Business Vantage Point Blog

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.

Stradley Ronon advised Team Epiphany, a consumer marketing agency based in New York City, in its acquisition by Stagwell, a digital-first global marketing network. Founded in 2004, Team Epiphany is a BIPOC-owned-and-operated firm that specializes in cultural relevance, experiential marketing and influencer integration. The terms of the transaction were not disclosed. Team Epiphany will join Stagwell’s Constellation network, a collective of best-in-class marketing agencies. For more, read Stagwell’s announcement.

A cross-practice team of Stradley Ronon lawyers represented Mini Melts USA, a producer and distributor of novelty ice cream products headquartered in the Philadelphia area, in the acquisition of a controlling interest by Altamont Capital Partners. Altamont Capital is a Palo Alto, California-based private investment firm with more than $4 billion in assets under management. Altamont Capital partnered with Mini Melts to provide growth capital and support an expansion of its distribution footprint and manufacturing capabilities. Mini Melts’ CEO and founder will remain in his role and as a major investor alongside Altamont Capital and the company’s existing shareholders. For more information on the deal, read this Wall Street Journal article. (Subscription required.)

Over much of the last year, M&A activity saw a significant slowdown globally — one not seen for a decade. Economic uncertainties, interest rate increases, market volatility and geopolitical instability all converged to create an adverse environment for both buyers and sellers. Given that several of these factors will extend into the next year, what can we expect for the industry in 2024? Expect a potential bounce-back in deal volume thanks to a probable end in Federal Reserve rate hikes and trends such as AI; increased regulatory scrutiny; and environmental, social and governance (ESG) factors to come into play this year. What Happened in 2023? The total volume of global M&A deals through the third quarter of 2023 was approximately $1 trillion lower than the same time period in 2022, Bloomberg Law reported, and the lowest three-quarter deal volume since 2013. A variety of macro-level issues contributed to the historic slowdown. Recession Fears Amid Market Volatility Widespread concern of a recession persisted throughout much of 2023, tempering the appetite for buyers to engage in dealmaking. As the year drew to a close, there seemed to be greater optimism about the health and resiliency of the U.S. economy, bolstered by a pause in the Federal Reserve’s interest rate hikes. Rising Interest Rates Lead to Historic Bank Failures When Silicon Valley Bank collapsed in March, it represented the largest bank failure since the 2008 financial crisis. When the second largest arrived two days later with the closing of Signature Bank, the events sent ripples throughout Wall Street, creating a volatile stock market and banking concerns globally. Rising interest rates put in place by the Federal Reserve to curb inflation, combined with both banks’ high-net-worth customer base rooted in the tech and cryptocurrency industries, ignited the firestorm that led to their collapses and, in turn, left buyers and sellers in a prolonged period of uncertainty, with a particularly acute impact on the venture capital and emerging technology asset classes. As a result, transactions that required bank financing were particularly challenging, and cash buyers had a distinct advantage over less liquid competitors in pursuit of acquisitions. Geopolitical Tensions Put Increased Focus on Risk Management Large-scale conflicts involving several major global powers did nothing to ease the minds of potential dealmakers. In a survey conducted by Oxford Economics in August, more than 125 companies identified geopolitical tensions as the top risk to the global economy over the next two years. Persistent supply-chain disruptions, trade restrictions and an increased focus on risk management and predictability led to a decreased appetite for cross-border transactions. Aggressive Antitrust Enforcement Results in More Merger Challenges The U.S. Department of Justice (DOJ) and Federal Trade Commission (FTC) filed 10 lawsuits in 2022 to block deals they considered anti-competitive — a significant increase over previous years. This heightened scrutiny of M&A transactions has caused some market participants to sit on the sidelines or, at a minimum, be more thoughtful and creative about potential business combinations. What Trends Can We Expect to See in 2024? In mid-December, the Federal Reserve left its interest rate unchanged for the third-straight time. The Fed went a step further in a recent news conference, indicating that it was done with rate hikes and expects to lower its benchmark rate by three-quarters of a percentage point this year. The announcement led to a rebound for the S&P 500, which was up around 23 percent as of December 15, CNBC reported. Globally, the International Monetary Fund forecasts a steady decline in global inflation, from 6.9 percent in 2023 to 5.8 percent in 2024, according to its latest World Economic Outlook report. These more favorable macroeconomic conditions could potentially pave the way for a more favorable borrowing environment, a decrease in the cost of capital and increased deal volume in 2024. AI and ESG will continue to factor into transactions from the tech to energy industries significantly. However, the final merger guidelines recently released by the DOJ and FTC will significantly impact the number of transactions that will come under regulatory review. Dealmakers to Cautiously Leverage AI Technology Artificial intelligence has infiltrated most every industry sector, and its widespread adoption and increasing usage will undoubtedly be a prominent focus in upcoming transactions. In the tech industry, the highest-profile deals involving generative AI startups were announced in June: Databricks’ agreement to acquire MosaicML for $1.3 billion and Thomson Reuters' $650 million acquisition of Casetext. Transactions to acquire generative AI capabilities will likely dominate much of 2024, particularly for Big Tech companies. Generative AI will also increasingly feature in M&A strategies, with potential utilization in conducting due diligence, identifying targets and executing deals. Leveraging the tools for integration post-merger could also lead to a more streamlined process for involved entities. ESG Considerations to Factor into Transactions Similarly to AI, companies will continue to target ESG assets and capabilities to meet their sustainability goals and socially conscious initiatives. Transactions related to ESG and environmental considerations have steadily increased over the last two decades, according to Boston Consulting Group’s 2023 M&A Report — and that growth is expected to continue into 2024. Increased Regulatory Scrutiny to Continue The DOJ and FTC released their 2023 merger guidelines in December, modifying the draft merger guidelines in July, which responded to public comment and feedback that criticized the agencies’ aggressive merger enforcement stance. In addition, as of January 1, 2024, domestic and foreign entities registered to do business in the United States will now need to comply with new beneficial ownership reporting requirements imposed under the Corporate Transparency Act (CTA). Looking Forward While 2023 presented several challenges to M&A dealmaking activity, a reversal of some of those trends, including a predicted drop in inflation and the cost of capital, may lead to an increased pace of M&A activity in 2024. However, a close eye will need to be kept on the expected rebound in view of the continuing geopolitical climate and regulatory landscape, particularly in the backdrop of the 2024 presidential election.

In the ever-evolving landscape of technology, the emergence of generative artificial intelligence has ushered in a new era of possibilities. Unlike traditional software, generative AI possesses the ability to create, innovate and even surprise its users. As legal professionals, we stand at the crossroads of this profound technological advancement, tasked with negotiating software licensing agreements that grapple with unprecedented challenges related to ownership, liability and customization. Ownership: Defining the Uncharted Territory The concept of ownership takes on a nuanced dimension in the realm of generative AI. Unlike traditional software, which is crafted with a finite set of predefined rules, generative AI can produce outcomes that are not explicitly programmed. This raises two fundamental questions: Who owns the output of a generative AI system, and to what extent can it be considered the intellectual property of its creator? Lawyers must carefully delineate ownership rights when negotiating software licensing agreements for generative AI. Clarity on the ownership of generated content, algorithms and any novel creations is paramount. Consideration should be given to crafting agreements that address potential disputes over ownership and providing a framework for resolution should such conflicts arise. Additionally, legal professionals should emphasize the importance of regularly updating licensing agreements to reflect the evolving nature of generative AI technologies. Liability: Navigating the Waters of Accountability The unpredictable nature of generative AI introduces a layer of complexity regarding liability. Traditional software operates within the confines of predetermined instructions, making it relatively straightforward to assign responsibility in the event of errors or malfunctions. However, the inherent creativity of generative AI complicates matters, as it can produce unforeseen outcomes that may not align with the intentions of its creators. When negotiating software licensing agreements for generative AI, legal professionals should focus on clearly defining liability parameters. Agreements should outline the responsibilities of both parties in ensuring the ethical use and deployment of the AI system. Moreover, provisions addressing potential legal consequences arising from unexpected outputs should be integrated. Lawyers should advocate for comprehensive indemnification clauses that protect clients from legal repercussions stemming from the actions of generative AI. Customization: Adapting to the Ever-Changing Landscape Generative AI’s ability to adapt and evolve challenges the traditional notion of static software. Customization becomes a key consideration in negotiating licensing agreements, as clients may seek the flexibility to modify and enhance the AI system to meet evolving business needs. Lawyers must facilitate agreements that strike a balance between granting their clients the necessary customization rights and protecting the integrity and security of the underlying AI technology. Legal professionals should advocate for a clear delineation of customization boundaries in addressing customization challenges. Licensing agreements should specify the extent to which clients can modify the AI system and the obligations associated with such modifications, including potential impacts on performance, security and compliance. Emphasizing the importance of regular communication between the parties to address evolving customization requirements is essential in ensuring that licensing agreements remain relevant and effective in an ever-changing technological landscape. Moving Forward: Implementing a Paradigm Shift in Strategy Negotiating software licensing agreements for generative AI requires a paradigm shift in strategy for legal professionals. Ownership, liability and customization present unprecedented challenges that demand thoughtful consideration and strategic drafting. As we stand at the intersection of law and technology, lawyers must navigate these uncharted waters with a keen awareness of the unique characteristics of generative AI, ensuring their clients are well positioned to harness the benefits of this groundbreaking technology while mitigating the potential legal risks.

Partner Lori Smith has authored the first 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 first installment, Lori focuses on novel reporting obligations for U.S. and foreign businesses and a continued increase in antitrust enforcement. Read the full article.

Net operating losses (NOLs) represent a valuable asset for corporations realizing a net loss in a given year. The Internal Revenue Code permits taxpayers, including corporations, to carry forward NOLs to offset against taxable income and reduce tax liabilities for future years. However, as they are generally not transferable, the IRS Code limits corporations from utilizing NOLs following a change in ownership. Pursuant to Section 382 of the IRS Code, an ownership change occurs when the percentage of a corporation’s equity held or beneficially owned by persons holding 5 percent or more of the corporation’s stock increases by more than 50 percentage points over the lowest percentage of equity owned by such shareholders at any time during the preceding three-year period or since the last ownership change. An ownership change can also result from a worthless stock deduction claimed by any person or entity owning 50 percent or more of the corporation’s stock. Sections 382 and 383 of the IRS Code limit the amount of future taxable income if an ownership change occurs, that may be offset by a corporation’s pre-change losses and excess credits, which include the corporation’s NOLs. When a corporation files for protection under Chapter 11 of the U.S. Bankruptcy Code, it can set off a flurry of activity by shareholders, including both trading — as shareholders seek to dump their stock before losing any more value and distressed debt investors seek to acquire such stock at a discount — as well as claiming deductions for worthless stock. Once NOLs or other similar tax credits are limited under Sections 382 and 383 of the IRS Code, their use is limited forever. When a corporation files for Chapter 11 protection and the resulting transfers of stock result in an ownership change before the corporation’s exit from Chapter 11, such transfer may negatively impact the corporation’s ability to utilize its NOLs to offset tax liabilities following successful restructuring. A successful Chapter 11 restructuring almost always results in a change of ownership because equity cannot retain its ownership unless all unsecured creditors first get paid. However, under specified circumstances, the IRS Code permits a debtor to retain its NOL credits during a Chapter 11 restructuring, notwithstanding substantial change of equity holders under a confirmed Chapter 11 plan. Therefore, where valuable NOL credits are in play, a debtor may need to limit any potential for ownership change during a Chapter 11 case that could negatively affect its ability to utilize NOL carryovers after emerging from bankruptcy. Accordingly, debtors are interested in closely monitoring their shareholders’ identities during a Chapter 11 case and potentially limiting trading. It has become increasingly common for corporate Chapter 11 debtors to seek the intervention of the bankruptcy courts at the outset of the case to place limits on stock trading and prevent any change in ownership that could impact the availability of NOL credits and, in turn, the value of the corporation’s bankruptcy estate. Such relief is often sought via a first-day motion — i.e., a motion filed on the first day of the bankruptcy case — requesting entry of both preliminary and final orders enjoining shareholders from transferring stock, requiring shareholders to provide notice of any material transfer, voiding any transfers that are made without such notice and/or limiting the shareholders’ ability to take a worthless stock deduction. Although the Bankruptcy Code does not expressly authorize bankruptcy courts to impose such injunctive relief, courts reason that NOL credits represent a valuable asset of the bankruptcy estate that must be protected via trading injunctions, finding justification for such relief in Section 362(a)(3) of the Bankruptcy Code, which acts as a stay of “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.” (See In re Prudential Lines, 928 F.2d 565 (2d Cir. 1991).) Because trading injunctions typically are sought early in Chapter 11 cases, and the bankruptcy courts usually adjudicate first-day motions on an expedited basis, stock trading injunctions may be entered before many creditors or shareholders are even aware of the bankruptcy filing or have time to get their arms around such requests and appropriately respond. It is important for institutional investors, upon learning of a corporation’s bankruptcy filing, to promptly consult with bankruptcy counsel to determine whether the debtor is seeking a trading injunction and the impact that any such injunction will have on the investors’ ability to trade their shares or claim a deduction for stock that has become worthless. Among other things, a holder of a debtor’s equity must quickly address the following questions: Has the debtor requested a trading injunction? What is the scope of any such request? What equity threshold would trigger trading restrictions or notice requirements (typically around 5 percent)? What form of notice is required to be provided to the debtor before a transfer of stock? Are there any substantive objections that should be raised to the request for a trading injunction? Because the specifics of each request for a trading injunction will depend on the circumstances, the exact terms of a trading injunction will vary from case to case. Trading injunctions might include provisions that enjoin the transfer of equity interests outright. Such injunctions should be tailored and limited to investors holding 5 percent or more of the debtor’s stock. In addition, trading injunctions may provide for a prohibition on trading that is only triggered upon a certain dollar amount of claim trades. These injunctions may limit claims trading to protect a debtor’s ability to preserve NOLs through a confirmed plan. When an investor has owned 50 percent or more of a debtor’s stock during the prior three-year period, debtors may seek to limit investors’ ability to take a worthless stock deduction, which could also result in a loss of NOL tax deductions. Although corporate Chapter 11 debtors may have a strong interest in protecting their NOL carryovers and trading injunctions may well preserve value for a debtor’s bankruptcy estate, the imposition of trading injunctions is strong medicine, and the practice is not without its critics. Critics assert that Congress never intended the automatic stay imposed by Section 362 of the Bankruptcy Code to extend to NOLs. They claim the automatic stay is intended to limit actions to exercise possession or control over estate property and should not be extended to limit investors’ ability to exercise their rights for their property — i.e., their stock holdings — simply because such exercise may have an incidental effect on a debtor’s NOLs. Critics have also argued that the imposition of trading injunctions goes far beyond the bankruptcy court’s equitable powers and that trading injunctions violate the Fifth Amendment by interfering with shareholders’ property rights. In consultation with bankruptcy counsel, shareholders should consider whether any requested trading injunction is overly broad and has a greater limiting effect than is necessary to protect the debtor’s NOL carryovers. Where trading injunctions are sought on the first day of a Chapter 11 filing, shareholders may argue that such injunctions are premature, particularly where the value or utility of the debtor’s NOLs has yet to be determined, and no plan of reorganization has been formulated. At the outset of a case, a debtor likely cannot show that it will generate future taxable income before the NOLs expire or that its NOLs have not already been limited by pre-bankruptcy trading. To obtain a preliminary trading injunction in connection with a first-day motion, a debtor must show: The debtor is likely to succeed on the merits. The debtor will suffer irreparable harm without the injunction. Whether the injunction will harm others or serve the public interest. As some critics have noted, these standards are challenging to establish on the first day of a Chapter 11 case because a debtor will have difficulty showing that successful reorganization and future profits are likely or that NOL credits will be limited without such an injunction. (See “Winning Losses: Trading Injunctions and the Treatment of Net Operating Loss Carryovers in Chapter 11,” Yale Journal on Regulation, Vol. 32 (2015).) Trading injunctions frequently include provisions rendering stock trades void ab initio where an affected investor fails to provide the debtor with the requisite notice required by the court’s order. Accordingly, consultation with bankruptcy counsel is necessary regardless of whether a shareholder intends to challenge the imposition because noticing provisions might impose affirmative reporting obligations upon the shareholder.

In assessing whether voluntary stock repurchases or tender offers may make sense for a privately held company, there are several business and legal factors to consider. Public companies regularly use open-market stock repurchase programs, individually negotiated stock repurchases and issuer tender offers for various reasons. These include acquiring company shares they believe are undervalued, providing additional liquidity opportunities for their investor base and accommodating certain shareholders looking to reduce or exit their investment. Although it is not nearly as common for private companies to pursue these techniques, there are a number of situations in which private companies may use them to accomplish similar goals. Read on for an overview of key business and legal considerations that private companies should keep in mind when contemplating the use of a stock repurchase or tender offer. Reasons to Pursue Buybacks or Tender Offers Many companies choose to remain private or delay their initial public offerings (IPOs) for multiple reasons, including periodic softness in the IPO market; a desire to further grow their businesses to support increased valuations for either an IPO, additional private capital infusions or sale of the company; and a reluctance to incur the direct and indirect costs of being a public company. Although private company investors generally have become more accepting of these choices, there are often circumstances in which investors (particularly early-stage venture capital investors) and employees (who often hold meaningful amounts of shares, options and restricted stock) are looking to monetize some or all of their investment in the near term rather than wait for an IPO or other exit event, and companies are willing to consider alternative ways of providing liquidity to them. In addition, companies choosing to stay private for a longer period often have a larger number of shareholders than pre-IPO companies have had in the past. In order to facilitate later-stage investments and/or prepare for an IPO, companies may benefit from reducing the number of shareholders (particularly smaller shareholders), eliminating one or more outstanding classes or series of securities, or both. Later-stage investors may want a simplified capital structure to ensure their superior rights, and, as a practical matter, a company with few shareholders and a simplified capital structure can reduce the number of issues to be resolved in connection with undertaking an IPO. In both cases, selective repurchases or tender offers may provide ways to accomplish these goals. Buybacks vs. Tender Offers: Which to Choose? The choice between share repurchases from one or a number of shareholders or undertaking a broader-based tender offer is usually driven by several considerations, including the company’s goals, the preferences or demands of current and potential investors, the availability of financing and regulatory concerns. Although each situation is different, as a general matter, the choice between share repurchases and tender offers may be summarized as follows: Providing a liquidity opportunity to one or a few shareholders on individually negotiated terms and not necessarily at the same time. Share repurchases are likely to be the better choice. Providing a liquidity opportunity to a larger number of shareholders. A tender offer is likely the better choice and may even be necessary to comply with U.S. Securities and Exchange Commission rules, as discussed below. Cleaning up capital structure to accommodate new investors or as pre-IPO preparation. Either share repurchases or tender offers, depending on the circumstances. Securities law compliance is one particular driver of the choice between repurchases and a tender offer. Although a majority of the SEC’s rules covering tender offers apply only to public companies, a number of them apply to any tender offer — public or private company — and complying with those rules may impact a company’s choice of approach. Legal Compliance: Is It a Buyback or Tender Offer? Before pursuing share repurchases or a tender offer, it is advisable to consult with counsel regarding regulatory, disclosure and related issues. A company’s charter, bylaws, shareholder/investor rights agreements and similar governing documents may limit and, in some cases, even prohibit the acquisition of its stock. In addition, state corporation laws may inhibit a company’s ability to effect share repurchases or tender offers, as acquisitions by the company of its securities are considered to be returns of capital (similar to cash dividends), and state corporation laws impose certain limitations on a company’s ability to return capital. Compliance with federal securities laws and SEC rules can also present challenges for private companies. Determining whether planned share repurchases have risen to the level where they could be deemed a tender offer is a critical step before proceeding with any share repurchases. Other than the potential disclosure issues discussed below, no federal securities laws or SEC rules directly govern share repurchases. Specific SEC rules apply to private company tender offers, but no bright-line test separates share repurchases from tender offers. Courts considering the issue apply what is commonly referred to as the Wellman test to define the boundary between repurchases and tender offers. The Wellman test looks at eight factors in analyzing whether repurchases rise to the level of tender offers that trigger the SEC’s tender offer rules: An active and widespread solicitation of shareholders to acquire their shares. The solicitation for repurchases is made for a substantial percentage of the company’s stock. The offer to purchase is made at a premium over the prevailing price/value of the stock. The terms of the offer are firm rather than negotiable. Completion of the repurchases is contingent on the tender of a fixed number of shares, often subject to a fixed maximum number to be purchased. The offer is open only for a limited period of time. The offerees are subjected to pressure to sell their stock. Any public announcements of a purchasing program precede or accompany the rapid accumulation of large amounts of the company’s securities.   Not all of these factors are relevant (or as relevant) to private companies, and no particular factor or group of factors is determinative, so even with these guidelines, it is not always clear when repurchases have crossed the line into a tender offer. Most companies that want to avoid compliance with the tender offer rules limit the number of shareholders from whom they repurchase securities and individually negotiate the terms of the repurchase with each shareholder. These techniques counter several of the key factors cited in the Wellman test. If possible, a company may want to preserve flexibility and avoid the distraction and expense of complying with these requirements and related private tender offer best practices, such as preparing a formal offer to purchase. A company in this situation may prefer to achieve its goals through individually negotiated repurchases between each selling stockholder and the company. If the repurchases, either by design or by application of the Wellman test, trigger the tender offer rules, the company will be required to adhere to the following requirements: The tender offer must be held open for at least 20 business days. The number of shares subject to the offer and the amount of consideration being offered cannot be changed unless the tender offer remains open for at least 10 business days from the date that the notice of the change is provided (with some limited exceptions). Consideration for the tendered shares must be paid promptly upon completion of the tender offer. (As a practical matter, this means the company must have the cash on hand by the closing of the offer.) The tendered shares must be returned promptly to shareholders if the tender offer is terminated or withdrawn prior to completion. Any extension of the tender offer must be announced to all holders, and the extension notice must inform them of the amount of shares already tendered. The company must disclose its position with respect to the tender (meaning that it must recommend “for” or “against” shareholders tendering their shares or state that the company does not take any position). Repurchase transactions outside of the tender offer while the tender offer is open are essentially prohibited. Disclosure of the issuer’s position is required with respect to the offeror’s tender offer for the issuer’s securities. Anti-fraud rules apply, such that the company should not pursue tender offers (or repurchases generally) when it is in possession of material nonpublic information.   Disclosure Considerations Because the SEC’s anti-fraud rules generally apply to repurchases and tender offers specifically, in the context of negotiated repurchases and tender offers, the focus of the anti-fraud rules is primarily on information asymmetry. In other words, does the company have in its possession material undisclosed information that the shareholder would reasonably need to know to make an informed decision as to whether to sell or tender the shares to the company? In public company tender offers, SEC rules mandate that certain disclosures be provided to recipients of the tender offer. Although those mandates do not apply specifically to private company tender offers because of potential liability under the anti-fraud rules, private companies undertaking tender offers usually provide some sort of disclosure documentation to recipients of the tender offer. The types of disclosure, including the level of detail, will vary from situation to situation. Evaluating the appropriate level of disclosure in repurchase and tender offer situations is substantially similar to evaluating the appropriate level of disclosure if the company was offering its securities to investors for purchase, and factors like the level of sophistication of the shareholders and the shareholders’ access to information about the company are particularly relevant to the evaluation. This is another area where consultation with securities counsel is advisable. While different companies take different approaches, the disclosure-related documentation for a private company tender offer typically consists of the following: An Offer to Purchase, which contains the specific details of the offer, including the total number of shares proposed to be purchased, the offer price, allocation methodology (if the offer is oversubscribed and not all tenders will be accepted in full), the termination date of the offer and detailed instructions on how to participate. A disclosure document that may be a part of the Offer to Purchase. A letter of transmittal for use by participating shareholders to tender their shares.   Pricing and Other Considerations Public company tender offers are often priced at some premium to the current market price of the shares in order to encourage shareholders to tender. The pricing of private company tender offers varies based on the surrounding circumstances. Because the purpose of the tender offer is often to provide liquidity opportunities to current shareholders, a price at or near the current fair market value (often determined by the latest 409A valuation or some other observable value, such as a recent capital-raising transaction) is often used. One practical pricing consideration involves an assessment of the company’s planned timing for an IPO: If the tender offer price is meaningfully lower than the IPO price and the tender offer and IPO are close in time to one another, the company may face complaints from shareholders. In addition to the pricing considerations, it is important to take into account other agreements, arrangements and understandings that are in place and may impact the ability of the company and/or some of the shareholders to pursue and complete a tender offer. Investor rights and similar agreements could limit or prohibit company buybacks or require approvals or waivers from certain security holders. Those agreements may also include rights of first refusal or similar rights that could be triggered by a tender offer without the agreement or waiver of the rights holders. It is important to review all relevant governing documents and key agreements for issues that may impact a tender offer.

More than 60 years after their debut single, the Beatles have released a new recording, “Now and Then,” advertised as the last ever Beatles song. With classic Beatles symmetry, their first release, “Love Me Do,” serves as the B side for this last song. Not as classic, however, was their use of newly created artificial intelligence (AI) to create the track. In the late 1970s, John Lennon wrote and performed a demo of “Now and Then” on his cassette recorder, which was given to the surviving Beatles members approximately two decades later by his widow, Yoko Ono. While working on “The Beatles Anthology” retrospective project, the group attempted to use the vocals from the demo but encountered audio issues with the recording. The cassette tape Lennon recorded made for a messy demo: It was scratchy with a persistent electric buzz, the TV could be heard in the background and Lennon’s voice was on the same track as his piano — with one often drowning out the other. There was little they could do with the technology of the time, so the band abandoned the song. Using technology made possible due to recent advances made by film director Peter Jackson and his team — developed while creating the documentary series “The Beatles: Get Back” — Paul McCartney and Ringo Starr were able to isolate Lennon’s vocal track from the rest of the original recording. The machine-assisted learning (MAL) technology developed by Jackson’s team could distinguish between different instruments and voices. The MAL machine “allows us to take any soundtrack and split all the different components into separate tracks,” Jackson said in a new short film about the making of “Now and Then.” The technology separated Lennon’s vocals from the piano parts on the “Now and Then” demo, and “there it was, John’s voice, crystal clear,” McCartney said in the film. Controversy in the Music Industry – AI Safety, Security, & Other Implications. In the Beatles’ case, because Ono and the remaining members of the band participated in the project and all relevant parties consented, the band’s use of AI may well be the least controversial issue in the music industry. However, putting aside the debate over the quality of the song or whether it is a “real” Beatles release, the technology used to create the track has resulted in controversy. In a recent appearance on “The Tonight Show,” singer-songwriter Sheryl Crow argued that a machine creates AI music and, therefore, that music is without soul. AI is everywhere. It has long been behind the scenes functioning in largely uncontroversial ways. AI processes photos on smartphones and provides wording prompts when texting — and it is an emerging tool for making music. Unlike other useful applications such as auto-tune, AI can replace writers, artists and musicians. Will it? Unchecked, the answer is undoubtedly yes; it already is. Case in point: During that same “The Tonight Show” appearance, Crow told host Jimmy Fallon that she had met a young songwriter who had produced demos that the songwriter intended to pitch to established singers. But there was a problem: The upstart composer needed a male singer to perform on one of the demos. Rather than hire a singer, Crow said, the composer paid $5 to have an AI application reproduce the sound of singer-songwriter John Mayer singing over her demo. It is fair to assume that Mayer had no say in this creation and did not receive any compensation. While not a wide release, it still seems a highly problematic use of a talent’s protectible rights. In an even more troubling example, a song created by a user through the AI music composition platform Amper Music, “Heart on My Sleeve,” featured AI versions of musical artists Drake and The Weeknd. The track, which went viral, was uploaded to well-known streaming services but was quickly removed following copyright infringement claims by Universal Music Group. The song was also submitted for consideration for a Grammy Award but held ineligible for various reasons, including that it was not generally commercially available. SAG-AFTRA Tentative Deal Includes AI Provisions – AI Safety & Security. These concerns are not unique to the music industry. The SAG-AFTRA union, which represents tens of thousands of actors, was, until recently, on strike for about four months. One of the main issues was the use of AI by producers to create digital replicas of talent without informed consent and fair compensation. For example, the likenesses of both actor Tom Hanks and TV personality Gayle King were used in advertisements that were not authorized by either. The final details of the tentative agreement have not yet been released. However, the Alliance of Motion Picture and Television Producers — the group that represented studios, streaming services and production companies in the negotiations — said in a statement that the Nov. 8 deal “represents a new paradigm” that “gives SAG-AFTRA the biggest contract-on-contract gains in the history of the union, including the largest increase in minimum wages in the last 40 years; a brand new residual for streaming programs; extensive consent and compensation protections in the use of artificial intelligence; and sizable contract increases on items across the board.” SAG-AFTRA was concerned that studios could use AI to reanimate actors who had passed away or to create a digital Frankenstein out of actors’ body parts. In the negotiations, the union secured a requirement that if a Frankenstein actor contains recognizable features of real-life actors, studios must get permission from those actors, who also must be paid for the performance. “If you’re using Brad Pitt’s smile and Jennifer Aniston’s eyes, both would have a right of consent,” said Duncan Crabtree-Ireland, the union’s chief negotiator, in an interview with Variety. Executive Order Aims to Balance AI Benefits, Risks – What This Could Mean for Emerging Businesses, Venture Capital, & Finance (as well as the Entertainment Industry, of course). These issues, as well as security and other concerns, resulted in President Biden issuing a first-of-its-kind executive order on Oct. 30, which seeks to balance the benefits of AI with its inherent risks. The executive order aims to establish new standards for AI safety and security, protect Americans’ privacy, advance equity and civil rights, stand up for consumers and workers, promote innovation and competition, and advance American leadership worldwide. The order also establishes standards and practices for detecting AI-generated content and authenticating the creators of content. This latest development is a start, but Congress will have to act swiftly and decisively to control the use of AI or, at a minimum, to ensure the consuming public is informed when AI is used in creative endeavors. Historically, the law is years behind new technology. In this instance, it may be too long to wait.

The market has seen a steady rise in the number of troubled commercial loans over the last few months. Consequently, companies and their financial officers who previously had minimal experience with loan workouts are faced with varying proposals from their lenders on how to restructure credit facilities and operations. Many companies will go through this process and emerge better disciplined and more focused on their core businesses, while others won’t survive. Whether a company survives and thrives may depend entirely on how well its executives understand the options and strategies available to them. Once an event of default occurs under a loan facility and the loan-workout process starts, lenders will often take one of the following remedial approaches: Do Nothing: This may surprise some companies, but lenders often take a patient wait-and-see approach to troubled credits. After an intensive review of the loan documentation and collateral package, the lender may issue a reservation of rights letter, notifying the company of all of the known events of default and informing the company whether the lender intends to exercise any initial remedies, like imposing a default rate of interest or charging other fees and penalties. In certain loan facilities, this step will also trigger increased reporting requirements. Note that even at this stage, institutional lenders will often have handed the loan package off to an internal restructuring department, which means that company representatives should expect to become acquainted with new bank relationship and credit officers (and possibly lender’s counsel engaged specifically for workout transactions).   Restructuring and Forbearance Agreements: Forbearance agreements are often a hybrid between the reservation of rights letter and a standard amendment to the loan facility. Under the forbearance agreement, lenders will agree not to exercise certain remedies for a set period of time in exchange for modifications to the loan or the collection of waiver and other fees. These modifications may entail introducing additional collateral or guarantor support, amending loan covenants to increase reporting, adding new financial covenants or requiring the engagement of outside consulting firms. This stage also allows lenders to correct deficiencies in the original loan documentation; a company’s default may motivate lenders to enhance the substance of the “remedies” provisions (for example, ensuring that the facility is cross-collateralized and cross-defaulted with other facilities or the facilities currently extended to affiliated parties). Lenders may also ask principals to provide a capital infusion large enough to give the company the necessary liquidity to resolve its current issues. The goal of the forbearance agreement is to give a company the time it needs to alter performance enough to convince the lender that there is a path to repayment or, alternatively, the time it needs to find a new lender that will refinance the existing loan.   Alternative Types of Financing: An almost infinite number of loan structures are available to companies. In addition to standard mortgages and revolving lines of credit, companies might consider equipment term loans, cash flow term loans, subordinated loans, mezzanine loans and asset-based lending (ABL) lines of credit, to name a few. Companies with a standard cash flow revolving line of credit may be required to obtain additional or alternative types of financing. One alternative is subordinated debt. This may come from business owners or other non-bank lenders willing to make riskier loans in exchange for higher interest rates and other compensation. Another asset-intensive business option is obtaining a new ABL facility. ABL loans adjust the size of the loan facility periodically to a percentage of the company’s assets, most often accounts receivable and inventory. This provides benefits to both the lender and the company: The lender can control the loan’s balance to what it reasonably thinks it can fully recover in the event of a future bankruptcy or other liquidation while often providing a company with larger availability than a traditional cash-flow deal may offer. ABL loans involve additional reporting requirements, but the benefits of additional liquidity may greatly outweigh the costs of satisfying those requirements. Finally, a lender may be willing to “term out” some existing lines of credit in exchange for a lien on previously excluded collateral (for example, a lien on real property that a revolving loan lender decided to forgo at the original closing). By providing this additional support, the lender may allow the company to repay the outstanding balance over time in exchange for immediately providing additional working capital availability.   Accelerate and Liquidate: At a certain point, not all businesses can be saved, and a lender’s priority is always loan repayment. The lender and the company will often have worked through at least one of the preceding options before reaching this point. If a lender does not see a viable option for repayment, it will be forced to foreclose on the collateral and/or exercise its rights to collect from the company’s guarantors. Because liquidating and collecting on collateral is costly and time-consuming, lenders will often decide to either sell the loan or the business as a going concern.   It is important to remember that lenders are not necessarily the enemy. Lenders often benefit more from helping a company correct its course and overcome the fundamental issues that led to the events of default rather than simply foreclosing on the collateral and shutting down the business. Companies and finance executives who prioritize working with their lenders may see profound benefits in both the short and long term as a result of the workout. Navigating the initial hurdles of increased reporting and tighter financial covenants may be difficult, but a company’s cooperation and compliance with the redesigned covenants will give the lender greater incentive and visibility into a rehabilitative path forward.

In acquisition transactions, consideration is often composed of a combination of cash and equity from the buyer. Equity consideration is attractive for a number of reasons, including aligning the interests of both buyer and seller post-closing and giving the seller some tax deferral and the potential for additional upside as the business continues to succeed. Structuring the transaction to include a partial tax-free equity component, or “rollover,” is a crucial element in facilitating these transactions, potentially offering substantial tax benefits to the seller. This strategic maneuver allows the seller to avoid triggering immediate federal income tax liabilities on receipt of the equity consideration, ensuring the seller retains a larger portion of its cash proceeds from the sale. In this post, we will discuss common federal income tax considerations for achieving a tax-free equity rollover applicable to U.S. buyers and sellers. Additional federal income tax considerations would apply to non-U.S. parties, which are beyond the scope of this discussion and will only be briefly highlighted at the end. Typically, a tax-free equity rollover – more accurately, a tax-deferred rollover – will be structured such that the buyer will purchase a portion of the property being sold, whether equity in a target company or assets, in exchange for cash and the remaining portion in exchange for equity of the buyer (or a parent entity of the buyer). In order for the latter part of the deal (i.e., the rollover) to be tax-free from a federal income tax perspective, it is typically structured as a contribution of the relevant property to the buyer or parent entity in exchange for equity of the buyer or parent entity (i.e., the Buyer Issuer). Accordingly, the ability to achieve a tax-free equity rollover for the seller and any challenges that must be overcome will primarily, but not exclusively, depend on the entity classification of the Buyer Issuer (e.g., partnership, C corporation, S corporation) for federal income tax purposes. Buyers Classified as Partnerships Tax-free equity rollovers are subject to relatively fewer restrictions if the Buyer Issuer is a partnership for federal income tax purposes. Contributions of property to a partnership are governed by Section 721 of the Internal Revenue Code of 1986 (IRC), as amended. Section 721 generally provides that no gain or loss is recognized for a contribution of property to a partnership in exchange for an interest in the partnership. These rules also apply to multimember limited liability companies (LLCs), which are by default classified as partnerships for federal income tax purposes (although LLCs can file tax elections to be classified differently). The exceptions to such tax-free equity rollovers under Section 721 generally cover more complicated and bespoke fact patterns that are less likely to be encountered in typical acquisition transactions. These include, but are not limited to, disguised sales, situations where the partnership is an investment company (as opposed to one that primarily holds business assets or real estate), and fact patterns involving related parties. Accordingly, while buyers and sellers should always consult with their tax advisors, it is relatively straightforward for a seller to transfer property, whether equity of an existing target company or assets, to a Buyer Issuer classified as a partnership in exchange for tax-deferred rollover equity. Buyers Classified as C Corporations Alternatively, if the seller desires to receive tax-deferred rollover equity in a Buyer Issuer classified as a C corporation for federal income tax purposes, any contribution to the Buyer Issuer in exchange for stock of the Buyer Issuer would be governed by Section 351 of the IRC. These rules have more requirements than those governing partnership contributions. The most common obstacle to a tax-free equity rollover into a C corporation is the requirement pursuant to Section 351 that any seller making a contribution to the C corporation must “control” the corporation immediately after such contribution (i.e., the Control Test). For this purpose, “control” means both ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock. In most transactions, it is unlikely that a seller would contribute property with sufficient value to become an 80 percent, or more, stockholder of the Buyer Issuer. Instead, achieving a tax-free equity rollover into a corporate Buyer Issuer would typically require the Buyer Issuer’s existing stockholder(s) to also make contributions to the Buyer Issuer that are contemporaneous with the seller’s rollover. For example, if the Buyer Issuer is a subsidiary corporation, its parent company can contribute cash to the Buyer Issuer in order to fund the cash portion of the purchase consideration. If done correctly, the Control Test would be measured based on the combined stock ownership of the seller and the Buyer Issuer’s other contributing stockholders immediately after the contributions. Apart from the Control Test, and similar to Section 721, there are further exceptions to tax-free equity rollover treatment under Section 351, including but not limited to: receipt by the seller of non-qualified preferred stock, situations where the corporation is an investment company, or whether property contributed to the corporation is encumbered by liabilities in excess of such property’s tax basis. Based on the foregoing, it is even more important for the parties to immediately consult their tax advisors to ensure that a tax-free equity rollover is possible when the buyer is classified as a C corporation; in particular, this would allow the tax advisors sufficient time to consider possible structures for the Control Test or other applicable rules under Section 351. Special Issues for S Corporations For federal income tax purposes, an S corporation is a type of corporation subject to special rules that allow it to be taxed as a flow-through entity in many respects, similar to a partnership. Most importantly, an S corporation generally is not subject to federal income tax at the entity level but instead allocates to its shareholders any income, gain, deduction or loss that is recognized by the S corporation. Notwithstanding an S corporation’s similarities to a partnership in federal tax treatment, rollover by a seller into a Buyer Issuer that is an S corporation is generally subject to the same C corporation rules under Section 351. However, due to the special rules governing an S corporation, there are a number of additional considerations and potential issues when either the buyer or seller is an S corporation. Buyers and sellers should be particularly careful when a transaction includes an S corporation and should communicate with their tax advisors early. A detailed discussion of the S corporation-specific considerations is beyond the scope of this post, but some of the more common concerns are highlighted below. Common Considerations and Pitfalls As demonstrated by the foregoing discussion, there are several rules to navigate in order to properly structure a tax-free equity rollover for a seller. Beyond the items described above, following is a high-level list of certain considerations and pitfalls that buyers and sellers should keep in mind: For a buyer, any letter of intent (LOI) or term sheet should be appropriately open-ended or qualified with respect to the seller’s ability to achieve a tax-free equity rollover. In the early stages of a deal, certain critical facts or structuring considerations may not be obvious and a buyer could be placed in a challenging position if an LOI or term sheet unequivocally offers a tax-free equity rollover for the seller. A seller should inquire early on as to the Buyer Issuer’s classification for federal income tax purposes and entity structure. This is the first step in evaluating whether a tax-free equity rollover can be achieved – including situations where the seller might receive rollover equity in an entity (e.g., a parent or holding company) different from the one making the cash purchase component. It is not uncommon for the seller to receive rollover equity in a direct or indirect parent entity of the buyer. In that case, it is important to ensure that subsequent transfers of the property contributed by the seller to that parent entity do not inadvertently trigger federal income taxation or otherwise adversely impact the seller’s tax-free equity rollover into the parent entity. For a target company that is an S corporation, a buyer will typically request the transaction be structured to achieve a “step-up” in the tax basis of the underlying business assets. If the cash component of a transaction is structured as a sale of certain S corporation shares followed by an election under Section 338(h)(10) of the IRC (to obtain an asset tax basis step-up), the selling shareholders of the S corporation will not be able to achieve a tax-free equity rollover. Alternatively, if the transaction is structured as a sale of the business by an S corporation (i.e., the S corporation itself is the seller), receipt of rollover equity by the S corporation will not be completed tax-free to the S corporation shareholders if they decide to either distribute any of the rollover equity from the S corporation or economically participate in the rollover on a non-pro-rata basis (i.e., some of the shareholders receive more of the cash consideration while the rest hold onto a larger share of the rollover equity via their continuing ownership of the S corporation). Finally, if either buyer or seller is a non-U.S. entity, additional federal and non-U.S. tax rules may apply, including U.S. withholding tax implications relating to dispositions of U.S. trade or business assets or U.S. real property interests, including equity of a U.S. real property holding company. The ability to achieve a tax-free equity rollover is a powerful tool for buyers and sellers when structuring transactions. However, given the complex rules involved, the importance of obtaining expert tax advice early in the process cannot be overstated.

In merger and acquisition transactions, a quality of earnings (QofE) analysis is an important piece of financial accounting due diligence. A reputable independent accounting or other advisory firm that has an extensive background in conducting financial due diligence and expertise in the target company’s industry should be used to prepare the QofE report, which involves several stages, including data collection, analysis and reporting. The analysts will review the company’s financial statements and other documents, conduct interviews with key personnel, and analyze relevant industry data. In order to complete the QofE report, the financial statements, general ledger, tax returns, management reports, certain sales and vendor contracts, and other documents and records pertaining to the company’s financial performance will be examined. The data will then be analyzed to identify the financial strengths and weaknesses of the company. The QofE report will provide a complete picture of the company’s financial health and will also identify potential risks and uncertainties. Buyers regularly engage an independent firm to produce a buy-side QofE as part of their due diligence with respect to a target company. Many sell-side M&A advisers have recently encouraged the target company to obtain a sell-side QofE early in the M&A process because of the benefits it brings to the seller’s transaction. A sell-side QofE that is prepared before the marketing of the target company to potential buyers begins can result in significant advantages for the seller, including the following: Validating EBITDA: As M&A transactions are typically valued as a multiple of adjusted EBITDA (earnings before interest, taxes, depreciation and amortization expenses, adjusted for nonrecurring revenue or expenses), the ability of the seller to validate the target company’s adjusted EBITDA based on the QofE’s independent analysis is very beneficial to defending the value for the target company that is being sought by the seller. Identifying Issues Earlier: The sell-side QofE may uncover issues that could negatively impact the sale process. Such issues, when identified early, before commencing the marketing of the target company, can potentially be resolved or a strategy can be developed to address the issues. Expediting Due Diligence: As a result of the sell-side QofE process, the seller will have already assembled and analyzed many of the documents and the data that the buyer will be requesting as part of its due diligence. Such advance preparation will accelerate the deal process and free the seller’s management team from searching for and compiling data, allowing them to instead address other transaction matters and continue running the target’s business. Further, the sell-side QofE provides a practice run of what the seller and its management team, particularly the chief financial officer, will face during the buyer’s due diligence and will enable the buyer to progress through its due diligence more efficiently. Supporting Working Capital Calculations: The sell-side QofE will help establish the appropriate components of the working capital calculations and support the determination of the target net working capital required to operate the business. The working capital mechanism is often an area of potential disagreement in M&A transactions. A QofE can help avoid vagueness or uncertainly and post-closing disputes in connection with the working capital determinations in M&A transactions. Engaging an independent firm to produce a sell-side QofE is becoming common practice for sellers, largely due to the benefits of supporting the purchase price and facilitating the process, thereby leading to a successful closing.

The search for value often requires turning over a lot of stones and thinking creatively about structures and capital. In the search, an entrepreneur or investor often comes across an array of tax-exempt entities and considers whether they might be untapped potential resources. Whether it’s a new business idea that might fill a social need or a valuable opportunity to associate with a trusted brand, the nonprofit sector can present appealing options, even while investors lack an understanding of the real limitations of these entities. But while the strictures on public charities and private foundations (the Internal Revenue Code Section 501(c)(3) class of entities) are fairly well known, other tax-exempt forms are less well understood. Specifically, the entities qualifying under Section 501(c)(4) have drawn a lot of attention as social welfare organizations – those civic leagues and organizations described as “operated exclusively for the promotion of social welfare” and for “the general welfare of the people of the community” under Treasury regulations. What attracts the attention of both for-profit and nonprofit (i.e., 501(c)(3)) organizations is the ability of 501(c)(4) organizations to engage in some practices that are prohibited for 501(c)(3) entities, such as conducting an unlimited amount of lobbying and engaging in political campaign activities. In both cases, the activity is permitted to 501(c)(4)s provided that it’s not the primary purpose of the organization. However, identifying the primary purpose of an organization’s activities remains an inquiry that is based on all the facts and circumstances, and popular perception often overlooks this requirement. Similar to the wider allowance of political and lobbying activity, the 501(c)(4) form has also historically had more flexibility in what qualified as a purpose that promoted social welfare and the good of the community. Once a qualifying community benefit is established, its exemption, for the most part, is not jeopardized by undertaking other activities as long as that social welfare purpose is the primary function of the organization. Much of this is predicated on the lack of a firm definition of “social welfare” and the broad explanation that these organizations provide for “common good and general welfare” and “civic betterments and social improvements” along the lines described in regulations. While the standard for tax-exempt status is to operate “exclusively” for the promotion of social welfare, the practice has been to define “exclusively” as being met when the organization is primarily engaged in activities that promote the common good and general welfare of people in the community. As a result, some organizations take a liberal interpretation of what is covered by the social welfare umbrella for purposes that would otherwise most likely fail to qualify as tax-exempt under Section 501(c)(3), and then they cobble together other activities that are generally beneficial but sometimes overly narrow in those they benefit. In fact, this broad construction approach needs to be closely examined if a component of a proposed or existing business relationship is based on a 501(c)(4) relationship where the benefit to the community resembles activities that would normally be the domain of non-tax-exempt (i.e., for-profit) businesses. One common example comes from organizations claiming a social welfare purpose because they serve the “promotion of health” by offering healthcare, pharmaceutical or health-related services outside an organization that otherwise qualifies as a 501(c)(3). Other examples might be the provision of services to members, even members that are nonprofits, and to individuals who resemble a customer base more closely than the community as a whole. A hypothetical example might include an entrepreneur who develops a database and tracking system to manage the maintenance and upkeep of real estate holdings. The entrepreneur decides to put the software services in a 501(c)(4), making it available to low- and moderate-income housing units, many of which are maintained and operated by nonprofit organizations. He or she reasons that the organization benefits the community because it makes it possible to improve the maintenance and upkeep of low-income housing. Maybe our entrepreneur also licenses the services to for-profit real estate managers for a higher fee, funneling the licensing profits back into the development of more features that benefit both nonprofit and for-profit housing managers. While the purpose of the organization may be meritorious, the facts, only slightly embellished here, mirror a revenue ruling explicitly determining that the organization did not qualify for 501(c)(4) status. Unlike in the for-profit sector, what makes a purpose or activity one that serves the community goes beyond just meeting a market need. The key principle is that the organization’s activities provide a benefit to the community at large, as opposed to a group of members or select individuals. As a result, many goods and services that provide a market benefit to those individuals whose needs are met by those things being provided will not meet the threshold set for a community benefit in the context of a tax-exempt organization. Recent tax determinations and court cases have rejected tax-exempt organizations when the benefit included providing healthcare coordination services, pharmaceuticals, management consulting and software services. In many of these cases, the IRS has increasingly taken the position that the “exclusive” requirement more closely resembles the standard applied to 501(c)(3) organizations than the more-malleable popular perception that 501(c)(4) organizations have gained. In the run-up to an election year, the usual focus for 501(c)(4) organizations is on the amount of political activity these organizations engage in. While these organizations’ political activities have recently drawn the attention of the House Committee on Ways and Means, business investors should also be aware that these organizations also crop up in conjunction with organizations and individuals interested in the seemingly greater capacity of these organizations to engage in activities that are tangential to or only loosely qualify as a social welfare purpose. This trend in recent denials and decisions against 501(c)(4) organizations because they represent typical business purposes may signal increased attention to the social welfare purposes of 501(c)(4)s. As always, business transactions that involve or relate to tax-exempt entities require both close scrutiny and assistance from counsel with significant tax-exempt experience.

In the current market conditions, carve-out transactions are becoming increasingly common as companies look to divest noncore businesses and assets in order to restructure and focus on their core operations. This is due to many factors, including the need to improve profitability, reduce debt and focus on innovation. In these transactions, a portion of a company is sold to a buyer while the remaining portion continues to be held by the seller. One of the key considerations in carve-out transactions is data sharing. In many cases, the carved-out business will need to continue to have access to data that the seller currently holds. This data could include sensitive customer information, financial data or intellectual property. The sharing of data in a carve-out transaction can pose a number of risks, including: Data security risks: Buyers must ensure that any data received is secure and will not be misused. This includes taking steps to protect the data from unauthorized access, disclosure, modification or destruction. Compliance risks: Buyers must ensure compliance with all applicable data privacy and security laws and regulations. This includes laws and regulations in the countries where the data is located as well as laws and regulations in the countries where the buyer and seller are located.¹ This also includes an analysis of the seller’s own data privacy policies, including whether the seller reserved the right to disclose data in the event of the sale or transfer of a business. Litigation risks: Buyers may be exposed to liability if the data they receive is used in a way that violates the rights of third parties. This could include using the data to commit fraud, to violate the privacy of individuals or to receive the data in a manner that does not comply with contracts or other licensing agreements. Business disruption risks: If the data-sharing process is not properly managed and the data necessary to operate the carved-out business is not transferred or made available, it could disrupt the operations of both the seller and the buyer. This could impact the transaction and lead to lost revenue, increased costs and damage to the reputation of both companies. In Stradley Ronon’s experience handling carve-out transactions, we have developed a list of factors for parties to carefully consider in order to mitigate risk as a transaction progresses: The nature of the data that will be shared, including where it resides, the infrastructure it operates on and how it may be associated with other bundled information (such as user accounts). The purpose(s) for which the data will be used. The contracts and licensing agreements that apply to the data. The security measures that will be put in place to protect the data. The applicable data privacy and security laws and regulations. The potential risks of litigation. The impact on the operations of both the seller and the buyer. In previous carve-out transactions, we have also found it particularly important to carefully negotiate the terms of the data-sharing agreement, which should include provisions addressing the following issues: The scope of the data that will be shared. The scope of the data that will no longer be maintained by the seller. The purpose(s) for which the data can be used. The security measures that must be put in place to protect the data. The duration of the data-sharing agreement. The termination provisions. The dispute resolution process. The number of carve-out transactions is expected to continue to increase in the near term. As a result, it is important for businesses to be aware of the risks of data sharing in these transactions and to take steps to mitigate those risks. In addition to the factors mentioned above, there are several other considerations that should be taken into account in carve-out transactions involving data sharing. These include: The shared assets, systems and employees that may be used by the carved-out business. In some cases, the carved-out business may need to rely upon assets, systems and employees shared with the seller. This could pose a security risk, as the buyer may not have the same level of control over these aspects of the business, and post-closing transfer of data between buyer and seller may increase the likelihood of an inadvertent data breach. It is important to carefully consider the risks and benefits of such an arrangement before entering into an agreement. The tax implications of a data-sharing transaction. The data-sharing transaction could have tax implications for both the seller and the buyer. For example, the buyer may be required to pay taxes on the data it receives, or the seller may be required to withhold taxes on the data it shares. It is important to consult with a tax adviser to understand the tax implications of the transaction. The impact of data sharing on the competitive landscape. Data sharing could give the buyer an unfair advantage over its competitors. For example, if the buyer receives customer data from the seller, it could use this data to target its marketing campaigns more effectively. It is important to consider the impact of potential data sharing on the competitive landscape before agreeing to it. Over and above these points, it is also important to consider the specific circumstances of the transaction. Ultimately, the factors that are most important will vary depending on the nature of the data that is being shared, the purpose for which the data is being shared and the laws and regulations that apply. By approaching each carve-out transaction carefully, considering the risks of data sharing and taking steps to mitigate those risks, parties to a carve-out transaction can protect their interests and ensure a smooth and successful transaction. ¹ Of particular note, the European Union’s (EU) General Data Protection Regulation (GDPR) applies to any entity that processes the personal data of EU citizens or residents or offers services to people who are EU citizens or residents. The GDPR applies even if the entity is not located within the EU and may impose significant fines for noncompliance. In the United States, the California Consumer Privacy Act and California Privacy Rights Act are the most likely to apply; however, there are nine other states with comprehensive privacy laws that are either in effect now or will go into effect over the next few years.

In a decision rendered on May 29, 2023, the Delaware Court of Chancery, in the case HControl Holdings LLC et al. v. Antin Infrastructure Partners S.A.S. and OTI Parent LLC,¹ enforced a buyer’s right to terminate a merger agreement on the basis that certain representations made by the sellers in the merger agreement concerning the target companies’ capitalization were not true and correct in all respects. Factual Background Antin Infrastructure Partners S.A.S., a private equity firm formed under French law, and OTI Parent LLC (collectively, the Buyers) entered into a merger agreement (Merger Agreement) with the Purchased Entities (as defined below) and Mario Bustamante, as the sellers’ representative (together with the Purchased Entities, collectively, the Sellers) to acquire a group of privately held Florida broadband companies, collectively referred to as OpticalTel, for a base purchase price of $230 million plus an earnout of up to $30 million contingent on meeting certain milestones after closing. OpticalTel consists of four top-level limited liability companies (collectively referred to as the Purchased Entities) and their subsidiaries. The Merger Agreement is governed by Delaware law. Under the Merger Agreement, the Sellers made representations and warranties concerning who owned the businesses being sold (Capitalization Representations) and agreed that all Fundamental Representations, which were defined to include the Capitalization Representations, would be true and correct in all respects at closing (the Bring-Down Provision). During negotiations, the Sellers and Buyers went back and forth on whether a de minimis failure of the Fundamental Representations to be true and correct would be excluded from the Bring-Down Provision. Ultimately, the Sellers and Buyers agreed on a flat Bring-Down Provision that would require the Fundamental Representations, including the Capitalization Representations, to be true and correct in all respects at closing and would not include a de minimis qualification. After the Merger Agreement was signed, an employee of OpticalTel, Rafael Marquez, claimed an ownership interest in an OpticalTel entity, HControl Corporation (HControl Corp.), a subsidiary of one of the Purchased Entities, HControl Holdings LLC, based on a software development agreement entered into with Marquez pursuant to which he provided certain services related to the implementation of software used in OpticalTel’s business. The software development agreement provided for HControl Corp. to pay Marquez, as consideration for his services, among other things, “5% ownership of HControl Corp. to be distributed upon a liquidation event.” The interest that Marquez claimed he had in HControl Corp. was not included in the disclosure schedule to the Merger Agreement relating to the Capitalization Representations. Marquez aggressively pursued his claim, including by directly contacting the Buyers. The Sellers made several attempts to settle with Marquez and ultimately made an offer to him of $300,000, based on a $9.5 million valuation of HControl Corp., which was rejected. Marquez’s counsel made an offer of $4.5 million to $5.4 million to resolve the claim, based on Marquez’s position that he was entitled to 5% of the total deal proceeds, not only the proceeds attributable to HControl Corp. The Sellers were unable to reach a settlement with Marquez. The Sellers then proposed restructuring the merger transaction to exclude HControl Corp. and provide the other OpticalTel entities with access to its software via a licensing arrangement. The Buyers rejected this proposal and shortly thereafter served a notice of breach of the Merger Agreement on the Sellers based on a breach of the Capitalization Representations. The Sellers then proposed a plan (the Transfer-Dissolution Plan) to transfer HControl Corp.’s proprietary software to HControl Holdings – one of the Purchased Entities that would be acquired by the Buyers in the merger – in exchange for $215,000, or 5% of the software’s valuation of $4.3 million, paid into a trust and then dissolve HControl Corp., with the objective of reducing any claim to equity by Marquez to a claim for monetary damages. The Buyers took the position that the Transfer-Dissolution Plan would breach certain interim covenants regarding the Sellers’ operation of the OpticalTel business between signing and closing, and they noted that the dissolution process could take months and the statute of limitations period for bringing claims against HControl Corp. would extend for another four years. The Sellers responded by seeking the Buyers’ consent to the Transfer-Dissolution Plan. The Buyers did not consent. Nonetheless, the Sellers went forward and consummated the Transfer-Dissolution Plan. Following the Sellers’ consummation of the Transfer-Dissolution Plan, the Buyers sent a second notice of breach, stating that the dissolution of HControl Corp. failed to resolve the Sellers’ breach of the Capitalization Representations related to Marquez and resulted in further breaches of the Merger Agreement. Shortly thereafter, the Buyers terminated the Merger Agreement due to the Sellers’ failure to cure the breach of the Capitalization Representations relating to Marquez, and about a month after that, the Buyers sent another notice terminating the Merger Agreement due to the Sellers’ failure to cure their breaches of the Merger Agreement arising out of the Transfer-Dissolution Plan and certain other breaches. The Sellers filed suit against the Buyers for specific performance. The Sellers claimed that the Buyers breached the Merger Agreement by, among other things, wrongfully terminating the Merger Agreement and failing to use their best efforts to consummate the merger. The Court’s Findings The court found that Marquez’s rights under the software development agreement to a cash payment upon a liquidation event in the amount of 5% of the value of HControl Corp. constituted phantom equity, which rendered the Capitalization Representations false, and that the Transfer-Dissolution Plan did not cure the Sellers’ breach of the Capitalization Representations. The court noted that the Bring-Down Provision does not include a de minimis qualifier. The Buyers negotiated for the Fundamental Representations, including the Capitalization Representations, to be true and correct in all respects. The Capitalization Representations were not true and correct in all respects, and the Buyers proved that the Sellers breached the Capitalization Representations based on the Marquez issue. In its decision, the court noted that the parties disputed the Buyers’ motive for serving notice of breach and that the Sellers came to believe that the notice had something to do with an investigative report on the OpticalTel companies, the principal owner and the CEO that was prepared by a third party that the Buyers commissioned upon learning about the Marquez issue. The report cast a number of aspersions on the Sellers that the Sellers denied. The Sellers pointed to this report as the impetus behind the Buyers’ decision to back out of the deal and insinuated that the Buyers’ legal grounds were pretextual. However, the court found that the Buyers’ representatives testified credibly that the Marquez issue concerned them. In that regard, the Buyers acknowledged that the post-closing risks related to Marquez were not primarily financial and that they viewed Marquez’s claim as worth a minimal amount of money compared to the deal. The Buyers believed that Marquez would continue to pursue his claims aggressively post-closing and that litigation would consume and distract the Sellers’ management. The Buyers also had reputation concerns related to the Marquez issue. Notwithstanding the analysis in the court decision concerning the Buyers’ motives, the court noted that, in all events, the parties’ dispute over the Buyers’ motives was largely beside the point and the real issue was whether they had a legal basis to notice a breach and terminate the Merger Agreement. The court found that the Sellers did not prove that the Buyers breached their obligation to use best efforts to close, noting that the Buyers continued to take specific steps to proceed to closing even after learning about the issue involving Marquez. The court stated that between signing and closing, the Buyers had the right not to close if the Capitalization Representations were not true and correct in all respects and that the best-efforts provision did not require the Buyers to sacrifice their negotiated contractual rights to solve a breach. The court held that the Buyers had the right to terminate the Merger Agreement as a result of the Sellers’ breach of the Capitalization Representations with respect to the Marquez issue. However, with regard to the Transfer-Dissolution Plan, the court found that the consummation of the Transfer-Dissolution Plan neither breached the Sellers’ obligations under the Merger Agreement to operate OpticalTel in the ordinary course of business between signing and closing or use commercially reasonable efforts to preserve intact its business organization nor breached the provision of the Merger Agreement that prohibits the Sellers from dissolving any member of the OpticalTel companies, other than immaterial subsidiaries, without the Buyers’ consent. The court found that the Optical-Tel business was not altered by the transfer of the assets of HControl Corp. to HControl Holdings because the OpticalTel companies still held the assets following such transfer and noted that before and after the transfer, the OpticalTel companies owned the same assets and had the same contracts and that the business was essentially the same as it was at the time of the signing of the Merger Agreement. The court also found that while HControl Corp. was a material subsidiary before the consummation of the Transfer-Dissolution Plan, it was not a material subsidiary after its assets were transferred pursuant to the Transfer-Dissolution Plan. Nevertheless, the court’s findings with regard to the Transfer-Dissolution Plan did not affect the Buyers’ right to terminate the Merger Agreement based on the breach of the Capitalization Representations. Conclusion This case indicates that (i) the Delaware courts may enforce the right of a buyer to terminate a merger agreement based on the failure of a seller’s representations and warranties to be true and correct at closing even where the financial value of the breach is minor relative to the overall deal value if the terms of the merger agreement require the applicable representations and warranties to be true and correct in all respects at closing (without any de minimis or materiality qualification) and (ii) any obligation of the parties under a merger agreement to use best efforts to consummate the merger may not require a buyer to take actions to assist a seller with curing the seller’s breach of representations and warranties in order to satisfy a condition to the buyer’s obligation to consummate the merger. Accordingly, counsel for buyers and sellers should give careful consideration in negotiating such bring-down provisions and the extent to which those provisions should be qualified by materiality. ¹ 2023 WL 3698535 (Del. Ch. May 29, 2023)

With 2023 off to a rocky start for entrepreneurs and startups due to rising interest rates, inflationary pressures and the collapse of highly recognized banks for venture-backed companies – such as Silicon Valley Bank (SVB), Signature Bank and other financial institutions with a greater appetite to do business with these types of riskier companies – the market saw both a pullback by venture capital firms, limiting follow-on equity rounds for the weaker companies in their portfolio as well as a sharp decline in the availability of venture debt. The simultaneous pullback in both the equity and debt markets for these early- and growth-stage companies has left many of these companies in a precarious position, focused on capital preservation and, in some cases, survival, with many ending up in a fire sale or shutdown mode. There was a great deal of uncertainty as to what the future held in terms of venture debt after the upheaval in the banking market. For the remainder of 2023 and beyond, it initially seemed unlikely that traditional banks, including those remaining banks that targeted the startup world, would be the source of venture debt due to the riskier nature of these loans (which generally would not meet their underwriting criteria) as well as more uncertainty and unpredictability in the growth prospects of many of these companies, given the instability in the financial markets for both debt and equity. However, recent trends suggest that there may be more banks than expected that have jumped in to fill the void, with HSBC and Stifel starting to offer new financing alternatives (both institutions picked up former SVB team members) and CIBC and First Citizens Bank (which acquired SVB) continuing to make and honor existing loans. It will be interesting to see how HSBC targets the market, as it recently launched a venture banking practice, but the growing consensus is that loans will start at $1 million post-Series A. To understand venture debt as it is today, one must understand its history. Venture debt became prominent in the 1970s and 1980s with the rise of SVB and similar lending institutions willing to accept more risk and do business with high-growth startups. Many of the great companies that we all know of today were, in part, the product of venture debt. Venture debt seemed to peak during what is known as the pre-dot-com era (mid/late 1990s). During this period, venture debt financing topped out at around $5 billion. This was until 2001 when events took place that led to the bursting of the dot-com bubble and the crash of the markets in the early 2000s. This crash led to many venture capital firms exiting the market and others becoming much more conservative and risk averse. Things again started to look up in the mid-2000s, but the market was again crushed by the crash of 2008. Much as in the 2001 crash, lenders became significantly more risk averse or they exited the market completely. Venture debt only works if there is venture capital (equity behind it), and much of the exit of venture debt in these prior financial crises was tied to the lack of new equity investment. As the market came back with a vengeance in recent years, lenders had again become more flexible in their lending habits, and the venture debt market grew tremendously. However, the rapidly rising interest rates, inflationary pressure, volatile public markets and other macroeconomic factors, including the collapse of SVB and other banks as noted above, that converged in late 2022 and early 2023 led many to speculate that venture debt markets would tighten significantly – and they did, in fact, do so for the first half of 2023. But there does seem to be a light at the end of the tunnel, although likely with more conservative terms and underwriting. What Is Venture Debt, and How Does It Work? What is venture debt? So, what is venture debt? At a high level, venture debt is similar to any other kind of debt. It is a loan from a bank or a nonbank lender to early-stage companies that have previously completed round(s) of venture capital equity funding. Most of the time, these companies have strong growth potential but little to no marketable collateral such as cash, real estate or liquid investments with which the lender can secure its obligations under the loan, making them risky candidates for conventional bank loans. When they lend, venture debt lenders, as opposed to conventional banks, focus more on a company’s growth potential and equity backing than its cash flow and profits. Additionally, venture debt can be attractive to early-stage companies, as it can be used as a complement to equity financing that will not dilute existing equity ownership or change management control in the company. Who are the lenders? Venture debt lenders and equity investors are very different. In a nutshell, equity investors, such as venture capital firms and high net worth individuals, infuse a certain amount of capital into a company in exchange for an equity ownership interest in the company. Equity investors hope to achieve a big return on their investment once the company matures and declares and issues dividends and/or there is a sale event, among other liquidity events. They usually get a preferred return of capital and perhaps an accruing dividend on that capital that is paid when and if there is a liquidity event, but they generally do not have a set timetable or the equivalent of a maturity date nor a guaranteed repayment obligation from the company as to either return of invested capital or a certain return on their investment. To the contrary, when venture debt lenders enter into a credit facility, the lender expects to be repaid every cent that is lent plus interest. This is no different from a residential mortgage company demanding that you repay your entire mortgage plus interest, but the venture debt lender does not have a lien on your residence as security for the loan. How does venture debt work? As an initial matter, before a venture debt lender agrees to lend to an early-stage company, the lender generally will assess the company’s business plan, financials and growth potential to determine whether they will proceed with a loan and, if so, how much funding they will provide. Because lenders in this space assume a greater risk when loaning to unproven companies, as compared to traditional loans to established companies, it goes without saying that lenders want to be protected and compensated accordingly. For example, venture debt normally follows a round of venture capital (e.g., equity or subordinated debt) funding as a form of support for the lender’s extension of credit. Instead of securing its obligations through the company’s assets as a traditional bank does, it instead uses the amount of venture capital funding previously supplied as a source of validation. This is in part due to the overall theory behind venture debt; lenders place significant value on their trusted relationships with the venture capitalists behind the companies, which are often clients of the lender. Not only does the equity funding provide comfort to the lender in the form of support for the borrower from its existing or new investors, but the available loan amount also is set based on the previous round of venture capital funding. Normally, loans are limited to 25% to 35% of the most recent round of equity funding and are relatively short term (one to three years). These venture debt loans typically have an interest rate higher than the traditional loans we would customarily think of, due in large part to the speculative nature of the business that is borrowing the funds and the need to compensate the lender for the additional risk. In addition to higher interest rates to compensate the lender for its risk, venture debt is usually coupled with warrants to purchase the borrower’s equity to provide additional upside for the lender, assuming the company achieves future success. The total value of warrants issued to a venture debt lender is between 5% and 20% of the principal loan amount. These warrants are usually a right to buy the last round of priced equity and generally have a term of one to 15 years. Finally, venture debt lenders aim to protect themselves with certain operating covenants in the loan agreement by including affirmative and negative covenants that place limits on the borrower’s activities. However, as compared to a more traditional asset-based loan, the number of covenants included may be minimal and limited to just a few financial covenants. These financial covenants normally lay out conditions that the borrower must fulfill or avoid to maintain the relationship with the lender. Financial covenants are normally limited to the borrower promising to maintain a positive growth rate and/or maintain a certain level of liquidity. Venture lenders also historically required that borrowers maintain 100% of their cash balances with the bank acting as a lender. When depositors became aware of SVB’s problems, they quickly tried to withdraw their funds, even if it put their loans in jeopardy. This was, in part, a major issue during the collapse of SVB. Therefore, newer venture debt models appear to be more flexible, with some lenders willing to limit the deposit requirement to a lower percentage of cash or a fixed amount tied to the loan balance to cover debt service for a period of time. Relevance in 2023 In the first half of 2023, venture debt deals declined a whopping 38% across the board, going from $20.07 billion in 2022 to only $6.34 billion in 2023. This most likely can be attributed to the failure of SVB and the lack of larger banks and venture debt funds stepping up to fill SVB’s void, rising interest rates, and uncertainty in the markets. However, more recently, we have seen alternative lenders and other banks step in to try to fill this void. In the meantime, only time will tell how the venture debt market will react to the current macroeconomic environment.

The release and popularity of programs like Chat GPT, Bard and Dall-E have brought to light the power of generative artificial intelligence (generative AI), which is a form of artificial intelligence capable of creating information in response to prompts. While standard AI systems can only synthesize existing information, generative AI can produce new text, images, videos and code. This trait enables generative AI to “think” and “act” similarly to humans. As such, the practical uses for generative AI are widespread and are beginning to redefine how tasks are completed. In the field of law, generative AI has the ability to alter the workflow of attorneys and law firms and hence impact the client experience. With respect to mergers and acquisitions specifically, in time, generative AI likely will impact almost all steps of the deal-making process. On the front end of a potential transaction, generative AI has the potential to significantly improve the screening process for identifying potential target companies. For example, certain generative AI platforms have the capability to identify company objectives, analyze business performance and predict future company success. This technology could generate return-on-investment values for different acquisition candidates or provide relatively accurate probability-of-success numbers for hypothetical mergers. In time, generative AI platforms should be able to perform these tasks at a significantly faster pace than deal-sourcing professionals utilizing traditional methods. Therefore, using generative AI to identify strategic and profitable acquisitions should enable potential acquirers to ultimately increase both the volume of potential target companies they can scan and the likelihood of locating target companies whose acquisition would complement the acquirer’s objectives. In addition, generative AI is beginning to alter the way in which due diligence may be conducted. Nongenerative forms of AI (like machine learning platforms and simple computer algorithms) only collect data and analyze given information, yet the use of such nongenerative AI can significantly lessen the time required for a law firm or in-house attorney to review, analyze and summarize the information received as part of the due diligence process. For example, nongenerative AI may have the ability to quickly assess which contracts in an electronic data room include “anti-assignment” provisions - a task that is traditionally handled by junior attorneys. Given the current state of such technology, however, nongenerative AI may miss anti-assignment provisions which include unconventional wording. This could prove problematic for an acquirer who needs to know whether third-party consent is required. As clients begin to have the option to utilize nongenerative AI for certain aspects of due diligence, clients may be faced with important decisions regarding whether the accuracy of results or the costs of legal fees are more important. At present, generative AI has only begun to emerge as a due diligence tool, but it has promising capabilities, such as synthesizing information from various folders in an electronic data room to create graphs and visualizations or even providing insight into possible business and legal risks associated with a potential transaction. Finally, generative AI can make purchase agreement drafting and review less laborious and time-consuming. Both generative and nongenerative AI systems use algorithms that provide the capability to scan documents and help with formatting and structure. Called “contract AI,” there is a growing demand for such products in the legal industry. Generative AI, on the other hand, is not widely used currently in contract drafting, but efforts to enhance the intuitive nature of this technology have the ultimate goal of assisting lawyers in creating contracts, such as purchase agreements, from start to finish. For example, an attorney could ask a generative AI platform to create a purchase agreement for company X using the basic structure from template Y but with certain conceptual deal-specific revisions, which would then be converted to precise contractual verbiage by the generative AI program. Or an attorney could ask the AI system to analyze language within the contract to determine whether it favors a particular party. While it will take time for generative AI systems to become advanced enough to accurately draft complex contracts, in the interim, lawyers may increase efficiency by using this technology in tandem with their own expertise to create rough drafts and compare contracts. Some law firms have already begun to see the impact of emerging generative AI platforms in the M&A space. Harvey AI was the first comprehensive generative AI legal tool created and is currently in beta testing. Harvey AI is designed to act as an intuitive and comprehensive legal interface, helping with research, due diligence, contract drafting and analysis. While Harvey AI is one of the most advanced legal generative AI platforms available, other algorithms have also proven to be applicable to M&A. For instance, during beta testing, the generative AI platform roBERTa was recently used to predict the effectiveness of hypothetical mergers. While systems like Harvey AI and roBERTa are still in beta testing, they are showing promising progress toward being implementable in M&A transactions. Given the emerging applications of generative AI in M&A transactions, strategic acquirers and private equity firms can expect generative AI to gradually provide increased opportunities to source transactions and more efficiently complete due diligence by offloading time-consuming work to AI systems. Ultimately, utilizing such AI during the deal process should have multiple positive effects, such as shortening the time between signing a letter of intent and closing the transaction and lessening the aggregate amount paid for M&A attorneys’ time. However, given the learning curve associated with utilizing the new technology incorporated in generative AI, it will take time for strategic acquirers, private equity firms and attorneys to efficiently integrate generative AI into routine deal processes. Also, in its current state, AI can provide misinformation, inaccurate answers or incomplete responses and therefore is only appropriate to use as a complement to attorney work product rather than as a replacement. Despite these obstacles, when implemented in a measured manner, generative AI will undoubtedly have multiple positive impacts on the ability of dealmakers to effectively and efficiently consummate successful M&A transactions.

In July 2013, the market cap of Bitcoin, the largest and most widely recognized cryptocurrency, stabilized at just over $1 billion – growth in excess of 1,000% from the prior year. In July 2023, Bitcoin’s market cap oscillates around the $600 billion mark, dwarfing its market cap from a decade prior as it recovers from a precipitous fall from a peak of more than $1.2 trillion in November 2021. Digital assets such as cryptocurrencies and non-fungible tokens have, thanks to their recent and meteoric rise in value and notwithstanding their generally high volatility, become a significant source of collateral in financing transactions and a prevalent asset in purchase transactions. Despite their digital and intangible nature, digital assets constitute “property” under the Uniform Commercial Code (UCC). As such, sellers, purchasers, borrowers and lenders have applied the existing provisions of the UCC as best they could to address transactions involving sales and transfers of, and security interests in, these digital assets. The UCC, as in effect in the majority of states in July 2023 (the current UCC), however, is inadequately suited to address certain of these transactions, resulting in inconsistency in transaction structures and questions regarding transfers of rights and whether liens in these assets are properly perfected. The increasing adoption of digital assets has also caused unforeseen complications in the already murky treatment and classification of these assets under the current UCC. El Salvador and the Central African Republic, for example, have adopted Bitcoin as official legal tender, which would cause Bitcoin to be reclassified from a general intangible to “money” under the UCC, thus rendering previously sufficient financing statements ineffective to perfect a secured party’s security interest in Bitcoin.1 Overview of UCC Article 12 In July 2022, the Uniform Law Commission (ULC) approved and recommended for enactment amendments to the current UCC to address the issues stemming from transactions that involve digital assets and electronic records, specifically those that are susceptible to control and not already adequately addressed by the current UCC. These digital assets and electronic records are referred to as controllable electronic records (CERs) under the amendments to the UCC, which are commonly and colloquially referred to as “UCC Article 12” due to the addition of a 12th article to the UCC. Still, these amendments modify nearly every other article of the UCC as well, including substantial revisions to Article 9. These amendments answer fundamental questions that arose from the recent prevalence of CERs: Which types of digital assets constitute CERs, and which types remain general intangibles or another class of property under the UCC?A CER is a record that (i) is stored in an electronic medium and (ii) can be subjected to control. A CER specifically is not a controllable account, a controllable payment intangible, a deposit account, an electronic copy of a record evidencing chattel paper, an electronic document of title, electronic money, investment property or a transferable record. How does a secured party perfect its security interest in CERs?A secured party may perfect its security interest in a CER by either filing a financing statement or obtaining control over the CER under Section 12-105 of the UCC, but it is strongly advised to obtain control, as, consistent with the UCC’s treatment of other “control vs. filing” priority constructs, a party with control over the CER has priority over a party that perfects its security interest by simply filing a financing statement. Control of a CER is established when the electronic record (a record attached to or logically associated with the electronic record) or a system in which the electronic record is recorded:(i) gives the secured party (a) power to avail itself of substantially all2 the benefit from the electronic record; (b) exclusive power to prevent others from availing themselves of substantially all the benefit from the electronic record and (c) exclusive power to transfer control of the electronic record to another person; and (ii) enables the secured party readily to identify itself in any way, including by name, identifying number, cryptographic key, office or account number, as having the powers specified above. How does a secured party enforce and protect its perfected lien against third parties, including bona fide purchasers?UCC Article 12 contains a “take-free rule” like those found in Articles 3 and 8 with respect to holders of negotiable instruments and purchasers of securities. UCC Article 12 provides that if a secured party or good faith purchaser of a CER obtains control without notice of a competing property right, it will acquire rights in the CER free of any competing property rights that may exist in that CER. Only a person3 who establishes control of a CER qualifies as a qualifying purchaser under the take-free rule discussed above. Accordingly, owners and secured parties who properly establish exclusive control of a CER minimize their risk of losing their interest in the CER under the take-free rule. Adoption Status As of July 12, eight states have enacted the UCC Article 12 amendments and 20 other states and the District of Columbia have introduced bills to adopt the same.4 While many legal practitioners were optimistic about the rate at which each state would introduce and adopt UCC Article 12, certain media commentators and then lawmakers raised concerns about the treatment and definition of “money” in the amendments, which resulted in certain states making non-uniform modifications of the definition of money, following which the ULC created a “hip pocket” amendment to the originally proposed UCC Article 12 amendments to assuage these concerns.5 As more states adopt these revisions to the UCC, the reduction in legal risk stemming from the uncertainty of the treatment of digital assets under the UCC, coupled with the recent rally of the value of cryptocurrencies and other digital assets, may provide a much-needed source of collateral relief in tightening debt finance and M&A transactions. Potential Issues and Questions for Transactions Going Forward While a secured party’s establishment of control over deposit and securities accounts, negotiable instruments and certificates representing securities has become commonplace in the finance space, will debtors push back on a secured party establishing control of digital assets such as cryptocurrencies? One feature of these assets is the anonymity and independence that a decentralized currency stored on an electronic medium can offer. How much does an owner’s grant to a third party of access to these assets undermine the value of those assets to their owner? While several proffered methods exist for a secured party to obtain control over a CER involving third parties and control agreements, smart contracts and escrows, a secured party may also obtain control over the CER by receiving the private key to the CER. Any party with the private key to the CER has de facto ownership of that CER. Will debtors trust secured parties with the safekeeping of private keys, or will an alternate method become the preferred means of a secured party obtaining control? Additionally, what regulatory and compliance controls, particularly with respect to the safekeeping of means of control, use of proceeds and anti-money laundering regulations, must be established on the secured party’s side prior to digital assets becoming ubiquitous in financing and M&A transactions?6 An important business and valuation consideration also stems from the volatility of digital assets and assets related to or dependent on them. Common transaction features such as post-closing purchase price adjustments and earn-outs, which include the value of digital assets in the valuation formula, could significantly increase the range of a potential post-closing payment or refund. Further, the appetite for secured parties to lend against digital assets and tangible assets related to digital assets – coin mining equipment, for example – is unlikely to approach that for more established assets such as securities and traditional goods and equipment. In conclusion, while issues will most certainly arise as states continue to adopt UCC Article 12 and digital assets become more widely adopted in the market, the proposed amendments to the UCC provide much-needed clarity, a road map to consistency and a reduction in legal documentation risk in transactions involving digital assets. 1 Under UCC §9-310, a filed UCC-1 financing statement is sufficient to perfect a security interest in general intangibles. Under UCC §9-313(b)(3), however, a security interest in money may only be perfected by the secured party’s taking possession (via actual possession) of the money. Accordingly, the reclassification of Bitcoin from a “general intangible” to “money” under the UCC changed the means by which a secured party may perfect its lien against Bitcoin. 2 The concept of “substantially all the benefit” of a CER is a somewhat sticky subject – certain rights, e.g., the ability to spend digital currency, may be limited based on how the CER is recorded. In determining whether a person has the power to avail itself of substantially all the benefits from a CER or to prevent others from availing themselves of substantially all the benefits from a CER, only the benefit that the system makes available (subject to the system’s inherent limitations) should be considered. 3 Under the UCC, a “person” means an individual, corporation, business trust, estate, trust, partnership, limited liability company, association, joint venture, government, governmental subdivision, agency or instrumentality, public corporation or any other legal or commercial entity. 4 Colorado, Indiana, Iowa, Nebraska, Nevada, New Hampshire, New Mexico, North Dakota and Washington have adopted the amendments, and Alabama, Arizona, Arkansas, California, Delaware, the District of Columbia, Hawaii, Kentucky, Louisiana, Maine, Massachusetts, Missouri, Montana, New York, Oklahoma, Rhode Island, South Dakota, Tennessee, Texas and West Virginia have introduced the amendments. Legislative bill tracking may be found at https://www.uniformlaws.org/committees/community-home?communitykey=1457c422-ddb7-40b0-8c76-39a1991651ac#LegBillTrackingAnchor. 5 While not all states adopted the precise language found in the “hip pocket” amendment, the general theme of the amendment has been to (i) exclude electronic forms of “money” from the definition of “money” under the UCC; (ii) eliminate the concept of “electronic money”; (iii) revert related means of perfecting a lien against money to actual possession and (iv) exclude central bank digital currencies of any type and issued by any government from qualifying as “money” under the UCC. 6 Privacy and control concerns have also been raised in connection with the implementation of the Corporate Transparency Act’s requirement for reporting information about the beneficial owners of all U.S. business entities following the Financial Crimes Enforcement Network’s (FinCEN) issuance of proposed regulations to implement the Corporate Transparency Act. Owners of U.S. business entities are seeking to protect identities by limiting who may access the beneficial ownership information that FinCEN will be collecting.

Successful business succession planning for a closely held and family owned business requires a multidisciplinary approach, bringing together professionals in several areas, including financial/wealth advisory, accounting, trust and estate law and corporate law. National surveys over the past 15-plus years have shown that the two most popular succession events are a sale of the business to an unrelated third party (representing over 50% of such events), followed by a transition of the business to the next generation of family owners (representing around 20% to 25% of such events). In a number of instances when the business owner wants to exit via the sale of the business, they may initiate the sale process with an investment banker or directly with a potential buyer who has approached the owner; then, they must properly gather their succession planning team and consider their options. In these instances, if the sales process gets too far down the road, to where bid proposals are received by the owner or the owner’s representatives, the ability to do important trust and estate planning by moving some company equity (typically, nonvoting equity) out of the owner’s estate to a family trust will be compromised. In a recent experience, the principal owner of a closely held corporate client engaged a nationally known investment banker to sell his company. As the investment banking firm began to ramp up its sales activities with the year-end financials from the company’s outside accounting firm, we convened a call with the owner’s succession planning team, consisting of the accounting firm, one of Stradley Ronon’s trusts and estates lawyers, his wealth advisory firm, and me – as the lead corporate M&A lawyer for the client. In that call, we mapped out a plan. We were able to put the investment banker’s sale process on a temporary hold; to recapitalize the company by creating two classes of equity (voting and nonvoting); and to get a valuation of the business before any bid proposals were received, which also allowed utilizing discounts for lack of control and marketability. We also planned to establish a trust for his wife and children and to transfer via gift, using the newly issued nonvoting equity from the recap, a material portion of his equity, valued at approximately $5 million, to a family trust before the investment banker’s sale process resumed, offering a sufficient gap in time between the company valuation used for this gifted equity and the receipt of bid proposals from third parties. Based on the projections of the investment banking firm, there is the expectation that the valuation of the company in the sale process will be three to four times higher than the company valuation used for the gifting, which will be a significant win for the owner.

Debt relief assistance is an often-overlooked, relatively low-cost employee benefit available to any employer. A recent study found that employees were increasingly distracted from work due to debt stress, with 62% of respondents reporting that they would be more likely to stay with an employer that offered debt relief assistance. Employers seeking to include debt relief assistance in their benefit plan offerings will encounter a wide range of options. Examples include: Employers may provide up to $5,250 per year tax-free to assist each employee in repaying the employee’s student loan debt. To qualify as tax-free, the program must be in writing, cannot favor only highly compensated employees and must satisfy other IRS criteria for an educational assistance program.   Healthcare-related debt benefits focus on both avoiding and managing the debt. Examples include salary-supported loans, emergency savings funds, conversion of unused paid time off to an emergency medical leave bank, varying the employee share of health insurance premium based on wage level, tailoring company health insurance plan offerings to the needs of the particular workforce and employer contributions toward tax-advantaged health accounts such as health savings accounts (HSA), health reimbursement accounts (HRA) and flexible spending accounts (FSA).   Credit card and mortgage debt are often targeted through offering free access to financial planning resources and counseling, including referrals to debt consolidation services. Employers seeking to make debt relief assistance part of their benefit offerings should speak with their employee benefits advisor to explore the options that best fit their workforce. The benefits program also should include processes for employees to confidentially access a particular benefit and ask questions about its application to their specific debt situation.

As we explained in a prior blog post – The Basics of Granting Equity-Based Compensation Awards – state laws governing corporate governance provisions typically apply to certain aspects of executive compensation arrangements, including, for example, who has the authority to grant equity awards. In 2022, Delaware amended Sections 152 and 157 of the Delaware General Corporation Law (DGCL) to expand the board of directors’ ability to delegate grantmaking authority with respect to stock rights and options. More recently, on May 16, 2023, and June 30, 2023, the Delaware State Senate and the Delaware State House, respectively, adopted further amendments, which are awaiting the Governor’s signature. If signed into law, the 2023 amendments would become effective on Aug. 1, 2023. 2022 DGCL Amendments Under the amended DGCL § 152 and 157, the board may delegate to any person or body, regardless of whether the delegates are officers or board members, authority to approve issuances of stock, stock rights and stock options. The delegates will be able to determine the recipients of grants, the timing of grants, the exercise price, the number of stock options or rights to be granted, and other terms and conditions of the awards, including vesting and expiration.1 Board resolutions must be adopted, delegating such power to implement the new authority allowed by these amendments. The 2022 DGCL amendments provide that in order for the delegation to a non-board member or body to be proper, the board resolutions must specify the following: The maximum number of stocks, stock rights or stock options that may be granted, and the maximum number of shares issuable upon exercise thereof. A time period during which such stock, stock rights or stock options, and during which the shares issuable upon exercise thereof, may be issued. A minimum amount of consideration (if any) for which such stock, stock rights or stock options may be issued, and a minimum amount of consideration for the shares issuable upon exercise thereof.2 Notwithstanding the limitations of DGCL § 152 and 157 with respect to non-board members and bodies, board committees remain empowered to exercise the full power and authority of the board to make grants of stock, stock rights and stock options. 2023 DGCL Amendments The 2023 Amendments clarify that a corporation’s issuance of stock under Section 153 must meet the minimum consideration requirements (if any) as provided in DGCL § 153. DGCL § 153 was amended to confirm that the minimum consideration requirement (typically any par value) does not apply to the corporation’s disposition of treasury shares. The corporation may also receive cash, any tangible or intangible property, or any benefit to the corporation (or any combination of those) as consideration for treasury stock. DGCL § 157 was amended to (a) clarify that DGCL §157(c) is the exclusive means for the board to delegate authority (b) require the board resolution authorizing delegation to specify a separate time period for the issuance of shares on the exercise of the rights or options, (c) enable the board resolutions to delegate the power to fix the terms on which shares may be acquired from the corporation on the exercise of rights or options and (d) remove the requirement that the board resolution authorizing delegation specify the maximum number of rights or options that may be issued under the resolution. If signed into law by the Governor, these amendments would become effective Aug. 1, 2023. Takeaways As a practical matter, when deciding how much grantmaking authority to delegate to management, it is critical for the board to strike a balance between allowing the expanded flexibility provided by the recent DGCL amendments while ensuring the board retains sufficient control and oversight over the issuance of securities and awards that will dilute the ownership interests of the company’s stockholders. If permitted by state law and the terms of the equity plan, the administrative challenges of granting off-cycle equity awards may be reduced by delegating grantmaking authority to one or more officers. The delegation of grantmaking authority could be especially helpful in instances where companies want to streamline hiring employees or hold on to valued ones without having to go through the time-consuming process of calling a board or committee meeting. On the other hand, prior to the 2022 DGCL amendments, it was the practice in some privately held companies for a CEO (who was also a member of the board) to constitute a one-person board committee for purposes of making equity-based grants. Corporations may continue such practice of delegating the authority to make grants of equity awards to a one-person board committee. Note that the foregoing is more common where the CEO is the founder and still retains significant majority ownership. This is generally not the case in venture capital or private equity-backed companies where institutional investors want control over equity compensation for key employees. As a matter of prudence, boards should consider requiring that delegates provide regular reports of grants made pursuant to delegated authority, as it is important to carefully track and document equity grants made by delegates to ensure compliance with delegated authority and state law, as well as being a matter of good housekeeping. 1 Under prior Delaware law, the scope of an officer’s delegated authority was limited to designating recipients of the awards and/or determining the number of shares issued to each recipient. Delegates generally could not determine vesting requirements or other terms and conditions, which were required to be approved by the board or a committee thereof. 2 The consideration paid for stock rights or options may be set by reference to a formula provided in the board resolution, such as by reference to the trading price of the company’s stock.

Businesses operating within the U.S. market have been facing a growing list of challenges. Rapidly rising interest rates, reduced access to equity investment and debt facilities, and continuing supply chain issues, as well as the lingering effects of the COVID-19 pandemic, have forced many businesses to rethink their operations and reevaluate their financial models. This market volatility presents a unique set of challenges for companies that either wish to sell all or part of their business or otherwise wish to expand their operations through the acquisition of another company. Any business considering a merger, divestiture or acquisition (M&A) – from either the buy or sell side – may consider utilizing an earnout provision. Earnout provisions provide for a portion of the purchase price to be paid in future installments based on the performance of the acquired business after the closing of the transaction. Typically, payments are conditional on the acquired business achieving certain agreed-upon metrics, such as sales, revenue or gross profit levels. Often earnouts operate on a sliding scale within a minimum and maximum range, where the payment amount within this range increases based on a formula as the agreed-upon metrics are met or exceeded. This mechanism helps align the interests and valuation expectations of buyers and sellers and reduces the risk of overpricing or undervaluing the acquired company. But how does the current market volatility impact the way an earnout provision should be structured? This article will provide an overview of the increased use and scrutiny of earnout provisions in M&A deals during a down or volatile market. It considers how economic macro conditions impact the way earnout provisions should be drafted in M&A deals from both the buyer and seller perspectives. Advantages and Challenges of Using Earnouts One of the primary challenges of using earnouts in M&A deals is the uncertainty of future performance. The COVID-19 pandemic and current economic policy to address the inflationary pressure that has arisen as the world has emerged from this crisis have created unique challenges for businesses, and these have led to an uncertain economic climate, which makes predicting future financial outcomes of a target company particularly challenging. In this situation, determining the appropriate earnout formula or milestones can be difficult. Earnouts can provide a benefit to a buyer by delaying payment of a portion of the purchase price and ultimately reducing risk by tethering the purchase price to the performance of the newly acquired business. Utilizing an earnout may also be advantageous to a buyer during a bidding process – allowing a potential buyer to present a larger possible purchase price, while still minimizing risk around a target’s earning potential. The use of earnouts comes with its own challenges, however. Earnouts represent uncertainty in the final purchase price and risk to the seller. How a particular business will fare after a sale will depend on factors both inside and outside the control of management. An economic downturn may negatively impact at least the short-term ability to maximize the earning potential of a newly purchased business. Similarly, the buyer and the seller may have conflicting views regarding how the acquired business should be operated. An earnout is likely to cause the seller to be more focused on short-term growth, while the buyer may be more invested in the long-term success of the company. In the event an earnout threshold is met, buyers may have to secure additional sources of financing to pay the earnout amount, which may be more costly than anticipated. Even under good market conditions, earnouts require careful drafting, but a down or volatile market exacerbates these concerns. Sellers will always want the agreement to include protections regarding the ability to freely operate the business without interference from the buyer or changes with which they may disagree, such as changes in the management team or key employees, the incurrence of additional costs they deem unnecessary, or imposition of additional overhead on the business. Sellers may also be concerned about matters that are specific to the buyer, such as changes in the buyer’s business that could impact their earnout, including additional acquisitions; restrictions on a buyer’s business that limit customer growth, such as industry verticals in which they cannot pursue new business because of noncompetes; requirements to focus on less-profitable business lines due to synergy issues with the buyer;  a change in control of the buyer or a material adverse change in the buyer’s business unrelated to the target business. Buyers, on the other hand, want the ability to integrate the newly acquired business into their overall business and to have the seller’s operations conform to other parts of their business as well as potentially to either impose potential short-term cost-cutting measures on the business or require additional investments that could hamper or distract from achieving the earnout milestones. Therefore, buyers resist controls that might tie their hands or require specific actions on their part. They generally will not want any obligation to cooperate to maximize earnout potential or have any fiduciary-type obligations to the seller. As a general rule, a buyer will want minimal controls on its ability to operate the business and, at most, an obligation to act in good faith so as not to interfere with such operations in a manner intended to materially and adversely impact a seller’s ability to achieve an earnout. These covenants become very complicated and require significant thought and analysis. Earnout Trends From the 2022 Financial Year The 2023 SRS Acquiom M&A Deal Terms Study1 provides a useful overview of how earnouts are being used under current market conditions based on data trends observed throughout the preceding year. In 2022, approximately 21% of non-life science deals2 included an earnout provision. This represents a somewhat significant increase from the 2021 period, which had 17% of M&A deals use an earnout. Overall, this figure has been increasing since 2018 (a year in which we saw the year close with the worst stock market declines and volatility since the financial crisis of 2008), which saw a low of 13% of deals using earnouts but is comparable to the 2017 figure of 23%. Of the 21% of 2022 deals that included earnouts, 42% of these had a single trigger event, while 58% had multiple trigger events. Of these trigger events, revenue-based triggers were the most significant, representing 61% of the total deals. Trigger events relating to hitting certain earnings or EBITDA targets represented 23%, while 22% of deals used other forms of measurement (including such things as unit sales, product launches or divestiture of stocks). In terms of earnout numbers as a percentage of the overall deal size, the median earnout potential as a percentage of the closing payment3 remained relatively steady, at 31%, compared with the 30% figure from the 2021 period. Meanwhile, earnout length had a median period of 24 months, with 30% of earnouts being one year or less and 85% of earnouts having a period of three years or under. The use of certain earnout covenants was also considered by the SRS Acquiom study. Covenants to run the business in accordance with the seller’s past practices were included in only 23% of all earnout provisions surveyed. A mere 1% of earnout provisions included language requiring the business to maximize earnout payments. Earnout acceleration upon change of control was implemented in 30% of all deals included in the study. Finally, 73% of earnout provisions allowed the buyer to offset indemnity claims against future earnout payments. Specific language disclaiming that earnouts are not considered securities was increasingly used in the 2022 period; approximately 45% of all deals included such language, up significantly from 30% in the 2021 period. Finally, 19% of earnouts specifically disclaimed a fiduciary relationship between the parties. Use of Earnouts for Bridging Valuation Differences Earnouts can be particularly useful when there is a valuation gap between a buyer and seller, a situation that becomes more prevalent when a market quickly changes direction, as we have seen over the past 12 months. By agreeing to an earnout, both parties can align their interests and work together to achieve specific financial metrics. In this scenario, an earnout can act as a bridge between the two parties, providing the seller with the potential to receive additional payment and the buyer with the ability to spread the acquisition cost over time and not overpay if the targets are not achieved. Additionally, where a target company has a short operating history, earnouts may be a useful tool for sellers to increase their valuation price. Down-Market Controls To Negotiate in Earnout Provisions Be specific with performance metrics. Uncertainty in the market has caused both buyers and sellers to seek more control over their exposure to performance metrics. For sellers, this often materializes as heightened concern over whether the metric is practicably achievable under current market conditions and a push for more conservative milestones, as failure to reach the metric results in a lower purchase price, often leading to seller’s remorse as the seller receives less than it thought the business was worth. Meanwhile, buyers will typically seek to limit the risk of overpaying for the target company if the performance metrics are not achieved or only partially achieved. The buyer will still be pushing for reasonable growth targets that may be unpalatable to the seller. In negotiating targets that are reasonably acceptable to both sides, parties should draft the earnout provisions with specificity, including resolving issues of ambiguity with respect to accounting principles, overhead costs, intercompany charges and other factors that could impact the measurements in a way that varies from historical seller practices. While these issues are common to earnouts in any situation, whether or not it is a down market, defining the metrics is harder in a volatile market, where there are at play macroeconomic factors, such as inflation, increasing interest rates and supply chain issues that increase costs and make it harder to project results for the near term. Consider the length of the earnout period. The macro conditions of the economy can have a significant impact on performance metrics. During a down market, it may be more challenging for a newly acquired company to meet financial metrics that would have been more achievable in a steady market. To address these concerns, parties should consider provisions that mitigate the impact of macroeconomic conditions. This includes the use of measurement periods that could be longer than those in typical earnout provisions, which would allow a target company more time to achieve specific financial metrics. Consider “catch-up” or proration clauses. Ambiguity in a down market primarily concerns uncertainty about predicting future performance. Rather than draft an earnout provision to be “all or nothing,” parties should consider a sliding scale of payments. Alternatively, “catch-up” earnout provisions give sellers the right to collect at least a partial earnout payment if an acquired company fails to meet a specified target in one year but makes up the deficit in a subsequent year. Takeaway The use and scrutiny of earnout provisions during a down market have become increasingly common due to the uncertain economic climate. Despite the challenges associated with using earnouts and the need for careful drafting of these provisions, earnouts are still a useful tool for bridging valuation gaps and aligning interests between the buyer and seller. 1 SRS Acquiom Inc., M&A Deal Terms Study (2023), available at: https://info.srsacquiom.com/2023-srs-acquiom-deal-terms-study. 2 Earnouts are considered the industry standard in life-science deals and, as such, tend to skew overall figures, so such deals were excluded from the study. 3 Calculated as the sum of potential earnout payments over the amount paid at closing, including escrowed amounts.

Artificial intelligence (AI) is a driving force behind advancements in software and computer-implemented innovation, and it raises important considerations with patents. In the world of AI, patents can cover more than just hardware components – they can also encompass new software functionality, computer processes and innovative solutions. Patents play a critical role in protecting the underlying technology that allows AI systems to perform tasks like natural language processing, image recognition and autonomous decision-making. Securing patents for software, computer-implemented innovation and AI is complex due to the challenges posed by the patent eligibility criteria of Section 101 of the Patent Act. The Supreme Court’s 2014’s Alice Corporation Pty. Ltd. v. CLS Bank International, et al. (Alice) decision introduced a two-step framework to determine patent eligibility. First, the framework evaluates whether the invention is an abstract idea, law of nature or natural phenomenon. Software and computer-implemented innovation, including AI, are generally evaluated as abstract ideas. If an invention is an abstract idea, the second step of Alice requires assessing whether the invention includes an inventive concept beyond the abstract idea itself. This means the invention must present a new and inventive solution to a technical problem rather than a trivial variation on existing technology. The Alice decision clarified that abstract ideas, e.g., algorithms or software, operating on a generic computer could not be patented. This is intended to prevent overly broad concepts from being patented and to encourage innovation beyond basic ideas. As a result, many instances of computer-implemented innovation have been considered abstract ideas that lack the inventive concept required by Alice. The Alice decision raised the bar for patent eligibility, making it more challenging to obtain patents for software and computer-implemented innovation, including those incorporating AI. To navigate these challenges successfully, it is crucial to carefully consider the technical aspects and practical applications of computer-implemented innovation when preparing patent claims. For patent applications covering software, computer-implemented innovation and AI, detailed claim language should be used to describe how the software or computer-implemented innovation solves specific technological problems. This can include explaining how the invention operates at the level of a computer processor. Claim language should also highlight the practical applications and tangible benefits provided by the invention while emphasizing specific technical aspects and innovative features that enable it to function effectively in a computer system. Moreover, it can be beneficial to demonstrate how the invention improves on an existing technology or leverages the capabilities of a computer processor to solve complex problems, enhance performance or provide unique functionalities. This detail is used to describe how a novel process or interaction occurs within a computer system and achieves practical and tangible results. In summary, when seeking patent protection for software and computer-implemented innovation, including AI, it is crucial to strategically navigate the requirements of Section 101 in the Alice framework. The chances of obtaining a patent increase significantly when the focus is on the technical aspects, practical applications and inventive concepts of software and computer-implemented innovation.

Exploring the Pros and Cons of an IMF Business Model: In this final article of this three-part series, we explain the pros and cons of certain investment advisers utilizing an internally managed private fund (IMF) business model as a means for avoiding increasingly burdensome U.S. Securities and Exchange Commission (SEC) regulation of private fund advisers.   Pros and Cons of Forming an IMF With an increasingly active SEC that has significantly expanded the scope of its regulation and oversight of private fund advisers in recent years (and provides all indications that it plans to continue this trend into the future), investment groups employing a joint venture fund or club deal (collectively, JV) or single investor fund (SIF)-type structure with the proper alignment of investors’ and managers’ interests, may wish to form an appropriately structured IMF with internal directors, managers, officers and employees (collectively, Internal Managers) who are not subject to Investment Advisers Act of 1940 (Advisers Act) registration requirements and related SEC regulation and examination. Despite its potential regulatory advantages, an IMF normally entails some limitations and restrictions. For example, an IMF typically cannot manage capital outside of the IMF or provide investment advice to third parties. Its only source of income is attributable to the proceeds of its own investment portfolio. Accordingly, one disadvantage would be its limited investor base and restrictions on its ability to advise outside clients. Also, due to an IMF’s internalized governance structure, increased investor participation and lack of a separate management fee, an IMF’s management team may have less autonomy over the scope of permitted activities, hiring practices, annual budgets, use of outside service providers, etc. than it would in a traditional hedge fund or private equity fund structure. Similarly, IMF investors should be sufficiently sophisticated and comfortable with overseeing the fund’s management activities and/or participating in the investment process, negotiating customized arms-length terms, understanding the regulatory and compliance risks and generally being an active partner in the venture. As noted in prior articles in this series, given the JV or SIF-type circumstances in which an IMF is typically utilized, other exemptions from SEC investment adviser registration may not be available. For example, the family office exclusion is available only for advisers to single family office clients,1 and the more limited exempt reporting adviser (ERA) exemption is available only for small private fund advisers (i.e., those with less than $150 million in private fund assets under management and no non-private fund clients) and venture capital fund advisers.2 Like family office advisers but unlike ERAs, Internal Managers of an IMF who are not investment advisers under the Advisers Act are not subject to the antifraud rules, fiduciary obligations or any other provisions of the Advisers Act and related SEC rules (including certain rules that are applicable to ERAs and other unregistered advisers). While utilizing an IMF may be advantageous for avoiding burdensome SEC investment adviser regulation in circumstances in which other exemptions may not be available, an IMF should not be utilized to avoid properly addressing relevant conflicts of interest, fiduciary obligations, disclosure and consent issues, cybersecurity risks and other applicable risk management and compliance issues that would otherwise be required to be addressed by a registered investment adviser. Rather, an investment group that is considering forming an IMF should seek to develop an internal legal and operational framework that allows them to achieve their business goals while enacting appropriately tailored risk management and compliance programs suitable for the IMF and its limited and sophisticated investor base, despite the lack of SEC oversight. Conclusion Although the inapplicability of the Advisers Act to Internal Managers of an IMF is not incontrovertible, there is a sound basis for concluding that the Advisers Act was not intended to cover the types of properly structured SIF and JV arrangements described in the articles in this three-part series. In view of the current regulatory environment for private fund advisers, for a SIF or JV business model, an IMF may be an attractive business structure option for management teams and investors seeking to minimize regulatory compliance costs and related risks. This is especially true for emerging managers and spinout management teams who may be more willing and sufficiently flexible to embrace an IMF business model than more institutional asset managers already operating through a traditional registered investment adviser business model. ________________ 1 SEC Rule 202(a)(11)(G)-1. 2 See Advisers Act sections 203(l) (venture capital funds) and 203(m) (small private fund advisers), and SEC Rules 203(l)-1 and 203(m)-1. Note that the status of private funds investing in real estate, cryptocurrencies and/or other potential non-securities instruments, which may offer similar exclusions from Advisers Act coverage while involving other types of restrictions or regulation, is beyond the scope of this discussion.

From step-counting fitness bands and sleep-grading watches to reproductive-tracking mobile applications, the Internet of Things has empowered consumers with an incredible variety of tools that allow them greater involvement as patients and insights into their own health and fitness. According to Market.us, the wearable medical device market grew to an estimated $30.1 billion in 2022 (and this projection did not include mobile applications that also collect their users’ health data). In addition to wearable health devices and apps, the COVID-19 pandemic forced many traditional healthcare interactions into the digital space, a trend that has shown no signs of reversing post-pandemic. The results of these trends: Americans are creating massive amounts of health-related data outside traditional professional medical interactions. As exciting as this new market growth has been, healthcare data holders are still swimming in murky waters when it comes to their privacy obligations. The disconnection between and overlap of information that is protected by state privacy law and information protected under the Health Insurance Portability and Accountability Act (HIPAA) not to mention information protected by some other privacy regime have created a precarious landscape proving difficult to navigate. Storm clouds are gathering for stewards of healthcare data that operate both inside and outside HIPAA, and providers will need to adjust quickly if they want to remain on safe ground. The collection of consumer health data – that is, data that does not constitute Protected Health Information (PHI) under HIPAA – can create significant confusion for both consumers and providers. For starters, many consumers assume that the nature of their data, i.e., that it relates to their physical or mental health, means that it is protected under federal privacy law. This assumption is frequently incorrect; the only protections or limitations on the use of consumer health data are likely to be found in the app’s or device’s privacy policy or terms of use. More often than not, these policies allow for downstream sharing and disclosure of consumer health data that is inconsistent with consumer expectations. HIPAA is not the only operable federal statute, and the failure to fully identify and comply with privacy regulations relating to consumer health data can prove to be a costly mistake. The Federal Trade Commission’s (FTC) Health Breach Notification Rule (16 CFR 318) applies to breaches of “unsecured” health information and requires vendors of personal health records (including service providers) and related entities that are not covered by HIPAA to notify consumers, the FTC and, for certain breaches, prominent media outlets serving a state of jurisdiction, of a breach of unsecured personally identifiable health data.1 The rule applies to apps, etc. that draw data from “multiple sources” that are not covered by a rule from the Department of Health and Human Services (for example, a blood sugar app that combines a glucose level and calendar data would qualify). A breach results from “unauthorized access,” and in 2001, the FTC clarified that this includes unauthorized sharing in violation of a privacy policy. A breach can result in monetary penalties of up to $43,792 per violation per day, affording the agency considerable flexibility in tailoring any potential penalty to the offender. In February 2023, the FTC announced its first enforcement action under its Health Breach Notification Rule against GoodRx, a telehealth and prescription drug discount provider. According to the settlement, GoodRx: Shared personal health information with advertisers and third parties in violation of its privacy policies. Used personal health information to target its users with personalized health- and medication-specific advertisements, Misrepresented its HIPAA compliance. Failed to implement policies to protect personal health information. GoodRx agreed to a no-admit/no-deny settlement, a $1.5 million civil penalty, a notification to impacted consumers and a court order that did the following: Prohibited the sharing of personal health data for advertising. Required user consent for any other sharing. Required the company to seek the deletion of data held by third parties. Required the company to limit its own retention of data and to implement a mandated privacy program. On May 17, the FTC settled with another entity, Easy Healthcare Corporation (EHC), the developer of the fertility app Premom. EHC allegedly deceived users by doing the following: Sharing their sensitive personal information with third parties when its privacy policies promised that it would not share health information without users’ consent. Disclosing users’ sensitive health data to third parties when its privacy policy stated that any data it did collect was non-identifiable and used only for its own analytics or advertising. Failing to take reasonable measures to address the privacy and data security risks created by its use of third-party tracking tools. Failing to notify consumers of these unauthorized disclosures in violation of the Health Breach Notification Rule The company agreed to pay a $100,000 civil penalty, provide a notification to impacted consumers and obey a court order similar to the one given above for the GoodRx settlement. On May 18, the FTC proposed further amendments to the Health Breach Notification Rule that would do the following: Revise several definitions to clarify how the rule applies to health applications and similar technologies that are not covered by HIPAA. Codify the agency’s interpretation that a breach includes an unauthorized disclosure. Clarify the scope of the entities covered by the rule. Clarify what it means for a personal health record to draw information from multiple sources. Expanding the ability to provide electronic notice of a breach to consumers (and provide additional requirements regarding such notices) The FTC’s comment period will run for 60 days from the publication of the new rule in the Federal Register. 1 HIPAA-covered entities and their “business associates” must instead comply with the Department of Health and Human Services’ breach notification rule.

Legal Status of an IMF:  In this second article, in a series of three, we define what an IMF is and explain its status under the Investment Advisers Act of 1940 (Adviser Act). What Is an Internally Managed Private Fund? An IMF is generally understood to refer to a private non-U.S. Securities and Exchange Commission (SEC) registered investment fund that pursues a typical hedge, venture, real estate, private equity or other common private fund investment strategy, but rather than being managed by a separate investment manager or general partner entity, it is managed internally by a board of directors, if established as a corporation, or (more commonly) by a board of managers if established as a limited liability company.1 In our experience, an IMF is often best suited for a joint venture fund or club deal (collectively, JV) or a single investor fund (SIF) type scenario in which one or a limited number of sophisticated institutional or family office investors engages a U.S.-based management team to manage investor assets through an IMF that is internally governed and reflects highly negotiated terms, including capital contribution requirements, permitted withdrawals of capital, investor consent to major decisions, distribution waterfalls and carry participation rights for the management team, investor reporting, liquidation events and other fund-like terms. Rather than paying a separate asset-based management fee, however, an IMF typically entails an agreed-upon salary for management team members and an approved budget to cover annual operating expenses. Many aspects of an IMF are, therefore, similar to a traditional private fund JV or SIF arrangement that is managed by a separate general partner or investment manager entity. Though investors in an IMF typically have more governance and information rights than investors in a traditional private fund structure, the IMF management team can typically negotiate its majority or minority representation rights on the board and/or investment committee as well as its compensation, D&O insurance coverage and the other bespoke fund-like terms described above. For regulatory reasons, the management team typically would not invest its own capital alongside the investors in an IMF. An IMF structure is often used by corporate venture arms of public and private operating companies seeking to make strategic technology investments utilizing the parent company’s capital and other resources, which investments are managed either by the parent’s own employees or by an outside management team. In such circumstances, the parent company typically retains voting control and input into investment operations while entering into negotiated compensation arrangements with the internal or external management team. Advisers Act Analysis2 Under the Advisers Act, an “investment adviser” is generally defined as a person who “engages in the business of advising others” regarding securities. The Advisers Act is silent on the treatment of internal directors, managers, officers and employees (collectively, Internal Managers) of investment companies such as an IMF. Commentators have pointed out that the SEC and the industry have long understood that Internal Managers of investment companies are not advisers under the Advisers Act.3 This is mainly due to both the history of the Advisers Act and the fact that Internal Managers typically do not bear the business risk of the enterprise, generally act as a group rather than as individuals, are subject to the oversight of their superiors (in the case of officers and employees) and are subject to state law fiduciary duties (in the case of directors). As outlined in more detail below, other relevant factors include the exclusivity of the services, the lack of investment of personal capital, the non-existence of any marketing or solicitation activities (or holding oneself out to the public as providing advisory services) and the sophistication of IMF investors. Overall, the Advisers Act was intended to cover persons who advise clients as part of conducting a separate investment advisory business and was not intended to cover internal corporate relationships.4 In the case of an IMF structured as a SIF, there is additional support for the exclusion of Internal Managers from investment adviser status based on the analogous precedent of a wholly owned corporate subsidiary exclusively advising the parent company and/or other wholly owned direct or indirect subsidiaries of the parent. In such circumstances, the SEC has confirmed the lack of investment adviser status for the wholly owned adviser subsidiary and its management personnel.5 These precedents are substantively similar to a SIF structured as an IMF employing Internal Managers to manage its own assets (i.e., the assets invested by the single investor and controlling equity owner) rather than employing a separate wholly owned advisory subsidiary for such purpose. Relevant Considerations for an Exempt IMF In view of the foregoing, a U.S. management team seeking to partner with one or a limited number of sophisticated institutional or family office investors to form an IMF should consider the following factors, among others, in structuring its business and negotiating the venture’s governing documents in order to assess whether the Internal Managers of the IMF are subject to Advisers Act registration: The ability and willingness of the Internal Managers to provide advisory services exclusively to the IMF and not to any outside persons and otherwise forgo conducting any advisory business apart from the IMF. Whether the Internal Managers conduct any marketing or solicitation activities or otherwise hold themselves out to the public as providing advisory services. The willingness of Internal Managers not to invest their own capital in the IMF and otherwise not to assume any downside business risk. The ability to limit investment discretion to the board or investment committee acting as a group and not to any individual director or committee member.6 Whether the board, the investment committee or both will exercise investment discretion. The sophistication of IMF investors and their willingness to play an active role in the venture, including negotiating terms and having board representation, an oversight role and consent rights. Which investor or group of investors are the ultimate beneficial owners and funders of the IMF for regulatory purposes? The appropriate compensation structure for the Internal Managers. Whether the IMF is a collaboration between the Internal Managers and investors or involves a more passive relationship. Whether the Internal Managers provide periodic reports or advice on whether IMF investors should redeem their interests. Whether the IMF investors need the protections of the Advisers Act and SEC regulation. In the next and final article in this three-part series, we explain the pros and cons of forming an IMF and how an IMF structure may be an attractive option for those investment management groups seeking to avoid Advisers Act registration and related SEC regulation and examination but whose business model may not fit within any of the traditional Advisers Act registration exemptions. ______________ 1 The use of corporate blockers and other tax considerations would apply in structuring an IMF to the same extent as in traditional private fund structuring. 2 This discussion only addresses federal investment adviser status and not state law investment adviser status, although many states adhere to the Federal Advisers Act definition of “investment adviser.” 3 Regulation of Money Managers: Mutual Funds and Advisers – Frankel and Laby (3rd Edition, 2022-2 Supp.). 4 See note 13. Note that a general partner of a limited partnership, however, is not treated as an Internal Manager, and the SEC and the courts would normally consider a general partner to be an investment adviser to the limited partnership or its limited partners under the Advisers Act. See Abrahamson v. Fleschner, 568 F.2d 862, 869-71 (2d Cir. 1977), cert. denied, 436 U.S. 905, 913 (1978); and SEC Rule 203(b)(3)-1 under the Advisers Act. 5 See MEAG MUNICH ERGO Asset Management GmbH, SEC Staff No-Action Letter (Feb. 14, 2014) (MEAG); and Zenkyoren Asset Management of America Inc., SEC Staff No-Action Letter (June 30, 2011) (ZAMA). Note that in MEAG and ZAMA, the SEC did not see any need to look through the wholly owned advisory subsidiary to its Internal Managers and treated the parent investor (and not its underlying insureds) as the ultimate beneficial owner of the managed assets for the Advisers Act purposes. See also SEC Staff Report on Regulation of Investment Advisers (March 2013) at p. 4. 6 To the extent that an Internal Manager does not exercise investment discretion, there may be an argument that such a person does not have “regulatory assets under management” sufficient to trigger an ERA filing or full investment adviser registration (assuming such a person is otherwise considered to be an adviser under the Advisers Act). See Form ADV Instructions, item 5(b)(3).

One question we consistently receive from both startups and venture capital investors is whether qualified small business stock (QSBS) applies to a structure. They may have previously experienced the benefits of QSBS first-hand or have seen headlines such as the New York Times’ “A Lavish Tax Dodge for the Ultrawealthy Is Easily Multiplied – The New York Times” or Businessweek’s “When an Eight-Figure IPO Windfall Can Mean a Zero-Digit Tax Bill.” This article is intended to provide an overview of QSBS, its usage and some general planning observations based on our experience in this area. What is QSBS? QSBS, or Section 1202 stock, generally: Is issued by a C corporation after 1993. Is acquired by a non-corporate taxpayer at original issuance. Is held for at least five years. Meets certain requirements consistent with the C corporation being a small business, including: The business’s gross assets cannot exceed $50 million at any time before the issuance. At least 80% of the assets of the business must be used in a qualified, active business (non-qualified businesses generally include service-related businesses, including services in the fields of health, engineering, financial services, law, consulting, performing arts and others). Why QSBS? The primary benefit of owning QSBS is that upon the sale of the stock, a shareholder can exclude up to $10 million of gain (or, if greater, 10 times the shareholder’s basis in the stock). If a taxpayer would otherwise be taxed at a 23.8% rate on that gain, the tax savings from owning QSBS would be $2.38 million. There are further tax planning opportunities with respect to gifting (to be able to utilize the exemption several times among family and friends) and rolling over stock to another qualifying C corporation. Planning and Pitfalls: Some Highlights Below is a short list of planning observations based on our client representation in this area: Election: The QSBS tax exclusion must be elected; it does not automatically apply. Exchanges for stock: Original issuances by the C corporation in exchange for stock do not qualify for QSBS treatment. Redemptions: Original issuances by the C corporation also do not qualify for QSBS treatment if the C corporation has made significant redemptions within a certain two-year testing period or if the shareholder at issue has had the C corporation’s stock redeemed within a certain four-year testing period. The tests related to redemptions can be complex due to related party rules, de minimis rules and certain other exceptions. Working capital exception: There is an exception to the 80% test described above for working capital. In the aftermath of the failure of Silicon Valley Bank and other bank failures, in addition to seeking to diversify banks in which companies have cash deposits, some companies have reimagined their business models and questioned whether they should pursue alternatives to cash deposits. Owning mutual funds or minority stakes in portfolio companies would generally not qualify for the working capital exception and could result in jeopardizing QSBS status. The Road Ahead While QSBS has been part of the Internal Revenue Code since 1993 and has been used in the venture capital community for years (particularly after a 2010 change in law resulted in an exclusion of 100% rather than 75% of the applicable gain), its utilization has become more widespread since a 2018 income tax rate reduction for C corporations (21% rather than 35%) made QSBS even more attractive. As a result, we are now seeing an increase in case law and guidance as audits and ruling requests proceed. In recent months, we have seen case law emerge on a conversion from a limited liability corporation to a C corporation and guidance from the IRS regarding what constitutes a qualified business for QSBS purposes. Stradley Ronon is continuing to monitor developments in this important space for startups and their investors.

Forming an IMF in the Current Regulatory Environment:  For years internally managed private funds (IMFs) have been a seldom-used business model that has not proliferated in the private funds industry. Given the current regulatory environment, however, private fund advisers may want to consider forming an IMF that is tailored to their investor base in order to organize and operate their business in a more cost-efficient manner outside the purview of the Investment Advisers Act of 1940 (Advisers Act) and related U.S. Securities and Exchange Commission (SEC) regulation and examination. In the first article in this three-part series, we summarize the current regulatory environment for private fund advisers. The current regulatory environment for private fund advisers is one of increasing regulation and supervision, primarily due to a number of recently adopted and proposed new rules by the SEC. Unlike advisers to registered investment funds, which are subject to enhanced regulation and compliance requirements under the Advisers Act and the Investment Company Act of 1940 (1940 Act), advisers to private unregistered investment funds have long enjoyed a less onerous regulatory regime under the Advisers Act, primarily due to the limited number and greater sophistication of the investors authorized to invest in such funds.1 However, the regulatory gap between advisers to registered funds and advisers to private funds appears to be narrowing. In particular, the SEC has recently taken the following actions specifically targeting and/or significantly impacting private fund advisers: Marketing Rule. Adopting a new marketing rule, effective Nov. 4, 2022, with specific standards and requirements for, among other things, performance advertising, use of placement agents, testimonials and endorsements and new Form ADV disclosures.2 Investor Reporting. Proposing new investor reporting and disclosure requirements for liquid and illiquid funds, including extensive quarterly reports detailing adviser compensation, fees and expenses and fund performance data.3 Conflicts of Interest. Proposing new rules prohibiting certain conflicts of interest transactions and other private fund adviser practices, including: (i) reducing a clawback obligation by the amount of any taxes owed, (ii) causing investment-related expenses to be allocated across funds on a non-pro rata basis, (iii) borrowing from a private fund client and (iv) causing a fund to bear expenses associated with a regulatory examination or investigation of the adviser. The proposal also bars certain types of adviser compensation and indemnification practices.4 Secondaries; Preferential Treatment. Proposing new rules requiring fairness opinions in GP-led secondary transactions and prohibiting or restricting certain preferential treatment of fund investors (notwithstanding existing side letter arrangements and disclosure practices).5 Form PF. Adopting amendments to Form PF reporting for private funds, including requiring (i) increased reporting from large private equity fund advisers and (ii) event reporting from large hedge fund advisers (on a current basis) and all private equity fund advisers (on a quarterly basis) of the occurrence of any of several designated reportable events.6 Cybersecurity. Proposing new cybersecurity rules that would, among other things, require advisers to (i) disclose cybersecurity risks and significant incidents within the last two years on their Form ADV brochure, (ii) report significant cybersecurity incidents to the SEC within 48 hours on a new Form ADV-C and (iii) develop enhanced and tailored cyber policies and procedures covering oversight of third-party service providers and other items.7 ESG. Proposing new rules requiring advisers pursuing environmental, social and governance (ESG) related investment strategies to provide enhanced ESG-related disclosures to the SEC and investors.8 Custody Rule. Proposing amendments to the SEC’s custody rule, which would, among other things: (i) expand the rule to cover a broader array of client assets (e.g., crypto, real estate and other physical assets in addition to securities), (ii) enhance the custodial protections for client assets (e.g., the new written agreement required between adviser and custodian and various written assurances required from the custodian regarding the safeguarding of client assets) and (iii) expand the audit exemption from the surprise exam requirement to require the auditor to notify SEC of certain events.9 Third-Party Service Providers. Proposing amendments that would require advisers to satisfy specified due diligence elements before retaining a service provider that will perform certain advisory services or other “covered functions” and to subsequently carry out periodic monitoring of the provider’s performance and reassess its retention.10 Exam Priorities. Releasing the SEC’s Division of Examinations 2023 Examination Priorities report (SEC Report), which focused on various private fund issues, including conflicts of interest, calculation and allocation of fees and expenses, compliance with the new marketing rule, use of alternative data and custody rule compliance. The SEC Report also noted that the SEC would look closely at highly levered funds, funds with hard-to-value investments, adviser-led restructurings, funds with ESG-related offerings, cybersecurity practices, electronic communications and use of third-party service providers. Many of these new initiatives and the SEC’s increased focus on private funds stem from Chairman Gensler’s apparent vision for a more activist and paternalistic SEC that is increasingly advancing a more granular and prescriptive rules-based approach to regulating private fund advisers rather than the traditional principles and disclosure-based approach historically taken by Congress under the Advisers Act and reflected in prior SEC rulemaking. Though there may be sound policy reasons for many of the SEC’s new rulemaking proposals and compliance initiatives,11 there is no denying that the regulatory burden and related compliance costs and risks associated with being an SEC-registered private fund adviser are on the rise. Regardless of the ultimate outcome and final form of the proposed rules, registered private fund advisers will need to comply with a bevy of new rules and limitations on their activities and can expect the SEC to pursue an increasing number of enforcement actions as it assumes a more aggressive oversight role.12 Accordingly, existing exemptions to Advisers Act registration available for single family offices, foreign private advisers, venture capital fund advisers and small private fund advisers have become more valuable in allowing emerging asset management firms to establish and structure their business in a more cost-efficient manner while still meeting investor expectations. Many adviser firms, however, cannot fit within any of the foregoing Advisers Act registration exemptions and may want to consider forming an IMF. In the next article in this series, we will define an IMF and explain its status under the Adviser Act, which will be followed by an article discussing the pros and cons of forming an IMF as a viable business model for investment advisers to avoid burdensome SEC regulations. 1 See registration exemptions under sections 3(c)1) and 3(c)(7) of the 1940 Act, which are typically relied upon by most private funds and their advisers. 2 SEC Rule 206(4)-1. 3 SEC Release No. IA-5955 (March 24, 2022), 87 FR 16886. 4 See note 3. 5 See note 3. 6 SEC Release No. IA-6297 (May 3, 2023). 7 SEC Release Nos. 33-11038, 34-94382 and IC-34529 (March 23, 2022), 87 FR 16590. 8 SEC Release Nos. 33-11068, 34-94985, IA-6034 and IC-34594 (June 17, 2022), 87 FR 36654. 9 SEC Release No. IA-6240 (February 15, 2023), 88 FR 14672. 10 SEC Release No. IA-6176 (October 26, 20223), 87 FR 68816. 11 As stated in the SEC Report, the SEC’s enhanced focus on private funds stems, in part, from the fact that (i) registered private fund advisers manage approximately $21 trillion in private fund assets deployed in a variety of fund types, including hedge funds, private equity funds and real estate funds, (ii)  there has been an 80% increase in private fund assets under management over the past five years and (iii) the SEC is seeking to increase protections for investors in pension plans which, in turn, invest in private funds, including working family beneficiaries, charities and endowments, notwithstanding the fact that most pension plans have sophisticated institutional plan fiduciaries who manage their assets. 12 Consistent with its increasingly activist and aggressive approach to regulating private fund advisers, the SEC has brought several recent enforcement actions against private fund advisers, including sanctioning (i) a private equity fund adviser for failing to disclose that it had allocated a disproportionate share of deal expenses to its fund client instead of co-investors in the deal (In the Matter of Energy Capital Partners Management, LP, Advisers Act Release No. 6049 (June 14, 2022)) and (ii) a venture capital fund adviser for misleading investors about its fee practices and for engaging in improper inter-fund loans and cash transfers (In the Matter of Alumni Ventures Group, LLC and Michael Collins, Advisers Act Release No. 5975 (March 4, 2022)).

In the recent case New Enterprise Associates 14, L.P. et al. v. Rich et al., the Delaware Court of Chancery denied the defendants’ motion to dismiss a breach of fiduciary duty claim notwithstanding that the plaintiffs had previously agreed not to sue the defendants based on the precise claim at issue. The plaintiffs, minority investors in a Delaware corporation, had signed a voting agreement under which the defendants agreed not to sue the majority – including for breach of fiduciary duties – if the majority proceeded with a drag-along sale that satisfied certain requirements. The court characterized its decision as “grapp[ling] with a conflict between two elemental forces of Delaware corporate law: private ordering and fiduciary accountability.” Private ordering, which is based on “the contractarian nature of Delaware corporate law,” refers to restrictions on the exercise of stockholder rights that are imposed by a corporation’s charter and bylaws or by a stockholder agreement. By contrast, fiduciary accountability refers to the fiduciary duties that may be tailored but not waived under Delaware law. The court noted that while fiduciary duties and private ordering ordinarily operate in harmony, they pulled in opposite directions in this case, requiring the court to reconcile the conflict. Ultimately, the court concluded that as a matter of public policy, private ordering could not shield defendants from liability for intentional breaches of fiduciary duties, such as bad faith. Accordingly, the court held that the plaintiffs could prevail – notwithstanding their covenant not to sue – if the plaintiffs are able to prove that the defendants’ breaches of fiduciary duty constituted intentional harm. In light of this narrow avenue for the plaintiffs’ possible success on the merits, the defendants’ motion to dismiss was denied. This decision could have significant consequences for companies that rely on drag-along provisions, fiduciary duty waivers and/or covenants not to sue that appear in letters of transmittal, employee stock grants or other documents that could be viewed as imposing these restrictions on less sophisticated investors. Background The plaintiffs were investment funds that held a minority interest in Fugue, Inc., a startup that found itself in desperate need of capital. Following an unsuccessful sale process, Fugue agreed to a recapitalization in which the defendants purchased shares of Fugue’s preferred stock that carried powerful management rights. In connection with the recapitalization, Fugue and most of its stockholders entered into a voting agreement based on the National Venture Capital Association’s model form. The voting agreement contained (i) a drag-along provision that obligated the signatory stockholders to support a sale of Fugue if the sale was approved by the board of directors and a majority of the preferred stockholders and (ii) a covenant not to sue the directors or their affiliates in connection with a sale of the company that met the requirements of the drag-along provision. Three months after the recapitalization, when Fugue was no longer in severe financial distress and had received an expression of interest from a potential acquirer, Fugue’s new board of directors approved an “amendment” to the recapitalization pursuant to which certain preferred stockholders, including the defendants, purchased additional Fugue shares at the same distressed price as in the original recapitalization. Additionally (as described in more detail in the court’s companion opinion issued March 9), the directors granted themselves millions of options with a strike price set at one-tenth of the value of the common stock implied by the recapitalization. When the sale of Fugue closed, the preferred stockholders received consideration reflecting a return of almost 750%, while the option holders received a return of 3,200%. These returns came at the expense of Fugue’s original investors, prompting those original investors to sue the defendants for breach of their fiduciary duties. The defendants argued that the claims based on the sale must be dismissed since the sale satisfied the requirements of the drag-along provision in the voting agreement under which the plaintiffs had agreed not to sue for such claims. The Court’s Decision The court noted initially that the plaintiffs had argued neither that the covenant not to sue was ambiguous nor that it was induced by fraud or overreaching by the defendants. Rather, the plaintiffs relied on the “short and sweet” argument that the covenant not to sue was facially invalid simply because “[u]nder well-settled law, parties cannot waive fiduciary duties of loyalty in Delaware corporations.” Examining this argument in detail, the court proceeded to distinguish each statutory provision and case law precedent cited in support of the plaintiffs’ position, concluding that: The [plaintiffs] have advanced one reasonable interpretation of the law, but it is a stark account that elevates fiduciary accountability above all else, fails to explore the permissible bounds of fiduciary tailoring and ignores the difference between limitations in the constitutive documents of an entity and limitations in a stockholder-level agreement. The [plaintiffs’] absolutist framing pays no heed to the importance of private ordering, which is another fundament of Delaware entity law. Turning to the arguments in favor of enforcing the covenant not to sue, the court began by examining fiduciary tailoring in the contexts of trust law and agency law, under which the court determined that the covenant not to sue would be upheld. Expanding its analysis to Delaware corporate law, the court found support for the tailoring of fiduciary duties and the validity of covenants not to sue in various sections of the Delaware General Corporation Law – including notably Section 102(b)(7) regarding exculpation, Section 141(a) regarding limits on board authority and Section 145 regarding indemnification and insurance. The court also found support for the enforceability of the covenant not to sue in the common law doctrines of contractual preemption of fiduciary claims and advance ratification of interested transactions as well as in the equitable doctrine of laches. Finally, the court noted that the enforceability of a limitation on stockholder rights is greatest when the limitation appears in a stockholder agreement rather than in the corporate charter or bylaws. These considerations supported the court’s determination that the covenant not to sue falls within the realm of private ordering and is not facially invalid as a waiver of the defendants’ fiduciary duties. The court then quickly dispatched three additional arguments against enforcing the covenant, concluding that (i) the right to sue for breach of fiduciary duty is not “too big” to waive, (ii) enforcing a provision like the covenant not to sue does not threaten Delaware’s corporate brand and (iii) upholding a provision like the covenant not to sue does not collapse the distinction between corporations and limited liability companies. Having determined that the covenant not to sue was not facially invalid, the court turned to the Delaware Supreme Court’s decision in Manti Holdings, LLC v. Authentix Acquisition Co., 261 A.3d 1199 (Del. 2021) and the Chancery Court’s decision in In re Altor Bioscience Corp., C.A. No. 2017-0466-JRS (Del. Ch. May 15, 2019), which required the court to look beyond the facial validity of the covenant not to sue to determine whether it was valid as applied. Based on these cases, the court developed a two-part analysis. The first part requires that the provision be narrowly tailored to address a specific transaction that otherwise would constitute a breach of fiduciary duty – “If the provision is not sufficiently specific, then it is facially invalid.” The covenant not to sue in the instant case satisfied this requirement because it applied only to drag-along transactions meeting a specific list of criteria. The second part of the analysis requires the provision to survive close scrutiny for reasonableness. In deciding that the covenant not to sue was in fact reasonable, the court pointed to the following non-exclusive factors: “(i) a written contract formed through actual consent, (ii) a clear provision, (iii) knowledgeable stockholders who understood the provision’s implications, (iv) the [plaintiffs’] ability to reject the provision and (v) the presence of bargained-for consideration.” By contrast, the court identified several scenarios where a claim of reasonableness of a fiduciary duty waiver or covenant not to sue would face “deep skepticism and a steep uphill slog,” including an agreement binding a retail stockholder, an employee stock grant, a dividend reinvestment plan, an employee stock compensation plan and a stock transmittal letter. After determining that Delaware corporate law regarding fiduciary tailoring and private ordering permits the enforceability of a covenant not to sue for breach of fiduciary duties so long as the covenant is sufficiently specific and its application survives the court’s strict scrutiny for reasonableness, the court appeared ready to grant the defendants’ motion to dismiss. But one final consideration caused the court to decide for the plaintiffs. Citing the Restatement (Second) of Contracts §195, the court noted that a contract term that would exempt a party from tort liability for harm caused intentionally by the party is unenforceable on the grounds of public policy. Further noting that a claim for breach of fiduciary duty is an equitable tort, the court held that, “To the extent the [covenant not to sue] seeks to prevent the [plaintiffs] from asserting a claim for an intentional breach of fiduciary duty, then the [c]ovenant is invalid – not as an impermissible form of fiduciary tailoring, but because of policy limitations on contracting.” Thus, the plaintiffs’ agreement not to sue the defendants in connection with the drag-along sale would be enforceable, notwithstanding the defendants’ receiving an outsized share of the sale consideration, unless the plaintiffs could prove that the harm to them was intentional. If the defendants acted in good faith or even with reckless disregard for the best interests of the company, then the covenant not to sue would protect them. Takeaways and Practice Pointers The court rejected the argument that a waiver of duties of corporate fiduciaries is invalid on its face. It affirmed that Delaware corporate law generally permits tailoring of fiduciary duties and that private ordering through stockholder agreements among sophisticated investors will generally be enforceable if the provisions are specific and reasonable, but the court drew the line at covenants not to sue for bad faith or other intentional harm. The covenant not to sue for fiduciary duty breach at issue in this case might be unenforceable if plaintiffs can prove intentional harm, but absent such proof, the plaintiffs’ covenant not to sue for defendants’ breaches of corporate fiduciary duties would be enforceable. This case reinforces the following practice pointers: Waivers of fiduciary duties, including covenants not to sue, must be drafted clearly and unambiguously.   The waiver should relate to a specific transaction or a narrowly defined subset of transactions; an overly broad scope risks unenforceability.   Waivers of fiduciary duties and covenants not to sue may only be upheld against sophisticated investors who are represented by counsel, and clients should be alerted to the potential difficulty of enforcing such provisions against employee option holders or less sophisticated stockholders in a company sale.   Similarly, caution should be used when relying on fiduciary duty waivers or covenants not to sue when such provisions appear in plans or documents that are presented to investors as non-negotiable.   Effective private ordering should be in exchange for valuable consideration and part of a bargained-for exchange.   Limits on stockholder rights, such as waivers of fiduciary duties and covenants not to sue, will not protect clients from liability for bad faith or other intentional harm.