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The "New and Improved" Paycheck Protection Program

Evansj5 — Fri, 26 Feb 2021 17:20:30 GMT

By: Steven J. Dickinson, Robert K. Magovern, and James F. Van Orden, Cozen O’Connor

The omnibus budget act signed by President Trump on December 27 reinstituted the Paycheck Protection Program (PPP), with significant changes. The act allows new borrowers to receive PPP loans and some existing borrowers to receive additional PPP funding. It also restores the tax deduction for expenses paid with PPP loan proceeds, makes a number of changes in PPP and other Small Business Administration (SBA) programs, and creates a new grant program for performance venues and businesses.

The new act extends the effectiveness of the original Paycheck Protection Program (now referred to as the first draw) creates a new program (the second draw) for some previous PPP borrowers, and permits some original PPP borrowers to receive an addition to their original PPP loans. SBA announced that first draw loan applications will be accepted starting January 11 and second draw applications begin January 13. For at least the first two days of each period, SBA will only accept applications from community financial institutions. SBA has also issued new interim final rules governing first and second draw loans. This article summarizes the act together with the implementing rules.

First Draw Loan

The first draw program is an extension of the original PPP and follows the original PPP unless otherwise changed. Thus, in many respects, it will be familiar to practitioners in this area. Here are some of the major changes in the new program:

PPP is extended through March 31, 2021.
Maximum loan amount is unchanged—2.5 times average monthly payroll costs, up to $10 million. The SBA’s rule incorporates the Economic Aid Act change in the definition of payroll costs by adding group life, vision, disability, and dental insurance costs. In the original program, SBA allowed a borrower to calculate payroll based on either calendar year 2019 or the 12 months prior to the loan applications. This is continued, with the addition of calendar year 2020 as a third alternative. There was some concern that the SBA might not allow use of 2019 payroll, but the rule says that will continue in order to place first draw participants on the same footing as borrowers in the original program. It is important to note that a borrower must use the same period for calculating both number of employees (for eligibility purposes) and payroll costs (for loan amount purposes). As in the previous rules, the new rule gives step-by-step guidance on how to calculate loan size for different types of borrowers.
The SBA’s rule continues its previous policy (not required by the statute) that a corporate group may not receive an aggregate of more than $20 million of PPP loans, even if otherwise eligible (for example, because of the waiver of the affiliation rules or the ability to calculate loan amounts on a per-location basis). The rule does not indicate whether second draw loans count against the $20 million cap. However, the rule refers to the $20 million group cap together with the $10 million individual loan cap, and the second draw rule creates a separate corporate group cap for second draw loans (see below), so unless the SBA issues future guidance suggesting otherwise, it seems reasonable to conclude that second draw loans do not count against the $20 million cap.
The SBA is to establish an expedited loan application process for loans up to $150,000. This is supposed to be a one-page form.
Categories of eligible borrowers are expanded to include housing cooperatives with no more than 300 employees, certain television stations and newspapers, certain 501(c)(6) organizations (e.g., chambers of commerce), and destination marketing organizations. The SBA’s rule specifies that eligible entities include those designated in the original program, and the rule confirms that SBA’s alternative size test, which considers net worth and revenues rather than number of employees, still applies in determining whether an entity is a small business concern. In addition, the rule clarifies the new eligible categories of housing cooperatives, 501(c)(6) organizations, destination marketing organizations, and media organizations. The rule also confirms that the SBA’s affiliation rules continue to apply in calculating the number of employees in meeting the size standard (e.g., 500 or 300).
Two specific ineligible categories are also established—(i) publicly traded companies and (ii) businesses or organizations not in operation on February 15, 2020. The SBA’s rule continues to apply its previous guidance on ineligible businesses, and adds new ineligible categories from the Economic Aid Act, including publicly traded companies and businesses controlled, either directly or indirectly, by the president, vice president, head of executive departments, and members of Congress (or their spouses). The rule also continues the SBA’s previous guidance that private equity portfolio companies are not automatically ineligible, although they are subject to the affiliation rules in calculating size and must be able to make the necessity certification. Businesses that are permanently closed are ineligible, but temporarily closed businesses may still apply.
The act authorizes the SBA to permit small business debtors in bankruptcy proceedings (i.e., debtors with less than $7.5 million in debt) to receive PPP loans, if they otherwise qualify. The loan would receive priority as an administrative expense. However, the new rule continues the SBA’s previous position that debtors in bankruptcy proceedings are not eligible.
Eligible costs (for which PPP money can be spent) in the original program—payroll, rent, utilities, and interest on secured debt—continue in the first draw program. The act clarifies that payroll costs include group insurance for life, disability, vision and dental, in addition to health.
New categories of eligible costs have been added: covered operations expenditures (software or cloud computing services), covered property damage costs (uninsured damage caused by 2020 disturbances), covered supplier costs (expenditures to suppliers under contracts entered into prior to the date of the loan that are essential to operations), and covered worker protection expenditures (PPP and adaptive investments to comply with health and safety requirements or guidelines). The new categories fall within the 40 percent portion for non-payroll costs.
Lobbying activities are specifically prohibited as a use of PPP proceeds.
A borrower may elect a covered period of any length between eight and 24 weeks. Previous SBA guidance had suggested a borrower could shorten the covered period if proceeds had been spent, but not all lenders allowed this.
Forgiveness and repayment provisions remain the same, except that previous December 31, 2020, deadlines have been appropriately extended. For example, the rehire safe harbor has been extended for new loans until the end of the covered period.
For loans up to $150,000, a streamlined forgiveness application and documentation process is to be established, with an application no more than one page long and no requirement to submit supporting documentation. Borrowers will still be subject to document retention and audit requirements.

These changes are not retroactive to loans already forgiven even if a borrower would, for example, no longer be eligible under the new first draw PPP provisions or would be in a position to obtain a greater amount of forgiveness under those provisions.

An entity that has submitted an application for forgiveness that has not yet been granted by the SBA and for which these changes may be beneficial, may wish to speak with its lender about amending its forgiveness application prior to any grant of forgiveness by the SBA.

Second Draw Loans

The act creates a new second draw PPP loan for borrowers that previously received a PPP loan. Major aspects of the new program include:

Except as specifically provided, second draw loans are to be made under the same terms, conditions, and processes as under the first draw program.
A second draw borrower must have received a first draw loan and must have used prior to disbursement of the second draw loan all of the first draw loan. This includes the amount of any increase received on a first draw loan (as discussed in Part III). In addition, the SBA’s rule adds a requirement not in the Economic Aid Act—the first draw loan must have been used only for eligible purposes. An entity may only receive one second draw loan.
Eligibility is limited to business concerns, nonprofit organizations, housing cooperatives, veterans organizations, Tribal business concerns, eligible self-employed individuals, sole proprietors, independent contractors and small agricultural cooperatives (all as defined for first draw purposes) that meet two additional criteria—(i) employ not more than 300 employees and (ii) had gross receipts in the first, second, or third quarter or 2020 that are at least 25% less than the same quarter in 2019. For applications submitted on or after January 1, 2021, the revenue reduction may also be shown for the fourth quarter of 2020 compared to the fourth quarter of 2019. There are alternative calculation methods for businesses not in operation in 2019 and for seasonal businesses and a simplified process for demonstrating revenue loss for loans up to $150,000. For convenience, the SBA’s rules also allow a borrower that was in operation for all four quarters of 2019 to demonstrate through its tax returns that its gross receipts for all of 2020 were at least 25% less than for all of 2019.
The Economic Aid Act does not define gross receipts, so the SBA’s rule defines the term consistent with the SBA’s standard size regulations—all revenue of any form received by the borrower, including sales, interest, dividends, royalties, fees, or commissions, reduced by returns and allowances. The rule says this is generally total income plus cost of goods sold, but excluding capital gain or loss. However, the rule specifically excludes several items from gross revenues—taxes collected and to be remitted to a tax authority (e.g., sales tax paid by customers), proceeds of transactions between the borrower and its affiliates, and amounts collected for another by a travel agent, real estate agent, conference management service provider, freight forwarder or customs broker. All other items, including subcontractor costs, reimbursements for purchases made at a customer’s request, investment income and employee-based costs such as payroll taxes, are included in gross receipts. Any forgiveness amount of a first draw loan that a borrower received in calendar year 2020 is excluded from a borrower’s gross receipts.
Unlike the first draw loan, second draw eligibility does not also include businesses that otherwise qualify as a small business concern under the SBA’s size standard regulations, such as under the alternative size test based on net worth and revenue rather than number of employees. Presumably, this is because the Economic Aid Act regulates the size of a second draw borrower through the 300-employee limit. Since small business concerns are not included in the second draw law, borrowers that qualified as a small business concern under the SBA’s regulations, but do not meet the new 300-employee limit, do not appear to be eligible for a second draw loan, although the rule does not address this directly. SBA affiliation rules apply in calculating the number of employees, except as provided in the Act for borrowers in NAICS code 72 (hospitality), for-profit broadcasters that employ no more than 300 persons per location, and nonprofit broadcasters.
However, none of the following may be an eligible entity: (i) certain entities not eligible for SBA loans under existing SBA rules (financial businesses, passive businesses, illegal businesses, and the like), (ii) businesses primarily engaged in lobbying or political activities, specifically including think tanks, (iii) entities owned 20 percent or more by businesses organized under the law of the Peoples Republic of China (PRC) or that have significant operations in the PRC, (iv) entities having a PRC resident as a director, (v) any person required to be registered under the Foreign Agents Registration Act, or (vi) a person receiving a grant under the program for shuttered venue operators created under the act.
In general, the maximum loan amount is the lesser of (i) 2.5 times average total monthly payroll costs during either the year before the loan application or calendar year 2019, at the borrower’s option, or (ii) $2 million. There are alternate calculation methods for seasonal employers and new employers. For entities with a NAICS code beginning with 72 (restaurants, hotels, and other hospitality businesses), the multiplier is 3.5.
For NAICS code 72 businesses with more than one location, there is a rule similar to first draw PPP loans. The borrower is eligible for a loan if each location meets the eligibility criteria—300 employees and a 25% revenue decrease.
The waiver of the affiliation rule used in first draw loans (NAICS code 72, SBA-registered franchises and businesses receiving SBIC assistance) also applies to second draw loans, but instead of 500 employees the limit is 300.
Businesses that are part of a single corporate group are limited to an aggregate of $4 million of second draw loans. This is not required by the Economic Aid Act, but is a procedure adopted by SBA.
Second draw loans will be eligible for forgiveness on the same basis as first draw loans, except there will be a simplified forgiveness application and documentation process for loans of $150,000 or less.

Additional Loans

The general rule is that a borrower may only receive one first draw loan. However, the act instructs SBA to issue rules within 17 days of the effective date that allow a recipient of a first draw loan that is not yet forgiven to seek an additional loan in three cases. First, a borrower that returned all or part of its first draw loan may apply for a new loan equal to the difference between the amount they actually received and the maximum amount applicable. Second, a borrower that did not accept the full amount to which they were entitled may request a modification of the loan to receive the maximum amount applicable. Last, certain partnerships and seasonal employers may be eligible for increases in their original loans due to changes in SBA guidance.

Changes Applicable to Existing Loans

Several of the changes in first draw loans are applicable not only to new loans but also to existing loans that have not yet been forgiven. As a result, current borrowers may wish to alter their spending or wait to apply for forgiveness until these provisions are fully implemented.

The Economic Aid Act allows recipients of original PPP loans to receive additional funding in two main instances, as part of the first draw program. First, borrowers that received a loan and then returned it in whole or in part or were approved for a loan but did not accept it may now receive a loan in the amount that was originally approved. Second, because of changes in SBA guidance that increased the maximum loan amount for partnerships and seasonal employers, such employers that received a smaller loan than was available under the amended guidance may now apply for an additional to the original loan. The first draw loan rule confirms that such loans or increases in loans are available, but states that additional guidance will be provided on the process to reapply or request a loan increase in these cases.

The retroactive provisions (previously summarized) include the following:

The new categories of permissible costs—covered operations expenditures, covered property damage costs, covered supplier costs, and covered worker protection expenditures.
The inclusion of group life, disability, and vision and dental insurance as a payroll cost.
The streamlined forgiveness application and documentation process for loans up to $150,000.
Elimination of eligibility for borrowers not in operation on February 15, 2020.

PPP and the Employee Retention Tax Credit

The CARES Act created an employee retention credit (ERC), a refundable tax credit available to taxpayers that either had their business fully or partially suspended during at least one quarter of 2020 or had a significant drop in gross receipts for quarters in 2020 relative to the same quarter in 2019. Eligible businesses may claim a maximum credit of $5,000 per employee who is paid qualified wages. The appropriations act extends ERC from January 1, 2021, to July 1, 2021.

The CARES Act prohibited a PPP borrower from receiving the ERC. Because ERC applies to a single employer on an aggregated basis, in general a taxpayer could not use a PPP loan for one company and still have that company or any other member of the corporate group be eligible for ERC. This provision is repealed by the appropriations act, so now even the same party may receive a PPP loan and take the ERC.

To prevent double dipping, a taxpayer may not receive the ERC for payroll costs that are paid for with a PPP loan, to the extent the loan is forgiven. However, a taxpayer is permitted to elect not to include certain payroll costs in the computation of the ERC, which allows them to be funded by a PPP loan. The act also requires the SBA to adopt rules so that a borrower whose PPP loan is not fully forgiven may elect for the unforgiven portion of payroll costs to be eligible for ERC.

As a result of these changes, a PPP borrower may now have payroll costs paid from PPP proceeds to the extent required to receive full forgiveness of a loan and then to take ERC with respect to the excess payroll costs. These changes are effective as of the original effective date of the CARES Act.

Tax Treatment of Expenses Paid with PPP Proceeds

The IRS issued guidance that expenses paid with PPP loan proceeds may not be deducted on the borrower’s federal income tax return if the borrower reasonably expects to receive forgiveness of the loan, even if forgiveness has not been received or even applied for. The premise for this position is to prevent double dipping because the forgiveness of the PPP loan is not taxable as cancellation of debt. This position had been widely criticized as taking away much of the economic benefit to a borrower intended by the program. The act remedies this situation by specifically mandating that no deduction shall be denied, no tax attribute shall be decreased, and no basis increase shall be denied because the forgiveness of a PPP loan is not subject to tax as cancellation of debt. As a result, the IRS has now rescinded its previous guidance.

Necessity and Audits of PPP Loans

In November, the SBA began using new Forms 3509 and 3510 to require certain borrowers to provide additional information concerning the necessity for their PPP loan. There has been considerable controversy surrounding the question of necessity and the use of the new forms. Some hoped that Congress would modify the necessity requirement or the SBA forms in the stimulus act, but it did not. A necessity certification continues to be required for new PPP loans of all types. In fact, for the new second draw program, Congress waived two of the certifications required in the previous PPP loan application, but not the necessity certification.

The House Select Subcommittee on the Coronavirus Crisis has identified what it believes is more than $4 billion in questionable PPP loans. The SBA fraud hotline has received thousands of complaints, and the U.S. Department of Justice has filed criminal charges against more than 80 individuals for suspected fraud in CARES Act relief programs. As a response to concerns about fraud and waste in PPP, the act requires the SBA to submit to the House and Senate small business committees within 45 days of the effective date an audit plan with regard to forgiveness of loans over $150,000, and to provide updates on that plan every 30 days. The audit plan is to include policies and procedures for conducting forgiveness reviews and audits and the metrics the SBA will use to determine which loans will be audited. The act also appropriates $50 million for PPP audits and fraud mitigation efforts.

It appears borrowers will need to respond to Form 3509 or 3510 when received, unless the new administration changes policy or the pending litigation challenging the forms is successful.

Other Provisions

The act establishes a Shuttered Venue Operator Grant program to provide financial assistance to live venue operators or promoters, theatrical producers, live performing arts organizations, museum operators, motion picture theatre operators, and talent representatives that meet certain requirements. Fifteen billion dollars is appropriated for the program.

The act continues the payment of principal and interest on certain qualifying SBA loans existing prior to the CARES Act. Borrowers receive an additional three months of full payments, starting in February 2021. Thereafter, the payments will be capped at $9,000 per month. Certain borrowers are eligible for more favorable treatment.

The SBA’s regular 7(a) loan and Express Loan programs continue to operate. The act increases the 7(a) guarantee percentage to 90 percent and increases the amount and guarantee percentage for Express Loans. Changes are also made in SBA’s 504 loan program for fixed assets, microloan program, and Economic Impact Disaster Loan (EIDL) program. The act repeals the CARES Act section requiring the amount of an EIDL advance (up to $10,000) to be deducted from a PPP borrower’s loan forgiveness amount. The EIDL changes are expected to increase the availability and usability of that program. PPP borrowers may also receive an EIDL loan. Companies may wish to take another look at EIDL as a funding source.

Funding

The unused money from the original PPP is returned to the Treasury, and a new appropriation of $284.45 billion is made for PPP and related programs. Of this, $131.72 billion is set aside for various purposes, including PPP loans for first-time borrowers, small borrowers, or small loans in low-income areas. After 25 days, the SBA may adjust these set-asides. The total unrestricted appropriation for PPP (both first and second draw) is $152.73 billion.

Steve Dickinson is a partner in the Corporate and International practices of Cozen O’Connor and represents companies in a full range of domestic and international business matters. He is a leader of Cozen O’Connor’s Paycheck Protection Program (PPP) team and has advised dozens of companies on PPP-related issues. He has also spoken and written extensively on the PPP, including more than a dozen client alerts, webinars for national industry groups, and interviews with The Wall Street Journal, Independent Retailer, and Glossy.

James Van Orden is a partner at Cozen O’Connor who focuses his practice on environmental and energy law. In addition, he draws on his 11 years of prior government service to advise clients on a variety of general regulatory and strategic matters. He has helped to spearhead Cozen O’Connor’s PPP team and has advised dozens of companies on PPP-related issues.

Robert Magovern is a partner in the Transportation and Trade practice of Cozen O’Connor. With an emphasis on Government Contracts, International Trade and Antitrust, he counsels U.S. and foreign companies and trade associations on a variety of domestic and international trade regulation issues. His Government Contracts work includes issues related to the formation of small businesses, applications to and issues arising under all Small Business Administration (SBA) programs, including 8(a) Business Development, teaming agreements and joint ventures, affiliation issues, size challenges, and bid protests. He has also helped to spearhead Cozen O’Connor’s PPP team and has advised dozens of companies on PPP-related issues.

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Survey of Commercial Lease Terms Reveals Ongoing COVID-19 Implications

Evansj5 — Fri, 26 Feb 2021 17:02:23 GMT

By: Kim Seib, Sara Kolb, and Rebecca Calzontzi, Practical Guidance Real Estate Team

This article uses survey results and graphics collected from the Practical Guidance Survey of Commercial Lease Terms to explore commercial leasing trends and the impact of COVID-19 on the commercial leasing market. Click here to take the survey and gain access to the latest market standards for more than 40 leasing deal points.

Commercial Leasing Today

COVID-19 upended the commercial leasing market. Some impacts were immediate: tenants stopped paying rent, demand for office and retail space plummeted, businesses and properties that relied on physical density became untenable, seemingly overnight. While the initial scramble to deal with COVID-triggered disruption has settled down, longer-term impacts will turn on behavioral changes and are still working themselves out. How many Americans will return to the office? Will the open floor plans embraced in recent years fall out of favor? Will employers shift workers out of cities to save money?

“I think it’s inevitable that, in the short-term, tenants are going to continue to try to downsize. In the office market, tenants have realized that they need less space to function – their employees have successfully navigated working from home,” says Michelle McAtee, co-chair of Jenner & Block’s Real Estate Practice. McAtee thinks this will change—but only to a point. “In the long-run, I do think there will be a bit of a recovery, as we all realize that certain things happen better in person. But I don’t predict a return to where we were pre-pandemic,” says McAtee.

Even with so much in flux, leasing carries on and attorneys continue to negotiate leases with the same concerns as always—How much can I get for my client? What’s market right now?—except now these concerns are being reshaped by COVID-19. Negotiating standard leasing clauses like interruption of services, termination options, and force majeure has taken on a new sense of urgency as attorneys adapt to changing times. “Force majeure provisions are the hot topic right now,” reports McAtee, “and if they did not already include references to pandemic and civil unrest, tenants are certainly pushing for them now.”

Most leases are not publicly filed, and it has never been easy to determine what’s market. Even in stable times, real estate attorneys often find themselves turning to old-fashioned listservs and message boards for information and insight. It is probably safe to say that most real estate attorneys are not risk takers by nature, and this desire for information is typically countered by concerns over client confidentiality or losing a competitive edge. But as the need for up-to-date information becomes crucial in the COVID and post-COVID world, real estate practitioners are likely to seek new avenues and tools to access information on the latest leasing trends.

Survey of Commercial Lease Terms

To meet this need, Practical Guidance recently launched its Survey of Commercial Lease Terms. This ongoing survey provides up-to-date intelligence about the commercial leasing market and gives real estate attorneys a clear view of market standards and trends to aid in lease negotiations. Drawn from the survey, this article highlights COVID-specific leasing data and attorney insights on the pandemic’s immediate impact on lease negotiations. It also summarizes key retail and office lease terms for use in negotiating and gauging the market going forward.

The data set referenced in this article includes 299 recently negotiated commercial leases obtained from private sources. These leases are spread across the country, with 26% located in the northeast, 26% in the west, 24% in the southeast, 11% in the southwest, and 11% in the midwest. (Approximately 1% of respondents did not identify a location.)

Office leases (60%) are in the majority, followed by retail (30%) and industrial (10%) leases. The leases include triple net (42%), gross or full-service (30%), and modified gross (28%).

Click here to take the survey and access the latest survey results

COVID-19 Impact

Survey results indicate that in response to COVID-19, many parties restructured force majeure provisions, delayed lease negotiations, and made significant changes to general lease terms such as rent abatement and termination rights.

Lease Negotiations

The majority of survey respondents observed effects on lease negotiations that were pending at the start of the pandemic, including negotiations that were put on hold or halted entirely. When asked about leases that were under negotiation when the COVID-19 pandemic began, over 70% of respondents stated that they observed one or more of the following:

Note: Changed lease terms included co-tenancy, release provisions, rent and allowance terms, security, force majeure, assignmnet, continuous operations, delivery or closing date, termination, insurance, and move-in date

Lease Modifications

Not surprisingly, many parties have needed to modify their existing leases during the pandemic. McAtee of Jenner & Block reports that lease modifications and amendments have “been the focus of my practice during the pandemic.” When asked about the tenor of these negotiations, McAtee was largely positive: “Generally speaking, it has been less contentious than it has been collaborative. Both tenants and landlords have worked through the difficulty of the situation.” However, the news is not all rosy for landlords, and McAtee added, “On the other hand, tenants have tended to ask for more than they have in the past. There has been a general feeling of landlords being a bit stuck—they would rather have a paying tenant, even if for less space, than no tenant and empty space without much of a market for reletting.”

Looking to the survey, 55% of respondents have recently restructured a lease or negotiated a lease amendment due to COVID-19. The modifications identified included the following:

Force Majeure

A force majeure clause is a contract provision that excuses a party’s performance of its contractual obligations when certain circumstances arise beyond its control. The clause typically lists a series of events that constitute a force majeure event and imposes specific obligations on the party seeking to invoke the clause to excuse its performance. Events such as acts of God, weather conditions, war, government orders, labor strikes, and the inability to obtain materials are among the excuses that a force majeure provision typically contains.

Since the onset of the COVID-19 pandemic, force majeure provisions have become a central focus of many lease negotiations. Tenants facing financial hardship are looking to force majeure clauses to excuse (or delay) their lease obligations while staying in possession of their premises. Landlords, on the other hand, are pushing for restrictive force majeure clauses to protect their rental income. And parties on both sides are considering whether to modify existing leases or lease forms going forward to account for the pandemic’s effects.

Approximately half of all survey respondents stated that the force majeure clause in their lease specifically covered one or more of the following pandemic-related events:

Governmentally declared emergencies/imposed shutdowns (109)
New laws that render performance unlawful (75)
Pandemics (69)
Public health crisis (62)

Of the respondents whose force majeure clauses did not include any of the events listed above, 52% plan to restructure their provisions to include one or more of them, as follows:

Survey responses also show the direct effect of COVID-19 on force majeure provisions over time. Only 45% of leases from 2018 and 2019¹ included one or more of the events listed above in their force majeure clauses, and only 4% listed pandemics specifically as a force majeure event. Of the leases from March 2020, 57% included one or more of these events as a force majeure, and 21% specifically listed pandemics. And in the second, third, and fourth quarters of 2020, over 60% of leases included one or more of these events as a force majeure, and over 30% specifically listed pandemics.

Business Interruption Insurance

Property insurance policies often cover only the cost of repairing and replacing damaged property, not consequential economic losses. Business interruption insurance can help fill in the gap, covering certain types of economic losses that a business suffers when it is unable to operate for a period of time.

Some landlords require their tenants to carry business interruption insurance to ensure that, even if a tenant’s business is disrupted, it will still be able to make rent payments. Survey responses show that the COVID-19 pandemic may be leading more landlords to include a requirement for business interruption insurance in their leases: Only 32% of leases from 2018 and 2019 required tenants to carry business interruption insurance, compared to 50% of leases from 2020.

Rent Abatement

Landlords sometimes agree to grant rent abatements if they are unable to provide essential services to their tenants for a certain period of time. McAtee reports that in her practice “the interruption of services provision is getting more attention than ever, with tenants pushing to provide that rent abates if they cannot use their premises due to any interruption, including due to state mandates. The key here is that tenants want the lease to provide that that determination is made by them and not the landlord.”

While only 46% of leases surveyed include a rent abatement provision, they reveal a trend shaped by the pandemic. Of the leases from 2018 and 2019, approximately 40% gave the tenant this abatement. The percentage of leases with an abatement provision increased dramatically to 86% in March 2020, and then dropped back down to 40% in the second, third, and fourth quarters of 2020. It remains to be seen if this trend will shift upward once again as the pandemic continues into 2021. As more survey results are generated in the coming months, attorneys will be able to monitor and assess what is market for rent abatement provisions in a pandemic and post-pandemic world. Click here to take the survey and access the latest survey results.

Tenant Termination Option

Only 34% of leases from 2018 and 2019 gave the tenant the option to terminate the lease prior to the end of the term. There was a slight increase in leases with a tenant termination option in March 2020 (36%), but only 25% of leases after March 2020 contained this provision. While the percentages here did not range as widely over time as with rent abatements, responses indicate that landlords may be granting tenant termination options less frequently now than they were before the onset of COVID-19.

Other Trends and Findings

Looking ahead, longer-term impacts of the pandemic, including lingering economic uncertainty, have the potential to influence both landlords’ and tenants’ approaches to many standard lease provisions. Some of these provisions are discussed below, through an examination of recent market trends.

Percentage Rent

Base rent for retail space is usually calculated on a per square foot basis and paid in monthly installments. Typically, base rent is increased at the beginning of each lease year or 12-month period at an agreed upon rate.

In addition to base rent, retail tenants may also pay percentage rent, meaning a share of sales, as well as some portion of the operating expenses, insurance, and real estate taxes associated with the operation of the property. The survey reveals that only 28% of recently negotiated retail leases require the tenant to pay percentage rent. However, some analysts suggest that because percentage rent provides the flexibility needed to deal with business interruptions, it is becoming more appealing to both landlords and tenants and that its appeal may outlast the pandemic.

Notice and Cure Rights for Default

All commercial leases contain provisions detailing the acts or omissions of the tenant that will result in a lease default and the landlord’s remedies following a default. Typically, the tenant tries to negotiate for written notice, grace periods, and cure periods for specific defaults while, for their part, landlords are reluctant to waive or limit any remedies they may have following a tenant default. As the pandemic and its after-effects continue, tenant defaults are likely to rise, perhaps leading to an increased focus on notice and cure rights in lease negotiations.

Retail Leases

In over half of the retail leases surveyed, the tenant successfully negotiated for notice and cure rights for not only nonmonetary defaults (71%) but also monetary defaults (59%). 23% of retail leases did not include any notice and cure rights. Five retail leases granted cure rights for monetary defaults only while 16 retail leases granted cure rights for nonmonetary defaults only.

The amount of notice/time to cure given to retail tenants following default varied widely. For monetary defaults, most tenants were entitled to between three and 15 days, although more than 20% of those with notice and cure rights received 30 days or more. For nonmonetary defaults, the notice/cure periods also varied, but over 50% of tenants with notice and cure rights received 30 days or more.

MONETARY DEFAULTS
NUMBER OF RETAIL LEASES

NONMONETARY DEFAULTS
NUMBER OF RETAIL LEASES

Office Leases

As with retail leases, in a majority of the office leases surveyed (78%), the tenant was able to negotiate for notice and cure rights for nonmonetary defaults. Over half of office leases (67%) also provided for notice and cure rights for monetary defaults. 19% of office leases did not include any notice and cure rights.

Of the office tenants that were granted notice and cure rights for monetary defaults, 70% were entitled to no more than 10 days’ notice and cure. 13% of these tenants received 30 days’ notice and cure, and only 3% received 60 days’ notice and cure.

While the length of notice and cure periods for nonmonetary defaults varied among office leases, the majority of office leases with this notice/cure period (51%) gave tenants 30 days’ notice and cure.

MONETARY DEFAULTS
NUMBER OF RETAIL LEASES

NONMONETARY DEFAULTS
NUMBER OF RETAIL LEASES

Lease Guaranty

Landlords typically require lease guaranties when they have concerns about the tenant’s financial strength or experience. But financial hardship caused by COVID-19 may lead both landlords and tenants to look to guaranties for protection and leverage. Landlords might be more likely to require substantial guarantors if they are concerned about their tenants’ ability to pay rent going forward. At the same time, some tenants might offer up guarantors in return for concessions, such as a delay in initial rent obligations or a reduction in security.

Retail Leases

67% of the retail leases surveyed were guaranteed. 60% of retail leases with guaranties had full guaranties while the remainder had guaranties that were limited in some way.

Two regional differences stood out:

Guaranties were less common in the central region of the United States (Texas, Colorado, Arkansas, Illinois, Missouri, Nebraska, Indiana, and Kansas), where only 53% of retail leases had a guarantor.
30% of retail lease guaranties were good guy guaranties, and all of those leases were for retail space in New York City. (A good guy guaranty, in its simplest form, is one where an individual guarantor warrants to the landlord that they will be liable for all rent payments that accrue until the tenant vacates the leased premises. Upon the tenant’s surrender of the premises and the landlord’s receipt of these payments, the guarantor’s personal liability ends.)

Office Leases

Office leases in the survey were less likely than retail leases to be guaranteed, and a slight majority (54%) were not guaranteed. 62% of office leases with guaranties had full and unconditional guaranties and 38% had guaranties that were limited in some way. 27% of the limited guaranties were identified by respondents as good guy guaranties; as with retail leases, all were in the New York City market.

Security Deposit

As with a guaranty, whether a landlord requires a security deposit is often tied to the tenant’s financial strength. Once again, continuing instability resulting from COVID-19 is likely to increase landlords’ focus on security deposit requirements.

Retail Leases

69% of retail leases required a security deposit. In 18% of these leases, the tenant was entitled to interest earned on the deposit.

Office Leases

The numbers are similar for office leases, where 71% required security deposits and 29% did not. In 15% of office leases with a security deposit, the tenant was entitled to receive interest earned on the deposit.

Tenant Improvements

Frequently, improvements or alterations are required to make the leased premises usable by the tenant. These are referred to as tenant improvements. Tenant improvements can be as simple as installing new carpeting, though sometimes the alterations are significant enough to cost several millions of dollars. If, as some have suggested, a long-term effect of the COVID-19 pandemic will be a distaste for open floor plans, both Landlord performs the work and pays for the entire buildout 13% Landlord performs the work and pays up to a certain amount 21% Tenant performs the work and receives a TI allowance 42% Tenant performs the work and pays, no TI allowance 4% Other 20% BUILDOUT PERFORMANCE AND PAYMENT RETAIL office and retail space may require more significant alteration than in the past to be acceptable to tenants. Responsibility for both performing and paying for this work is likely to be a key negotiating point post-COVID-19.

Tenant improvements are common in both retail and office leases but can be more complicated and heavily negotiated in retail leases. For the average retailer (whose space can be quite individualized and distinct), the necessary work typically consists of more than mere cosmetic changes. In many cases, the tenant will work with the landlord and, if applicable, an architect or contractor to agree upon a scope of work and at least preliminary pricing before the lease is actually signed. The business terms agreed upon by the parties before a lease is drafted typically include the amount of any agreed-upon tenant improvement allowance and which party will be responsible for completing the work that needs to be completed before the tenant takes occupancy or opens for business. A retail tenant will often prefer to do the work itself; it may have a concept or brand that it desires to put in place, it will likely be more familiar with the buildout, and it might even have preferred contractors or subcontractors with whom it wishes to work. At a minimum, the landlord will want the ability to approve the contractors and the plans and specifications for the work.

To induce a tenant to lease space in the landlord’s building, the landlord may agree to pay a tenant improvement allowance. Tenant improvement allowances are lump sums of money that the landlord makes available to the tenant to customize the leased premises to the tenant’s specifications. Sometimes the tenant improvement allowance will be paid to the tenant in the form of a rent credit, but more frequently it comes in the form of a reimbursement by the landlord for the tenant’s construction costs.

Tenants should be sure to negotiate an appropriate remedy should the landlord fail to fund any allowance to a tenant when it is due and owing, such as an offset right against rent. This provision is typically included in a work letter agreement, if there is a separate one, but can also be included in the lease itself.

Retail Leases

59% of retail leases included in the survey required some sort of initial buildout of the leased premises. The survey also reveals how the cost of and responsibility for performing the initial buildout was allocated. Understanding these trends and prevailing terms can provide valuable insight when negotiating the tenant improvement clause in a retail lease.

The survey shows the following allocation of responsibility for the performance and payment of work under retail leases with a buildout:

Office Leases

The survey reveals that 54% of recently negotiated office leases required an initial buildout, with the following allocation of responsibility for the performance and payment of work under those leases:

Initial Buildout: Performance and Payment of Tenant Improvement Work OFFICE

Tenant Options

Common leasing options—those granting extension and termination rights as well as rights of first refusal (ROFR) and rights of first offer (ROFO)—provide tenants with flexibility should their needs change, which is desirable in an uncertain world. Whether more tenants will successfully negotiate for these options post-COVID-19 in unknown. In fact, as explained in the COVID-19 Impact section above, although the inclusion of termination options in commercial leases increased in the initial stages of the pandemic, this trend may have already run its course. As for extension options, ROFRs, and ROFOs (see data below), one unanswered question is whether the options will actually become less common if tenants choose to forgo them in exchange for securing things like rent flexibility and concessions. As more leases are added to the survey in the coming months, we may be able to answer this question. Click here to contribute your leasing data to the survey.

Extension Options

Retail Leases

Extension options were common among retail leases with 70% of retail leases including this type of option. The majority of retail leases with extension options (60%) required the tenant to provide the landlord with 1-6 months’ notice to exercise the option.

The full breakdown is as follows:

Office Leases

Extension options were the most common option found in the office leases surveyed. Over two-thirds of office leases granted the tenant an extension option while fewer than one-third did not. Of those leases with extension options, 50% required the tenant to give the landlord 1-6 months’ prior notice to exercise the option. The full breakdown of notice requirements is as follows:

Of the office leases with extension options, 30% used fair market value to determine rent during the extension term and 8% used CPI. The remaining office leases provided for either fixed rental rates set forth in the lease or other rates to be agreed upon by the parties.

ROFR/ROFO

Retail Leases

68% of retail leases had neither an ROFR nor an ROFO. 32% had one or the other; ROFOs were fairly uncommon and were included in only 10% of retail leases, while 22% of retail leases had a ROFR.

Office Leases

20% of office leases gave the tenant an ROFO. ROFOs were most commonly found in New York City office leases. ROFRs were fairly uncommon in office leases, with only 8% including them. 71% of office leases contained neither a ROFO nor a ROFR.

To take the survey and gain access to the latest market standards for over 40 leasing deal points, click here.

Kim Seib is a Content Manager with the Practical Guidance Real Estate team. Before joining LexisNexis, Kim practiced with a number of New York City-based law firms, focusing primarily on commercial real estate transactions.

Sara Kolb is a Content Manager for Practical Guidance in its Real Estate practice area. Before joining LexisNexis, Sara represented purchasers, borrowers, and sellers in acquisitions, financings, and dispositions of large-scale commercial projects throughout the United States.

Rebecca Calzontzi is a Content Manager for the Practical Guidance Real Estate team. Rebecca practiced law for nine years, first as a finance associate at Debevoise & Plimpton LLP and then as a real estate associate at Lazer, Aptheker, Rosella & Yedid, P.C. Rebecca represented clients in a wide range of real estate transactions, including commercial leasing matters and the purchase, sale, and financing of commercial and multifamily properties.

Impact of Biden-Harris Administration on Financial Regulation

Evansj5 — Fri, 26 Feb 2021 17:00:36 GMT

By: Amy J. Greer and A. Valerie Mirko, Baker & Mckenzie LLP

This article discusses the change in the U.S. presidential administration, including its impact on financial regulation generally and the U.S. Securities and Exchange Commission (SEC) specifically. This article addresses transition matters and timelines for new leadership as well as the potential impact of the Biden-Harris Administration's priorities on the direction of the SEC, with a focus on retail investors, COVID-19, and Economic Social and Governance (ESG) matters.

Immediate Transition Matters

Gary Gensler Announced Nominee to Chair SEC in the Biden Administration

On January 18, 2021, Gensler was nominated to be the next SEC Chair. As of the date of this article, Gensler’s Senate confirmation hearings had not yet been scheduled.

Gensler brings with him significant relevant experience, having served as chair of the Commodity Futures Trading Commission (CFTC), a partner at Goldman Sachs, the Department of Treasury Undersecretary for Domestic Finance, and an advisor to then-Senator Paul Sarbanes on the drafting of the 2002 Sarbanes-Oxley Act. Gensler also was an early and prominent critic of the London Interbank Offered Rate (LIBOR)―calling for reforms to the LIBOR system as early as 2012. When Gensler was CFTC chair, the agency settled enforcement actions with several major financial institutions charged with LIBOR manipulation.¹

In recent years, Gensler has been a professor of global economics and management at the MIT Sloan School of Management, with a focus on public policy, financial technology, blockchain, and cryptocurrencies. Gensler also chaired the Maryland Financial Consumer Protection Commission, which made several recommendations to the Maryland legislature in January 2019―most notably legislation to broaden the fiduciary duty standard to apply to broker-dealers, their representatives, and insurance producers.² As detailed below, he has also been a key leader in Biden-Harris administration transition efforts.

Gary Gensler Led Agency Review Team for Federal Reserve, Banking and Securities Regulators

On November 10, 2020, the Biden-Harris team announced several agency review teams, including the Federal Reserve, Banking, and Securities Regulators team led by Gary Gensler. This team was charged with reviewing the following agencies: the SEC, the CFTC, the Federal Deposit Insurance Corporation, the Federal Reserve, and the National Credit Union Administration. The choice of Gensler as team lead, as well as the range of perspectives represented on the 15-person team, indicated the potential for a forward-looking approach to the review, driven by both academic and labor-oriented points of view. Gensler’s choice also indicated the possibility―but not the certainty―of his eventual nomination to be SEC Chair.

CFPB Review

Gensler’s transition review team was not the only one focusing on the review of financial regulators. The Consumer Financial Protection Bureau (CFPB) was the subject of its own 10-person review team, chaired by Leandra English, formerly Deputy Director of the CFPB and senior policy advisor to New York Department of Financial Services Superintendent Linda Lacewell. This was a considerable investment of resources in the transition for a single agency, which suggests there may be a more prominent future role for the CFPB. On the same day that Gensler's nomination was announced, Rohit Chopra, who is currently a commissioner with the Federal Trade Commission, was nominated to lead the CFPB.

Interim Changes in Leadership at the SEC

Following a presidential election, a new SEC chair is usually in place by late winter, though that timing is driven by administration priorities and the then-current economic climate. For example, after the 2008 election, when the United States was deep in the financial crisis, then-incoming Chair Mary Schapiro began her term on January 27, 2009, underlining the Obama administration’s priorities in light of the crisis. In contrast, Mary Jo White began her term on April 10, 2013 and Jay Clayton on May 4, 2017.

Along with Chair Clayton’s previously announced departure at the end of 2020, several additional departures were announced and have since occurred. This is a fairly typical year-end and election-cycle rotation among the senior staff of the SEC, though it does seem a bit more hectic this go-round; and it generally has trickle-down impacts, as new and open senior staff slots are and will be filled. Bill Hinman, Director of the Division of Corporate Finance, departed December 4, 2020; Enforcement Division Director Stephanie Avakian departed at the end of 2020, as did Trading and Markets Director Brett Redfearn. SEC General Counsel Bob Stebbins departed in early January 2021, and Investment Management Division Director Dalia Blass announced her departure at year-end, leaving in early February 2021, followed by the Commission's Chief Accountant, Sagar Teotia. In addition, at the CFTC, Chair Heath Tarbert, who has led the agency since last year, announced that he would depart in January 2021.

Upon the departure of Chair Clayton, in late December, then-President Trump appointed Commissioner Elad Roisman to the role of Acting Chairman, a position he held only until January 21, 2021, when President Biden appointed Commissioner Allison Herren Lee to serve as Acting SEC Chair, pending Gary Gensler's confirmation.

At the Division of Enforcement, Marc Berger, who was Acting Enforcement Director upon the departure of Stephanie Avakian, followed her out the door in January 2021, leaving the top spots of this key Division open. The SEC acted quickly, on January 22, 2021, appointing Melissa Hodgman, then an Associate Director of the Division, to serve as Acting Director of Enforcement; and on February 5, 2021, appointing Kelly Gibson, the Director of the Philadelphia Regional Office, to serve as the Acting Deputy Director of Enforcement.

Biden-Harris Administration Priorities and Impact on Financial Regulation

The Biden-Harris administration had announced its priorities as part of its transition plans as follows: COVID-19, economic recovery, racial equity, and climate change. The SEC under the Biden-Harris administration and led by Gensler is expected to continue to emphasize the protection of retail investors and market integrity while giving greater weight to ESG matters. The SEC’s existing COVID-19 relief is expected to also continue, as that is a bipartisan issue and one directly in line with the Biden-Harris transition plan’s focus on COVID-19.

Continued Focus on Retail Investors

The SEC has emphasized retail investor protection for the last four years, but has done so in a selective manner―largely in the enforcement realm―as opposed to a holistic manner. For example, while Regulation Best Interest (Reg BI) is focused on retails investors, other rulemakings—such as those relating to the use of derivatives by registered investment companies and business development companies and improving access to capital in private markets—have not been perceived to be as protective of retail investors.³ A Democratic-majority SEC that is focused on building confidence in the economy and the markets will likely broaden the retail investor focus and implement additional regulatory measures or approaches, such as the following:

Reg BI. Given the SEC's work in getting Reg BI over the finish line, and the heavy lift that the industry has undertaken to implement and comply with Reg BI, there will likely not be a wholesale repeal of or significant revisions to Reg BI. Another key indicator that Reg BI is here to stay is the Department of Labor's decision, announced on February 12, 2021, to leave in place its Trump-era fiduciary rule. More assertive enforcement of Reg BI, however, is expected, with the SEC focusing on the conflicts and care obligations. This will be in contrast to the 2020 examinations by the newly renamed Division of Examinations (but for now, we're just going to call it OCIE), which focused largely on the compliance and, to some extent, disclosure obligations of Reg BI.
Conflicts of interest. There will be a continued exams and enforcement focus on conflicts of interest of both broker-dealers and investment advisers, including compensation disclosure issues and revenue sharing.
Custody requirements for investment advisers. The Division of Investment Management has been working through pre-rulemaking efforts to revise SEC Rule 206(4)-2 (Custody Rule).⁴ It is likely these efforts will accelerate as the current Custody Rule has become unwieldy in the sheer number of interpretations required. In addition, the rule’s structure is more suited to advisers with separately managed accounts rather than to fund advisers.
Business continuity and remote supervision. OCIE has focused since March 2020 on how broker-dealers and investment advisers have reacted to the COVID-19 pandemic and has already published a risk alert on the subject.⁵ This work could lead, in the medium-term, to additional SEC guidance, or potentially more prescriptive rulemaking, intended to enhance industry resiliency with lessons learned from the pandemic.
Cybersecurity and vendor management. With more remote working, these issues have become even more critical, and have also been the subject of recent OCIE risk alerts.⁶ The risk alert provides notice to the industry, such that some enforcement actions may follow, particularly for firms that have neglected to address cybersecurity hygiene and lack appropriate policies and procedures. With a more regulatory-focused SEC, as with business continuity and remote supervision, these areas may also be subject to additional regulation or guidance.

ESG

There is a strong likelihood that the SEC becomes more active in the ESG area, in contrast to the lighter touch disclosure-focused activity to date. Until now, ESG-related disclosures have remained largely voluntary in the United States, and the SEC and its staff have focused on ESG through disclosure alone, whether for public companies or in the investment management space. For example, OCIE conducted a sweep in 2018 in which it asked firms with ESG product offerings (1) about their criteria for defining ESG; (2) whether firms were following established principles like the United Nations-supported Principles for Responsible Investments (UNPRI); and (3) to what degree firms were engaging on ESG matters with issuers in which they invest. OCIE also asked about firms’ marketing of ESG products and the degree to which the products were advertised as sustainable or green. In its report on examination priorities in 2020, OCIE referred to ESG investment offerings as an area of concern in which examiners would pay particular attention. More recently, at least three SEC offices (Boston, Philadelphia, and Los Angeles) have begun or continued local ESG-focused exam initiatives.

Another key indicator is the recent appointment of Satyam Khanna as Senior Policy Advisor for Climate and ESG to the office of Acting Chair Lee, a newly created role that will likely transition to Gensler’s office when he becomes Chair. Looking ahead, the SEC’s focus on ESG may take one or more of the following approaches in addition to simply focusing on whether products sold to investors actually are what they claim to be―a perennial issue for the Enforcement Division:

Leverage global ESG regulatory developments, evaluate existing taxonomies, and consider standardized climate change and ESG disclosure requirements. Currently, ESG frameworks in the United States remain undefined, in sharp contrast to other countries. A likely initial first step would be the establishment of a cross-divisional ESG working group tasked with examining other countries’ ESG efforts. Similar efforts occurred in the context of crowdfunding during rulemaking pursuant to the Jumpstart Our Business Startups Act. Based on Acting Chair Lee’s climate change disclosure speech from November, as well as the stated Biden-Harris priorities, SEC staff efforts will likely focus first on climate change.⁷
Finalize the March 2020 Names Rule update. Earlier this year, the SEC issued a request for comment on potential updates to the 2001 Names Rule, which is designed to protect investors from product names that are deceptive or misleading by ensuring that the names of mutual funds and other registered investment products reflect the types of assets in which they actually invest.⁸ In considering revisions to the Names Rule, the SEC highlighted the growth in sustainable investing since 2001, noting the often subjective and amorphous standards for what constitutes a fund holding itself out as an ESG fund.
Focus on processes representing ESG expertise or credentials. Currently, a claim of ESG expertise relies on undefined terms and market-driven frameworks. As the SEC examines potential rulemakings and definitions, it is expected to focus on the process by which advisers and companies represent and publish to investors their ESG expertise and credentials. Additional focus on such processes will serve both as an input to any policy initiatives and as a way for existing OCIE initiatives to dive more deeply into potential disclosure issues.
Examine approaches to board structures and roles. In addition to examining existing taxonomies, the SEC―and particularly the Division of Corporate Finance―may evaluate ESG-related approaches to the structures and roles of boards of directors.

Amy J. Greer serves as the co-chair of Baker McKenzie’s North America Financial Regulation & Enforcement Practice and is on the steering committees of the Global Financial Services Regulatory and Global Financial Institutions Groups. Amy advises all manner of financial industry clients and SEC reporting companies in connection with regulatory enforcement investigations and examinations, as well as internal investigations. Her clients include broker-dealers, investment advisers, hedge funds, mutual funds, securities issuers and reporting companies, commodities traders, and those providing services to those businesses. Drawing on her experience leading an SEC regional office trial program, Amy provides practical and forward-looking guidance to clients, who seek her advice on matters as diverse as conflict-of-interest disclosures, sales practices concerns, insider trading/market abuse, financial reporting and accounting issues, securities offerings, investigations into complex products and trading, and whistleblower concerns.

A. Valerie Mirko advises on federal and state securities laws and regulations impacting the financial services industry, with a focus on the investment adviser and brokerage industries. Valerie’s practice includes a wide range of regulatory, compliance, examinations, and enforcement matters. Immediately prior to joining Baker McKenzie, Valerie was general counsel of the North American Securities Administrators Association (NASAA). As general counsel, Valerie advised NASAA’s board of directors on developments in the federal securities laws, including the SEC Regulation Best Interest rule set, and their impact on state securities regulations. Earlier in her career, Valerie advised broker-dealers and investment advisers on regulatory matters and enforcement investigations as an associate at a Washington law firm and held legal and compliance roles at Oppenheimer & Co., Inc., and Merrill Lynch (now BofA Securities) in New York. Valerie is also a member of the adjunct faculty at the George Washington University Law School and a committee chair within the DC Bar Corporation, Finance, and Securities Law Section.

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The Consolidated Appropriations Act, 2020 H.R. 133: An Analysis

Evansj5 — Fri, 26 Feb 2021 17:00:12 GMT

By: The Practical Guidance Tax Team

This article discusses the Consolidated Appropriations Act (the Act), passed by the House and Senate on December 21, 2020, and signed by President Trump on December 27, 2020. The Act pairs a roughly $900 billion novel coronavirus relief bill with a $1.4 trillion omnibus appropriations package to fund the government through September 30, 2021, the end of the fiscal year. The Act provides taxpayers monetary relief from the novel coronavirus pandemic, extends expiring tax provisions and health extenders, includes a deduction for corporate meals, and prohibits surprise medical bills. The Act also clarifies that forgiven loans are not included in taxable income. The Act also includes new Internal Revenue Code (I.R.C.) sections tied to health care, referred to as the No Surprises Act. These provisions restrict plans and insurers from charging health care plan holders out-of-network rates for certain services.

Novel Coronavirus Relief

The Act represents the fourth piece of legislation intended to address the economic impacts of the novel coronavirus pandemic. It represents one of the longest pieces of legislation at almost 5,600 pages. The Act includes about 80 tax-related provisions. The total cost of the tax break is about $328 billion, according to the Joint Committee on Taxation.

The Act is intended to provide relief to mitigate COVID-19 effects driving increased unemployment, evictions, and food insecurities. To this end, the Act provides direct payments to U.S. residents meeting income thresholds. Adults earning up to $75,000 will receive a $600 check. Couples who earn up to $150,000 combined will receive a $1,200 check. Parents will also receive $600 for each child dependent under the age of 17, but there is no relief provided for older children or adult dependents. There is a phase-out at certain rates for those earning above $75,000. The Act establishes a $300 per week supplemental jobless benefit that spans 11 weeks. The $300 per week for 11 weeks represents half of what the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) (H.R. 748) provided in March 2020. The direct $600 payment represents half of what the CARES Act provided. CLICK HERE TO READ THE FULL ARTICLE IF YOU ARE A PRACTICAL GUIDANCE SUBSCRIBER

The "New and Improved" Paycheck Protection Program

Evansj5 — Tue, 23 Feb 2021 17:48:33 GMT

By: Steven J. Dickinson, Robert K. Magovern, and James F. Van Orden, Cozen O’Connor

First Draw Loan

PPP is extended through March 31, 2021.
Maximum loan amount is unchanged—2.5 times average monthly payroll costs, up to $10 million. The SBA’s rule incorporates the Economic Aid Act change in the definition of payroll costs by adding group life, vision, disability, and dental insurance costs. In the original program, SBA allowed a borrower to calculate payroll based on either calendar year 2019 or the 12 months prior to the loan applications. This is continued, with the addition of calendar year 2020 as a third alternative. There was some concern that the SBA might not allow use of 2019 payroll, but the rule says that will continue in order to place first draw participants on the same footing as borrowers in the original program. It is important to note that a borrower must use the same period for calculating both number of employees (for eligibility purposes) and payroll costs (for loan amount purposes). As in the previous rules, the new rule gives step-by-step guidance on how to calculate loan size for different types of borrowers.
The SBA’s rule continues its previous policy (not required by the statute) that a corporate group may not receive an aggregate of more than $20 million of PPP loans, even if otherwise eligible (for example, because of the waiver of the affiliation rules or the ability to calculate loan amounts on a per-location basis). The rule does not indicate whether second draw loans count against the $20 million cap. However, the rule refers to the $20 million group cap together with the $10 million individual loan cap, and the second draw rule creates a separate corporate group cap for second draw loans (see below), so unless the SBA issues future guidance suggesting otherwise, it seems reasonable to conclude that second draw loans do not count against the $20 million cap.
The SBA is to establish an expedited loan application process for loans up to $150,000. This is supposed to be a one-page form.
Categories of eligible borrowers are expanded to include housing cooperatives with no more than 300 employees, certain television stations and newspapers, certain 501(c)(6) organizations (e.g., chambers of commerce), and destination marketing organizations. The SBA’s rule specifies that eligible entities include those designated in the original program, and the rule confirms that SBA’s alternative size test, which considers net worth and revenues rather than number of employees, still applies in determining whether an entity is a small business concern. In addition, the rule clarifies the new eligible categories of housing cooperatives, 501(c)(6) organizations, destination marketing organizations, and media organizations. The rule also confirms that the SBA’s affiliation rules continue to apply in calculating the number of employees in meeting the size standard (e.g., 500 or 300).
Two specific ineligible categories are also established—(i) publicly traded companies and (ii) businesses or organizations not in operation on February 15, 2020. The SBA’s rule continues to apply its previous guidance on ineligible businesses, and adds new ineligible categories from the Economic Aid Act, including publicly traded companies and businesses controlled, either directly or indirectly, by the president, vice president, head of executive departments, and members of Congress (or their spouses). The rule also continues the SBA’s previous guidance that private equity portfolio companies are not automatically ineligible, although they are subject to the affiliation rules in calculating size and must be able to make the necessity certification. Businesses that are permanently closed are ineligible, but temporarily closed businesses may still apply.
The act authorizes the SBA to permit small business debtors in bankruptcy proceedings (i.e., debtors with less than $7.5 million in debt) to receive PPP loans, if they otherwise qualify. The loan would receive priority as an administrative expense. However, the new rule continues the SBA’s previous position that debtors in bankruptcy proceedings are not eligible.
Eligible costs (for which PPP money can be spent) in the original program—payroll, rent, utilities, and interest on secured debt—continue in the first draw program. The act clarifies that payroll costs include group insurance for life, disability, vision and dental, in addition to health.
New categories of eligible costs have been added: covered operations expenditures (software or cloud computing services), covered property damage costs (uninsured damage caused by 2020 disturbances), covered supplier costs (expenditures to suppliers under contracts entered into prior to the date of the loan that are essential to operations), and covered worker protection expenditures (PPP and adaptive investments to comply with health and safety requirements or guidelines). The new categories fall within the 40 percent portion for non-payroll costs.
Lobbying activities are specifically prohibited as a use of PPP proceeds.
A borrower may elect a covered period of any length between eight and 24 weeks. Previous SBA guidance had suggested a borrower could shorten the covered period if proceeds had been spent, but not all lenders allowed this.
Forgiveness and repayment provisions remain the same, except that previous December 31, 2020, deadlines have been appropriately extended. For example, the rehire safe harbor has been extended for new loans until the end of the covered period.
For loans up to $150,000, a streamlined forgiveness application and documentation process is to be established, with an application no more than one page long and no requirement to submit supporting documentation. Borrowers will still be subject to document retention and audit requirements.

Second Draw Loans

The act creates a new second draw PPP loan for borrowers that previously received a PPP loan. Major aspects of the new program include:

Except as specifically provided, second draw loans are to be made under the same terms, conditions, and processes as under the first draw program.
A second draw borrower must have received a first draw loan and must have used prior to disbursement of the second draw loan all of the first draw loan. This includes the amount of any increase received on a first draw loan (as discussed in Part III). In addition, the SBA’s rule adds a requirement not in the Economic Aid Act—the first draw loan must have been used only for eligible purposes. An entity may only receive one second draw loan.
Eligibility is limited to business concerns, nonprofit organizations, housing cooperatives, veterans organizations, Tribal business concerns, eligible self-employed individuals, sole proprietors, independent contractors and small agricultural cooperatives (all as defined for first draw purposes) that meet two additional criteria—(i) employ not more than 300 employees and (ii) had gross receipts in the first, second, or third quarter or 2020 that are at least 25% less than the same quarter in 2019. For applications submitted on or after January 1, 2021, the revenue reduction may also be shown for the fourth quarter of 2020 compared to the fourth quarter of 2019. There are alternative calculation methods for businesses not in operation in 2019 and for seasonal businesses and a simplified process for demonstrating revenue loss for loans up to $150,000. For convenience, the SBA’s rules also allow a borrower that was in operation for all four quarters of 2019 to demonstrate through its tax returns that its gross receipts for all of 2020 were at least 25% less than for all of 2019.
The Economic Aid Act does not define gross receipts, so the SBA’s rule defines the term consistent with the SBA’s standard size regulations—all revenue of any form received by the borrower, including sales, interest, dividends, royalties, fees, or commissions, reduced by returns and allowances. The rule says this is generally total income plus cost of goods sold, but excluding capital gain or loss. However, the rule specifically excludes several items from gross revenues—taxes collected and to be remitted to a tax authority (e.g., sales tax paid by customers), proceeds of transactions between the borrower and its affiliates, and amounts collected for another by a travel agent, real estate agent, conference management service provider, freight forwarder or customs broker. All other items, including subcontractor costs, reimbursements for purchases made at a customer’s request, investment income and employee-based costs such as payroll taxes, are included in gross receipts. Any forgiveness amount of a first draw loan that a borrower received in calendar year 2020 is excluded from a borrower’s gross receipts.
Unlike the first draw loan, second draw eligibility does not also include businesses that otherwise qualify as a small business concern under the SBA’s size standard regulations, such as under the alternative size test based on net worth and revenue rather than number of employees. Presumably, this is because the Economic Aid Act regulates the size of a second draw borrower through the 300-employee limit. Since small business concerns are not included in the second draw law, borrowers that qualified as a small business concern under the SBA’s regulations, but do not meet the new 300-employee limit, do not appear to be eligible for a second draw loan, although the rule does not address this directly. SBA affiliation rules apply in calculating the number of employees, except as provided in the Act for borrowers in NAICS code 72 (hospitality), for-profit broadcasters that employ no more than 300 persons per location, and nonprofit broadcasters.
However, none of the following may be an eligible entity: (i) certain entities not eligible for SBA loans under existing SBA rules (financial businesses, passive businesses, illegal businesses, and the like), (ii) businesses primarily engaged in lobbying or political activities, specifically including think tanks, (iii) entities owned 20 percent or more by businesses organized under the law of the Peoples Republic of China (PRC) or that have significant operations in the PRC, (iv) entities having a PRC resident as a director, (v) any person required to be registered under the Foreign Agents Registration Act, or (vi) a person receiving a grant under the program for shuttered venue operators created under the act.
In general, the maximum loan amount is the lesser of (i) 2.5 times average total monthly payroll costs during either the year before the loan application or calendar year 2019, at the borrower’s option, or (ii) $2 million. There are alternate calculation methods for seasonal employers and new employers. For entities with a NAICS code beginning with 72 (restaurants, hotels, and other hospitality businesses), the multiplier is 3.5.
For NAICS code 72 businesses with more than one location, there is a rule similar to first draw PPP loans. The borrower is eligible for a loan if each location meets the eligibility criteria—300 employees and a 25% revenue decrease.
The waiver of the affiliation rule used in first draw loans (NAICS code 72, SBA-registered franchises and businesses receiving SBIC assistance) also applies to second draw loans, but instead of 500 employees the limit is 300.
Businesses that are part of a single corporate group are limited to an aggregate of $4 million of second draw loans. This is not required by the Economic Aid Act, but is a procedure adopted by SBA.
Second draw loans will be eligible for forgiveness on the same basis as first draw loans, except there will be a simplified forgiveness application and documentation process for loans of $150,000 or less.

Additional Loans

Changes Applicable to Existing Loans

The retroactive provisions (previously summarized) include the following:

The new categories of permissible costs—covered operations expenditures, covered property damage costs, covered supplier costs, and covered worker protection expenditures.
The inclusion of group life, disability, and vision and dental insurance as a payroll cost.
The streamlined forgiveness application and documentation process for loans up to $150,000.
Elimination of eligibility for borrowers not in operation on February 15, 2020.

PPP and the Employee Retention Tax Credit

Tax Treatment of Expenses Paid with PPP Proceeds

Necessity and Audits of PPP Loans

It appears borrowers will need to respond to Form 3509 or 3510 when received, unless the new administration changes policy or the pending litigation challenging the forms is successful.

Other Provisions

Funding

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COVID-19 from a Securities Law Perspective

Evansj5 — Fri, 19 Jun 2020 02:11:58 GMT

By: Michael L. Hermsen, Anna Pinedo, and Laura D. Richman, Mayer Brown LLP

THE ARTICLE ALSO HIGHLIGHTS KEY FORM 10-K AND FORM 10-Q matters, including risk factors, management discussion and analysis (MD&A), and financial statement issues, and examines various financing alternatives for companies considering their options to bolster their capital structure.

We are experiencing an unprecedented event, the COVID-19 pandemic, which, in addition to the terrible human toll, has also led to an economic crisis. Companies that are subject to U.S. securities reporting requirements are navigating the challenges posed by the pandemic. Addressing these developments may pose distinct issues for companies, depending on their industry, their regional focus, their supply chains, and their personnel. Nonetheless, all reporting companies must tackle their duties to report on a timely basis about their financial results, their business and operations, and their future prospects. Doing so is especially difficult when there are so many uncertainties.

The SEC and the staff of the SEC have responded to the pandemic by acting promptly and providing reporting companies and other market participants with relief in the form of extensions to certain filing deadlines, alternative approaches to meeting certain paper filing requirements, and guidance regarding the types of qualitative and quantitative disclosures that the SEC and the markets generally require regarding the effects of the pandemic. This article summarizes many of the key actions taken by the SEC to address the effects of the pandemic as well as the guidance provided by the SEC and the SEC staff regarding disclosures and accounting matters. In many respects, the guidance from the SEC serves to remind reporting companies and their advisers of fundamental and longstanding disclosure principles: the need for timely disclosures that provide some transparency in order to promote market integrity; the importance of providing investors with insights through well-crafted trend and forward-looking statements regarding the potential impact of material developments; and the need to avoid potentially misleading non-GAAP and key performance indicators in SEC filings and other investor-focused communications. While the events of the last few months are deeply unsettling, it should be a source of comfort that these underlying principles have served reporting companies well in providing a path forward as they communicate with stakeholders.

SEC Exemptive Order for Public Companies

On March 25, 2020, the SEC issued a new exemptive order¹ (Public Company Order) under the Securities Exchange Act of 1934, as amended (Exchange Act) to provide relief to public companies and persons required to make filings with respect to public companies. The Public Company Order covers the period from March 1, 2020 to July 1, 2020, and supersedes and extends an exemptive order² that the SEC previously issued on March 4, 2020.

Under the Public Company Order, any public company that is unable to timely make a filing due to COVID-19 is given extra time, provided that the company otherwise complies with the order’s provisions. Any company relying on the Public Company Order must furnish to the SEC a current report on Form 8-K or, if a foreign private issuer, on Form 6-K, no later than the original filing deadline for each filing that is delayed. This interim disclosure must state that the company is relying on the Public Company Order and briefly describe the reasons why the company could not file the report, schedule, or form due during the relief period (Required Document) on a timely basis. In addition, the interim disclosure must state the estimated date by which the company expects to file the Required Document and include company-specific risk factors explaining the impact, if material, of COVID-19 on the company’s business. If the Required Document cannot be timely filed because of the inability of a third person to furnish a necessary opinion, report, or certification, the interim disclosure must attach as an exhibit a statement signed by the third person explaining the reason for the delay. The company relying on the Public Company Order must file the Required Document with the SEC no later than 45 days after its original due date and must disclose in the Required Document that the Public Company Order is being relied on and the reasons why it could not be filed on a timely basis.

Any company complying with the provisions of the Public Company Order will be considered current and timely in its Exchange Act filing requirements for purposes of eligibility to use Form S-3 or Form F-3 (and for purposes of well-known seasoned issuer status), if it was current and timely as of the first day of the relief period and it files the Required Document within 45 days of its original filing deadline. A company relying on the Public Company Order will also be deemed to satisfy Form S-8 and Rule 144(c) requirements if it was current as of the first day of the relief period and it files the Required Document within 45 days of its original filing deadline.

It is important to remember that companies taking advantage of the relief provided by the Public Company Order must furnish a separate Form 8-K or 6-K for each Required Document that will not be timely filed. In addition, companies should keep in mind that they can also rely on Rule 12b-25³ if they are unable to file a Form 10-K or 10-Q, or comparable reports filed by a foreign private issuer, on or before the extended due date.

The Public Company Order also provides relief relating to the obligations under the SEC’s proxy rules to furnish materials to security holders when mail delivery is not possible, as long as certain conditions are satisfied. For this exemption to apply, those security holders must have a mailing address located in an area where the common carrier has suspended delivery of service of the type or class usually used for the solicitation as a result of COVID-19, and the company or other person making the solicitation must have made a good faith effort to furnish the soliciting materials to the security holder.

SEC Division of Corporation Finance Guidance

Also on March 25, 2019, the SEC’s Division of Corporation Finance (Division) issued CF Disclosure Guidance: Topic No. 9⁴ (CF#9) to provide guidance on disclosure and other securities law obligations that companies should consider with respect to COVID-19. CF#9 recognizes that it may be difficult for companies to assess or predict with precision the broad effects of COVID-19 and that its actual impact will depend on many factors beyond a company’s control and knowledge. At the same time, CF#9 observes that “the effects COVID-19 has had on a company, what management expects its future impact will be, how management is responding to evolving events, and how it is planning for COVID-19-related uncertainties can be material to investment and voting decisions.”

CF#9 emphasizes that under the SEC’s principles-based disclosure framework, “disclosure requirements can apply to a broad range of evolving business risks even in the absence of a specific line item requirement that names the particular risk presented.” As examples, CF#9 notes that COVID-19-related disclosures “may be necessary or appropriate in management’s discussion and analysis, the business section, risk factors, legal proceedings, disclosure controls and procedures, internal control over financial reporting, and the financial statements.”

Assessing and Disclosing the Evolving Impact of COVID-19

To illustrate the types of impacts COVID-19 may have that could give rise to disclosure obligations, CF#9 includes a non-exhaustive series of questions for companies to consider with respect both to their present and future disclosure obligations, including:

How has COVID-19 impacted your financial condition and results of operations?
How has COVID-19 impacted your capital and financial resources, including your overall liquidity position and outlook?
How do you expect COVID-19 to affect assets on your balance sheet and your ability to timely account for those assets?
Do you anticipate any material impairments, increases in allowances for credit losses, restructuring charges, other expenses, or changes in accounting judgments?
Have COVID-19-related circumstances such as remote work arrangements adversely affected your ability to maintain operations, including controls and procedures?
Have you experienced challenges in implementing your business continuity plans or do you foresee requiring material expenditures to do so?
Do you expect COVID-19 to materially affect the demand for your products or services?
Do you anticipate a material adverse impact of COVID-19 on your supply chain or the methods used to distribute your products or services?
Will your operations be materially impacted by any constraints or other impacts on your human capital resources and productivity?
Are travel restrictions and border closures expected to have a material impact on your ability to operate and achieve yourbusiness goals?

CF#9 encourages disclosure that is tailored to the company’s business, providing material information about the impact of COVID-19 through the eyes of management. In addition, CF#9 encourages companies to “proactively revise and update disclosures as facts and circumstances change.” CF#9 further reminds companies that they can present forward-looking information in a manner that would be covered by the safe harbors in Section 27A of the Securities Act of 1933, as amended (Securities Act) and Section 21E of the Exchange Act.

Investors and the SEC are likely to review any COVID-19 disclosure carefully. Therefore, public companies should allow plenty of time prior to filing a periodic report for drafting and internal review of any proposed COVID-19 related disclosures.

For example, it would be useful for companies to begin drafting more detailed risk factors, or updating existing risk factors, relating to COVID-19 for inclusion in their next SEC filing for which risk factor disclosure is required. As pointed out in CF#9, such disclosure should be specific and tailored to the specific impacts to the company’s operations from the COVID-19 outbreak. Similarly, companies should also be preparing and revising their MD&A COVID-19 related disclosures well in advance of their next SEC filing.

Because of the rapidly changing COVID-19 situation and related impacts on companies, it is especially important for companies to take into account all aspects of their business, including reaching out to business units that may not normally be part of their disclosure controls and procedures, to ascertain whether any developments could require disclosure.

Trading Before Dissemination of Material Non-Public Information

CF#9 reminds companies and related persons that they need to consider their federal securities law obligations when issuing or trading in their company’s securities. CF#9 emphasizes that when companies, directors, officers, and other corporate insiders are aware of material COVID-19 impacts or risks to their company that have not been publicly disclosed, they “should refrain from trading in the company’s securities until such information is disclosed to the public.”

In addition, CF#9 warns companies to avoid selective disclosures regarding the impact of COVID-19 by broadly disseminating such material information. Companies should consider, depending on their particular circumstances, whether “they need to revisit, refresh, or update previous disclosure to the extent that the information becomes materially inaccurate.” As discussed below, companies also should consider when they have a duty to disclose and ensure that they are not releasing positive news while in possession of negative news, and the need for any disclosure, if made, to be accurate in all material respects and not to contain a material omission.

Reporting Earnings and Financial Results

CF#9 also addresses earnings releases recognizing that the ongoing and evolving COVID-19 situation “may present a number of novel or complex accounting issues, that, depending on the particular facts and circumstances, may take time to resolve.” Therefore, CF#9 encourages companies to address financial reporting matters earlier than usual, consulting with experts as needed.

CF#9 also reminds companies of their obligations with respect to non-GAAP financial measures, including the SEC’s recent guidance with respect to disclosure of key performance indicators and metrics discussed below.

The SEC has expressed its willingness to discuss on a case-by-case basis issues that may arise in connection with COVID-19, in addition to the ones in the Public Company Order and CF#9 discussed above, for reporting companies. Companies that have particular concerns should reach out to the staff of the Division to discuss how to handle issues that may arise.

Joint Statement

On April 8, 2020, SEC Chair Jay Clayton and Division Director William Hinman issued a joint statement titled The Importance of Disclosure–For Investors, Markets and Our Fight Against COVID-19⁵ (the Statement). In the Statement, Chair Clayton and Division Director Hinman noted that “[i]n the coming weeks, our public companies will be issuing earnings releases and conducting analyst and investor calls.” They urged “companies to provide as much information as is practicable regarding their current financial and operational status, as well as their future operational and financial planning.” Finally, they provided several observations and requests for companies to consider as they prepare their disclosures, focusing primarily on forward-looking statements. These observations and requests build upon previous guidance issued by the Division.

In short, Chair Clayton and Division Director Hinman highlighted several disclosure points, including:

Company disclosures should reflect the current state of COVID-19 affairs and outlook and, in particular, respond to investor interest in:
- Where the company stands today, operationally and financially
- How the company’s COVID-19 response, including its efforts to protect the health and well-being of its workforce and customers, is progressing
- How the company’s operations and financial condition may change.
Historical information may be relatively less significant.
Providing detailed information regarding future operating conditions and resource needs is challenging, but important.
High quality disclosure will not only benefit investors and companies, it will promote valuable communication and coordination across the economy.
Companies that respond to the call for forward-looking disclosure should avail themselves of the forward-looking safe harbors in the U.S. federal securities laws.
Good faith attempts to provide appropriately framed forward-looking statements would not be second-guessed by the SEC.

There are four important takeaways for public companies to consider as they plan their upcoming earnings calls and quarterly disclosures.

First, quarterly earnings reports and related investor and analyst calls will not be routine. Historical information may be substantially less relevant as shareholders want to know where companies stand today, and how they have adjusted and expect to adjust in the future as they continue to deal with COVID-19. While recognizing that producing comprehensive financial and operational reports, both historical and forward-looking, may present challenges for public companies, the SEC continues to encourage earnings and related disclosures to be as timely, accurate, and robust as practicable under the circumstances.

Second, Chair Clayton and Division Director Hinman request that companies provide as much information as practicable regarding their current status and plans for addressing the effects of COVID-19, including information regarding their current operating status and their future operating plans under various COVID-19-related mitigation conditions. They note that investors and the markets may be particularly interested in, among other things, detailed discussions of current liquidity positions and expected financing needs, whether the company is receiving or intends to apply for financial assistance under various COVID-19 related federal and state programs, including the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, and how such assistance has had or may have a material effect on the company.

Third, in requesting that companies produce more forward-looking information under the current circumstances, the SEC recognizes the particular challenges companies will face to produce forward-looking information in light of the unknowns that still exist, including the making of a variety of assumptions, some that relate to factors that are beyond their control. Nonetheless, they encourage companies to consider the broad frameworks that have been proposed to have the economy move forward and discuss how following those frameworks may affect their operations if it would be of material interest to investors, while avoiding generic or boilerplate discussions.

Fourth, as is always the case, companies providing forward-looking information are encouraged to avail themselves of the safe harbors for forward-looking statements in the federal securities laws. The SEC recognizes that in many cases actual results may differ substantially from what were reasonable estimates when the forward-looking statements were made.

Although the Statement says that the SEC would not expect to second-guess good faith attempts at providing forward-looking information, the SEC will not be the only interested party reviewing disclosures. Investors, and more particularly the U.S. plaintiffs’ bar, will have the benefit of hindsight when deciding how to view the adequacy of disclosure previously made. Since these parties will not be bound by the views of the SEC, it is important to follow the conditions necessary to take advantage of the safe harbor provisions of the U.S. federal securities laws to provide a defense against any future lawsuits in the event actual results differ from the forward-looking information as discussed below.

Other Related SEC Pronouncements

In addition to the Public Company Order, CF#9 and the Statement discussed above, the SEC and its various divisions and offices have issued a significant amount of COVID-19 driven or related guidance and relief in a relatively short period of time, including for public companies in dealing with their disclosure obligations, SEC filings, shareholders, and the markets in general. Some of the other actions relate to the following.

Form 144 Paper Filings

On April 10, 2020, the Division announced⁶ that it was providing temporary relief with regard to the requirement to file paper copies of Form 144 during the period from April 10, 2020, through June 30, 2020. Specifically, the staff said that it will not recommend enforcement action to the SEC if Forms 144 are submitted via email in lieu of mailing or delivering the paper form to the SEC if the filer attaches a complete Form 144 as a PDF attachment to an email sent to PaperForms144@SEC.gov.

In addition, if a filer is unable to provide a manual signature on the Form 144 submitted by email, the SEC staff will not recommend enforcement action if the filer provides a typed form of signature in lieu of the manual signature and:

The signatory retains a manually signed signature page or other document authenticating, acknowledging, or otherwise adopting his or her signature that appears in typed form within the electronic submission and provides such document, as promptly as practicable, upon request by Division or other SEC staff.
Such document indicates the date and time when the signature was executed.
The filer or submitter (with the exception of natural persons) establishes and maintains policies and procedures governing this process.

Shareholder Meetings

On April 7, 2020, the Divisions of Corporation Finance and Investment Management announced that they were providing guidance⁷ to assist issuers, shareholders, and other market participants affected by COVID-19 with meeting their obligations under the federal proxy rules. The guidance focused on the following matters:

Changing the date, time, or location of a shareholder meeting. In the guidance, the staff took the position that an issuer that has already mailed and filed its definitive proxy materials can notify shareholders of a change in the date, time, or location of its shareholder meeting without mailing additional soliciting materials or amending its proxy materials if it (1) issues a press release announcing such change; (2) files the announcement as definitive additional soliciting material on EDGAR; and (3) takes all reasonable steps necessary to inform other intermediaries in the proxy process (such as any proxy service provider) and other relevant market participants (such as the appropriate national securities exchanges) of such change.
Virtual shareholder meetings. In recognition of the fact that many issuers were contemplating the possibility of conducting a virtual shareholder meeting through the internet or other electronic means in lieu of an in-person meeting, the staff said that it expects the issuer to notify its shareholders, intermediaries in the proxy process, and other market participants of such plans in a timely manner and disclose clear directions as to the logistical details of the virtual or hybrid meeting, including how shareholders can remotely access, participate in, and vote at such meeting. Issuers that have already filed and mailed their definitive proxy materials would not need to mail additional soliciting materials (including new proxy cards) solely for the purpose of switching to a virtual or hybrid meeting if they follow the steps described above for announcing a change in the meeting date, time, or location.
Presentation of shareholder proposals. In light of the possible difficulties for shareholder proponents to attend annual meetings in person to present their proposals, the staff encourages issuers, to the extent feasible under state law, to provide shareholder proponents or their representatives with the ability to present their proposals through alternative means, such as by phone, during the 2020 proxy season. Furthermore, to the extent a shareholder proponent or representative is not able to attend the annual meeting and present the proposal due to the inability to travel or other hardships related to COVID-19, the staff would consider this to be good cause under Exchange Act Rule 14a-8(h)⁸ should issuers assert the absence as a basis to exclude a proposal submitted by the shareholder proponent for any meetings held in the following two calendar years.
Delays in printing and mailing of full set of proxy materials. The staff understands that some issuers in the current COVID-19 environment would like to furnish their proxy materials through the notice-only delivery option permitted by Exchange Act Rule 14a-16⁹ (17 CFR 240.14a-16), but have concerns about their ability to comply with certain provisions of the rule. The staff encouraged issuers affected by printing and mailing delays caused by COVID-19 to use all reasonable efforts to comply with the rule without putting the health or safety of anyone involved at risk. In circumstances where delays are unavoidable due to COVID-19 related difficulties, the staff would not object to an issuer using the notice-only delivery option in a manner that, while not meeting all aspects of the notice and timing requirements of Rule 14a-16, will nonetheless provide shareholders with proxy materials sufficiently in advance of the meeting to review these materials and exercise their voting rights under state law in an informed manner and so long as the issuer announces the change in the delivery method by following the steps described above for announcing a change in the meeting date, time, or location.

Notarization and Timing Requirements of Certain Filings

On March 25, 2020, the SEC adopted several temporary final rules.¹⁰ One provides relief from the notarization requirements of Form ID from March 26, 2020, through July 1, 2020, subject to certain conditions, including that the filer indicate that it could not provide the required notarization due to circumstances relating to COVID-19 and that the filer submit a PDF copy of the notarized manually signed document within 90 days of obtaining an EDGAR account. The others extend the filing deadlines for certain reports and forms due between March 26, 2020, and May 31, 2020, that companies must file pursuant to Regulation A and Regulation Crowdfunding, subject to certain conditions, including that the company promptly disclose to its investors reliance on the extension relief, and when a company files the required report or form, it must disclose that it is relying on the temporary final rules and state the reasons why, in good faith, it could not file the report or form on a timely basis.

Authentication Document Retention Requirements

On March 24, 2020, the SEC staff from the Divisions of Corporation Finance, Investment Management, and Trading and Markets announced¹¹ relief to certain of the manual signature and document retention requirements. Rule 302(b) of Regulation S-T requires that each signatory to documents electronically filed with the SEC “manually sign a signature page or other document authenticating, acknowledging or otherwise adopting his or her signature that appears in typed form within the electronic filing.” Such documents must be executed before or at the time the electronic filing is made. Further, electronic filers must retain such documents for a period of five years and furnish copies to the SEC or its staff upon request. Pursuant to this relief, the SEC staff of the three divisions announced that they would not recommend the SEC take enforcement action if:

A signatory retains a manually signed signature page or other document authenticating, acknowledging, or otherwise adopting his or her signature that appears in typed form within the electronic filing and provides such document, as promptly as reasonably practicable, to the filer for retention in the ordinary course pursuant to Rule 302(b).
Such document indicates the date and time when the signature was executed.
The filer establishes and maintains policies and procedures governing this process.

Finally, as the COVID-19 pandemic continues and governments and companies take additional precautionary measures that may impact businesses, more disclosure-related and filing or compliance issues may arise. Therefore, companies should monitor the SEC for any further developments.

Materiality and Forward-Looking Statements

In light of the guidance from the SEC and SEC staff, companies and their advisers have to review, reconsider, and discuss anew basic concepts, including materiality. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision. In terms of considering COVID-19 related disclosures, the concept of whether a fact is material or not is a mixed question of law and fact. The SEC has consistently noted that the issuer is in the best position to know what is likely to be material to investors. This is no different under these unusual circumstances. However, since materiality is often judged with the benefit of hindsight, and the SEC has often looked to trading volume and price movements as evidence of materiality, it is essential to consider closely whether disclosures relating to COVID-19 would be viewed as impacting the market. As discussed further below, even after the Sarbanes-Oxley Act, the principle survives that material information need not be disclosed currently unless there is a specific event or circumstance that affirmatively triggers a disclosure duty

As noted above, in connection with CF#9 and the Statement, the SEC and the SEC staff has emphasized the importance of trend disclosures. In crafting its disclosures in MD&A to account for the effects of COVID-19, a reporting company will have to consider the objective of this section in periodic reports, which is intended to provide stockholders with a view through the eyes of company management of the business and financial results. MD&A also must have a forward-looking component. Management must discuss known trends. Disclosures may be required even when the likelihood of occurrence of a known trend or uncertainty is less than certain. In fact, in SEC guidance, the SEC has called for a discussion of material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition. Known trends include both matters that would have an impact on future operations and have not had an impact in the past and matters that have had an impact on reported operations and are not expected to have an impact upon future operations.

In considering MD&A trend disclosure, the analysis differs from traditional materiality analysis and sets an arguably lower disclosure threshold: is the known trend, demand, commitment, event, or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required. However, if management cannot make that determination, it must evaluate the consequences of the known trend, demand, commitment, event, or uncertainty on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the company’s financial condition or results of operations is not reasonably likely to occur. In light of all the many unknowns related to the effects of COVID-19, government measures to address the pandemic, including economic and public health and safety measures, and the international reactions to the pandemic, the assessment outlined above may be particularly time-consuming.

There are a number of other sections of a periodic report, as well as other statements, such as earnings releases, in which a reporting company will need to consider the appropriateness of the inclusion of forward-looking statements. As noted above, in CF#9 and in the Statement, there is an emphasis placed on transparent disclosures. Transparency, to some extent, requires giving stakeholders a window into a company’s expectations regarding its business and prospects. In order to encourage companies to provide additional forward-looking statements, there are safe harbors that may be helpful. The Private Securities Litigation Reform Act of 1995 (PSLRA) includes a safe harbor for forward-looking statements. In the context of a private action brought under the Securities Act or the Exchange Act that is based on an untrue statement of a material fact or an omission of a material fact necessary to make the statement not misleading, an issuer (covered by the PSLRA safe harbor) would not be liable for a forward-looking statement if the statement is identified as a forward-looking statement and is accompanied by meaningful cautionary statements that identify the factors that could cause actual results to differ materially from those in the forward-looking statement, or it is immaterial, or the plaintiff fails to prove that the forward-looking statement if made by a natural person was made with actual knowledge by that person that the statement was false or misleading or if made by a business entity was made by or with the approval of an executive officer and made or approved by such officer with actual knowledge that the statement was false or misleading.

In crafting disclosures, it is important to consider whether a statement a forward-looking statement. This will depend on the context and the facts and circumstances, but would include projections of future performance, plans for future operations, and assumptions regarding the projections and plans. Language that suggests that the statement is forward-looking—like “we expect,” “we believe,” “we intend,” etc.—is helpful in making clear that the outcome that is discussed depends on future events. Often, there will be comments that may be mixed—meaning that part of the comment may speak to actual events, and part of the comment may refer to expectations regarding future occurrences.Drafting forward-looking disclosures relating to the potentialCOVID-19 effects on a company’s business and financial results will require a careful review in this and future quarters.

The forward-looking statement also must be accompanied by meaningful cautionary language. This requires identifying the particular risks associated with the statement. Cautionary language and risks should be tailored to the projections, estimates, and opinions that are expressed, and issuers should take care not to default to generic or boilerplate statements. To the extent that the language warns against something that already has happened, the warning would be inadequate—that may be the case for many companies thisquarter. An issuer’s disclosure committee or other preparers of periodic reports should consider as well whether there is any actual knowledge that a forward-looking statement ismisleading or that the risks described by the issuer in its filings already had manifested.

For this most recently concluded quarter and for upcoming quarters this year, in preparing for earnings announcements and periodic reports, the issuer should consider:

Updating its forward-looking statements disclosure
Ensuring that its risk factors are updated
Not referencing an occurrence in a risk factor as a hypothetical if the event has actually come to pass
Eliminating boilerplate disclaimers and disclosures regarding trends since these are unlikely to reflect current events
Reviewing carefully with counsel all forward-looking and trend disclosure in order to vet the cautionary language

Non-GAAP Financial Measures and Key Performance Indicators

Non-GAAP Financial Measures

The SEC provides two sources of guidance relating to non-GAAP financial measures. Item 10(e) of Regulation S-K applies to non-GAAP financial measures in SEC filings. Regulation G applies to all public statements made by SEC reporting companies that contain non-GAAP financial measures, including earnings releases, earnings calls, and investor presentations, as well as SEC filings.

Regulation G permits public companies to disclose material information that includes a non-GAAP financial measure, but only if that measure, whether or not in an SEC filing, is accompanied by a presentation of the most directly comparable GAAP financial measure and a reconciliation of the differences between the non-GAAP financial measure and the comparable GAAP financial measure. For oral public disclosure, like earnings calls, Regulation G permits the company to post the reconciliation simultaneously to its website and announce the location to investors. Rule 100(b) of Regulation G prohibits the use of “a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.”

Item 10(e) of Regulation S-K governs the use of non-GAAP financial measures included in SEC filings. It requires that a non-GAAP financial measure be accompanied by a presentation, of equal or greater prominence, of the most directly comparable GAAP financial measure, with a reconciliation to such measure. The filing must disclose the reasons why management believes that presentation of the non-GAAP financial measure provides useful information to investors. Also, there must be a statement disclosing the additional purposes, if any, for which management uses the non-GAAP financial measure. In addition, Item 10(e) also contains some express prohibitions on the calculation and presentation of non-GAAP financial measures.

The Division staff issued¹² a series of compliance and disclosure interpretations (C&DIs) devoted to non-GAAP financial measures. Among other matters, these C&DIs provide guidance concerning what the Division staff considers to be misleading use of non-GAAP financial measures and what it considers to be unacceptable prominence of a non-GAAP financial measure presentation. These C&DIs also offer guidance in specialized areas.

As noted above, the Division staff issued CF#9 to provide guidance on disclosure and other securities law obligations that companies should consider with respect to the effect of COVID-19. According to CF#9, if a GAAP financial measure is not available at the time of the earnings release because COVID-19-related adjustments require additional information and analysis to complete, “the Division would not object to companies reconciling a non-GAAP financial measure to preliminary GAAP results that either include provisional amount(s) based on a reasonable estimate, or a range of reasonably estimable GAAP results.” The non-GAAP financial measure should not be disclosed more prominently than the most directly comparable GAAP financial measure or range of GAAP measures. However, for SEC filings, such as Form 10-K or Form 10-Q, where GAAP financial statements are required, companies should reconcile to GAAP results and not include provisional amounts or a range of estimated results.

CF#9 specifies that in a circumstance where a company presents non-GAAP financial measures that are reconciled to provisional amount(s) or an estimated range of GAAP financial measures, the company must only include non-GAAP financial measures that it uses to report financial results to its Board of Directors. According to CF#9, companies should use non-GAAP financial measures and performance metrics “for the purpose of sharing with investors how management and the Board are analyzing the current and potential impact of COVID-19 on the company’s financial condition and operating results,” and not for the purpose of presenting a more favorable view of the company. When reconciling non-GAAP financial measures to provisional amount(s) or an estimated range of GAAP financial measures, companies should explain to the extent practicable why the line item(s) or accounting is not complete and what additional information or analysis may be needed.

As companies prepare to report their earnings, they should take into account the portion of CF#9 relating to non-GAAP financial measures, while also being mindful of the SEC’s guidance in recent years regarding the limited and careful approach that companies must take when presenting non-GAAP financial measures.

Key Performance Indicators

On January 30, 2020, the SEC provided guidance¹³ (KPI Guidance) regarding the disclosure of key performance indicators (KPIs) and metrics used in the MD&A section of SEC filings. This guidance, which reflects the SEC’s interpretation of existing MD&A requirements, became effective on February 25, 2020.

For some time now, SEC representatives have expressed concerns regarding the use of KPIs. These concerns are similar to those raised by the SEC with respect to the use of non-GAAP financial measures. See, for example, remarks¹⁴ by then-Commissioner Kara Stein addressing KPIs. The SEC’s Division of Enforcement also has taken action in recent years against companies relating to the use of misleading KPIs. The KPI Guidance describes how Item 303(a) of Regulation S-K and comparable requirements of Forms 20-F and 1-A apply to KPIs and metrics. Item 303(a) not only specifies particular items for disclosure in the MD&A (such as liquidity, capital resources and results of operations), it also requires discussion of “such other information that the registrant believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations.” In addition, Instruction 1 to Item 303(a) requires discussion of “statistical data that the registrant believes will enhance a reader’s understanding of its financial condition, changes in financial condition, and results of operations.”

Although the KPI Guidance came out before COVID-19 reached pandemic levels in the United States, as principles-based guidance, it is applicable to KPIs used in COVID-19 disclosures. CF#9 expressly reminded companies of their obligations with respect to non-GAAP financial measures, including the SEC’s recent guidance with respect to disclosure of KPIs and metrics. For example, if a company presents a non-GAAP financial measure or performance metric to adjust for or explain the impact of COVID-19, “it would be appropriate to highlight why management finds the measure or metric useful and how it helps investors assess the impact of COVID-19 on the company’s financial position and results of operations.”

The KPI Guidance observes that some companies disclose non-financial and financial metrics when describing the performance or the status of their business. These metrics vary by company and industry, and some metrics include company- or industry-specific matters. These metrics may reflect external or macro-economic matters, or they may be a combination of external or internal information.

The KPI Guidance reminds each company that uses metrics in its MD&A that, under existing requirements, it “need[s] to include such further material information, if any, as may be necessary in order to make the presentation of the metric, in light of the circumstances under which it is presented, not misleading.” According to the KPI Guidance, a company must consider whether an existing regulatory disclosure framework—such as GAAP or, for non-GAAP financial measures, Regulation G or Item 10 of Regulation S-K—applies in the context of the metrics it uses and assess what “additional information may be necessary to provide adequate context for an investor to understand the metric presented.” The KPI Guidance states that, based on facts and circumstances, the SEC generally expects that a metric be accompanied by the following disclosure:

A clear definition of the metric and how it is calculated
A statement indicating the reasons why the metric provides useful information to investors
A statement indicating how management uses the metric in managing or monitoring the performance of the business

According to the KPI Guidance, a company needs to consider whether there are underlying estimates or assumptions for a metric or its calculation that need to be disclosed in order for the metric not to be materially misleading. If a company changes the calculation method or presentation of a metric from one period to another or otherwise, it should consider disclosing, to the extent material:

The differences in the way the metric is calculated or presented compared to prior periods
The reasons for the change
The effects of the change on the amounts or other information being disclosed or previously reported
Other differences in methodology and results that would reasonably be expected to be relevant to an understanding of the company’s performance or prospects

Depending on significance, following a change in methodology or presentation, it may be necessary to recast prior metrics to conform to the current presentation and place the current disclosure in the appropriate context.

The KPI Guidance emphasizes the importance of disclosure controls and procedures in the context of key performance indicators and metrics that are derived from the company’s own information. If these indicators and metrics are materialto either an investment decision or a voting decision, the KPI Guidance states that “the company should consider whether it has effective controls and procedures in place to process information related to the disclosure of such items to ensure consistency as well as accuracy.”

The KPI Guidance contains the following non-exclusive list of examples of metrics to which this guidance applies:

Voluntary and/or involuntary employee turnover rate
Percentage breakdown of workforce (e.g., active workforce covered under collective bargaining agreements)
Total energy consumed
Data security measures (e.g., number of data breaches or number of account holders affected by data breaches)

Companies should assess whether they currently use, or plan to use, any key performance indicators or metrics. If the answer is yes, they should consider whether there is additional information that should be disclosed and develop the presentation for that new disclosure.

Because the KPI Guidance is already in effect, companies that will be using KPIs in their upcoming MD&A disclosures should promptly assess whether they need to make any changes to the MD&A to reflect the KPI Guidance. In particular, companies adjusting KPIs to give effect to the COVID-19 pandemic must take the KPI Guidance into account.

A company that discloses performance indicators and metrics in its MD&A section that are derived from the company’s own information should review its disclosure controls and procedures to be sure these are effective with respect to the calculation of these indicators and metrics. The review should also include a discussion with the audit committee. The audit committee should understand the performance indicators that are used—what their purpose is, whether they are well-understood and well-defined, what the methodology is for their calculation, and whether there have been any significant changes in the indicators presented by the company or in their calculation methodology. This review and any update of disclosure controls and procedures should be completed before the company files its next annual report on Form 10-K or quarterly report on Form 10-Q.

Often, a company will use KPIs in its investor presentations, including in its earnings releases. The same level of review and care should be undertaken in relation to the preparation of these presentations and the use of performance indicators in these materials.

Earnings Releases and Analyst Calls

During this period of uncertainty, many companies and their boards of directors may be struggling with competing desires to communicate with their stakeholders and to restrict or control their communications until such time as more complete information is available and the company and those speaking on its behalf can do so with greater certainty. It is useful to keep in mind that under the federal securities laws, there is no general obligation for issuers to disclose material information; rather, issuers are required to do so only where the federal securities laws specifically impose such a duty. Of course, there are certain periodic reporting obligations and the occurrence of certain events may trigger the mandatory filing of a Current Report on Form 8-K, but generally speaking, a failure to speak (an omission) is a violation of Rule 10b-5 under the Exchange Act only if there is a duty to speak. As a result, if there is no obligation under the securities laws to make a disclosure by a particular date, an issuer can remain silent. Of course, if an issuer decides to make positive announcements, it must ensure that it also discloses any additional information (which may be negative) that would be necessary in order to make the statement not misleading. During these unusual times, companies also should give thought to their usual pattern of communication. Many companies have set a precedent in terms of when and how and how frequently they communicate with the public. Similarly, companies should consider their disclosures, including the timing and content of these, in light of other events, such as their insider-trading and blackout periods and any potential offerings of securities or other transactions in their securities.

In addition to considering their duties to disclose, companies will always want to be mindful of Regulation FD, which was adopted to address the problem of selective disclosure of material information by companies, in which “a privileged few gain an informational edge—and the ability to use that edge to profit—from their superior access to corporate insiders, rather than from their skill, acumen, or diligence.” Regulation FD fundamentally reshaped the ways in which public companies conducted conference calls, group investor meetings, and “one-on-one” meetings with analysts and investors. Even in the case of a pandemic, it is essential to keep core principles of fair disclosure intact.

During these uncertain times, companies may be more likely to be communicating more regularly with their lenders, their suppliers, their vendors, and their bankers and other advisers. Regulation FD only covers disclosures to certain enumerated persons: securities market professionals such as brokers, dealers, investment advisors, institutional investment managers and sell-side or buy-side analysts, and shareholders who it is reasonably foreseeable would trade on the basis of the information. Regulation FD does not cover disclosures to customers, suppliers, strategic partners, and government regulators in ordinary-course business communications. It also does not cover communications with attorneys, investment bankers, accountants, and others who owe a duty of confidence to the company, including parties that have entered into an express undertaking to maintain confidential nonpublic information shared by the company with them (a temporary insider). That said, a company should be very careful to identify any material nonpublic information that is to be shared with a temporary insider and have formulated a clear view regarding when the company will make such information public or when such information will become stale or outdated as a result of the passage of time or otherwise.

Again, during tumultuous times, representatives of a company may be called upon to respond to questions from stakeholders or to comment in the context of investor presentations or investor updates on the company’s financial condition. It is important to keep in mind that whenever a public company, or any person acting on its behalf, discloses material non-public information to certain enumerated persons (as discussed above), then the company must disclose that information, either simultaneously (in the case of intentional disclosures) or promptly (in the case of unintentional disclosures) using a reasonable method of broad public disclosure.

In connection with earnings releases and other investor calls, a reporting company will want to consider Section 10(b) and Rule 10b-5 of the Exchange Act, which prohibit material misstatements or omissions, compliance with Regulation FD, protecting forward-looking statements as discussed above, compliance with the non-GAAP measure rules, and the KPI Guidance. Balancing all of these regulatory considerations, while striking the right balance between providing some insights into the company’s results and prospects, is challenging. In the course of reviewing periodic filings, the SEC staff has been increasingly focused on information communicated in earnings releases and earnings calls and the consistency of those messages with the disclosures contained in periodic reports.

In addition, the SEC has paid particular attention to the practice of providing guidance (and subsequent confirmation of guidance) to analysts and others. Companies take on a “high degree of risk under Regulation FD” when engaging in private discussions with analysts seeking guidance or affirmation of prior guidance. Of course, as a result of the pandemic, many companies have chosen to withdraw prior guidance and provide adjusted guidance or not provide any guidance given the many unknowns. Nonetheless, it is useful to remind management teams that no earnings guidance can be shared in discussions with analysts or others without simultaneous public disclosure. The same cautionary notes apply to the affirmation of prior guidance. It is also useful for in-house legal and investor relations teams to remind those speaking on behalf of the company to the market of the company’s Regulation FD and other communications policies. There may be pressure on management teams at this time to be more forthcoming or to provide more insights to the investment community regarding their views of the company’s future results. Investor calls should be scripted, if possible, and attended by at least two representatives of the company. All communications should be closely tracked to ensure that consistent messages are communicated and to react promptly if an inadvertent disclosure has occurred.

Form 10-K and Form 10-Q Matters

In order to allow time for drafting and internal review of appropriate language, public companies should begin preparing COVID-19 disclosures in advance, given heightened investor and SEC scrutiny. Such disclosure should be specific and must be tailored to the specific impacts to the company’s operations from the COVID-19 outbreak.

SEC disclosure requirements are principles-based to a large degree and there are many areas where existing SEC rules, while not expressly mentioning pandemics, could require disclosure. Areas in which COVID-19 may give rise to disclosure or other securities law considerations are elaborated upon below.

Risk Factors

Item 105 of Regulation S-K requires risk factors to discuss the most significant factors that make an investment in a company speculative or risky, as opposed to presenting risks that could apply generically to any company. As the impact from COVID-19 has intensified, companies may become increasingly aware of additional ways in which the pandemic poses specific risks beyond what they may have previously disclosed. As the situation persists and evolves, it may be necessary to continue to assess COVID-19 risk factor disclosures throughout the year. It would be useful for companies to begin drafting more detailed risk factors relating to COVID-19 for inclusion in their next SEC filing that requires risk factor disclosure and then to re-evaluate these throughout the year to determine if they need to be supplemented or re-evaluated. Although there is no requirement to include risk factors in a quarterly filing or on a current report, a company may consider doing so if it believes that it may be likely that it will seek to undertake a securities offering in the near-term and would like to ensure that its filings present an accurate picture of the company.

There are many ways in which COVID-19 may pose risks for a company. Revenues may decline in some lines of business. Some companies may face liquidity challenges and credit may be less expensive and/or more expensive. To the extent that a company maintains an investment portfolio, it may be exposed to greater market volatility. Remote working might give rise to greater cybersecurity concerns. There could be increased litigation risk. Uncertainty with respect to the ultimate scope and duration of the pandemic may itself be a risk. The list of questions for assessing and disclosing the impact of COVID-19 that the Division staff provided in CF#9 is a helpful starting place for such analysis, but companies need to reflect on how the pandemic has impacted their own particular circumstances. It is possible that various segments of a company may be affected in different matters. For example, some segments might be having supply chain or distribution issues as a result of government shutdown orders while others may be more susceptible to a decline in discretionary spending arising from economic turbulence.

If a company determines that a particular risk or development relating to COVID-19 is sufficiently material that it should be disclosed prior to its next periodic report or registration statement filed with the SEC, such as might be the case if it is currently in the market buying or selling its securities, it may decide to disclose a new COVID-19 risk factor through a current report filing.

Management’s Discussion and Analysis

MD&A must include information that a company “believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations.” With COVID-19 impacting so many companies, often negatively, but in some cases providing opportunities, it is important for the MD&A to not only disclose COVID-19 as a known trend or uncertainty but also management’s perspective on the type and extent of COVID-19’s effect on the company, to the extent material. There are many possible questions for companies to assess for materiality in the COVID-19 context as they prepare their MD&A. For example, has the company experienced problems within its supply chain or distribution network, and if so, are such issues anticipated to be ongoing? How has COVID-19 affected liquidity? Has the company drawn down on bank facilities for any reason, including because it has not been able to finance in the capital markets? Has the company needed to close any locations? Does the company operate any facilities where there has been a significant outbreak of COVID-19? If the company switched its workforce to telecommuting, has there been any reduction in productivity? Is the company party to contracts with force majeure provisions that are or may be triggered by the COVID-19 pandemic, and if so, is that having a material impact on the company’s business? Is the company having a dispute with its insurance carrier regarding business continuity coverage?

Financial Statement Issues

Companies should discuss with their accountants whether COVID-19 disclosure is needed as part of their financial statement footnotes, including a subsequent event footnote. Contingency disclosures are another area that should be carefully assessed, particularly from the perspective whether a contingent COVID-related loss is remote, reasonably possible, or probable. Companies will also need to make determinations from an accounting perspective whether COVID-19 has led to any impairment of various types of assets. Among other financial statement concerns to be considered with respect to COVID-19 in extreme cases are going concern issues.

Controls and Procedures

Item 307 of Regulation S-K requires a company to disclose the conclusions of its principal executive officer and principal financial officer regarding the effectiveness of its disclosure controls and procedures as of the end of each quarterly period. Similarly, Item 308(c) of Regulation S-K requires a company to disclose any change in its internal control over financial reporting that occurred during each quarter that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting.

“Disclosure controls and procedures” is defined in Exchange Act Rule 13a-5 and 15d-15 to mean controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the SEC’s rules and forms. “Internal control over financial reporting” is defined in each rule as a process designed by, or under the supervision of, a company’s principal executive and principal financial officers and effected by the company’s board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company.
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors.
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

Because the COVID-19 pandemic is affecting so many aspects of business, and many employees are now working from home rather than at their usual work locations, companies should continually monitor and evaluate their disclosure controls and procedures and internal control over reporting to make sure that they remain effective in the current environment, as well as to consider whether changes need to be made to ensure that they remain effective in gathering and reporting all required information. Companies may also want to consider making the potential impacts of COVID-19 an express part of their applicable controls and procedures in light of the fact that many disclosure decisions for the foreseeable future will be made with regard to COVID-19 and its impacts.

In addition, because of the swiftly moving changes in the COVID-19 situation and its related impacts, it is especially important for companies to take into account all aspects of their business, including reaching out to areas that may not normally be part of their controls and procedures processes, to ascertain whether anything is happening that could require disclosure.

Litigation

Item 103 of Regulation S-K requires a company to briefly describe material pending legal proceedings, other than in the ordinary routine litigation incidental to the business, to which the company or its subsidiaries are subject. Companies are beginning to be subject to litigation arising out of the impacts of COVID-19. It does not matter whether the company is a plaintiff or a defendant. For example, some companies are suing their insurers for failure to cover damages under an insurance policy due to a loss of business income. Other companies are being sued by employees who have contracted COVID-19 allegedly in the workplace. Just as COVID-19 has been rapidly expanding, the number of lawsuits filed because of it will likely continue to grow.

Description of Business

Item 101 of Regulation S-K requires a company to provide a narrative description of the business, including the business done and intended to be done by the company. Among the things that should be addressed as part of this disclosure are the principal products produced and services rendered by the company, the sources and availability of raw materials, the dependence on a single customer, the amount of backlog orders, competitive conditions in the business, and the number of employees. Each of these items could be changing as the impacts of COVID-19 evolve.

To the extent a company is filing a report or registration statement with the SEC that requires a business description, the company will need to consider whether additional or revised disclosure is needed to the extent that COVID-19 has materially changed, or is expected to materially change, its business. When looking at its disclosure, a company should start by asking a series of questions that will help inform its disclosures. For example:

Did the company exit any business line?
Did the company close any facility?
Is the company having difficulty sourcing inventory and considering alternative sources to those previously used?
Are some segments of the company’s business impacted more than others?
Did the company lay off workers as a result of a business slowdown?
Were there any acquisitions or previously disclosed organic growth initiatives put on hold?

Financing Alternatives

Many companies may be considering their financing alternatives at this time in order to bolster their capital, to provide third parties with confidence regarding the company’s ability to weather continued volatility, to continue to comply with bank or other contractual covenants, or simply for opportunistic reasons. The financing alternatives may be quite dependent on whether the company is undergoing financial distress or merely wants to strengthen its financial position. For many companies, the best alternative may be a private investment in public equity or PIPE transaction. In a PIPE transaction, a placement agent, acting as the company’s financial intermediary, will engage potential institutional investors confidentially and gauge their interest in participating in a financing transaction. The company is not required to disclose the potential financing until definitive securities purchase agreements are entered into with the investors. Some companies may not be able to use their shelf registration statements (to the extent that these are effective) unless or until they update their disclosures for the effects of COVID-19. Others may prefer to share material nonpublic information to investors that have committed to keep such information confidential and negotiate financing terms with investors that have been able to consider this data. A number of companies may need significant capital injections. Venture capital funds, private equity funds, and other financial sponsors may be interested in participating in a financing round and negotiating financial or other ongoing affirmative or negative covenants with the company. In addition, from time to time, these financial sponsors may negotiate for themselves governance rights, such as board seats or observer rights. Given that these transactions led by financial sponsors may involve highly structured securities, and the negotiation of other ongoing rights, a private placement may be the most appropriate financing alternative. The rules of the securities exchanges, which require a shareholder vote in the case of certain private placement transactions completed at a discount, upon the consummation of a transaction that will result in a change of control, or in connection with a transaction that involves related parties, should be considered in connection with a proposed PIPE transaction.

To the extent that a company has an effective shelf registration statement and its disclosures are current, it may consider as an alternative to a PIPE transaction conducting a shelf takedown that may be structured as a registered direct, or agency best efforts, public offering, or as a firm commitment confidentially marketed public offering. A registered direct offering may be a practical alternative, especially for a company that will offer its securities to a small number of institutional investors through a placement agent. In a registered direct offering, investors introduced to the company by the placement agent purchase securities directly from the company. Investors that may not want to hold restricted securities (such as those sold in a PIPE transaction) will prefer a registered direct or confidentially marketed public offering.

In connection with any financing transaction, the company and its advisers will have to consider closely whether all of the company’s disclosures, including risk factors, business, and MD&A disclosures, are current. While, during more stable markets, it may be quite common to undertake a financing transaction after the release of quarterly earnings and before the filing of that quarter’s Form 10-Q, there may be some reluctance to do so in this environment. A company may want to minimize the gap in time between its earnings announcement and the filing of its Form 10-Q, and placement agents and underwriters may wish to see the quarterly report prior to undertaking an offering. All of the questions raised by the SEC in CF#9 and in the Statement are highlighted in the context of a securities offering.

Market Outlook

As discussed above, these are unusual and uncertain times and reporting companies and their advisers will have to consider the very fundamental principles of securities laws as they consider when and how to make disclosures relating to the effects of COVID-19 on their businesses, results of operations, and future prospects. The relief provided by the SEC has been timely and provides much-needed flexibility for issuers struggling to operate amidst stay-at-home and similar orders. Additional SEC guidance, whether in the form of CF#9 or the Statement, provide useful reminders for interpreting and applying longstanding principles to an unprecedented pandemic.

Michael L. Hermsen has an extensive practice at Mayer Brown LLP that focuses on securities matters, including the representation of issuers in securities offerings and liability management transactions; corporate clients in connection with compliance, reporting, and stock exchange matters; and companies, boards of directors, and management on, among other things, corporate governance matters and executive compensation disclosures and reporting. Mike has been included in The Best Lawyers in America in the practice areas of securities/capital markets law and securities regulation for over a decade and Legal 500 recommends Mike in “Capital Markets – Equity Offerings,” noting Mike has “unsurpassed knowledge of SEC rules.” In addition, Mike is frequently cited in the media regarding new regulatory initiatives. Anna Pinedo is a partner in Mayer Brown’s New York office and a member of the Corporate & Securities practice. She concentrates her practice on securities and derivatives. Anna represents issuers, investment banks/financial intermediaries, and investors in financing transactions, including public offerings and private placements of equity and debt securities, as well as structured notes and other hybrid and structured products. She works closely with financial institutions to create and structure innovative financing techniques, including new securities distribution methodologies and financial products. She has particular financing experience in certain industries, including technology, telecommunications, healthcare, financial institutions, REITs and consumer finance. Anna has worked closely with foreign private issuers in their securities offerings in the United States and in the Euro markets. She also works with financial institutions in connection with international offerings of equity and debt securities, equity- and credit-linked notes, and hybrid and structured products, as well as medium term note and other continuous offering programs. Laura D. Richman’s wide-ranging corporate and securities practice at Mayer Brown LLP has a strong focus on corporate governance issues and public disclosure obligations. Laura’s practice includes Securities and Exchange Commission reports, such as proxy statements and annual, quarterly, and current reports. She advises on executive compensation disclosure, insider trading regulation, and Dodd-Frank and Sarbanes-Oxley compliance. Laura represents listed company clients with respect to stock exchange compliance matters. She advises clients on governance policies and other board and shareholder matters. In addition, her practice includes representing clients on transactions such as securities offerings and mergers and acquisitions, as well as providing general securities, corporate, limited liability company, and contract advice.

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Climate Change Considerations In M&A Transactions

Evansj5 — Tue, 05 Nov 2019 18:38:17 GMT

By: Annemargaret Connolly and Thomas D. Goslin, Weil, Gotshal & Manges LLP

Climate change is arguably the most high-profile and rapidly evolving environmental issue facing the global business community today. Governments of nearly every nation have acknowledged the risks posed by a warming climate and have taken some action either to combat those risks, to mitigate the physical effects of climate change, or both. In addition, many corporations have publicly announced efforts to reduce emissions of greenhouse gasses (GHGs) associated with their operations and to otherwise take steps to combat climate change. Companies involved in certain mergers and acquisitions need to be aware of the risks related to climate change that may arise in the transactional context. While not every deal will involve climate change-related diligence, more and more industries are becoming subject to regulations and legal actions aimed at combatting climate change. Others have found that a changing climate may present direct risks to property and supply chains. And many companies have taken to marketing themselves as climate-friendly organizations in an effort to attract businesses and investment, creating a risk that failure to live up to their claims could prove off-putting to customers and investors and possibly result in legal liability. In order to properly assess and value corporate assets in M&A transactions, buyers and sellers of regulated assets need to understand the potential impact of climate change on business and successfully anticipate developments in this rapidly evolving area of law and policy.

There is no set formula for assessing climate risk in the transactional context. Due diligence will need to be tailored to the target and will vary substantially depending on the industry and the location of the target’s operations. That said, risks associated with climate change generally fall into one of four categories: physical risks, customer and investor considerations, compliance risks, and litigation risks, each of which is discussed in more detail below. Given the potential enormity of the issues presented by climate change, and the wide-ranging efforts taken in response, climate change due diligence is no longer limited to deals involving power plants and heavy industry. At a minimum, parties in nearly every M&A transaction should conduct a preliminary assessment to determine whether any or all of these categories of risk are present with respect to a target.

Physical Risks

While perhaps the most difficult to assess, climate change’s most obvious risks relate to disruptions to a company’s business or damage to a company’s assets (e.g., facilities, infrastructure, land, or resources) due to physical impacts, such as rising sea levels, more extreme storms, floods, fires, and drought. Recent destructive hurricane seasons and the forest fires that have blazed across the western United States serve as a reminder of the devastation that can be caused by natural disasters, the prevalence and intensity of which some are attributing to climate change. Although it can be argued that virtually every sector of the U.S. economy faces risks for the short- and long-term physical effects of climate change, it appears likely that certain sectors will be disproportionately impacted. For example, the agriculture sector faces greater risks associated with water scarcity, droughts, and other changing weather patterns, as well as increased exposure to new pests and diseases.

Likewise, due to climate change, the tourism industry is vulnerable to increased weather extremes, rising temperatures, coastal erosion, droughts, and changes in precipitation patterns and snow reliability. The insurance industry, perhaps more than any other, faces increased risks from virtually all physical impacts of climate change. At meetings at the United Nations in 2015, top insurers called on governments to step up global efforts to build resilience against natural disasters exacerbated by climate change and highlighted that average economic losses from disasters in the last decade amounted to around $190 billion annually, while average insured losses were at about $60 billion.

Assessing the physical risks posed by climate change can be extraordinarily difficult, given the randomness of natural disasters and the vicissitudes in weather. Droughts, hurricanes, floods, and fires are nearly impossible to predict with any certainty. That said, it is becoming easier in certain circumstances to observe trends, particularly with respect to rising sea levels. For example, a recent study by the University of Miami found that Miami Beach flooding events have increased significantly over the last decade due to an acceleration of sea-level rise in South Florida.1 Thus, should a target company hold significant assets in South Florida, or in any other coastal area experiencing increased flooding, a potential buyer would be wise to assess what impacts such flooding could have on the target’s operations and assets. Likewise, tourism-based assets such as ski or beach resorts may have a limited carbon footprint yet face substantial physical risks due to warmer long-term temperatures or rising sea levels. A recent study by the European Geosciences Union found that European ski resorts may lose up to 70% of their snow cover by 2100 due to climate change.

In addition, there may be significant physical risks associated with a target’s supply chain potentially affecting its ability to reliably produce its products and deliver services. For example, at first glance, a clothing manufacturer targeted in an acquisition may seem unlikely to be subject to material risks associated with climate change; however, if such clothing manufacturer sources its products from a low-lying area like Bangladesh, an essential source for many clothing retailers globally, risks associated with climate may be far greater than originally anticipated, as Bangladesh is frequently cited as a country most likely to be impacted by the anticipated sea-level rise associated with climate change. While supply chain due diligence is now a common element of any M&A transaction, it is becoming increasingly important to assess how climate change could impact a target’s suppliers as well as raw materials used in the target’s operations.

Shareholder Activism Considerations

Carbon-intensive businesses, such as oil and gas exploration and production, electric utilities, and chemical manufacturers, also face risks related to a growing cadre of institutional and other investors who have pledged to reduce or eliminate the carbon-intensity of their investments and portfolios. Known as fossil fuel divestment or portfolio decarbonization, these socially motivated campaigns seek to achieve reductions in GHG emissions by shifting investment capital from particularly carbon-intensive companies, projects, and technologies in each sector and by reinvesting that capital into carbon-efficient companies, projects, and technologies of the same sector. If a sufficient number of institutional investors start to engage and/or reallocate capital on the basis of companies’ GHG emissions, it can provide a strong incentive for those companies to rechannel their own investments from carbon-intensive to low-carbon activities, assets, and technologies. According to a report prepared by Arabella Advisors, as of 2018, nearly 1,000 institutional investors with $6.24 trillion in assets have committed to divest from fossil fuels, an increase of 11,900% in just four years.2 Although the direct financial impact on share prices related to such campaigns is likely to be small in the short term, the report concluded that the reputational damage, or stigmatization, can still have major financial consequences. In particular, significant reputational damage to carbon-intensive businesses could reduce the availability or increase the cost of debt, both short-term working capital and long-dated securities.

In the wake of the agreement reached at the 2015 United Nations Framework Convention on Climate Change (UNFCCC) meeting in Paris, known widely as the Paris Agreement, there were 89 shareholder resolutions filed on climate change in 2016. Many institutional investors are now considering climate-related factors in their investment decisions. In fact, Blackrock, the world’s largest asset manager with $5.4 trillion in assets under management, has identified climate risk disclosure as one of five top engagement priorities.

There is perhaps no better example of the shifting in opinions on this issue than the case of ExxonMobil. In May 2017, 62% of shareholders voted for a nonbinding measure that would require ExxonMobil to report on the risks to its business from new technologies and global climate change policies. This represented a substantial increase over the 38% of voting shareholders who voted for a similar measure just one year earlier, indicating that the proposal was backed by at least some of Exxon’s top institutional shareholders. Exxon opposed the proposal, arguing that it already provided information on risks to its business from clean energy technologies and global climate change policies. A separate proposal seeking a report on Exxon’s efforts to reduce emissions of methane, a particularly potent GHG, received support by 38.7% of ballots cast, raising the possibility that a similar resolution could pass in the near future. Ostensible effects of such shareholder activism can be evidenced in ExxonMobil’s subsidiary XTO Energy expanding its methane emissions reduction initiative and signing onto the Environmental Partnership, which is composed of U.S. oil and natural gas companies with a mission statement of continuous improvement of the industry’s environmental performance.

In a similar vein, another concept potentially relevant to carbon-intensive businesses is that of stranded assets, a financial term that describes corporate assets that become subject to unanticipated or premature write-downs, devaluations, or conversion to liabilities. With respect to climate change, the term has become more prevalent in recent years as economists and scientists study the potential ramifications of regulatory policies, technological advances, consumer behaviors, or other market actions that could dramatically decrease the use of fossil fuels. Investors too, are beginning to take notice, expressing concern that action needed to curtail the increase in global temperatures ultimately will result in a regulatory mandate to leave proven reserves of fossil fuels in the ground or will otherwise make it uneconomical to produce or use fossil fuels. Certain institutional investors have gone on record to state that stranded asset-related concerns have led them to divest, while others are pressuring companies to disclose their strategies to deal with the potential for stranded assets.

When assessing carbon-intensive targets in an M&A transaction, it is important to understand how that target, and its industry, is perceived by investors and financial institutions. Coal companies, for example, may have a much more difficult time attracting investment given perceptions about the negative environmental attributes of the industry. This could result in depressed pricing for the target’s assets, and it could also make it more difficult to obtain debt financing, if needed. Certainly, financial investors should understand the risks of reputational damage to carbon-intensive businesses, and any trends in those risks, as such concerns may increase during the hold period and jeopardize a successful exit.

Compliance Risks

Despite a varied and rapidly shifting regulatory landscape on climate, parties to an M&A transaction should identify and assess compliance risks. Many jurisdictions have passed laws or promulgated rules and regulations aimed at combatting climate change. Some of these legal requirements may directly affect a target company, while others may have indirect effects on supply chains, the price of raw materials, or otherwise impact operating costs. Buyers and lenders in M&A deals, therefore, need to understand the current state of climate change regulation to determine whether a target’s business is directly or indirectly affected by such regulation. Given the rapid developments in climate change regulation, this is not always an easy task.

Federal Climate Change Regulation

The U.S. federal government’s effort to regulate climate change serves as a vivid example of the unsettled state of domestic climate change law. In 2007, the United States Supreme Court ruled in Massachusetts v. EPA, that GHGs must be regulated under the federal Clean Air Act, a law first passed in 1970 (long before climate change entered the lexicon), provided that the Environmental Protection Agency (EPA) issues a finding that GHGs endangered the public health and welfare, which the EPA has since done.3 Around this time, Congress made several attempts to amend the Clean Air Act to impose restrictions on GHG emissions; however, these efforts never met with success. Frustrated with Congress’ inability to pass what it saw as important restrictions on GHG emissions, the Obama administration attempted to bypass Congress by promulgating several regulations under the existing Clean Air Act aimed at reducing GHG emissions from the power sector, the largest emitter of GHGs in the United States. These rules, promulgated by the EPA, imposed standards on both new and existing power plants. These rules were immediately challenged in court by plaintiffs who argued that the EPA overstepped its authority under the Clean Air Act, and many of these challenges remain pending. As such, it remains unclear to what extent the EPA can regulate GHGs, notwithstanding the Supreme Court’s finding that it must.

The state of federal climate change regulation was further disrupted by the 2016 election of Donald Trump to the presidency. Since taking office, President Trump has made it clear that his administration has no interest in taking any legislative or regulatory action to mitigate or adapt to the effects of climate change. Rather, he has suggested that climate change is a hoax and has taken steps to withdraw the United States from the Paris Agreement, which is discussed in greater detail below.

In furtherance of these views, the EPA issued a public notice in 2017 that the EPA will repeal the rules imposing GHG emission standards on existing power plants.4 The EPA also issued a mid-term evaluation in April 2018, in which it determined that the model year 2022-2025 light-duty vehicle GHG standards were too stringent and should be revised. Actions like these are certain to spur a new round of legal challenges, where plaintiffs will almost certainly argue that, given the Supreme Court’s ruling in Massachusetts v. EPA, the federal government is required to regulate GHG emissions. One example is a lawsuit against the EPA filed in May 2018 by a coalition led by California of 17 states and the District of Columbia. The suit seeks to preserve the country’s single vehicle emission standard, which the coalition says former EPA Administrator Scott Pruitt refused to enforce, and claims the EPA’s plan to weaken vehicle emissions standards violates the Clean Air Act. In December 2018 the Environmental Defense Fund brought a lawsuit against the EPA for failure to release public records on industry compliance with limits on pollution of methane and GHGs released during oil and gas production, which would provide key information relevant to the EPA’s effort to weaken pollution limits, as well as records of EPA’s review of the Clean Power Plan.5 If the past is predictive, legal disputes over federal regulation of GHG emissions likely will remain unresolved well into the next presidency.

In addition to the disarray surrounding the direct regulation of GHG emissions, other aspects of the federal government’s climate change regulation currently are in doubt. For example, in an attempt to reduce total GHG emissions, the United States has adopted several programs aimed at promoting renewable energy production, including research and development grant programs and tax credits for renewable energy investment and production that have been subject to the ever-changing political whims of Congress, leaving those in the industry unsure whether certain government benefits will be available from year to year.

On March 11, 2019, President Trump announced his 2020 budget request, which included a 31% reduction for the EPA. While the EPA’s main projects and core missions will still remain in place, the proposed budget as compared with FY 2019 reduces funds for clean air and research regarding air and energy. A closer look at the FY 2020 EPA budget shows elimination of some sub-program projects under the Atmospheric Protection Program and Global Change Research Program.

The unsettled state of federal law concerning climate change makes it very difficult to assess what impact, if any, federal regulation will have on a particular business operating in the United States. Certainly, those in the power generation industry remain subject to a shifting legal regime that could have profound impacts on their operations. For companies assessing potential M&A transactions with targets in the traditional or renewable energy industries, including any of their suppliers or major customers (which now include many Fortune 500 companies that have directly contracted for energy from solar and wind farms), assessing possible impacts from federal climate regulation will be key to any due diligence exercise.State Regulation of Climate ChangeIn the absence of stable federal policy concerning climate change, many states have taken action to reduce GHG emissions or otherwise respond to climate change. For example, a block of nine states in the Northeast and Mid-Atlantic have joined together to establish a cap-and-trade program, known as the Regional Greenhouse Gas Initiative (RGGI), regulating GHG emissions from power plants located within the member states (as of the date of this writing, Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont).6 Under a cap-and-trade program, GHG emitters either are granted or must purchase credits equal to the amount of GHGs emitted over a certain period of time. The number of available credits is capped, ensuring that total GHGs emitted from all regulated sources do not exceed a preset amount, which often lowers over time. Under the RGGI program, for example, the cap is reduced by 2.5% each year until 2020. It is up to the source either to reduce emissions or obtain sufficient credits to match its emissions. In general, market forces set the price of a credit on an open market.

While RGGI is focused exclusively on the power generation sector, California (the world’s sixth-largest economy) has enacted, under the California Global Warming Solutions Act of 2006,7 a more expansive cap-and-trade program that applies to utilities, large industrial facilities, and certain fuel distribution companies, regulating 85% of all of California’s GHG emissions. One interesting aspect of the California program is that it allows for what are known as offset credits, whereby businesses that voluntarily reduce GHG emissions can generate credits equal to their GHG reduction, which credits can then be sold to regulated entities to meet their compliance obligations under the cap-and-trade program. California recently renewed its commitment to its cap-and-trade law, extending the program until 2030, and requiring that it reduce GHG emissions by 40% below 1990 levels over the next 11 years.

In addition to cap-and-trade programs, a majority of states have taken action to promote the use of renewable energy technologies. Twenty-nine states as well as the District of Columbia currently have adopted binding renewable portfolio standards, which require that a certain percentage of the retail electricity power consumed, or generated, come from renewable energy sources, typically wind, geothermal, solar, hydro, landfill gas, or biomass (and nine additional states have renewable or alternate energy goals, which generally are not legally binding). Minnesota, for example, has had a program in place for over a decade aimed at boosting renewable energy use throughout the state economy by requiring utilities to procure 25% of its power from renewable sources by 2025 and has tracked GHG emission reductions in a variety of industrial, agricultural, and transportation sectors.8 Hawaii requires utilities to procure 100% of its electricity from renewable sources by 2045 and, in addition, has placed caps on GHG emissions from major sources, such as power plants and refineries.9 In Massachusetts, which also has a renewable portfolio standard on its books and is a member of RGGI, the legislature currently is considering a pair of bills that would impose a tax on transportation fuels, such as gasoline and diesel, as well as heating oil, based on their GHG-emitting potential, which will affect anyone operating in the state.10

In short, many states have acted to fill the void left by the federal government in the area of climate change regulation. Parties to M&A transactions need to be aware of state-level requirements, both those on the books and those pending in the state legislatures and regulatory agencies. Much like the federal government, the status of climate change regulation at the state level remains in flux, though unlike at the federal level, the trend appears to be towards greater regulation. Depending on the state and the industry, the operating costs associated with these regulations could be substantial.

International Climate Change Regulation

Parties to M&A transactions that involve overseas operations also need to be aware that many foreign jurisdictions have enacted laws aimed at combatting climate change, and it is likely that many more will in the next decade. This is because 185 nations (out of 197 parties to the convention) have ratified the Paris Agreement, which requires signatories to take steps to keep global temperature rise below 2 degrees Celsius above pre-industrial temperatures while pursuing efforts to limit it to 1.5 degrees Celsius. The Paris Agreement seeks to increase the ability of the global community to adapt to, and directs funds towards, low-emission and climate-resilient development. Paris Agreement parties generally are permitted to adopt whatever means they choose for achieving those goals, though countries are to submit plans to the UNFCCC by 2020 detailing those efforts and are required to update those plans every five years.

Of course, the Paris Agreement is not the first international undertaking to combat climate change. Businesses operating in the European Union likely are familiar with its GHG cap-and-trade program, known as the EU Emissions Trading System (EU ETS), which is the world’s first international emissions trading system to address GHG emissions from companies and is by far the biggest carbon market today. It covers more than 11,000 power plants and manufacturing facilities in the 28 EU member states as well as Iceland, Liechtenstein, and Norway. In addition, airline operators flying within and between most of these countries are also regulated under the programs such that, in total, around 45% of total EU emissions are limited by the EU ETS.

China, the world’s largest emitter of GHGs, is also taking steps to combat climate change. A Paris Agreement signatory, China has committed to reducing GHG emissions by up to 45% from 2005 levels by 2020 and increasing renewable energy production so that it will meet 20% of national electricity needs by 2030. In addition, since 2011, China has implemented a number of cap-and-trade pilot programs in cities and provinces around the country, testing market-based mechanisms for reducing GHG emissions.

Outside the United States, it is largely accepted that climate change poses a significant threat to human health, the environment, and many industries. Almost without exception, the trend internationally has been towards greater regulation, and given the commitments embodied in the Paris Agreement, there is little reason to believe this trend will not continue. Therefore, parties to M&A deals involving foreign operations will need to assess what steps the foreign jurisdiction is taking to combat climate change, and because there is no overarching international agreement as to what those steps should be, a country-by-country analysis will be required.

Litigation Risks

It also is increasingly important in M&A transactions to assess potential litigation risks arising out of climate change. Over the past few years, climate change litigation against private parties has arisen in numerous contexts, though the largest GHG emitters, particularly those in the oil and gas industry, appear to be the most likely targets.

Government Investigations into Climate-Related Disclosures

One litigation risk concerns government investigations into disclosure practices surrounding the existence or potential impacts of climate change. These investigations seek to determine whether certain energy companies have participated in a long-standing disinformation campaign to create doubt about the existence of climate change and to undermine scientific findings regarding climate change. In November 2015, the New York Attorney General announced that a two-year investigation found that Peabody Energy Corporation, the largest publicly traded coal company in the world, had violated New York laws prohibiting false and misleading conduct in the company’s statements to the public and investors regarding financial risks associated with climate change and potential regulatory responses. As part of the agreement concluding the investigation, Peabody agreed to file revised shareholder disclosures with the U.S. Securities and Exchange Commission that are to “accurately and objectively represent these risks to investors and the public.” That same month, the New York Attorney General issued ExxonMobil a subpoena ordering the company to turn over four decades worth of research findings and communications into the causes and effects of climate change. Massachusetts and California have since commenced similar investigation into ExxonMobil’s conduct with respect to climate change disclosures. In addition, members of Congress have called on the Department of Justice to investigate whether Shell Oil deceived the public on climate change at the same time it was preparing its business operations for rising sea levels. The ultimate impact of such investigations into fossil fuel company conduct regarding climate change is unclear. To date, lawsuits generally have not been filed, and it is uncertain whether the investigations of the attorneys general will identify information that would allow a lawsuit to proceed against the companies under investigation. Nevertheless, governmental investigations can be costly, both in terms of legal fees and reputationally. As such, parties to M&A transactions involving energy companies and other large sources of GHGs should assess a target’s disclosures concerning climate change to determine whether they present any issues.11

Tort Litigation

Large emitters of GHGs also face litigation risks associated with tort claims alleging various injuries related to climate change. Several cases have been brought in courts across the country alleging damages related to climate change under tort theories such as nuisance, trespass, and negligence. For example, in Connecticut v. American Electric Power Co., eight states, the City of New York, and three environmental groups filed suit against five energy companies, alleging that the carbon dioxide emissions from the companies’ power plants contribute to the public nuisance of global warming.12 Plaintiffs asked the district court to cap carbon dioxide emissions and mandate annual emissions reductions. The court granted defendants’ motions to dismiss on the grounds that the case raised non-justiciable political questions; however, on appeal the U.S. Court of Appeals for the Second Circuit Court of Appeals reversed the decision, holding that the plaintiffs had standing to bring their claims.13 The U.S. Supreme Court later reversed the Second Circuit, holding that the plaintiffs’ claims were preempted by the Clean Air Act, which the Court found delegated authority to regulate harms associated with GHG emissions to the EPA.14

Another example of climate change tort litigation can be found in the case of Comer v. Murphy Oil. In the district court case, Mississippi property owners had brought suit against numerous insurers, chemical companies, oil companies, and coal companies, alleging that the defendants’ carbon dioxide emissions contributed to global warming, which warmed the waters in the Gulf of Mexico and increased the frequency and severity of hurricanes, including Hurricane Katrina.15 Under theories of private nuisance, trespass, and negligence, the plaintiffs sought damages for loss of property, loss of income, cleanup expenses, loss of loved ones, and emotional distress. The suit was dismissed on standing and political question grounds, and plaintiffs appealed to the U.S. Court of Appeals for the Fifth Circuit, which initially overturned the district court ruling for the same reasons cited by the Second Circuit in the Connecticut v. American Electric Power Co. case.16 However, after a protracted legal battle over procedural rules, the district court’s decision ultimately was allowed to stand.17

A further example of climate-related tort litigation is California v. GMC,18 where the state of California sued six manufacturers of automobiles alleging that emissions from the manufacturers’ vehicles contributes to global warming and constitutes a public nuisance under state and federal law. California sought compensation for its current and future expenditures related to global warming. The district court also dismissed the suit on political question grounds, and the case was not appealed.

One unique case employing creative legal theories combined a traditional public nuisance claim with a more innovative conspiracy claim to confront issues related to the effects of global climate change. In this case, Native Village of Kivalina v. ExxonMobil Corp.,19a coastal Alaskan city and village experiencing such drastic erosion and severe storm effects that experts declared the entire town must be moved to a safer location sued nearly two dozen large energy companies for contributing to the global public nuisance of climate change and for conspiracy to engage in a misinformation campaign about the effect of human activity on climate change. Attorneys for the village likened this claim of conspiracy to misinform the public to claims made against tobacco companies for similar behavior. The U.S. District Court for the Northern District of California dismissed the case on a number of grounds, and on appeal, the U.S. Court of Appeals for the Ninth Circuit found that the U.S. Supreme Court’s decision in Connecticut v. American Electric Power Co. meant that the plaintiffs could not proceed with their case.20

While none of these cases ultimately resulted in verdicts for the plaintiffs, largely due to the courts’ holding that the plaintiffs’ claims were preempted by the Clean Air Act, some are beginning to question whether the United States may soon experience a renewed round of climate-related tort litigation prompted, in part, by the Trump administration’s actions aimed at rolling back existing GHG regulations. In fact, in July of this year, three local governments in California (San Mateo County, Marin County, and the City of Imperial Beach) each sued 20 fossil fuel companies, including Chevron, ExxonMobil, Peabody Energy, and Arch Coal, under various state common law tort theories alleging that each defendant is responsible for contributing to climate change, which has resulted in sea level rise and increased flooding that resulted in the local governments’ incurring damages. Whether these three cases are a sign of things to come remains to be seen, but it is noteworthy that the plaintiffs’ claims were brought under state common law, which is not preempted by the federal Clean Air Act.

NEPA Litigation

Litigants also have turned to the National Environmental Policy Act of 1969 (NEPA) as a means by which to pursue climate change interests in court. In Border Power Plant Working Group v. Department of Energy,21 one of the first cases to raise climate change issues in challenging NEPA compliance, the court evaluated whether the Department of Energy and the Bureau of Land Managemen adequately complied with NEPA requirements in connection with granting permits and rights-of-way for construction of new utility lines between California and Mexico. The court determined that the agencies violated NEPA requirements by arbitrarily and capriciously failing in their Environmental Assessment (EA) to adequately account for, among other things, carbon dioxide emissions contributing to global warming. After the court struck down their initial Finding of No Significant Impact, the agencies undertook another EA to produce an Environmental Impact Statement (EIS) that included, inter alia, the cumulative impact of carbon dioxide emissions on the environment.22 In Mid States Coalition for Progress v. Surface Transportation Board, the court rejected an EIS submitted by the federal Surface Transportation Board (STB) for a proposed rail-line construction project geared toward coal transportation across the Midwest because the EA analysis failed to include environmental impacts from increased carbon dioxide, among other, emissions.23 The STB subsequently conducted another EA and produced another EIS, again approving the project. This time, the court upheld the EIS, which now included an analysis of the environmental impact of carbon dioxide and other emissions on the environment.24 Most recently, in the case of Sierra Club v. FERC, the U.S. Court of Appeals for the D.C. Circuit ruled that the Federal Energy Regulatory Commission (FERC) failed to adequately review the environmental impacts of the GHG emissions of a natural gas pipeline based on the FERC’s failure to assess the climate-related impacts of burning the gas transported by the pipeline.25 In response to the Sierra Club ruling, the FERC revised the final EIS to include a quantitative estimate of the pipeline project’s downstream GHG emissions and why the FERC regards the Social Cost of Carbon tool as not useful for NEPA compliance.26 While these NEPA-related cases were not filed directly against private parties (and, in fact, cannot be), it is clear that they can have a substantial impact on a private party’s operations.

To date, climate-related litigation has been limited largely to parties or projects involved in oil and gas and other major GHG-emitting industries. There also has been something of a recent lull in the number of climate-related cases filed in the courts; however, many attribute this to the fact that the Obama administration was seen as taking a proactive role in addressing climate change. Given the change in approach adopted by the Trump administration, it would not be surprising to see a surge in climate change litigation in the near future. As such, parties to M&A transactions involving major GHG emitters would be wise to assess the risk that the target may be named in such litigation.

Conclusion

Assessing climate change risks in M&A transactions can be difficult, at times subjective, and in many cases speculative. Any diligence exercise in this area must be tailored to the particular target, the location and operations of its assets, the nature of its supply chain, and the target’s own experience managing climate-related risk. There simply is no standard procedure for conducting this type of due diligence. That said, every climate change diligence exercise in an M&A transaction will require the parties to consider the totality of a target’s operations and anticipate infrequent occurrences that may present catastrophic risks.

When assessing companies that emit significant quantities of GHGs, the parties and their counsel must examine issues concerning the target’s current and future compliance obligations with climate change-related regulations. Some questions to ask in M&A due diligence include:

Does the target operate in jurisdictions where GHG emissions are regulated or where there are current or recent historic efforts to impose such regulation?
If currently regulated, will the target be required to make significant capital expenditures to obtain or maintain compliance?
Is the target part of an industry that has been subject to governmental investigations or litigation relating to climate change?
Has the target made public statements or disclosures concerning climate change risk that may in any way be considered misleading?

While it is perhaps obvious that climate change-related diligence of major GHG emitters is important, it is becoming clear that such diligence is just as important in M&A deals involving companies with little or no GHG emissions. These types of questions need to be asked regardless of whether the target operates in a carbon-intensive industry:

Does the target operate, or are its raw materials sourced, in areas prone to flooding or at risk of rising sea levels?
Is a warming climate likely to affect business operations or a target’s supply chain?
Is the company developing, or dependent upon, a project that may require a NEPA assessment?
Is the target procuring renewable energy from projects dependent on governmental subsidies or similar support programs?

Certainly not all of these risks will be present in every M&A deal; however, where they do materialize, they can be material to the transaction. As such, it is key for those involved in M&A deals to understand the risks and think creatively about how they can be assessed and, if possible, managed in the transactional context.

Annemargaret Connolly is a partner based in the Washington, D.C. office of Weil, Gotshal & Manges LLP. She is the head of Weil’s Environmental Practice, a leader of Weil’s Climate Change Practice Group, and a member of the firm’s hydraulic fracturing task force. She advises clients on a wide range of global environmental compliance and liability issues, most notably in the context of mergers and acquisitions, real estate transfers, financing transactions, and infrastructure projects. She also works closely with the firm’s European and Asian offices on cross-border transactions, assisting in identifying and allocating environmental risks and educating foreign clients on potential issues raised by global environmental movements. She undertakes and oversees due diligence assessments, retains and works with consultants, engineers and other environmental professionals to quantify potential liabilities, and drafts and negotiates contract language to effectively allocate the risk of environmental liabilities between the parties. She also advises on disclosure issues in the preparation of financial statements and public securities filings and negotiates transaction-specific environmental insurance transactions. ThomasD. Goslinis counsel based in the Washington, D.C. office of Weil, Gotshal & Manges LLP. He focuses on a wide range of environmental, energy, and other regulatory concerns in the context of mergers and acquisitions, private equity investments, financing transactions, infrastructure projects, and corporate restructurings. He has extensive experience with environmental and regulatory liability and risk allocation issues, drafting and negotiating contract terms, managing due diligence, and administrative and judicial proceedings to obtain regulatory approvals necessary to close client transactions.Mr. Goslin has been involved with teams representing a wide range of clients in a variety of industries, particularly the renewable and traditional power generation, oil and gas, natural resources, infrastructure, and automotive industries. Mr. Goslin also assists clients in identifying business opportunities and risks arising from proposed changes to federal and state legislation and regulation, with respect to renewable energy development and greenhouse gas emissions.

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U.S. Oil and Gas Industry M&A Trends 2018/19

Evansj5 — Tue, 05 Nov 2019 18:38:47 GMT

By: I. Bobby Majumder, Reed Smith LLP

Market Activity

2019 has been eventful for the domestic oil and gas industry. Oil and gas acquisitions in the United States hit a 10-year low in the first quarter, with deal value plunging by over 90% just from the fourth quarter of 2018. A rapid reduction in oil prices in late 2018 is believed to have triggered these effects. However, the second quarter of 2019 brought a resurgence, with deal value spiking to $118.7 billion, an all-time high for a second quarter, according to a study by PricewaterhouseCoopers.

Oil price volatility is a pervasive factor in the industry’s deal statistics, inevitably affecting deal value each quarter. When prices are stable, it allows both buyer and seller increased confidence that a deal is not heavily favorable to the counterparty and further suggests a maturation of the cost-cutting measures taken by domestic shale producers. More stable economics allow typical sellers—generally distressed sellers that are considering selling assets to de-lever their balance sheets—and typical buyers—generally strategic buyers and financial sponsors making bets that the market has reached a level of stability with respect to oil and gas prices—to have comfort that their decisions are not going to be second guessed because of massive fluctuations in price.

From 2009 to 2014, deal-making relied on stable oil prices between $70 and $80 per barrel. In 2015, oil prices fluctuated wildly, leading to uncertainty in deal making. Oil prices then stabilized, ranging between $42 and $52 per barrel beginning in June 2016, and that stability led to a moderate increase in oil and gas acquisitions and dispositions. 2017 brought similar stability at a range between $50 and $60 per barrel, but deal value and deal count took a small dive, with experts citing lasting effects of caution arising out of the lower for longer business environment of the past several years. Oil prices reached a four-year high by October 2018 before plunging and leading to such a dismal start to 2019.

Notably, three mega-deals (deals valued at $5 billion or more) represented 75% of the deal value in the second quarter of 2019, demonstrating a comeback of blockbuster transactions. Though it is unclear precisely whether this uptick in large acquisitions and dispositions will continue through the fourth quarter of 2019, the current geopolitical and macroeconomic landscape has the potential to create even more oil price volatility.

The oil and gas industry is capital-centric, so without adequate access to capital, oil and gas companies cannot survive. Low or volatile oil prices force oil and gas companies to be creative in their efforts to raise capital. The threat of a decreased borrowing base often motivates producers to consider strategic dispositions or alternative capital providers. These alternative providers include private equity funds and mezzanine funds, though these funding sources often come with heavy strings attached, and many private equity funds with substantial available cash are instead content to withhold capital and poach prized assets out of bankruptcy.

Recent Trends

The oil and gas industry comprises four main sectors:

Upstream: companies that explore for and produce the oil and gas
Oil field services: companies that provide services to the exploration and production industry
Midstream: companies that transport and store oil and gas
Downstream: companies that refine, process, and distribute oil and gas

Because of the different role each sector plays in the production and distribution of oil and gas, each sector experiences different effects from fluctuations in oil and gas prices. Accordingly, trends in merger and acquisition (M&A) activity are best examined at the sector level.

Upstream Trends

The upstream sector accounted for the majority of the U.S. oil and gas deal value in the second quarter of 2019. Deal activity is increasing due to the continuing attractiveness of shale plays, particularly in low-cost-of-production basins. The Permian basin and Marcellus basin each have a break-even point that is approximately $20 per barrel below that of higher cost-of-production locations. In 2018, upstream deals in the Permian basin had an aggregate transaction value of $25.7 billion, more than twice the value of deals in the next most active basin. The geology of the Permian basin and the high number of vertical wells drilled there lead to lower production costs. Additionally, most of the deal value is derived from the sale of undeveloped acreage—a product of producers being more willing to explore in low-cost basins than acquire producing wells in higher cost basins. Buyers possess more confidence when acquiring companies operating in low-cost basins because of the decreased costs of operation, which helps preserve positive operating margins. Conversely, dry gas production basins such as the Bakken have seen fewer acquisitions because of the higher costs of production; however interest has grown some over the past few years. Buyers are content to let operators in high-cost areas file for bankruptcy in order to secure a more attractive deal through the purchase of producing assets via transactions under Section 363 of the U.S. Bankruptcy Code.

Many small to midsize upstream companies have been pursuing royalty deals as a means of raising capital. With 29 deals worth $2.2 billion total for the year 2018, royalty deal volume and value reached an all-time high. All of these deals were for proven but undeveloped assets, which suggests a trending interest driving future growth by minimizing the risk involved in operating the assets. When 2019 comes to a close, it will be telling to see whether this trend has continued.

Oil Field Services Trends

Aggregate deal value in the oil field services sector fell to a five-year low in 2018, and there was limited activity into the first half of 2019. While market valuations of oil field services companies fell by nearly 40% from 2017, the last quarter of 2018 marked record-high asset sales of more than $6 billion. As the demand for rigs per drilling unit has decreased and midstream bottlenecking has held back demand growth for equipment, oil field services companies have resorted to selling assets that were not producing sufficient revenues.

A common strategy in oil field services deals is to supplement existing services as opposed to creating new segments. Nearly all the oil field services deals in 2018 were between a buyer and seller with significantly overlapping business models, which suggests that companies remain conservative at this time, focusing on what they already do well in the industry.

The Ensco/Rowan merger was the top oil field services deal of 2018. The merger’s goal was to combine the companies’ rig fleets and infrastructure in order to increase scale without neglecting high-specification assets. After years of bankruptcy and overcapacity in this sector, improving offshore margins is important for oil field services companies.

Midstream Trends

With years of low oil prices causing decreased deal activity, the midstream sector saw an increase in aggregate deal value in 2018, surpassing upstream deal value in three out of four quarters. Activity in the United States decreased in the first half of 2019, but a general bottlenecking of infrastructure has resulted in a general increased interest in existing, completed pipeline assets over the past couple years.

Long-term, fixed-price contracts are common in the midstream sector, as these agreements protect midstream revenue. Industry analysts believed the fixed-price contract structure would protect the midstream sector for a significant amount of time. However, deal activity in the midstream sector is susceptible to a prolonged downturn in oil prices. Since its spike in both deal count and deal value in late 2016, the sector has not quite picked up again, with deal counts ranging from about 10 to 20 each quarter. Gathering and processing deals have been at the forefront of deal activity in this sector, particularly in 2018.

Master limited partnership-backed deals continue to slow down in the midstream sector after the Federal Energy Regulatory Commission enacted an unfavorable tax policy toward this type of structure in early 2018. Private equity continues to show interest in the midstream sector, demonstrating the many creative ways an oil and gas deal may be structured. Special purpose acquisition companies (SPACs) have also proven to be a viable deal-making strategy in the sector, a notable example being the SPAC Kayne Anderson Acquisition Corporation’s $3.5 billion deal that created the first debt-free, cash-rich, publicly-traded, pure-play midstream corporation in the Permian Basin.

Downstream Trends

Worldwide, the downstream sector achieved a record aggregate deal value in 2018. Marathon Petroleum’s acquisition of Andeavor is one of the chief reasons for this accomplishment, as this U.S. transaction was not only the largest downstream deal globally to date, but one of the largest deals of the oil and gas industry in 2018. Increased activity in the marketing and storage business verticals also contributed to this deal value. Nearly half of the downstream deals in the last quarter of 2018 were in the storage vertical, and activity in this segment is slated to only increase over time.

The downstream sector comprises only a small portion of the U.S. oil and gas deal distribution in 2019. While the downstream sector provided 7% of oil and gas deal volume in the second quarter of 2019, it only comprised 4% of the total deal value. This is likely attributable to the increased activity of smaller-sized companies.

Industry-Specific Transactional Considerations

Deal Structure

Deal structuring issues tend to turn upon two factors: first, the involvement, if any, the sellers will have in the ongoing assets or enterprise; and second, the tax ramifications of the deal in question. In terms of post-transaction involvement, management of the selling entity will seek to retain some form of upside. A royalty spin-off and earn-outs are two attractive methods sellers use to protect upside.

Due Diligence

The cost of production is the first and foremost due diligence issue in oil and gas M&A. A low oil price environment demands an accurate cost of production picture. Due diligence must therefore be precise and complete. Engaging reputable industry consultants who are independent and not incentivized to close helps dealmakers gain a more accurate rendering of the cost of production. Additionally, due diligence concerning title issues, environmental liabilities, third-party processing and transportation agreements, and storage facilities continue to be necessary when conducting oil and gas due diligence.

Regulatory Requirements

Most commonly, oil and gas transactions are regulated by organizations such as the Environmental Protection Agency and the relevant state-level administrative agencies (for example, the Texas Railroad Commission). However, many practitioners would be unaware of the need to get approval from the Bureau of Land Management (BLM) (a part of the U.S. Department of the Interior) for transactions involving production or leases on Native American reservations. The BLM is an inherently convoluted and cumbersome area of regulation; therefore, the help of a BLM specialist is important when constructing deals that require BLM approval. For instance, the Dakota Access Pipeline—noteworthy due to Native American protests—had to receive permission from the BLM in order to develop the pipeline.

I. Bobby Majumder is the co-office managing partner of the Dallas office of Reed Smith LLP and co-head of the firm’s India practice. He focuses his practice on corporate and securities transactions primarily in the energy (oil & gas and coal), mining, health care, and information technology industry verticals. He represents underwriters, placement agents, and issuers in both public and private offerings of securities; public and privately-held companies in both cross-border and domestic mergers and acquisitions; private equity funds, hedge funds, and venture capital funds in connection with their formation as well as their investments; and companies receiving private equity and venture capital financing. Special thanks to Reed Smith associate Brooke Dorris for contributing her efforts to this article.

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Allocating Environmental Risks in the Transaction Agreement

Evansj5 — Tue, 05 Nov 2019 18:41:12 GMT

By: Annemargaret Connolly and Thomas D. Goslin, Weil, Gotshal & Manges LLP

UPON COMPLETION OF THE ENVIRONMENTAL DUE DILIGENCE investigation, the buyer should have obtained a solid understanding of the environmental issues requiring attention after operations are acquired. Furthermore, the new information allows the purchaser to intelligently address environmental issues in deal negotiations. The primary way in which environmental information is used in deal negotiations is to enable the parties to allocate financial responsibility between one another and to make sound business decisions in the context of the overall transaction. This allocation may occur in several ways. For example, the parties may negotiate a different purchase price or may change the structure of the transaction. Alternatively, the seller may agree to pay for some, or all, of the costs of cleanup, or choose to indemnify the purchaser against future environmental liabilities. In some cases, the purchaser may concede to all of the seller’s terms because the risks or liabilities, when evaluated from a worst case perspective, would not be material to the bottom line of the overall transaction.

Environmental Representations and Warranties

Environmental representations and warranties can serve two purposes: first, they can help facilitate due diligence by requiring a seller to disclose what it knows about certain environmental matters; second, they can help to allocate liability for environmental matters between the buyer and seller. As with any transaction agreement, the representations and warranties concerning environmental matters will vary depending on the nature of the assets or business being acquired. That said, in today’s environment, nearly every purchase agreement will contain at least some environmental representations and warranties. These typically require the seller to represent that, except as might otherwise be disclosed to the buyer:

There is no contamination present at the properties being acquired.
The operations of the acquired company have not caused any contamination at any other property.
The assets or business are and have been in compliance with environmental laws.
There are no environmental proceedings pending or threatened concerning the assets or the business.

Tailoring Representations and Warranties

Environmental representations and warranties should be tailored to the business or assets at issue. For example, if the target is a corporate entity that has been built through a series of acquisitions, it may make sense to include a representation that the business did not assume, by contract or otherwise, any liabilities of any third parties. If the target has a long history of manufacturing, a buyer might request a representation that the business does not and has not manufactured products containing hazardous materials such as asbestos. If a buyer feels that it has not had an opportunity to conduct ample facility-level diligence, it may request a representation that certain features are not present on any acquired real property, including underground storage tanks, landfills, or wetlands. Buyers also often seek to have a seller represent that the seller has made available to the buyer all material environmental documentation so that the buyer can obtain some level of comfort that they are aware of all known environmental liabilities.

Qualifying Representations and Warranties

Depending on the nature of the assets or businesses that are the subject of the transaction, it may be necessary to include certain qualifications on the environmental representations and warranties, particularly with respect to materiality and knowledge. For example, a purchase agreement for a highly-regulated chemical business would likely contain language in the representations providing that the business is and has been in material compliance with all environmental laws or that the business has been in compliance except for any noncompliance that could not reasonably be expected to result in the company incurring material liabilities. Representations also may be qualified by knowledge. For example, the seller would represent that, to its knowledge, the assets are free of any contamination. Whether and when materiality and knowledge qualifications are appropriate for environmental representations and warranties will largely depend on the nature of the transaction and the parties’ tolerance for assuming or retaining risk and the strength of its bargaining position.

Indemnification

Depending on the outcome of environmental due diligence, the nature of the deal and the bargaining strength of the parties, certain transaction agreements may provide the buyer with indemnity in the event that the seller breaches an environmental representation or warranty.

Survival Period

A key consideration in such agreements is whether the environmental representations survive. In agreements where the representations survive, the buyer may be entitled to indemnification (often subject to deductibles and caps) if it turns out that a representation was not true and the buyer incurred a loss as a result of the breach before the termination of the survival period. Survival periods for environmental representations vary, much like they do for other types of representations: they can survive for a brief period of time or, in some rare instances, they can survive forever.

One variant on the survival concept seen in some agreements provides that the representation will survive until the expiration of the statute of limitations. This presents a unique issue in the environmental context because the statute of limitations under certain environmental laws does not begin to run until the environmental issue is discovered. A survival period tied to the statute of limitations arguably creates a situation where that representation would survive indefinitely. For example, if an agreement contains a representation that there is no contamination present at real property acquired by the buyer, and that representation survives until the expiration of the statute of limitations, then arguably the buyer could demonstrate a breach of the representation if, 20 years hence, contamination attributable to the seller is discovered at the property.

Indemnification for Environmental Matters

In addition to indemnification for breaches of environmental representations, it may be appropriate for the parties to agree to specific indemnification for environmental matters. These can take many forms and cover specific known issues, contingent liabilities, or both. Specific environmental indemnities can be particularly useful when due diligence has identified a known issue, but the magnitude of the liability cannot yet be calculated. In those circumstances, the parties may not be able to agree on a purchase price adjustment to account for the liability. Thus, the parties, may agree to a special environmental indemnification clause that will provide the buyer with some level of protection while allowing the transaction to close before the full extent of the liability is known.

Agreements containing indemnification for environmental matters may also contain certain environmental-specific limitations:

No-dig provisions. For example, the agreement may provide that the buyer will not be entitled to any indemnification to which it might otherwise be entitled if the loss incurred by the buyer arises because the buyer conducted environmental sampling during the indemnification period. Often referred to as a no-dig, these provisions prevent a buyer from voluntarily looking for issues and then seeking indemnification under the agreement. No-dig provisions are often subject to several exceptions, including to the extent sampling is required by law or demanded by a governmental entity.
No recovery if changes to site. Environmental indemnities may also be subject to restrictions that prevent recovery to the extent the buyer changes the use of a site after closing or ceases operations, both of which can change the legal requirements applicable to the site.
No recovery for cleanup beyond required levels. In addition, there may be specific indemnity limitations that prevent recovery for losses incurred to cleanup a site to a level greater than required by law, for instance, if the law allows for low levels of contaminants to remain in the ground, the indemnity will not cover losses to clean up contaminants that the law would allow to remain.

In short, environmental indemnification rights and obligations can vary significantly from transaction to transaction and are often dictated by the issues identified (or not identified) during the due diligence process.

Access Rights

While a significant portion of environmental due diligence will occur prior to signing a definitive agreement, in certain transactions environmental due diligence will continue to occur between signing and closing. To the extent that the buyer wants to continue environmental due diligence after signing the agreement, the buyer will need to ensure that it has the right to do so in the agreement. Most transaction agreements will include provisions granting a buyer certain access to the seller’s properties and records. These access provisions often include limitations that prevent a buyer from conducting invasive environmental sampling. To the extent that a buyer believes it may wish to perform such sampling, it should seek to include language in the access provision explicitly authorizing it to do so. Sellers are often reluctant to provide buyers with the right to conduct invasive sampling because, if the buyer identifies a significant issue, the contract may allow the buyer to terminate the deal, leaving the seller to deal with a new environmental liability. Conversely, buyers may wish to seek to include rights to conduct sampling in the access provisions where earlier diligence suggests that there may be a potentially significant issue at a property. Depending on the deal dynamics, the seller may have no choice but to agree.

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Will More States Follow California on Deal with Automakers?

Evansj5 — Tue, 05 Nov 2019 18:39:14 GMT

BYPASSING THE TRUMP ADMINISTRATION, CALIFORNIA has reached agreement with four of the world’s largest automakers to improve fuel efficiency and reduce automobile emissions that contribute to global warming.

And more are likely to follow.

“This is about leadership, California asserting itself once again, and about automobile manufacturers, to their credit, doing the right thing,” California Gov. Gavin Newsom (D) said at a briefing announcing the deal struck with Ford, Honda, BMW, and Volkswagen.

The voluntary agreement, announced in July, notably “recognizes California’s authority.” It will allow the Golden State and 14 other states that accept its air pollution rules to continue with most of the regulations on auto emissions agreed to in 2012 by the Barack Obama administration, California, and the carmakers.

The Environmental Protection Agency (EPA) under President Donald Trump rejected California’s request to continue with the Obama-era standards. The agreement between California and the four automakers, which together have about 30% of the U.S. car market, is an end run around this rejection.

The agreement benefits the carmakers by enabling them to avoid a nightmare scenario of having to manufacture cars for multiple markets and gives them an extra year to reach the greenhouse gas emission standards agreed to in 2012.

“These terms will provide our companies much-needed regulatory certainty by allowing us to meet both federal and state requirements with a single national fleet, avoiding a patchwork of regulations while continuing to ensure meaningful greenhouse gas emissions reductions,” the automakers said in a joint statement.

The agreement was denounced by Michael Abboud, a spokesperson for the EPA, as “a PR stunt” that will have no impact on the agency’s plan to issue new relaxed national emissions standards. But climate experts and Gov. Newsom hailed the agreement as a game changer.

“I cannot recall another instance in which a state or state coalition has negotiated this kind of an arrangement with industry to out-flank the federal government,” said Barry Rabe, a professor of public policy at the University of Michigan and an expert on climate issues.

California Air Resources Board chief Mary Nichols said the agreement could set a precedent for further cooperation between states and industry.

“If other states take a strong line on environmental standards where they have a particular resource or sensitive area, they may be able to get industry to go along even when the federal government wants weaker standards,” said Nichols. “I am thinking about Florida and the Everglades where the Interior Department backed off on a proposal to lease oil drilling after the state objected and industry signaled they didn’t really want to bid on these leases.”

The states that accept California emissions standards are Colorado, Connecticut, Delaware, Maine, Maryland, Massachusetts, New Jersey, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Vermont, and Washington, as well as the District of Columbia. Canada has also agreed to abide by the California standards.

Under the Trump administration, the EPA and the National Highway Traffic Safety Administration want to freeze fuel economy standards at the current 37 mile-per-gallon fleet average target for 2020 through 2026.

The Obama administration in 2012 set a fleet average goal of 51 miles-per-gallon by 2026 although that number could be adjusted based on the mix of vehicles an automaker sold.

Under the agreement with California, Ford, Honda, Volkswagen, and BMW pledge to improve their fleet averages by 3.7% each year, or slightly less than the standards set under the Obama administration.

Rabe observed that the four companies had “already made a strong commitment to electric vehicles” (EV) and might therefore find the new agreement more attractive than firms which are not promoting fuel-saving electric cars. Ford and Volkswagen announced a new EV-based partnership days before the California announcement.

Days after the agreement was reached, a dozen states—California, Connecticut, Delaware, Maryland, Massachusetts, New Jersey, New York, Oregon, Illinois, Rhode Island, Vermont, and Washington—and the District of Columbia banded together to file suit against the Trump administration for easing penalties on carmakers that don’t meet the higher fuel standards. A second suit was filed by the Sierra Club and the Natural Resources Defense Council.

The auto industry as a whole is worried that the Trump administration’s standards, which have yet to be spelled out in EPA guidelines, will lead to lawsuits and the likelihood that car manufacturers will have to make one kind of vehicles for states that accept the California emission standards and another for states that do not. This prompted 17 automakers in June to send a letter to President Trump warning of “an extended period of litigation and instability” should his plans be implemented.

This conflict over fuel efficiency comes at a time when state climate policy is increasingly diverging along party lines. Democratic-controlled states are setting forward-looking clean energy goals, while Republican-controlled states are standing still or even reducing fuel efficiency goals.

A bill passed late in July in Ohio by a Republican-controlled legislature and signed into law by Gov. Mike DeWine (R) provides more than $1 billion in subsidies for power plant owners and reduces Ohio’s 12.5% renewable energy standard to 8.5%.

In contrast, New York State, where the legislature and the governorship are in Democratic hands, recently adopted one of the nation’s most ambitious climate targets. The Empire State’s goal is 100% carbon-free electricity by 2040 and economy-wide, net-zero carbon emissions by 2050.

In 2018 California and Hawaii established goals of relying entirely on zero-emission energy sources for electricity by 2045.

Other Democratic-controlled states that have since adopted targets of obtaining their electricity from carbon-free sources such as wind, solar, or nuclear by midcentury are Colorado, Maine, Nevada, New Mexico, and Washington.

Such state actions were encouraged during the Obama presidency by the Clear Power Plan, announced by the EPA in 2014, which sought to reduce emissions from the carbon sources by 32% below 2005 levels by 2030, which the Union of Concerned Scientists called “a modest but important first step.”

President Trump, who denies that the planet is warming, has replaced the Clean Power Plan with a rule that allows states to set their own power plant standards.

Historically, climate issues did not divide on party lines. In the 1960s smog had become so pervasive and even deadly in Southern California that Republican Gov. Ronald Reagan and legislators agreed to curb tailpipe emissions. In 1967 they created the California Air Resources Board (CARB).

Three years later Congress passed and President Richard Nixon signed the Clean Air Act, which recognized California’s efforts, and authorized the state to set its own separate and stricter-than-federal vehicle emissions regulations to address the unique circumstances of population, climate, and topography that generated what was then the worst air in the nation.

Under eight presidents from 1968 to 2017 California has been granted 107 waivers by the EPA to take actions to combat air pollution. Many of these actions became federal standards. Only nine waiver requests were denied, most for minor technical reasons, according to a study by Rabe. The refusal by the Trump administration to allow California to use the fuel efficiency standards of the Obama administration is the first reversal of a waiver request from the state.

In 2006, California Gov. Arnold Schwarzenegger, a Republican, signed the Global Warming Solutions Act, which made CARB responsible for monitoring and reducing greenhouse gas emissions that cause climate change.

There are current Republican officeholders who believe it is the government’s duty to address climate issues. These include the Republican governors of Maryland, Massachusetts, and Vermont, three of the 14 states that adhere to the California standards of fuel efficiency.

“We have many advantages in the fight against global warming, but time is not one of them,” another Republican said. “We stand warned by serious and credible scientists across the world that time is short and the dangers are great. The most relevant question now is whether our own government is equal to the challenge.”

This was John McCain, running for president in 2008.

McCain had the federal government in mind, but in 2019 it is state governments that are rising to the challenge he described.

States have long experimented with creative solutions to the public issues of the day, fulfilling their mission as “laboratories of democracy,” to use the famous phrase of Supreme Court Justice Louis Brandeis.

The agreement between California and the four carmakers is a different kind of experiment. If Mary Nichols is right, it could set a precedent for the way in which state governments can work with industry to address a global issue.

Lou Cannon, State Net Capitol Journal

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State Legislatures Moving to Expand Consumers’ Controlover Personal Information

Evansj5 — Mon, 26 Aug 2019 14:09:41 GMT

FOLLOWING THE EXAMPLE SET BY THE CALIFORNIA legislature,which enacted a sweeping data privacy statute in June 2018, state legislatures have begun to enact, or at least propose, similar laws to give consumers greater control over their personal information. As states continue to put privacy statutes on the books, the result is likely to be a patchwork of standards for businesses and other entities to follow.

Background

The California Consumer Privacy Act (CCPA) was signed into law a week after its introduction and just hours after its unanimous approval by the State Assembly and Senate. The wide-ranging law gives consumers greater control over how businesses can use their personal information. Under the new law, which takes effect on January 1, 2020, consumers will have the right to request that businesses disclose how their personal information is used and to ask that personal information be deleted under some circumstances.

Approximately a dozen amendments are making their way through the legislature in advance of the statute’s January 1 effectiveness date.

Nevada

In neighboring Nevada, the legislature has passed a bill amending the state’s existing online privacy law to require entities that operate websites to establish a designated address for consumers to submit requests to opt out of the sale of personal information. The Nevada statute is narrower than the California law, limiting the definition of “sale” to the “exchange of covered information for monetary consideration by the operator to a person for the person to license and sell the covered information to additional persons.” The term “operator” is defined as a person who “(a) Owns or operates an Internet website or online service for commercial purposes; (b) Collects and maintains covered information from consumers who reside in this State and use or visit the Internet website or online service; and (c) Purposefully directs its activities toward this State, consummates some transaction with this State or a resident thereof or purposely avails itself of the privilege of conducting activities in this State, or otherwise engages in any activity that constitutes sufficient nexus with this State to satisfy the requirements of the United States Constitution.”

The statute, SB 220, was signed into law by Governor Stephen F. Sisolak on May 29 and takes effect on October 1. It does not create a private cause of action; its enforcement lies with the state Attorney General.

New York

In New York, a bill proposed by State Senator Kevin Thomas would amend the general business law to add a new article entitled New York Privacy Act. The bill contains many of the same provisions as the California law, but also imposes on companies the role of “data fiduciary,” providing as follows: “Personal data of consumers shall not be used, processed or transferred to a third party, unless the consumer provides express and documented consent. Every legal entity, or any affiliate of such entity, and every controller and data broker, which collects, sells or licenses personal information of consumers, shall exercise the duty of care, loyalty and confidentiality expected of a fiduciary with respect to securing the personal data of a consumer against a privacy risk; and shall act in the best interests of the consumer, without regard to the interests of the entity, controller or data broker, in a manner expected by a reasonable consumer under the circumstances.”

The New York bill provides a private right of action for injunctive relief and monetary damages by “any person who has been injured by reason of a violation of this article.”

The bill, S5642, has been referred to committee.

Task Force Creation in Texas, Connecticut

In Texas, the Texas Consumer Privacy Act, HB 4518, which contained many of the provisions in the CCPA, failed to pass the state House of Representatives before the end of the legislative session. However, a second bill, HB 4390, which amends the Texas Identity Theft Enforcement and Provision Act by strengthening notification requirements in the event of a data privacy breach, creates the 15-member Texas Privacy Protection Advisory Council to propose data privacy legislation by September 2020. The bill was signed by Governor Gregory Abbott on June 14.

Similarly, in Connecticut, SB 1108, a bill modeled on the CCPA, was referred to committee, then amended to create a consumer privacy task force. The bill was signed by Governor Ned Lamont on July 9, 2019.

Legislators in a number of other states have introduced data privacy bills similar to the CCPA, many of them currently pending before relevant committees. Among the states with pending bills are Pennsylvania (HB 1049); Massachusetts (SB 120); Rhode Island (HB 5930); and Maryland (SB 613). Other states are expected to follow suit as consumers continue to demand greater control over their personal data, especially in the absence of federal legislation addressing the issue.

Ohio Incentivizes Protection Practices

The Ohio Data Protection Act (ODPA) provides legal safe harbor against data breach claims and incentivizes the adoption of strong cybersecurity practices rather than punishing entities for failure to adhere to specific regulations. This safe harbor is provided to entities that create, maintain and comply with a cybersecurity program conforming to an industry-recognized cybersecurity framework recognized by the ODPA. Ohio Rev. Code Ann. § 1354.02.

Initial Guidance

As more states enact laws that significantly expand consumer privacy rights, counsel should be aware of the potential impact on companies located or doing business in any of these states, including:

The disproportionate burden and cost of compliance for small and midsized companies
The technical challenges of reconfiguring a company’s system to process consumer requests for disclosure, delivery, and deletion of their personal information
Incurring significantly higher litigation costs in states that allow for a private right of action by consumers
Statutory requirements on companies to implement new workplace policies and provide internal training to employees -and-
Anti-discrimination protections for consumers who exercise their rights under these laws

These laws are subject to further legislative amendments, agency regulations, and court challenges as both consumer and industry groups seek clarification of and consider further changes. As a result, companies need to anticipate making material revisions to their relevant compliance programs to adjust as these laws evolve.

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Current News and Legal Updates Fall 2019

Evansj5 — Mon, 26 Aug 2019 14:09:20 GMT

NINTH CIRCUIT REINSTATES EMPLOYEES’ SUITS OVER PAYMENT FOR POST-SHIFT INSPECTION PERIODS

EMPLOYEES OF NIKE AND CONVERSE MAY PROCEED with class action suits alleging that the athletic wear companies violated California law by refusing to pay them for time spent during mandatory post-shift security checks, the U.S. Court of Appeals for the Ninth Circuit has ruled. Rodriguez v. Nike Retail Services, 2019 U.S. App. LEXIS 19475 (9th Cir. June 28, 2019); Chavez v. Converse Inc., 2019 U.S. App. LEXIS 19494 (9th Cir. June 28, 2019).

The appeals court reversed two rulings by the U.S. District Court for the Northern District of California entering summary judgment for Nike and Converse in class actions brought by Isaac Rodriguez and Eric Chavez on behalf of employees of retail stores operated by the two companies in California. The suits allege that employees were required to submit to inspections of their belongings after punching out for the day and were not paid for their time in violation of the California Labor Code.

In two separate rulings, the district court held that the employees’ claims are barred by the federal de minimis doctrine, which precludes recovery under the Fair Labor Standards Act (FLSA) for otherwise compensable amounts of time that are small, irregular or difficult to record administratively.Rodriguez and Chaves appealed. The Ninth Circuit stayed proceedings pending the California Supreme Court’s ruling in Troester v. Starbucks Corp., 5 Cal. 5th 829 (Calif. Sup. 2018). In that case, a Starbucks shift supervisor alleged that the company’s failure to pay for closing tasks performed after he clocked out violated state law. Starbucks contended that the time spent was de minimis. The state high court held that the de minimis doctrine does not apply to wage and hour cases brought under state law.

Citing Troester, the Ninth Circuit vacated the entry of summary judgment in both cases and remanded for reconsideration by the district court, rejecting the argument by Nike and Converse that the exit inspections are de minimis even under the Troester holding.

“To the extent Nike urges us to interpret Troester as replacing the federal de minimis doctrine’s 10-minute daily threshold with a state-law 60-second analogue, we decline to do so,” the court said. “Not only would this interpretation read far too much into Troester’spassing mention of ‘minutes,’ but it would also clash with Troester’sreasoning, which emphasized the requirement under California labor laws that ‘employee[s] must be paid for all hours worked or any work beyond eight hours a day.’ We doubt that Troester would have been decided differently if the closing tasks at issue had taken only 59 seconds per day.”

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SUPREME COURT TAKES ON QUESTION OF HEALTH INSURER REIMBURSEMENT UNDER ACA

THE U.S. SUPREME COURT WILL HEAR THREE CASESnextterm that raise the issue of whether health insurers are entitled to reimbursement for $12 billion in losses incurred under the Affordable Care Act (ACA). (Moda Health Plan Inc. v. United States, 2019 U.S. LEXIS 4338 (June 24, 2019); Maine Community Health Options v. United States, No. 18-1023; Land of Lincoln Mutual Health Insurance Co. v. United States, 2019 U.S. LEXIS 4281 (June 24, 2019).

At issue is the so-called risk corridors, a three-year stabilization program set forth in Section 1342 of the ACA intended to encourage insurers to participate in the ACA by capping financial losses. The program required the Secretary of Health and Human Services (HHS) to administer a payment adjustment system for qualified health plans based on the ratio of the allowable costs of the health plan to its aggregate premiums. However, Congress specifically excluded payments under Section 1342 from the HHS budget in fiscal years 2015, 2016, and 2017.

Three insurers—Moda Health Plan Inc., Maine Community Health Options, and Land of Lincoln Mutual Health Insurance Co.—filed separate suits in the U.S. Court of Federal Claims, seeking recovery of money due under the program. The insurers argued that removal of the funding for the risk-corridors program did not negate the government’s responsibility to make the payments since the statute was not amended or repealed.

The Claims Court ruled for Moda but found for the government in the suits filed by Land of Lincoln and Maine Community Health, finding that the removal of funding negated the HHS’ responsibility under the statute. On appeal, the U.S. Court of Appeals for the Federal Circuit reversed with respect to Moda and affirmed on the other two cases, effectively ruling for the government in all three cases.

The insurers filed separate petitions for writ of certiorari; all three were granted on June 24. The cases were consolidated for oral argument, expected to take place in the Supreme Court’s next term, which begins on Oct. 7.

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BAN ON “IMMORAL,” “SCANDALOUS” TRADEMARKS VIOLATES CONSTITUTION, SUPREME COURT RULES

A FEDERAL BAN ON THE REGISTRATION OF “IMMORAL” OR “scandalous” trademarks violates the First Amendment to the U.S. Constitution, the U.S. Supreme Court ruled June 24 in Iancu v. Brunetti, 2019 U.S. LEXIS 4201 (2019). The court’s ruling means that the owner of a clothing line can register the trademark FUCT to identify his products and that other trademarks previously barred from registration on the same grounds may now be registrable.

Citing its June 2017 decision in Matal v. Tam, 137 S.Ct. 1744 (2017), which invalidated the Lanham Act’s ban on registering disparaging marks as discriminatory “on the basis of viewpoint,” the court said, “Today we consider a First Amendment challenge to a neighboring provision of the Act, prohibiting the registration of ‘immoral[]’ or ‘scandalous’ trademarks. We hold that this provision infringes the First Amendment for the same reason: It too disfavors certain ideas.”

The court, in a 6-3 decision written by Justice Elena Kagan, upheld a ruling by the U.S. Court of Appeals for the Federal Circuit reversing a holding by the Trademark Trial and Appeal Board that the proposed trademark was unregistrable under Section 2(a) of the Lanham Act ̧15 U.S.C.S. § 1052, which lists “immoral” or “scandalous” material among the content that is not registrable.

“[E]ven assuming the Government’s reading would eliminate First Amendment problems, we may adopt it only if we can see it in the statutory language. And we cannot,” the court said. “The statute as written does not draw the line at lewd, sexually explicit, or profane marks. Nor does it refer only to marks whose ‘mode of expression,’ independent of viewpoint, is particularly offensive. It covers the universe of immoral or scandalous—or (to use some PTO synonyms) offensive or disreputable—material. Whether or not lewd or profane. Whether the scandal and immorality comes from mode or instead of viewpoint. To cut the statute off where the Government urges is not to interpret the statute Congress enacted, but to fashion a new one.”

Dissenting, Chief Justice John G. Roberts Jr. said that while the “immoral” portion of the statute violates the First Amendment, the “scandalous” portion is susceptible of a narrowing construction. Justice Stephen G. Breyer also wrote in favor of bifurcating the “immoral” language from the “scandalous” portion, noting that a ban on registration of vulgar or obscene marks would not prohibit unregistered use of those marks.

Justice Sonia Sotomayor also agreed with the majority’s reasoning on the “immoral” portion of the statute, but she said that striking down the “scandalous” portion will mean that “the Government will have no statutory basis to refuse (and thus no choice but to begin) registering marks containing the most vulgar, profane, or obscene words and images imaginable.” Justice Breyer joined in Justice Sotomayor’s dissent.

Following the Supreme Court’s ruling, trademark owners are free to register trademarks that consist of or comprise immoral or scandalous matter (if such marks are otherwise registrable). The eagerness of brand owners to do so remains to be seen.

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THIRD CIRCUIT UPHOLDS NATIONWIDE INJUNCTION AGAINST ACA CONTRACEPTION REGULATIONS

THE U.S. COURT OF APPEALS FOR THE THIRD CIRCUIT HAS upheld a preliminary nationwide injunction against enforcement of proposed regulations that would expand the category of employers who can refuse to offer contraceptive coverage to employees on religious or moral grounds (Commonwealth of Pennsylvania v. President United States of America, 2019 U.S. App. LEXIS 20778 (3rd Cir. 2019).

A three-judge panel affirmed an order by U.S. Judge Wendy Beetlestone of the Eastern District of Pennsylvania blocking enforcement of two regulations that would have taken effect on Jan. 14, 2019. Religious Exemptions and Accommodations for Coverage of Certain Preventive Services Under the Affordable Care Act, 83 Fed. Reg. 57,536 (Nov. 15, 2018) and Moral Exemptions and Accommodations for Coverage of Certain Preventive Services Under the Affordable Care Act, 83 Fed. Reg. 57,592 (Nov. 15, 2018). While religious organizations were already exempted from the obligation to provide coverage, the new regulations would apply to non-religious employers, including publicly traded companies.

The regulations, issued by the U.S. Departments of Health and Human Services (HHS), Labor and the Treasury, and finalized in November 2018, stem from an executive order issued in May 2017 by President Donald J. Trump directing federal agencies to consider issuing amended regulations to address “conscience-based objections” to a provision in the Patient Protection and Affordable Care Act (ACA) (Pub. L. No. 111-148, 124 Stat. 119 (Mar. 23, 2010)) requiring employers to provide no-cost birth control coverage to employees. “Promoting Free Speech and Religious Liberty,” Exec. Order No. 13798, 82 Fed. Reg. 21,675 (May 4, 2017)

The Commonwealth of Pennsylvania and the State of New Jersey challenged the rules and moved for preliminary injunctive relief.

Granting the motion, Judge Beetlestone said that the regulations exceed the scope of the authority granted to the three agencies under the ACA and are not authorized by the Religious Freedom Restoration Act (RFRA) (42 U.S.C.S. § 2000bb). Further, she said, Pennsylvania and New Jersey have demonstrated the sufficient requisite likelihood of irreparable harm in the absence of injunctive relief to justify issuance of an injunction.

Affirming, the Third Circuit panel held that the two states are likely to succeed in proving that the agencies did not follow the Administrative Procedure Act’s notice and comment requirements in promulgating the regulations. Further, the panel said, the regulations are not authorized by the ACA or the RFRA.

Finally, the appeals court said, the states have shown that a nationwide injunction, rather than an order limited to the states within the Third Circuit, is necessary to provide relief.

In a similar proceeding, the U.S. Court of Appeals for the Ninth Circuit heard arguments on June 6 in an appeal from a January 2019 ruling by a federal judge in Oakland, California, enjoining enforcement of the same regulations in 13 plaintiff states (California, Connecticut, Delaware, Hawaii, Illinois, Maryland, Minnesota, New York, North Carolina, Rhode Island, Vermont, Virginia, and Washington) and the District of Columbia. Prior to the hearing, the appeals court ordered supplemental briefing by the parties on the impact of the Pennsylvania court’s ruling. California v. United States HHS, 2019 U.S. App. LEXIS 12917 (9th Cir. April 29, 2019).

Both cases are likely to be appealed to the U.S. Supreme Court, regardless of the outcome in the Ninth Circuit.

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RESEARCH PATH: Labor & Employment > Employment Policies > Safety and Health > Articles

Handling I-9 Investigations By Government Agencies

Evansj5 — Wed, 31 Jul 2019 15:45:50 GMT

By: Jacob T. Muklewicz—Kirton McConkie

This article provides guidance on responding to an investigation (i.e., an audit) by a government agency of an employer’s I-9 records. The article mainly focuses on the Department of Homeland Security’s (DHS) Immigration and Customs Enforcement (ICE) agency, which conducts most I-9 government audits.

ALL U.S. EMPLOYERS ARE REQUIRED TO VERIFY THE identity and work authorization of their U.S. employees hired after November 6, 1986, pursuant to the Immigration Reform and Control Act of 1986 (IRCA). Employers should document employment authorization verification on Form I-9. Further, employers are required by law to maintain the forms for government inspections.

Step 1: Who Performs Government Audits?

The following government entities may conduct Form I-9 audits:

Department of Justice’s (DOJ) Office of Special Counsel (OSC) for Immigration-Related Unfair Employment Practices
Department of Labor (DOL)
ICE, which carries out most I-9 government audits

OSC Investigations

The OSC investigates and prosecutes allegations of discrimination under Section 274B of the Immigration and Nationality Act (the Act or INA) (INA § 274B; 8 U.S.C. § 1324b). Investigations focus primarily on allegations of national origin and citizenship status discrimination in hiring, firing, and recruiting for a fee, but they also deal with unfair documentary practices during the I-9 employment verification process.

You must therefore advise employers that they may not specify which documents the employee must present to establish identity and employment authorization as this may lead to charges of discrimination by the OSC. You must also advise employers that they may not over-document (i.e., ask for more documents than necessary to complete the I-9 process) or require re-verification for certain classes of employees, such as lawful permanent residents. This may also lead to charges of document abuse by the OSC.

To read the full practice note in Lexis Practice Advisor, follow this link.

Jacob T. Muklewicz is a shareholder at Kirton McConkie. His practice focuses on business and investor immigration. He helps employers and investors obtain the proper visas for their executive, managerial, and professional personnel and their families. He also counsels foreign nationals regarding the employment-based green card and naturalization process

Public Company Reporting and Corporate Governance

Alainna Nichols — Wed, 31 Jul 2019 15:44:47 GMT

By: Glen Schleyer Sullivan & Cromwell LLP

THIS ARTICLE DISCUSSES RECENT DEVELOPMENTS RELATING to U.S. public company reporting and corporate governance and the outlook going forward. The U.S. election season and the change in administration have resulted in a period of more limited activity by the Securities and Exchange Commission (SEC), which operated with only three commissioners for all of 2016 and only two (less than a quorum) from January through early May of 2017. However, the SEC staff has remained active, and there have been continuing developments in the rollout (and potential roll-back) of disclosure and governance regulations called for by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank or the Dodd-Frank Act) (111 P.L. 203, 124 Stat. 1376).

Intensified Scrutiny of Non-GAAP Financial Measures by SEC Staff

In May 2016, the SEC’s Division of Corporation Finance issued new guidance in the form of Compliance and Disclosure Interpretations (C&DIs) identifying a number of potentially problematic uses of non-generally accepted accounting principles (non-GAAP) financial measures. This 2016 guidance represented a more restrictive stance by the staff, particularly compared to 2010 staff guidance that was widely viewed as emphasizing flexibility. The 2016 guidance was accompanied by public statements by SEC staff members of their intent to increase scrutiny of non-GAAP usage in SEC filings.

As of April 14, 2017, the SEC staff had publicly released more than 500 comments to nearly 250 companies challenging the calculation and presentation of non-GAAP financial measures in filings made subsequent to this guidance. Based on an analysis of these comments, the following have been the most common areas of SEC staff focus during this period, in descending order of frequency:

GAAP measure not given equal or greater prominence (C&DI 102.10)
Inadequate explanation of usefulness of non-GAAP measure
Misleading adjustments, such as exclusion of normal recurring cash expense (C&DI 100.01)
Inadequate presentation of income tax effects of non-GAAPmeasure (C&DI 102.11)
Individually tailored revenue recognition or measurement methods (C&DI 100.04)
Misleading title or description of non-GAAP measure
Use of per share liquidity measures (C&DI 102.05)

As indicated previously, five of these top seven areas relate specifically to concerns addressed by the May 2016 guidance, with the comments usually citing the relevant C&DI, while the other two reflect continued focus on issues (explanation of usefulness and misleading titles) that have long been the subject of staff comment. This demonstrates that the staff’s efforts to monitor and enforce compliance are expanding, rather than replacing, its traditional areas of focus regarding non-GAAP measures.

To read the full practice note in Lexis Practice Advisor, follow this link.

Glen Schleyer is a partner at Sullivan and Cromwell. He has broad experience advising on a variety of registered and unregistered securities offerings, including initial public offerings, secondary offerings, structured transactions, complex debt issuances, and exchange offers. He advises numerous corporate clients on ongoing public company matters, including their 1934 Act periodic reports, Section 13(d) and Section 16 reporting, executive compensation matters, corporate governance, and regulatory compliance.

Health Reimbursement Accounts: Navigating Compliance Landmines

Alainna Nichols — Wed, 31 Jul 2019 15:42:54 GMT

By: Emily D. Zimmer and Lynne S. Wakefield, K&L Gates LLP.

This article discusses how to design and operate compliant employer-sponsored health reimbursement accounts (HRAs) under the Internal Revenue Code (I.R.C.), with a particular focus on the Patient Protection and Affordable Care Act (ACA).

WITH CONTINUED INCREASES IN HEALTH CARE COSTS and the evolution of the post-ACA health care marketplace, HRAs are an increasingly common feature of employers’ benefits packages for both employees and retirees. The increased prevalence of HRAs suggests that for many employers, the cost savings and flexibility that can be achieved through the use of HRAs outweigh the risks arising from the complex legal framework within which HRAs must be designed and administered. Although there are, in fact, many benefits to using HRAs, this is not an area in which employers should tread lightly. There are numerous compliance risks, pitfalls, and traps for the unwary associated with the design and administration of HRAs, particularly under the ACA and related guidance.

Introduction to HRAs

An HRA is a notional account that an employer credits with dollar amounts that may be used to pay or reimburse eligible health care expenses incurred by participants and their eligible dependents. No specific section of the I.R.C. created the concept of HRAs. Rather, Internal Revenue Service (IRS) guidance issued beginning in 2002 describes a particular type of health care expense reimbursement arrangement, referred to as an HRA, that can include a carryover feature, qualifies for tax-favored treatment under I.R.C. §§ 105 and 106, and is subject to the non-discrimination requirements under I.R.C. § 105(h).

HRAs are self-funded group health plans that are subject to the same mandates that apply to traditional major medical plans. However, due to the unique nature of HRAs, the impact of the group health plan mandates on HRAs and traditional major medical plans can be different.

To read the full practice note in Lexis Practice Advisor, follow this link.

Emily D. Zimmer is a partner with K&L Gates focusing her practice on employee benefits, including advising private and public companies with respect to the design, implementation, and administration of qualified and non-qualified retirement plans and welfare benefit programs. She has experience in a wide range of employee benefit and executive compensation issues, including issues related to corporate mergers and acquisitions. Lynne Shore Wakefield is a partner with K&L Gates focusing her practice on employee benefits. Notably, she regularly assists private and public companies with ACA, HIPAA, COBRA, and ERISA compliance; the negotiation of administrative services agreements; the design, implementation, and administration of group health plans, cafeteria plans, wellness programs health savings accounts (HSAs), and health reimbursement arrangements (HRAs); and other aspects of consumer-driven healthcare.

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