Louis Brandeis, speaking for the Court, declared:

Courts have (at least in the absence of legislation to the contrary) inherent power to provide themselves with appropriate instruments required for the performance of their duties. . . . This power includes authority to appoint persons unconnected with the court to aid judges in the performance of specific judicial duties, as they may arise in the progress of a cause.¹

Federal courts sitting in equity have exercised the power to appoint auditors (or neutrals) from their very beginning, and here it was held that this power is the same whether the court sits in law or equity.

Rule 66

In federal courts, Rule 66 of the Federal Rules of Civil Procedure authorizes the appointment of receivers by federal court judges with the following language:

The practice in the administration of estates by receivers or by other similar officers appointed by the court shall be in accordance with the practice heretofore followed in the courts of the United States or as provided in rules promulgated by the district courts.²

The federal system, unlike many states, relies primarily on decisional law—the reported usages of equity—rather than on statutes to delineate when and under which circumstances receivers may be appointed. “[T]he district court has broad powers and wide discretion to determine the appropriate relief in an equity receivership.”³ The basis for broad deference to the district court’s supervisory role reflects the reality that most receiverships involve multiple parties and complex transactions.⁴

Additionally, some districts have interpreted these powers to be extremely wide in breadth. The Ninth Circuit in SEC v. Hardy acknowledged that a primary purpose of equity receiverships is to promote orderly and efficient administration of the estate by the district court for the benefit of creditors.⁵

According to the Hardy decision:

A district judge supervising an equity receivership faces a myriad of complicated problems in dealing with the various parties and issues involved in administering the receivership. Reasonable administrative procedures, crafted to deal with the complex circumstances of each case, will be upheld. A district judge simply cannot effectively and successfully supervise a receivership and protect the interests of its beneficiaries absent broad discretionary power. We would be remiss were we to interfere with a district court’s supervision of an equity receivership absent a clear abuse of discretion.⁶

State Law and Authority

Many states also have specific statutory schemes devoted to the appointment of receivers. For instance, in California, applicable provisions of the Code of Civil Procedure, commencing at Cal. Code Civ. Proc. § 564, govern the appointment of receivers.⁷

Most states confer considerably broad power to the receiver to operate a business, sell real and personal property, and, in some instances, even seek to restructure debt or liquidate the assets of a business. Receivers can also collect and enforce accounts receivable, obtain and sell trademarks and domain names, and transfer liquor licenses, among other broad powers, all for the benefit of creditors and claimants.

Secured Lenders and Receivers

Receiverships, in general, tend to become more prominent in distressed economic times. When used properly, a receivership can be a flexible and creative avenue to assist in the restructuring or turnaround of a business, real property, or other asset.

Protecting Collateral

A common situation in which a receiver is appointed is one where a secured lender seeks to harbor or preserve its real property collateral. It may be as simple as having a receiver manage a rental property and continue to collect rents until the dispute relating to the real property is adjudicated, or it may result in a more complicated situation where a receiver is asked to take over the day-to-day operations of an ongoing business in order to preserve or ultimately liquidate that business.

Protection from Liability

In the context of real property, a receiver can insulate a financial institution from many claims and hardships that the financial institution would inherit by foreclosing or otherwise taking title to real property and assuming the burdens and liabilities of ownership. To this end, financial institutions and special servicers may seek the appointment of receivers to remediate and rehabilitate assets and, rather than following the traditional route of foreclosure, obtain a court order for the receiver to sell the real property assets out of the receivership estate and turn over proceeds to the appropriate parties.

Importantly, particularly from a lender’s perspective, the legal liability of actions that a receiver takes, such as the remediation of an environmental hazard or the eviction of tenants, falls not on the lender that sought the receiver’s appointment, nor on the party being dispossessed of their business or assets. Rather, the liability belongs to the receiver, which benefits from quasi-judicial immunity

Receivership and Workouts

A lender typically wants to take immediate action to protect and maintain the value of its real property collateral. As a mechanism for maintaining the status quo during workout negotiations, the appointment of a receiver serves to protect the value of the collateral while at the same time giving the parties the time to discuss and negotiate a potential workout. Absent the protections that the receiver affords, the parties may be unwilling to devote substantial resources to discussing a workout due to the fear that the property could be losing value during the workout negotiations.

Costs of Receivership

Before seeking the appointment of a receiver, lenders should consider a variety of factors to determine if it is a viable option. One of the principal concerns lenders have when considering the appointment of a receiver is the cost involved. In the typical receivership, the receivership estate is responsible for all fees and costs, including administrative costs, the receiver’s fees, and the fees of other professionals that the receiver retains, if necessary.

The receivership estate is usually funded from one or more of the following sources:

Income that the receivership property generates (i.e., rents)
Proceeds from the receiver’s sales of estate assets
Advances that the lender makes to the receiver during the pendency of the action

The costs of the receivership could result in a net reduction of the lender’s recovery. Depending on the real property, though, incurring these costs may be in the lender’s best interest, especially when the receiver can maximize the value of the property, whether by completing construction, finalizing entitlements, or taking other action that increases the property value. In these situations, the potential recovery outweighs the costs of the receiver.

Benefits of Receivership and Consideration of Alternatives

Taking title to the real property, whether through a deed in lieu, foreclosure, or other form of transfer, guarantees that all costs, liabilities, and problems associated with that property will absolutely become the burden of the lender. Even if the lender identifies new management, that management will not share in the insulation that the receiver enjoys. And management will likely be equivalent in cost.

For example, if the receiver sells units at the property, those sales will be consummated by the entry of a court order selling the units “as is, where is,” with no representations or warranties—a proverbial get out of jail free card for lenders that never touch or take title. Conversely, if the lender (or its agent) sells the property, construction liability, consumer protection regulations, department of real estate requirements, and many more representations and warranties will become the burden of that lender.

Lenders and servicers do not want to take title to assets or real property collateral if it can be avoided. Since most real property is an operating and going concern, maintenance, management, and day-to-day operations—and, of course, all of the liabilities that come with such responsibilities—will be in the hands of the lender (or its designee) if it takes title through foreclosure or a deed in lieu. Further, the operational costs will fall squarely on the lender rather than being funded by a protective advance, receivership certificate, or other protected means of advancing secured funds in a receivership.

This creates lawsuit exposure for the lender, which is now on title forever. While the applicable law is complex, it is unequivocal that the lender will be seen as a deep pocket in any known or unknown future litigation. Any action that a lender can take to protect itself and insulate itself from claims has an enormous value.

Powers of a Receiver

In many instances involving real property, there are multi-unit structures, open escrows, operational concerns, remaining construction, affiliated management, and other problems particular to the property at issue. When considering the appointment of a receiver, it is helpful to establish a clear roadmap of what the parties expect from the receiver and what benefit the receivership will provide. From the simple completion of construction to the more complex resolution of claims, the court can grant the receiver the authority to work out issues prior to a disposition of the real property (whether by sale, foreclosure, or some other means). Seeking the appointment of a receiver provides numerous benefits for the lender while avoiding a host of potential problems. A receiver can:

Limit exposure and liability to the lender by providing a shield against claims and by keeping the lender off of title
Provide the receiver the ability to sell real property “as is, where is,” thus limiting exposure to the lender/servicer and the receiver
With court guidance, manage complex construction issues and make claims on completion bonds or other sureties
Address problems with homeowners’ associations, entitlement concerns, and other state or federal regulatory requirements
Renew, obtain, or forfeit governmental licenses and permits
Acquire, confirm, and/or reinstate insurance (including wrap-up policies)
Bring interested third parties, including governmental agencies, before the court, if needed to effectuate the receiver’s mandate
Provide experienced day-to-day management for the real property
Provide expertise in hospitality, operations, construction, property management, and other skills (depending on the business needs and property needs)
Allow for funding to complete projects through receiver certificates
Provide lenders with transparency into ongoing operations
Encourage a borrower’s continued cooperation, motivating the borrower to see the project through and avoid insolvency
Assess and, in many instances, reduce exposure to mechanics’ liens
Provide for equitable powers of the court usually beyond those of a bankruptcy court
Secure and maximize the value of the asset

Importantly, the receiver can accomplish these aims without disrupting the ongoing operation of the property or waiving the lender’s rights against borrowers or guarantors (or vice versa).

With respect to complex debt structures (senior and mezzanine debt), the court can craft a receivership order to work within the existing terms of the intercreditor agreement, expand the terms of the intercreditor agreement, or even, if necessary, modify the terms of the intercreditor agreement in a manner that will best protect and preserve the asset. Further, a claimant (such as the lender) can make its case to the court if, at any time, it disagrees with the actions of the receiver.

A well-crafted order can also give the lender options when it finds that maintenance of a receiver is no longer cost effective or is diminishing the value of collateral. For example, a primary tenant may vacate a property in receivership, reducing the revenue that the asset generates, or a party to the dispute may file bankruptcy, restricting the receiver’s ability to manage or monetize the collateral. By placing triggers such as these in the order, the court allows the lender to maintain a modicum of control to steer the fate of the receiver and the receivership estate. While not absolute, as part of a court order, they will provide further assurances to the lenders.

Important Factors in Considering a Receiver

The lender must carefully craft its preparation of a lawsuit and application to appoint a receiver. Each case is different, and the complaint and appointment order must be tailored to each situation. Some of the factors to be mindful of include:

Are the borrower and tenants cooperative?
Are the borrower and commercial tenants solvent or operating?
If applicable, is the general contractor cooperative?
Is there an equipment lease in place?
Is the borrower an individual or legal entity?
Is there a guaranty?
Where is the property located? (A foreclosure action must be filed in the district in which the property lies; the court’s jurisdiction must be in rem.)
Are there any code violations, state regulatory concerns, or other administrative or legal problems?
What funds are available in the estate?
Are there construction defect claims?
Are there mechanics’ liens?
Are there other secured lenders? Are they priority or subordinate claims?
Are there tax liabilities (recorded and unrecorded)?

Proposed Order Provisions

The appointment order is the most important pleading because it is the document that creates the parameters in which the receiver may operate. If an important provision is missing from the order, a receiver may be limited in its ability to carry out his or her duties properly. (Note that as a case progresses, it may be necessary from time to time to amend the receiver’s confirming order.)

The order should anticipate the powers and instructions that the receiver may require. It is beneficial to have the proposed receiver review the order before it is filed. Also, the proposed order should account for issues such as filing of taxes, authority to open cabinets, authority to change mailing address, and other minute details. A receiver’s powers are, in essence, much broader than those of a bankruptcy court or a bankruptcy trustee.

An order appointing a receiver may contain provisions authorizing the receiver to:

Operate and/or liquidate a business
Enter into contracts or leases (a receiver has general authority to enter into leases for up to one year in length, including any option periods, or minor contracts without specific court authorization)
Redirect mail
Use a locksmith to enter the receivership premises
Bring unlawful detainer actions (or possibly to engage in other litigation)
Investigate, report about, and maintain adequate insurance coverage regarding the receivership estate
Use the tax identification number(s) previously used in connection with the operation of the receivership business or property
Borrow funds
Sell real or personal property of the estate
Apply at any time for further instructions
Open bank accounts
Collect rents, income, profits, etc.
Compromise debts
Avoid liens

A receiver’s ability to hire employees and professionals is critical in many receiverships, and the employment of such professionals should be explicit in the receiver’s appointment order. Note that, typically, a receiver cannot employ an attorney without a specific court order authorizing such employment. Most courts require that an application to employ an attorney be in writing and state the necessity for the employment, the name of the attorney, and that the attorney is not the attorney for, is not associated with, and is not employed by an attorney for any party to the action.

The order may state that all obligations and liabilities that the receiver incurs are incurred solely in his or her official capacity and are to be satisfied by receivership funds only. It should also include a provision regarding payment of the receiver’s fees and costs, as well as the fees and costs of other professionals that the receiver employs. The typical provision specifies that these fees and costs may be paid from the receivership estate each month upon service of the receiver’s monthly report, subject to future court confirmation. Copies of the detailed bills of the receiver and other professionals should be included in the receiver’s monthly reports. Note that the court orders typically give the parties a specified time period (usually 5–14 days) in which to object before the receiver may pay such fees and costs. If there is an objection in such an instance, the court will intervene (upon request) to resolve the objections.

The order, similar to a broad injunction, should be recorded in every county where receivership estate real property is located.

Conclusion

Receivership law provides imaginative, equitable, and practical solutions to complex problems, giving courts and litigants flexibility in reaching a commonsense remedy during the course of a lawsuit or judgment enforcement.

From protecting assets to running a business, a receiver can protect, harbor, and preserve value of assets that form the basis of a civil dispute, and provide transparency in a situation where the parties are not in a position to fully trust each other. It is one of the mainstays of common law and sets the common law system apart from other judicial systems that do not have these powers of equity, thus limiting their ability to fashion remedies.

Richard P. Ormond has over 20 years experience that includes business law, real estate, banking, receivership, cannabis regulations, commercial litigation, and restructuring. He has tried numerous cases in state, federal, and bankruptcy courts, and has arbitrated dozens of matters. Mr. Ormond is recognized as one of the nation’s leading experts concerning receivership law and cannabis regulations, banking, and financing. Mr. Ormond serves as the chair of the California Receivers Forum and he is the former chair of the Remedies Division of the Los Angeles County Bar Association.

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Market Trends 2020/21: Shareholder Proposals

sheika — Fri, 11 Jun 2021 15:38:30 GMT

By: Trevor S. Norwitz, Sabastian V. Niles, and Justin C. Nowell, Wachtell, Lipton, Rosen & Katz

This article discusses recent market trends related to shareholder proposals, a popular and effective mechanism enabling shareholders to recommend or require that a company and/or its board of directors take a specified action.

CURRENTLY, TO BE ELIGIBLE TO SUBMIT A PROPOSAL FOR consideration at a meeting of the company’s shareholders and to have such proposal included in the company’s proxy statement and proxy card under federal law, a shareholder must have held company shares with a market value of at least $2,000 (or at least 1% of the company’s securities entitled to vote on the proposal at the shareholder meeting) for at least one year and comply with additional substantive and procedural rules set forth in Rule 14a‑8¹ under the Securities Exchange Act of 1934, as amended.

In September 2020, the Securities and Exchange Commission (SEC) voted to adopt amendments to modernize its shareholder proposal rule. The final rule, among other things, amends the current ownership requirements to incorporate a tiered approach that provides three options to submit a shareholder proposal under Rule 14a-8.² A shareholder will now be required to demonstrate continuous ownership of at least:

$2,000 of the issuer’s securities for three years
$15,000 of the issuer’s securities for two years
$25,000 of the issuer’s securities for one year

The amendments reflect ongoing criticism that the dollar threshold in Rule 14a‑8,³ which was adopted decades ago in 1998, was too low to ensure shareholders have meaningful, long-term interests in the companies in which they invest.⁴

In addition to the updated ownership requirements, the amendments limit the ability of shareholders to submit multiple proposals at a single meeting and impose additional restrictions on the resubmission of proposals.

The amendments clarify the existing one-proposal-per shareholder rule to preclude a single person from submitting one proposal in his or her own name and another proposal as a representative, or multiple proposals as a representative of different shareholders. These changes further support the direct engagement of the proposing shareholder and attempt to limit circumvention of the SEC’s eligibility requirements.

The amendments also revise the levels of shareholder support a proposal must receive to be eligible for resubmission at the same company’s future shareholder meetings from 3% if voted on once within the preceding five calendar years, 6% if voted on twice in such period, or 10% if voted on three or more times in such period, to the following thresholds:

5% for matters previously voted on once in the last five calendar years
15% for matters previously voted on twice in the last five calendar years
25% for matters previously voted on three or more times in the last five calendar years

The amendments will be applicable for all shareholder meetings to be held on or after January 1, 2022, although transition rules will permit a shareholder that has held $2,000 of an issuer’s securities for one year as of the effective date of the amendments, and continuously maintains ownership of at least $2,000 of the issuer’s securities, to qualify to submit a proposal for a meeting to be held before January 1, 2023.

Under Rule 14a‑8,⁵ a company may seek to exclude certain shareholder proposals for a variety of reasons, such as relevance, violation of laws or proxy rules, interference with management functions, or conflicts with the company’s proposals. In September 2019, the Division of Corporation Finance of the SEC announced that beginning with the 2019-2020 proxy season, SEC staff may determine to respond orally, instead of in writing, to some no-action requests from companies seeking to exclude Rule 14a‑8⁶ shareholder proposals. The SEC added that should it decline to take a view on an exclusion request, such silence should not be interpreted “as indicating that the proposal must be included.” It remains to be seen how the SEC’s revised approach will impact companies’ engagement with proponents, and whether companies will increasingly negotiate with proponents for a withdrawal of a shareholder proposal as opposed to historically seeking written no-action relief from the SEC. However, the SEC’s publicly available shareholder proposal no-action response chart has fostered some confidence in the revised approach and enhanced visibility around the SEC staff’s responses to no-action requests.

Alternatively, albeit infrequently used, a shareholder may also submit a proposal under state law, without regard to the requirements of Rule 14a-8,⁷ but must bear the cost of preparing and mailing its own proxy statement to the company’s shareholders.

The total number of shareholder proposals submitted to U.S. public companies rose in 2020 despite trending downwards in recent years (from 819 in 2017, to 809 in 2018, to 807 in 2019, and up to 858 in 2020), according to the Institutional Shareholder Services (ISS) Voting Analytics database and other privately sourced data. (All 2020 data herein is as of December 31, 2020.) There have been 511 proposals so far in 2021, as of March 31, 2021. The average investor support for shareholder proposals has fluctuated in recent years, from 24.8% in 2018 to 25.2% in 2019 and down to 24.34% in 2020. The average investor support for shareholder proposals is 23.82% for 2021, as of March 29, 2021. Nonetheless, 2020 was a notable year for climate-related shareholder proposals, with a record number of proposals receiving majority shareholder support, and this trend is likely to continue in 2021.

Looking ahead, shareholder proposals will likely continue to mirror growing shareholder scrutiny toward sustainability practices and climate-related risk disclosures, as well as human capital management and other environmental, social, and governance (ESG)-related matters. In particular, it is expected that:

Environmental and social proposals will continue to grow as shareholders increasingly focus on issues such as executive compensation, human capital management, and oversight and planning in connection with climate-related risks.
Social concerns arising out of the COVID-19 pandemic, notably worker health and safety (e.g., adoption of paid sick leave policies) and social impact and purpose, will likely remain popular in the 2021 proxy season.
Shareholder proposals will continue to focus on traditional corporate governance matters, with the most common proposals relating to the appointment of an independent board chair, disclosure of political contributions, board diversity, and director overboarding.
Specific compensation-related proposals will reappear in light of the COVID-19 pandemic and renewed focus on pay disparities within a company’s workforce.
Shareholder support for workforce and board diversity— gender, racial, and ethnic diversity on boards in particular— will continue to increase.
While less common, shareholder proposals may continue to address economic/business issues and be put forward by economic-oriented activists/hedge funds.

2020 Proxy Season

2019 Proxy Season

2018 Proxy Season

Governance

Board Diversity

Board diversity, notably gender, racial, and ethnic diversity, remains a key concern of shareholders, with focus expanding beyond board diversity to include management diversity and diversity in the workforce. It is likely that these trends will continue to accelerate in the coming years as shareholders and regulators continue to scrutinize diversity at all levels. A number of the largest institutional shareholders, including BlackRock, State Street, and Vanguard, have publicly called on companies to improve gender, racial, and ethnic diversity on boards. Out of the 67 shareholder proposals regarding board and workforce diversity that were filed in 2019, four proposals received majority support. While only 52 shareholder proposals were filed in the 2020 proxy season (of which four proposals received majority support), the proposals pushed companies for greater disclosure of board and workforce diversity and inclusion policies and programs, as well as the gender, racial, and ethnic composition of their workforce according to Equal Employment Opportunity Commission-defined job categories.

Shareholder voting policies continue to support increased board diversity and inclusion: BlackRock’s voting policies state that BlackRock will vote against nominating and governance committee members of companies that fail to improve diversity where there are fewer than two women directors on the board. Vanguard will also vote for shareholder proposals that seek disclosure related to director diversity, company diversity policies, and skills matrices (which have become an increasingly common feature of proxy statements). Proxy advisor ISS will also generally recommend voting against the chair of the nominating committee and other directors, on a case-by-case basis, if there are no women serving on the board as of the previous annual meeting. There is an increasing expectation by investors for companies to have clear and concise disclosure on their board and workforce diversity (e.g., EEO-1 data).

Regulators have also weighed in on board diversity, with a number of states, including New Jersey, Michigan, and Pennsylvania, following California’s lead to mandate women directors for companies headquartered in those states. Other states, such as Illinois, Maryland, and New York, have introduced laws that require disclosure of board and/or management diversity.

Shareholder Proposals on Board Diversity (2018-2020)

Separate Chair and Chief Executive Officer (CEO)

Shareholder proposals regarding the separation of the chair and CEO positions saw an uptick in support in 2020 as changes in the voting policies of institutional investors such as State Street led to growing scrutiny of the robustness of the roles of lead independent directors. This past year saw 46 shareholder proposals calling for an independent chair, down from the 60 proposals filed in 2019, but on par with the 47 proposals filed in 2018. However, support for such proposals rose to 34.9% in 2020, compared to 29.8% in 2019 and 31.9% in 2018. Twenty-seven proposals have been filed in 2021, as of March 31, 2021 with support for such proposals at 31.60%. While companies in the past have successfully argued that the separation of the chair and CEO roles is a strategic decision that should be left to the discretion of boards, institutional investors have continued to express a growing preference for a robust lead independent director and have, in some cases, lent support to calls for a separation of chair and CEO roles, particularly where there are other governance concerns or contingencies. For example, in 2020, Rayonier Advanced Materials, Inc. agreed to separate its chair and CEO roles as part of its settlement with venture capital firm Pangaea Ventures, L.P. and activist investor Ortelius Advisors, L.P. Similarly, in 2019, Boeing stripped CEO Dennis Muilenburg of his chair title following the Boeing 737 Max groundings that raised concerns regarding corporate culture—in particular, whether the quality and safety of Boeing’s products were given sufficiently high priority and whether the Boeing Board of Directors exercised sufficient oversight of management to mitigate business strategy risks. Following its 2020 annual meeting, Boeing formally implemented a policy requiring an independent chair whenever possible.

Proxy advisory firms have been traditionally vocal in recommending a separation of the chair and CEO roles.

INDEPENDENT CHAIR PROPOSALS SUBMITTED TO A VOTE (Excludes Withdrawn or Omitted Proposals
# of Proposals Voted On			Average % Support			Proposals Passed
2020	2019	2018	2020	2019	2018	2020	2019	2018
46	60	47	34.89%	29.85%	31.91%	2	0	1

Shareholder Proposals by Category

Shareholder Off-Cycle Action Rights

Proposals regarding shareholders’ right to call a special meeting or to act by written consent are also relatively common.

A significant majority of companies already grant shareholders the right to call special meetings, so most new shareholder proposals on the topic call for a reduction in the ownership threshold of existing special meeting rights. While institutional shareholders will generally vote in favor of amendments to the governance documents to enhance shareholder enfranchisement via the right to call a special meeting or to act by written consent, many have also indicated a need to balance the need to expand shareholder enfranchisement with the need to prevent a minority of shareholders from dominating key decision-making. As such, many key institutional investors will not vote in favor of recommendations to lower the ownership threshold required to access such rights.

Other Governance Topics

Traditional governance proposals that focused on removing takeover defenses and increasing board accountability, such as elimination of supermajority voting, board declassification, and majority voting for director elections, have become less common as most large-cap companies have already adopted these measures. However, such proposals continue to receive significant shareholder support: in 2020, nine proposals to eliminate supermajority voting were passed, six amendments to declassify the board were passed, and three proposals adopting majority voting were passed.

Compensation

Continuing on trends in recent years, shareholders continue to scrutinize say-on-pay proposals, which provide investors an alternative mechanism to express their approval or disapproval of a company’s executive compensation program.

In 2020, average support for say-on-pay proposals remained strong, with 97.9% of companies receiving 50% or more support, a slight increase compared to 97.55% of companies receiving 50% or more support in 2019 and 2018.

In light of the COVID-19 pandemic, compensation issues may come to the fore, particularly as they relate to pay disparities within companies, compensation mix, and performance targets. Additionally, due to investors’ heightened focus on climate change and other ESG issues, shareholder proponents submitted eight proposals relating to the linking of executive pay to sustainability or climate metrics. More of these proposals may be on the horizon.

Environmental and Social

Climate-focused proposals have attracted significant attention, with 10 shareholder proposals on the ballot related specifically to aligning a company’s strategy with emission reduction targets going to a vote in 2020. These proposals received an average support level of 38.5%, up sharply from 27.2% in 2019. Many of the shareholder proposals focus on how companies plan to address climate-related risks and disclosures. Other climate-related shareholder proposals request reporting on energy efficiency and renewable energy as well as environmental management. Notwithstanding the impact of the COVID-19 pandemic, it is likely that climate and sustainability-related proposals will continue to grow as key institutional shareholders, notably BlackRock, State Street, and Vanguard, continue to call for greater disclosure of climate-related risks and business strategies to adapt to a low-carbon economy.

Other topics in the broad environmental and social category include climate change and climate regulation; environmental health and safety; political, lobbying, and charitable disclosure; human rights; diversity, gender, and discrimination topics; and other miscellaneous social topics. Specifically, diversity-focused proposals continue to gain traction, with focus shifting beyond the boardroom into management and the workforce, reflecting growing concerns regarding human capital management. The New York City Comptroller’s Office has been particularly active in pushing for greater diversity: in 2020, the Comptroller’s Officer submitted shareholder proposals at 17 companies that it viewed as not implementing its request to include consideration of qualified women and ethnically diverse candidates. Thirteen of those proposals were withdrawn after the target companies adopted policies requiring consideration of diversity in director and CEO searches; among the four remaining companies, two proposals received majority support.

In addition to climate change, sustainability, and diversity-related proposals, shareholder proposals relating to political expenditures and lobbying remain in the top spot in terms of filings and are generally difficult to omit, with 95 filings submitted in 2020, slightly down from 102 submissions in 2019. However, shareholder support for proposals relating to political expenditures and lobbying is generally quite low, with only seven proposals out of 95 voted on in 2020 receiving majority support.

Looking ahead, it is likely that environmental and social issues will continue to increase as the COVID-19 pandemic has exacerbated a number of social issues, including issues related to lobbying and political contribution disclosures, board composition, and human capital management.

Proponents

The most prolific proponents of shareholder proposals are individual investors: John Chevedden, James McRitchie, Myra Young, and William and Kenneth Steiner. Chevedden alone accounts for approximately 17% of all shareholder proposals submitted in the 2020 season. Individuals of this ilk are sometimes referred to as gadfly investors as their interests are generally not as typical investors but to instigate and bring about change. As part of its Boardroom Accountability Project, the New York City Comptroller has also become an active filer of shareholder proposals relating to diversity and the adoption of the Rooney Rule, a policy originally created by the National Football League to increase the number of minority candidates considered for head coaching and general manager positions, and for director and CEO searches.

Other proponents of shareholder proposals include:

Public pension funds, which focus their proposals mainly on governance issues related to board diversity and social proposals relating to employee diversity, political contribution disclosure, and environmental issues
Labor unions, which primarily focus on governance and compensation-related issues
Asset management or advisory institutions, which primarily focus on environmental and social issues

Legal and Regulatory Trends

The 2020 proxy season was overshadowed by the COVID-19 pandemic, whose impact will likely continue to be felt during the 2021 proxy season. Among the key trends is a growing focus among shareholders on ESG issues, particularly with respect to climate change, social justice, and human capital management. From the deaths of George Floyd and Breonna Taylor to the inauguration of a new presidential administration, the 2021 proxy season is ripe for ESG issues. While such issues are yet to be fully reflected in regulatory shifts, the SEC, for example, has indicated that it intends to provide recommendations on ESG and related disclosures. The SEC’s Investor Advisory Committee has already recommended that the SEC “begin in earnest an effort to update the reporting requirements of Issuers to include material, decision-useful, ESG factors.”

Additionally, in March 2021, the SEC announced the creation of a Climate and ESG Task Force in the Division of Enforcement that will develop initiatives to proactively identify ESG-related misconduct and launched a new webpage to bring together all of the SEC’s actions and information on ESG. The Biden administration has also prioritized climate considerations as an essential element of its U.S. foreign policy and national security, including via re-entry into the Paris Agreement. Although the SEC has not yet indicated that it plans to move beyond its current materiality standards with respect to mandated public disclosures, the demand from shareholders for standardized ESG data and reporting is likely to continue and may result in a further uptick in environmental and social shareholder proposals. It is also notable that proxy advisory firm ISS launched its Climate Voting Policy in March 2020, which, together with its Sustainability Voting Policy, will continue to lend support for ESG-related shareholder proposals.

In the vein of ESG, organizations, including the Shareholder Commons, an independent non-profit organization that leverages existing platforms and addresses systemic issues and structures that hinder a just and sustainable economy, have begun to put forth shareholder proposals requesting that companies reincorporate as public benefit corporations (PBCs).

The core principle of these shareholder proposals is that long-term investors will benefit if the corporate governance structure of companies is altered to address the needs of society and not just the financial interests of shareholders. Although a meaningful shift to PBCs has not occurred, it is expected that companies will increasingly integrate ESG throughout their businesses to help address the wide-ranging interests of their broader stakeholders (e.g., customers, employees, suppliers).

Amid the COVID-19 pandemic, businesses that availed themselves of federal aid may also see scrutiny over compliance of their terms. In particular, the Coronavirus Aid, Relief and Economic Security Act (CARES Act) imposes, among other things, limitations on executive compensation, mass layoffs of employees, dividends, and share buybacks. Even companies that did not seek CARES Act relief may face increased shareholder scrutiny with respect to compensation and workforce-related matters. Shareholder proposals seeking disclosure on pay disparities and workforce retention may become more common in the coming proxy season.

It is also notable that the SEC has continued to revise the proxy rules, with the latest proposed changes setting heightened restrictions on shareholders seeking to include their proposals on the company’s proxy statement. The proposal increases the dollar threshold, and the holding period required to submit a proposal could make it more difficult for smaller shareholders, and potentially gadfly investors, to submit proposals. In addition, the SEC’s announcement that should it decline to take a view on an exclusion request, such silence should not be interpreted “as indicating that the proposal must be included,” may encourage more companies to exclude shareholder proposals.

A company looking to submit a no-action letter with respect to a shareholder proposal should also look back to the October 2019 guidance issued by the Division of Corporation Finance in which the SEC noted that its decision whether or not to exclude a shareholder proposal under the ordinary business exception of Rule 14a-8(i)(7)8 is guided by consideration of the significance of the subject matter and whether the proposal seeks to micromanage the company. In drafting a no-action letter, a company may wish to eschew a one-size-fits-all or an overly technical approach in justifying why no-action relief is justified, and tailor its disclosures on company-specific facts and circumstances.

Market Outlook

Overall, while the aggregate number of shareholder proposals will likely remain stable going forward, environmental and social proposals will increasingly be featured alongside more traditional governance proposals. In particular, companies should expect a higher number of proposed resolutions on climate change, requests for lobbying and political expenditure disclosure, and human capital management. Climate-related and diversity proposals will likely see increasing support, and companies should be attentive to changes in their investors’ voting policies and practices to best prepare and predict the outcome of proposals that go to a vote.

As in past years, boards that are seen as insufficiently responsive to shareholder votes may suffer from a negative ISS or Glass Lewis recommendation. It is also important to note that while the legal duties of care owed by boards have not changed, the long-term impacts of COVID-19 remain unknown, and large institutional investors will continue to hold companies to high expectations with respect to corporate governance and stewardship.

Approaches to Proxy Season

Heading into the next proxy season, companies should refresh and update their stakeholder and shareholder outreach plans to ensure a clear narrative that articulates the company’s purpose and strategy for delivering sustainable long-term value to stakeholders. Companies should develop a keen understanding of stakeholder and shareholder perspectives on the company and foster long-term relationships with major shareholders, including by appropriately handling shareholder requests to discuss ESG matters, its business portfolio, capital allocation and operating strategy, and response to COVID-19, and be open to providing greater transparency into the board’s practices, oversight of management, and company priorities. Companies should also integrate business relevant environmental and social governance considerations, including feedback from stakeholder and shareholder engagement, into long-term strategies and crisis management and be prepared to respond to increasing investor attention on these topics.

Boards should evaluate every shareholder proposal thoughtfully and resist changes that the board believes will not be constructive, while addressing any modifications that in the board’s judgment will result in transparent, good governance, and promote decisions in the best interests of their stakeholders.

Trevor S. Norwitz is a partner in the Corporate Department at Wachtell, Lipton, Rosen & Katz, where he focuses primarily on mergers and acquisitions and corporate governance matters. He has advised public and private entities across many industries in connection with mergers, acquisitions, divestitures, hostile takeover bids and defenses, proxy contests, joint ventures, financing transactions, and corporate governance and crisis management situations.

Sabastian V. Niles is a partner at Wachtell, Lipton, Rosen & Katz, where he focuses on rapid response shareholder activism and preparedness; takeover defense and corporate governance; risk oversight, including cybersecurity and crisis situations; U.S. and cross-border mergers, acquisitions, buyouts, investments, divestitures, and strategic partnerships; and other corporate and securities law matters and special situations. Sabastian advises worldwide and across industries, including technology, financial institutions, media, energy and natural resources, healthcare and pharmaceuticals, construction and manufacturing, real estate/ REITS, and consumer goods and retail.

Justin C. Nowell is an associate at Wachtell, Lipton, Rosen & Katz, where he focuses on advising companies on corporate governance, mergers and acquisitions, shareholder activism and preparedness, takeover defense, ESG, financing transactions, and related matters impacting their business and key stakeholders. Justin advises worldwide and across industries, including technology, financial institutions, media, energy and natural resources, healthcare and pharmaceuticals, construction and manufacturing, real estate/REITS, and consumer goods and retail.

To find this article in Lexis Practical Guidance, follow this research path:

RESEARCH PATH: Market Trends 2020/21: Shareholder Proposals in Practical Guidance.

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