Lori S. Smith

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

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

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

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

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

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

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 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.

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.

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.

After several years of record-breaking levels of merger and acquisition (M&A) activity, late 2022 into 2023 has seen market volatility, persistent inflation, rising interest rates, continuing supply chain issues, global conflicts and fears of a possible economic downturn that have resulted in a significant slowing in deal flow as well as decreased exit values. As the U.S. economy emerged from the COVID-19 pandemic, the Federal Reserve aggressively raised interest rates to combat inflation, raising rates by a historic 3.75 percentage points in 2022 alone. Although only one of many factors at play, interest rates play a critical role in shaping the decisions of both buyers and sellers in acquisition transactions in various ways. While deal volume and valuations have drastically fallen from the highs of recent years, the prevailing high-interest rate environment can provide both challenges and opportunities. Cost of Capital Financing Structure One of the most significant ways interest rates affect M&A transactions is financing structure. When interest rates are low, debt financing is cheaper. This lower cost allows buyers the option to use more debt to fund acquisitions as they can afford to borrow more money to finance a deal. On the other hand, when interest rates are higher, buyers may need to rely more on cash on hand and equity financing, which leads to lower leverage ratios and the need for higher equity contributions toward the purchase price. The adverse effect of rising interest rates on the cost of capital also increases the costs of servicing existing debt which impacts the target’s operating expenses and profitability as it is more expensive for companies to pay back such loans. These increased costs of financing acquisitions and servicing debt, as well as the need to contribute more equity financing to support the borrowing, put downward pressure on M&A activity as buyers become cautious about borrowing to finance deals they might otherwise be willing to pursue in a lower interest rate environment. Sellers, particularly those who are considering accepting rollover equity (selling less than 100%) or are subject to an earn-out as a portion of the purchase price, also are impacted by these higher debt service costs in terms of the value of their retained interest. Further, the increased costs of buyer debt generally may also impact the value of any stock portion of the purchase price if the equity of the buyer is offered as part of the consideration. Therefore, even if buyers are able to obtain debt financing on acceptable terms, sellers in this environment may push for lower leverage (more cash upfront) or all-cash deals. Increased interest rates may also impact a buyer’s “cash on hand” or “dry powder.” As interest rates rise, investors tend to favor fixed-income and credit securities. Higher interest rates increase the “risk-free rate,” which is the rate of return on virtually risk-free investments like government bonds. This, in turn, narrows the equity risk premium or the excess return earned by an investor above the risk-free rate in alternative investments and, therefore, indirectly puts pressure on important M&A activity by impacting new fundraising by PE funds, which restricts the amount of capital available on the buy-side of the M&A market. For example, “dry powder,” or the amount of available cash in private markets/private equity, has been estimated to have reached a record $3.7 trillion at the end of 2022, according to Bain & Company’s Global Private Equity Report 2023. However, the markets are seeing a slowdown in new fundraising, so existing funds are being more conservative with how they deploy the existing dry powder, in part preserving cash for supporting their existing portfolio companies. This same conservative approach applies to strategic buyers with cash on hand as borrowing for their own business needs becomes more expensive, so they tend to conserve cash and slow acquisition activity. As a result, with higher interest rates and volatility in the equity markets, including the market for private capital raises, buyers become conservative and look to preserve cash on hand except for very opportunistic deals. Nevertheless, with higher borrowing costs, buyers with cash on hand may be less constrained than others and find a competitive advantage under current market conditions. Discount Rate and Valuations Interest rates can also impact valuations when assessing targets or deciding to put a company up for sale. When interest rates are high, the cost of capital is higher, which means future cash flows are discounted at a higher rate. This can result in lower valuations, as future cash flows, and thus a company’s revenue projections, are worth less in terms of today’s dollars. A higher discount rate of future cash flows can be particularly biting for early-stage or high-growth companies that are not expected to become cash-flow positive for some time. Also, higher interest rates can diminish the value of company assets, further driving down valuations. Lower valuations may induce potential sellers to hold back on putting their companies up for sale, opting instead to wait for an improved economic landscape where valuations might be higher. At the same time, lower valuations can provide an opportunity to make certain targets more attractive (i.e., less expensive), but this would need to be weighed against higher capital costs and economic uncertainties. Another consideration is that significant declines in valuations of companies and their assets, particularly at a time with higher capital costs, can make private investment exits much less attractive for current owners who may have acquired or invested in these companies at a time when valuations were much higher. Deal Structure Interest rates can also impact the structure of acquisition transactions and the strategic decisions of dealmakers. As noted above, deals may involve more cash and equity rather than debt financing. However, in difficult financing environments, especially where valuations are trending downward (in this case, in part because of rising interest rates), we may see an increase in earn-outs and contingent payments, which are often used in M&A transactions to bridge gaps in valuation expectations between buyers and sellers. These structures allow for additional payments to be made to the seller if certain performance metrics are achieved post-closing. Higher interest rates can have an impact on the use and structure of earn-outs and contingent payments. Where increased interest rates may be driving buyers and sellers further apart in terms of valuations, these structural components can be useful but difficult to navigate. Earn-outs and contingent payments always add complexity and uncertainty to a deal and require careful negotiation between the parties. Sellers will want adequate controls in place to maximize their ability to achieve full payment, while buyers will want maximum flexibility to operate the business in their best interests. This is always the case, but the concerns are heightened in an unpredictable and potentially downward-trending economic environment. In such cases, it becomes much harder to set realistic milestones or for a buyer to commit to long-term obligations such as maintaining the seller’s key team members and continuing to fund certain initiatives. Also, the cost of capital in and of itself may impact financial results. Another potential deal tool that buyers may use is to propose seller financing (having the seller agree to be paid over time in the form of a promissory note, often subordinated to any outside debt financing for the deal). Sellers will be particularly wary of the likelihood of timely payment of such subordinated debt with high-interest rate senior debt that likely includes tighter covenants than in a more favorable deal environment, although the interest on such sub-debt may be attractive. Conclusion While rising interest rates increase the cost of capital, decrease valuations and lower deal volumes and activity, higher rates do not necessarily mean fewer opportunities. Companies with cash will have an advantage over those without, as cash can provide certainty, and with lessened demand for acquisitions in the market, those buyers may find less competition for potential deals. Lower valuations may also create more attractive acquisition targets, and some sellers may be interested in selling now rather than waiting indefinitely for the markets to calm. Staying vigilant and monitoring macroeconomic developments will allow M&A parties to make informed decisions – where and how the U.S. Federal Reserve steers monetary policy and interest rates will have a real impact on deal values, deal volumes and deal structures. Savvy M&A operators who understand the challenges and opportunities of a high-interest rate environment and how to effectively adapt therein will still be able to make successful deals happen.

The venture capital and emerging company communities were rocked last week by the collapse of Silicon Valley Bank (SVB) and the subsequent collapse of Signature Bank. While the federal government stepped in on Sunday to assure depositors that all insured and uninsured deposits are safe and SVB is up and running through a newly formed bridge bank in an almost business-as-usual fashion in the US, the reality is that the future is unclear for the bank on which much of the community has depended for over 25 years. There is still much to learn about the situation beyond the obvious that has already been widely reported. The coming weeks will uncover more about the who, what and why of what happened; what can be done to shore up the US banking system further and avoid similar situations in the future; and whether SVB will be sold in whole, in parts, wound down or file for bankruptcy (among the many options). However, one thing that is certain at this point is that this changes the landscape in the near term for both debt and equity venture financing – the loss of SVB as a significant player, especially in the venture debt space, is a void that needs to be filled by viable alternatives beyond the current alternative of much more limited, costly, private debt sources. I sincerely hope the community pulls together to ensure minimal fallout, not just financially but to the lives of individuals who devoted themselves to supporting the emerging company community. Stradley Ronon will be monitoring this situation closely, and we are available to assist clients impacted by this situation. Sincerely, Lori Smith

One of the most important yet overlooked aspects of any commercial or corporate transaction involves confidentiality obligations. Often, parties gloss over the scope of the covenants, treat them as boilerplate using precedent without thinking through the details, such as what information needs to be protected in the particular transaction at hand, who should be subject to the restrictions, what limitations need to be imposed on the use of any disclosed information and sometimes, forget to include the covenant or enter into a separate confidentiality agreement altogether. This is especially true for venture capital, private equity and related fundraising transactions where companies may have numerous stockholders with varying or conflicting interests. For expediency and cost savings, early-stage venture capital deals typically involve the use of standardized forms, such as the Series A financing documents published by the National Venture Capital Association (NVCA). The NVCA forms include typical information and inspection rights which give at least significant investors broad-based access to confidential information regarding the company. Therefore, the NVCA forms do include a confidentiality provision protecting information received by investors in this context. Having said this, lawyers should still review these documents carefully and consider the specifics of the company and transaction, for example, the types of investors involved (e.g., funds vs. strategic investors), as there may be different sensitivities based on the nature of the investor. However, not all early-stage venture capital transactions use the NVCA forms, and many later-stage venture and private equity deals use bespoke sets of agreements prepared by individual law firms. And, even when precedential forms have been supposedly fine-tuned over time, they may not have adequate provisions for confidentiality in the context of the specific transaction. Further, there may be certain investors not covered by the provisions of the NVCA forms or other primary transaction documents (either because they don’t meet the threshold set forth in the documents to qualify for information rights in such documents or they are investing through another type of instrument, such as a convertible note). In such cases, it is customary for such investors to request information rights, rights to inspect company records and access to management in a side letter. It is important to make sure that side letter rights also are subject to adequate confidentiality and non-use restrictions. In addition to contractual rights, Delaware corporations need to keep in mind that under Section 220 of the Delaware General Corporation Law (the DGCL), stockholders of a Delaware corporation have the statutory right to access corporate books and records for a “proper purpose.” The term “proper purpose” is not expressly defined in the DGCL, but cases involving such demands generally arise in the context of allegations that a stockholder desires to value its interest in the company or has a credible basis to believe there is wrongdoing or mismanagement at the company or a breach of fiduciary duties by officers or directors. This was seen in a recent Delaware case1 (Rivest v. Hauppauge Digit., Inc.) in which the court permitted the disclosure of nonpublic information to a stockholder of a public corporation who exercised his Section 220 rights and did not afford confidential treatment to the corporation’s books and records. This case involved an individual plaintiff seeking to value his shares in a corporation that went “dark” for a number of years, did not make any public disclosures and ignored the requests of the plaintiff for financial and other information concerning his investment. The court stated that there is no presumption of confidentiality as it relates to a Section 220 demand, and the relevant facts and circumstances at hand would be weighed in determining whether or not to afford confidential treatment. The court went through a thorough and detailed analysis of the harm that could be imposed on the corporation for not affording confidential treatment of the corporation’s financial information, including that such information could be used by competitors of the corporation and could put the corporation out of business. On the contrary, the court also detailed the benefits of allowing the plaintiff to obtain such financial information without confidential treatment, including that the plaintiff was seeking basic financial information to value his shares, which falls within the criteria for a proper purpose for a Section 220 demand. In determining not to afford confidential treatment to the disclosed information and permitting the plaintiff to inspect the corporation’s financial records, the court stated that “Rivest has established a significant interest in obtaining financial statements for closed periods free of any confidentiality restriction [and] [t]he Company has not made a showing sufficient to outweigh Rivest’s interest and warrant a two-year confidentiality restriction.” While the company at issue in Rivest v. Hauppauge Digit., Inc. was a public company, in a recent transaction in which we were involved, a venture capital-backed company was pursuing a sale transaction and had a strategic investor who was potentially interested in acquiring the company. The company received a written request from such stockholder, purportedly in the context of wanting to monitor its investment. The request (which was not a formal Section 220 demand) was for various information pursuant to such stockholder’s information rights in an investor rights agreement. The information requested was highly sensitive because of the ongoing negotiations of the sale, certain prior communications with such stockholder indicating such stockholder was not necessarily supportive of the sale, and the fact that this stockholder had a commercial relationship with the company. In that matter, the investor was subject to adequate contractual confidentiality and non-use restrictions on the information, but in the absence of such limitations, this could have been highly problematic because disclosure could have violated agreements with the potential acquirers and could have led to leaks of information on a highly confidential transaction and potentially disrupted the closing of the sale. The absence of such restrictions could have allowed the recipient to share the information or use the information for a purpose other than monitoring its investment. If this stockholder had sought to make a Section 220 demand, the existence of the confidentiality provision in the agreement would likely have led a court to provide confidential treatment to any disclosed information – however, in future transactions, we have already made a note to make sure we explicitly extend these provisions to any demand, not just the information provided under the investment documents. Statutory information rights can be waived, and the investor rights agreement published by the NVCA does include an optional provision for the waiver of statutory information rights, though we don’t typically see investors agreeing to such a provision. Therefore, when statutory information rights are intact and not expressly waived, any contractual confidentiality obligation needs to take into account not only information provided pursuant to contractual information rights but also information provided in other contexts, such as statutory information rights. Further, it is critical, especially in private companies, to include strong confidentiality obligations in investment documents whether or not such documents provide stockholders with explicit rights to disclosure of, or access to, confidential and proprietary information, in order to protect such information from unwanted use and/or disclosure beyond the particular stockholder and for proper purposes. Such agreements should clearly define the types of information protected, the defined purposes for which such information may be used and the parties with whom such information may be shared (e.g., a venture capital or private equity fund may request the right to share certain limited information with its partners for valid reporting purposes). In the absence of such pre-existing agreement at the time of the demand (often made without court intervention), companies should also keep in mind that it is customary to ask for a confidentiality agreement before sharing such information. 1See Rivest v. Hauppauge Digit., Inc., 2022 WL 3973101, at * 1 (Del. Ch. Sept. 1, 2022).

Angel investors, venture capital and private equity funds often seek to secure some presence, formal or informal, within the board meetings of the corporations in which they invest. Such representation and participation in corporate governance provide potential benefits to both the investor and the portfolio corporation. The corporation can benefit from having experienced investors participate and provide guidance in board meetings and beyond. While some corporations may be wary of offering such investors a formal seat on the board of directors, one option commonly employed is to grant investors or their representatives rights as “board observers.” Such persons may observe and even participate, usually in some limited fashion, in meetings of the board of directors. They generally get rights to attend meetings and obtain all materials provided to formal members of the board, but in a non-voting capacity. Granting such rights, however, introduces a number of unique issues and subtle potential pitfalls that both the corporation1 and the investor should carefully assess. Little caselaw or statutory guidance exists on the rights and obligations of board observers. Corporations and investors, each seeking to protect themselves, should therefore ensure that they expressly delineate those rights and obligations in advance via a detailed board observer agreement executed by both the corporation and the observer. Some of the key considerations to address in such an agreement, and related issues, are discussed below. Fiduciary Duties Corporate law generally does not impose fiduciary duties on board observers. Such fiduciary duties typically arise where one party manages an asset or group of assets for another, as a result of which the law will accordingly impose on the manager certain duties of loyalty and care with respect to the beneficiary. Directors, officers and managers of the corporation, having been charged with the duty to manage the assets of the corporation, are deemed fiduciaries with respect to the stockholders. But since board observers, by contrast, will typically have no formal responsibility for managing the corporation’s assets, they will typically not be deemed to owe the corporation any fiduciary duty. From the corporation’s perspective, the lack of fiduciary duties can lead to conflicts of interest, especially with strategic investors who may be in the same industry or business as the corporation. Such conflicts would not be addressed by an overriding duty of loyalty or duty not to act in a self-interested manner. Where an investor designates a representative to sit on the board, either formally or informally, that director could be said to be wearing two hats, one as a representative of the investor and one as a fiduciary to the corporation. In fact, that representative may even owe fiduciary duties to the investor who designated such person to sit on the board. As a formal board member, the duty of loyalty would protect the corporation from such conflicts. Therefore, on the one hand, companies often attempt to include language in board observer agreements that requires the board observer to act as if it were subject to fiduciary duties. On the other hand, investors often want the opposite, to expressly state that the board observer is not a fiduciary of the corporation. In fact, often, an investor will prefer an observer seat specifically because they are concerned about conflicts of interest created by such fiduciary obligations. The investor is interested in access to information and a window into its investment but doesn’t necessarily feel the need for a formal board seat that would give it the power to direct the affairs of the corporation through a vote on the board. Regardless of whether the board observer agreement expressly addresses fiduciary obligations, the agreement should both define the scope of the board observer’s rights to participation and access to information as well as seek to protect the corporation by imposing express limitations on such rights. For instance, the agreement should make clear that the observer is not entitled to vote at board meetings, may not veto any decision or action taken or being considered by management and may be excluded from receiving certain information or attending portions of meetings, as more fully discussed below. It may even subject the observer to additional restrictions on the use and disclosure of information that are not necessary for voting members of the board. The agreement may also specify the conditions upon which the board observer’s rights may sunset, for instance, if the investor who has the right to designate the observer does not continue to hold a specified amount of stock or by or before an identified end date. Confidentiality and Privilege As a non-member of the board and a representative of a third party, the board observer’s mere presence in the board meeting may compromise the confidentiality of information shared or discussed in the meeting. The observer’s presence may also destroy the privilege that attaches to a meeting between the corporation’s board and the corporation’s attorneys. Special care should accordingly be taken to address these issues in the board observer agreement. Courts considering the issue have reached varying conclusions on whether the provision of confidential or privileged information to a board observer waives the attorney/client privilege with respect to such information. In Finjan, Inc. v. SonicWall, Inc., a decision issued by the United States District Court for the Northern District of California in 2020, the Court found that a corporation’s disclosure to a board observer of information otherwise protected by the attorney/client privilege constituted a waiver of the privilege with respect to that information. By contrast, the United States District Court for the Eastern District of North Carolina held the exact opposite in a 2005 case, PharmaNetics, Inc. v. Aventis Pharmaceuticals, Inc. Corporations and investors should attempt to address this uncertainty upfront through their board observer agreement. The agreement should expressly define “Confidential Information” and impose unambiguous obligations on the observer to protect and maintain the confidentiality of such information and to not use the information for any purpose other than for monitoring the relevant investor’s investment in the corporation. In many situations, it should also contain appropriate limitations upon the sharing of competitively sensitive information. The agreement should also make clear that all such information is proprietary to the corporation and may contain trade secrets, the disclosure of which would harm the corporation. The restrictions imposed should apply broadly to all those parties with whom the observer is authorized to share information obtained from the corporation. The board observer agreement may also expressly provide the corporation the right to withhold certain proprietary information, especially if it could jeopardize trade secret protection for such information. The board observer agreement should also give the corporation the tools necessary to protect the corporation’s attorney/client privilege by expressly stating the corporation’s right to exclude the observer from any meetings or discussions with counsel where the observer’s presence might constitute a waiver of privilege. The corporation’s right to exclude the observer should also extend to situations in which matters being discussed may give rise to a potential conflict of interest. Of course, even when an agreement allows the corporation to exclude the observer for privilege reasons, the corporation must remain vigilant and actually exercise such right at appropriate times, or the privilege could be inadvertently waived. Conclusion Though the presence of board observers is fairly common in privately held corporations, corporations should think twice before liberally agreeing to allow any investor to appoint an observer, as their access to information and participation in a corporation’s board meetings raises a number of potentially significant issues for both the corporation and the investor. Given the relative lack of statutory guidance or caselaw governing the rights and obligations of these observers, both sides should ensure that they protect themselves in advance through the careful drafting and execution of a comprehensive board observer agreement. Stradley Ronon has a deep bench of experienced attorneys who regularly draft board observer agreements for a variety of corporate and investor clients. We are well-prepared to assist you with any legal needs you may have in this area or any related area, including those involving startup investments, compliance and governance. 1 Though this article focuses on observer rights with respect to corporations, observer rights can also be granted in entities that use other forms if they have boards or functionally similar governing bodies.

Throughout the pandemic, we all got accustomed to holding virtual meetings as a necessity, but recently I have received a number of questions from clients about continuing to hold virtual or hybrid board meetings or whether they should be encouraging more fully in-person meetings to the extent practicable. This is definitely a discussion that a number of companies are having as we try to move back to more in-person activities. There are, of course, pluses and minuses to the ability to use Zoom, Teams and other similar technology to meet with colleagues, but I believe the conversation should focus on the most effective way to hold a meeting of the Board of Directors, such that the Board properly engages with management and is diligent in exercising its fiduciary duties. Having attended a number of virtual meetings recently, there are certainly positives. The meetings can be easier to schedule and attend on shorter notice with reduced travel and consequently reduced time commitments by attendees. This is extremely important for companies operating globally or with directors that are located in geographic regions different from the company’s management. This also usually means reduced costs as companies generally reimburse non-employee directors for their airfare, hotel and other related travel expenses. In-person meetings also generally are longer, often running for a full day or more and involving dinners or lunches. Shorter meeting times and time commitments mean the Board can meet more frequently if necessary and have shorter sessions on specific issues or topics rather than needing to devote days to quarterly or semi-annual meetings. It also makes it easier to bring in outside advisors without the expense of such advisors committing to travel and attend a whole meeting when only needed for a segment of the meeting. However, there are a couple of big negatives that I see from virtual board meetings (which are not necessarily unique to a Board of Directors, but the concerns are heightened as a result of a Board’s duty of care in exercising oversight over the corporation.). The Board’s duty of care requires that it engage in reasonable diligence in evaluating actions to be taken by the corporation and make careful, informed decisions. To do so, the Board needs to be actively engaged in the process of evaluation and decision-making. While the directors are attending a meeting virtually, are they all actively participating? Are cameras on and everyone focused on the meeting, or are Board members multi-tasking or being distracted by other matters in their environment (the ones we all have working from home like children, dogs and ringing doorbells)? Is the meeting structured to allow directors to question management and ask for more information, or is the virtual setting making it more of a PowerPoint presentation followed by a rubber stamp by the Board? What materials did the Board review and consider, and when are they being provided? Was there sufficient time for the Board to gather the requisite information and deliberate? Are the Board members meeting before and/or after the “official” meeting in executive session or informally? An important part of a functioning Board is that the Board members have good interpersonal relations and trust one another. This is much harder to do when meeting virtually. Without the time before and after the meeting and during breakout sessions, there is less time to get to know one another or to have sidebars or other important discussions between and among specific members of the Board or between a Board member and management. You also lose the dynamics of being around one table together where eye contact, body language and even where people are seated in relation to each other can impact discussions. This could be a positive or a negative – maybe some Board members feel more comfortable speaking up in a virtual setting, but you lose the ability to really control the dynamics when, for example, a particular Board member might be monopolizing the conversation or time allotted for a meeting or topic or being disruptive to the flow of the meeting. The bottom line is that virtual or hybrid board meetings are probably here to stay, so it is important to set some guidelines. Meeting materials should be sent out far enough in advance that directors have a chance to review, digest and ask for additional information. The Board should consider a pre-meeting, even if it isn’t an in-person dinner, the night before the board meeting. This allows the Board to not only become more familiar with each other but also for Board members to raise issues in advance of the meeting and provide focus and direction for the discussions at the actual meeting – it is a time for the Board as a group to formulate important questions or issues they want to highlight for management. Given that virtual meetings tend to have a shorter time span, it is important to make sure the time is used wisely. At the meeting, there should be a clear agenda, and Board members should be instructed to keep cameras on if possible, as this will help with engagement. Board members should be strongly encouraged to ask questions and actively participate in discussions. The meeting should be structured to be just as interactive as an in-person meeting, and there should be time afterward in executive session or otherwise for board members to debrief on the meeting and plan and prepare for what issues need further discussion and evaluation between one meeting and the next. Companies might also consider alternating between virtual and in-person meetings or at least holding one or more regularly scheduled quarterly or semi-annual meetings in-person to the extent practicable and reserving the virtual meeting setting for special meetings on specific topics. The most important thing is that a company makes sure its Board is functioning in a cohesive and productive matter that has everyone rowing in the same direction in the best interest of the company and its stockholders.

The legal landscape around the enforceability of restrictive covenants, such as non-compete and non-solicitation provisions, is clearly changing. Businesses and their attorneys would do well to pay attention to these changes and learn the lessons being handed down at the state and federal levels. Recent Developments In the context of employment-based restrictions, the trend over the last several years has clearly been to disfavor restraints on an employee’s ability to earn a living utilizing their training and skills. California has long prohibited non-competition restrictions in the employment setting. Massachusetts enacted legislation in 2018 curtailing the permitted scope of non-competition agreements, requiring advance notice to employees and providing an opportunity to consult with counsel. States such as Colorado, Illinois, Oregon and Washington DC have all made recent changes limiting the enforceability of post-employment non-compete agreements, and a growing number of states, including New York, New Jersey, Connecticut, Maryland, Maine, New Hampshire, Rhode Island and Oklahoma are considering changes or have pending legislation. And though the regulation and enforcement of non-competition agreements have traditionally been by the individual states, President Biden issued an executive order in July 2021 calling upon the Federal Trade Commission (FTC) to undertake greater scrutiny of non-compete clauses indicating the growing disfavor of restrictive covenants has also reached the federal level. Restrictive covenants imposed on sellers in conjunction with the sale of a business have traditionally been afforded greater leeway than those in employment agreements, and courts throughout the U.S. have long found that buyers have a legitimate business interest to protect the assets and goodwill acquired in a sale/purchase. This is especially true in situations where sophisticated parties represented by counsel have knowingly negotiated such restrictions as part of the overall transaction. M&A attorneys have historically believed that courts would generally uphold restrictive covenants in acquisitions or at least apply the “blue pencil” rule to reform overly broad covenants to make them enforceable in order to allow a business to protect its bargained-for-interests. There are, of course, overriding antitrust considerations that must be part of this analysis, but most states have not taken a proactive approach to restrict contractually agreed upon restrictive covenants on sellers of businesses so long as they are reasonable in scope. As an example, California, where all non-competes have been generally disfavored, allows an exception to this in the sale of a business context to protect the goodwill/assets acquired, but such restrictive covenants are only enforceable to the extent they are reasonable and necessary to protect the buyer’s specific and immediate interests resulting from a particular transaction. While most of the focus on reining in non-competes and other restrictive covenants has been in the employer/employee context, there is a clear and increasing trend for all restrictive covenants to be disfavored, including those found in the M&A context, as a recent opinion from the Delaware Chancery Court and an FTC, settlement demonstrate. Delaware – Kodiak Building Partners, LLC v. Adams Delaware law with respect to non-competition and non-solicitation covenants calls for courts to carefully review such restrictive covenants to ensure they are (i) reasonable in geographic scope and duration, (ii) advance a legitimate economic interest of the party seeking enforcement and (iii) survive a balancing of the equities. On Oct. 6, 2022, in the case Kodiak Building Partners, LLC v. Adams (Kodiak), the Delaware Chancery Court ruled that a restrictive covenant imposed on a stockholder in an acquisition was overbroad and unenforceable. Moreover, and perhaps both surprising and reflective of recent trends, the Court declined to revise the covenants to such reasonable limitations as would make them enforceable. In this case, Kodiak Building Partners, LLC, a serial acquirer of businesses in the building materials, sales and distribution industries, entered into a stock purchase agreement to acquire all of the assets of two companies (which operated from a single location), including goodwill, and the 8.33% equity interest of the target company’s general manager, Phillip Adams. As part of the deal, Adams agreed to non-competition and non-solicitation restrictions for 30 months after closing that included a geographic scope of 100 miles within any one of Kodiak’s 81 locations (including those of what was defined as the Company Group so as to pick up Kodiak affiliates) across 16 states, not just the single location acquired in the immediate transaction. The Court found that Kodiak went beyond what was reasonable to include (i) a geographic scope far wider than pertaining to the single location involved in the transaction and (ii) an overly broad definition of “Business” and the Company Group covered by the restrictive covenants to cover all lines of business of Kodiak and its affiliated companies, not just the single line of business (roof trusses) engaged in by the acquired companies. The Court reasoned that protectable goodwill should be limited to the immediate transaction and the competitive space in which the target company operates. Interestingly, the Court in Kodiak repeatedly referred to Adams as an employee throughout the opinion focusing on the impact of the restrictions on him as an employee even though they discuss the result in the context of an acquisition. Although Kodiak alleged Adams was a senior executive of the acquired company and that he had expressly agreed to the reasonableness of the scope, he was a minority owner, and it was not alleged that he separately negotiated his restrictive covenants nor that he was separately represented by counsel in the negotiations (which might have made a difference in the analysis of the allocation of risk as noted in another case cited in a footnote in the decision). It is at least worthy of questioning whether the Court would have looked at this differently or at least given more weight to Kodiak’s arguments as to contractually getting the benefit of its bargain if Adams had been (i) a majority or more significant owner represented by experienced legal counsel, (ii) more actively involved in the sale negotiations or (iii) a recipient of more substantial consideration. Kodiak did argue that the proceeds he received from the sale were more than token consideration at seven times Adam’s annual compensation, but again the Court appeared to look at this in the context of Adam’s as an employee and not primarily with the lens of Adams as a sophisticated selling stockholder. Perhaps further worth noting is that the Court made this determination in the context of a request for a preliminary injunction which is a very high standard – they ultimately determined the restrictive covenants were not enforceable in such context, which focuses on whether it was more likely than not that Kodiak would succeed on the merits in the ultimate case. FTC Settlement – ARKO/Corrigan Earlier this year, the FTC issued an administrative complaint in response to an acquisition of ARKO Corp. of 60 gas stations from Corrigan Oil Company in Michigan and Ohio, taking issue with certain non-compete provisions that were alleged to be unreasonably overbroad in geographic scope and beyond what was reasonably necessary to protect a legitimate business interest. The terms of the non-competition agreement restricted Corrigan’s ability to compete not only in the local markets around those locations acquired as part of the deal but also in any other markets in which ARKO operates. The final Decision and Order effectively rewrote the ARKO/Corrigan Asset Purchase Agreement limiting the scope of non-compete covenants to only apply to locations acquired in the transaction, limiting the terms to be no broader than three years in duration and no more than three miles from the acquired locations, along with a number of other requirements signaling the FTC’s willingness to be proactive in protecting sellers where a buyer might overreach. As Lina Khan, Chair of the FTC, shared in her statement on the matter, “[F]irms may not use a merger as an excuse to impose overbroad restrictions on competition or competitors” and that “[a] general desire to be free from competition following a transaction is not a legitimate business interest.” Takeaways for Businesses and Practitioners The Kodiak opinion and ARKO settlement should be taken as cautionary tales for M&A attorneys and acquirers to carefully construct restrictive covenants so that they are narrowly tailored to protect the legitimate business interest of the acquirer in protecting the value and goodwill associated with the business being acquired, tethered to the specific geographic locations and operations of the acquired company. Courts may be more and more unlikely to rewrite overbroad restrictive covenants where taking the “blue pencil’ to reform such covenants could be seen as inequitable. In negotiating a deal, buyers should ensure that any restrictive covenants, such as non-competes or non-solicitation provisions, are appropriately limited with respect to the time, geographic scope and industry/business such that the focus is on the target, not the overall business of a buyer and its affiliated companies prior to the acquisition. It would also be wise to avoid catchall definitions that are overly broad.

In a recent M&A transaction, a nuanced issue regarding the exculpation of directors under the Delaware General Corporation Law (DGCL) arose in the context of a potentially conflicted director serving on the board of a company considering a sale transaction. The company was an early-stage Delaware corporation that had completed multiple rounds of equity financing, the most recent of which was led by a strategic investor in the same industry as the company. At the time of its investment, the strategic investor negotiated for the right to designate one director to the company’s board. Due to the strategic investor’s potential interest in acquiring the company, when the company began considering acquisition offers, the strategic investor’s designated director had at least the appearance of a conflict of interest. In considering the potentially conflicted director’s obligations in the context of the board’s deliberations, counsel for the strategic investor incorrectly assumed that the exculpation language in the company’s certificate of incorporation, which is explicitly permitted (and limited) by Section 102(b)(7) of the DGCL1, amounted to a waiver of all fiduciary duties by the company.2 As Section 102(b)(7) makes clear, however, no such provision may exculpate a director for any breach of the duty of loyalty. Under the counsel’s mistaken interpretation, the director would have been free to share information he received in his capacity as a director with the strategic investor for whom he worked, potentially to the detriment of the company. As noted in prior Delaware case law, while it is possible to cleanse an interested party transaction under Delaware law, a director cannot disclose information to the appointing stockholder when such director is wearing two hats, i.e., if the disclosure could cause harm to the company to which such director owes a duty of loyalty.3 This is definitely a conundrum for directors appointed by private equity firms or other purely financial investors in many situations, but can be even more of a challenge for directors designated by strategic investors, who often have interests that are not solely focused on maximizing the economic value of their investment in a manner that is aligned with other stockholders. While the duty of loyalty issue was ultimately resolved between counsel, the scenario highlighted an interesting secondary issue: whether Delaware law would have required the same outcome if the target company had been a Delaware LLC. As practitioners know, while a corporation is a creature of statute, LLCs are generally creatures of contract. There are also important differences between the DGCL and the Delaware Limited Liability Company Act, particularly with respect to fiduciary duties. As the Delaware Court of Chancery noted in the recent Manti case4, and as is well established in Delaware law: “Waiver of fiduciary duty is a permitted feature of the LLC form.” The DGCL allows corporations to eliminate director liability for breaches of the duty of care, as described in Section 102(b)(7), and to renounce corporate opportunities, but the DGCL does not expressly authorize a contractual waiver of fiduciary duties or of claims to enforce such duties. By contrast, the Delaware Limited Liability Company Act has broad enabling provisions that allow for private ordering, including the modification or elimination of all fiduciary duties. The Manti case hinged on a purported contractual waiver of corporate directors’ fiduciary duties, but due to the court’s rejection of the waiver interpretation, the court did not ultimately rule on whether such a contractual waiver would be permissible in the corporate context. Exculpation from financial liability under Delaware corporate law has express limits and does not amount to the type of broad waiver that can be contracted for in LLCs. While there are many reasons that venture capital investors, in particular, prefer the use of Delaware corporations for their investments, when structuring investments generally, in addition to tax and other factors, consideration should be given to whether a corporation or LLC is the best vehicle in light of potential conflicts of interest that may arise in connection with exits and future financing arrangements. From the company’s perspective, these types of conflicts should be given serious consideration when deciding upon the composition of the board of directors, especially as it relates to strategic investors’ access to all of the information that would normally be shared with a board. Relatedly, as previously noted in Business Vantage Point, recently enacted amendments to the DGCL will likewise extend the right of a corporation to exculpate officers in certain situations, but it is clear that this expansion relates solely to the duty of care, as the prior version of the statute was also so limited with respect to directors. The expanded exculpation right does not apply to the duty of loyalty implicated in most conflict of interest cases involving a director appointed by, and in many cases employed as an officer or manager of, a stockholder who may be interested in a sale or other significant transaction. 1 DGCL Section 102(b)(7): Section 102: Contents of certificate of incorporation. … (b) In addition to the matters required to be set forth in the certificate of incorporation by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters: … (7) A provision eliminating or limiting the personal liability of a director or officer to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director or officer, provided that such provision shall not eliminate or limit the liability of: (i) A director or officer for any breach of the director’s or officer’s duty of loyalty to the corporation or its stockholders; (ii) A director or officer for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) A director under § 174 of this title; (iv) A director or officer for any transaction from which the director or officer derived an improper personal benefit; or (v) An officer in any action by or in the right of the corporation. No such provision shall eliminate or limit the liability of a director or officer for any act or omission occurring prior to the date when such provision becomes effective. An amendment, repeal or elimination of such a provision shall not affect its application with respect to an act or omission by a director or officer occurring before such amendment, repeal or elimination unless the provision provides otherwise at the time of such act or omission. All references in this paragraph (b)(7) to a director shall also be deemed to refer to such other person or persons, if any, who, pursuant to a provision of the certificate of incorporation in accordance with § 141(a) of this title, exercise or perform any of the powers or duties otherwise conferred or imposed upon the board of directors by this title. All references in this paragraph (b)(7) to an officer shall mean only a person who at the time of an act or omission as to which liability is asserted is deemed to have consented to service by the delivery of process to the registered agent of the corporation pursuant to § 3114(b) of Title 10 (for purposes of this sentence only, treating residents of this State as if they were nonresidents to apply § 3114(b) of Title 10 to this sentence). 2 The language in question originated from the National Venture Capital Association’s model Certificate of Incorporation, Article Ninth, which is available here. 3 Also worth noting is that the strategic investor had contractual information rights, as is typical for major investors in venture capital equity rounds. Information provided by the company to the investor pursuant to these contractual rights would not be subject to the same limitations based on fiduciary duties, although it would remain subject to applicable contractual confidentiality obligations. Further, all stockholders of Delaware corporations have the right to demand certain books and records pursuant to Section 220 of the DGCL, and other recent Delaware caselaw suggests that nonpublic company information furnished pursuant to a Section 220 request may not always be protected by confidentiality obligations. 4 Manti Holdings, LLC v. The Carlyle Group Inc., C.A. No. 2020-0657-SG (Del. Ch. Feb. 14, 2022).

In August of this year, Section 102(b)(7) of the Delaware General Corporation Law (DGCL) was amended to permit Delaware corporations to amend their Certificates of Incorporation to include a provision providing for the exculpation of officers from monetary damages for breach of certain duties owed to the corporation.1 These amendments represented a significant step in providing greater protection for a corporation’s officers with respect to actions taken on behalf of the corporation. Historically, the exculpatory language permitted by the DGCL in a corporation’s Certificate of Incorporation would have shielded only a corporation’s directors rather than its officers. Perhaps unsurprisingly, at least two suits concerning the new law have already been filed in the Delaware Court of Chancery. On Nov. 4, the Electrical Workers Pension Fund, Local 103, I.B.E.W. filed a class action complaint against Fox Corporation, who recently took advantage of the changes in the law to amend its Certificate of Incorporation to include a provision providing for the exculpation of its officers.2 Rather than challenging the amendment to the DGCL, the case hinges upon the procedure Fox Corporation used to amend its Certificate of Incorporation. Fox Corporation has a dual-class share structure – shares are either voting or non-voting. The amendment to the Certificate of Incorporation was approved by the voting class of shares but not by the non-voting class. Plaintiffs allege that the amendment was inconsistent with Section 242(b)(2) of the DGCL, which provides that holders of a class of stock are “entitled to vote as a class upon a proposed amendment, whether or not entitled to vote thereon by the certificate of incorporation if the amendment would alter or change the powers, preferences or special rights of the shares of such class so as to affect them adversely.” The complaint alleges that the amendment to the Certificate of Incorporation required the vote of the non-voting stock because “[t]he right to seek judicial relief to hold officers accountable for reckless or grossly negligent behavior is a component of the ‘bundle of rights’ appurtenant to ownership of Fox Class A Common Stock.”3 Electrical Workers appears to be just the first of perhaps several cases that may challenge the expansion of the DGCL to allow for the exculpation of officers. In another case recently filed, a stockholder of Snap Inc. (the company behind Snapchat) sued the company, alleging that when the company amended its Articles of Incorporation, it implemented a measure that stripped the rights of non-voting stockholders. Similar to the argument presented in Electrical Workers, here plaintiff stockholder alleged that Section 242(b)(2) of the DGCL guaranteed the holders of any class of stock (including non-voting stock) the right to vote on any amendment that adversely affects any of the powers or rights appurtenant to that stock, regardless of whether the stock itself is considered voting or non-voting. Plaintiff argued that the “only reasonable reading [of Section 242(b)(2)] is that even if a class of stock is typically not entitled to vote on other matters, a charter amendment adversely affecting the ‘powers, preferences or special rights’ appurtenant to that class of stock still requires an approving vote.”4 This raises the question – is there such a power, preference or right attributable to non-voting shareholders that would allow them to challenge such an amendment? The complainants in Electrical Workers ground the basis of their argument in favor of such a right upon language the Delaware Chancery itself relied upon in the 2015 case of In re Activision Blizzard, Inc., S’holder Litig.5 Here, the court held that such “peculiar rights” held by stockholders included the right to assert direct claims for breach of fiduciary duty against a company officer.6 The court in Activision recognized that the right to sue for breach of fiduciary duty might – in limited circumstances – adhere to the stock itself and vest in the stockholder. Regardless of when and whether the Delaware Chancery renders a decision in either the Electrical Workers case, or the Snap, Inc. case, as we discussed in our earlier article, should carefully weigh the pros and cons of amending their respective Certificates of Incorporation to include such protections for corporate officers. While such an amendment may provide protection from certain stockholder litigation, ultimately, both officers and directors owe a duty of care to stockholders to exercise business judgment in good faith and in a reasonably prudent manner when acting on behalf of the corporation, in a manner that the officers and directors believe is in the best interests of the corporation and its stockholders. While the statute now permits exculpation in certain cases, a board of directors should carefully consider the implications of proposing such an amendment and its impact on stockholder rights. 1 See 8 Del. C. § 102(b)(7). 2 Electrical Workers Pension Fund, Local 103, I.B.E.W. v Fox Corporation, Case No. 2022-1007-MTZ (filed Nov. 4, 2022). 3 Id. at ¶ 7. 4 Karen Sbroglio v Snap Inc., Case No. 2022-1032 (filed Nov. 16, 2022), at ¶ 2. 5 In re Activision Blizzard, Inc., S’holder Litig., 124 A.3d 1025, 1049 (Del. Ch. May 20, 2015). 6 Id. at 1049. See, e.g., In re Baker Hughes Incorporated Merger Litig., 2020 WL 6281427, at *15-16 (Del. Ch. Oct. 27, 2020) (declining to dismiss a direct claim for breach of the duty of care against an officer).

ESG has graduated from a reference in the financial statements of major corporations to a barometer for the health and long-term prospects of any business valued by investors Understanding the growing importance of environmental, social and corporate governance (ESG) in the world of mergers and acquisitions requires looking no further than social media. Countless posts on these social platforms demonstrate society’s rising concerns around sustain- ability standards and corporate accountability. In fact, Elon Musk’s recent attempt to acquire Twitter is the perfect example of the reach that ESG has in today’s M&A market and the broader business world. Twitter is the most high-profile acquisition on the rocks right now. While the primary reason Musk has cited for backing away from the deal is his allegation that the social media platform is infected with bots that impact fake news and, ultimately, the company’s valuation, he has pointed to diversity concerns. “Musk has tweeted frequently about Twitter employing workers who are insufficiently diverse in embracing a wide variety of viewpoints and perspectives,” says Dr. Michael Kraten, an ESG expert and professor of accounting at Houston Baptist University. “Ironically, the lack of diversity that he mentions involves a lack of conservative and libertarian representation.” He suggests Musk’s concerns represent issues around the G in ESG. The components of ESG that are most in vogue are constantly shifting, but investors and companies alike have moved beyond viewing the standards as just another item to check off in the deal process to something that adds intrinsic value. Politics, ever-changing regulations and even the economic environment may color the way deals are evaluated at any given time. Still, the importance of ESG continues to grow, with the European Union leading the direction for where standards are heading. While countless metrics and organizations specializing in ESG due diligence have sprung up to meet rising demand, a major gap remains in the criteria used to rate ESG for major organizations and middle-market companies. As general partners and limited partners struggle to sift through the myriad components that comprise today’s ESG, one thing is clear: It isn’t going away and social pressures are proving to be the greatest driver of ESG adoption.

Effective Aug. 1, 2022, the Delaware General Corporation Law (DGCL) has been amended to include exculpation protections for corporate officers, as well as expanded flexibility in connection with the delegation of authority to corporate officers and others with respect to the granting of stock options and other rights to acquire stock. The amendments are part of a growing trend within the DGCL to empower corporate officers with more flexibility and control with respect to employee equity award programs and provide additional protection for corporate officers against certain types of stockholder litigation. Expanded Exculpation Protections for Corporate Officers Historically, directors have benefited from protections in the DGCL, which provide that a corporation’s charter can eliminate or limit such directors’ personal liability for monetary damages arising from breaches of the fiduciary duty of care.1 However, the DGCL did not authorize similar exculpation of corporate officers. As a result, corporate officers have increasingly become the target of stockholder litigation based upon breach of fiduciary duties. As of Aug. 1, 2022, it will be possible for Delaware corporations to adopt charter provisions that provide for similar exculpation protection for certain corporate officers subject to various limitations as described below. Newly formed corporations will be able to include exculpatory provisions for covered corporate officers in their original certificate of incorporation, similar to the current practice of including such provisions with respect to directors. For an existing corporation to benefit from the exculpation protections, it will require board and generally stockholder approval to amend the company’s certificate of incorporation. The protections provided under the adopted amendments are limited and only protect corporate officers from direct claims by stockholders. Unlike the provision for directors, the amendments do not permit exculpation from derivative claims brought by, or in the right of, the corporation. This means corporate officers are still subject to personal liability for monetary damages arising out of breach of fiduciary duty claims brought by the corporation or a derivative suit brought by stockholders. Similar to the exculpation provisions applicable to corporate directors, corporate officers also remain subject to personal liability for breaches of the fiduciary duty of loyalty, as well as for acts or omissions not in good faith, which involve intentional misconduct or knowing violation of law or involving receipt of an improper personal benefit. The exculpation protections provided under the newly amended DGCL are only applicable to certain corporate officers. The amendments limit applicability to only those officers who have consented to service of process under Delaware’s long-arm statute (as described in 10 Del. C. § 3114(b)), as well as a corporation’s president, CEO, CFO, COO, chief legal officer, controller, treasurer, chief accounting officer and other named executives in SEC filings. Despite the availability of this expanded protection, boards and stockholders will need to carefully consider the implications of exculpating corporate officers from monetary damages arising out of the duty of care before adopting a charter amendment. While such provisions may provide protection from certain stockholder litigation, the duty of care is a very important protection for stockholders requiring that officers and directors exercise business judgment in good faith and in a reasonably prudent manner when acting on behalf of the corporation in a manner that they believe is in the best interests of the corporation and its stockholders. When Sec. 102(b)(7) was originally added to the DGCL, it was in response to a 1985 Delaware Supreme Court decision that held directors of a Delaware corporation liable for a multi-million dollar damage award for violating the duty of care in connection with the approval of a merger hastily without considering all of the relevant material information. As a result, there was concern that qualified individuals would be unwilling to serve as directors of Delaware corporations, making it impossible to find independent directors and that D&O premiums would skyrocket. The same considerations do not necessarily apply to officers, although corporations routinely extend indemnification protection to the extent permitted by law to the most senior officers. Of course, the same D&O implications apply in the case of officers as stockholder litigation proliferates. Delegation of Authority to Grant Stock Options and other Rights to Acquire Stock The Aug. 1, 2022, amendments to the DGCL provide for the delegation to corporate officers of expanded rights with respect to the grant and modification of stock options and other grants of rights to acquire stock. The amendments permit a board of directors to delegate authority to an officer to issue stock2, sell treasury shares3 and issue rights or options to acquire stock.4The changes are part of a trend within recent amendments to the DGCL which have increasingly permitted boards and board committees to delegate authority to officers with respect to the issuance of stock outright, subject to certain limiting parameters set by the board. Previously, boards had broad rights to delegate authority to officers to issue stock in the company, but this broad delegation authority did not extend to stock options and other rights to acquire stock which were limited. In particular, a board could delegate authority to officers to select the other officers or employees who would receive grants of stock options and the size of their awards so long as the board or board committee set a numerical “ceiling” within which such grants could be made and approved the terms of the awards. These recent changes now enhance the delegated authority by expanding the group of potential recipients of such grants to others besides corporate officers and employees and providing the ability to vary the terms of the grants. However, the amendments prohibit any delegated person or entity from issuance of stock, options or rights to themselves. The amendments also permit the issuance of rights or options in book entry or electronic form. These changes should provide corporations with increased flexibility in designing or amending equity award programs. Importantly, any corporate instrument authorizing such a delegation to a corporate officer must contain language which sets parameters for the limit of an officer’s authority. Specifically, the instrument delegating such authority to the officer must specify: (1) the maximum number of shares, rights or options that can be granted; (2) the time period during which the issuance of shares, rights or options may take place and (3) the minimum amount of consideration to be received for the issuance of shares, rights or options. Any provision in a corporate resolution delegating authority with respect to the grant of stock options or other rights to acquire equity may be made dependent on facts ascertainable outside the resolution, provided the manner in which such facts shall operate is clearly and expressly set forth in such resolution.5 Other Amendments While the above are the most noteworthy of the recent amendments, the amendments also lowered the stockholder approval threshold required to convert a Delaware corporation to a foreign corporation or any other entity from unanimous approval to majority approval. Because stockholder approval of conversion no longer must be unanimous, non-consenting stockholders will now have appraisal rights in connection with a conversion.6 This amendment aligns the authorization requirements for conversion of a Delaware corporation with that for other fundamental transactions such as mergers. It is worth noting that the amendments also state that for existing corporations formed before Aug. 1, 2022, and in any applicable voting agreement relating to mergers and other similar transactions in effect before Aug. 1, 2022, those provisions will automatically be deemed to apply to conversions unless expressly provided otherwise. Therefore, corporations should consider reviewing and amending their existing governing documents (and stockholder agreements) if they do not want these provisions to apply automatically to conversions. Somewhat inconsistently, for newly formed corporations after Aug. 1, 2022, conversions will not automatically be deemed to be included in provisions relating to mergers and similar significant transactions, and conversions must be separately addressed in the certificate of incorporation and other documents impacting stockholder voting.7 Further, certain changes were made to the appraisal statute, including an amendment8 that allows a beneficial owner of stock to demand appraisal directly instead of relying on the record holder and eliminating appraisal rights in a merger, consolidation or conversion authorized by a plan of domestication under Section 388. There were also several other administrative amendments to the statute, including changes to the requirements regarding the availability of stockholder lists for examination at meetings and notices of adjournments of meetings which may require review and amendment of a corporation’s bylaws in order to implement. Conclusion All of the above changes should be considered by both those newly forming Delaware corporations as well as existing corporations who may want to review their certificates of incorporation and bylaws in light of the changes. If a public corporation is considering any such changes based on the recent amendments, it should also consider whether any changes need to be made to any SEC filings that may describe matters such as exculpation or indemnification of officers. The changes relating to delegation of authority should also prompt a review of existing equity plans and practices, keeping in mind that equity compensation is also subject to other statutory limitations, including tax considerations. ___________ 1 See 8 Del. C. § 102(b)(7) (expanding exculpation protections to senior officers). 2 See 8 Del. C. § 152. 3 See 8 Del. C. § 153. 4 See 8 Del. C. § 157. 5 See 8 Del. C. § 157(d). 6 See 8 Del. C. § 262. 7 See 8 Del. C. § 266. 8 See 8 Del. C. § 262.