Business Vantage Point Blog

Whether a New York limited liability company is a party to and bound by its own operating agreement has been examined in a recent decision by the New York Supreme Court, Appellate Division, First Judicial Department. The opinion distinguished New York’s Limited Liability Company Act from the Revised Uniform Limited Liability Company Act (RULLCA), ultimately delineating a bright-line rule: An LLC organized under the laws of the State of New York that has not executed its own operating agreement is not a party to, and therefore cannot be bound by, such operating agreement. Background In Wythe Berry v. Goldman, a dispute arose between two real estate entrepreneurs, Yoel Goldman and Zelig Weiss, relating to the development of a hotel in New York. Pursuant to Section 11 of the Fifth Amendment to the operating agreement of the developers’ primary operating company, Wythe Berry LLC, Goldman and Weiss agreed that any dispute arising under the operating agreement would be determined by the American Arbitration Association. Significantly, the Fifth Amendment only refers to the members — including Goldman and Weiss, in their individual capacities as members — as parties to the agreement. Accordingly, the signature block of the Fifth Amendment made no reference to Wythe Berry. When a dispute later arose in connection with financing the hotel development, Goldman commenced arbitration against Weiss and several of Weiss and Goldman’s entities, including Wythe Berry, pursuant to the arbitration clause in the Fifth Amendment. In response, the petitioner entities, including Wythe Berry, filed a petition to stay the arbitration pursuant to New York Civil Practice Law and Rules Section 7503(b), which allows courts to stay arbitration proceedings on the basis that a valid agreement does not exist. In opposing the petition, Goldman presented a contract referred to as the “Side Agreement,” wherein Weiss and Goldman agreed that the Fifth Amendment would be the governing agreement should any dispute arise between Goldman and Weiss in connection with the hotel development. Specifically, Goldman cited a provision in the Side Agreement that he argued expressed an intent to bind Weiss and Goldman, as well as certain entities registered under their names, such as Wythe Berry, to the Side Agreement. As translated from Hebrew to English, the relevant provision in the side agreement provided that “Goldman and Weiss ‘hereby acknowledge, both on our own behalf and on that of all the corporations registered under our names, whether in whole or in part, and that have any relevance or connection to the [hotel] land and building, without exception — fully acknowledge … everything that is written’ in the Side Agreement. The Side Agreement further provide[d] that the ‘main and principal agreement that shall be determinative and dispositive between us in any case of doubt, dispute, or … conflict that may perhaps arise between us … shall be … [the] [Fifth Amendment], which was signed by us on the said date.’”1 Like the Fifth Amendment, however, the Side Agreement was not executed by Wythe Berry. The lower court held that Wythe Berry had agreed to arbitrate, reasoning that the Side Agreement incorporated the Fifth Amendment’s arbitration clause and that Weiss and Goldman had acted on behalf of Wythe Berry when they signed the Side Agreement. Legal Analysis on Appeal The Appellate Division relied on a comparative analysis to illustrate how the New York LLC Act diverges from the RULLCA on the issue at hand. The appellate court explained that under the RULLCA, an LLC would be bound by its operating agreement, even if the LLC had not itself manifested assent to said agreement. Under Delaware law, for example, Section 18-101(9) of the Delaware Limited Liability Company Act explicitly provides that a “limited liability company … is bound by its limited liability company agreement whether or not the limited liability company … executes the limited liability company agreement.” In sharp contrast to Delaware’s law and the RULLCA, the court explained that under the New York LLC Act, an “operating agreement” is defined as a written agreement among the members of an LLC that concerns the business of the LLC and the conduct of its affairs.2 Moreover, because the LLC and its members exist as separate legal entities pursuant to Section 203(d) of the New York LLC Act, an LLC that does not execute its own operating agreement is not a party to such agreement. The court further explained that the New York LLC Act does not otherwise provide that operating agreements necessarily govern the relationship between an LLC and its members. Therefore, unlike Delaware and other states that have adopted the RULLCA, the operating agreement of an LLC organized under the New York LLC Act (1) can be exclusively among the members of the LLC and (2) a nonsignatory LLC is a nonparty to any such operating agreement among members.3 The Appellate Division rejected the lower court’s determination that Wythe Berry’s acknowledgment of the Side Agreement manifested an intent for Wythe Berry company to be bound by the Fifth Amendment’s arbitration clause. Rather, the appellate court determined that the more consistent interpretation of the Side Agreement is that Wythe Berry merely acknowledged that the Fifth Amendment would be the governing agreement between Goldman and Weiss, the signatories to the Side Agreement. Because Wythe Berry did not sign the Fifth Amendment and because its mere acknowledgment of the side agreement did not constitute “a clear and unequivocal manifestation of an intent to arbitrate”4 by Wythe Berry, the court determined that Wythe Berry was not bound by the arbitration provision under the Fifth Amendment. A Bright-Line Rule Emerges In Wythe Berry, the Appellate Division made one thing very clear: Under the New York LLC Act, an LLC shall not be bound by its operating agreement unless it signs the agreement separately from the members themselves. Therefore, if it is the intent of the parties that an LLC formed in New York be bound by the same contractual rights and duties as the members under the operating agreement, then it is imperative that the LLC be a signatory to its operating agreement. 1 Wythe Berry v. Goldman (230 AD3d 1081 [1st Dept 2024]). 2 New York Limited Liability Company Act Section 102(u). 3 Wythe Berry v. Goldman. (230 AD3d 1081 [1st Dept 2024]). 4 Id.

This is the second part of a two-part series on bankruptcy options for subsidiary or affiliate winddowns. Part one provides an introduction and discusses the benefits and drawbacks of Chapter 7 of the U.S. Bankruptcy Code. Part two discusses the benefits and drawbacks of Subchapter V. Benefits and Drawbacks of Subchapter V The intent of Chapter 11 of the U.S. Bankruptcy Code’s Subchapter V is to provide a streamlined, cost-efficient process by which small businesses can reorganize under Chapter 11 of the Bankruptcy Code. Subchapter V allows small businesses to utilize the benefits of a Chapter 11 filing without expending substantial funds. Although Subchapter V was enacted ostensibly to allow small businesses to inexpensively and quickly reorganize, it may also be used to sell the debtor’s assets and winddown operations. To qualify for Subchapter V, a debtor must be engaged in commercial or business activities (per the courts, a low bar), at least 50% of the debtor’s debt must be business-related, and the debtor must have less than $7.5 million in non-contingent secured and unsecured debts. The primary benefit of Subchapter V bankruptcy as compared to Chapter 7 bankruptcy is that the ownership or management remains in control of the debtor pursuant to Section 1107 of the Bankruptcy Code. Moreover, a Subchapter V is substantially more cost-effective than a traditional Chapter 11 case for all of the aforementioned reasons. The primary downside, as compared to Chapter 7, is that it will be more expensive since the debtor remains in control and must administer the estate, arrange and obtain approval of the sale process, incur the cost of preparing a proposed plan, negotiate with creditors, and pay the fees of a Subchapter V trustee. Subchapter V modifies or does away with many of the requirements and/or hurdles present in most Chapter 11 cases with the intent to effectuate a less costly and quicker process. Among other things, in a Subchapter V, there is typically no creditors’ committee to drive up costs. In a Subchapter V, as in most Chapter 11 bankruptcies, existing ownership or management continues to operate its business and a traditional bankruptcy trustee is not appointed to take control of and manage the debtor’s business. Instead, a Subchapter V trustee is appointed. However, the Subchapter V trustee does not have the same powers as the Chapter 7 or Chapter 11 trustee. Instead, they act as something akin to a mediator, facilitating negotiations between the debtor and its creditors to attempt to achieve a fully consensual Subchapter V plan. Although in some cases the Subchapter V trustee’s role may be expanded, the Subchapter V trustee does not have the same broad powers as the Chapter 7 or Chapter 11 trustee to investigate causes of action, operate the debtor’s business, receive estate property, review and object to claims, and propose a Chapter 11 plan. The Subchapter V trustee’s fees must be paid out of the bankruptcy estate. Subchapter V confers significant benefits upon debtors. For example, the Subchapter V debtor is not required to file a disclosure statement in connection with its plan, which can greatly reduce the expense of a Chapter 11 filing. Subchapter V also does away with the absolute priority rule, meaning that ownership may retain its equity interests in the debtor even where senior creditors are not paid in full. Rather than pay all unsecured creditors in full before equity is permitted to retain its interest, a Subchapter V debtor need only propose a plan that pays unsecured creditors all projected “disposable income” over three to five years. This is a substantial benefit for reorganizing small businesses although less so for liquidating debtors. Further, unlike traditional Chapter 11 bankruptcies, creditors cannot propose competing plans, so the debtor remains fully in control of the plan process. Finally, although one of the fundamental goals of a Subchapter V bankruptcy is to obtain a fully consensual plan, the Subchapter V debtor can confirm the Subchapter V plan without obtaining the consent of any creditors. In contrast, in a typical Chapter 11 bankruptcy, where the debtor proposes to impair creditors’ rights, the debtor must obtain the approval of at least one impaired class of creditors. However, in exchange for such benefits, Subchapter V debtors are expected to move quickly and, among other things, must propose a plan within 90 days of filing. Missing the plan deadline can result in dismissal or forced conversion to a Chapter 7 bankruptcy. Because of these tight deadlines, ownership should not put an entity into Subchapter V without a preformulated plan and strategy already in hand so that the bankruptcy court can establish and approve a sale process early in the case. Generally, the sale process would be similar to the sale process described in the first part of our series regarding Chapter 7, but the debtor remains in control rather than a bankruptcy trustee. The debtor will typically market its assets for sale, identify an initial bidder, obtain the bankruptcy court’s approval of the bidding procedures, and then obtain the bankruptcy court’s approval to sell the assets to the winning bidder. Along the way, interested parties have an opportunity to object to the process and the sale. In Subchapter V, the debtor’s efforts to sell its assets to an insider may face increased scrutiny from creditors, interest holders and the bankruptcy court since the debtor remains in control of the process. However, so long as the court approves the sale, the court finds that the process is fair, the debtor maximizes value for the bankruptcy estate, and the sale is made in good faith, ownership, management and any buyer of the assets should largely be insulated from exposure to any post-sale claims that they breached their fiduciary duties or that there was a fraudulent transfer. Ultimately, although the debtor remains in control of the process, it remains an open, court-supervised sale process that presents ample opportunity for interested parties to object. As such, any exposure arising from a sale of the debtor’s assets should be de minimis. It should be noted that just as in a Chapter 7 case, the debtor-in-possession in a Chapter 11 case has the power and, indeed, an obligation to investigate potential claims against third parties, including potential claims against directors and officers for prepetition breaches of fiduciary duties. However, in the absence of a creditors’ committee, a creditor is much less likely to challenge such a decision. Nevertheless, a particularly invested or active creditor could elect to challenge that decision and make the process more costly and drawn out. Consult with Bankruptcy Counsel Any parent or management considering how to most effectively dissolve or wind down an affiliate or subsidiary, particularly when considering whether or how to first transfer valuable assets out of the dissolving entity, should consult with bankruptcy counsel for a fuller evaluation of whether a Chapter 7 or Subchapter V bankruptcy makes sense. Although a non-bankruptcy dissolution or winddown may make sense for some entities, there are circumstances in which a Chapter 7 or Subchapter V bankruptcy will be more desirable, particularly where liabilities exceed assets but there nevertheless are valuable assets to be administered.

This is the first part of a two-part series on bankruptcy options for subsidiary or affiliate winddowns. Part one provides an introduction and discusses the benefits and drawbacks of Chapter 7 of the U.S. Bankruptcy Code. Part two will discuss the benefits and drawbacks of Subchapter V. Navigating the hazards of an affiliate or subsidiary winddown is no easy task, and extensive planning is needed to minimize any potential liabilities. When a parent company is contemplating the dissolution or winddown of an affiliate or subsidiary but also wants to transfer assets out of the entity prior to dissolution or winddown, bankruptcy can provide a feasible mechanism for transferring such assets free and clear of liabilities while protecting the parent, managers and transferee from potential fiduciary or fraudulent transfer claims. Although such a process can be achieved through a traditional Chapter 11 bankruptcy, such proceedings can be expensive. Where the dissolving entity has limited assets and liabilities, a bankruptcy proceeding under either Chapter 7 or Chapter 11’s Subchapter V of the U.S. Bankruptcy Code can provide a less costly and more efficient means of effectuating a free and clear transfer of assets while limiting any potential resulting liabilities. Under either process, the assets can be sold in an open, court-supervised process that should reduce, if not eliminate, any potential exposure. Making the Appropriate Decision for Your Business Choosing between Chapter 7 or Subchapter V is ultimately one of control versus cost. The primary benefit of Chapter 7 is that it is relatively cost-effective, with the catch that management cedes control of the dissolving entity to a Chapter 7 trustee who is charged with, among other things, liquidating available assets through a potential sale. A Subchapter V bankruptcy will entail significantly more cost than Chapter 7, but provides a less expensive, more efficient alternative to a traditional Chapter 11 that allows existing management to retain control of the bankruptcy and sale process — provided the dissolving entity meets the qualifications for filing a Subchapter V. Benefits and Drawbacks of Chapter 7 Chapter 7 of the Bankruptcy Code provides a liquidation process in which an independent trustee is appointed to administer the liquidation by marshaling all available assets, liquidating them and distributing the available funds to creditors pursuant to the absolute priority scheme of the Bankruptcy Code. The primary benefit of a Chapter 7 filing is cost. The debtor files a bankruptcy petition, its schedules of assets and liabilities, a statement of financial affairs, and a schedule of executory contracts and unexpired leases. The debtor must also provide the Chapter 7 trustee with recent tax returns and turn over its books and records. In addition, a representative of the debtor will be required to appear at a meeting of creditors during which the Chapter 7 trustee and creditors may question such representative under oath regarding the assets and liabilities of the debtor. Otherwise, the Chapter 7 trustee is charged with administering the bankruptcy estate, and the costs will be paid out of the money realized through the liquidation. Generally speaking, commencing a Chapter 7 bankruptcy is relatively inexpensive. The most significant downside of Chapter 7 is that the debtor immediately loses control of the process, and the company, upon filing. Instead, the Chapter 7 trustee is promptly appointed to administer the bankruptcy estate. Thus, if a parent or management puts an entity into Chapter 7, they will have no control over the sale process which is controlled by the Chapter 7 trustee and subject to bankruptcy court approval. Individual debtors most often utilize Chapter 7, but it is also frequently utilized by corporate debtors where there is no possibility of a restructuring. In all bankruptcy proceedings, distributions are made to creditors in accordance with the absolute priority scheme outlined in Section 507 of the Bankruptcy Code, with the administrative costs of the bankruptcy satisfied first, followed by secured claims, priority unsecured claims, general unsecured claims and finally, equity holders to the extent there is anything left over. Under the absolute priority rule, each class of creditors must be paid in full, in order of priority, before distributions may be made to the next junior class. As previously mentioned, the Chapter 7 trustee fees are paid from the funds realized by liquidating the debtor’s assets. The debtor is not required to pay the Chapter 7 trustee who is entitled to a commission based on the value of assets marshaled, liquidated and distributed to creditors. In fact, upon filing a Chapter 7, other than in exceptionally rare circumstances, a corporate debtor’s operations terminate, and the debtor is out of business as of the filing date. Unlike an individual debtor, a corporate Chapter 7 debtor does not receive a discharge of its debts following liquidation, as discharge is only available to individual Chapter 7 debtors. Nevertheless, through the Chapter 7 process, all, or most, of a corporate debtor’s assets are typically liquidated with the proceeds distributed to creditors, meaning that any post-bankruptcy actions taken against the debtor would be of little value to claimants and in most circumstances would be unnecessary to defend in litigation. A Chapter 7 trustee may conduct a sale of assets pursuant to Section 363 of the Bankruptcy Code, which permits a trustee, with the court’s permission and oversight, to sell a debtor’s assets free and clear of all liens and encumbrances. Typically, such a sale is conducted pursuant to an auction and bidding process in which the Chapter 7 trustee initially negotiates a baseline bid with a stalking horse buyer. The sale must be conducted pursuant to procedures approved by the bankruptcy court to obtain the highest potential sale price. Once the bankruptcy court approves the process, the Chapter 7 trustee will conduct the auction, select the highest and best bid, and return to the bankruptcy court for approval of the sale. Creditors and interest holders have at least two opportunities to object. First, such parties may object to the sale process and bidding procedures proposed by the Chapter 7 trustee. Second, such parties may object to the sale once the winning bidder is determined. Although less common, it is also possible for a Chapter 7 trustee to conduct a private sale of a debtor’s assets pursuant to Section 363 without subjecting them to a bidding process. Such private sales are typically entered into where there is limited interest in the assets, and no competing offers are forthcoming. A private sale remains subject to the scrutiny and approval of the bankruptcy court. As with an auction, creditors and other interested parties must have an opportunity to object to such a sale, which remains subject to notice and a hearing. Private sales, without a bidding process, are much more susceptible to objections based on arguments that the Chapter 7 trustee did not sufficiently market the assets or that the sale price does not represent fair market value. It is also sometimes the case that once the trustee files a motion for approval of a private sale, an interested party comes forward with a higher and better offer, at which point the trustee may pivot to a private sale to the higher bidder or an auction process. Chapter 7 and Your Board In a Section 363 sale, it is possible for an insider — such as a parent, affiliate, stockholder or board member — to bid on the assets. It may even be the case that such an insider may act as the stalking horse bidder. Such a process may be subject to greater scrutiny, and there remains the possibility that another interested party will submit a higher bid and walk away with the assets. It should be noted that for a Chapter 7 trustee to proceed with a Section 363 sale, there will need to be sufficient value in the assets to justify the trustee’s time and expense. This is because the trustee is compensated based on the value of assets liquidated and distributed to creditors. Such a sale process must realize sufficient value to cover the trustee’s commission, the fees of the trustee’s professionals, and the cost of administering the sale process — yet leave enough on the table for a meaningful distribution to creditors. However, such distributions can be as little as pennies on the dollar. Ultimately, it is up to the Chapter 7 trustee to make a value determination and decide whether the cost of a sale process is justified. Alternatively, the trustee can elect to abandon assets of minimum value to the bankruptcy estate. In a Chapter 7 bankruptcy, ownership should be more or less insulated from any claims for breaches of fiduciary duties or fraudulent transfer relating to the sale of the assets because the sale process is public and is subject to the oversight of the bankruptcy court. The organization’s board members would have no involvement with the sale or bidding procedures. Because creditors and other interested parties, such as the shareholders, have an opportunity to object to the sale process and the sale itself, and because the sale is subject to the oversight and approval of the bankruptcy court, following a Section 363 sale, creditors and shareholders generally do not have any viable claims for fiduciary breaches or fraudulent transfer. In addition, if the bankruptcy court finds that the sale was made for fair consideration, it will insulate the sale from any fraudulent transfer claims. Similarly, if the bankruptcy court finds that the sale was consummated in good faith, it further protects the sale from any potential unwinding on appeal by a disgruntled party. Stay tuned for part two of our two-part series.

In merger and acquisition (M&A) transactions, parties commonly include a post-closing mechanism to adjust the purchase price to accurately reflect the agreed value of the acquired asset. Many of these mechanisms are accounting-related and require specific calculations. While practitioners typically describe detailed methods for these calculations in the purchase agreement, disputes may still arise, making it crucial for the parties to include clear provisions on how such disputes should be resolved. In some cases, parties opt for arbitration, while in others, they choose to have accounting-related disputes handled by an expert. A recent Delaware Superior Court opinion emphasizes the importance of clarity and precision in drafting these dispute resolution provisions, particularly regarding the scope and authority of the decision-maker and the availability of judicial review. In Pazos v. AdaptHealth, plaintiff Cynthia Pazos, founder and former CEO of Diabetes Management and Supplies LLC, sold her company to the defendant, AdaptHealth LLC, an operator of a network of medical equipment companies providing products and services to outside-hospital patients. The membership interest purchase agreement (MIPA) included post-closing purchase price adjustment calculations, specifically to account for the closing working capital of the company. The MIPA also contained dispute resolution provisions for disagreements about the closing date statement, stating that if the parties failed to agree, any disputed amounts would be submitted to independent public accountants for determination. The accountant’s determination would be deemed final and binding, subject to review only in the case of a “manifest error.” Notably, the MIPA explicitly stated that the accountant would act as an expert, not an arbitrator. In this case, after the accountant made its determination, the plaintiff, dissatisfied with the result, filed a complaint in Delaware court, alleging that the accountant had committed several manifest errors. In response, AdaptHealth argued that the Federal Arbitration Act should apply to the court’s review, contending that the dispute resolution provision functioned as an arbitration clause. The court disagreed, clarifying the difference between arbitration and expert determination provisions. Using the “authority test,” the court concluded that the provision in question was an expert determination one because its scope was limited to resolving cost adjustment disputes. Additionally, the use of the term “expert” rather than “arbitrator” signaled the parties’ clear intent. Through this ruling, the court clarified that practitioners must be deliberate and cautious when drafting dispute resolution clauses, ensuring the parties’ intentions are explicitly reflected. Having established that the accountant’s role was to act as an expert and confirming the court’s limited oversight role based on the clear language of the MIPA, the court also examined the definition of “manifest error” in the context of expert determinations. The plaintiff objected to the accountant’s exclusion of certain receivables from the working capital calculation, arguing that these exclusions constituted manifest errors. The court disagreed, concluding that a manifest error would exist only where the expert made a plain and obvious error and the record demonstrated a strong reliance on that error. The court also determined that an expert’s decisions, such as which documents to credit or discredit, fall within that expert’s contracted-for authority. As such, the manifest-error standard sets a high bar for overturning an expert’s determination. This case serves as a reminder that precision in drafting dispute resolution provisions is critical in M&A transactions. Parties must clearly define the roles, scope and authority of the individuals resolving accounting-related disputes, whether they choose arbitration or expert determination. The failure to do so can be detrimental to one’s ability to bring a claim in court. Furthermore, practitioners should be aware of the high threshold for establishing “manifest error” in expert determinations, as courts are unlikely to intervene in decisions that fall within the expert’s contractual authority.

Ensuring that all requirements of Kahn v. M&F Worldwide (MFW)1 are complied with is paramount in order for the business judgment rule to apply to transactions involving a controlling stockholder who receives a non-ratable benefit at the expense of the minority stockholders. In case you missed it, the Delaware Supreme Court rendered a decision on this very issue earlier this year in In re Match Group Derivative Litigation.2 The ruling held that entire fairness is the presumptive standard of review where (1) a controlling stockholder stood on both sides of a transaction with the controlled corporation and received a non-ratable benefit and (2) the defendant failed to satisfy all of the requirements set forth in MFW to change the standard of review to business judgment. What the Chancery Court Found IAC/InterActiveCorp incorporated Match Group Inc. in 2009 to hold its Match.com business and other dating platforms. A portion of Match’s common stock was sold in 2015 to the public in a public offering, and in 2019, IAC announced in a letter to its stockholders that it was considering separating from Match. Match’s board appointed three of its directors to a “separation committee” to assess a proposed transaction. One of the directors appointed to the separation committee was IAC’s former chief financial officer (CFO), who had worked for IAC from 1999 to 2012, including seven years as the CFO. The separation committee retained its own legal counsel and financial adviser. The proposed transaction envisioned creating two separate public companies and eliminating Match’s dual-class capital structure via a reverse spin-off (the separation). After reaching a final agreement with IAC, the separation committee recommended that Match’s board approve the separation. The board approved the separation and submitted it to a vote of the stockholders, who voted in favor of the separation. At the time, IAC held 98.2% of Match’s voting power through ownership of 24.9% of Match’s common stock and all of Match’s Class B high-vote common stock. Certain former Match stockholders challenged the separation in the Delaware Court of Chancery, claiming that the separation was a conflicted transaction where IAC, as Match’s controlling stockholder, stood on both sides of the transaction and obtained significant non-ratable benefits to the detriment of Match and its minority stockholders. The defendants made a motion to dismiss. The Court of Chancery held that the defendants satisfied the requirements set forth in MFW for the application of the business judgment rule and dismissed the case, finding that the separation conditioned the transaction on the approvals of a fully empowered, well-functioning special committee of independent directors and the uncoerced, fully informed vote of the minority stockholders. What the Delaware Supreme Court Found Following the transactions consummated in connection with the separation, the Delaware Supreme Court found that: (1) the former minority stockholders of Match owned common stock in a widely held and highly leveraged corporation (referred to herein as New Match), subject to short-term restrictive governance provisions; and (2) the former stockholders of IAC received most of the interest in New Match, as well as shares in a cash-rich corporation with little to no debt that was spun off from IAC in connection with the separation. After reviewing the development of Delaware case law related to judicial review of controlling stockholder transactions, the court found that entire fairness is the standard of review in transactions between a controlled corporation and a controlling stockholder when the controlling stockholder receives a non-ratable benefit, except that, under MFW, the business judgment rule applies when all of the following are satisfied: A controlling stockholder conditions a transaction from the start on the approval of both a special committee and a majority of the minority stockholders. The special committee is independent. The special committee is fully empowered. The special committee meets its duty of care. The vote of the minority is informed. There is no coercion of the minority.   The defendants argued that MFW and the cases that preceded it involved freeze-out mergers and that outside the context of a freeze-out merger, traditional principles of Delaware corporate law recognize that any one of the following three cleansing mechanisms suffices to invoke the business judgment standard of review in a conflicted transaction: approval by (1) a board with an independent director majority; or (2) a special committee of independent directors; or (3) a majority of the unaffiliated stockholders. According to the defendants, the rule has always been that, other than freeze-out mergers, any one of such procedural devices described in (1) through (3) above could invoke business judgment review in controlling stockholder transactions. The court rejected that argument and held that the requirements set forth in MFW are not limited to freeze-out merger transactions and that all requirements of MFW must be satisfied for the business judgment rule to apply where a controlling stockholder stands on both sides of a transaction and receives a non-ratable benefit. The court further found, for purposes of applying the business judgment rule, that when a controlling stockholder transacts with the corporation and receives a non-ratable benefit, the special committee created and empowered to oversee and consider such a conflicted transaction must be fully independent — not just a majority independent. The court noted that a controlling stockholder’s influence is not disabled when the special committee is staffed with members loyal to the controlling stockholder. In the present case, the court found that the complaint pleaded facts that raise a reasonable doubt about the former CFO’s independence from IAC and, therefore, the entire separation committee’s independence. Accordingly, the court reversed the Court of Chancery’s decision to apply the business judgment rule, dismissed the plaintiffs’ claims, and held that entire fairness remains the standard of review. Moving Forward All of MFW’s requirements must be satisfied in order for the business judgment rule to apply when a controlling stockholder stands on both sides of a transaction with the controlled corporation and receives a non-ratable benefit. Companies should ensure that all members of a special committee created and empowered to oversee and consider a transaction involving a controlling stockholder that receives a non-ratable benefit are independent. 1 88 A.3d 635 (Del. 2014). 2 315 A.3d 446 (Del. 2024).

As deal activity is expected to rise heading into the fourth quarter, companies of all sizes may be gearing up to negotiate transactions with new and existing lenders. From startups seeking a first line of credit to longstanding enterprises aiming to restructure existing debt, understanding the nuances of loan negotiation is crucial for securing favorable terms and ensuring long-term financial stability. Representations and Warranties As in other transactions, the representations and warranties requested by a bank or other lending institution serve as an initial snapshot of a company and offer baseline insights into a company’s function and operations. Representations provide assurances about certain aspects of the business, such as its financial health, legal standing, operational status (e.g., the company is in compliance with all relevant laws and regulations) and the collateral against which the lender is extending the facility (e.g., the company has good title to its real property and valid ownership of its equipment or other inventory). Warranties constitute the company’s guarantee of the truthfulness of the representations, promising recourse to a lender in the event that any representation is found to be untrue or inaccurate. Representations and warranties allocate risk between the parties. In a loan transaction, these terms are part of the consideration for a lender’s agreement to extend credit and stand as a legal touchpoint to the perceived creditworthiness of a company. When negotiating these provisions, a company should consider the following concepts to shift risk away from its own operations and officers. While lenders are hesitant to remove representations from a credit agreement altogether, there may be room to qualify their scope: Knowledge. Knowledge qualifiers limit the scope of the borrower’s assurances to what it actually knows, or should reasonably know, at the time of the transaction. These qualifiers may commonly appear in representations regarding compliance with laws, the accuracy of financial statements and the absence of undisclosed liabilities. The incorporation of knowledge qualifiers not only serves the purpose of shifting risk away from a company, but it may also encourage more thorough diligence on the part of both borrower and lender to ensure that all parties understand the company’s status quo and the potential risks of the transaction. Materiality. Materiality qualifiers limit the scope of the borrower’s assurances to only those issues that are deemed “material,” essentially defining the threshold above which certain facts or conditions become significant enough to warrant disclosure or affect the deal (e.g., the company is in compliance with all relevant laws in all material respects). Negotiating the incorporation of materiality qualifiers may prevent minor or insignificant issues from becoming points of contention. A counterpoint, however, is the inherent ambiguity in what may rise to the level of “material.” As an alternative approach, lenders are typically receptive to materiality qualifiers set using dollar thresholds that strike a balance of providing sufficient protection to the lenders without placing too much burden for disclosure on the company. Lenders may also accept such qualifiers when the materiality is determined by the lenders at their sole discretion. Duration and Survival. Capping the duration of representations is another way to mitigate the company’s future liability in the event that certain items become untrue at a later point in the term of the loan. Covenants Covenants codify a company’s operational commitments during the life of the credit. Their primary function is to establish a framework to ensure that the company continues to operate in a way that allows it to repay the loan on time. These are typically the most fertile ground for negotiation and are almost entirely composed of business, not legal, points. Affirmative covenants require a company to take certain actions or maintain specific standards (e.g., financial reporting, insurance requirements, compliance with laws, payment of taxes). Negative covenants, on the other hand, restrict or prohibit certain actions in order to prevent behaviors that could jeopardize the financial position for which the lender has underwritten the loan (e.g., limitations on additional indebtedness, asset sales, payment of dividends, changes to management structure, mergers and acquisitions). A company often finds success in its positions when it can clearly demonstrate why it needs a particular type of accommodation — from extended delivery periods to increased debt baskets — based on situational or historical data and other projections. Another effective tactic is to propose practical alternatives to covenants as drafted. For instance, a borrower might consider suggesting a tiered approach for debt limits, where limits become more restrictive only upon the basis of eventual financial performance or other milestones. Events of Default Events of default are predefined conditions that, once met, trigger a lender’s right to exercise remedies. These typically include payment defaults, breaches of covenants, insolvency, misrepresentations or cross-defaults with other facilities from the same lender. Lenders generally seek to establish events of default that cover both the borrower as well as any guarantor of the facility. While many lenders refuse to make concessions in this section of a credit agreement, borrowers may find a foothold by negotiating cure periods for certain defaults or pushing to increase the dollar thresholds for others (e.g., related to judgments, claims, litigation and employee pension plans). Note that a “default” is the first component of an “event of default,” which is usually deemed to have occurred at the expiration of any grace or cure period following a company’s initial noncompliance with a provision of the credit agreement. Many lenders view proper events of default (unlike defaults) as incapable of being “cured” once they occur. Securing a Positive Relationship with Lenders The outcome of negotiations varies by the type of lending institution, the relative size of the facility, the value of the collateral and other risk factors unique to the company. By thoroughly researching the lender, understanding the terms of the loan, and effectively communicating business needs and expectations, a company can significantly enhance its bargaining position. In loan transactions, negotiations are not just about striking the best deal possible at closing, but also setting the stage for a positive working dynamic with the lender that can accommodate what may become a long-term relationship.

Artificial intelligence (AI) is everywhere these days — integrated into our personal and professional lives — whether we realize it or not. AI solutions enhance user interactions, improve daily life and drive technology development. Programmers and developers grasp AI and machine learning, but the intricate workings often remain a mystery to most users who interact with AI-enabled technologies for practical, real-time applications. For example, with an AI-powered neural network that identifies images, like facial recognition, most people find it challenging to understand exactly how the system identifies images. In the area of intellectual property law, AI serves as a key platform for innovation. Unlike tangible inventions such as, for example, foldable smartphone screens, AI’s abstract nature makes it difficult to patent. The U.S. Patent and Trademark Office often classifies AI-enabled technologies as abstract and unpatentable. To increase the likelihood of patent approval for an AI-enabled invention, it is essential to lay a clear strategy to prepare for the inevitable view that the invention is abstract. For example, effective strategies highlight specific technical advancements in areas such as AI training methods, data processing, optimization techniques or new applications designed to solve well-known technical problems. Additionally, demonstrating how an AI-enabled network enhances performance, efficiency or accuracy in particular tasks can help establish a concrete use. One effective strategy involved the patenting of AI-enabled computer vision technology, which used an infinite training loop to train a convolutional neural network with 2D synthetic images captured from a 3D computer-generated synthetic image. The training loop developed models capable of accurately identifying objects shown in real-world photographs. The infinite training process does not exhaust data; instead, it evolves, ensuring that the training loop continuously encounters new data. In this approach, the convolutional neural network is trained continuously with updated data sets of synthetic, computer-generated images, so the deployed model met precision and recall goals of greater than 95%. This result shows that the deployed model successfully and accurately identifies most of the true positives and true negatives of the objects shown in digital images and video. For patenting with AI technology, it is best to chart a specific path to prepare for eligibility challenges, which will be rigorously assessed under Section 101 of the U.S. Patent Act, particularly in light of significant court decisions such as the U.S. Supreme Court’s 2014 opinion in Alice v. CLS Bank International.

In the contract-centric world of limited liability companies (LLC), the Delaware Court of Chancery’s decision last month in Gurney-Goldman v. Goldman, C.A. No. 2023-1124-JTL (Del. Ch. July 12, 2024), serves as a stark reminder of the perils of informality, the consequences that can befall businesses failing to formalize management succession, and the importance of clear contracting in connection with all things LLC. While the case centers around a factually intricate dispute among siblings who inherited a vast real estate empire, the legal principles highlighted by the Court of Chancery resonate beyond the realm of familial discord, underscoring the importance of contractual specificity in matters of LLC management and succession planning. Transferring Management of an LLC The Gurney-Goldman saga unfolded against the backdrop of a sophisticated network of companies, many of which constituted LLCs lacking formal operating agreements or clear documentation regarding the transfer of membership interests. Two siblings, acting as de facto managers of the relevant LLCs, were the “decision-makers” on behalf of the sibling group. However, upon the death of one of these “decision-making” siblings, his son sought to step into his father’s managerial role. The remaining three siblings resisted, resulting in protracted litigation during which the Court of Chancery had to navigate the ambiguous management structure of the LLC in dispute. Relying on the default statutory guidance of the Delaware Limited Liability Company Act (LLC Act, 6 Del. C. § 18-101, et. seq.), the parties’ course of conduct, and relevant estate law, the Court of Chancery concluded the son could not just assume the role of manager upon his father’s death. One of the key takeaways from Gurney-Goldman is that the transfer by inheritance of a membership interest of a manager of an LLC upon the death of that member/manager does not constitute the transfer of the managerial rights of the deceased member. This general policy, grounded in the “pick-your-partner” principle, safeguards existing members from having new co-managers foisted upon them without consent or advance contractual notice in the LLC’s governing instrument. Thus, while succession planning for members of an LLC is important, transfer of management of the LLC does not occur absent an explicit provision in the governing operating agreement. As Gurney-Goldman demonstrates, the absence of such explicit contractual forethought can lead to protracted and costly litigation. Section 18-705 of the LLC Act Of additional interest is the Gurney-Goldman analysis of Section 18-705 of the LLC Act, which governs the rights of personal representatives of a deceased member to exercise the member’s rights. The Court of Chancery notes the statute circumscribes these rights, which are more akin to those of an assignee than a full-fledged member, without the transfer of any “governance rights” the deceased member had in the LLC: When a member of an LLC transfers its member interests to another person, then by default under the LLC Act the recipient of the interest does not automatically become a member. The recipient only holds the rights of an assignee, which consist of the economic rights associated with the interest, plus the power to sue derivatively. The assignee does not receive any of the governance rights associated with the interest, nor does an assignee have the right to seek books and records or seek statutory dissolution. (Internal citations removed.) (Emphasis added.)1 This distinction underscores the limitations inherent in Section 18-705, indicating that personal representatives, while granted certain rights, do not inherit the full spectrum of privileges enjoyed by active members. Again, this is an example of where clear documentation in an LLC agreement regarding succession planning could avoid disputes regarding membership interests and associated rights. Perils of Informal Documentation An example of the challenges presented by informal attention to the governance of an LLC upon the death of a member/manager is the Gurney-Goldman discussion of the Schedule K-1 forms. The K-1 forms, reporting a partner’s or LLC member’s share of income, deductions and credits of the LLC, highlighted the confusion regarding the LLC’s management structure — confusion a concisely drafted LLC agreement could have avoided had it addressed succession planning for transfer of both membership and managerial interests. The forms presented a stark, binary choice: “general partner or LLC member-manager” or “limited partner or other LLC member.” Here, both the living siblings and the estate of the deceased member/manager claimed the latter, suggesting a limited role within the LLC. However, both sides’ theory of the case contradicted such a limited role as all parties asserted status as members and managers of the LLC. The plaintiffs argued all three living siblings were member/managers, while the defendant/estate argued the son was also a member/manager. Ultimately, the designation as “other LLC member” on the K-1 forms contradicted the parties’ assertions regarding their roles within the LLC.2 While the use of K-1 forms in this case did not benefit either party, it serves as a reminder that even the LLC’s tax forms can prove inconclusive regarding the membership and managerial status for an LLC lacking formal and clear documentation. Avoiding Similar Disputes The Gurney-Goldman case underscores the imperative of meticulous documentation and proactive planning in LLC formation, management and succession planning. To the extent possible, an operating agreement should anticipate potential contingencies such as the death or incapacity of a member and, if that member is also a manager, how the LLC will determine who fills that management void. Clarity and precision in drafting can help avoid informal practices that lead to ambiguity and disputes. While the LLC Act permits oral or implied operating agreements, the tangled dispute featured in the Gurney-Goldman litigation provides valuable insight into the inherent challenges of proving the terms of such agreements. As the Court of Chancery notes, “[p]ermitting oral and implied agreements thus makes the lawyers’ lives easier, even if it makes adjudication harder.” By investing the time and resources to create comprehensive operating agreements that adhere to contract formalities, members and managers of LLCs can safeguard their interests and avoid the pitfalls that ensnared the parties in Gurney-Goldman. Gurney-Goldman is a cautionary tale, particularly for family-managed LLCs, as the allure of informality collides with the chaotic reality that informal understandings and undocumented practices can have dire consequences. It serves as a poignant reminder that the absence of clear documentation and proactive planning can derail even the most well-intentioned business ventures. By heeding the lessons of this case, members and managers of LLCs can protect the longevity and success of their enterprises. 1 See id at 20-21 (Internal citations removed) (Emphasis added). 2 See id. at 30.

Pennsylvania Gov. Josh Shapiro signed House Bill 1716 into law on July 15, officially designating it Act 59 of 2024. Act 59 ushers in crucial clarifications to Title 15 of the Pennsylvania Consolidated Statutes regarding Corporations and Unincorporated Associations. Derivative Actions The changes to Section 1781 of Title 15 refine shareholder derivative action rights. In the event a shareholder makes a demand on the corporation or the board of directors requesting that the corporation bring an action, the board must notify the shareholders within 60 days after the demand was made of the board’s determination on how it plans to proceed, or not proceed, with the shareholder’s demand. Corresponding changes were also made to Sections 5781 (for nonprofit corporations), 8692 (for limited partnerships) and 8882 (for limited liability companies). Contents of Partnership Agreements Section 8415(c)(2) of Title 15 preserves the right of an interest holder to object to a fundamental transaction in which the interest holder will become subject to personal liability in respect of an entity in which the interest holder will continue to own an interest after the transaction. The existing language of Subsection (c)(2) treats a domestication in the same way as it treats other fundamental transactions for this purpose. Corresponding changes are also being made to Sections 8615 (for limited partnerships) and 8815 (for limited liability companies). Registration of Name of Domestic Nonfiling Association Domestic nonfiling associations (other than limited liability partnerships, which are required to file a statement of qualification to elect limited liability partnership status and, therefore, are already covered) may now register their names with the Pennsylvania Department of State in accordance with Section 202 of Title 15 (relating to requirements for names generally). The domestic nonfiling association must renew its name annually by filing an application for renewal between October 1 and December 31 of each year. Nature of Transactions Act 59 clarifies that a fundamental transaction (i.e., merger, conversion, interest exchange, domestication, etc.) should not be reclassified as a different form of transaction merely because such transaction could have been achieved through a different transaction type under Chapter 3 or any other law. Foreign Association Registration The changes to Sections 412 and 1103 of Title 15 reflect that the concept formerly referred to as “qualification to do business” is now referred to as “registration to do business.” Other provisions of law continue to use the older terminology of qualification, but new Section 412(b)(6) states that any references to “qualification to do business” includes “registration to do business.” Application of Article Act 59 deleted the words “savings association” from Section 4101 of Title 15, recognizing that the Savings Associations Code was repealed in 2013. Overall Impact Although most of these changes are more technical in nature, Act 59 revises Title 15 to conform with previous changes in entity constituent statutes, reducing inconsistencies and ambiguity in Pennsylvania business organizations law.

The Delaware General Corporation Law grants stockholders and directors wide latitude to pass and implement corporate bylaws, and the boards of Delaware companies may be tempted to revise bylaws in the face of a hostile takeover bid to help defend against that bid. However, the Delaware Supreme Court recently issued an important decision reaffirming its willingness to strike down bylaws issued in such situations under a two-pronged “enhanced scrutiny” test. In Kellner v. AIM ImmunoTech, 2024 WL 3370273 (Del., Jul. 11, 2024), the Supreme Court on July 11 addressed a long-simmering dispute between a rotating cast of activist stockholders seeking to assume control of the publicly traded biopharmaceutical company AIM ImmunoTech Inc. (AIM) and the members of AIM’s existing board. Blaming AIM’s management for downturns in the company’s value, the activists made two prior attempts to nominate a slate of new directors to AIM’s board. These attempts were each rejected for failure to comply with AIM’s existing bylaws. Delaware General Corporation Law – Enhanced Scrutiny: When the activists initiated a third attempt to nominate their preferred slate, the existing board responded by passing a series of new and amended bylaws imposing onerous advance-notice requirements. These bylaws required the activist stockholders to satisfy a lengthy and detailed set of procedural and substantive preconditions to get their nominees on the ballot for the next stockholder vote. The board rejected the activists’ nominations for failing to comply with these new bylaws, and the activists sued. In its decision, the court made clear that advance notice bylaws are a legitimate exercise of board power and an important tool to “assist the board’s information-gathering and disclosure functions, allowing boards of directors to knowledgeably make recommendations about nominees and ensuring that stockholders cast well-informed votes” (internal quotation marks omitted). But the court also recognized that such bylaws “can be misused to thwart stockholder choice and entrench the existing board of directors.” As a result, “bylaws must, as a matter of equity, be reasonable in their application and not unfairly interfere with stockholder voting” (internal quotation marks omitted). Enhanced Legal Scrutiny & Balance: To strike this balance, the court reaffirmed the two-part “enhanced scrutiny” test first applied in Coster v. UIP, 300 A.3d 656 (Del. 2023). Under this test, a court assessing whether a board acted properly in accordance with its fiduciary duties in enacting or amending advance notice bylaws during a proxy contest (and therefore, the validity of such advance notice bylaw provisions) must first assess whether the board acted in response to a “threat ‘to an important corporate interest or to the achievement of a significant corporate benefit.’ The threat must be real and not pretextual, and the board’s motivations must be proper and not selfish or disloyal.” Actions taken for the primary purpose of precluding challenges to the existing board’s control are “selfish or disloyal” and are therefore prohibited. A court must next determine “whether the board’s response to the threat was reasonable in relation to the threat posed and was not preclusive or coercive to the stockholder[’s]” right to vote. Applying this two-part test, the court accepted the Delaware Court of Chancery’s prior conclusion that the board had amended its bylaws specifically to thwart activist stockholders’ efforts and maintain control of AIM. The court, therefore, held that the amended bylaws failed the first prong of the “enhanced scrutiny” test and were, therefore, invalid. Boards of Delaware corporations considering any change to existing bylaws in the face of a hostile takeover bid or otherwise dealing with activist stockholders should carefully study the Kellner decision to ensure that their actions are lawful and valid when assessed under the higher two-pronged enhanced scrutiny standard of review rather than a simple analysis under the traditional business judgment rule. New bylaws or amendments issued in such circumstances should further legitimate corporate interests separate and apart from the mere preservation or entrenchment of the existing board and should be narrowly tailored to the issue or threat being addressed.

Law enforcement officials are now offering money to employees to report their colleagues’ and employers’ bad conduct. A new program implemented by the U.S. Department of Justice (DOJ) incentivizes employees to report corporate misconduct directly to the government rather than inform employers about their concerns. The DOJ’s Corporate Whistleblower Awards Pilot Program, launched August 1, offers payments to employees who become successful whistleblowers and increases the pressure on companies to self-report wrongdoing to authorities. This new program supplements similar successful programs already in place at other federal agencies, including the U.S. Securities and Exchange Commission (SEC), Commodity Futures Trading Commission, Internal Revenue Service (IRS) and the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN). Now, employees at private corporations, partnerships and even nonprofits who might not have been compensated in the past for reporting wrongdoing to the government are incentivized to do so. The DOJ asserts that its program is focused on four main areas: foreign corruption, crimes involving financial institutions, domestic corruption and healthcare fraud. However, the pilot program’s language is broad and will motivate employees across a spectrum of industries to divulge suspicious conduct to law enforcement officials. Incentives to Whistleblowers Will Lead to Increased Reporting As anticipated in our March 2024 client alert, the DOJ’s final pilot program presents incentives aimed at increasing the likelihood that employees will report misconduct directly to the DOJ instead of internally reporting to their employers. Under the new DOJ program, individuals are not required to make internal reports to their employers as a prerequisite for obtaining compensation. Rather, individuals who meet the specified criteria and alert the DOJ to significant corporate misconduct could be compensated with a monetary award based on the “net proceeds forfeited” if the investigation and prosecution lead to a forfeiture greater than $1 million. This award may be up to 30% of the first $100 million in net proceeds forfeited and up to 5% of any net proceeds forfeited between $100 million and $500 million. The percentage that whistleblowers will be paid is subject to various factors, including the “usefulness of the whistleblower’s information and the level of assistance” provided to the DOJ. The program could result in more DOJ investigations and more government investigations in general. The DOJ program encourages individuals reporting to the DOJ to also share their reports with multiple government agencies. The program specifically states that whistleblowers who are not sure which program to submit information to “should submit information to both programs so that the Department can assess the information.” The result could be multiple simultaneous investigations and even greater trouble for unprepared companies. The DOJ Is Providing More Incentives to Companies to Self-Disclose In addition to incentivizing whistleblowing, the pilot program encourages companies to self-report to the DOJ. In its simultaneously revised Corporate Enforcement and Voluntary Self-Disclosure Policy (VSD Policy), the DOJ said that if a company reports misconduct to the DOJ within 120 days of learning of it, the entity will still be eligible for a presumption of declination,1 even if the whistleblower also reported the conduct directly to the DOJ. To be eligible for a presumption of declination, in addition to reporting within 120 days, the company must fully cooperate with the DOJ investigation and remediate any harm caused by the criminal conduct. However, for this to apply, companies must first receive an employee’s internal report. Receiving an internal report is only feasible if a business has reporting mechanisms in place and its employees are educated to report internally. Once a report is made, companies should be prepared to respond by quickly initiating internal investigations and making swift reports after confirming the presence of problematic activity. Whistleblower Awards Are Subject to Exceptions and Discretion The DOJ’s program includes provisions similar to those in the SEC’s program, such as prohibiting award payments to individuals who “directed, planned, initiated or were convicted of the misconduct they reported.” The DOJ’s program goes a step further by prohibiting payments to “any whistleblower who meaningfully participated in the criminal activity they report.” Another notable provision unique to the DOJ’s pilot program is that any award given to whistleblowers is discretionary. A discretionary award will likely be less appealing to whistleblowers and their lawyers than a mandatory award. In the past, discretionary award programs such as those offered by the SEC were not vastly successful in obtaining whistleblower tips. Ultimately, changes to the SEC, IRS and False Claims Act programs were made to provide non-discretionary awards to whistleblowers. Subsequently, whistleblower programs have been more successful, both in terms of the number of whistleblower reports and the amount of monetary award. While the success of the DOJ’s ability to incentivize whistleblowers is yet to be determined and may be limited, the DOJ’s program does not prohibit whistleblowers from submitting information to several whistleblower programs spanning multiple agencies. Key Considerations for Companies Risk of Multiple, Simultaneous Investigations: As noted, the DOJ program is structured to incentivize whistleblowers to share their reports simultaneously with multiple government agencies. The DOJ will now receive information at the same time as other agencies with whistleblower programs. Because employees are encouraged to report to multiple agencies, companies may face the prospect of multiple investigations, which may be concurrent, coordinated or even competing. Companies will need to employ more complex and calculated decision-making to navigate these multi-agency investigations. Companies should take proactive approaches by having in place plans to coordinate responses to subpoenas and other government inquiries from multiple agencies. Incentivizing Prompt Investigations and Self-Reporting: The DOJ’s program should incentivize even more companies to invest in robust internal reporting structures and promptly self-report potential wrongdoing. The DOJ amended its existing VSD Policy so that if a company that receives an internal report from a whistleblower in turn reports the misconduct to the DOJ within 120 days and before the DOJ reaches out to the company, that company will be eligible for a presumption of declination. DOJ Whistleblower Pilot Program – Policies & Logistics However, in order to take advantage of this policy, companies must be prepared. If an individual reports misconduct to a business, that business has 120 days to act. If no internal report is ever made, companies will not receive the opportunity to make a disclosure under the 120-day provision. Companies can always decide whether to report over the course of 120 days, but first they must focus on what they can do to best position themselves for having the option to do so. Companies need to create comprehensive internal reporting systems, educate employees on how to use such mechanisms, and convince employees that such reports are taken seriously. Upgrading Internal Reporting Tools: In our previous client alert, we suggested that clients consider taking steps to evaluate and review their existing compliance policies and procedures, including internal hotlines and other reporting mechanisms. This consideration is even more imperative now that Principal Deputy Assistant Attorney General Nicole Argentieri explicitly stressed the clear importance of companies prioritizing making the “necessary compliance investments to help prevent, detect and remediate misconduct.” The 120-day deadline should provide companies with a heightened sense of urgency to get their compliance programs and internal investigations procedures up to date. If an internal report comes in at any time, companies should be prepared to act quickly. This can only be done if a business is prepared with the tools, policies and procedures to evaluate any reports efficiently, effectively and in a timely manner to determine whether a disclosure to the DOJ should be made. 1 A declination is a decision not to prosecute a company that would have otherwise been prosecuted or criminally resolved except for the fact that the company has voluntarily disclosed potential criminal violations and fully cooperated with the DOJ.

A recent decision by the Delaware Court of Chancery emphasizes the importance of strong integration and non-reliance clauses, especially when a seller stands to receive an earnout payment. In Trifecta Multimedia Holdings v. WCG Clinical Services, the court ruled certain pre-transactions representations made by defendant WCG Clinical Services LLC were actionable for fraud in the absence of a specific anti-reliance provision. Anti-Reliance Language in Purchase Agreements: In Trifecta, the founder of Trifecta Multimedia Holdings Inc., a healthcare technology business, sold his firm to WCG. As part of the transaction, the seller stood to receive an earnout payment equivalent to roughly one-third of the purchase price. Following the earnout period, WCG claimed that the threshold for an earnout was not met, and therefore, the seller stood to receive nothing. The seller then sued WCG, claiming that, among other claims, WCG made material misrepresentations and omissions during the negotiation process. Among the seller’s allegations was the claim that WCG made numerous promises to him regarding the post-closing operation of Trifecta. According to the seller, these promises induced him to select WCG as the buyer. Importantly, these promises were not contained in the purchase agreement. On a motion to dismiss, WCG argued that such statements were mere “puffery” and not actionable as a basis for fraud. The court disagreed. The court first noted that some of the statements made by WCG were actionable, although the line between “puffery” and actionable statements remains quite blurred. Significantly though, in examining the element of justifiable reliance, the court found that an integration clause in the purchase agreement, on its own, was insufficient to defeat a claim for fraud. Specifically, the court ruled that an “agreement must also contain explicit anti-reliance language.” Because the subject purchase agreement did not contain one, and finding that the seller’s reliance on WCG’s representations was reasonable, the court concluded that he had sufficiently alleged a claim for common law fraud. Following Trifecta, buyers must ensure that they include specific anti-reliance language in their agreements, especially when subject to an earnout requirement. This is especially true where the distinction between statements that are actionable for fraud and/or misrepresentation continues to get muddled.

At the height of an election year, it is a good time to remind nonprofits under Section 501(c)(3) of the Internal Revenue Code about the rules on political campaign activities tied to their tax exemption ― one of the trade-offs that go hand in hand with the benefit of being exempt from income taxes. Usually, by the presidential conventions in the summer, we have moved past some of the vague questions about who qualifies as a candidate and on to what activities are permitted and prohibited. However, given the changes in this election cycle, it’s worth a second look at those questions as well. While the current presidential election is remarkable so far, it’s important not to lose sight of the fact that the same rules apply to lower-profile elections. These include those ranging from either house of Congress, state gubernatorial offices and municipal governance to mayors, council members, sheriffs and dogcatchers. Potential Implications The rules for 501(c)(3) organizations place conditions on various types of political speech, including limits on the amount of lobbying that can be done by the organization and an absolute prohibition on political campaign activity. The prohibition in Section 501(c)(3) is commonly referred to as a prohibition against “political activity,” “political campaign intervention” or “electioneering.” In short, any activity that endorses or opposes a political candidate could result in the organization losing its tax-exempt status. The resulting loss would not only subject all income to corporate-level taxation but would cost donors to the organization their charitable deductions for gifts. Short of losing the exemption completely, the IRS can levy a tax on the political expenditure of the organization and, in serious cases, may impose both a tax and revoke the exemption. What Counts as Electioneering? Given these high stakes, it’s important to understand what constitutes electioneering and know how to keep it from jeopardizing an organization’s exemption. In general, political campaign intervention includes actions related to any candidate, political party or political action committee, such as: Statements of support or opposition in any medium. Providing or soliciting financial support. Providing or soliciting in-kind support. Distributing biased voter education materials. Conducting biased public forums, debates or lectures. Conducting biased voter registration or get-out-the-vote drives.   Who counts as a candidate and when an organization’s actions become support or opposition can be complex in primary season as candidates enter and leave races or tease their participation. The term “candidate” refers to any individual who enters the contest for an elected public office or is proposed by others to run for office at any level of government, whether national, state or local. The timing of when a person becomes a candidate isn’t always clear-cut and must be determined based on all relevant facts and circumstances. Simply being a political figure doesn’t automatically make someone a candidate without more — usually a connection to an election that is close in time. Permitted and Prohibited Activities Not everything to do with the political process is off-limits. Organizations are permitted to provide nonpartisan information about voting processes, monitor or recommend changes to election procedures, and broadly encourage citizens to vote. Most activities focused on the process and not the person or party are likely to be permitted. Clear statements that voters should cast or withhold a vote for a candidate are entirely prohibited. Fortunately, those are easy to spot (and to avoid). However, endorsements also come in many other forms, including statements that support or oppose a political party in general or distinguish a group of candidates running for office. The flipside of opposition is support, and prohibited support can come in monetary or in-kind contributions. It’s not just writing a check but also providing resources (such as copiers, paper, office supplies, vehicles, etc.), the organization’s space, or staff time and publicity that count as promoting a candidate or opposing his or her opponents. For example, organizations with substantial spaces may be asked to rent facilities to candidates or political parties for partisan activities, such as party conventions or caucuses, candidate rallies, or local community gatherings. An organization’s first-ever rental of its space likely should not be to a candidate or political party. Putting appropriate policies in place could make the difference between prohibited support and nonpartisan (and permitted) activity. For example, policies may require that a fair market rate be charged rather than providing the facility for free or at a nominal cost, demonstrating that the facility is equally available to all candidates or parties with no preference for one over another. Candidate Events Many nonprofits in the civic area may naturally want to focus on voter education and access to candidates as part of their mission. Others may have an independent reason why a politician would normally be invited to address the group. Any candidate event can present issues of both actual and perceived electioneering. In the case of an independent purpose for the candidate being present at an event, it should be clear that the candidate is invited to speak in his or her capacity as a public figure, expert or celebrity. If the purpose is more to provide access to the candidates and issues in an election, then it must invite and provide equal access to the event to all candidates in the race. It cannot just be a perfunctory invitation, as the IRS has indicated that an organization that invited two opposing candidates knowing and expecting that one would not accept the invitation to the event because of well-known opposing viewpoints would likely not be considered to have provided equal access and could be engaging in electioneering. If a candidate attends a non-political event sponsored by an exempt organization that is open to the public and no political intervention is automatically assumed, the organization should ensure that no political campaigning occurs, such as letting the candidate distribute literature or speak about the campaign. Individual Capacity What about the political opinions of individuals associated with an organization, whether board members, senior leadership or other employees? While they don’t give up their right to participate in the political process and voice opinions on the candidates, it is important that they only do so while acting in their individual capacities. If they identify themselves as being in connection with the organization, they should make it clear they are acting in their individual capacities and not on behalf of the organization. Statements or actions in their individual capacity should never be in the context of an employee’s scope of employment or the organization’s publications, websites or organizational events. Actions of employees within the scope of their employment will generally be treated as having been conducted with the organization’s authorization. Inadvertent Electioneering A frequent issue is when an organization identified inadvertent prohibited political campaign intervention; for example, through an unauthorized statement made by an employee on the organization’s official social media accounts. Even individual actions will be attributed to an organization if the organization either ratifies those acts or fails to disavow the individual actions performed under its apparent authority. In such an example, the organization should immediately delete and clearly announce that the statement was not authorized or ratified by the organization. The disavowal should be communicated in the same medium as the original prohibited action. If the inadvertent activity includes the expenditure of funds (including the use of resources), that activity should be corrected and safeguards established to prevent a similar problem from occurring. This might include refunding or restoring money spent, implementing policies, or conducting staff or board training. Inquiries into Political Activities When considering what a potential inquiry into prohibited political activities would look like, keep in mind the standard applied by the IRS is one of “facts and circumstances” considered in the totality of the activity’s context. While it may seem reassuring on its face that all the factors would be considered, since an actual or alleged infraction may only be understood in hindsight, this test provides little certainty or opportunity to document those facts and circumstances contemporaneously in the event of a future inquiry. With a few more months to go before this election season wraps up, it is not too late to make sure your organization understands and is protected from electioneering violations. Available Resources IRS, Revenue Ruling 2007-41: Complete official guidance regarding election participation. IRS, Political Campaigns and Charities: The Ban on Political Campaign Intervention: Video presentation on prohibited campaign activities for 501(c)(3) organizations.

DGCL Amendments: Delaware Legislature & SB 313: Senate Bill 313 is the latest development in a high-stakes battle for control between the boards of corporations and their stockholders, an issue that drew national attention after a series of rulings1 from high-profile cases were issued by the Delaware Court of Chancery. Those rulings have created uncertainty for Delaware corporations and their advisers because the court’s decisions were contrary to the customary practices that had developed over time in relation to stockholder agreements and processes for merger approvals.2 Last week, the Delaware state Senate and House of Representatives both overwhelmingly approved SB 313, which is currently awaiting Gov. John Carney’s signature. Behind the scenes, however, a contentious debate has played out between the corporate bar and certain opponents of any change to the existing provisions of the law. Although SB 313 has broader implications for other corporate law issues,3 much of the criticism the bill has received involves the proposed new Section 122(18) of the Delaware General Corporation Law (DGCL), which grants corporations the broad powers to enter into contracts with one or more stockholders and to grant such stockholders approval powers outside of a corporation’s certificate of incorporation. Section 122(18) also provides a non-exclusive list of contract provisions by which a corporation may allocate certain decision-making authority. This amendment is a direct response to the Court of Chancery’s February ruling in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., which invalidated a provision in a stockholder agreement that granted a powerful stockholder extremely broad decision-making authority over certain matters that the DGCL traditionally reserved for a company board. The Moelis decision was based on an extreme set of facts where virtually all decisions traditionally reserved to the board required the majority stockholder’s approval, which, in the court’s view, undermined the power of the board to manage the corporation as required by the DGCL. Critics of SB 313 argue that Section 122(18) of the DGCL was drafted hastily and that its expansive language will make it easier for boards to hand over their decision-making authority to powerful stockholders.4 By providing this alternate pathway through which the decision-making power of the board can be redistributed, such critics fear that Section 122(18) will ultimately be leveraged to the detriment of less powerful stockholders. In a letter sent to the Delaware Legislature by more than 50 law school professors, the authors allege that the proposed amendment to Section 122(18) would “allow corporate boards to unilaterally contract away their powers without any shareholder input,” and by exempting such contracts from Section 115 of the DGCL, the amendment would create a “separate class of internal corporate claims — including claims of breach of fiduciary duty — that could be arbitrated and decided under non-Delaware law.” More broadly, concerns are being raised that by passing SB 313, lawmakers have sought to undermine Delaware courts, which have a longstanding reputation for taking a neutral and balanced approach to disputes involving stockholders and the delegation of decision-making power traditionally reserved for the board. In addition, critics argue that lawmakers overreached because they intervened before the Delaware Supreme Court had a chance to weigh in on the Court of Chancery’s decision in the Moelis case. Further, some critics have warned that the bill’s overreach may invite federal regulation by the U.S. Securities and Exchange Commission of Delaware corporate law issues. On the other hand, proponents of SB 313 have argued that its passage is necessary for Delaware corporations to overcome the uncertainties created as a result of the recent decisions by the Court of Chancery. This sentiment was echoed by the chair of the Delaware State Bar Association’s Council of the Corporation Law Section in a statement made to senators just prior to the bill being voted on and also in a letter drafted by the New York City Bar Association’s Committee on Mergers, Acquisitions and Corporate Control Contests, which implored lawmakers to put an end to the “disruptive uncertainty that now hangs over Delaware-incorporated companies” and to restore the “clarity, predictability and practicality which has long been the hallmark of Delaware corporate law.” Delaware Legislature and SB 313 – Final Thoughts: With SB 313 being passed by Delaware lawmakers in both the Senate and House and expected to be signed into law by Carney in the coming days, it appears that the corporate bar has won for now. Hopefully, this victory will provide much-needed guidance for those who advise corporations on governance and transactional matters and avoid disruption to customary practices followed by those engaged in venture capital, private equity and M&A transactions. 1 See West Palm Beach Firefighters’ Pension v. Moelis & Co.; AP-fonden v. Activision Blizzard. 2 Read more about the amendments to the DGCL and background. 3 For example, among other changes, SB 313 would amend Section 147 of the DGCL to permit a company’s board of directors to approve any agreement, instrument or document requiring board approval under the DGCL, including merger agreements, provided that it is in its final or “substantially final” form. 4 In Moelis, the Court of Chancery held that the board’s powers cannot be constrained through stockholders’ agreements. Rather, the board’s powers can be constrained only through those channels that are expressly identified in the DGCL, such as through an amendment to a corporation’s certificate of incorporation.

Allocations of purchase price are critical tax-related aspects of asset sale transactions. However, these allocations often do not receive much attention from the parties until the transaction process is well underway, and possibly not until the eve of closing or after closing when associated tax reporting is required. At that point, a buyer’s or seller’s ability to negotiate a more favorable result can be significantly limited. Consequently, buyers and sellers should become familiar with the potential federal income tax considerations of purchase price allocations and strive to address those considerations at the beginning of a transaction.1 Allocations in the Asset Sale Context Purchase price allocations are primarily relevant for asset sales where a buyer is directly purchasing assets (and assuming liabilities) from a seller.2 This includes transactions that are structured as an equity purchase but nonetheless result in a deemed asset sale for federal income tax purposes. Examples of deemed asset sales include: (1) an acquisition by a buyer of equity interests of either a limited liability company that is treated as a disregarded entity for federal income tax purposes or a partnership, including if the partnership has made (or will make) an election under Internal Revenue Code (IRC) Section 754 (a 754 election)3; and (2) an acquisition of the stock of a target corporation where an election is made under IRC Section 338.4 Tax Implications and Requirements If a transaction is considered an asset sale for federal income tax purposes, it will be treated as a sale of each acquired business asset in exchange for an applicable portion of the aggregate purchase price.5 As a result, the aggregate purchase price needs to be allocated among all such transferred assets in order for the seller to determine its gain or loss with respect to the transaction (and character thereof — i.e., ordinary or capital) and for the buyer to calculate its tax basis in the acquired assets immediately following the close of the transaction. Furthermore, if the transaction qualifies as a sale of a business for federal income tax purposes (which is often the case), the parties must adhere to special allocation rules under IRC Section 1060.6 These rules require the purchase price to be allocated among the acquired assets based on seven different asset classes in sequence based on fair market value. This means that the purchase price is allocated first to Class I assets, then if any purchase price is remaining, to Class II assets and so on, with any final amounts allocated to Class VII assets. The buyer and seller must also separately report a purchase price allocation to the Internal Revenue Service by filing IRS Form 8594. Generally, the asset classes can be described as follows: Class I: Cash. Class II: Marketable securities and government bonds. Class III: Accounts receivable and certain debt instruments. Class IV: Stock in trade (e.g., inventory). Class V: Other fixed or tangible assets (e.g., property, plant, equipment, vehicles). Class VI: IRC Section 197 intangibles, including covenants not to compete but excluding goodwill and going concern value. Class VII: Goodwill and going-concern value.   Practical Impact on the Parties Buyers and sellers typically have competing interests when it comes to how the purchase price should be allocated among the above categories. Generally, a non-corporate seller wants to maximize recognition of capital gain and minimize recognition of ordinary income. For a non-corporate seller, ordinary income is taxed at a maximum federal income tax rate of 37%, while capital gain that qualifies for the preferential rate on long-term capital gains is only taxed at a federal rate of 20% (although an additional 3.8% tax on net investment income might also apply to such capital gain).7 Accordingly, such a seller would prefer to allocate the purchase price to assets that generate preferentially taxed long-term capital gain such as goodwill and going-concern value, and allocate as little as possible to assets that may generate ordinary income, such as accounts receivable, inventory or fixed assets.8 In contrast, a buyer typically prefers to allocate the purchase price to accounts receivable or inventory (which are expected to turnover relatively quickly), or assets that have a shorter useful life.9 This would permit a buyer to recover its tax basis faster — either by reducing income that would be recognized when accounts receivable is collected or inventory is sold, or generating depreciation deductions more quickly. Common Considerations and Approaches As a result of these competing interests, it would be advisable for the parties to take steps early in the transaction (such as at the letter-of-intent stage) to get ahead of potential conflicts that may arise when it comes time to prepare the purchase price allocation. This is especially relevant if the rules under IRC Section 1060 apply, in which case it would be in the interest of both parties to agree to an allocation such that buyer and seller do not report inconsistently to the IRS, which can increase the risk of a tax audit. A seller, for example, can require in the letter of intent that the buyer pay an additional purchase price. Such additional purchase price can be calculated explicitly to provide a tax “gross-up” such that the seller will receive proceeds on an after-tax basis that puts the seller in the same economic position as if all the recognized income or gain was taxed as long-term capital gain. The additional purchase price could also be calculated as a proportion of the net present value of tax savings that the buyer anticipates recognizing as a result of achieving a basis step-up in the acquired assets. Alternatively, the letter of intent could provide that the parties will simply cooperate in good faith to mitigate any adverse tax impact to the seller from recognizing ordinary income. This approach would be less explicit but can, at the very least, give support for the seller to request changes to the transaction structure or ask for a tax gross-up later once the anticipated tax cost can be more clearly estimated. From the buyer’s perspective, the letter of intent could clearly state that the buyer expects the transaction to result in a tax basis step-up with respect to the acquired business or business assets and that the buyer’s proposed purchase price has factored in such tax result. This approach would help set expectations between the parties and can also be used to counter any request by the seller for additional purchase price either based on a tax gross-up or sharing of the buyer’s anticipated tax benefits. Sale transactions are complex and the parties must often tackle many different business and other critical issues to successfully complete a deal. As a result, it may be tempting to focus less attention on issues that are viewed as more procedural or compliance-oriented, such as allocations of purchase price. However, planning for the purchase price allocation in the early stages of the transaction can help the parties avoid potentially difficult or contentious negotiations later in the deal process, obtain certainty as to anticipated federal income tax treatment, and possibly extract additional economic value. 1 Unless otherwise specified, all sections referenced herein are to the Internal Revenue Code of 1986, as amended (the IRC) or the U.S. Department of the Treasury regulations promulgated thereunder. 2 While beyond the scope of this discussion, an allocation of purchase price can also be necessary where multiple entities are acquired as part of the same transaction. In that case, the aggregate consideration may need to be assigned among the multiple targets, which can be especially important from a non-U.S. tax perspective where the target companies are organized in different jurisdictions. 3 A 754 election results in a tax basis adjustment to the underlying assets of the partnership that are represented by the acquired partnership interests pursuant to IRC Section 743. Regardless of a 754 election, a purchase price allocation can also be relevant if all of the equity interests of the partnership are being acquired or under the “hot asset” rules contained in IRC Section 751. 4 Most commonly, such a transaction would involve the purchase of 80% or more of the stock of an S corporation where the buyer and seller agree to make an IRC Section 338(h)(10) election. 5 For federal income tax purposes, any assumption of liabilities by a buyer would be considered an additional purchase price in addition to any cash or non-cash property actually received by the seller. 6 Given their prevalence and the certainty these rules can provide both parties, as a practical matter, buyers and sellers often also follow the IRC Section 1060 allocation rules for transactions that may not strictly be considered the sale of a business. 7 Corporate sellers may be less concerned because their ordinary income and capital gain are taxed at the same 21% federal rate. However, recognition of capital gain versus ordinary income may still be relevant, for example, if such a seller has significant capital loss carryovers, which cannot be used to shelter ordinary income. 8 Gain recognized on fixed assets can generate ordinary income to the extent of depreciation previously claimed for federal income tax purposes (commonly referred to as depreciation recapture). 9 Equipment and other fixed assets can often have a useful life of only three to seven years (and may also qualify for bonus depreciation). On the other hand, goodwill (to which any residual purchase price would be allocated) is amortized straight-line over 15 years.

The U.S. Supreme Court issued a decision on June 6 with significant repercussions for business owners who use life insurance as part of their business succession planning. In an uncommon 9-0 ruling, the justices in Connelly v. United States held that for federal estate tax purposes, the value of life insurance proceeds payable to a company upon a shareholder’s death was included in the corporation’s federal estate tax value, and this value was not offset by the company’s obligation to redeem the deceased shareholder’s stock under a buy-sell agreement. The Stock Redemption Agreement at Issue Brothers Michael and Thomas Connelly were the sole shareholders of a building supply business. The brothers and the company entered into a stock redemption agreement that allowed the surviving brother to purchase the shares of the first brother to pass away. If the surviving brother declined to purchase the shares, the company would be obligated to purchase them. The company obtained $3.5 million of life insurance on each brother to finance the redemption. After Michael Connelly died, Thomas Connelly declined to purchase his shares, and pursuant to the stock redemption agreement, the company became obligated to redeem them. The agreement laid out a number of methods for setting the redemption value of the shares (e.g., periodically executing a certificate of agreed value or having multiple independent appraisers provide valuation reports). However, the brothers never performed any of the valuation mechanisms. Instead, Thomas Connelly (as executor of his brother’s estate) and Michael Connelly’s son (an estate beneficiary) privately agreed to value Michael Connelly’s shares at $3 million. The company paid $3 million to the estate, and the estate valued Michael Connelly’s shares at $3 million on the estate tax return. The Internal Revenue Service (IRS) audited the return and assessed additional federal estate tax on the basis that the value of Michael Connelly’s shares included a proportional share of the life insurance proceeds. Michael Connelly’s estate paid the tax and sued the IRS for a refund. The estate claimed that the company’s obligation to redeem Michael Connelly’s shares was a liability on the company’s balance sheet, which offset the life insurance proceeds dollar for dollar. In contrast, the government argued that a redemption obligation is not a liability in the traditional sense and that a hypothetical buyer of Connelly’s shares would not have treated this obligation as a factor in reducing the purchase price. Supreme Court Affirms Lower Court Decisions The U.S. District Court for the Eastern District of Missouri and the U.S. Court of Appeals for the Eighth Circuit both ruled in favor of the government and the Supreme Court agreed, affirming the lower court decisions. The Supreme Court considered what a willing arm’s-length buyer would reasonably pay for Michael Connelly’s shares as of the date of his death. In the court’s view, the stock redemption at fair market value had no economic impact on either shareholder. Therefore, a willing buyer would not consider the redemption obligation as a liability. The court was careful to limit its holding to the specific facts of the case. In a footnote, the court mentioned that it does “not hold that a redemption obligation can never decrease a corporation’s value” if the underlying facts differ. For instance, a redemption obligation could “require a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity.” However, the company’s obligation to purchase the shares from the deceased shareholder’s estate did not, on its own, offset the life insurance proceeds used to finance the purchase. The Supreme Court did not address Internal Revenue Code Section 2703(b) and its regulations, which allow shareholders to set the value of company shares for federal estate tax purposes by agreement if certain criteria are met. However, the lower court opinions made it clear that the Connelly brothers’ failure to follow the terms of their agreement caused Section 2703(b) to not apply and instead allowed the IRS to determine the fair market value of the shares without reference to the agreement. The value of a decedent’s property at death should reflect its fair market value, which is the price at which the property could change hands between a willing buyer and a willing seller. In Connelly, the court determined that the fair market value of the corporation was increased by the life insurance proceeds payable to the corporation. Going Forward While Connelly held that a stock redemption obligation is not a liability that offsets life insurance proceeds in an estate tax analysis, careful planning and the use of alternative buy-sell arrangements (e.g., cross-purchase agreements or life insurance LLCs) may significantly reduce estate tax exposure. Business owners with buy-sell agreements in place should consider meeting with their advisers to review current valuation and funding provisions to ensure that their business documents will meet their intended planning objectives.

A series of recent decisions from the Delaware Court of Chancery has muddied the waters for dealmakers and lawyers, raising questions about the legality of certain longstanding market practices relating to stockholders’ agreements and the approval process for mergers. In deciding these recent cases, the court made clear that in construing the language of the Delaware General Corporation Law (DGCL), the court will apply a strict reading of the express language of the statute. In response to the uncertainties caused by the court’s recent decisions in Moelis and Activision, on March 28, the Council of the Corporation Law Section of the Delaware State Bar Association proposed certain amendments to the DGCL. These proposals are intended to conform the statute with customary market practice. Implications to Stockholder Agreements In West Palm Beach Firefighters’ Pension Fund v. Moelis & Co.,1 the court cast a shadow over the enforceability of provisions in agreements between a corporation and its stockholders that provide such stockholders with veto powers or protective voting rights that could be viewed as impinging on the authority and discretion of the board to manage the corporation. These types of agreements are widely used, especially in private equity and venture capital deal structures. At issue in Moelis were certain “Pre-Approval Requirements” in the stockholders’ agreement requiring the board to obtain the prior written consent of a founder stockholder (the founder) prior to taking virtually any meaningful corporate action, including, among others: (1) the issuance of common and preferred stock; (2) the appointment or removal of certain officers, such as the CEO, which was an office held by the founder; (3) entering into or amending any material contract; (4) adoption of a stockholder rights plan; and (5) any equity or debt commitment in an amount greater than $20 million. Read the full article here. ¹ West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., No. 2023-0309-JTL (Del. Ch. February 23, 2024).

The recent rulemaking by the Federal Trade Commission (FTC) on worker noncompetes has garnered an avalanche of publicity, mostly for its impact on employment agreements and employees’ ability to work for competitors. However, the rule’s effect on previously protected trade secrets is equally important. Read on as we highlight the rule’s restrictions and provide practical solutions for businesses looking to continue to protect valuable intellectual property. First, it should be noted that the ban does not take effect for 120 days after its May publication in the Federal Register. Second, leaving the 120-day period aside, the rule already has been the subject of litigation, which may ultimately modify or overturn it. The U.S. Chamber of Commerce filed one of the first actions in the U.S. District Court for the Eastern District of Texas seeking injunctive relief, declaring that the ban is invalid and preventing the ban from taking effect. The Chamber’s lawsuit asserts, among other things, that the FTC’s ban is overbroad and violates the basic legal principle against the FTC’s lawful authority. Other similar litigation has also been filed against the FTC. The new ban on noncompetes seeks to prohibit employers from requiring workers — including employees, independent contractors and unpaid workers — to execute noncompete clauses. The FTC’s ban also requires employers to notify most workers by the effective date that any current noncompete agreements will not, and cannot, be enforced against them. The FTC identifies only two exceptions to the ban: noncompete clauses executed by senior executives (employees who make more than $151,164 and are in policymaking positions) and certain types of noncompete clauses executed pursuant to the sale of a business. To date, noncompetes effectively protected trade secrets, which can be a critical component of a company’s intellectual property portfolio. Trade secrets can be defined as information used in a business (trade) that gives the owner a competitive advantage over others who do not know the information (secret), and the owner takes reasonable measures to protect the information from disclosure. Common examples of trade secrets include technical know-how, customer lists, product development plans, recipes or formulas, processes, data, software code, customer lists and business plans. Internally, companies limit access to trade secrets to those who “need to know” and provide strict guidelines for employees and contractors on how they can use and protect the trade secrets. Externally, businesses protect their intellectual property through confidentiality agreements, nondisclosure agreements and licenses. Both federal and state laws protect trade secrets. On the federal level, sources include the Economic Espionage Act of 1996 and the Defend Trade Secrets Act of 2016 (DTSA). For state law, sources include the Uniform Trade Secrets Act, the Restatement of Unfair Competition and the Restatement of Torts Section 757. However, these laws are not uniform. While most states allow confidentiality and nondisclosure agreements, some states strongly disfavor noncompete agreements. The FTC’s new rule sides with those states, noting, “Trade secret laws and nondisclosure agreements (NDAs) both provide employers with well-established means to protect proprietary and other sensitive information” independent of noncompete clauses. With the current uncertainty surrounding noncompete agreements, many companies are exploring different ways to protect their valuable trade secrets. Among the alternatives to noncompete agreements that can be used to protect trade secrets are: NDAs: Require employees or contractors to keep specific information confidential and not disclose that information to others. When NDAs are carefully tailored and seek to protect proprietary information rather than prevent competition, they are more likely to be found enforceable. Limited use agreements: Allow employees or contractors to use trade secrets for a specific purpose but prohibit them from either using the trade secrets for any other purpose or disclosing the trade secrets to others. Use of existing trade secret laws: The aforementioned federal and state laws allow owners of trade secret information to sue in court and seek remedies for misappropriation of their trade secrets. The DTSA specifically allows for the recovery of attorney fees if the misappropriation has been in “bad faith.” Efforts to protect trade secret information will also help demonstrate that the owner has taken reasonable measures to maintain confidentiality. Encryption and security measures: Companies can implement secure methods for storing and transmitting trade secret information, which can help prevent unauthorized access or theft by third parties. Timely response to disclosures: If a trade secret is disclosed, companies should move swiftly to investigate the disclosure and, if necessary, take legal action.   It is important for companies to have a comprehensive strategy in place to protect their trade secrets, including both legal and practical measures. This strategy can help prevent the loss of valuable assets and maintain a competitive advantage in the marketplace. With respect to the FTC’s ban on worker noncompetes, Stradley Ronon will continue to monitor these developments. We are available to assist clients with their obligations in navigating these new requirements while maintaining trade secret protections.

Following an Alabama federal court’s decision in March declaring the Corporate Transparency Act (the CTA) unconstitutional, two similar lawsuits have been filed in different states challenging the constitutionality of the CTA. On March 1, 2024, Judge Liles C. Burke of the U.S. District Court for the Northern District of Alabama, in National Small Business United v. Yellen (NSBU), ruled that the CTA exceeded constitutional limitations on congressional powers (see our previous article for more in-depth analysis on this case). The government appealed the decision to the U.S. Court of Appeals for the Eleventh Circuit, where it is being reviewed on an expedited basis. It is anticipated that the case may go on further to the U.S. Supreme Court, based on constitutional arguments raised in the matter. Status of the NSBU Appeal (in the context of the Corporate Transparency Act). On March 11, the government appealed the ruling in NSBU to the Eleventh Circuit. The court has granted expedited appeal, and briefing is set to be concluded by June 3, with arguments to be held on the first available argument calendar vacancy after that date.1 The appellant’s brief addresses the reasoning used by the District Court, which, as we have discussed previously, did not address the strongest constitutional arguments against the CTA. It could be anticipated that appellees will raise additional arguments in the alternative, which were ignored in the District Court’s decision. Ultimately, the Eleventh Circuit has four potential choices as to how to proceed with the NSBU appeal: Affirm the District Court’s opinion; Affirm the ruling based on alternative grounds raised in the appeal process; Reverse the decision, after taking alternative grounds into account; or Vacate the ruling, and remand for consideration of the alternative grounds raised on appeal. A crucial unknown factor remains: the identities of the judges who will be assigned to the appellate panel. Knowing their backgrounds will be vital in assessing the likely outcome of the case. While the order granting expedited status was signed by Judge Robin Rosenbaum, an Obama appointee, Judge Rosenbaum served only as a motions judge with respect to this matter. The composition of the hearing panel will presumably be determined by availability. Other Legal Challenges to the Corporate Transparency Act. While the ruling in the NSBU decision was limited to the plaintiffs in that case, two new key suits have been filed in other states that similarly challenge the constitutionality of the CTA: (1) Boyle v. Yellen in Maine; and (2) Small Business Association of Michigan v. Yellen in Michigan. These post-NSBU cases are in addition to Robert J. Gargasz Co. v. Yellen, which was filed in the U.S. District Court for the Northern District of Ohio on December 29, 2023. Maine — Boyle v. Yellen On March 15, 2024, William Boyle, a beneficial owner with reporting obligations triggered by the CTA, brought an action in the U.S. District Court for the District of Maine, challenging the constitutionality of the CTA as an “encroachment on the sovereignty of the State of Maine to regulate entity formation.”2 Boyle’s argument centers on the concept that the U.S. Constitution does not grant the federal government, including Congress and the Treasury Department, the authority to dictate the terms under which companies are chartered. Similar to the NSBU decision in Alabama, plaintiff Boyle puts forward the argument that the CTA’s broad language captures entities that are primarily holding companies that may not be engaged in foreign, interstate, or Indian commerce. Additionally, Boyle argues that the penalties imposed by the CTA were outside of Congress’s authority, as they did not constitute a tax. The Alabama court in NSBU rejected the idea that the CTA’s penalties constituted a tax, so it remains to be seen if we can expect similar treatment from the District of Maine. Michigan — Small Business Association of Michigan v. Yellen On March 26, 2024, the Small Business Association of Michigan, along with the Chaldean American Chamber of Commerce and several other plaintiffs, filed suit in the U.S. District Court for the Western District of Michigan challenging the CTA on three constitutional grounds: Commerce Clause. Plaintiffs argue that merely because an entity has been formed under state or tribal law, this does not necessarily mean that such entity has been engaged in any sort of commerce — interstate or otherwise. Plaintiffs argue that the Commerce Clause does not permit Congress to regulate entities solely by reason of their existence. Fourth Amendment privacy rights. Plaintiffs argue that the CTA is predominantly a tool to be utilized by law enforcement against crime (white collar or otherwise), and the reporting requirements oblige beneficial owners to provide sensitive information to federal law enforcement agencies that may be shared with domestic or foreign law enforcement. Plaintiffs note that no court oversight is required for any of the processes required under the CTA, and argue that the Fourth Amendment does not allow warrantless, suspicionless searches of American citizens or companies. Constitutional vagueness. Plaintiffs argue that the CTA’s definition of “beneficial owner” is unconstitutionally vague, and too indefinite for ordinary people to know precisely when they are required to report an interest or not.3 The plaintiffs sought a preliminary injunction against enforcement of the CTA against them while the case is pending. The court has denied the motion for a preliminary injunction and has ordered briefing to be concluded by July 26, as proposed by the parties.4 Ohio — Robert J. Gargasz Co. v. Secretary of the Treasury In this case, which was pending prior to the decision in NSBU, the court has granted the defendants’ motion to hold the case in abeyance pending the outcome of the appeal to the Eleventh Circuit.5 Proceedings in the Maine and Michigan cases are ongoing. Regardless of the outcome of these two cases, however, ultimately the Supreme Court is likely to have the final say on the CTA’s fate. This is especially true if lower courts disagree and Congress does not amend the law. What Can Businesses Expect for Now? Businesses should expect the Financial Crimes Enforcement Network (FinCEN) to maintain its current stance that the CTA applies broadly, absent a specific court ruling, and that reporting obligations continue to be enforceable. Save any action by Congress or the Supreme Court, entities created prior to January 1, 2024, are expected to have provided reporting information on beneficial owners by January 1, 2025, and entities created in 2024 are expected to file similar reports within 90 days after formation. Members of Stradley Ronon’s CTA Task Force — a multidisciplinary team established to provide guidance on all facets of the CTA — will continue to monitor these developments and are available to assist clients with any questions that may arise. 1  National Small Business United v. U.S. Dep’t of the Treasury, No. 24-10736 (11th Cir. Apr. 22, 2024). 2  Complaint, Boyle v. Yellen, No. 2:24-cv-00081-LEW (D. Me. Mar. 15, 2024). 3 Verified Complaint, Small Business Ass’n of Mich. v. Yellen, No. 1:24-cv-00314-RJJ-SJB (W.D. Mich. Mar. 26, 2024). 4  Small Business Ass’n of Mich. v. Yellen, No. 1:24-cv-00314-RJJ-SJB (W.D. Mich. Apr. 26, 2024). 5  Robert J. Gargasz Co. v. Secretary of the Treasury, No. 1:23-cv-02468-CEF (N.D. Ohio Apr. 17, 2024).

Gig work rapidly evolved into a fixture of the job market, with constant innovation from the businesses operating in the space. Popular gig work roles expanded beyond ride-share and delivery drivers to graphic designers, freelance writers, mobile shoppers, fitness trainers, online tutors, virtual assistants and social media content creators. As the world of gig work continues to evolve, so does the legal landscape. The gig economy offers flexibility, but it also lacks many of the basic worker legal protections afforded to more traditional occupations. The classification of gig workers as independent contractors continues to be a key financial driver for the gig economy, as contractor status comes with lower business costs and flexibility. California’s Assembly Bill 5 (AB 5), which effectively presumes most workers are employees entitled to enhanced legal rights unless they meet specific criteria, remains controversial, with one recent study finding that AB 5 adversely impacted the California job market overall while other economists disagreed. The U.S. Department of Labor recently implemented its own independent contractor status rule, which does not go as far as AB 5 but renders contractor classification more challenging; court cases and efforts by lawmakers to overturn the rule remain pending. New York City adopted its own Freelance Isn’t Free Act applicable to most gig workers, while also requiring minimum pay standards for some delivery workers. Ride-share companies recently reached a settlement that includes enhanced protections and benefits for drivers across the entire state. Many other states and some cities, such as Chicago and Seattle, also have current or pending regulations aimed at providing more legal rights to gig workers. What does this evolving legal landscape mean for business? Compliance Uncertainty. Whether operating in the gig economy or simply using a gig worker occasionally, businesses face challenges when navigating changing regulatory requirements and varying federal, state and city regulations. Collective Bargaining. Current labor laws allow unionization by employees, not independent contractors. The movement to expand those legal rights to gig workers continues to gain momentum. Business Model Changes. As the law continues to evolve, companies should anticipate the potential need to reclassify certain gig workers as employees or change their pay practices.

Deputy Attorney General Lisa Monaco announced on March 7 that the U.S. Department of Justice (DOJ) will launch a pilot whistleblower program that will offer financial incentives for individuals to report allegations of criminal wrongdoing to the DOJ. The program will be launched later this year following a 90-day process to develop and implement the pilot. The new initiative will expand upon the DOJ’s recent efforts to incentivize voluntary self-disclosure and will create a counterpart program to those already underway at the U.S. Securities and Exchange Commission (SEC), Commodity Futures Trading Commission, Internal Revenue Service and Financial Crimes Enforcement Network. The program will also serve as an alternative to qui tam actions, which offer their own whistleblowing incentives but are limited to cases of fraud against the government. In Monaco’s announcement, she stated that the DOJ’s whistleblower program rests on the premise that “if an individual helps DOJ discover significant corporate or financial misconduct — otherwise unknown to [DOJ] — then the individual could qualify to receive a portion of the resulting forfeiture.” An individual will be entitled to a whistleblower payment at the conclusion of a criminal proceeding resulting in a conviction where: (1) all victims have already been properly compensated; (2) the information the individual provides to the DOJ is not already known to the government; (3) the individual is not involved in the criminal activity itself; and (4) there is not an existing financial disclosure incentive, such as through the qui tam program. Monaco emphasized certain categories of cases that would be most lucrative to whistleblowers and should be most concerning to businesses. She explained that the DOJ is “especially interested in information about” the following: “criminal abuses of the U.S. financial system; foreign corruption cases outside the jurisdiction of the SEC, including [Foreign Corrupt Practices Act] violations by non-issuers and violations of the recently enacted Foreign Extortion Prevention Act; and domestic corruption cases, especially involving illegal corporate payments to government officials.” This new DOJ whistleblower program is designed to parallel and supplement the SEC’s existing whistleblower program and assist in cases outside the SEC’s jurisdiction. Like the SEC’s whistleblower program, the DOJ’s program will allow whistleblower awards only in cases involving penalties above a certain, yet to be determined, monetary threshold. Because of the high monetary threshold, the program will target only the most significant criminal conduct and motivate individuals to report large-dollar cases. The SEC’s whistleblower program has paid over $1.9 billion since its creation in 2011, including nearly $600 million in the last year alone. Unlike the SEC program, which focuses on public companies, U.S. listed entities and regulated entities under the SEC’s purview, this new DOJ program is notable because it will incentivize individuals to report on misconduct at companies and organizations not otherwise covered by the SEC’s program, including purely private corporations, partnerships and even nonprofits. What Actions Should Companies Take Now? In an effort to anticipate the impact of the new DOJ program on businesses, the SEC’s whistleblower program provides guidance in predicting the potential key implications of the DOJ program and how businesses can best prepare for these new policies: We expect the DOJ pilot program will add to the existing complexity surrounding the decision on whether and when an entity should self-report misconduct to the DOJ. The program’s incentives may increase the likelihood that employees will report misconduct directly to the DOJ instead of internally reporting to their employers. Companies will face a greater dilemma in deciding whether and when to self-report to the DOJ, knowing that benefits to companies for self-disclosure only exist if the government is unaware of the misconduct. Any disclosure and its timing will need to be even more carefully considered. Given the potential financial reward for reporting misconduct directly to the DOJ, companies will likely face more challenges in encouraging employees to report misconduct internally. A key takeaway is that companies should act now to create or optimize a framework that further encourages employees to report potential misconduct internally. Therefore, it is imperative that companies use the time before the pilot program is implemented to evaluate and review their existing compliance policies and procedures, including internal hotlines and other reporting mechanisms, to ensure that they are straightforward and may be thoughtfully utilized by employees. The goal is to create an environment where employees know that their disclosures will be promptly and appropriately handled so employees do not need to turn to the government for assistance. Entities covered by the SEC’s regulations are prohibited from taking actions that can be seen as restricting employees from reporting misconduct to the SEC, such as including provisions in employment policies, nondisclosure agreements or severance agreements that prohibit such voluntary disclosure. Companies should utilize the time before the DOJ pilot program is implemented to review employment policies, settlement agreements, severance agreements and the like to remove any language prohibiting voluntary government disclosure. Ultimately, it is important to ensure that employees do not feel motivated to go outside of their companies to make reports to the DOJ despite the new incentives being put in place. While more about the DOJ program will be released in the upcoming weeks and months, companies can take steps now to ensure they are prepared for the impact of these new policies.

Restricted stock awards are generally taxed when they vest, which can often occur months or years after such awards are granted. Stock options are generally taxed at exercise after they have vested (for incentive stock options, the spread between strike price and fair market value at exercise is a tax adjustment item for purposes of alternative minimum tax) and at a subsequent disposition. However, in certain instances, an option holder may purchase stock that is not vested. These awards are sometimes referred to as early exercise options. Section 83(b) of the U.S. Internal Revenue Code (IRC) provides taxpayers the ability to elect to pay taxes on the fair market value (FMV) of restricted property at the time the property is granted as opposed to when the property is vested, effectively accelerating the recognition of ordinary income tax. The 83(b) election can be a powerful tax-savings tool, particularly for startup companies, where the value of the stock may be de minimis at the time of grant but is expected to increase over time. Benefits of an 83(b) Election Tax Savings at the Time of Issuance: An 83(b) election allows a taxpayer who is granted an equity award to pay income tax on the award at the time it is granted instead of waiting for the award to vest. Because the FMV of the shares is typically de minimis in a startup’s earliest stages, the taxpayer generally can pay the small amount of applicable taxes (if any) associated with the grant rather than paying taxes on the value of the stock at the time of vesting, when the FMV of the stock is potentially higher. Thus, where the value of stock increases over time, an 83(b) election can result in significant tax savings. Capital Gains Treatment: Filing an 83(b) election starts the taxpayer’s capital gains holding period clock earlier. A taxpayer who makes the 83(b) election will receive the long-term capital gains rate if the sale of the shares occurs more than one year after the date of grant (or exercise date for early exercise options) rather than one year after vesting. Potential Drawbacks of an 83(b) Election One potential drawback of making an 83(b) election is that if the taxpayer later forfeits the shares before the shares vest, the taxpayer is not entitled to a refund for the taxes paid. Thus, there is the potential for a taxpayer to be out of pocket for the amount of taxes paid on stock that the taxpayer never owns. Additionally, if the shares depreciate between the date of grant and the date they vest, a taxpayer who makes an 83(b) election will pay a higher tax by making the election. How to File an 83(b) Election To make a valid 83(b) election, the taxpayer must sign and complete the required election forms and return the forms to the IRS no later than 30 days after the date that the stock award is granted. For restricted stock, the grant date is typically the effective date of the agreement. In the case of early exercise options, it is the date on which the option holder exercises his or her options early (before the options vest). Failure to file within the timeframe will render the election void, and a taxpayer may recognize ordinary taxable income as vesting restrictions lapse. In general, the taxpayer will need to provide the following information on the 83(b) election form: Taxpayer’s general information. A description of the property, including the quantity of shares of the issuer/company. The date of grant. The taxable year for which the election is being made. The nature of restriction or restrictions to which the property is subject. The FMV of the shares of the company on the date granted. The amount, if any, paid for the property. The amount to include in gross income. The taxpayer must file the form with the IRS office that the taxpayer files his or her annual income tax return. A copy of the form should also be provided to the issuer/company. The taxpayer should retain a copy of the completed election form for his or her personal records.

A federal district court in Alabama issued a significant decision in National Small Business United v. Yellen on March 1, declaring the Corporate Transparency Act (CTA) unconstitutional as it exceeds the Constitution’s limits on the power of Congress.1 Background of the Corporate Transparency Act The CTA, enacted as part of the National Defense Authorization Act for Fiscal Year 2021, aims to combat money laundering and terrorist financing by requiring certain businesses to report beneficial ownership information to the Financial Crimes Enforcement Network (FinCEN). This information includes beneficial owners’ full legal names, dates of birth, residential street addresses, and the identifying number and an image of a government-issued identification document. Although the CTA passed with bipartisan support, it was criticized by some business groups that argued the act imposed a heavy reporting burden on legitimate businesses. The plaintiffs in this case included one such group: National Small Business United, a nonprofit trade group also known as the National Small Business Association (NSBA) that represents more than 65,000 member companies. Plaintiff Isaac Winkles owns an Alabama corporation that is an NSBA member. The plaintiffs filed suit in the U.S. District Court for the Northern District of Alabama challenging the constitutionality of the CTA. The named defendants were the U.S. Department of the Treasury, Treasury Secretary Janet Yellen and FinCEN Acting Director Himamauli Das in their official capacities. Ultimately, the court sided with the plaintiffs and held that the CTA was unconstitutional. Key Points of the Alabama Court’s Decision Exceeding Enumerated Powers: The court held that the CTA exceeds Congress’s enumerated powers under the Constitution. U.S. District Judge Liles Burke focused on (1) the powers over foreign affairs and national security, (2) the Commerce Clause and (3) the taxing power. Foreign Affairs and National Security: The court rejected the defendants’ argument that the CTA fell within the defendants’ powers over foreign affairs and national security because it aids in preventing money laundering and terrorism financing. The court reasoned that even if these are legitimate goals, the CTA’s means to achieve them are not necessary and proper. The act’s broad scope and intrusion into areas traditionally regulated by states were deemed excessive. Commerce Clause: The court considered whether the CTA could be considered under one of three broad categories of Commerce Clause jurisprudence: (1) channels of interstate and foreign commerce; (2) the instrumentalities of, and things and persons in, interstate and foreign commerce; and (3) activities that have a substantial effect on interstate and foreign commerce. The court acknowledged that the CTA targets entities that may utilize interstate commerce channels. However, it found that the CTA lacks a sufficient nexus to the Commerce Clause because it does not regulate interstate commerce. Judge Burke distinguished the CTA from other cases in which Congress regulated activities with a substantial effect on interstate commerce. Here, the focus on the non-commercial, intrastate activity of incorporating entities was not sufficient to justify the federal intrusion. The court noted that the CTA does not regulate activities that, although purely intrastate, substantially affect interstate commerce. Further, the court reasoned that many entities are established for purposes that may or may not be commercial. The court also suggested that FinCEN already has the means of obtaining ownership information through its Customer Due Diligence (CDD) rule, which requires financial institutions to obtain certain beneficial ownership information from their customers. “FinCEN’s CDD rule and the CTA provide FinCEN with nearly identical information, but the CDD rule does so in a constitutionally acceptable manner,” the court said.2 Taxing Authority: The court rejected the Treasury’s argument that the CTA is justified by the taxing power. “The CTA’s civil penalties are not a tax: they are not paid into the Treasury and have no income thresholds; the penalty amounts are fixed rather than variable; the penalties are not ‘found in the Internal Revenue Code and enforced by the IRS’; and the penalties are imposed only on those who ‘knowingly’ or ‘willfully’ violate the law,” Judge Burke noted.3 Plaintiffs’ Claimed Violations of Multiple Constitutional Amendments: The court declined to address the plaintiffs’ arguments that the CTA’s expansive reporting requirements violate several amendments to the Constitution, including the following:First Amendment: The plaintiffs raised concerns regarding the potential chilling effect on the formation of new entities due to the disclosure of personal information. Fourth Amendment: The plaintiffs questioned whether broad data collection authorized by the CTA constitutes an unreasonable search and seizure. Fifth Amendment: The plaintiffs argued that the potential for self-incrimination due to the reporting requirements was a point of concern. Ninth and Tenth Amendments: The plaintiffs noted the potential infringement on unenumerated rights and the power reserved to the states, particularly regarding corporate formation and regulation.   Outcome and Impact on the Future of the Corporate Transparency Act Ultimately, the court declared the CTA to be unconstitutional and enjoined the defendants, along with any other agency or employee acting on behalf of the United States, from enforcing the statute against the plaintiffs.4 The decision represents a setback in the government’s efforts to combat financial crime through enhanced beneficial ownership transparency and creates some confusion for those covered by the CTA. However, it is important to note that this is a single district court ruling, and the injunction imposed by the judge applies only to the specific plaintiffs. FinCEN’s published response to the decision states FinCEN would comply strictly with the court’s order: “As a result, the government is not currently enforcing the Corporate Transparency Act against the plaintiffs in that action: Isaac Winkles, reporting companies for which Isaac Winkles is the beneficial owner or applicant, the National Small Business Association, and members of the National Small Business Association (as of March 1, 2024). Those individuals and entities are not required to report beneficial ownership information to FinCEN at this time.”5 Accordingly, the decision has no binding impact on any other reporting company or beneficial owner thereof. The government will likely appeal, potentially leading to a lengthy legal battle. In a statement reported by The New York Times, U.S. Sen. Sheldon Whitehouse (D-Rhode Island), an advocate of the CTA, “urge[d] the government to appeal quickly to correct the erroneous decision and ensure the law’s transparency requirements can be fully and uniformly implemented.” Industry groups also criticized the ruling. Zorka Milin, policy director at the Financial Accountability and Corporate Transparency (FACT) Coalition, described the decision as being “off the mark in terms of constitutional interpretation and is based on a misunderstanding of U.S. anti-money laundering law.” It also remains to be seen if this decision will result in the filing of additional lawsuits challenging the constitutionality of the CTA in other jurisdictions, whether on the same or different grounds from those on which this case was decided. What Steps Does Your Business Need to Take Now? Stradley Ronon Stevens & Young can help you adequately prepare – from Venture Capital to Corporate & Securities. While the Alabama decision clouds the future of the CTA, businesses should take note of the narrow scope of the remedy applied by the court. For now, reporting requirements under the CTA remain in effect as written for all covered entities other than the plaintiffs in this case, and reporting companies are still subject to civil and criminal penalties should they willfully fail to report on a timely basis. Consider taking the following actions: Identify entities within your organization that may be reporting companies. Identify whether you and any or all of your affiliate entities qualify for any exemption. If any entity within your organization is not exempt from the reporting requirements, identify such entity’s beneficial owners. Collect the required information about the entity and its beneficial owners. Develop a system for updating and correcting beneficial ownership information regularly. This may include reviewing agreements to ensure that anyone who could be a beneficial owner is required to provide the company with updated and accurate information on a timely basis. Establish procedures for filing initial and updated reports with FinCEN.   More Information – Helping Emerging Companies & Venture Capital Funds from Philadelphia, to New York, to Chicago. The CTA requirements remain subject to further modification and guidance. FinCEN has published guidance tools that may be useful in interpreting the regulations as they are implemented. For current guidance and updates from FinCEN on the rules and existing regulations, see FinCEN’s BOI Small Entity Compliance Guide. Stradley Ronon’s CTA Task Force will continue to monitor these developments, and we are available to assist clients with their obligations to navigate these complicated new requirements. 1  National Small Business United v. Yellen, No. 5:22-cv-01448 (N.D. Ala. March 1, 2024). 2 Id. at 44. 3 Id. at 50. 4 This was the remedy sought by the plaintiffs, who did not request a broader injunction. 5 Notice Regarding National Small Business United v. Yellen, No. 5:22-cv-01448 (N.D. Ala.) (March 4, 2024).

Most contracts will straightforwardly require the parties to take or refrain from taking specified actions. However, some contracts require that a party attempt to bring about a result that may or may not be within the party’s control. Such provisions are commonly qualified so that the party will not have breached the provision, even if the goal is not achieved, so long as the party has used its “reasonable efforts” to bring about the desired result. Because the steps that a party must take to satisfy a reasonable-efforts requirement will depend on the facts and circumstances surrounding the obligation, lawyers may struggle to advise their clients on what is required to satisfy such an “efforts clause.” In the recent case of Chordia v. Lee, the Delaware Court of Chancery reviewed the factors to be considered in analyzing an efforts clause while holding that a majority stockholder had failed to use its reasonable efforts to carry out the terms of a stockholders’ agreement. What Happened in Chordia? Zenith Electronics LLC, an indirect, wholly owned subsidiary of major appliance and consumer electronics company LG Electronics Inc., purchased a controlling interest in ad tech company Alphonso Inc. in 2020. Although Alphonso’s founders wanted to retain control of the company so that they could drive it toward an initial public offering, the founders and other Alphonso stockholders (the key holders) ultimately settled for significant upfront cash together with some heavily negotiated minority protections. The key holders’ minority protections were intended principally to preserve liquidity for their minority interests in Alphonso. Specifically, the parties entered into a stockholders’ agreement that gave the key holders a demand registration right exercisable after December 2025 and a right to annual tender offers in 2024, 2025 and 2026. These liquidity rights were protected, in turn, by the combination of (1) a right of the key holders to appoint up to three of the seven directors on Alphonso’s board and (2) a prohibition on any change to the registration right or the scheduled tender offers absent the consent of at least one director appointed by the key holders. The key holders’ right to appoint directors to the Alphonso board was subject to two conditions. First, they had to retain collective ownership of at least 10 percent of Alphonso’s outstanding shares. Second, at least one of the key holders had to remain as an officer or employee of Alphonso. LG Electronics had the right to terminate the stockholders’ agreement in its entirety if all key holders ceased to serve as officers and employees of Alphonso. The stockholders’ agreement further provided that Alphonso’s board — controlled by four LG Electronics-appointed directors — retained the exclusive right to terminate the employment of Alphonso’s officers and any of its employees with annual compensation of $500,000 or more, which applied to five of the key holders (the executive key holders). As the court noted, “Given these mechanics, it might seem that [the key holders’ right to appoint Alphonso directors] requires protection of its own.” That protection, according to the key holders, was to be found in the stockholders’ agreement’s efforts clause, which read: Alphonso “agrees to use its reasonable efforts, within the requirements of applicable law, to ensure that the rights granted under this Agreement are effective and that the Parties enjoy the benefits of this Agreement. Such actions include, without limitation, the use of [Alphonso’s] reasonable efforts to cause the nomination and election of the directors as provided in this Agreement.” Not long after the closing, friction developed between LG Electronics and the executive key holders, including LG Electronics’ realization that a sale of Alphonso pursuant to the key holders’ liquidity rights would be inconsistent with LG Electronics’ long-term objective of incorporating Alphonso’s technology into LG Electronics’ products. By mid-2022, LG Electronics sought ways to terminate the stockholders’ agreement and eliminate its obligations to the key holders. At the end of the year, Alphonso’s board held a special meeting at which the board (1) terminated the employment of the five executive key holders and (2) elected a new interim CEO, who immediately fired the two remaining key holders who were neither officers nor employees with annual compensation of $500,000 (the non-executive key holders). Later that day, Zenith signed a written consent (the December consent) removing all Alphonso directors who had been appointed by the key holders. On March 30, 2023, the key holders filed a complaint seeking an order pursuant to Section 225 of the Delaware General Corporation Law that Zenith’s removal of the directors appointed by the key holders pursuant to the December consent was invalid and, therefore, those directors remain members of Alphonso’s board. The court agreed with the key holders. Chancery Court Examines Efforts Clause with Four-Factor Analysis After determining that a court hearing a case under Section 225 of the Delaware General Corporation Law could decide an appropriately tailored breach of contract claim, the court conducted an analysis that “begins and ends with the ‘reasonable efforts’ provision in the Stockholders’ Agreement.” Specifically, the court focused its analysis on four questions: “(1) which parties are required to use reasonable efforts, (2) toward whom reasonable efforts must be used, (3) the scope of the obligation imposed by the words “reasonable efforts,” and (4) whether the party that must use reasonable efforts acted in the manner required by the obligation toward those to whom reasonable efforts must be used.” Which Parties Must Use Reasonable Efforts? Turning to the first of these questions, the court, while noting the “truism that a corporation acts through individuals,” nonetheless also noted that “the Stockholders’ Agreement itself distinguishes in various instances between Alphonso and the Board,” treating the board and Alphonso as distinct parties with differing rights and obligations. This distinction was so prevalent that “in some instances the Stockholders’ Agreement refer[red] separately to the Board and Alphonso in the same provision.” Under these circumstances, the court adopted the defendants’ approach and interpreted the rights and obligations under the stockholders’ agreement as applying separately to Alphonso and to its board. This was important because the efforts clause, by its terms, applied only to Alphonso and not to the board. In determining which human agents’ actions should be attributed to Alphonso, the court relied on the theory that a corporation acts through its officers and held that the interim CEO, in particular, acted for Alphonso. (In a footnote, the court indicated that it would reach the same result on the alternate theory that the acts of a corporation’s officers, acting within the scope of their authority, are imputed to the corporation itself.) Thus, the court determined that the board was free to exercise its bargained-for contract right to terminate the five executive key holders and appoint Alphonso’s new interim CEO without regard to the efforts clause. By contrast, when the interim CEO terminated the non-executive key holders, the interim CEO was acting for Alphonso and had to comply with the corporation’s reasonable-efforts obligation. Toward Whom Must Reasonable Efforts Be Used? The court next concluded that Alphonso owes its reasonable efforts with respect to the appointment of Alphonso’s directors for the benefit of the two non-executive key holders. The efforts clause required Alphonso “to ensure that the rights granted under [the stockholders’ agreement] are effective and that the Parties enjoy the benefits of” [the stockholders’ agreement].” As parties to the stockholders’ agreement, all of the key holders were generally entitled to the benefit of Alphonso’s reasonable-efforts clause, but the efforts clause did not apply to the actions of the board. Accordingly, when the board exercised its right to terminate the executive key holders as directors, officers and employees, only the two non-executive key holders retained the right to appoint up to three members of Alphonso’s board, subject to the conditions that they hold at least a 10 percent interest in Alphonso and that at least one of them remain an employee of the corporation. In other words, the fact that the board had the right to terminate the executive key holders without regard to the efforts clause meant that the non-executive key holders were the ultimate beneficiaries of Alphonso’s reasonable efforts. But Alphonso, through the interim CEO’s immediate termination of the employment of the non-executive key holders, denied them any opportunity to exercise their right to appoint directors, in violation of the efforts clause. What Is Meant by ‘Reasonable Efforts’? Noting that Delaware interprets various efforts clauses (best efforts, reasonable best efforts, reasonable efforts, commercially reasonable efforts, etc.) as having the same general meaning, the court clarified that absent a specific contractual definition, Delaware courts will interpret such provisions as creating “an affirmative obligation on the parties to take all reasonable steps.” Because this is an affirmative obligation, a party may breach an efforts clause by failing to use any efforts, i.e., by doing nothing. Beyond that, the court identified two specific factors that Delaware courts have indicated should be examined in determining whether a party has breached an efforts clause: “whether the party subject to the clause (i) had reasonable grounds to take the action it did and (ii) sought to address problems with its counterparty.” Did the Party Bound by the Efforts Clause Act in the Manner Required? Applying the first of the above factors, the court concluded that Alphonso had no grounds for terminating the non-executive key holders while it owed them a specific and affirmative obligation to undertake reasonable efforts to ensure their ability to appoint directors to its board. Notwithstanding that the non-executive key holders were “at will” employees of Alphonso, the court noted that the efforts clause under the stockholders’ agreement provided them a measure of employment security so that they could continue to exercise their right to appoint directors under the stockholders’ agreement: “Given that the rights were conditioned on employment, which was a condition within Alphonso’s control, Alphonso committed itself to use reasonable efforts in that regard to ensure the rights were effective.” It is particularly telling that, in contrast to the disruptive actions of the executive key holders, the non-executive key holders cooperated with Alphonso even after their termination, including volunteering to assist with knowledge transfer to other Alphonso employees. Turning to the second factor, the court noted that Alphonso had “many less drastic alternatives to terminating the remaining Key Holders,” such as asking them to appoint new directors or negotiating with them for another resolution. The court noted that reasonable actors who are subject to an efforts clause would typically seek to discuss an issue and its potential resolution with the party to whom efforts are owed. “But here, there is not a shred of evidence demonstrating that Alphonso or [the interim CEO] gave any consideration to the [non-executive key holders’] rights, much less interacted with them in any meaningful way prior to their terminations,” the court noted. Because Alphonso neither had reasonable grounds for the termination of the non-executive key holders nor attempted to work with them to arrive at a solution short of termination, the court held that Alphonso breached its obligations under the efforts clause. The court goes on to note that, while some discussions occurred between the executive key holders and the LG Electronics-appointed directors on Alphonso’s board, those discussions cannot satisfy Alphonso’s obligation to use reasonable efforts to protect the rights of the non-executive key holders, who were not party to those discussions. Effect of Alphonso’s Breach of the Efforts Clause The non-executive key holders had a right to appoint directors to Alphonso’s board so long as certain conditions were met, including the continued employment of at least one non-executive key holder. In the absence of the efforts clause, Alphonso’s termination of both non-executive key holders would have resulted in failure of the condition and would have terminated the non-executive key holders’ right to appoint directors. But the stockholders’ agreement required Alphonso to use its reasonable efforts to protect the non-executive key holders’ right to appoint directors, which limited Alphonso’s right to terminate their employment. Since Alphonso’s breach of the efforts clause caused the failure of the condition, the court held that the condition must be excused. Referring to the “prevention doctrine” from the Restatement (Second) of Contracts, the court noted that “when a promisor’s non-performance of a contractual duty materially contributes to the non-occurrence of a condition, the condition is excused.” Applying this doctrine to the current facts, the court found that (1) Alphonso’s non-performance of its obligations under the efforts clause resulted in the termination of the non-executive key holders and (2) that termination not only contributed to, but effectively eliminated, the non-executive key holders’ right to appoint certain Alphonso directors, which was necessary to protect their liquidity rights under the stockholders’ agreement. Accordingly, the court held that the condition that at least one key holder remain employed by Alphonso was excused, and the key holders were entitled to designate directors of Alphonso in accordance with the stockholders’ agreement, notwithstanding the termination of their employment. Because the December consent was adopted by the LG Electronics-appointed directors without the participation of directors appointed by the non-executive key holders, it was declared invalid. What Are the Key Takeaways from the Court’s Decision? Framework for Drafting and Interpreting Efforts Clauses This opinion provides a helpful framework not only for interpreting efforts clauses but also for drafting them. When an efforts clause appears in an agreement, the agreement should answer at least three of the court’s questions: (1) which specific party or parties are bound by the efforts clause; (2) toward whom, or for whose benefit, must reasonable efforts be used; and (3) what reasonable steps should the party take in furtherance of the stated goal (using specific examples if possible). When an efforts clause is interpreted, this framework expands to include a fourth inquiry — whether the party that must use reasonable efforts acted in the manner required by the obligation — which can, in turn, be answered through an examination of (1) whether the party had reasonable grounds to take the action it did and (2) whether the party sought to address problems with the party to whom the efforts obligation was owed. This framework allows counsel to provide clients with meaningful guidance as to their rights and responsibilities when asked about efforts clauses, rather than vaguely responding, “It depends.” Distinguishing Between an Entity and the Individuals Who Act for the Entity One key element of this decision is the distinction between Alphonso and its board of directors, each of which has different rights and obligations under the stockholders’ agreement. Such a dichotomy can arise in any agreement to which both an entity and one or more of its constituents (e.g., stockholders, directors, officers or employees) are parties, such as stockholders’ agreements, limited liability company agreements, executive employment agreements, etc. Care should be taken to clearly delineate the individuals who have authority to act on behalf of the entity under such an agreement, and that delineation should take into account both the fiduciary duties of directors, which prevent directors from delegating their rights to vote on board decisions, and potential conflicts of interest of all of the parties.

When whistleblowers lose their jobs or otherwise experience an adverse employment action, employers often face retaliation claims. With respect to retaliation claims brought under the Sarbanes-Oxley Act, the U.S. Supreme Court recently clarified the parties’ respective burdens of proof in a way that may encourage more whistleblower suits and impact an employer’s litigation strategy and settlement calculus. In Murray v. UBS Securities, the Supreme Court resolved a split that had arisen between the U.S. Court of Appeals for the Second Circuit and the Fifth and Ninth circuits regarding whether a whistleblower plaintiff under Sarbanes-Oxley is required to prove that his or her employer acted with “retaliatory intent.” Rejecting the Second Circuit’s position — and in line with the Fifth and Ninth circuits — the court on February 8 unanimously ruled that a Sarbanes-Oxley plaintiff is not required to make such a showing. As the Supreme Court noted in Murray, Sarbanes-Oxley was passed in the wake of the Enron scandal, where Congress’ subsequent investigation uncovered “abundant evidence” that Enron’s “massive shareholder fraud” had succeeded in large measure as the result of a “corporate code of silence” enforced through firing employees who attempted to report misconduct. Congress accordingly incorporated into Sarbanes-Oxley an express provision, 18 U.S.C. Section 1514A, to prohibit “publicly traded companies from retaliating against employees who report what they reasonably believe to be instances of criminal fraud or securities law violations,” the court said. In Murray, plaintiff Trevor Murray worked for UBS as a research strategist in the firm’s commercial mortgage-backed securities business. U.S. Securities and Exchange Commission regulations required Murray to certify his reports to UBS’s current and potential customers as accurately reflecting his views. Murray alleged that his direct supervisors pressured him to alter his reports and that he was terminated after bringing this pressure to the attention of other superiors. He filed an action against UBS in federal court alleging a violation of Section 1514A. UBS argued on summary judgment that Murray had failed to supply evidence that UBS held any “retaliatory animus” toward him. The district court rejected that argument, holding that Murray was not required to make any such showing, and the jury later found in Murray’s favor. But the Second Circuit reversed on appeal, finding that “retaliatory intent is an element of a Section 1514A claim.” After engaging in a detailed statutory analysis of the language of Section 1514A and the burden-shifting framework it imposes on employees and employers, the Supreme Court rejected the Second Circuit’s interpretation in its entirety. As the district court had instructed the jury, the plaintiff alleging retaliation under Sarbanes-Oxley must only prove that: (1) the employee engaged in whistleblowing activity protected under the act; (2) the employer knew of the protected activity; (3) the employee was fired or suffered some other adverse employment action; and (4) the protected activity was a “contributing factor” in the adverse employment action. The employee is not additionally required to prove the employer’s “retaliatory intent,” the Supreme Court said. If the plaintiff proves each of the required four elements, the burden then shifts to the employer to prove that it would have terminated the plaintiff’s employment (or taken the adverse employment action at issue) even if the employee had not engaged in the whistleblowing activity. By removing the requirement that whistleblower plaintiffs under Sarbanes-Oxley show “retaliatory intent,” the court’s decision lowers a plaintiff’s evidentiary bar and makes defending a retaliation claim trickier for employers. Indeed, finding and presenting evidence of the employer’s intent was previously one of the most difficult burdens placed on a whistleblower plaintiff. Now, however, the whistleblower only needs to show that the whistleblowing activity was a “contributing factor” to the adverse employment action. This may lead to publicly traded companies facing more whistleblower suits and being incentivized to settle where they may have previously opted to defend aggressively. Employers covered by Sarbanes-Oxley should acquaint themselves with the Murray decision and take steps to ensure they are in a position to succeed if a retaliation action is brought and the burden ultimately shifts to the employer. Thoroughly documenting the adverse employment action and the full set of bases for such action, along with ensuring that the employer has put in place both comprehensive policies to protect whistleblowers and meaningful employee training regarding such policies, will help set the company up to demonstrate that the adverse employment action would have occurred even if the employee had not engaged in protected whistleblowing activity.

For much of 2023, it seemed like barely a week would pass by without a new data breach or privacy violation finding its way into the headlines, making it clear that the threat actors of the world have not given up. In response, last year saw several significant federal and state regulatory developments in the cyber and privacy landscape. Regulators will remain focused on these issues and how they might be addressed. Federal Regulatory Developments U.S. Securities and Exchange Commission The U.S. Securities and Exchange Commission (SEC) took a number of aggressive regulatory and enforcement positions in 2023. The agency began the year by suing law firm Covington & Burling to obtain the names of almost 300 clients impacted by a 2020 cyberattack attributed to a nation-state actor. A district court ruling in July required Covington to disclose the identities of seven clients whose material nonpublic information was exposed through the hack. One of those clients has anonymously proceeded to contest the disclosure of its identity. That same month, the SEC finalized new rules for disclosures regarding cybersecurity risk management, strategy, governance and incident response for public companies subject to the reporting requirements of the Securities Exchange Act of 1934. The new rules require companies to disclose material cybersecurity incidents under Item 1.05 on Form 8-K. The SEC also initiated litigation against SolarWinds Corp. and its chief information security officer (CISO) in October — the SEC’s first action against a CISO. The SEC alleges the company and its CISO defrauded investors by overstating the company’s cybersecurity practices and understating or failing to disclose known risks in filings made with the commission. The litigation related to these charges is ongoing. The SEC has not yet finalized its 2022 proposed rulemaking for other securities market participants (such as broker-dealers, clearing agencies, registered investment advisers and investment companies) for cybersecurity risk management, strategy, governance and incident response. The expectation is that the commission will try to finalize the rules this year. Federal Trade Commission Early in the year, the Federal Trade Commission (FTC) initiated several litigations related to alleged Children’s Online Privacy Protection Act (COPPA) violations, including against Microsoft, educational technology provider Edmodo and Amazon. Microsoft agreed to pay $20 million to settle charges related to its illegal collection and retention of personal information from children who signed up for its Xbox Live service. Edmodo agreed to a $6 million civil penalty for its collection of personal data from children, the use of that data in advertising and the unlawful outsourcing of COPPA compliance responsibilities to schools. The FTC’s litigation against Amazon remains ongoing. The FTC also began to enforce the Health Breach Notification Rule in 2023 with respect to the unauthorized sharing of health information in violation of an organization’s privacy policy. The FTC settled with GoodRx, a telehealth and prescription drug discount provider, on a no-admit/no-deny basis for $1.5 million in February. In May, the FTC settled with another entity, Easy Healthcare Corp., for $100,000. In June, the FTC reached a settlement with 1Health.io over allegations the company left sensitive generic and health data unsecured, deceived consumers about their ability to get their data deleted and made retroactive changes to the company’s privacy policy without adequately notifying and obtaining consent from customers whose data the company had already collected. These acts constituted unfair or deceptive acts or practices in violation of Section 5(a) of the Federal Trade Commission Act. 1Health.io agreed to pay $75,000 and take additional remedial actions to address the violations. The FTC settled with BetterHelp Inc. in July over allegations that the company revealed consumers’ sensitive data to third parties for advertising purposes after promising in its privacy policy to keep such data private. The company also failed to employ reasonable measures to safeguard the health information it collected from consumers, such as failing to train its employees on how to protect the information when using it for advertising; failing to provide consumers with the proper notice as to the collection, use and disclosure of their health information; and failing to limit contractually the manner in which third parties could use consumers’ health information. BetterHelp agreed to pay $7.8 million and to take additional remedial actions to address the violations. At the start of the fourth quarter, the FTC approved an amendment to the Safeguards Rule (16 CFR 314) of the Gramm-Leach-Bliley Act requiring non-banking financial institutions (such as mortgage brokers, motor vehicle dealers and payday lenders) to report certain data breaches and other security events to the agency. The FTC must be alerted as soon as possible — and no later than 30 days after discovery — of a breach involving the information of at least 500 consumers where unencrypted customer information has been acquired without the authorization of the individual to which the information pertains. After the FTC sought to impose additional privacy requirements against Meta Platforms Inc. (formerly Facebook Inc.) for alleged violations of its prior 2012 and 2020 privacy settlements, the company sued the FTC to contest the constitutionality of the commission’s in-house proceedings and sought an injunction against the FTC’s reopening of the 2020 order. A district court judge rejected Meta’s arguments in November, and Meta has appealed that decision to the U.S. Court of Appeals for the D.C. Circuit. In December, the FTC proposed changes to the COPPA Rule that would place additional restrictions on the use and disclosure of children’s personal information and the ability of companies to monetize children’s data. The proposed rule includes: (1) separate opt-in for targeted advertising; (2) prohibition against conditioning a child’s participation in an activity on the collection of personal information; (3) additional requirements around the use of information in support of a website’s internal operations; (4) limitations on the use of push notifications to encourage children to remain online; (5) codification of the FTC’s guidance on education technology; (6) increased accountability for COPPA safe harbor programs; (7) a requirement for a written children’s personal information security program; and (8) a limit on the retention of personal information to the period necessary to fulfill the specific purpose for which it was collected. The FTC settled with Rite Aid Corp. in December over the company’s use of facial recognition technology for surveillance purposes. Rite Aid allegedly deployed artificial intelligence (AI)-based facial recognition technology in an effort to identify customers who engaged in shoplifting or other problematic behavior. However, the company failed to implement reasonable measures to prevent harm to consumers who were erroneously accused of wrongdoing because the facial recognition technology falsely flagged them. The FTC’s order banned Rite Aid from using the technology for five years and required other programmatic changes to be addressed. Consumer Financial Protection Bureau In October, the Consumer Financial Protection Bureau (CFPB) proposed the Personal Financial Data Rights rule. This rule is intended to provide consumers with more control over their financial data and to effectuate sharing of data at a consumer’s direction across companies — so-called “open banking.” The rule would require banks and other providers to: (1) make personal financial data available at no charge to consumers or their agents through dedicated digital interfaces that are safe, secure and reliable; and (2) recognize a consumer’s legal right to grant third parties access to information associated with credit card, checking, prepaid and digital wallet accounts. Companies receiving data under the rule face strict limitations on what they can do with the information. They are not permitted to collect, use or retain data to advance their own commercial interests through actions like targeted or behavioral advertising. U.S. Department of Health and Human Services The U.S. Department of Health and Human Services (HHS)’s Office for Civil Rights issued a proposed rulemaking in April intended to strengthen Health Insurance Portability and Accountability Act (HIPAA) Privacy Rule protections by prohibiting the use or disclosure of protected health information to bring criminal, civil and/or administrative proceedings against patients, providers and others involved in the provision of legal reproductive healthcare, including abortion. At the beginning of November, the American Hospital Association (AHA) sued HHS over a rule prohibiting the use of certain online tracking technologies that would result in impermissible disclosures of protected health information to tracking technology vendors or other HIPAA rule violations. In its suit, the AHA claimed the HHS rule exceeded the government’s statutory and constitutional authority, failed to satisfy the agency rulemaking requirements and harmed the population it purported to protect. The AHA also noted that the government’s own healthcare providers continued to deploy the prohibited technologies on their websites. The litigation remains ongoing. Also in November, a nonprofit academic hospital in New York settled with HHS over its sharing of protected health information of COVID-19 patients with a national media outfit in 2020. The hospital had disclosed the information of three patients without first obtaining their written authorization. It agreed to pay an $80,000 penalty and to take remedial actions to address the violations. Executive Office of the President of the United States President Joe Biden issued an executive order in October intended to address the development of AI, also referred to as language models/generative pre-trained transformers. The White House had previously acted in this space in 2022 through the publication of “Blueprint for an AI Bill of Rights” and in a February executive order directing executive agencies to take further steps to combat algorithmic discrimination, among other things. The October executive order establishes new standards for AI safety and security. It requires certain developers of “any foundation model that poses a serious risk to national security, national economic security or national public health and safety” to notify the U.S. government and to share safety test results and other critical information. It also calls upon the National Institute of Standards and Technology (NIST) to develop standards, tools and tests to help ensure that AI systems are safe, secure and trustworthy. The order also called for: (1) new standards for biological synthesis screening to protect against the risks of using AI to engineer “dangerous biological materials”; (2) the establishment of “standards and best practices for detecting AI-generated content and authenticating official content”; (3) the establishment of an “advanced cybersecurity program to develop AI tools to find and fix vulnerabilities in critical software”; and (4) additional work by the National Security Council and White House Chief of Staff to guide the U.S. military and intelligence community in their use of AI. The executive order also calls upon Congress to pass bipartisan data privacy legislation. The House and Senate have previously conferred on such legislation but it has yet to pass. The executive order also directs: (1) the prioritization of “federal support for accelerating the development and use of privacy-preserving techniques”; (2) research and development on technologies to preserve individuals’ privacy; (3) strengthening “privacy guidance for federal agencies to account for AI risks”; and (4) the development of “guidelines for federal agencies to evaluate the effectiveness of privacy-preserving techniques, including those used in AI systems.” The executive order directs agencies to ensure the “collection, use and retention of data is lawful, is secure, and mitigates privacy and confidentiality risks.” It also specifies numerous steps to be taken by specific agencies to bolster privacy protections and mitigate privacy risks potentially exacerbated by AI. These include the development of AI standards that may include “best practices regarding data capture, processing, protection, privacy, confidentiality, handling and analysis.” The deadlines in the executive order direct executive agencies to perform most of this work during 2024. Federal Communications Commission The Federal Communications Commission (FCC) adopted updated data breach notification rules in December for telecommunications carriers and relay service providers. The new regulations would require notice of breaches to be provided to the FCC as well as the U.S. Secret Service and the FBI. Notification would not need to be provided in those instances where the affected entity could reasonably determine that no harm to consumers is likely to occur due to the breach. That same month, the FCC announced that it had signed memoranda of understanding with the attorneys general of Connecticut, Illinois, New York and Pennsylvania to share expertise and resources and coordinate efforts in conducting privacy, data protection and cybersecurity-related investigations to protect consumers. U.S. Department of Defense Not content to sit on the sidelines, the U.S. Department of Defense ended 2023 by proposing a new version of its Cybersecurity Maturity Model Certification program (CMMC 2.0). The proposed rule expands on prior 2019 and 2021 proposals and calls for a tiered model of cybersecurity standards (depending on the type and sensitivity of the information), as well as assessment requirements to allow for the verification of cybersecurity standards. These standards and requirements are to be implemented through the department’s contracts. State Regulatory Developments Data Privacy Laws Last year began with one state, California, having a comprehensive data privacy regime in place and another state, Nevada, having certain privacy protections in effect. Privacy acts took effect in Colorado, Connecticut, Utah and Virginia during the year. Nine more states have data privacy regimes that will go into effect between July 1, 2024, and January 1, 2026: State Law Effective Date Florida Digital Bill of Rights July 1, 2024 Oregon Consumer Privacy Act July 1, 2024 Texas Data Privacy and Security Act July 1, 2024 Montana Consumer Data Privacy Act October 1, 2024 Delaware Personal Data Privacy Act January 1, 2025 Iowa Consumer Data Protection Act January 1, 2025 New Jersey Data Privacy Act January 15, 2025 Tennessee Information Protection Act July 1, 2025 Indiana Consumer Data Protection Act January 1, 2026 As of publication, at least another nine states have active privacy bills in their legislatures. New York State Department of Financial Services The New York State Department of Financial Services updated its cybersecurity regulations on November 1. The revised regulations: (1) strengthen governance requirements; (2) require additional controls to prevent unauthorized access and prevent or mitigate the spread of an attack; (3) impose requirements for more regular risk and vulnerability assessments, as well as more robust incident response, business continuity and disaster recovery planning; (4) contain updated notification requirements (including a requirement to report ransomware payments); and (5) include updated direction for companies to invest in at least annual training and cybersecurity awareness programs. The intent is to build out the robustness of an organization’s cybersecurity program and to ensure it has adequate resources. My Health, My Data Act In April, Washington state passed a new act that expands privacy protections for personal health data falling outside of HIPAA. The My Health, My Data Act requires consent or necessity for collecting and processing consumer health data. Regulated entities must obtain separate consent or meet the same necessity standard to share the data. The sale of data requires a written and signed authorization from the consumer. The act contains a definition of consumer health data that is significantly broader than what is typically considered health-related data. (For example, “data that identifies a consumer seeking healthcare services” is covered by the act.) Non-small-business regulated entities must comply with the act beginning March 31, 2024, and small businesses must comply beginning June 30, 2024. The act provides for a private right of action, which means that plaintiffs will likely begin testing its boundaries soon after it goes into effect. California Privacy Protection Agency The California Privacy Rights Act of 2020 established a new state agency, the California Privacy Protection Agency (CPPA), which the state is transitioning much of its administrative apparatus to for consumer privacy issues. The CPPA has not been content to accept the existing regulatory structure and is emerging as an aggressive actor with further ideas for regulation. In November, the CPPA proposed draft regulations that would define new protections against the use of automated decision-making technologies (ADMT), defined as “any system, software or process — including one derived from machine-learning, statistics or other data-processing or AI — that processes personal information and uses computation as whole or part of a system to make or execute a decision or facilitate human decision-making.” The new regulations would apply to situations where AMDT is used for: (1) decisions about employment or compensation; (2) profiling employees, contractors, applicants or students; (3) profiling consumers in publicly accessible places (such as through facial-recognition technology or automated emotion assessment); and (4) profiling consumers for behavioral advertising. Under the draft regulations, businesses are required to provide pre-use notices; allow consumers to opt out, except in certain cases, such as protecting life and safety; and provide information about how the business uses ADMT to make a decision about a consumer. In December, the CPPA voted to advance a legislative proposal to require browser vendors to include a feature that allows users to exercise their California privacy rights through opt-out preference signals. Currently, only three browsers (Mozilla Firefox, DuckDuckGo and Brave) offer native support for these signals. Given that several states either currently or will soon require businesses to honor browser privacy signals to opt out of the sale of personal data, it is likely that other states will support this effort. The CPPA suffered a setback in June when it received an unfavorable ruling that it could not enforce regulations it had created until a year after they had been finalized. This ruling delays the enforcement of the CPPA’s initial set of rules, covering topics such as privacy notice requirements and responses to consumer opt-out requests, until March 29, 2024. Looking Forward Expect this pattern of stimulus and response to continue through 2024, with regulators continuing to expand their authority to address perceived cybersecurity and privacy threats. Perhaps the greatest spur to regulators will be the continued use of AI. Given the privacy concerns raised by many of these technologies, it does not take an oracle to foresee that a great deal of additional regulation will likely be forthcoming as the world adjusts to the use of these tools.

“Yeah, one more thing, um … none of them wanna pay taxes again. Ever.” — Harry Stamper (Bruce Willis), “Armageddon” (1998) With a flurry of changes to tax laws starting with the Tax Cuts and Jobs Act of 2017 (TCJA) and continuing through the early COVID-19 years, the pace and scope was dizzying to business owners and their tax and deal advisers. Now, after a quiet few years, a wave of new potential changes looms in the next 18 to 24 months. Major provisions of the TCJA are scheduled to sunset by their own terms at the end of 2025. The changes would be so comprehensive that some commentators are referring to 2025 as tax “Armageddon.” TCJA provisions of note for businesses and their owners that are scheduled to expire include: The deduction for pass-through business income (199A deduction). The reduction of marginal income tax rates (including the reduction of the top rate from 39.6 percent to 37 percent). The $10,000 cap on deductions from state and local taxes (SALT cap). The elimination of overall limitations on the amount of itemized deductions an individual may take (Pease limitations). Certain income deductions for domestic C corporations related to the TCJA’s new global intangible low-taxed income (GILTI) regime (the deduction will be reduced from 50 percent to 37.5 percent starting in 2026) and foreign-derived intangible income (FDII) regime (the deduction will be reduced from 37.5 percent to 21.875 percent starting in 2026). The doubling of the estate tax exemption. The TCJA required research and development expenses beginning in 2022 to be amortized over time rather than immediately deducted. We are monitoring that provision, along with certain bonus depreciation provisions of the TCJA that are subjects of legislation currently pending in Congress. Other related items of note from the TCJA include: The TCJA’s new limitation on excess business losses is scheduled to sunset in 2028 and might be a part of a future tax package involving TCJA provisions. The TCJA’s imposition of a 21 percent corporate tax rate is not scheduled to sunset. Tax advantages with respect to qualified opportunity zones are scheduled to sunset for new investments made after 2026. In parallel, the Internal Revenue Service and U.S. Department of the Treasury are currently considering offering guidance to better define the contours of what constitutes a limited partner for self-employment tax purposes, particularly in light of the Soroban Capital Partners v. Commissioner decision from November 2023. In Soroban, the U.S. Tax Court ruled that limited partners in state law limited partnerships could be subject to self-employment taxes. It is yet to be seen whether any changes to the self-employment tax regime will be part of a tax package that will potentially extend the otherwise expiring TCJA provisions. The upcoming presidential and congressional elections this fall will significantly impact the extent to which any of the expiring TCJA provisions are extended and/or modified. We will be monitoring closely and are hopeful that watching the legislative process unfold will not be like watching a disaster movie. Stay tuned.

As of January 1, domestic and foreign entities registered to do business in the United States must comply with new beneficial ownership reporting requirements imposed under the Corporate Transparency Act (CTA). View our webcast from January 30 on “Unpacking the Corporate Transparency Act,” during which panelists answer looming questions, including: Which entities are subject to reporting requirements? Who counts as a “beneficial owner”? What level of “substantial control” is required? How do you calculate the 25 percent ownership test? What constitutes a “filing” to determine if an entity is a “filing entity”? Watch the webcast and download the slide presentation.

Partner Lori Smith authored the second in a two-part series for Reuters Legal News exploring key items that should be on the radar of private equity and venture capital funds and their portfolio companies for 2024 and beyond. In this last installment, Lori focuses on the changes in the law relating to the enforceability of restrictive covenants and legal issues surrounding artificial intelligence. Read the full article.