On August 7, 2022, the Senate voted 51-50 to pass the Inflation Reduction Act of 2022 (the “Act”), which broadly addresses climate change, taxes, health care, and inflation. The action sends the measure to the House of Representatives for a vote as early as Friday of this week. The House is expected to pass the $430 billion Act without amendments and send it to the White House for President Biden’s signature. Federal agencies then would implement the law and promulgate rules as to the deployment of the funding.
Our previous alert analyzed proposed changes to U.S. tax law that were in an earlier draft of the legislation that was released on July 27, 2022. Consistent with the prior version of the legislation, the Senate-passed version of the Act includes a 15-percent corporate minimum tax, provides multi-year IRS funding with a dramatic increase in funding for tax enforcement, and extends and expands tax incentives for clean energy.
Notably, the Senate-passed version of the Act differs from the prior draft legislation in certain major respects, including that the Act (1) does not change existing law regarding the tax treatment of carried interests, (2) adds a one-percent excise tax on certain corporate stock buybacks, and (3) eases some of the effects of the new corporate minimum tax by, for example, taking into account certain depreciation and amortization deductions. A change relating to the corporate minimum tax in the draft legislation that may have adversely affected private equity funds was rejected.
Excise Tax on Stock Buybacks
As noted above, the Act introduces a one-percent excise tax on certain corporate stock buybacks. The proposal for the excise tax is identical to the excise tax that was proposed as part of the Build Back Better Act (H.R. 5376) at the end of 2021.
More specifically, the Act would impose a non-deductible one-percent excise tax on the fair market value of certain stock that is “repurchased” during the taxable year by a publicly traded U.S. corporation or acquired by certain of its subsidiaries. The taxable amount is reduced by the fair market value of certain issuances of stock throughout the year. On August 9, 2022, the Joint Committee on Taxation released its revenue estimate projecting that the excise tax will raise more than $73 billion in revenue over ten years.
A special rule would impose the tax on a publicly traded non-U.S. corporation that owns a U.S. entity that expatriated (as determined for U.S. tax purposes) after September 20, 2021. Another special rule would tax certain majority-owned U.S. subsidiaries in connection with certain acquisitions of the stock of their publicly traded non-U.S. parent corporations. (A publicly traded non-U.S. corporation’s non-U.S. subsidiary that undertakes such an acquisition generally would not be subject to the tax, except in the case of a subsidiary non-U.S. partnership with a U.S. entity as a direct or indirect partner.[1])
A “repurchase” includes a “redemption” (generally, any acquisition by a corporation of its stock in exchange for cash or property other than the corporation’s own stock or stock rights) and any other “economically similar” transaction, as determined by the Treasury. Certain repurchases, however, would be specifically excepted from the excise tax. Those include: (1) a repurchase to the extent it is part of a tax-free reorganization and no gain or loss is recognized on the repurchase by the shareholder “by reason of” the reorganization, (2) repurchases followed by a contribution of the repurchased stock (or stock with an equivalent value) to an employee pension plan, employee stock ownership plan, or similar plan, (3) stock repurchases the total value of which does not exceed $1 million during the taxable year, (4) repurchases by a dealer in securities in the ordinary course of business, (5) repurchases by regulated investment companies or real estate investment trusts, and (6) a repurchase that is treated as a dividend for U.S. federal income tax purposes.
The excise tax has a potentially broad reach. For example, certain split-off transactions and leveraged acquisitions that constitute redemptions for U.S. federal income tax purposes may be “repurchases.” Further, the definition of “repurchase” includes transactions that are “economically similar” to redemptions (as determined by the Treasury), so it is possible that a wide range of other corporate transactions that would not constitute stock buybacks in the traditional sense may be subject to the excise tax.
The excise tax would apply to “repurchases” occurring after December 31, 2022.
Revisions to the Corporate Alternative Minimum Tax
In the course of Senate negotiations, one significant change was made to the Act’s 15-percent corporate alternative minimum tax and one potentially significant change was rejected:
- In a taxpayer-favorable development, the Act’s calculation of adjusted financial statement income was modified to allow depreciation generally (and amortization deductions for certain wireless spectrum specifically) to be computed using U.S. federal tax accounting methods, conventions, and class lives in lieu of corresponding financial statement principles. This modification will be beneficial to participants in industries that tend to make significant investments in property, plant and equipment (such as manufacturers). We also anticipate it will be a welcome development for sponsors of and investors in clean energy projects (which are further incentivized in the Act as described in our previous alert) because depreciation is one of the key tax attributes that is monetized by a tax equity investor in connection with a clean energy project financing transaction.
- A change to the rules for aggregating entities in applying the minimum tax’s $1 billion income threshold (previously proposed as part of the Build Back Better Act and incorporated in a revised draft of the legislation) that would have grouped together additional entities (including, notably, private equity funds) was rejected via an amendment from Senator Thune shortly before passage of the Act.[2] It is hoped that additional clarification or confirmation in the form of committee reports or legislative history will be forthcoming to give guidance and instruction to the IRS and Treasury regarding the import of this aspect of the Act.
- The Joint Committee on Taxation has projected that the minimum tax will raise more than $222 billion in revenue over ten years, a decline from the more than $318 billion in revenue that was projected to be raised from a similar provision included in the Build Back Better Act at the end of 2021.
Partnership Issues and Other Guidance Needs
Significant guidance from the IRS and Treasury will be necessary to administer the tax law changes included in the Act, in particular with respect to partnerships. For example, the new 15-percent corporate alternative minimum tax requires a determination of an applicable corporation’s “distributive share” of a partnership’s “adjusted financial statement income” without providing guidance as to how that “share” is to be determined. In addition, the excise tax on corporate stock buybacks applies to stock acquired by a partnership that is majority-owned “directly or indirectly” by the corporation, but the statutory provision itself does not include any further rules for determining such ownership. Further, the new tax credit transfer regime has a rule addressing a transfer of an eligible credit by a partnership, but no rules for the subsequent treatment of an eligible credit transferred to a partnership.
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[1] The intended interaction of these rules with the “May Company” regulations of Treas. Reg. § 1.337(d)-3 is not entirely clear.
[2] In connection with this amendment, the disallowance of excess of business losses by noncorporate taxpayers under section 461(l) was ultimately extended for two years (through 2028).
This alert was prepared by Josiah J. Bethards, Michael Q. Cannon, Michael J. Desmond, Matthew J. Donnelly, Pamela Lawrence Endreny, Bree Gong, Brian Hamano, Roscoe Jones Jr., Jamie Lassiter, and Eric B. Sloan.
Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Tax, Global Tax Controversy and Litigation, or Public Policy practice groups:
Tax Group:
Dora Arash – Los Angeles (+1 213-229-7134, darash@gibsondunn.com)
Sandy Bhogal – London (+44 (0) 20 7071 4266, sbhogal@gibsondunn.com)
Michael Q. Cannon – Dallas (+1 214-698-3232, mcannon@gibsondunn.com)
Hanna Chalhoub – Dubai (+971 (0) 4 318 4634, hchalhoub@gibsondunn.com)
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213-229-7531, mdesmond@gibsondunn.com)
Anne Devereaux* – Los Angeles (+1 213-229-7616, adevereaux@gibsondunn.com)
Matt Donnelly – Washington, D.C. (+1 202-887-3567, mjdonnelly@gibsondunn.com)
Pamela Lawrence Endreny – New York (+1 212-351-2474, pendreny@gibsondunn.com)
Benjamin Fryer – London (+44 (0) 20 7071 4232, bfryer@gibsondunn.com)
Brian R. Hamano – Los Angeles (+1 310-551-8805, bhamano@gibsondunn.com)
Kathryn A. Kelly – New York (+1 212-351-3876, kkelly@gibsondunn.com)
Brian W. Kniesly – New York (+1 212-351-2379, bkniesly@gibsondunn.com)
Loren Lembo – New York (+1 212-351-3986, llembo@gibsondunn.com)
Jennifer Sabin – New York (+1 212-351-5208, jsabin@gibsondunn.com)
Eric B. Sloan – Co-Chair, New York (+1 212-351-2340, esloan@gibsondunn.com)
Jeffrey M. Trinklein – London/New York (+44 (0) 20 7071 4224 /+1 212-351-2344), jtrinklein@gibsondunn.com)
John-Paul Vojtisek – New York (+1 212-351-2320, jvojtisek@gibsondunn.com)
Edward S. Wei – New York (+1 212-351-3925, ewei@gibsondunn.com)
Lorna Wilson – Los Angeles (+1 213-229-7547, lwilson@gibsondunn.com)
Daniel A. Zygielbaum – Washington, D.C. (+1 202-887-3768, dzygielbaum@gibsondunn.com)
Global Tax Controversy and Litigation Group:
Michael J. Desmond – Co-Chair, Los Angeles/Washington, D.C. (+1 213-229-7531, mdesmond@gibsondunn.com)
Saul Mezei – Washington, D.C. (+1 202-955-8693, smezei@gibsondunn.com)
Sanford W. Stark – Co-Chair, Washington, D.C. (+1 202-887-3650, sstark@gibsondunn.com)
C. Terrell Ussing – Washington, D.C. (+1 202-887-3612, tussing@gibsondunn.com)
Public Policy Group:
Michael D. Bopp – Co-Chair, Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)
Roscoe Jones, Jr. – Co-Chair, Washington, D.C. (+1 202-887-3530, rjones@gibsondunn.com)
* Anne Devereaux is an of counsel working in the firm’s Los Angeles office who is admitted only in Washington, D.C.; Bree Gong is an associate working in the firm’s Palo Alto office who is admitted only in New York; and Jamie Lassiter is an associate working in the firm’s Los Angeles office who is admitted only in New York and Texas.
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
This Client Alert provides an update on shareholder activism activity involving NYSE- and Nasdaq-listed companies with equity market capitalizations in excess of $1 billion and below $100 billion (as of the last date of trading in 2021) during 2021.
Announced shareholder activist activity increased relative to 2020. The number of public activist actions (76 vs. 63), activist investors taking actions (48 vs. 41), and companies targeted by such actions (69 vs. 55) each increased. Such levels of activism are comparable to those found prior to the market disruption caused by the COVID-19 pandemic, as reflected in public activist actions in 2019 (76 vs. 75), activist investors taking actions (48 vs. 49), and companies targeted by such actions (69 vs. 64). The period spanning January 1, 2021 to December 31, 2021 also saw several campaigns by multiple activists targeting a single company, such as the campaigns involving Kohl’s Corporation that included activity by 4010 Partners, Macellum Advisors, Ancora Advisors and Legion Partners Asset Management; Adtalem Global Education that included activity by Engine Capital and Hawk Ridge Capital; and Bottomline Technologies that included activity by Clearfield Capital Management and Sachem Head Capital Management. In addition, certain activists launched multiple campaigns during 2021, including Carl Icahn, Elliott Investment Management, JANA Partners, Land & Buildings and Starboard Value. Indeed, each of these investors launched four or more campaigns in 2021 and collectively accounted for 20 out of the 76 activist actions reviewed, or 26% in total. Proxy solicitation occurred in 18% of campaigns in 2021, relative to 17% in 2020. These figures represent modest declines relative to 2019, in which proxy materials were filed in approximately 30% of activist campaigns for the entire year.
By the Numbers—2021 Public Activism Trends
*Study covers selected activist campaigns involving NYSE- and Nasdaq-traded companies with equity market capitalizations of greater than $1 billion as of December 31, 2021 (unless company is no longer listed).
Additional statistical analyses may be found in the complete Activism Update linked below.
Notwithstanding the increase in activism levels, the rationales for activist campaigns during 2021 were generally consistent with those undertaken in 2020. Over both periods, board composition and business strategy represented leading rationales animating shareholder activism campaigns, representing 58% of rationales in 2021 and 51% of rationales in 2020. M&A (which includes advocacy for or against spin-offs, acquisitions and sales) remained important as well; the frequency with which M&A animated activist campaigns was 19% in both 2021 and 2020. At the opposite end of the spectrum, management changes, return of capital and control remained the most infrequently cited rationales for activist campaigns, as was also the case in 2020. (Note that the above-referenced percentages total over 100%, as certain activist campaigns had multiple rationales.)
Seventeen settlement agreements pertaining to shareholder activism activity were filed during 2021, which is consistent with pre-pandemic levels of similar activity (22 agreements filed in 2019 and 30 agreements filed in 2018, as compared to eight agreements filed in 2020). Those settlement agreements that were filed had many of the same features noted in prior reviews, including voting agreements and standstill periods as well as non-disparagement covenants and minimum- and/or maximum-share ownership covenants. Expense reimbursement provisions were included in half of those agreements reviewed, which is consistent with historical trends. We delve further into the data and the details in the latter half of this Client Alert.
We hope you find Gibson Dunn’s 2021 Annual Activism Update informative. If you have any questions, please reach out to a member of your Gibson Dunn team.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this publication. For further information, please contact the Gibson Dunn lawyer with whom you usually work, or any of the following practice leaders, members, or authors:
Barbara L. Becker (+1 212.351.4062, bbecker@gibsondunn.com)
Dennis J. Friedman (+1 212.351.3900, dfriedman@gibsondunn.com)
Richard J. Birns (+1 212.351.4032, rbirns@gibsondunn.com)
Andrew Kaplan (+1 212.351.4064, akaplan@gibsondunn.com)
Daniel S. Alterbaum (+1 212.351.4084, dalterbaum@gibsondunn.com)
Joey Herman (+1 212.351.2402, jherman@gibsondunn.com)Mergers and Acquisitions Group:
Robert B. Little – Dallas (+1 214-698-3260, rlittle@gibsondunn.com)
Saee Muzumdar – New York (+1 212-351-3966, smuzumdar@gibsondunn.com)Securities Regulation and Corporate Governance Group:
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Brian J. Lane – Washington, D.C. (+1 202.887.3646, blane@gibsondunn.com)
James J. Moloney – Orange County, CA (+1 949.451.4343, jmoloney@gibsondunn.com)
Ronald O. Mueller – Washington, D.C. (+1 202.955.8671, rmueller@gibsondunn.com)
Lori Zyskowski – New York (+1 212.351.2309, lzyskowski@gibsondunn.com)© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On July 29, 2022, the New York Department of Financial Services (“DFS”) released Draft Amendments to its Part 500 Cybersecurity Rules; the Draft Amendments would update the Cybersecurity Rules in a manner consistent with the “catalytic” role it took in 2017 as the first state to codify certain cybersecurity best practices and guidance into explicit regulatory requirements for covered entities. The cybersecurity landscape has evolved in the past five years, and the Draft Amendments demonstrate that DFS continues to take a forward-leaning role in strengthening cybersecurity practices. The Draft Amendments propose increased expectations for senior leaders, heightened technology requirements, an expanded set of events covered under the mandatory 72-hour notification requirements, a new 24-hour reporting requirement for ransom payments and a 30-day submission of defenses, significant new requirements for business continuity and disaster recovery, and heightened annual certification and assessment requirements. Notably, the amended regulations propose a new class comprising larger entities which will be subject to increased obligations for their cybersecurity programs. Even the definition of a cybersecurity program has been expanded to include coverage of nonpublic information stored on those information systems—a substantial increase in covered information that will have significant downstream effects on reporting and certification requirements. The cybersecurity regulations by DFS were first released in March 2017 and went into full effect in March 2019, as previewed in our prior alert and subsequently discussed in our agency round-ups (2020 & 2021).
Key provisions of the Draft Amendments are highlighted below.
- More Stringent Notification Obligations
The Draft Amendments establish additional requirements on top of DFS’s existing 72-hour notification requirements, including:
- Requiring notification to DFS within 72 hours of unauthorized access to privileged accounts or the deployment of ransomware within a material part of the company’s information systems. These are in addition to the existing requirements to notify DFS within 72 hours of any cybersecurity events that require notice to a supervisory body or that have a reasonable likelihood of materially harming a material part of the company’s normal operations. Notably, these newly proposed requirements would significantly lower the notification threshold, as they could be triggered before any sign of actual data compromise or exfiltration.
- A new 24-hour notification obligation in the event a ransom payment is made, and a 30-day requirement to provide a written description of why the payment was necessary, alternatives to payment that were considered, and all sanctions diligence conducted.
- Heightened Requirements for Larger “Class A” Companies
Adhering to the mantra “with great data comes great responsibility,” the Draft Amendments also increase cybersecurity obligations for a newly defined class of larger entities, which are under DFS’s authority. These “Class A” companies are defined as entities with over 2,000 employees or over $1 billion in gross annual revenue average over the last three years from all business operations of the company and its affiliates. Under the Draft Amendments, Class A companies are required to comply with heightened technical requirements as well as risk assessments and audits. They must:
- Conduct weekly systematic scans or reviews reasonably designed to identify publicly known cybersecurity vulnerabilities, and document and report any material gaps in testing to the board and senior management;
- Implement an endpoint detection and response solution to monitor anomalous activity and a solution that centralizes logging and security event alerting;
- Monitor access activity and implement a password vaulting solution for privileged accounts and an automated method of blocking commonly used passwords;
- Conduct an annual, independent audit of their cybersecurity programs; and
- Use external experts to conduct a risk assessment at least once every three years.
- Increased Obligations on Company Governing Bodies
The original Part 500 regulations imposed a number of new obligations on companies’ governing bodies, including the need for a chief information security officer (“CISO”) or equivalent personnel, detailed cybersecurity reporting to the board, and written policies approved by a senior officer. The Draft Amendments enhance in a very meaningful way many of the Part 500 governance requirements, further indicating how important DFS views strong governance in the quest for effective cybersecurity. The Draft Amendments include obligations:
- To ensure the boards of covered entities have sufficient expertise and knowledge, or be advised by persons with sufficient expertise and knowledge, to exercise effective oversight of cyber risk;
- To provide the CISO with adequate independence and authority to appropriately manage cyber risks;
- That the CISO will provide the board with additional detailed annual reporting on plans for remediating issues and material cybersecurity issues or events;
- That the CISO will annually review the feasibility of encryption and the effectiveness of any compensating controls for any unencrypted nonpublic information;
- That covered entities’ cybersecurity policies must be approved by the board on an annual basis; and
- That add significantly to the annual certification requirements, requiring covered entities to not only certify to their compliance or acknowledge any noncompliance, but also provide sufficient data and documentation to accurately determine and demonstrate compliance, and have such certification or acknowledgment of noncompliance be signed by both the CEO and the CISO.
The Draft Amendments also provide an option for covered entities to submit written acknowledgement that, for the prior calendar year, they did not fully comply with their cybersecurity obligations. Covered entities who submit this acknowledgment will be required to identify all the provisions of the compliance rules that were not followed, describe the nature and extent of the noncompliance, and identify all the areas, systems, and processes that require material improvement, updating, or redesign.
These additional reporting requirements are substantial, and would greatly increase the burden on CEOs, CISOs, and other personnel involved in the preparation of these annual certifications or acknowledgements.
- Expanded Requirements for Operational Resilience and Incident Response
The Draft Amendments expand measures directed at “operational resilience” beyond incident response plans, requiring covered entities to also have written plans for business continuity and disaster recovery (“BCDR”). Notably, the original Part 500 cybersecurity regulations were the first of its kind to stipulate detailed requirements for cybersecurity incident response plans. Again, DFS is breaking similar ground with BCDR plans, requiring proactive measures to mitigate disruptive events by, at a minimum:
- Identifying business components essential to continued operations (documents, data, facilities, personnel, and competencies) and personnel responsible for implementation of the BCDR plans;
- Preparing communications plans to ensure continuity of communications with various stakeholders (leadership, employees, third parties, regulatory authorities, others essential to continuity);
- Maintaining procedures for the back-up of infrastructure and data; and
- Identifying third parties necessary to continued operations.
Furthermore, DFS has proposed a significant revision to its requirements for incident response plans, requiring that they differentiate based on incident type (e.g., ransomware), while continuing to require that such plans address the previously enumerated areas (e.g., internal response processes; incident response plan goals; definitions of clear roles, responsibilities and levels of decision-making authority; communications and information sharing; identification of remediation requirements; documentation and reporting, etc.) as well as the newly added requirement to address recovery from backups.
Under the Draft Amendments, relevant personnel must receive copies of the incident response plan and BCDR plan, copies must be maintained offsite, and all personnel involved in implementation of the plans must receive appropriate training. In addition, covered entities are required to conduct incident response and BCDR exercises.
- Enhanced Technology and Policy Requirements
The Draft Amendments strengthen technical requirements and written policy requirements for covered entities, codifying certain best practices in key cyber risk areas. The Draft Amendments specifically:
- Clarify the definition of “privileged accounts” as covering any account that can be used to perform security-relevant functions that ordinary users are not authorized to perform, or affect a material change to technical or business operations. Under the proposals, privileged accounts must:
- Have multi-factor authentication (with exceptions for certain service accounts); and
- Be limited in both number and access functions to only those necessary to perform the user’s job;
- Be limited in use to only when performing functions requiring their use of such access;
- Require stricter access management, including periodic review of all user access privileges and removal of accounts and access that are no longer necessary, as well as disabling or securely configuring all protocols that permit remote control of devices;
- Require that emails are monitored and filtered to block malicious content from reaching authorized users;
- Mandate penetration testing be conducted by an independent party at least annually, and also adjust the required frequency of vulnerability assessments from bi-annually to “regular[ly],” with Class A companies conducting weekly scans as noted above;
- Require the use of strong, unique passwords—and Class A companies have additional requirements, as discussed above, relating to passwords and monitoring of access activity;
- Require multi-factor authentication for remote access to the network and enterprise and third-party applications that access nonpublic information; and
- Mandate that covered entities must maintain backups isolated from network connections.
The Draft Amendments also contain new measures for asset inventory and management, which may cost companies significant time and resources to implement. These measures require all covered entities to:
- Implement written policies and procedures to ensure a complete and documented asset inventory for all information systems and their components (e.g., hardware, operating systems, applications, infrastructure devices, APIs, and cloud services); and
- Have asset inventory that must, at a minimum, track each asset’s key information (e.g., owner, location, classification or sensitivity, support expiration date, and recovery time requirements).
The Draft Amendments further require additional written cybersecurity policies to include procedures for end of life management, remote access, and vulnerability and patch management. Notably, despite the prominence of recent supply chain cybersecurity attacks, there are not substantive changes to the Part 500 requirements relating to third-party service providers.
- Increased Requirements for Risk Assessments, Impact Assessments
The Draft Amendments further expand the requirements for and definition of “risk assessment” to make clear that they must be:
- Tailored to consider the “specific circumstances” of the covered entity, including size, staffing, governance, businesses, services, products, operations, customers, counterparties, service providers, vendors, other relations and their locations, as well as the geographies and locations of its operations and business relations; and
- Updated at least annually.
While DFS has not changed the core cybersecurity functions that must be covered by the risk assessment per se, covered entities will need to ensure that it covers the broadened scope of “cybersecurity program” under the Draft Amendments (nonpublic information stored on the covered entity’s information systems). Furthermore, another substantial proposal is the requirement that covered entities must conduct impact assessments whenever a change in the business or technology causes a material change to the covered entity’s cyber risk.
- Clarified Enforcement Considerations
Finally, the Draft Amendments contain two significant clarifications regarding the enforcement of the Part 500 Cybersecurity Rules:
- A violation occurs by committing any act prohibited by the regulations or failing to satisfy a required obligation. This includes the failure to comply for more than 24 hours with any part of the regulations or the failure to prevent unauthorized access to nonpublic information due to noncompliance with the regulations.
- DFS may consider certain aggravating and mitigating factors when assessing the severity of penalties, including: cooperation, good faith, intentionality, prior violations, number or pattern of violations, gravity of violation, provision of false or misleading information, harm to customers, accuracy and timeliness of customer disclosures, participation of senior management, penalties by other regulators, and business size.
Next Steps
This report is not an exhaustive list of the changes contained in the Draft Amendments, but it provides a high-level overview of the impact of the Draft Amendments on the Part 500 Cybersecurity Rules, should they be adopted. These recent Draft Amendments will go through a short pre-proposal comments period, which ends on August 18, 2022. After official publication of the proposed amendments, there will be a 60-day comment period. Pending further revisions, most of the amendments would take effect 180 days after adoption, while some requirements—i.e., notification requirements and changes to annual notice of certification—would take effect on an expedited timeframe of 30 days after adoption. Other requirements (e.g., regarding access controls) would take effect a year after adoption.
These amendments signal DFS’s continued focus on ensuring the Part 500 Cybersecurity Rules continue to raise the regulatory bar on covered entities’ cybersecurity programs in an era of a rapidly evolving cyber threat landscape. While many of the Draft Amendments reflect the current state of best practice guidance, covered entities will need to intentionally review the Draft Amendments and ensure they are well-positioned from a governance, technology, and budgetary perspective to ensure compliance.
This alert was prepared by Alexander H. Southwell, Stephenie Gosnell Handler, Terry Wong, and Dustin Stonecipher*.
Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any member of the firm’s Privacy, Cybersecurity & Data Innovation practice group:
United States
Matthew Benjamin – New York (+1 212-351-4079, mbenjamin@gibsondunn.com)
Ryan T. Bergsieker – Denver (+1 303-298-5774, rbergsieker@gibsondunn.com)
S. Ashlie Beringer – Co-Chair, PCDI Practice, Palo Alto (+1 650-849-5327, aberinger@gibsondunn.com)
David P. Burns – Washington, D.C. (+1 202-887-3786, dburns@gibsondunn.com)
Cassandra L. Gaedt-Sheckter – Palo Alto (+1 650-849-5203, cgaedt-sheckter@gibsondunn.com)
Svetlana S. Gans – Washington, D.C. (+1 202-955-8657, sgans@gibsondunn.com)
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, shandler@gibsondunn.com)
Nicola T. Hanna – Los Angeles (+1 213-229-7269, nhanna@gibsondunn.com)
Howard S. Hogan – Washington, D.C. (+1 202-887-3640, hhogan@gibsondunn.com)
Robert K. Hur – Washington, D.C. (+1 202-887-3674, rhur@gibsondunn.com)
Kristin A. Linsley – San Francisco (+1 415-393-8395, klinsley@gibsondunn.com)
H. Mark Lyon – Palo Alto (+1 650-849-5307, mlyon@gibsondunn.com)
Vivek Mohan – Palo Alto (+1 650-849-5345, vmohan@gibsondunn.com)
Karl G. Nelson – Dallas (+1 214-698-3203, knelson@gibsondunn.com)
Ashley Rogers – Dallas (+1 214-698-3316, arogers@gibsondunn.com)
Alexander H. Southwell – Co-Chair, PCDI Practice, New York (+1 212-351-3981, asouthwell@gibsondunn.com)
Deborah L. Stein – Los Angeles (+1 213-229-7164, dstein@gibsondunn.com)
Eric D. Vandevelde – Los Angeles (+1 213-229-7186, evandevelde@gibsondunn.com)
Benjamin B. Wagner – Palo Alto (+1 650-849-5395, bwagner@gibsondunn.com)
Michael Li-Ming Wong – San Francisco/Palo Alto (+1 415-393-8333/+1 650-849-5393, mwong@gibsondunn.com)
Debra Wong Yang – Los Angeles (+1 213-229-7472, dwongyang@gibsondunn.com)
Europe
Ahmed Baladi – Co-Chair, PCDI Practice, Paris (+33 (0) 1 56 43 13 00, abaladi@gibsondunn.com)
James A. Cox – London (+44 (0) 20 7071 4250, jacox@gibsondunn.com)
Patrick Doris – London (+44 (0) 20 7071 4276, pdoris@gibsondunn.com)
Kai Gesing – Munich (+49 89 189 33-180, kgesing@gibsondunn.com)
Bernard Grinspan – Paris (+33 (0) 1 56 43 13 00, bgrinspan@gibsondunn.com)
Penny Madden – London (+44 (0) 20 7071 4226, pmadden@gibsondunn.com)
Michael Walther – Munich (+49 89 189 33-180, mwalther@gibsondunn.com)
Vera Lukic – Paris (+33 (0) 1 56 43 13 00, vlukic@gibsondunn.com)
Asia
Kelly Austin – Hong Kong (+852 2214 3788, kaustin@gibsondunn.com)
Connell O’Neill – Hong Kong (+852 2214 3812, coneill@gibsondunn.com)
Jai S. Pathak – Singapore (+65 6507 3683, jpathak@gibsondunn.com)
* Dustin Stonecipher is an associate working in the firm’s Washington, D.C. office who is admitted only in Maryland.
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
When the COVID 19 pandemic first hit European shores in early spring 2020, the German legislator was quick to introduce wide-reaching legislative reforms to protect the German business world from unwanted consequences of an economy struggling with unprecedented upheaval, the lock-down and the ensuing social strain.[1] One key element of the overall legal reform in March 2020 was the temporary derogation from the regular mandatory German-law requirement to file for insolvency immediately whenever a company is either illiquid (Zahlungsunfähigkeit) or over-indebted (Überschuldung). This derogation has now been extended in time for over-indebted companies, but restricted in scope for illiquid companies.
I. The Temporary Insolvency Law Reform in March 2020
At the time the German Act on the Temporary Suspension of the Insolvency Filing Obligation and Liability Limitation of Corporate Body in cases of Insolvency caused by the COVID-19 Pandemic (“Gesetz zur vorübergehenden Aussetzung der Insolvenzantragspflicht und zur Begrenzung der Organhaftung bei einer durch die COVID-19-Pandemie bedingten Insolvenz” – COVInsAG)[2] was introduced in March 2020, it was felt that the strict insolvency filing requirement that obliges management to file for insolvency without undue delay, but in any event no later than three weeks after such insolvency reason first occurs, would (i) place undue time pressures on companies to file for insolvency in situations where this short time period did not even allow management to canvass its financial or restructuring options or access to newly introduced state funding or other financing sources, (ii) result in a wave of insolvencies of otherwise healthy entities based purely on the traumatic impact of the pandemic and (iii) result in unwanted distortions of the market by failing to differentiate appropriately between businesses facing merely temporary cash-flow problems and genuinely moribund companies with long-standing challenges or issues.
In a nutshell and without going into all details, the interim reform of the German Insolvency Code (Insolvenzordnung, InsO) via the COVInsAG introduced a temporary suspension of the mandatory insolvency filing requirement until September 30, 2020 for both the insolvency reasons of illiquidity (Zahlungsunfähigkeit) and of over-indebtedness (Überschuldung) by way of a strong legal assumption that any such insolvency was caused by the pandemic if (i) the company in question was not yet illiquid on December 31, 2019 and (ii) could show that it would (still or again) be in a position to pay all of its liabilities when due on and after September 30, 2020.
This temporary exemption from having to file for insolvency was flanked by a number of other legislative tweaks to the Insolvency Code that privileged and protected a company’s continued trading during such time window against management liability risks and/or later contestation rights of the insolvency administrator in case the temporary crisis in the spring and summer of 2020 would ultimately result in a later insolvency, after all. Access to new financing was similarly privileged in this time window when the company could show that it traded under the protection of the COVID 19 exemption from the regular insolvency filing requirement.
Finally, the COVInsAG also contained a clause that allowed an extension of this protective time window beyond September 30, 2020 up to the maximum point of March 31, 2021 by way of separate legislative act.
II. The Modified Extension Adopted on September 17, 2020
While an extension of the temporary suspension of the filing requirement was consistently deemed likely by insolvency experts and in political cycles, Germany has since moved beyond the initial lock-down and has mostly opened up the country for trading again. It has also become apparent that, in particular, a continued blanket derogation from the mandatory filing requirement for companies facing severe cash-flow problems to the point of illiquidity (i) would often only delay the inevitable and (ii) create an unwanted cluster of many insolvency proceedings which are ultimately all filed for at the same time when the suspension comes to an end, rather than a steady and progressive cleansing of the market by gradually removing companies that have failed to recover from the pandemic in a reasonably short period of time.
As a consequence, Germany has chosen not simply to extend the current provisions in unchanged form, but rather has significantly modified the wording of the COVInsAG to address the above concerns.
- Over-Indebtedness
In particular, as of October 1, 2020 and until December 31, 2020, a continued derogation from the immediate obligation to file for insolvency henceforth only applies to companies which otherwise would only file for insolvency due to over-indebtedness (Überschuldung) but which are not also illiquid. Such companies remain protected from having to file for insolvency based on the above-described rules until December 31, 2020, if (i) they were not already illiquid by December 31, 2019 and will not be illiquid after September 30, 2020 and thereafter.
Unlike illiquid companies, it was felt that companies which are over-indebted, i.e. (i) whose assets based on specific insolvency-driven valuation rules are not sufficient to cover their liabilities and (ii) which do not currently have a positive continuation prognosis (positive Fortführungsprognose), deserve a further grace period during which they may address their underlying structural issues, provided they do not enter illiquidity during this time window.
This extension until year end for over-indebted companies also addresses the often-voiced concerns that the uncertain future effects of the pandemic on a company’s medium-term prospects currently do not allow for a meaningful continuation prognosis which by general consensus has to cover the liquidity situation over the next 12 to 24 months.
- Illiquidity
This new restriction of the interim derogation from the filing requirement to over-indebtedness only, in turn, means that companies that cannot pay their liabilities when they fall due on September 30, 2020 (and beyond) and, therefore, are illiquid under German insolvency law terms, may no longer justify such financial distress by claiming it is caused by the pandemic. Instead, they will now be obliged to file for insolvency based on illiquidity once the initial protection accorded to them by the March 2020 rules runs out at the end of September 30, 2020.
With it being mid-September 2020 already, this will give the management of any entity facing serious current cash-flow problems only another two weeks to either remedy such cash flow problems and restore full solvency or file for insolvency on or shortly after October 1, 2020 due to their illiquidity at that point in time.
- Consequential Issues
The new, changed wording of the COVInsAG consequently restricts the other privileges connected with the temporary exemption from the filing requirement, i.e. that companies are permitted to keep trading during the extended time-window with certain protections against subsequent insolvency contestation rights, personal liability derogations or privileges and simplified access to new external or internal restructuring financing or loans, only to over-indebted companies. For them, these additional rules, which they may have already become accustomed to in the period between March 2020 and September 30, 2020, are simply extended until December 31, 2020.
III. Immediate Outlook
This law reform is of utmost importance for the management and the shareholders of any German entities that are currently in significant financial distress. The ongoing, periodic monitoring of their own financial position will need to determine in an extremely short time-frame whether or not the respective company is either illiquid or over-indebted as of September 30, 2020. If necessary such analysis should be firmed up by involving external advice or restructuring experts.
If the company is found to be over-indebted but not illiquid, the focus of any future turn-around must be December 31, 2020, i.e. the continued applicability of the COVInsAG rules may continue to provide some respite until then. If the company is found to be illiquid, the remaining time until September 30, 2020 must be used productively to either restore future liquidity via external or internal funding in the shortness of the available time or the filing for insolvency in early October 2020 becomes inevitable and should be prepared.
Managing directors of illiquid companies that do not file for insolvency without undue delay, but continue trading regardless of the insolvency reason, will again face the twin risks of personal civil and criminal liability based on a delayed or omitted filing. They and their trading partners and creditors, furthermore, face the full power of the far-reaching array of insolvency contestation rights (Insolvenzanfechtungsrechte) for a subsequent insolvency administrator of any measures now taken outside of the protective force of the COVInsAG interim rules.
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[1] In this context, see our earlier general COVID 19 alerts under: https://www.gibsondunn.com/whatever-it-takes-german-parliament-passes-far-reaching-legal-measures-in-response-to-the-covid-19-pandemic/ as well as under: https://www.gibsondunn.com/european-and-german-programs-counteracting-liquidity-shortfalls-and-relaxations-in-german-insolvency-law/.
[2] In this context, again see: https://www.gibsondunn.com/whatever-it-takes-german-parliament-passes-far-reaching-legal-measures-in-response-to-the-covid-19-pandemic/, under section II.2, as well as with further analysis in this regard https://www.gibsondunn.com/european-and-german-programs-counteracting-liquidity-shortfalls-and-relaxations-in-german-insolvency-law/.
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The following Gibson Dunn lawyers have prepared this client update: Lutz Englisch, Birgit Friedl, Marcus Geiss.
Gibson Dunn’s lawyers in the two German offices in Munich and Frankfurt are available to assist you in addressing any questions you may have regarding the issues discussed in this update.
For further information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, or the three authors:
Lutz Englisch (+49 89 189 33 150, lenglisch@gibsondunn.com)
Birgit Friedl (+49 89 189 33 122, bfriedl@gibsondunn.com)
Marcus Geiss (+49 89 189 33 115, mgeiss@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
- Introduction
Section 364(e) of the Bankruptcy Code provides important protections to lenders that provide post-bankruptcy financing (known as “DIP Financing”) to companies that are in chapter 11 bankruptcy cases (known as “Debtors”). By its plain terms, Section 364(e) provides a lender with material protections in the event that an order authorizing DIP Financing is later reversed or modified on appeal:
The reversal or modification on appeal of an authorization under this section to obtain credit or incur debt, or of a grant under this section of a priority or a lien, does not affect the validity of any debt so incurred, or any priority or lien so granted, to an entity that extended such credit in good faith … unless such authorization and the incurring of such debt, or the granting of such priority or lien, were stayed pending appeal.[1]
These protections have the practical effect of mooting appeals of orders authorizing DIP Financing where the order contained findings that the lender acted in good faith and the objecting party did not obtain a stay of the order pending appeal.
Many courts have held that Section 364(e)’s protections should be strictly limited to (a) lenders providing DIP Financing (“DIP Lenders”) because Section 364 only applies to DIP Financing and (b) preserving the validity of debt incurred and priorities and liens granted by a Debtor to secure DIP Financing.[2] According to one leading decision, “[t]he questions which arise under this section are: (1) whether the creditor attempting to challenge an authorization of credit obtains a stay pending an appeal; and (2) whether the lender or group of lenders acts in good faith in extending the new credit.”[3] In contrast to these other courts, on June 9, 2020, the Ninth Circuit took a more expansive view of the scope of Section 364(e) by applying that section’s protections to pre-bankruptcy lenders that did not provide any DIP Financing. See Official Committee of Unsecured Creditors of Verity Health System of California v. Verity Health System of California (“Verity”).[4] The Ninth Circuit applied Section 364(e) to moot an appeal seeking to revoke certain rights afforded to pre-bankruptcy lenders, even though (a) those rights were wholly unrelated to the validity of debt or any priority or lien granted to a DIP Lender, and (b) the DIP Financing had been paid in full.
- Background
The Debtors in Verity owned hospitals and other healthcare facilities. On August 31, 2018, the Debtors commenced chapter 11 bankruptcy cases in the United States Bankruptcy Court for the Central District of California. To sustain their operations during the chapter 11 cases, the Debtors sought bankruptcy court approval of DIP Financing. If approved, the DIP Lender would receive a “superpriority lien” on the Debtors’ assets pursuant to Section 364(d) of the Bankruptcy Code, giving the DIP Lender priority over the liens and claims held by the Debtors’ pre-bankruptcy lenders (the “Pre-Bankruptcy Lenders”). The DIP Lender was not one of the Pre-Bankruptcy Lenders, and the Pre-Bankruptcy Lenders provided no DIP Financing in the chapter 11 cases.
The DIP Lender conditioned the DIP Financing on the Pre-Bankruptcy Lenders’ agreement to subordinate their pre-bankruptcy liens and claims to the liens and claims that would secure the DIP Financing. The Pre-Bankruptcy Lenders conditioned that agreement upon, among other things, the bankruptcy court’s approval of waivers of (a) the Debtors’ right to surcharge the Pre-Bankruptcy Lenders’ collateral for the costs and expenses of preserving or disposing of such collateral, and (b) the court’s authority to exclude post-petition proceeds of the Debtors’ assets from the Pre-Bankruptcy Lenders’ collateral based on the “equities of the case,” pursuant to Sections 506(c) and 552(b) of the Bankruptcy Code, respectively. The Official Committee of Unsecured Creditors appointed in the Debtors’ chapter 11 cases (the “Committee”) objected on the grounds that the waivers would undermine the unsecured creditors’ prospect for a recovery by precluding their ability to obtain recoveries from the Pre-Bankruptcy Lenders. The bankruptcy court entered an order overruling the objection and approving the DIP Financing, and granted the waivers demanded by the Pre-Bankruptcy Lenders as necessary to induce the DIP Lender to extend DIP Financing. The bankruptcy court further held that the waivers constituted part of the “adequate protection” afforded pre-bankruptcy lenders under Bankruptcy Code Section 361, which is mandated by Section 364(d) to protect against any diminution in value of the Pre-Bankruptcy Lenders’ claims as a result of the DIP Financing.[5]
The Committee appealed the bankruptcy court’s order to the United States District Court for the Central District of California. Following Ninth Circuit precedent in In re Adams Apple, Inc., 829 F.2d 1484 (9th Cir. 1987), the district court explained that “if the court’s order ‘is within the purview of section 364,’ then the protections of § 364(e) apply.”[6] The district court concluded that the waivers were “a condition that was necessary to obtain credit” and the court was “not persuaded that it can cause the modification of a necessary term in the DIP Agreement without implicating § 364(e).”[7]
Having determined that Section 364(e) applied to the appeal, the district court dismissed the appeal as moot because neither of the exceptions to Section 364(e) applied; the Committee had not obtained a stay of the bankruptcy court’s order pending appeal or contended that the DIP Lender failed to act in “good faith.”[8] The Committee timely appealed to the Ninth Circuit.
III. The Ninth Circuit Affirms the Dismissal of the Appeal as Statutorily Moot Pursuant to Section 364(e) of the Bankruptcy Code
On appeal, the Committee argued that Section 364(e) did not cover the waivers because the statute’s plain language is limited to appeals regarding “any priority or lien … granted” to a DIP Lender. The Committee further argued that, whereas the purpose of Section 364(e) is to protect DIP Lenders in order to incentivize them to provide DIP Financing, the appeal could not adversely affect the DIP Lender because it had already been repaid in full and the Committee had stipulated that any ruling in the appeal would not affect the DIP Lender.
The Ninth Circuit affirmed the dismissal of the appeal as moot pursuant to Section 364(e). The court reasoned that, although the waivers were part of the Pre-Bankruptcy Lenders’ adequate protection package that is authorized under Section 361 of the Bankruptcy Code and is “not expressly included in § 364,” “the waivers are included in the Final DIP Order−a postpetition financing arrangement authorized under § 364.”[9] The court also relied on Ninth Circuit precedent holding that Section 364(e) “broadly protects any requirement or obligation that was part of a post-petition creditor’s agreement to finance.”[10] According to the Ninth Circuit, “the waivers were ‘part of a post-petition creditor’s agreement to finance’ and ‘helped to motivate [the DIP Lender’s] extension of credit’”[11] because (a) the DIP Lender conditioned the DIP Financing on the Pre-Bankruptcy Lenders’ consent to subordinate their claims and liens, and (b) the Pre-Bankruptcy Lenders conditioned that required consent on receipt of the waivers at issue in the appeal.
The Ninth Circuit also rejected the Committee’s argument that Section 364(e) was inapplicable because the DIP Lender had been repaid in full and the Committee stipulated that the appeal would not affect the DIP Lender. According to the Ninth Circuit, that argument “does not change the analysis” because “the [Pre-Bankruptcy Lenders] are also entitled to § 364(e)’s protections.”[12]
- Conclusion
Verity is noteworthy because it extended Section 364(e) beyond its plain language to bar any appeal regarding waivers that were approved for the benefit of pre-bankruptcy lenders that did not provide DIP Financing. It remains to be seen whether courts will follow Verity and apply the protections of Section 364(e) to non-DIP Lenders or if courts will seek to distinguish Verity by limiting Section 364(e)’s protections to the plain language of the statute.
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[1] 11 U.S.C. § 364(e) (emphasis added).
[2] See, e.g., Kham Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1355 (7th Cir. 1990) (holding that the purpose of § 364(e) is to assure a post-petition lender that extends credit in good faith reliance upon a financing order that it is entitled to the benefit of the order regardless of whether it is later determined to be legally or factually erroneous); Shapiro v. Saybrook Mfg. Co. (In re Saybrook Mfg. Co.), 963 F.2d 1490, 1493, 1495 (11th Cir. 1992) (held that Section 364(e) did not moot appeal regarding cross-collateralization of pre-petition debt because, “[b]y its own terms, section 364(e) is only applicable if the challenged lien or priority was authorized under section 364(d),” and section 364(d) “appl[ies] only to future—i.e., post-petition—extensions of credit” and “do[es] not authorize the granting of liens to secure pre-petition loans”); In re Joshua Slocum Ltd, 922 F.2d 1081, 1085 n.1 (3rd Cir. 1990) (“Section 364(e) concerns the validity of debts and liens.”); In re Main, Inc., 239 B.R. 59, 72 (Bankr. E.D. Pa. 1999) (held that Section 364(e) did not moot appeal from order permitting payment of debtor’s counsel because Section 364(e) “relates strictly to appeals from orders creating liens with preferential position or authorizing debt against the bankruptcy estate under 11 U.S.C. § 364(d)”).
[3] New York Life Ins. Co. v. Revco D.S., Inc. ( In re Revco D.S., Inc.), 901 F.2d 1359, 1364 (6th Cir. 1990).
[4] Case No. 19-55997 (9th Cir. June 9, 2020). This opinion was not published and, therefore, is not considered precedential even in the Ninth Circuit, though it can be cited to other courts in the circuit. See Ninth Circuit Local Rule 36-3.
[5] Section 361 provides that, “[w]hen adequate protection is required under section … 364 of this title of an interest of an entity in property, such adequate protection may be provided by … (1) requiring the trustee to make a cash payment or periodic cash payments to such entity … (2) providing to such entity an additional or replacement lien … or (3) granting such other relief … as will result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property.” 11 U.S.C. § 361. Section 364(d) provides that the bankruptcy court can approve a senior lien only if it finds that “there is adequate protection of the interest of the holder of the lien on the property of the estate on which such senior or equal lien is proposed to be granted.” 11 U.S.C. § 364(d).
[6] In re Verity Health System of California, Inc., Case No. 2:18-cv-10675-RGK, at 6 (C.D. Cal. Aug. 2, 2019) (quoting Adams Apple, 829 F.2d at 1488) (emphasis added).
[10] Id. at 2−3 (quoting Weinstein, Eisen & Weiss, LLP v. Gill (In re Cooper Commons, LLC), 430 F.3d 1215, 1219 (9th Cir. 2005)).
[11] Id. at 3 (quoting Cooper Commons, 430 F.3d at 1219−20) (bracketed material in original).
Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or any of the following:
Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@gibsondunn.com)
Douglas G. Levin – Orange County, CA (+1 949-451-4196, dlevin@gibsondunn.com)
Please also feel free to contact the following practice group leaders:
Business Restructuring and Reorganization Group:
David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com)
Scott J. Greenberg – New York (+1 212-351-5298, sgreenberg@gibsondunn.com)
Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@gibsondunn.com)
Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com)
Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On June 5, 2020, the President signed into law H.R. 7010, the Paycheck Protection Program Flexibility Act of 2020 (“PPP Flexibility Act”), which relaxes a number of requirements of and restrictions on the Paycheck Protection Program (“PPP”) established by the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) and clarified by subsequent guidance from the Small Business Administration (“SBA”) and the U.S. Department of the Treasury.[i] The bill passed the House by a vote of 417-1 and the Senate by voice vote, reflecting the strong bipartisan support behind the legislation. Below is a summary of the major changes to the PPP instituted by the PPP Flexibility Act.
Covered Period
The CARES Act established an eight week “covered period”—beginning on the loan origination date and ending no later than June 30, 2020. The portion of the PPP loan equal to the amount of loan proceeds used during this covered period for certain covered obligations, including payroll costs, mortgage interest payments, rent, and utilities, is eligible for forgiveness.
The PPP Flexibility Act extends the covered period to 24 weeks—ending no later than December 31, 2020. Borrowers who received a PPP loan prior to the PPP Flexibility Act may elect for the covered period to end 8 weeks after the origination of the loan. The PPP Flexibility Act does not address whether new borrowers can apply for forgiveness prior to the end of the 24 week covered period.
Covered Obligations
In the First Interim Final Rule published on April 1, 2020, SBA and the Department of Treasury stated that at least 75 percent of PPP loan proceeds “shall be used for payroll costs.” This ratio of payroll costs to other covered obligations was not in the CARES Act.
The PPP Flexibility Act codifies a new ratio: at least 60 percent of PPP loan proceeds “shall” be used for payroll costs in order to receive full loan forgiveness. Accordingly, up to 40 percent of loan proceeds may go to other covered obligations, including interest on covered mortgage payments, rent, and utilities.
The text of the law appears to create a cutoff precluding loan forgiveness for borrowers that spend less than 60% of PPP loan proceeds on payroll costs—as opposed to a reduction in the amount of forgiveness, as reflected in previous guidance. We expect additional guidance from SBA and the Department of Treasury to prevent this cutoff.
Loan Terms
For all PPP loan funds that are not forgiven, the CARES Act established that the outstanding balance will have a maximum maturity of 10 years and an interest rate not to exceed 4 percent. The First Interim Final Rule instituted a maturity of 2 years and an interest rate of 1 percent.
For new PPP loans originating on or after June 5, 2020, the PPP Flexibility Act extends the minimum maturity for outstanding balances to 5 years. Existing PPP loans are unaffected.
Rehiring Employees
Under the CARES Act, employers who reduced the compensation or number of full-time equivalent employees could eliminate those reductions by June 30, 2020, and avoid any reduction in loan forgiveness.
The PPP Flexibility Act extends the date to eliminate reductions to compensation or number of full-time equivalent employees to December 31, 2020.
Also, SBA and the Department of Treasury Frequently Asked Question No. 40 provided a safe harbor from the reduction in loan forgiveness with respect to laid-off employees who reject a borrower’s offer of re-employment. The FAQ states that the borrower must have made a good faith, written offer of rehire, and the borrower must document the former employee’s rejection of the offer.
The PPP Flexibility Act codifies this safe harbor, stating that loan forgiveness will not be reduced if the borrower can, in good faith, document an inability to rehire former employees or hire similarly qualified employees on or before December 31, 2020. The PPP Flexibility Act also provides a safe harbor for borrowers who cannot return to the same level of business activity at which the business was operating before February 15, 2020, due to compliance with standards for sanitation, social distancing, or any other worker or customer safety requirement related to COVID-19.
The PPP Flexibility Act does not articulate what “business activity” means or how it will be measured. We look forward to additional guidance clarifying this issue.
Loan Deferral Period
Under the CARES Act, borrowers could defer payment of the principal, interest, and fees of their PPP loans for not less than six months and not more than one year.
The PPP Flexibility Act changes this deferral period to end when the PPP loan forgiveness amount is remitted to the lender. Also, if a borrower fails to apply for forgiveness within 10 months after the last day of the covered period, the borrower shall make payments of principal, interest, and fees beginning no earlier than 10 months after the covered period ends.
Payroll Tax Deferral
The CARES Act allowed certain companies to defer paying payroll taxes, excepting companies who had their PPP loans forgiven.
The PPP Flexibility Act eliminates this exception, allowing companies whose PPP loans are forgiven to also defer payroll taxes.
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[i] For additional details about the PPP please refer to Gibson Dunn’s Frequently Asked Questions to Assist Small Businesses and Nonprofits in Navigating the COVID-19 Pandemic and prior Client Alerts about the Program: SBA “Paycheck Protection” Loan Program Under the CARES Act; Small Business Administration and Department of Treasury Publish Paycheck Protection Program Loan Application Form and Instructions to Help Businesses Keep Workforce Employed; Small Business Administration Issues Interim Final Rule and Final Application Form for Paycheck Protection Program; Small Business Administration Issues Interim Final Rule on Affiliation, Summary of Affiliation Tests, Lender Application Form and Agreement, and FAQs for Paycheck Protection Program; Analysis of Small Business Administration Memorandum on Affiliation Rules and FAQs on Paycheck Protection Program; Small Business Administration Publishes Additional Interim Final Rules and New Guidance Related to PPP Loan Eligibility and Accessibility; and Small Business Administration Publishes Loan Forgiveness Application.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work, or the following authors:
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)
Roscoe Jones, Jr.* – Washington, D.C. (+1 202-887-3530, rjones@gibsondunn.com)
Alisa Babitz – Washington, D.C. (+1 202-887-3720, ababitz@gibsondunn.com)
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, cmbrown@gibsondunn.com)
Alexander Orr – Washington, D.C. (+1 202-887-3565, aorr@gibsondunn.com)
William Lawrence – Washington, D.C. (+1 202-887-3654, wlawrence@gibsondunn.com)
Samantha Ostrom – Washington, D.C. (+1 202-955-8249, sostrom@gibsondunn.com)
* Not admitted to practice in Washington, D.C.; currently practicing under the supervision of Gibson, Dunn & Crutcher LLP.
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
The UK government announces the closure of the Coronavirus Job Retention Scheme from 1 July 2020 to those not previously furloughed on or before 10 June 2020 along with other updates in relation to next and final stages of the Coronavirus Job Retention Scheme and Self-Employment Income Support Scheme.
On 29 May 2020, the Chancellor announced how the Coronavirus Job Retention Scheme (“CJRS”) and Self-Employment Income Support Scheme will operate over the next five months and eventually terminate on 31 October 2020. Further guidance on the flexible furlough and how employers should calculate claims will be published on 12 June and we will accordingly publish further information.
Closure of CJRS to new entrants
A key takeaway from the Chancellor’s announcement is that, from 1 July onwards, employers will only be able to furlough employees that they have previously furloughed for a full three-week period prior to 30 June. Accordingly, any employer who has not already done so but wishes to place an employee on the CJRS must do so by 10 June 2020. Employers will have until 31 July to make any claims in respect of the period to 30 June.
Further, from 1 July claim periods will no longer be able to overlap months: employers who previously had submitted claims which had periods which overlapped calendar months will no longer be able to do this going forwards.
Employer costs going forwards
The level of grant available to employers under CJRS will be slowly tapered to reflect that the fact that people will be returning to work from August 2020.
| July | August | September | October | |
| Responsibility for Employer NICs and pensions contributions | Government | Employer | Employer | Employer |
| Responsibility for wages[1] | Government (80% up to £2,500)
Employer – N/A | Government (80% up to £2,500)
Employer – N/A | Government (70% up to £2,187.50)
Employer (10% up to £312.50) | Government (60% up to £1,875)
Employer (20% up to £625) |
| Employee Receives[2] | 80% up to £2,500 per month | 80% up to £2,500 per month | 80% up to £2,500 per month | 80% up to £2,500 per month |
Flexible Furlough in practice
What does ‘flexible furlough’ mean?
At present, employees on furlough are not permitted to do any work for their employer’s business. However, from 1 July 2020 businesses will be given the flexibility to bring furloughed employees back to work part-time. Employers can agree with their employees the hours and shifts their employees will work on their return.
Employers can still claim under the CJRS for the hours the employee is not working. Employees can still continue on full furlough and there is no requirement to provide employees with work, if the employer is not in a position to do so.
What should an employer pay an employee on flexible furlough for the hours they are working?
Employers will be responsible for paying full wages in respect of those hours when the employee is working but will be able to claim under the scheme in respect of that part of their normal working hours on which the employee is not working. Employers will need to submit information on the usual versus actual hours worked by an employee in a claim period. The cap will be proportional to the hours not worked.
Further detailed guidance on how to calculate claims following the introduction of flexible furlough will be released on 12 June.
How should flexible furlough be agreed?
Employers will have to agree any new flexible furloughing arrangement with their employees and confirm that agreement in writing.
A well drafted furlough agreement should currently prohibit employees from carrying out any work for the employer during their furlough period. Hence, it may be necessary for any furlough agreement to be amended by a side letter, or for a fresh furlough agreement to be entered into, which permits an employee to work during the furlough period commencing 1 July.
Amendments to the Self-Employment Income Support Scheme
The self-employed grant, which we reported on previously, is being extended, with applications opening in August for a second and final grant. There will be parity with the reducing furlough scheme, paying 70% (and not 80%) of average earnings in a single instalment covering three months’ worth of profit, and capped at £6,570 in total. The eligibility criteria remains the same for the second grant, as it did for the first with individuals needing to confirm that their business has been adversely affected by COVID-19.
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[1] Capped at 80% of wages, or employers are able to choose to top up employee wages above the CJRS grant at their own expense if they wish.
Gibson Dunn attorneys regularly counsel clients on the compliance issues raised by this pandemic, and we are working with many of our clients on their response to COVID-19. Please contact the Gibson Dunn attorney with whom you work in the Employment Group, or the following members of the UK employment team:
James Cox – London (+44 (0)20 7071 4250, jcox@gibsondunn.com)
Sarika Rabheru – London (+44 (0) 20 7071 4267, srabheru@gibsondunn.com)
Heather Gibbons – London (+44 (0)20 7071 4127, hgibbons@gibsondunn.com)
Georgia Derbyshire – London (+44 (0)20 7071 4013, gderbyshire@gibsondunn.com)
Charlotte Fuscone – London (+44 (0)20 7071 4036, cfuscone@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On 27 May 2020, the UK Financial Conduct Authority (the “FCA”) published Market Watch 63 (“MW63”). MW63 highlights that market participants (including issuers, their advisers and all other market participants) may be subject to new and emerging market conduct risks as a result of the current increase in primary market activity and working from home arrangements widely mandated as a result of public policy to deal with the COVID-19 pandemic. It then sets out the FCA’s expectations on market participants in terms of identifying and mitigating those risks in the current environment.
It is clear that while we have seen some limited regulatory forbearance from the FCA in certain areas in order to alleviate operational burden on market participants and the markets, there is no room for reducing risk appetites or anything other than strict adherence to rules and regulatory expectations in the context of market conduct. The FCA acknowledges the current challenges faced by market participants during the crisis, however the expectation remains that all continue to act in a manner that supports the integrity and orderly functioning of financial markets. As a warning, the FCA also stressed that it will continue to use the tools at its disposal to monitor, investigate and (as necessary) take enforcement action to ensure that requirements relating to market conduct are complied with.
This bulletin outlines the messages of MW63 and provides some practical guidance on the steps that market participants might take in order to ensure they meet the FCA’s expectations in the current environment.
Considerations for all market participants
The market conditions created by COVID-19 are giving rise to new challenges and considerations for all market participants attempting to manage their risks around identifying, handling and disclosing inside information for the purposes of Regulation 596/2014/EU on market abuse (“MAR”). This is a result of several factors, including (i) an increased number of capital raising events leading to greater flows of inside information; and (ii) existing systems and controls to restrict flows of inside information may not address working from home arrangements.
In previous Market Watch newsletters[1], the FCA highlighted the importance of relevant firms undertaking a comprehensive risk assessment to identify the market abuse risks to which they are or may be exposed and the controls necessary to mitigate those risks. Firms are strongly advised to revisit those risk assessments in response to the Coronavirus pandemic and update them to reflect new and emerging risks, and to modify or enhance their systems and controls, including surveillance techniques, to ensure they remain adequate and effective, especially in light of the working from home environment and the heightened risk environment.
The new types of risk which market participants may be exposed to include unlawful disclosure of inside information, as well as manipulative behaviour stemming from short selling activities. The FCA specifically addresses risks arising from short selling activity and makes it clear that the FCA will focus monitoring efforts on short selling activities in the secondary markets as part of its market monitoring. While the FCA does not specifically say so, it is clear when reading between the lines that the FCA is concerned that there is some evidence of abusive behaviour. The FCA will not shy away from bringing appropriate criminal or regulatory action where this is justified.
Some firms are experiencing increased numbers of surveillance alerts as a result of increased market volume and volatility. It is key that firms address this operational challenge by tailoring their response to the risks they are exposed to and ensuring that the response does not diminish the appropriateness and effectiveness of surveillance techniques. Firms may need to consider conducting retrospective reviews concentrating on areas of heightened risk.
Some specific issues raised
Short selling
In terms of compliance by market participants with their obligations under Regulation 236/2012/EU on short selling and certain aspects of credit default swaps (“SSR”), the FCA reminds market participants that they must, at all times, comply with:
- the prohibition on “naked” short sales; and
- the net short position reporting requirements.
Where market participants engage in short selling activity, it would be prudent for them to confirm that their cover arrangements remain appropriate and that they have adequate documentary evidence of their compliance with the cover requirements.
Market soundings
The MAR market soundings regime was introduced to provide a framework for controlling inside information when market participants undertake wall-crossings. The intent of the regime is to provide protection from allegations of unlawful disclosure of inside information. However, in order for market participants to have the benefit of this protection, the framework set out under MAR must be correctly followed. It is possible that in the current working from home environment firms may find it harder to adhere to the framework rules. It would be prudent for market participants to review their market sounding procedures to ensure they remain adequate and effective in the current environment. In particular, market participants should consider the following:
- disclosing market participants should ensure that they are maintaining appropriate records of their interactions, for example, through the use of recorded lines or written minutes (and that those written minutes are approved by the receiving market participant);
- receiving market participants should be aware that the purpose of the sounding is for issuers to gauge interest in and views on the proposed transaction. The information relating to the proposed transaction should only be shared internally on a strict need-to-know basis to enable relevant individuals to provide the necessary input to the issuer and for no other purpose; and
- the FCA has previously recognised the benefit of the gatekeeper model[2]; receiving market participants should consider whether their chosen method of receiving soundings remains adequate in the current environment and whether instructions to sell-side market participants need to be updated.
Personal account dealing
Given the FCA’s concern around the heightened risks relating to inside information in light of the current market environment, it would be prudent for all firms to revisit their arrangements for personal account dealing to ensure they adequately address the enhanced risks of most staff currently working from home. Market participants should remind their employees of relevant policies and address in particular how the policies apply in the current environment. This is particularly advisable as a result of the concerns expressed by the FCA in its preceding Market Watch newsletter[3] in relation to firms’ controls relating to personal account dealing, as it is highly likely that the FCA will conduct further thematic work in this area in the future. To the extent that firms have not reviewed and enhanced their policies and procedures in this area in response to Market Watch 62, now would be an opportune time to do so.
Considerations for issuers
In the context of increased capital raising activities, the FCA has specifically addressed some of the risks faced by issuers. We have set out a summary of the risks and some of the practical steps that issuers should take in order to mitigate those risks in the current environment.
| Types of heightened risks | Practical steps to take |
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[1] Market Watch 56 and Market Watch 58
[2] Market Watch 58 and Market Watch 51
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please contact your usual Gibson Dunn contacts or the following authors:
Authors: Michelle Kirschner, Martin Coombes, Chris Hickey, Patrick Doris, Steve Melrose and Chris Haynes
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
Issuers in the United States and their auditors have related, but distinct, obligations to evaluate on a periodic basis whether there is substantial doubt about the issuer’s ability to continue as a going concern.[1] In normal times, this evaluation, conducted with an appropriate level of diligence, results as to almost all major public companies in the conclusion that there is no substantial doubt about the entity’s ability to meet its obligations in the months to come.
But these are not normal times. As the COVID-19 crisis takes an ever-greater toll on the American economy, and as multiple well-known companies declare bankruptcy,[2] the going-concern assessment has taken on new relevance for issuers, auditors, and others in the financial-reporting community. As a result, the number of issuer filings that contain a going-concern disclosure appears to have substantially increased.[3] In this piece, we review some of the significant considerations that apply to the going-concern analysis from both the issuer’s and the auditor’s perspectives.
Summary of Issues
- Financial Accounting Standards Board (“FASB”) accounting standards and PCAOB auditing standards both require an assessment of whether there is substantial doubt about the issuer’s ability to continue as a going concern, including evaluating concrete management plans to address the circumstances giving rise to the reasonable doubt. The auditor is required to make an independent assessment, not simply evaluate management’s process.
- Important differences between the accounting and auditing standards include that the management assessment occurs quarterly and looks forward one year from the date the financial statements are issued, whereas the auditor annually considers the period one year from the balance sheet date, with different quarterly review procedures.
- Both auditors and issuers should anticipate potential exposure to regulatory and private litigation should their forecasts of the effects of the COVID-19 pandemic prove inaccurate.
Background
American Institute of Certified Public Accountants (“AICPA”) and, later, PCAOB auditing standards have for decades required auditors to evaluate on an annual basis whether there is substantial doubt about the ability of the audited entity to continue as a going concern.[4] Under current PCAOB standard AS 2415, an auditor assesses, based on the relevant information obtained during the audit,[5] whether substantial doubt exists about the entity’s ability to meet its obligations as they come due over a reasonable period of time after the balance sheet date (not to exceed one year in the future) without the entity’s having to resort to measures such as disposing of significant assets or restructuring its debt.[6] The relevant information could include evidence such as negative operating trends, loan defaults, loss of key customers or patents, or even natural disasters.[7] If the auditor concludes that substantial doubt does exist, then as a second step it is required to consider management’s plans to address the circumstances giving rise to the substantial doubt, such as selling assets, restructuring debt, or raising capital. Under AS 2415, the auditor’s focus is on whether those plans are feasible and whether the assumptions underlying them are reasonable, such that they represent an adequate plan to address the circumstances.[8] If the auditor concludes even after assessing management’s plans that substantial doubt about the entity’s ability to meet its obligations over the coming year still exists, then the auditor must, among other steps, include an explanatory paragraph to that effect in the audit report.[9]
In addition, if an auditor, during an interim review of an entity’s quarterly financial statements, becomes aware of “the entity’s possible inability to continue as a going concern,” the auditor is required to make certain inquiries of management and assess whether management’s disclosures are adequate.[10]
On top of this established framework, the FASB in 2014 adopted a requirement that companies make their own assessments on a quarterly basis of their ability to continue as a going concern, a requirement codified as ASC Subtopic 205-40.[11] Subtopic 205-40 differs from the PCAOB’s AS 2415 in some important ways. For example, unlike the PCAOB, the FASB defined the concept of “substantial doubt” in connection with its standard: specifically, it stated that substantial doubt exists as to an entity’s ability to continue as a going concern “when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued.”[12] In other respects, Subtopic 205-40 bears close similarities to AS 2415, including in the circumstances that can indicate that substantial doubt exists and in the requirement to assess management plans to alleviate the substantial doubt.[13]
Even apart from the considerations specific to the COVID-19 crisis, there are two differences between Subtopic 205-40 and AS 2415 that are important to bear in mind:
- First, management’s disclosure obligations differ from those of the auditor. While the auditor’s disclosure consists of an explanatory paragraph in the audit report,[14] management’s disclosure of substantial doubt about its ability to continue as a going concern is found in the notes to the financial statements and management typically also includes disclosure of the issue in the liquidity section of management’s discussion and analysis (“MD&A”), as well as in the issuer’s risk factors.[15] Additionally, under Subtopic 205-40, where an issuer that concludes that management’s plans have alleviated the substantial doubt about its ability to meet its obligations, the issuer still must disclose in the notes to the financial statements that substantial doubt existed in the absence of those plans.[16] AS 2415, on the other hand, does not require disclosure by the auditor in situations where management’s plans have alleviated the substantial doubt.
- Second, while management’s obligation to evaluate its going-concern status is identical at the annual and quarterly stages,[17] the auditor’s obligations vary considerably between year-end and quarter-end. Unlike many audit procedures, in which the auditor evaluates the reasonableness of management’s accounting or disclosures, the annual going-concern analysis represents a standalone process for the auditor to arrive at a conclusion regarding the entity’s status.[18] In an interim review, by contrast, the procedures are both more limited and more tied to management’s assessment.[19]
Although global pandemics were not included on the list of adverse conditions in either AS 2415 or Subtopic 205-40, the economic shock that COVID-19 has created will provide a basis for many companies and auditors to conduct a more searching going-concern analysis than usual in the months to come. As we address in the next section, this analysis will be especially difficult in a crisis such as COVID-19 whose duration and economic effects are so unpredictable. We will then address some other key considerations for issuers and auditors as they assess the potential for substantial doubt to exist concerning management’s ability to meet upcoming obligations.
Addressing the Significant Uncertainty of the COVID-19 Crisis
The list of adverse events set out in AS 2415 and Subtopic 205-40 that could potentially call a company’s viability into question includes items such as negative operating trends, work stoppages, and loan defaults.[20] In some cases, the ultimate outcome of those events or circumstances will be uncertain at the time of management’s or the auditor’s assessment. The COVID-19 pandemic, however, raises a set of global uncertainties—concerning areas from public health to financial markets—whose complexity is an order of magnitude greater than that of the circumstances that may drive an entity’s going-concern analysis in normal times.
While Subtopic 205-40 requires only that an entity assess its ability to meet its obligations based on “relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued,”[21] and AS 2415 similarly requires only that the auditor consider “his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report,”[22] both issuers and auditors should be aware that regulators and private plaintiffs will later assess their actions with twenty-twenty hindsight. Plaintiffs, in particular, will have an incentive to ignore that the auditor “is not responsible for predicting future conditions or events,”[23] and likely will seek to claim that the events of the next year were clearly on the horizon at the time that companies and auditors issued their financial statements and reports, based on the progression of the COVID-19 crisis as of that time. In assessing the risk that an entity will be unable to meet its obligations in the coming months, both issuers and auditors should anticipate that they will face potential legal exposure for failing to accurately predict the future.
In the current environment, both management and auditors are likely best served by: (i) making, documenting, and disclosing a good-faith attempt to identify the operational, financial, and economic factors that will affect the company’s ability to meet its obligations in the coming year, including those that are likely to indicate a worse outcome for the company; (ii) comprehensively documenting what they believe is known and reasonably knowable, as of their assessment date, about the implications of each factor for the company’s ability to meet its obligations in the coming months—including, as appropriate, based on consultation with third-party experts such as outside counsel or valuation experts; and (iii) making, and documenting, a good-faith assessment, based on that forecast, of how likely it will be that a point arrives within the relevant timeframe at which, individually or in the aggregate, one or more of those factors causes the company to be unable to meet its obligations as they come due.
Other Key Considerations
In addition to the problem of uncertainty in the progression of the COVID-19 crisis, there are other considerations that issuers and auditors should bear in mind as they conduct their going-concern assessments.
First, if an entity’s management concludes that substantial doubt exists concerning its ability to meet its obligations absent management plans to address the situation, then management should keep in mind the requirements that apply to the plans that it develops. Subtopic 205-40 makes clear that substantial doubt about an entity’s ability to continue as a going concern is alleviated only if two conditions are met: (i) “It is probable that management’s plans will be effectively implemented within one year after the date that the financial statements are issued,” and (ii) “It is probable that management’s plans, when implemented, will mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued.”[24]
Concerning the first condition, the standard states that for management’s plans to be considered probable for implementation, they generally must already have been approved by management at the time the financial statements are issued.[25] That is, they should generally not be merely theoretical or even under active consideration. This means that, if management anticipates that its quarter-end analysis may lead to an initial conclusion that substantial doubt exists concerning its ability to continue as a going concern, it should take anticipatory steps during the quarter to plan its response, to help ensure that it has time to approve any alleviating plans that may become necessary.
Concerning the second condition, Subtopic 205-40 states that the magnitude and timing of management’s plans must be measured against “the magnitude and timing of the relevant conditions or events that those plans intend to mitigate.”[26] If, for example, management adopts a plan to address its liquidity needs that will not become effective until after the principal period of its liquidity shortfall has passed, then it may be difficult for it to conclude that the plan is effectively timed to alleviate the substantial doubt concerning its ability to meet its obligations. Issuers should try to ensure, therefore, that they develop plans that will realistically meet their expected liquidity and related needs in terms of both timing and magnitude.
Management should remain aware as to both of these conditions that the probability of execution or success that it assigns to its plans may differ from the probability that its auditor assigns to those same plans; thus, if it hopes to avoid a going-concern explanatory paragraph in the audit report, it will need to communicate early and often with the auditor to understand the auditor’s views as to how it anticipates evaluating management’s plans.
Second, PCAOB standards similarly prescribe particular considerations should an auditor initially conclude that substantial doubt about the entity’s ability to continue as a going concern does exist such that management’s plans become relevant. AS 2415 directs the auditor to focus especially on two points: (i) “those elements that are particularly significant to overcoming the adverse effects of the conditions and events,” and (ii) any “prospective financial information [that] is particularly significant to management’s plans.”[27] The standard requires the auditor to obtain audit evidence specifically to address the most significant aspects of management’s plan, including the evidence that supports management’s assumptions about the prospective financial effects of its plans. This information should be considered with appropriate professional skepticism, and the auditor should keep in mind that the PCAOB would likely conclude that the provisions of auditing standards that require an auditor to consider contrary audit evidence would apply to this exercise.[28]
Third, complications may arise even after the annual audit if the issuer intends to incorporate by reference its financial statements with the Securities and Exchange Commission (“SEC”) as part of a registered offering conducted pursuant to the Securities Act of 1933, as amended. If the issuer does incorporate its financial statements by reference, the issuer is required to obtain the auditor’s consent to include the audit report as part of the registered offering. PCAOB standards require auditors to conduct certain procedures in that situation,[29] and if as a result of those procedures the auditor determines that its audit report would be misleading in the absence of a going-concern explanatory paragraph (even though the conditions giving rise to the substantial doubt occurred after the issuance of the report), then the auditor might re-issue its audit report to include a going-concern explanatory paragraph and require that the issuer update its financial statements to reflected this added disclosure. Depending on the timing, this re-issuance may or may not occur in conjunction with the issuer’s conducting its own quarterly evaluation of its ability to continue as a going concern.
Fourth, there is a slight discrepancy between the time period applicable to an issuer’s going-concern analysis and that applicable to the auditor, but the period during which both parties obtain the evidence that is relevant to their analysis is the same.
AS 2415 states that the auditor’s going-concern evaluation is conducted with reference to the balance-sheet date; meanwhile, Subtopic 205-40 states that management’s evaluation should occur as of the date the financial statements are issued.[30] FASB noted in adopting Subtopic 205-40 that it had received input “from many auditors indicating that, in practice, they already assess over a period of one year from the audit report date instead of one year from the balance sheet date.”[31] More importantly, however, AS 2415 makes clear that the auditor’s consideration of the going-concern question must be “based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report.”[32] The fact that the auditor’s balance-sheet date is used as a reference date, then, does not provide the auditor with an excuse to ignore subsequent events that occur prior to the audit report.
A recent SEC case addressing an auditor’s going-concern analysis demonstrated this fact in practice. In the Matter of the Application of Cynthia C. Reinhart, CPA was an appeal to the SEC from sanctions that the PCAOB had ordered be imposed on the engagement partner for an audit of a mortgage lender, Thornburg Mortgage, Inc. (“Thornburg”).[33] The PCAOB charged that Ms. Reinhart had, among other things, failed to properly assess whether there was substantial doubt about Thornburg’s ability to continue as a going concern. Although the SEC recognized that Ms. Reinhart and her team had, consistent with AS 2415, assessed the question of substantial doubt over a period lasting until the following fiscal year end, the SEC’s discussion of the sufficiency of her assessment concentrated in large part on events that occurred between the balance-sheet date and the report date, such as fluctuations in Thornburg’s ability to meet margin calls leading up to the filing of its Form 10-K.[34] The Reinhart case is a useful reminder that the difference between management’s and the auditor’s reference date does not create any distinction between them in terms of the available evidence that may affect their assessment.
Fifth, it has been discussed that auditors may be concerned about issuing going-concern opinions in part because doing so could accelerate the financial decline of the entity being audited, such that the going-concern paragraph becomes a self-fulfilling prophecy.[35] Given the widespread economic dislocations that the COVID-19 crisis has caused, there may be reason to think that the stigma of a going-concern opinion is not as acute as it has been under normal circumstances. In either case, however, audit engagement teams should keep in mind that protecting their own, and their firms’, interests depends on the team ensuring that it considers the relevant evidence with appropriate skepticism and documents that its process was thorough and appropriate.
Sixth, issuers should seek counsel sooner rather than later about their fiduciary obligations when potential going-concern issues exist because it is critical that officers and directors fully understand their fiduciary obligations and how best to comply with them and make reasoned, disinterested, good faith decisions that receive the benefit of the business judgment rule. Members of the Firm’s Business Restructuring and Reorganization Group can assist officers and directors to understand and comply with these obligations.
Conclusion
Hopefully, the period when going-concern analyses occupy a heightened level of attention will pass in the coming months as the COVID-19 health crisis wanes and the U.S. and world economies rebound. Until that time comes, issuers and auditors should ensure that they are approaching the going-concern analysis with the care that it will now warrant.
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[1] This alert focuses on the considerations applicable to issuers who report their financial statements on the basis of U.S. Generally Accepted Accounting Principles and to audits of those issuers performed pursuant to Public Company Accounting Oversight Board (“PCAOB”) auditing standards. We note, however, that International Financial Reporting Standards (“IFRS”) also contain a requirement that an entity assess its status as a going concern. See IAS 1.25, Presentation of Financial Statements. As a result, many of the observations contained herein may also be relevant to issuers who report using IFRS.
[2] See, e.g., Hertz Global Holdings, Inc., Form 8-K filed May 26, 2020; J. C. Penney Co., Inc., Form 8-K filed May 18, 2020; J.Crew Group, Inc., Form 8-K filed May 4, 2020.
[3] Among the companies that have recently issued going-concern notices are: Chesapeake Energy Corp., see Form 10-Q filed May 11, 2020; and Dave & Buster’s Entertainment, Inc., see Form 10-K filed Apr. 3, 2020. See also SandRidge Energy, Inc., Form 10-Q filed May 19, 2020 (disclosing substantial doubt concerning ability to continue as a going concern alleviated by management plans to sell headquarters).
[4] See AU § 341, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern. AU Section 341 was adopted as an interim standard by the PCAOB pursuant to PCAOB Rule 3200T, see PCAOB Rel. No. 2003-006 (Apr. 18, 2003), and is now codified in PCAOB auditing standards as AS 2415, Consideration of an Entity’s Ability to Continue as a Going Concern.
[5] AS 2415 does not require any procedures to be performed solely for purposes of the going-concern evaluation. Instead, it contemplates that “[t]he results of auditing procedures designed and performed to achieve other audit objectives should be sufficient for that purpose.” AS 2415.05.
[10] AS 4105.21, Reviews of Interim Financial Information.
[11] See Accounting Standards Update No. 2014-15, Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern (Aug. 2014) (“ASU 2014-15”).
[12] ASU 2014-15, Glossary (emphasis in original, other emphasis removed). FASB made clear that the term “probable” as used here has the same meaning as it does in the context of assessing loss contingencies under ASC Topic 450. See id. In the relevant contingencies standard, FASB defined “probable” to mean that “[t]he future event or events are likely to occur.” See Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, ¶ 3(a). Although the standard does not assign percentages to this term, practitioners generally note that “probable” represents approximately a seventy percent chance or greater of occurrence. See, e.g., A Roadmap to Accounting for Contingencies and Loss Recoveries, at 21 (Deloitte 2019).
[13] See ASC 205-40-55-2 (using same list of adverse conditions as that used by PCAOB); ASC 205-40-50-6 (consideration of management plans).
[15] See ASC 205-40-50-13 (requiring both footnote disclosure and “information that enables users of the financial statements to understand” three points: (i) the “[p]rincipal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern”; (ii) “[m]anagement’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations”; and (iii) “[m]anagement’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern”).
[16] Specifically, management’s disclosures must include (i) the “[p]rincipal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans)”; (ii) “[m]anagement’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations”; and (iii) “[m]anagement’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern.” ASC 205-40-50-12.
[17] In adopting ASU 2014-15, FASB explicitly stated that it considered limiting the going-concern analysis to an annual exercise but elected to adopt a quarterly requirement instead, “to ensure that uncertainties about an entity’s ability to continue as a going concern were being evaluated comprehensively for each reporting period, and being reported timely in the financial statement footnotes.” ASU 2014-15, ¶ BC23.
[18] In the wake of FASB’s adoption of Subtopic 205-40, the PCAOB staff issued a release emphasizing that an issuer’s “determination that no disclosure is required under [applicable accounting principles] is not conclusive as to whether an explanatory paragraph is required” under PCAOB standards. PCAOB Staff Audit Practice Alert No. 13, Matters Related to the Auditor’s Consideration of a Company’s Ability to Continue as a Going Concern (Sept. 22, 2014). The exception to the principle in AS 2415 that the auditor is in a proactive rather than reactive position in conducting its annual assessment is that, should the entity determine that substantial doubt exists, then the auditor is required to assess the reasonableness of management’s disclosures on that point. See AS 2415.10-.11.
[20] See ASC 205-40-55-2; AS 2415.06.
[28] See AS 1105.29, Audit Evidence (requiring auditor to perform procedures to address any inconsistency or lack of reliability in the audit evidence it obtains). As an example, the SEC in the Reinhart matter (see infra note 33) considered in connection with Ms. Reinhart’s going-concern analysis the predecessor standard to AS 1105, which likewise directs an auditor to “consider relevant evidential matter regardless of whether it appears to corroborate or to contradict the assertions in the financial statements.” AU 326.25, Evidential Matter. In its order, the SEC appeared to assume that Ms. Reinhart was required to consider inconsistent audit evidence as well as confirmatory evidence when assessing the issuer’s ability to continue as a going concern. See, e.g., In the Matter of the Application of Cynthia C. Reinhart, CPA, SEC Rel. No. 85964 at 19 n.38 (May 29, 2019).
[29] See AS 4101, Responsibilities Regarding Filings Under Federal Securities Statutes.
[30] Compare AS 2415.02 (“date of the financial statements being audited”) to ASC 205-40-50-1 (“date that the financial statements are issued”).
[32] AS 2415.02 (emphasis added).
[33] See generally SEC Rel. No. 85964.
[34] See id. at 8 (use of subsequent balance-sheet date for analysis); 8-11 (evidence concerning liquidity arising during subsequent period after balance-sheet date).
[35] See, e.g., John H. Eickemeyer, “The Concerns with Going Concern,” The CPA Journal (Jan. 2016).
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding developments related to the COVID-19 pandemic. For additional information, please contact any member of the firm’s Securities Regulation and Corporate Governance or Business Restructuring and Reorganization practice groups, the Gibson Dunn lawyer with whom you usually work, or the following authors:
Authors: Brian Lane, Michael Scanlon, Michael Rosenthal, Jeffrey Krause, David Ware, and David Korvin
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On May 21, 2020, the U.S. Copyright Office (the “Office”) released a nearly 200-page report (the “Report”)[1] suggesting changes to the Digital Millennium Copyright Act (17 U.S.C. § 512) (“DMCA”), which governs how online service providers (OSPs) police potential online copyright infringement. The report was the result of a multi-year study of the DMCA—the first comprehensive study by the Office on the DMCA’s operation—and was prepared to analyze whether the DMCA’s safe harbor provisions are successfully balancing the needs of OSPs and copyright holders, “particularly in light of the enormous changes that the internet has undergone in the last twenty-plus years.”[2]
The report concludes that the DMCA does not need “wholesale changes,” but may benefit from fine-tuning to better “balance the rights and responsibilities of OSPs and rightsholders in the creative industries.”[3] In particular, the Office “concluded that Congress’ original intended balance has been tilted askew” and “the scale of online copyright infringement and the lack of effectiveness of section 512 notices to address that situation remain significant problems.”[4]
Among other things, the Office suggested that Congress consider legislation regarding:
- What qualifies as “temporary” for 512(c) safe harbor and what activities are appropriately shielded from liability for being “related to” storage;[5]
- Whether technology services beyond those providing internet infrastructure should be eligible for the safe harbor provisions;[6]
- Whether unwritten policies regarding the account termination of “repeat infringers” serve the intended deterrent purpose and what constitutes “appropriate circumstances” for a user’s termination for repeated infringement;[7]
- The distinction between “actual” and “red flag knowledge” and the intended scope of the “willful blindness” doctrine;[8]
- Whether rightsholders must submit a unique, file-specific URL for every instance of infringing material on an OSP’s service to properly provide “information reasonably sufficient . . . to locate [infringing material]”:[9]
- The impact of the Ninth Circuit’s decision in Lenz v. Universal Music Corp.,[10] which held that copyright holders must consider fair use in good faith before issuing a takedown notice for content posted on the Internet. In particular, the Office recommended that Congress consider the “knowing misrepresentation” requirement for a lawsuit seeking redress for an improper infringement notification, and whether the Lenz decision reflects Congressional intent on this issue;[11]
- Appropriate changes to section 512(c)’s notice requirements, given new web-based submission forms and the possibility that some of 512(c)’s current notification standards may become obsolete;[12]
- Potential avenues to resolve disputes over whether material should be removed and reinstated that do not require a rightsholder to prepare and file a federal lawsuit in the current statutory timeframe of 10–14 days;[13]
- The parameters of a rightsholder’s ability to subpoena an OSP to identify an alleged infringer under section 512(h);[14] and
- The possibility and range of injunctive relief available to rightsholders after a takedown;[15]
At present, these remain just proposals for legislative action. And in its report, the Office does not provide non-statutory approaches to alter DMCA provisions or developments involving online intermediary liability in other countries, finding that both issues require further exploration. The Office expressed its intent to explore additional voluntary initiatives to address online infringement and help identify standard technical measures that can be adopted in certain sectors.[16] Additionally, the Senate Judiciary intellectual property subcommittee has announced plans to draft changes to the DMCA by the end of 2020.[17] Whether and to what extend the subcommittee follows the recommendations of this report bears watching for both OSPs and rightsholders.
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[1] United States Copyright Office, Section 512 of Title 17: A Report on the Register of Copyrights (May 2020), https://www.copyright.gov/policy/section512/section-512-full-report.pdf (the “Report”).
[2] Copyright Office Releases Report on Section 512, Issue No. 824, May 21, 2020, https://www.copyright.gov/newsnet/2020/824.html.
[10] 801 F.3d 1126, 1154 (9th Cir. 2015).
[11] Section 512 of Title 17 at 145–49.
[17] Margaret Harding McGill, Copyright Office: System for pulling content offline isn’t working, Axios (May 21, 2020), https://www.axios.com/copyright-office-system-for-pulling-content-offline-isnt-working-ed78fe62-eec4-44dc-bcdd-1c593e888fb8.html.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please feel free to contact the Gibson Dunn lawyer with whom you usually work in the firm’s Intellectual Property or Media, Entertainment and Technology practice groups, or the following authors:
Howard S. Hogan – Washington, D.C. (+1 202.887.3640,hhogan@gibsondunn.com)
Nathaniel L. Bach – Los Angeles (+1 213-229-7241,nbach@gibsondunn.com)
Ciara M. Davis – Washington, D.C. (+1 202-887-3783, cmdavis@gibsondunn.com)
Please also feel free to contact the following practice leaders:
Intellectual Property Group:
Wayne Barsky – Los Angeles (+1 310-552-8500, wbarsky@gibsondunn.com)
Josh Krevitt – New York (+1 212-351-4000, jkrevitt@gibsondunn.com)
Mark Reiter – Dallas (+1 214-698-3100,mreiter@gibsondunn.com)
Media, Entertainment and Technology Group:
Scott A. Edelman – Los Angeles (+1 310-557-8061, sedelman@gibsondunn.com)
Kevin Masuda – Los Angeles (+1 213-229-7872, kmasuda@gibsondunn.com)
Orin Snyder – New York (+1 212-351-2400, osnyder@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
Since California’s state and local governments began substantively responding to the novel coronavirus (COVID-19) pandemic in mid-March, a complex patchwork of overlapping and sometimes conflicting new regulations, executive orders, and judicial declarations has evolved. For example, on March 27, 2020 Governor Gavin Newsom issued Executive Order N-37-20, which offered several forms of eviction protection for certain residential tenants during the state of emergency, but left it within the discretion of local governments to decide whether to extend the same types of protections to commercial tenants. Some cities and counties, like San Francisco and Los Angeles, immediately enacted ordinances offering similar protections for commercial tenants in their jurisdictions, whereas others like Orange County have generally abstained from imposing new restrictions.
In response, several bills have been introduced before the state legislature that seek to homogenize the complicated legal landscape in California from the top down. These pending measures are summarized below. Certain elements of these legislative proposals could have a significant and adverse impact on landlords’ revenue streams, particularly from multi-family investments, including the ability to fully recover delinquent rents. This update outlines the current state of these measures as they stand in the legislative process, but these bills are constantly changing and will likely continue to evolve in the days and weeks ahead.
SB 939 – Prohibition on Evictions For All Commercial Tenants; Certain Commercial Tenants’ Right to Impose Modification Negotiations
Last Amended: May 13, 2020 (proposed amendments to be introduced by Senator Wiener on May 22, 2020 are discussed below)
Status: From committee with author’s amendments. Read second time and amended. Re-referred to the Senate Judiciary Committee on May 13, 2020. The bill has been set for hearing before the Judiciary Committee on Friday, May 22, 2020.
Introduced by Senators Scott Wiener and Lena Gonzalez, SB 939 would prohibit the eviction of tenants of commercial real property, including businesses and nonprofit organizations, during the pendency of the state of emergency related to COVID-19 proclaimed by the Governor on March 4, 2020. A proposed amendment to be introduced by Senator Weiner on May 22 would extend the duration of this moratorium by another 90 days after the state of emergency is lifted. Additionally, SB 939 would authorize certain qualifying commercial tenants to engage in negotiations with their landlords to modify rent or other economic requirements.
As currently drafted, SB 939 would make it unlawful to (i) terminate a tenancy, (ii) serve notice to terminate a tenancy, (iii) use lockout or utility shutoff actions to terminate a tenancy, or (iv) otherwise endeavor to evict a tenant of commercial real property, including a business or nonprofit organization, during the pendency of the COVID-19 state of emergency, unless the tenant has been found to pose a threat to the property, other tenants, or a person, business, or other entity. By including a prohibition on landlords serving a “notice to terminate,” SB 939 could be read to potentially prevent a landlord from serving a tenant with any notice that would otherwise precede or be a prerequisite to an eviction proceeding, including a three-day notice to quit.[1] The bill further states that if a commercial tenant does not pay rent during the COVID-19 state of emergency, the tenant has a period of twelve (12) months following the date in which the COVID-19 state of emergency ends to repay such amounts. As currently drafted, SB 939 would appear to apply to all commercial tenants, regardless of whether they would qualify for potential lease modification, as more particularly described below, or whether the tenant demonstrates an inability to pay rent due to COVID-19. SB 939 would prohibit Landlords from charging or collecting late fees for rent that became due during the pendency of the COVID-19 state of emergency.[2]
Senator Weiner’s proposed May 22 amendment would invert the structure of the commercial eviction moratorium. Instead of banning all commercial evictions except for those relating to public health and safety, the amended bill would allow all commercial evictions, except those based upon non-payment of rent that accrued during the state of emergency and only where the tenant meets specified criteria indicating that COVID-19 has or will have significant financial impact on the tenant. Relatedly, under the amended bill the only commercial tenants eligible for the twelve-month repayment grace period would be those meeting specified criteria indicating that COVID-19 has or will have significant financial impact on them.
SB 939’s prohibition on evictions would retroactively apply to any eviction or termination of a tenancy that occurs after the COVID-19 state of emergency was first proclaimed on March 4, 2020, but before the effective date of SB 939, by deeming the conduct void, against public policy, and unenforceable. SB 939 also imposes a fine of up to two thousand dollars ($2,000) for any harassment, mistreatment, or retaliation against a tenant aimed at forcing abrogation of the lease. Finally, any eviction or termination of a tenancy in violation of SB 939 is considered an unlawful business practice and an act of unfair competition under the California Business and Professions Code (Cal. Bus. Code § 17200 et seq.)
SB 939 expressly states that it would not “preempt any local ordinance prohibiting the same or similar conduct or imposing a more severe penalty for the same conduct.” It appears that this section intends to set a statewide floor for available tenant protections and establish the minimum punishment for violation of those protections, while allowing localities to set their own standards that are more protective of tenants. However, the current text of SB 939 does not differentiate between more restrictive and less restrictive local eviction moratoria. Thus, it is possible that this provision could actually prevent SB 939 from preempting a local ordinance that offers tenants less protection than the statewide bill itself.
Affirmative Notice Requirement
Landlords are required to provide commercial tenants with written notice of the protections afforded by SB 939 within thirty (30) days of the effective date of the legislation. The required form and content of this required notice is not addressed in the proposed statute as currently drafted.
Lease Modifications for Certain Commercial Tenants
SB 939 authorizes certain commercial tenants to initiate lease modification negotiations with their landlords, which, if unsuccessful, may allow such tenants to terminate their leases under more favorable terms than the law would ordinarily allow.
To qualify for the protections of the lease modification provisions of SB 939, a tenant (“Qualifying Commercial Tenant”) must be (a) a “small business” or an eating or drinking establishment, place of entertainment, or performance venue[3] that is (b) not a publicly traded company or any company owned by or affiliated with a publicly traded company, and which (c) operates primarily in California. Further, the Qualifying Commercial Tenant’s primary business must have (d) experienced a decline of forty percent (40%) or more of monthly revenue, and, if an eating or drinking establishment, place of entertainment, or performance venue, a decline of twenty-five percent (25%) or more in capacity due to a social or physical distancing order or safety concerns. Finally, SB 939 requires that a Qualifying Commercial Tenant be (e) “subject to regulations to prevent the spread of COVID-19 that will financially impair the business when compared to the period before the shelter-in-place order took effect” (requirements (a)-(e), collectively, “Financial Criteria”).
A Qualifying Commercial Tenant would be permitted to take advantage of the lease modification provisions of SB 939 by serving written notice on the premises affirming, under the penalty of perjury, that the commercial tenant meets the Financial Criteria outlined above and stating the modifications the commercial tenant desires to obtain (“Negotiation Notice”). If the tenant and landlord do not reach a mutually satisfactory agreement within thirty (30) days of the date the landlord receives the Negotiation Notice, then within ten (10) days thereafter, the tenant is permitted to terminate the lease without any future liability for future rent, fees, or costs that otherwise may have been due under the lease by providing written notification to the landlord (a “Termination Notice”). Upon service of the Termination Notice, the lease and any third-party guaranties associated with the lease are also terminated and no longer enforceable.
Under this scenario, a landlord’s subsequent ability to collect damages would be limited to the sum of three months’ worth of the past due rent incurred and unpaid during the period of COVID-19 regulations, and all rent incurred and unpaid during a time unrelated to COVID-19 through the date of the termination notice. Even for these limited damages, the tenant has a twelve (12) month grace period to repay the sum owed.
As currently drafted, and including the proposed May 22 amendments, SB 939 raises a number of significant questions, including those highlighted below:
- Qualifying Commercial Tenant Criteria:
- SB 939 and its proposed amendment do not establish criteria for defining “eating or drinking establishment, place of entertainment, or performance venue” or categorizing tenants with mixed-use businesses (e.g., tenants with business operations that blend retail and food and beverage services).
- The Financial Criteria do not contemplate whether or not that small business, on a relative basis, has other factors that dictate its revenue (such as seasonality) which are totally unrelated to COVID-19.
- The 25% reduction in capacity may be proven not only by an actual social distancing order, but also by undefined “safety concerns.”
- The Financial Criteria do not contemplate whether the receipt of other forms of aid, such as under the CARES Act or another federal or state stimulus bills, could otherwise disqualify a tenant from the protections of SB 939.
- SB 939 generally does not acknowledge any landlord’s possible mortgage obligations, including, without limitation, whether the landlords have the right to enter into negotiations to modify tenant leases without lender consent, and the economic impact of any such modification on the landlord’s debt service obligations.
- Lease Modification Process:
- A Qualifying Commercial Tenant may engage in “good faith” negotiations with its landlord to modify any rent or economic requirement of its lease regardless of the remaining term. This could be read broadly enough to include things like rent escalation or extension that may not be relevant until well after COVID-19 and its impacts are largely resolved.
- Landlord Remedies:
- Although a tenant is required to affirm under penalty of perjury that it meets the qualifying criteria outlined above, there is no duty on the tenant to produce any type of corroborating documentation to the landlord. Thus, while a tenant may be incentivized not to falsify this affirmation under the threat of criminal prosecution, there is no statutory remedy for the landlord if post-termination the tenant’s affirmation is ultimately found to be false.
- SB 939 requires a tenant to vacate the premises within fourteen (14) days of delivering a Termination Notice under this statute. However, if the tenant fails to comply with this term, the landlord may lack the judicial remedies to enforce it due to general court closures as well as the provisions of statute.
- The limit on damages that the landlord is permitted to recover under this statute does not specify whether expenses not constituting traditional “rent” would be included, such as reimbursements, expenses, and default interest.
- Guarantors: The bill critically leaves out significant details regarding the status of guarantors after the mutual renegotiation of a lease or the issuance of a Termination Notice under its provisions:
- Upon termination, is the payment of outstanding amounts under the grace period of twelve (12) months no longer guaranteed?
- What would happen to a claim under such a guaranty that was already pending before the period affected by COVID-19 regulation?
- What defenses might become available to lease guarantors where a lease modification is imposed, but has not been consented to by such guarantor, and where guarantor is not required under this legislation to consent to it?
Comments on SB 939 can be submitted to Senator Wiener online at https://sd11.senate.ca.gov/contact or by calling (916) 651-4011 and to Senator Gonzalez online at https://sd33.senate.ca.gov/contact/send-e-mail or by calling (916) 651-4033.
AB 828 – Temporary Moratorium on Residential Foreclosures and Unlawful Detainers
Last Amended: May 18, 2020
Status: Re-referred to Rules Committee May 11, 2020.
Introduced by Assembly Members Ting, Gipson, and Kalra, AB 828 would prohibit any action to foreclose on a residential real property, including without limitation, the following:
(a) Causing or conducting the sale of real property pursuant to a power of sale.
(b) Causing recordation of notice of default pursuant to Section 2924.
(c) Causing recordation, posting, or publication of a notice of sale pursuant to Section 2924f.
(d) Recording a trustee’s deed upon sale pursuant to Section 2924h.
(e) Initiating or prosecuting an action to foreclose, including, but not limited to, actions pursuant to Section 725a of the Code of Civil Procedure.
(f) Enforcing a judgment by sale of real property pursuant to Section 680.010.
The foreclosure prohibition of AB 828 would remain in effect during the pendency and for fifteen (15) days after the expiration of the state or local COVID-19 emergency period in the jurisdiction in which the residential real property is located. The bill as currently written does not discuss any potential impact on UCC foreclosures.
Eviction Moratorium
AB 828 would prohibit any state court, county sheriff, or party to an unlawful detainer action from proceeding with any unlawful detainer action, unless on the basis of nuisance or waste under paragraph (3) or (4) of Section 1161 of the Code of Civil Procedure. Actions under these sections may still result in an entry of judgment in favor of the plaintiff; however, rather than proceeding under default for a defendant that does not timely answer the complaint, subsection (b) directs the court to “proceed as though all named defendants had filed an answer denying each and every allegation in the complaint.” To the extent that any defendant otherwise does answer or would have answered timely by denying all allegations, there are no practical differences to the landlord.
The residential eviction prohibition of AB 828 would remain in effect during the pendency and for fifteen (15) days after the expiration of the state or local COVID-19 emergency period in the jurisdiction in which the residential real property is located.
Eviction for Nonpayment of Rent
For any residential eviction based on nonpayment of rent, a residential tenant may, at any time between the filing of the complaint and entry of judgment, notify the court of that defendant’s desire to stipulate to the entry of an order pursuant to this section. Upon receiving notice from the defendant, the court must notify the plaintiff and convene a hearing to determine whether to issue an order (“Order”) under the following guidelines:
(a) At the hearing, the court will determine whether the tenant’s inability to pay resulted from the COVID-19 pandemic. A court will infer a rebuttable presumption of causation for an increased cost or decreased earnings that occurred between March 4 and May 4, 2020. If the causation prong is established, then the landlord may present evidence that rent reduction would cause material economic hardship (not defined by the text of the statute), where if the landlord owns over ten (10) rental units, lack of hardship is presumed, but where a landlord’s ownership interest in just one or two rental units would be sufficient to establish hardship. If the court finds both causation for the tenant and lack of hardship for the landlord, it will issue an Order and dismiss the case with the court retaining jurisdiction to enforce the terms of the Order.
(b) The Order will provide that the tenant retains possession and the tenant shall make monthly payments to the landlord beginning in the next calendar month, in strict compliance with all of the following terms: (i) The payment shall be in the amount of the monthly rent, plus ten percent (10%) of the unpaid rent owing at the time of the Order,[4] excluding late fees, court costs, attorneys’ fees, and any other charge other than rent; (ii) the payment shall be delivered by a fixed day and time to a location that is mutually acceptable to the parties or, in the absence of an agreement between the parties, by no later than 11:59 pm on the fifth (5th) day of each month; and (iii) the payment shall be made in a form that is mutually acceptable to the parties or, in the absence of agreement between the parties, in the form of a cashier’s check or money order made out to the landlord.
(c) If the tenant fails to make a payment in full compliance with the terms of the Order, the landlord may, after forty-eight (48) hours’ notice to the tenant by telephone, text message, or electronic mail, as stipulated by the tenant, file with the court a declaration under penalty of perjury containing all of the following: (i) a recitation of the facts constituting the failure; (ii) a recitation of the actions taken to provide the forty-eight (48) hours’ notice required by this paragraph; (iii) a request for the immediate issuance of a writ of possession in favor of the landlord; and (iv) a request for the issuance of a money judgment in favor of the landlord in the amount of any unpaid balance plus court costs and attorneys’ fees.
Mortgage Notice of Default
For the duration of the state or locally declared emergency and for fifteen (15) days thereafter, a county recorder shall not accept for recordation any instrument, paper, or notice that constitutes a notice of default pursuant to Section 2924 of the Civil Code, a notice of sale pursuant to Section 2924f of the Civil Code, or a trustee’s deed upon sale pursuant to Section 2924h of the Civil Code for any residential real property located in a jurisdiction in which a state or locally declared state of emergency relating to the COVID-19 virus is in effect.
Sale of Tax-Defaulted Residential Real Property
For the duration of the state or locally declared emergency and for fifteen (15) days thereafter, a tax collector shall suspend the sale of tax-defaulted residential real property.
Comments on AB 828 can be submitted to Assemblymember Ting online at https://a19.asmdc.org/ or by calling (916) 319-2019, to Assemblymember Gipson online at https://a64.asmdc.org/2019-2020 or by calling (916) 319-2064, and to Assemblymember Kalra online at https://a27.asmdc.org/ or by calling (916) 319-2027.
SB 1410 – COVID-19 Emergency Rental Assistance Program
Last Amended: May 18, 2020
Status: Set for hearing May 26–27 as of May 14, 2020. Re-referred to Housing Committee May 18, 2020.
Introduced by Senator Lena Gonzalez, SB 1410 would create a “COVID-19 Emergency Rental Assistance Fund” to provide rental assistance payments on behalf of any residential tenants who demonstrate an inability to pay all or any part of the household’s rent due between April 1 and December 31, 2020, as a result of the COVID-19 pandemic, provided that the landlord consents to participation in the program.
Tenants can demonstrate an inability to pay rent by showing any of the following: (a) loss of income due to a COVID-19 related workplace closure; (b) childcare expenditures due to a COVID-19 related school closure; (c) health care expenses related to being ill with COVID-19 or to caring for a member of the household who is ill with COVID-19; and (d) reasonable expenditures that stem from government-ordered emergency measures related to COVID-19. In assessing whether a tenant has the ability to pay rent, any assistance received from unemployment insurance, disability insurance, and federal relief or stimulus payments may be considered.
Landlords who participate in the program receive rental assistance payments covering at least eighty percent (80%) of the amount of unpaid rent owed by a tenant for not more than seven (7) months of a household’s missed or insufficient rent payments. In exchange, the landlord would be required to agree to: (a) not increase rent until after December 31, 2020; (b) not charge or attempt to collect any late fee for any unpaid rent due between April 1 and December 31, 2020; and (c) accept the rental assistance payment as full satisfaction of late or insufficient rent payments covered by the program.
Comments on SB 1410 can be submitted to Senator Gonzalez online at https://sd33.senate.ca.gov/contact/send-e-mail or by calling (916) 651-4033.
AB 2501 – COVID-19 Homeowner, Tenant, and Consumer Relief Law of 2020
Last Amended: May 11, 2020
Status: Re-referred to Committee on Banking and Finance May 11, 2020.
Introduced by Assembly Member Limón, AB 2501 is a comprehensive bill that would provide relief to residential mortgage borrowers, multifamily mortgage borrowers, and vehicle owners by prohibiting creditors and loan servicers from initiating foreclosures during the period of the COVID-19 pandemic and for a one hundred eighty (180)-day period following the end of the COVID-19 state of emergency. As currently drafted, AB 2501 provides different protections for residential mortgage borrowers and multifamily mortgage borrowers which largely mirrors the protections provided to residential and multifamily borrowers of federally backed mortgages under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The bill defines a “multifamily mortgage borrower” as a borrower of a residential mortgage loan that is secured by a lien against a property comprising five (5) or more dwelling units.
Multifamily Mortgage Loans
AB 2501 requires multifamily mortgage loan servicers and creditors to grant multifamily borrowers a loan forbearance of one hundred eighty (180) days. Multifamily borrowers have the ability to extend the forbearance period for an additional one hundred eighty (180) day period upon request at least thirty (30) days prior to the end of the initial forbearance period. As currently drafted, AB 2501 seemingly purports to regulate lenders and loan servicers solely through jurisdiction over the California-based property, regardless of whether the lender or servicer which originated the loan is principally based in another state, or merely services a pool of mortgages across multiple states. To qualify, a multifamily mortgage borrower need only submit a request for forbearance to the borrower’s mortgage servicer, either orally or in writing, affirming that the multifamily mortgage borrower is experiencing hardship during the COVID-19 emergency. While mortgage servicers are required to request documentation of a multifamily mortgage borrower’s financial hardship, AB 2501 does not specify what documentation is required to be submitted.
During the term of the forbearance period, the multifamily mortgage borrower would be required to grant rent relief to the residential tenants of the borrower’s property and would be prohibited from evicting a tenant for nonpayment of rent. Additionally, the multifamily mortgage borrower would be prohibited from imposing any late fees or penalties for unpaid rent. As currently drafted, AB 2501 does not expressly define the extent of the rent relief that a multifamily mortgage borrower is required to provided. Further, AB 2501 seemingly prevents a multifamily mortgage borrower from evicting a tenant for unpaid rent or collecting late fees on unpaid rent during the forbearance period regardless of whether the nonpayment first occurs after the end of the COVID-19 emergency period.
Multifamily mortgage borrowers are required to bring a loan placed in forbearance current within the earlier of: (a) twelve (12) months after the conclusion of the forbearance period, effectively allowing a total forbearance period of two (2) years; or (b) within ten (10) days of the receipt by the of multifamily mortgage borrower any business interruption insurance proceeds. As currently drafted, a multifamily mortgage borrower would be required to bring a loan current upon receipt of any business interruption insurance proceeds, regardless of whether such funds would be sufficient to fully satisfy the total amount of delinquent debt service.
Comments on AB 2501 can be submitted to Assemblymember Limón online at https://a37.asmdc.org/ or by calling (916) 319-2037.
AB 2406 – Homeless Accountability and Prevention Act
Last Amended: May 11, 2020
Status: Re-referred to Committee on Housing & Community Development May 12, 2020.
Introduced by Assemblymember Wicks, AB 2406 is aimed at preventing homelessness by providing the public access to information relating to residential rental units within California. In pursuit of this goal, AB 2406 would require any multifamily residential landlord that accepts rental assistance payments from federal or state funds provided in response to the COVID-19 state of emergency to annually submit a rental registry form for any residential dwelling unit as required by Section 50468 of the Health and Safety Code. Until the rental registry form is submitted, landlords would be prohibited from: (a) increasing rents; (b) issuing a notice to terminate a periodic tenancy pursuant to California Civil Code Section 1946.1; or (c) issuing any notice or initiating any unlawful detainer action.
Upon submitting the rental registry form, multifamily residential landlords are further required to annually report comprehensive information pertaining to each residential rental unit. Notably, as currently drafted, multifamily residential landlords would be required to annually report such information as: (i) the legal name of the owner or ownership entity and all limited partners, general partners, limited liability company members, and shareholders with ten percent (10%) or more ownership of the entity; (ii) the occupancy status of each rental unit; (iii) the total number of days each rental unit was vacant; (iv) the effective date of the most recent rent increase for each rental unit and the amount of the increase; and (v) the number of tenants in which the landlord terminated a tenancy and the reason underlying each lease termination.
Comments on AB 2406 can be submitted to Assemblymember Wicks online at https://a15.asmdc.org/letstalk or by calling (916) 319-2015.
California Senate Democratic Caucus’ Budget and Tax Credit Proposal
On May 12, 2020, Senate President Pro Tempore Atkins unveiled the Senate Democratic Caucus’ proposal for the state budget and California’s economic recovery. Part of the proposal includes the creation of a Renter/Landlord Stabilization program that would enable tri-party agreements between renters, landlords, and the State of California to resolve unpaid rents.
Although a draft bill has yet to be introduced, the preliminary proposal indicates that a tri-party agreement would grant a renter immediate rent relief for the full amount of unpaid rent and provide protection against eviction based on the unpaid rent. In exchange, the renter simply provides a commitment to repay past due rents, without interest, to the state over a ten (10)-year period, beginning in 2024. Additionally, the preliminary proposal indicates that a tenant’s obligation to repay past due rents will be based solely on the tenant’s ability to pay and that cases of hardship could lead to full forgiveness of unpaid rent.
As a party to the tri-party agreement, a landlord agrees to relieve the tenant of the obligation to pay past due rent and waives the right to evict the tenant based on the unpaid rent. In exchange, the landlord will receive tax credits from the state equal to the value of the forgiven rent, spread equally over tax years 2024-2033. The tax credits would be fully transferable such that landlords would be permitted to sell the tax credits for immediate cash value.
The preliminary proposal leaves open a number of questions about the program. First, the proposal does not indicate to which tax obligations the credits would apply, nor does the proposal indicate whether the calculation of the value of lost rent will include late fees or interest that would otherwise have accrued on unpaid rent. Second, the proposal requires landlords to wait a four (4) year period before utilizing the value of the tax credit. While a landlord is permitted to immediately sell the tax credit, the delay in the ability of the purchaser to utilize the tax credit will likely require the landlord to sell the tax credit at a discount against the value of the credit, eroding the effectiveness of the tax credit to offset the landlord’s losses. Finally, the proposal seemingly fails to include a mechanism the state can invoke as a remedy should a tenant default on the obligation to repay past due rents to the state. Without a properly crafted remedy, tenant defaults on such decade-long obligations could further deplete the state’s coffers.
Comments on Senator Atkins’ proposal can be submitted online at https://sd39.senate.ca.gov/contact or by calling (916) 651-4939.
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[1] By its terms, SB 939 retroactively renders evictions that would otherwise be disallowed under SB 939, and which occurred after the proclamation of the state of emergency but before the effective date of SB 939, “void” against public policy and unenforceable. Because such “violations” of the section may include improper notices, arguably certain events as simple as a notice of a default, which had previously been issued with the intent of starting the clock for other remedies that were permissible at the time, could be unwound if that action is itself now voided. This distinction between eviction and other available remedies is particularly significant in the commercial context, where it may effectively limit landlord’s other remedies (i.e., limiting tenant improvement allowance draws or draws on letters of credit).
[2] The bill is silent as to the effect it would have on default interest.
[3] The May 22 amendment adjusts this criteria to require that the small business be an eating or drinking establishment, place of entertainment, or performance venue, rather than extending the protections to both small businesses and such venues. Additionally, the amendment adds a definition of “small business” as “a business that is not dominant in its field of operation, the principal office of which is located in California, the officers of which are domiciled in California, and which has 500 or fewer employees.”
[4] An earlier version of this bill would have reduced the amount of rent owed by a tenant by twenty-five percent (25%) for a year following the issuance of an Order under this section, but this provision has been removed in its most recent amendment.
Gibson Dunn’s lawyers are continually monitoring the evolving situation and are available to assist with any questions you may have regarding these developments. For additional information, please contact any member of the firm’s Real Estate or Land Use Group, or the following authors:
Doug Champion – Los Angeles (+1213-229-7128, dchampion@gibsondunn.com) (Real Estate)
Danielle Katzir – Los Angeles (+1213-229-7630, dkatzir@gibsondunn.com) (Real Estate)
Alayna Monroe – Los Angeles (+1213-229-7969, amonroe@gibsondunn.com) (Litigation)
Ben Saltsman – Los Angeles (+1213-229-7480, bsaltsman@gibsondunn.com) (Real Estate)
Matthew Saria – Los Angeles (+1213-229-7988, msaria@gibsondunn.com) (Real Estate)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
The COVID-19 global pandemic has changed the face of the world for businesses and customers as we know it. Public health mandates and local, state, and national shelter-in-place orders have required events to be canceled, plans to be postponed indefinitely, and facilities closed until further notice. In the wake of these closures and cancellations, consumer frustration has mounted, and scores of class action lawsuits have followed. This Article examines the industries facing these lawsuits, describes the theories that plaintiffs are asserting, and provides some practical considerations and potential defenses for these lawsuits.
Industries Facing COVID-19 Related Refund Class Actions
Plaintiffs’ lawyers have seized on the COVID-19 pandemic to bring class action lawsuits involving the following businesses:
Student Tuition and Fees
As schools have been forced to close their campuses and shift to online learning, students and parents have filed class actions seeking reimbursement of tuition, room and board, and other expenses. The student-plaintiffs allege that the value of their degrees, the quality of their education, and their enjoyment of on-campus facilities have been diminished by switching to online classes. As such, the students allege that they are entitled to refunds on the theory that schools are not fulfilling their alleged contractual obligations to provide an on-campus education. Scores of these lawsuits have been filed against private and public universities.[1] Multiple class actions have been brought that seek not only reimbursement of room and board fees, but also tuition.
Concerts and Sporting Events
Shelter-in-place orders have left no choice but to cancel or postpone concerts and sporting events. In response, ticketholders to these events have filed refund class actions against event sponsors, as well as the websites that facilitate ticket sales, seeking refunds. For example, season ticket holders have sued Major League Baseball for “unfairly” financially burdening customers by withholding refunds after MLB postponed the season.[2] Other class action complaints brought against ticket sellers allege that companies changed their refund policies after consumers had already purchased their tickets.
Season Passes and Memberships
Companies that offer memberships and season passes for access to physical facilities, such as fitness centers, yoga studios, and ski resorts, also find themselves facing class actions seeking refunds following long-term and seasonal closures resulting from COVID-19. For example, one plaintiff claims her gym is not refunding her monthly membership fee while the gym is closed.[3]
Travel Deposits
Consumers have filed a number of class actions against travel companies seeking refunds for canceled flights or cruises. While many travel companies have offered no-fee cancellations and provided a credit for future travel, plaintiffs allege that they should be entitled to refunds of the funds paid, rather than a credit for future travel.[4]
Defenses and Practical Considerations
Businesses that are facing class action lawsuits based on mandatory closures have several defenses that warrant consideration as part of any legal strategy.
Arbitration Agreements and Class Action Waivers
Arbitration agreements are included in many contracts that accompany consumer transactions. Since the Supreme Court’s landmark decision in AT&T Mobility LLC v. Concepcion,[5] these types of agreements are enforceable subject to any generally applicable contract defenses that do not interfere with the fundamental attributes of arbitration (e.g., fraud, duress, and unconscionability).
As a result, one of the first steps a company should take in defending a consumer class action is determining whether the parties have agreed to resolve the dispute outside of court and outside of a class action setting. This also includes looking at whether there are arbitration provisions in third-party contracts, such as contracts between plaintiffs and ticket resellers.
If the case is one in which California law applies, then recent caselaw confirms that a company must also evaluate whether any of plaintiffs’ claims that are the subject of an arbitration agreement seek a public injunction.
Other Contract-Based Defenses
Once a company has determined whether the case should proceed in court or before an arbitrator, it should consider other contract-based defenses, especially those that may excuse a company’s performance or otherwise limit a company’s liability.
A frequently invoked contract defense in the wake of COVID-19 is force majeure. These clauses vary from contract to contract, but as a general matter, the purpose of these clauses is to set forth when a party may terminate or fail to perform without liability due to an unforeseen event. We anticipate that these clauses will be a particular focus of COVID-19 related litigation, especially those based on forced closures and cancellations.
Another possible defense is that there has been no actual breach of contract. If a company is complying with its contractual obligations, there is arguably no liability. For example, a contract may contemplate that an event or season may be cut short due to unforeseen circumstances, and it may assign that risk to the purchaser. Similarly, a purchaser’s entitlement to a refund may turn on his compliance with the contractual procedures for receiving a refund.
Impossibility and frustration of purpose also may excuse performance. “Impossibility” applies where performance is objectively impossible, and “frustration of purpose” is triggered if circumstances make the required performance worthless to the receiving party. Companies may be subject to government orders that make it impossible to host an event or open facilities, and courts have held that impossibility during disasters, based on intervening government restrictions, can excuse performance.[6]
Causation and Reliance-Based Defenses
Depending on a plaintiff’s theory, intervening factors may preclude, or mitigate, a company’s liability. These factors could include state and local orders limiting large gatherings or evidence of a plaintiff’s unwillingness to attend an event even if it were to proceed as scheduled.
A purchaser’s conduct may also defeat his claim. If a purchaser does not mitigate his or her damages, recovery may be limited. For example, a purchaser who fails to accept a voucher may be subject to an offset, and a purchaser who fails to accept a refund offer may not have standing to bring a claim, depending on the circumstances. A purchaser may also waive or negate any claim based on subsequent conduct, such as continuing a membership or using a voucher.
Defenses based on COVID-19 may also exist on bad faith and unjust enrichment claims. Evidence that a company is thoughtfully considering different options for responding to COVID-19 may negate a finding of bad faith. Similarly, companies are still incurring substantial costs due to government orders and closures, even with events canceled and facilities closed. Thus, a company may respond to an unjust enrichment claim by arguing that it is not unjustly retaining benefits due to the excessive costs it is incurring as a result of forced closures.
Class Certification Defenses
As this discussion suggests, putative class members are not going to be similarly situated and/or affected by the pandemic. For example, entitlement to a refund could turn on individualized issues, such as the specific representations to each consumer, and the steps taken to secure a refund. Individualized inquiries may also exist based on customer expectations. A frequent traveler may understand that flights are subject to unforeseen cancellation, but not a less-experienced traveler. In addition, damages may vary and be incapable of a method that allows them to be determined across the class. For example, a class member who uses a gym pass 50 times per year is differently situated than a consumer who historically uses it more infrequently. The presence of arbitration clauses and class action waivers in contracts with at least some of the putative class members can also make a class action lawsuit an inappropriate forum.
Conclusion
Companies that have canceled or postponed events or closed their facilities face many difficult choices based on COVID-19, and the specter of class action lawsuits further complicates these decisions. Regardless of a company’s approach, and even if a company is already subject to a class action lawsuit, there are important considerations that companies should weigh with counsel in order to determine the best path forward.
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[1] See, e.g., Rickenbaker v. Drexel Univ., No. 2:20-cv-1358 (D.S.C. Apr. 8, 2020); Dixon v. Univ. of Miami, No. 2:20-cv-1348 (D.S.C. Apr. 8, 2020); Rosenkrantz v. Ariz. Bd. of Regents, No. 2:20-cv-00613 (D. Ariz. Mar. 27, 2020).
[2] Ajzenman v. Office of the Comm’r of Baseball, No. 2:20-cv-03643 (C.D. Cal. Apr. 20, 2020).
[3] Labib v. 24 Hour Fitness USA Inc., No. 4:20-cv-02134 (N.D. Cal. Mar. 27, 2020); see also Weiler v. Corepower Yoga LLC, No. 2:20-cv-03496 (C.D. Cal. Apr. 15, 2020); Kramer v. Alterra Mountain Co., No. 1:20-cv-01057 (D. Colo. Apr. 14, 2020).
[4] See, e.g., Manchur v. Spirit Airlines Inc., No. 1:20-cv-10771 (D. Mass. Apr. 21, 2020); Alvarez v. Hawaiian Airlines Inc., No. 1:20-cv-00175 (D. Haw. Apr. 20, 2020); Roman v. JetBlue Airways Corp., No. 1:20-cv-01829 (E.D.N.Y. Apr. 16, 2020); Herr v. Allegiant Air LLC, No. 2:20-cv-10938 (E.D. Mich. Apr. 15, 2020); Bombin v. Sw. Airlines Co., No. 5:20-cv-01883 (E.D. Pa. Apr. 13, 2020).
[5] AT&T Mobility LLC v. Concepcion, 563 U.S. 333 (2011).
[6] See, e.g., Bush v. ProTravel Int’l, 192 Misc. 2d 743, 752–53 (N.Y. Civ. Ct. 2002) (recognizing impossibility of performance due to state of emergency following September 11 terrorist attacks).
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team or its Class Actions practice group, or the following authors:
AUTHORS: Christopher Chorba, Timothy W. Loose, Daniel Weiss, Jeremy S. Smith, Emily Riff, and Andrew Kasabian.
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On 10 May 2020, the UK government announced a provisional roadmap for the phased relaxation of the current COVID-19 lockdown restrictions, including those restrictions which have impacted businesses across the UK. While the UK government continues to require those who can work from home to do so, employees who are not able to work from home are now being actively encouraged to return to the workplace provided that their workplace is permitted to open and can be operated within government guidelines. In recent client alerts, we have considered in detail the law regarding: (i) the options for reducing the risk of employee exposure to COVID-19, including (a) instituting work-from-home/telecommuting policies and (b) instructing employees not to work; (ii) what to do if an employee tests positive or needs to care for an ill family member and (iii) the Coronavirus Job Retention Scheme (“CJRS”). Below, we identify some of the key considerations for UK-based businesses when taking steps to comply with their health and safety obligations once certain groups of employees return to the workplace. We also outline key amendments to the CJRS.
The UK government response to the outbreak continues to evolve daily, and we encourage employers in the UK to monitor UK government and National Health Service guidance and legislative developments over the coming weeks.
Return-To-Work, Screening, and Safety
New Government Guidance and Return to Work Plans
On 11 May 2020, the UK government published both new and updated guidance to reflect the focus on getting workers back to work where possible. The guidance has been produced with the aim of helping employers ensure employees work safely during coronavirus, and includes measures to assist employers in making the workplace “COVID-19 secure”. The UK government has produced general guidance comprising of five key points, which we detail below, and eight workplace-specific guidance notes, formulated with the objective of meeting these five key points. We are available to guide clients through the specific guidance applying to their industry.
Five Key Points in the COVID-19 Secure Guidance
- Work from home, if you can
Individuals should work from home if they can, and “all reasonable steps” should be taken by employers to enable individuals to work from home. However, the guidance now clearly states that those who cannot work from home and whose workplaces are permitted to operate, should go to work.
To ensure readiness for staff returning to work, employers must devise a return to work plan with employees and those who represent them.
When devising a return to work plan, employers should consult employees, listen to their concerns and be mindful of their personal circumstances including childcare responsibilities. Employers should also think about identifying vulnerable employees and how they will be treated when the workplace reopens. If an employer requires certain roles or numbers of people to return, they should be mindful of how selection will be carried out to avoid any discrimination or other issues of unfairness which could lead to claims.
- Carry out a COVID-19 risk assessment, in consultation with workers or trade unions
Employers must carry out COVID-19 risk assessments in consultation with their trade unions or workers in order to establish what guidelines should be put in place, and identify sensible measures to control the risks in the workplace. Employers with over 50 employees should publish their workplace risk assessments on their website, with smaller employers being advised to do so. Employers should share the results of risk assessments with their workforce.
Once a risk assessment has been carried out, an employer should update appropriate policies and procedures accordingly.
Employers should also consider providing appropriate training for managers and employees and deliver this training before or upon their return to the workplace. Communications should be displayed around the workplace in prominent places such as handwashing points, entrances and exits. A downloadable notice is provided in each of the workplace-specific guidance documents. Employers should monitor the effectiveness of their policies and review their plans regularly, ideally each time the government updates its guidance.
- Maintain two metres social distancing, wherever possible
Employers may need to consider changing the layout of workspaces to maintain a two metre distance between individuals in compliance with social distancing advice. Employers should consider designating a one way system for entry and exit into the building; limiting the number of people allowed in confined spaces at any one time (e.g. lifts, meeting rooms, toilets); reducing face to face interactions, for example by introducing delivered desk-based lunch orders and restricting or prohibiting the use of communal areas such as kitchens and lunchrooms; encouraging non-public means of getting to work (e.g. bicycles or walking); and reducing non-essential work travel.
- Where people cannot be 2 metres apart, manage transmission risk
Employers are also encouraged to change the way work is organised in order to reduce the number of people with whom each employee interacts face to face as well as minimizing those interactions. Employers should consider limiting the number people in the workplace at any one time, by adjusting working hours or dividing employees into groups and rotating their attendance in the office, introducing protective screens into the workplace and encouraging video-conference meetings.
- Reinforcing cleaning processes
Workplaces should be cleaned more frequently than usual, focusing on high touch points like door handles or keyboards, ensuring access to hygiene facilities such as hand sanitizer, providing anti-bacterial wipes for equipment and disposing of waste frequently.
Risks of Failing to Implement the COVID-19 Secure Guidance
Employers who fail to comply with the COVID-19 secure guidance may find themselves in breach of health and safety obligations towards workers and visitors to their premises. Such breaches may attract criminal penalties and/or enforcement notices. To encourage compliance with the COVID-19 secure guidance, the Prime Minister has asked employees to report their employers’ failures to implement the guidance to the Health and Safety Executive (“HSE”), the organisation responsible for enforcing health and safety laws in the UK, and the UK government has made available up to an extra £14 million for the HSE for additional compliance-monitoring resources.
Screening Employees for COVID-19
Employers who wish to carry out COVID-19 screening, such as temperature checks, on their employees, workers or visitors will need their consent to do so. The results of any screening would need to be handled appropriately in accordance with the GDPR and Data Protection Act 2018 to the extent that it is stored or processed: a data protection impact assessment is likely to be required and employers will need to ensure any individuals it screens are provided an appropriate privacy notice detailing what personal data will be required, how their personal data will be used, who it will be shared with, the implications of the results and how long it will be kept for. Employers should also ensure any screening is applied consistently across their workforce to mitigate any risk of discrimination claims, which could arise upon the screening of a specific group of employees perceived to be at a higher risk of having contracted the virus. Finally, employers should seek to adopt the least intrusive means of protecting the health and safety of their employees and making the workplace safe.
If Employees Become Ill
Employers must follow government guidelines in respect of COVID-19 related illness. If anyone becomes unwell with a new, continuous cough or a high temperature, they should be advised to follow the stay at home guidance. If these symptoms develop whilst at work, the employee should be sent home immediately and advised not to use public transport if possible. Government policy currently states that it is not necessary to close the business or workplace or send any staff home in these circumstances. Please refer to our alert of 17 March 2020 for sick pay implications.
Employees who require shielding and those at high risk
Employees who have been informed by their GP or an NHS letter that they are clinically extremely vulnerable, because for example they suffer from severe respiratory conditions or are undergoing immunosuppression therapies sufficient to significantly increase risk of infection, are required to shield i.e. stay at home at all times and avoid all non-essential face to face contact. Employers should support members of staff who are clinically extremely vulnerable, as well as individuals with whom they live, as they follow the recommendations set out in the shielding guidance. In particular, they should be supported to stay at home, until UK government guidance suggests otherwise.
Employees who are not clinically extremely vulnerable but have medical conditions which place them at an increased risk of severe illness from COVID-19, such as pregnant women and those with diabetes, have been advised to take particular care to minimise contact with others outside their households, but do not need to be shielded. Employers should listen to such employees’ concerns and be flexible to their needs where practicable.
Employees who are unable to return to the workplace due to childcare commitments
The UK government’s plan for a phased reopening of nurseries and schools is not due to begin until 1 June at the earliest, with only certain year groups eligible to return in the early stages. As such, some employees may be unable to return to the workplace due to childcare commitments. The Prime Minister has encouraged employers to regard childcare commitments as an obvious barrier to an employee’s ability to return to the workplace. Employers should encourage open communication with employees with childcare commitments and endeavour to reach an agreement on flexible working arrangements where possible.
If Employees Hesitate or Refuse to Return to Work
Employees may also be reluctant to return to the workplace if they have to take public transport to get to work, if they do not feel the measures their employer has taken go far enough to ensure their health and safety, or if they live with a vulnerable person who requires shielding. Employers will have the best chance of identifying these issues at an early stage if they are able to engage in early consultation and ongoing communication with their employees.
If employees refuse to return to work, employers will need to consider whether they can be more flexible in the arrangements they have put in place taking into account the employees’ circumstances, or whether ultimately they wish to take further steps to require their employees to comply with the instruction to return to work, or treat a refusal to return to work as an unauthorised absence and consider disciplinary action.
Employers will need to ensure any such steps are taken in a fair, rational and non-discriminatory way to avoid potential liability in this area. It would also be advisable for employers to record their decisions and steps they take to be flexible to the needs of their employees where appropriate or necessary.
Update: Coronavirus Job Retention Scheme
General: We reported on the CJRS when it was first introduced in March 2020. On 12 May 2020, the Chancellor announced that the CJRS will be extended by a further four months until the end of October 2020, with no changes until the end of July 2020. From August 2020: (i) employees will be able to return to work on a part-time basis; (ii) employers will be required to pay a percentage towards the salaries of their furloughed employees and (iii) the employer’s payments will substitute at least part of the government’s contribution under the CJRS, ensuring that any furloughed workers continue to receive 80% of their salary (up to the maximum of £2,500 a month). From August 2020 employers will have to start sharing, with the UK government, the cost of paying people’s furloughed salaries. The UK government has committed to provide further details before the end of May 2020.
Holiday: On 13 May 2020, the UK government published guidance on workers’ entitlement to holiday, holiday pay and the right to carry over of holiday during coronavirus. The guidance confirms that furloughed workers continue to accrue holiday, including any contractual holiday they receive above the statutory minimum of 5.6 weeks (subject to any furlough agreement to the contrary), and may take holiday without it interrupting their period of furlough. It also confirms that a furloughed worker’s entitlement to holiday pay remains unchanged and is to be calculated in the normal way. This means that where the calculated holiday pay rate is above the pay the worker receives whilst on furlough, the employer may continue to claim the 80% CJRS grant, but must pay the worker the difference unless they have agreed that the employee’s pay is to be reduced to the furlough limit for the period of furlough. This applies to bank holidays where they fall within a worker’s furlough period.
As reported in our alert of 27 March 2020, the UK government previously introduced the Working Time (Coronavirus) (Amendment) Regulations 2020 (the “Regulations”) which allow up to 4 weeks of unused holiday to be carried over into the next two leave years if it has not all been taken due to COVID-19. The latest guidance advises that when determining whether it was not reasonably practicable for a worker to take holiday, employers should consider various factors, including: (i) increased demand for the business’ services due to COVID-19 that require the worker to continue working; (ii) the extent to which the business’ workforce is disrupted by COVID-19 and the ability to provide temporary cover of essential activities including the availability of the remaining workforce to cover the worker whilst they are on holiday; (iii) the worker’s health and the speed at which they need a period of rest and relaxation; (iv) the length of time left in the worker’s holiday year to enable them to take holiday later in the year; and (v) the impact of the worker’s holiday on society’s response and recovery from COVID-19.
The guidance states that employers should do everything reasonably practicable to ensure workers take as much of their holiday in the year to which it relates and notes that furloughed workers will be unlikely to need to carry forward their holiday as they can take it during furlough.
As reported in our alert of 27 March 2020, employers have the right to require workers to take or cancel holiday subject to providing a certain amount of notice, a right which continues to apply to furloughed workers under the latest guidance. This tool should assist employers in ensuring holiday is taken within the applicable year and also prevent employers facing unmanageable holiday requests from workers later in the year when restrictions are lifted However, if an employer is unable to fund the difference between furlough pay and holiday pay, this may result it in not being reasonably practicable for the worker to take holiday whilst on furlough and enable them to carry their entitlement forward under the Regulations. Employers should also consider whether a worker’s individual circumstances allow them to enjoy holiday whilst on furlough in the fundamental sense, taking into account any social distance or self-isolation restrictions they may be under which would prevent them from resting and relaxing, before requiring them to take holiday.
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Gibson Dunn attorneys regularly counsel clients on the compliance issues raised by this pandemic, and we are working with many of our clients on their response to COVID-19. Please contact the Gibson Dunn attorney with whom you work in the Employment Group, or the following authors:
James Cox – London (+44 (0)20 7071 4250, jcox@gibsondunn.com)
Sarika Rabheru – London (+44 (0) 20 7071 4267, srabheru@gibsondunn.com)
Heather Gibbons – London (+44 (0)20 7071 4127, hgibbons@gibsondunn.com)
Georgia Derbyshire – London (+44 (0)20 7071 4013, gderbyshire@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
In a speech on May 12, 2020, Steven Peikin, Co-Director of the U.S. Securities and Exchange Commission’s Division of Enforcement, provided insights on the Division’s enforcement priorities in light of the pandemic, as well as how the Division is managing the investigative process under remote work conditions.[1] The remarks provide helpful guidance on how companies and financial institutions can mitigate risk of investigative scrutiny for financial shocks resulting from the pandemic.
In response to the pandemic, the Enforcement Division has formed a Coronavirus Steering Committee, comprised of leadership from the Home and Regional Offices, the specialized units and the Office of Market Intelligence, to identify areas of potential misconduct and coordinate the Division’s response to COVID-19 related issues. The below areas of regulatory focus provide a helpful roadmap for companies and financial institutions, and reinforce the guidance we provided in our prior alert, to reduce the risk of drawing scrutiny.
- Insider Trading and Market Manipulation: The rapid and dramatic impact of the pandemic on the financial performance of companies increases the potential for trading that could be perceived as attributable to material non-public information. The Steering Committee is working with the Division’s Market Abuse Unit to monitor announcements in industries particularly impacted by COVID-19 and to identify potentially suspicious market movements.
- Accounting Fraud: As with other financial crises, the pandemic is likely to expose previously undisclosed financial reporting issues, as well as give rise to rapidly evolving financial reporting and disclosure challenges. The Steering Committee is on the lookout for indications of potential disclosure and reporting misconduct. In particular, the Steering Committee is reviewing public filings with an eye toward disclosures that appear out of step to companies in similar industries. The Committee is also looking for accounting that attempts to inaccurately characterize preexisting financial statement issues as coronavirus related.
- Asset Management: Asset managers confront unique challenges created by the pandemic, including with respect to valuations, liquidity, disclosures, and the management of potential conflicts among clients and between clients and the manager. The Steering Committee is working with the Division’s Asset Management Unit to monitor these issues, including failures to honor redemption requests, which could reveal other underlying asset management issues.
- Complex Financial Instruments: As with prior financial crises, the pandemic may reveal risks inherent in various structured investment products. The Steering Committee is working with the Division’s Complex Financial Instruments Unit to monitor complex structured products and the marketing of those products to investors.
- Microcap Fraud: The Steering Committee is working with the Division’s Microcap Fraud Task Force and Office of Market Intelligence, and has suspended trading in the securities of over 30 issuers relating to allegedly false or misleading claims related to the coronavirus.
As we discussed in our prior alert, by understanding the issues that can give rise to regulatory scrutiny, and consulting with counsel on how to navigate the unique challenges, issuers and financial institutions can both lower the risk of being in a regulatory spotlight, as well as resolve regulatory inquiries more efficiently.
Speaking more broadly on the Enforcement Division’s process during the pandemic, Peikin noted that the Division staff continues to remain engaged despite the new challenges of a remote work environment. The Division staff has been directed to work with defense counsel and others to reach reasonable accommodations concerning document production, testimony, interviews and counsel meetings, given the challenges of the pandemic, but also cautioned that the staff will need to protect potential claims and won’t agree to an indefinite hiatus in investigations or litigations. In particular, Peikin noted that in instances where defense counsel would not agree to tolling agreements, the Division will consider recommending that the Commission commence an enforcement action, despite an incomplete investigative record, and will rely on civil discovery to further support its claims.
Predictably, the pandemic has already led to a marked increase in Enforcement investigations and whistleblower tips. Since mid-March, the Division has opened hundreds of new investigations concerning issues related both to COVID-19 as well as traditional areas of investigation. In addition, the Division has triaged more than 4,000 whistleblower tips since mid-March, a 35% increase over the same period last year. Since March 23, the Commission has granted nine whistleblower awards, including one for over $27 million (though these awards were clearly in the pipeline long before the pandemic). Nevertheless, the notable increase in whistleblower complaints further reinforces the guidance in our prior alert on how companies can manage the heightened risks of whistleblowers resulting from the pandemic.
In sum, Peikin noted that while there is uncertainty ahead, the Enforcement Division expects the pandemic will result in increased enforcement activity as the market decline and volatility will lead to investigations of potential past misconduct as well as potential new misconduct.
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[1] See May 12, 2020 Keynote Address: Securities Forum West 2020, available at https://www.sec.gov/news/speech/keynote-securities-enforcement-forum-west-2020.
Gibson Dunn lawyers regularly counsel clients on the issues raised by this pandemic. For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team, the Gibson Dunn lawyer with whom you usually work in the firm’s Securities Enforcement Practice Group, or the following authors:
Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com)
Tina Samanta – New York (+1 212-351-2469, tsamanta@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
This Alert reports on the steady pace of patent litigation and patent review filings during the COVID-19 pandemic, and notes that some aspects of ongoing patent litigation are also proceeding as usual. The Alert also discusses intellectual property litigation involving a hand sanitizer manufacturer, and provides brief updates on the Open COVID Pledge, and on manufacturer 3M’s efforts to combat price gouging of personal protective equipment (“PPE”) (earlier developments reported here and here).
(1) Patent Lawsuit Filings Continue at a Steady Pace
Based on year-to-year filings, the pandemic does not appear to have deterred patent owners from commencing infringement lawsuits. In March 2020, a total of 313 patent complaints were filed in the federal courts, an increase from the 256 that were filed in March 2019. Likewise, in April 2020, 380 patent complaints were filed, an increase from the 292 filed in April 2019. Petitions seeking the review of patent claims before the U.S. Patent Trial and Appeal Board (“PTAB”) also continue to be filed at a level comparable to filings before the pandemic. In March 2020, 100 petitions for review were filed, and in April 2020, 99 petitions were filed. Although these numbers are lower than the 129 and 104 petitions that were filed in March and April 2019,[1] monthly filing rates in the PTAB varied even before the pandemic.[2] The simplest take-away is that new patent cases continue to be filed in the United States at rates similar to filing rates before the pandemic.
Although patent jury trials previously scheduled for March and April have been postponed, many other court proceedings have continued during the pandemic—with appropriate adaptations. The Federal Circuit now operates essentially as a virtual court; it held telephonic oral arguments in April, and another 26 telephonic oral arguments are expected in May. And some district courts are conducting bench trials in patent cases remotely. Judge Henry Coke Jr. in the U.S. District Court for the Eastern District of Virginia, for example, is currently presiding over a bench trial in a patent infringement case, Centripetal Networks v. Cisco Systems, No. 18-cv-00094-HCM-LRL (E.D. Va. 2018), in which the plaintiff is seeking up to $557 million in damages for alleged infringement of its cybersecurity patents. Opening statements took place over Zoom on May 7. The court’s pre-trial order is available here. One patent case that was originally scheduled for a virtual bench trial in late May, however, was postponed to July 6 at the request of the attorneys.[3]
(2) Continued Efforts to Facilitate the Donation of Patent Rights During the COVID-19 Pandemic
The Open COVID Pledge, which reflects a commitment by the signers to eliminate intellectual property rights as a potential obstacle to developing products and treatments for fighting against the virus, continues to gain support. Signatories to the Open COVID-19 pledge grant a non-exclusive, royalty-free, worldwide license to use their patents and copyrights “for the sole purpose of ending” the COVID-19 pandemic. Companies such as Intel and Mozilla were among the first to subscribe, followed shortly by additional technology giants, such as Amazon, Facebook, HP, IBM, Microsoft, and Sandia National Laboratories. Since our prior update, several Japan-based technology companies have also signed on, including Canon and Toyota. AT&T, noting in a press release last week that it “generates roughly 5 patents every business day,” has signed the pledge as well.
(3) The Department of Justice and Manufacturer 3M Obtain Injunctions Associated with, Respectively, the Sale of Hand Sanitizer and the Sale of N95 Masks
Last week, Judge Carter of the United States District Court for the Central District of California permanently enjoined Innovative Biodefense, Inc. (“IBD”), which manufacturers hand sanitizers and lotions under the brand name Zylast, from “directly or indirectly manufacturing, processing, packaging, labeling, holding or distributing” certain Zylast products, like the “Zylast Broad Spectrum Antimicrobial Antiseptic” and “Zylast XP (Extended Protection) Antiseptic Foaming Wash.”[4] The injunction was issued after the Department of Justice (“DOJ”) sued IBD, on behalf of the FDA, alleging that IBD was effectively marketing certain Zylast products as new drugs (by claiming that the products were effective against various infectious diseases like Ebola and norovirus) without the requisite FDA approval, in violation of the Food, Drug, and Cosmetic Act (“FDCA”). The court previously ruled on summary judgment that IBD and its co-defendants (the company’s CEO and another employee) had violated the FDCA as a matter of law, and then held a bench trial on the defendants’ affirmative defenses of laches and unclean hands—which were based on allegations that the DOJ was selectively enforcing the FDCA against IBD to benefit the makers of the competing Purell hand sanitizer.[5] The court found that no evidence supported those defenses.
The injunction against IBD is effective until either: (a) the company obtains FDA approval to market the Zylast products through a new, abbreviated, or investigational new drug application; or (b) the company retains independent experts to review the formulation and labeling of the products and certify to the FDA (among other things) that the products comply with FDA regulations concerning over-the-counter drug formulations.
Finally, as noted in our last alert, the manufacturer 3M previously secured a temporary restraining order (“TRO”) against Defendant Performance Supply, LLC, arising from 3M’s allegations that the defendant had offered to sell New York City’s Office of Citywide Procurement millions of N95 respirators bearing the 3M logo and at inflated prices.
Following a telephonic preliminary injunction hearing on May 4, Judge Preska, of the Southern District of New York, converted the TRO into a preliminary injunction against Performance Supply, LLC, enjoining the company from among other things, “using the ‘3M’ trademarks” in connection with “3M-brand N95 respirators” and other 3M goods; from “falsely representing that 3M has increased the price(s) of its 3M-brand N95 respirators”; and from otherwise “offering to sell any of 3M’s products at a price . . . that would constitute a violation of New York General Business Law § 369-[r]” (New York’s price gouging statute).[6] In addition to concluding that 3M had demonstrated that it met the Second Circuit’s factors for a preliminary injunction, the court emphasized 3M’s efforts to collaborate “with law enforcement, retail partners, and others to help thwart third-party price-gouging, counterfeiting, and fraud in relation to 3M-brand N95 respirators during COVID-19.”[7] The court also found that 3M has taken active steps to protect the goodwill of the 3M brand, including by filing other trademark suits in California, Florida, Indiana, and Wisconsin.
We are continuing to monitor intellectual property-related updates and trends in the response to COVID-19.
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[1] These figures were obtained from conducting searches in Docket Navigator. For each of the time frames discussed above, the numerical figures reflect the total number of (1) complaints filed in federal district courts asserting patent infringement and declaratory judgment claims, including claims pursuant to the Hatch Waxman Act and Biologics Price Competition and Innovation Act; and (2) petitions before the PTAB seeking inter partes review, post-grant review, or covered business method review.
[2] United States Patent and Trademark Office, Trial Statistics IPR, PGR, CBM (March 2020), https://www.uspto.gov/sites/default/files/documents/trial_statistics_20200331.pdf.
[3] Ferring Pharm. Inc. v. Serenity Pharm. LLC, No. 17-cv-9922 (CM) (SDA), Order (Dkt. 679) (S.D.N.Y. Apr. 28, 2020).
[4] United States of America v. Innovative Biodefense, Inc., No. 8:18 CV 996-DOC (JDE), Order of Permanent Injunction (Dkt. 215) at 2-3 (C.D. Cal. May 4, 2020).
[5] Id., Findings of Fact and Conclusions of Law (Dkt. 214) at 27-30.
[6] 3M Company v. Performance Supply, LLC, No. 20-cv-02949 (LAP)(KNF), Order (Dkt. 22) at 3-4 (S.D.N.Y. May 4, 2020).
[7] Id., Findings of Fact and Conclusions of Law (Dkt. 23) ¶¶ 27-29.
Gibson Dunn lawyers regularly counsel clients on the issues raised by this pandemic, and we are working with many of our clients on their response to COVID-19. For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team. Please also feel free to contact the Gibson Dunn lawyer with whom you usually work, or the authors:
Joe Evall (jevall@gibsondunn.com), Richard Mark (rmark@gibsondunn.com), Doran Satanove (dsatanove@gibsondunn.com), and Amanda First (afirst@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
New York State’s Appellate Division, First Department handles over 3,000 appeals each year—more than the number of appeals pending in eight of the federal appellate courts in 2019. Its docket includes some of the most high-profile and significant commercial appeals in the State and the nation, as it reviews trial-level decisions issued by the Manhattan branch of the New York Supreme Court, Commercial Division.[1] The Appellate Division is often the final word in a given case; the only courts that can review its decisions—the New York Court of Appeals (New York’s high court) and the U.S. Supreme Court—control their own dockets and take relatively few cases for consideration.
On March 17, 2020, the First Department issued an order “suspend[ing] indefinitely and until further directive of the Court,” all perfection, filing, and other deadlines, except for matters that were already perfected for the May 2020 and June 2020 Terms of the First Department.[2] The order essentially closed the Court to new appeals and left the First Department’s Fall calendar in COVID-19-related limbo. But on May 8, 2020 the First Department rescinded the March 17, 2020 Order and reinstated “the deadlines for the remaining 2020 terms of the Court (September through December 2020 terms).”[3] The First Department is in all material respects now back open for business for new appeals.
The details of the May 8 Order are important for any party considering taking an appeal to the First Department. And virtually any trial court-level decision or order, even if interlocutory, can be appealed to the Appellate Division under New York’s unusually broad appealability rules. But failure to comply with the Court’s deadlines in some instances can result in a dismissal of the appeal.[4]
First Department Filing Deadlines. Filing deadlines for appeals in the First Department are driven by the First Department’s Term calendar and rules for “perfecting” appeals. In general, an appeal is deemed “perfected” when the appellant’s brief, the record on appeal or the appendix, and the notice of argument are collectively filed with the First Department and served on the respondent.[5] The First Department’s rules provide that, except where the Court has directed that appeal be perfected by a particular time, an appeal must be perfected within six months from the date of the notice of appeal.[6] If an appellant fails to perfect the appeal within six months, or the deadline set forth in an applicable Court order, “the matter shall be deemed dismissed without further order.”[7] However, the appellant can decide when to perfect the appeal within the allotted six-month period.
The appellant must also perfect the appeal for a specific “Term” of the Court. The First Department has monthly Terms from January through June and September through December, in advance of which the Court accepts submissions at set deadlines.[8] Each Term in the calendar has a designated due date for the appellant to perfect the appeal, the respondent to serve and file the responding brief, and the appellant to serve and file the reply brief.[9] The “Term” of the Court for which an appeal is perfected determines the month in which the Court will hear oral argument in the case. Although appellants may perfect an appeal any day in which the Court is open, appellants frequently opt to perfect on the last filing day of a given Term, as this gives the appellant the maximum amount of time to work on opening papers while still being heard in the given Term, and doing so also gives respondent the fewest number of days to review the opening brief and file their responding brief.
The March 17 & May 8 Orders and Perfection Deadlines. The First Department’s March 17, 2020 Order “suspended indefinitely” all perfection, filing, and other appeal deadlines “until further directive of the Court,” except for matters that were already perfected for the May 2020 and June 2020 Terms of the First Department, the perfection deadlines for which had already passed as of March 17.[10] That means that appellants considering filing any new appeals had no due dates to do so—effectively putting the First Department on a pandemic-induced pause.[11]
Now, by reinstating the “deadlines for the remaining 2020 terms,” the May 8 Order effectively reopens the Court for new appeals. Specifically, the perfection and filing deadlines for the upcoming September through December 2020 Terms, as set forth in the First Department’s calendar issued prior to the outbreak of COVID-19, are reinstated and will remain in effect.[12] Namely, if an appealing party wants its case to be heard in the September Term (the next available Term), it needs to perfect by July 13, 2020; if it wants to be heard in the October Term, it needs to perfect by August 10, 2020.[13] And importantly, the March 17 Order did not alter the pre-pandemic deadlines—essentially allowing the Court to return to its regular Fall schedule.
While the First Department has reinstated its calendar for the remainder of the year, the requirement that parties file hard copy briefs, records, and appendices with the Court “continues to be suspended until further directive of this Court.”[14]
Finally, due to the pandemic, oral argument for the May and June Terms was conducted via videoconference technology. The Court has not yet provided information on the format for oral argument for the September through December 2020 Terms. We anticipate that the Court will issue further orders in the coming months providing that information to litigants.
Gibson Dunn is monitoring the situation with respect to the First Department and is available to assist with any questions.
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[1] Appellate Division, First Judicial Department, Supreme Court of the State of New York, http://www.courts.state.ny.us/courts/ad1/ (last visited May 12, 2020); see also Table B—U.S. Courts of Appeals Federal Judicial Caseload Statistics (March 31, 2019), Admin. Office of the U.S. Courts, https://www.uscourts.gov/statistics/table/b/federal-judicial-caseload-statistics/2019/03/31 (last visited May 12, 2020).
[2] Order In the Matter of the Temporary Suspension of Perfection, Filing and other Deadlines During Public Health Emergency, N.Y. App. Div. 1st Dep’t (Mar. 17, 2020), http://www.courts.state.ny.us/courts/ad1/PDFs/Temporary%20Suspension%20Order.pdf [hereinafter March 17 Order].
[3] Order In the Matter of the Rescission of Temporary Suspension Order, N.Y. App. Div. 1st Dep’t (May 8, 2020), https://www.nycourts.gov/courts/AD1/PDFs/RescissionOrder.pdf [hereinafter May 8 Order].
[4] 22 N.Y.C.R.R. 1250.10(a). The May 8 Order also sets a new deadline for filing responding and reply papers to motions that were returnable between March 16, 2020 and May 4, 2020, as discussed in more detail below.
[5] 22 N.Y.C.R.R. 1250.9(a).
[6] 22 N.Y.C.R.R. 1250.9(a), 1250.10(a).
[7] 22 N.Y.C.R.R. 1250.10(a).
[8] 2020 Calendar, New York Supreme Court, Appellate Division – First Department, https://www.nycourts.gov/courts/AD1/2020calendars.shtml (last visited May 12, 2020) [hereinafter 2020 Calendar].
[9] Id.
[10] March 17 Order, supra note 2.
[11] Per the March 17 Order, appellants were still permitted to file opening papers initiating a new appeal, should they choose to do so, but those appeals would not be calendared and respondents’ deadlines for filing opposition papers would not be triggered.
[12] May 8 Order, supra note 3.
[13] 2020 Calendar, supra note 8.
[14] May 8 Order, supra note 3. The May 8 Order also set a new deadline for the filing of responding and reply papers on motions that were returnable between March 16, 2020 and May 4, 2020. Motions in the appellate division include anything from motions to stay trial court proceedings pending appeal and motions for preferences (i.e., an expedited appeal). Generally, a motion is “returnable” on the date that the motion will be heard by the Court. The moving party may choose the specific return date, but motions should generally be made returnable at 10:00 a.m. on any Monday in which the Court is open. 22 N.Y.C.R.R. 1250.4(a)(1); CPLR 2214(b). The deadlines for responding papers and reply papers, if any, are determined based on the return date. 22 N.Y.C.R.R. 1250.4(a)(4), (5); CPLR 2214(b). The March 17 Order suspended all filing deadlines indefinitely, including the deadlines to file responding papers and reply papers to motions. The May 8 Order reinstates applicable filing deadlines, and states that for motions that were made returnable between March 16, 2020 and May 4, 2020, the responding and reply papers must be filed by May 22, 2020.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding developments related to the COVID-19 outbreak. For additional information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Coronavirus (COVID-19) Response Team, or the following authors:
Akiva Shapiro – New York (+1 212-351-3830, ashapiro@gibsondunn.com)
Lee R. Crain – New York (+1 212-351-2454, lcrain@gibsondunn.com)
Grace E. Hart – New York (+1 212-351-6372, ghart@gibsondunn.com)
Jason Bressler – New York (+1 212-351-6204, jbressler@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
The UK Financial Conduct Authority (“FCA”) has issued statements to financial services firms outlining its expectations on: (i) financial crime systems and controls; and (ii) information security, during the COVID-19 pandemic. These are further examples of the FCA requiring firms to take steps to prevent and/or limit harm to consumers and the market more generally in this challenging period. This client alert summaries these two statements and the steps that financial services firms should be taking to ensure continued compliance with their regulatory obligations.
Financial crime systems and controls
In its statement to firms, the FCA noted that criminals are already taking advantage of the COVID-19 pandemic to conduct fraud and exploitation scams through a variety of methods (including cyber-enabled fraud). The FCA flagged the importance of firms remaining vigilant to new types of fraud and amending their control environment where necessary to respond to new threats (including ensuring the timely reporting of suspicious activity reports).
Risk appetite
Firms should not address any current operational issues faced during the COVID-19 crisis by changing their risk appetite. For example, firms should not change or switch-off current transaction monitoring triggers/thresholds or sanctions screening systems, for the sole purpose of reducing the number of alerts generated to address operational issues.
Flexibility relating to ongoing customer due diligence reviews
The FCA does, however, acknowledge that firms may need to prioritise or reasonably delay some activities, whilst still operating within the anti-money laundering legislative framework. For example, this may involve, in some cases, delaying ongoing customer due diligence (“CDD”) reviews. This is subject to two important caveats:
- when there are delays, the firm has accepted these on a “risk basis” (such as delaying CDD reviews of customers posing a lower risk); and
- a clear plan is in place to return to the “business as usual” review process as soon as possible.
The FCA specifically flags that challenges of detecting terrorist financing still exist and firms must not, therefore, weaken their controls to detect such high-risk activity.
Decisions to amend controls to take account of the current circumstances should be clearly risk-assessed, documented and go through the appropriate governance process.
Client identity verification
Firms are still expected to comply with their obligations under money laundering legislation relating to client identity verification. They are reminded, in light of current travel restrictions, that such legislation, together with the Joint Money Laundering Steering Group guidance, allows for client identity verification to be carried out remotely. They also give indications of certain safeguards and additional checks which can help with verification. For example, firms can ask clients to submit digital photos or videos for comparison with other forms of identification gathered as part of the onboarding process
The FCA is, however, keen to point out that this does not constitute flexibility of the requirements – this is something already provided for under the anti-money laundering legislative framework and associated guidance.
Information security
Linked to the FCA’s concerns prompting the above statement on financial crime, the FCA has also issued a statement with respect to firms’ information security.
Changes to the “threat landscape”
The unprecedented circumstances caused by coronavirus have required firms to change their ways of working at some speed and have changed the threat landscape faced by many financial services firms. As more people are working from home, online systems are becoming increasingly mission-critical and cyber criminals are taking advantage of the situation for their own gain.
Managing the increased risk
Firms are expected to prioritise information security and ensure that adequate controls are in place to manage cyber threats and respond to major incidents. This may include implementing enhanced monitoring to protect end points, information and firm critical processes (including, but not limited to, video conferencing software).
Firms should “proactively manage the increased risks”. Amongst other things, they should be:
- vigilant to the potential increase in security breaches or cyber-attacks;
- ensuring that they continue to have appropriate governance and oversight arrangements in place; and
- ensuring that necessary regulatory notifications are made.
Ongoing areas of regulatory focus
Information security and financial crime are two areas on which the FCA has focused for some time prior to the COVID-19 pandemic. For example, there is an ongoing FCA consultation on operational resilience (published in December 2019), under which cyber security is a key theme.
Further, there are no indications of the FCA’s interests in these area waning. For example, the FCA Business Plan 2020/2021 provides that the FCA will start to implement changes to how it reduces financial crime. These include making greater use of data to identify firms or areas that are potentially vulnerable. It warns that it will continue to take enforcement action where it uncovers serious misconduct, particularly where there is a high risk of money laundering.
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Gibson Dunn’s lawyers are available to assist with any questions you may have regarding developments related to the COVID-19 outbreak. For additional information, please contact your usual contacts or any member of the Firm’s Coronavirus (COVID-19) Response Team, or the following authors:
Authors: Michelle Kirschner, Martin Coombes and Chris Hickey
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
In this second part of our German corporate law Client Updates on corporate law issues and the M&A business in Germany in times of the Corona crisis, we provide an overview of various tendencies and trends that will influence the German transaction business beyond and partially irrespective of the specific legislative steps taken in response to the pandemic.[1] Such consequences arise, on the one hand, for company acquisitions which have not yet been completed in full and which were signed before the current economic and social restrictions came into effect and will, therefore, by their very nature not contain any provisions specifically designed to deal with the pandemic and, on the other hand, for future transactions in which the parties, at least, have an opportunity to address such pandemic-related or general economic distortions in their transaction documents.
Section 1 (M&A in Times of Financial Distress) gives a general overview of selected provisions of German insolvency law which will be of increasing importance for business acquisitions in cases where either the seller or the target company operates under financial distress or close to insolvency. Particular emphasis is put on (i) the application of rules that give the insolvency administrator an election right to either reject or continue to perform partly unfulfilled mutual contracts to company acquisition agreements in insolvency cases and (ii) the rules on insolvency contestation (Insolvenzanfechtung).
Section 2 (COVID-19 and M&A Transactions in Germany) then deals with selected topics in which COVID-19 and the economic distortions resulting from the pandemic will have an impact on the conduct of the parties and the interpretation of existing as well as the recommended structure and design of future transaction documents, both now and going forward, and beyond the above cases of urgent financial distress.
Finally, Section 3 (W&I Insurance in Times of COVID-19) deals with the specialist domain of W&I insurance as a popular structuring tool of M&A practice, because this is an area where an early market reaction by insurers to the crisis is already discernible and potential parties to a W&I insurance contract should be aware of these gradual shifts in market expectations and practices.
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TABLE OF CONTENTS
1 M&A in Times of Financial Distress
2 COVID-19 and M&A Transactions in Germany
3 W&I Insurance in Times of COVID-19
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1. M&A in Times of Financial Distress
The cross-sectoral economic effects of the Corona crisis are likely to lead to an increased number of transactions in the medium term where the seller or the target companies, but in certain cases also the purchaser, are operating under distress or the threat of impending insolvency. This trend should apply irrespective of the German Act on the Temporary Suspension of the Insolvency Filing Obligation and Liabililty Limitation of Corporate Body in cases of Insolvency caused by the COVID-19 Pandemic (“Gesetz zur vorübergehenden Aussetzung der Insolvenzantragspflicht und zur Begrenzung der Organhaftung bei einer durch die COVID-19-Pandemie bedingten Insolvenz“ – COVInsAG) that recently entered into force.[2]
This kind of crisis scenario makes the initial planning and structuring of M&A transactions, as well as the later implementation thereof, particularly challenging for the parties: Both sides are forced to make an informed risk assessment on a potential insolvency of their contract partner and/or the target involved and then settle on a structure that best prevents or mitigates such risk. The possible privileges accorded by the COVInsAG, if applicable, will be of particular interest to the parties. If the seller is in distress, the purchaser should, for instance, evaluate up front whether it might be preferable in terms of legal certainty to acquire the target in the framework of a “pre-packaged deal” in subsequent insolvency proceedings. To the extent, however, that either the seller and/or its main creditors do not consent to this approach, the purchaser is only left with the choice of either not proceeding with the desired transaction or trying to mitigate the risks of a later seller insolvency to the largest extent possible.
If German insolvency law is applicable to one of the contract parties, either due to the fact that the “center of main interest” (COMI), which is used to determine the applicable insolvency law, is in Germany or because there would be an option of opening German secondary insolvency proceedings (Sekundärinsolvenzverfahren) on the basis of the target’s German operations, the contracting parties are, in particular, faced with two main risks triggered by a later insolvency: On the one hand, the insolvency administrator (or in case of debtor-in-possession proceedings, the insolvent contract party itself) could choose to reject the continued performance of the enterprise sale and transfer agreement (“Acquisition Agreement“) if this mutual agreement at the time of the opening of insolvency proceedings has not yet been completely fulfilled by at least one of the two contract parties. On the other hand, the insolvency administrator might under certain circumstances decide to contest either the Acquisition Agreement itself and/or individual completion acts or actions thereunder.
Under both scenarios, the solvent counterparty (typically, the purchaser) could be faced with significant disadvantages including a near-total loss of its own performance actions already rendered (payment of purchase price) while, at the same time, either not receiving title and ownership in the target or facing a restitution and unraveling of an already occurred transfer of ownership.
1.1 Rejection Risk of Mutually Unfulfilled Contracts and Potential Safeguards
If insolvency proceedings are opened over the estate of a contract party (seller) at a time when the Acquisition Agreement has not yet been fully performed by, at least, one of its parties, the insolvency administrator is entitled to choose whether or not to continue to perform under the agreement (§§ 103 et seq. of the Insolvency Code (Insolvenzordnung – InsO). If the insolvency administrator elects non-performance and contract rejection, the mutual obligation not yet fully performed or satisfied become unenforceable. The counterclaims of the solvent contract party due to such non-performance become regular insolvency claims that must be filed to the insolvency table and which in the normal run of events are, thus, almost completely worthless in economic terms.
In the time period between the signing of the Acquisition Agreement and the closing there is significant potential for delays based on the customary closing conditions such as merger clearances(s) and other regulatory clearances, further required corporate steps such as board approvals and/or share transfer restrictions, necessary waivers of pre-emption rights, the change of the fiscal year or the termination of existing enterprise agreements (Unternehmensverträgen). Furthermore, there are many cases where the seller and the purchaser have agreed on ancillary agreements like transition services or license agreements between the seller and the target, the details of which are finally negotiated in the time window between the signing and the closing of the Acquisition Agreement. Such agreements are often a key component of the overall transaction but are also themselves subject to the risk of contract rejection by the insolvency administrator.
If the closing under the Acquisition Agreement has already taken place, i.e. the in rem transfer of title has occurred or, at least, the purchase price component owed at closing has already been paid, purchasers often feel they are on safe ground. However, since the assessment of the question whether a contract is indeed fully performed and obligations have been completely satisfied does not only take into account the performance of the mutual primary obligations (Hauptleistungspflicht) of the parties, but also any currently open ancillary obligations (Nebenpflicht), it will, in practice, be very difficult in most relevant acquisitions to argue successfully that all relevant contract obligations of one party are already fully performed. This is even more so in pending, not yet fully performed transactions concluded in times prior to the Corona pandemic where the parties would in most cases not have had reason to dig deeper into potential insolvency-related issues.
There are a number of customary clauses that may end up acting as regular barriers against a successful argument of full performance of the Acquisition Agreement even if the closing has already taken place, including purchase price adjustment clauses, earn-out agreements or purchase price retention amounts aimed at securing possible breaches of representations and warranties. As far as asset deals are concerned, but sometimes also in share deals, where certain target entities are not all owned by one central holding company, certain individual transfer acts under applicable foreign laws are often deferred at the closing date, be it because local share certificates may yet have to be handed over under mandatory local laws or because the necessary registration of an asset or share transfer in a local jurisdictions has not yet been duly made with the competent authorities. To the extent mandatory third party consent to certain transfer steps is necessary (for example, for contract assumptions or transfers), the seller is also unable to argue that the complete fulfillment of all aspects of the agreement has already occurred. There, in addition, are typical other purchaser rights such as potential claims due to breaches of representations and warranties and/or indemnities or non-compete undertakings with time limitations of often several years, as well as obligations to release or replace seller securities granted by the seller for the benefit of the targets, which the insolvency administrator is likely to use as auxiliary considerations to support his argument that the Acquisition Agreement as such has not yet been completely satisfied by at least one of the parties.
In order to avoid or mitigate these risks, the following potential safeguards (which, of course, cannot be addressed comprehensively in this context) should be considered when negotiating future transaction documents with parties in distress:
- The purchaser is particularly well-advised to document in scenarios where the seller has (urgent) liquidity needs or where the transaction could be viewed as a “fire-sale” that the purchase price negotiated and ultimately agreed on is a fair market price. Because the insolvency administrator will otherwise (be forced to) reject the continued performance of a mutually not yet fully fulfilled mutual contract if such contract is shown to be unduly disadvantageous. A competitive auction procedure or a fairness opinion may further militate against such decision by the insolvency administrator. The insolvency administrator may, furthermore, consider such contract rejection in asset deal scenarios based on the argument of individual creditors being unduly disadvantaged if the purchaser only assumes selective liabilities of the seller, because in a later insolvency it can be argued that such selective debt assumption unduly benefits creditors whose claims end up fully paid by the assuming purchaser to the detriment of the remaining creditors of the insolvent seller who will only receive the far-lower insolvency quota on their claims which the purchaser chose not to assume.
- To agree on specific insolvency-based contractual termination rights in favor of the purchaser in the time period between the signing and closing of the Acquisition Agreement in order to address a possible seller insolvency are very likely to be viewed as an impermissible circumvention of the insolvency administrator’s contract rejection right. A contractual termination right of the purchaser based on a mere deterioration of the seller’s financial position may, however, be feasible.
- To reduce the time window between signing and closing as much as possible could be a tool to minimize or mitigate the risk of a (further) deterioration in the financial position of a party in distress. To the extent legally possible and depending on the individual bargaining power in each specific case, the purchaser could also try to negotiate weather or that certain legal steps and circumstances that usually become closing conditions or closing actions can already be implemented prior to the signing of the Acquisition Agreement.
- The complete fulfillment of the contract by the purchaser can probably only be argued beyond material doubt if the purchaser pays a final one-off purchase price at closing without any additional purchase price adjustments or earn-out provisions being agreed on. As a tendency, a sale agreement with a locked-box mechanism would, therefore, appear to be the preferred choice in such crisis scenarios. From an insolvency-law perspective, it should also be considered to forfeit any attempts to negotiate purchase price retention amounts as a means of securing potential claims under representations and warranties or indemnities (even if such retention amounts are paid to an escrow account), because such structures also mean that the seller has not yet received the purchase price in full. An alternative worth exploring would be a directly enforceable bank guarantee (selbstschuldnerische Bankbürgschaft) or to take out W&I insurance to secure such claims of the purchaser.
- With a view to avoiding multiple transfer acts at closing, a share deal will often be the preferred option to an asset deal. If the parties nevertheless opt for an asset deal, the corresponding transfer acts at closing should be prepared meticulously and in detail and should all be taken on or about the closing date. In the context of movable assets, the purchaser may acquire a strongly protected position already via a retention of title (Eigentumsvorbehalt) and regarding real estate may protect itself against contract rejection by way of a recorded priority notice (Vormerkung), see §§ 106, 107 InsO. As far as acquiring rights (shares, IP, receivables) is concerned, no such expectant or inchoate rights worthy of protection (schutzfähige Anwartschaftsrechte) are granted in the context of the insolvency administrator’s election right to perform or reject contracts.
- In certain cases, the provisions in the Insolvency Code on already made partial performance (§ 105 InsO) may also help the purchaser as such partial performance do not have to be restituted as a rule. For instance, if individual transfer measures regarding certain – usually non-essential – assets in a transaction remain pending, such partial performance may be argued to exist. It would follow that the insolvency administrator usually could not reclaim or unravel the already transferred parts of the business solely based on his choice not to perform the outstanding contract as a whole. As far as business sales are concerned, such separate deal parts are, however, only assumed to exist if there is a separate partial business unit (Teilbetrieb) and the outstanding transfer act or implementation measure does not concern the “inseparable core business”.
- In cases where the conclusion of ancillary transition services agreements, license, lease or supply agreements with the insolvent seller is provided for in connection with the closing of the Acquisition Agreement, the purchaser should be aware that each of these agreements may, in turn, be subject to selective contract rejections rights of the insolvency administrator.
- The solvent party is able to achieve legal certainty on the continued fate of the mutually unfulfilled agreement by formally requesting the insolvency administrator to exercise the corresponding election right.
At the end of the day, a comfortable safeguard against the risk of potential rejection of further contract performance by the insolvency administrator will only be realistic for the purchaser if the Acquisition Agreement contains a fixed purchase price based on a locked-box transaction which is settled in full at closing. Indemnities or claims for breaches of representations and warranties could, in addition, be secured by a directly enforceable bank guarantee (selbstschuldnerische Bankbürgschaft) or W&I insurance taken out by the purchaser.
1.2 Contestation Risk and Precautionary Steps
A further possible challenge to the existence and implementation of a business acquisition lies in the risk of a later insolvency contestation (Insolvenzanfechtung). If the relevant prerequisites are met, the insolvency administrator may contest the Acquisition Agreement itself and/or individual performance acts related thereto (§§ 129 et seq. InsO). Under certain circumstances and if the contestation succeeds in the seller’s insolvency, the purchaser may have to re-transfer the performance received by him (i.e. the ownership of company assets or shares) back to the insolvent estate, while his corresponding repayment claim regarding the purchase price paid will normally only be a regular unsecured insolvency claim and, thus, be largely worthless in economic terms due to the low insolvency quota.
The contestation rights of the insolvency administrator are manifold. Under certain circumstances, however, the COVInsAG, which recently entered into force, may privilege the Acquisition Agreement and/or measures taken to implement it for a transitional period. In addition, certain general, precautionary measures are well-advised which will, at least, mitigate the risk of subsequent insolvency contestation.
1.2.1 Contestation of the Acquisition Agreement Itself
- In the first instance, the new provisions of the COVInsAG which will be in force until 30 September 2020[3] aim at suspending the obligation to file for insolvency in spite of existing illiquidity caused by COVID-19 and privilege the conduct of the corporate bodies in such scenarios. From a contestation perspective, in particular, loan agreements which provide new liquidity are privileged and exempted from later contestation for a limited period of time. However, the new law stops short of expressly declaring all agreements contestation-proof which were concluded during the period where the obligation to file for insolvency was suspended and which serve restructuring purposes. As far as the contestability of the Acquisition Agreement itself is concerned, the existing contestation rules are, therefore, likely to apply.
- When structuring and drafting the Acquisition Agreement, it is, thus, of particular importance to prevent a potential later contestation of the Acquisition Agreement based on an argument that creditors are directly disadvantaged (§ 132 InsO). This contestation option exists if the disadvantage for creditors is directly caused by the Acquisition Agreement itself, the seller was illiquid at the time of the signing of the Acquisition Agreement and the purchaser knew of these circumstances, provided that the conclusion of the Acquisition Agreement occurred in a period three months prior to the filing for insolvency or after such filing. The argument that the purchase price was set below the threshold of the fair market value can be refuted by reference to a competitive auction process. Alternatively, a fairness opinion by an independent expert can be obtained. If the purchaser does, however, assume selected but not all of the seller’s liabilities in an asset deal, a disadvantage for creditors in a later insolvency may already be seen in the fact that only the creditors of the assumed liabilities were fully satisfied by the purchaser, whereas the remaining creditors of the seller were left to settle for the much lower quota.
Any imputed knowledge of illiquidity can, in practice, be refuted by a positive confirmation of solvency in an analysis of the insolvency status prepared by an expert according to standard IDW S 11 (Analyse der Insolvenzreife nach IDW S 11). In certain cases, it may also be opportune to fix a closing date that is more than three months after the signing of the Acquisition Agreement. However, such approach runs contrary to the above suggested aim of quickly achieving full performance of the agreement in order to preempt the insolvency administrator’ election right to either reject or continue to perform under a contract which is partly still unfulfilled by both parties.
- The contestation of the Acquisition Agreement due to disadvantaging creditors with intent (§ 133 InsO) in cases of impending illiquidity (drohende Zahlungsunfähigkeit) of the seller and seller’s intention to disadvantage his creditors requires the purchaser to know of such circumstances. The purchaser can protect himself against such allegation by submitting an expert analysis of the insolvency status, which also covers impending illiquidity, as well as a restructuring expert opinion under standard IDW S 6, which concludes that the seller’s restructuring efforts have a serious expectation of being successful.
1.2.2 Contestation of Closing Actions / Performance Measures
- The newly enacted COVInsAG (§ 2 para. 1 no. 4) generally declares performance acts which are congruent in terms of time and substance to be exempt from contestation for a transitional period until 30 September 2020[4], unless the restructuring and refinancing efforts of the seller were unsuitable to remedy the crisis and the buyer knew about this. According to the wording, the privileged exemption applies without restrictions to all performance acts, i.e. a restriction to performance acts related to credit agreements is not provided for in the new law. Having said that, the official legal justification of the new law (Gesetzesbegründung) reasons that the new provision is intended to protect the performance of existing contracts with suppliers or under recurring long-term obligations against insolvency contestation rights, as the relevant counterparties would otherwise be forced to terminate the business or contractual relationship, which, in turn, would frustrate restructuring efforts. Even though there is not yet any indication for a prevailing opinion on the scope of this protection clause against contestation under the COVInsAG, there are good reasons to argue that it also covers performance actions under an Acquisition Agreement. The purchaser would, thus, be protected if he is able submit an expert opinion on the restructuring of the company which considers a successful restructuring to be likely when taking into account the transaction proceeds.
- If the privileged exemption under COVInsAG is held not to apply, the seller would again need to evidence that the seller was not illiquid at the closing date by submitting an expert analysis of the insolvency status to avoid a contestation risk under the header of contestation of congruent performance actions (§ 130 InsO – Kongruenzanfechtung von Erfüllungshandlungen).
- When attempting to avoid a contestation under the header of intentionally disadvantaging creditors through performance acts that are congruent from a temporal and substantive perspective (§ 133 para. 3 InsO – Anfechtung wegen vorsätzlicher Benachteiligung durch inhaltlich und zeitlich kongruente Erfüllungshandlungen), the solvent party may refute the allegation that actual illiquidity existed at the time the closing actions were taken by submitting an expert analysis on the insolvency status according to standard IDW S 11. The counterparty’s imputed knowledge of a debtor’s possible intent to disadvantage creditors presumed by law is likely rebutted as well, although this has not yet been confirmed by rulings of the highest court(s). An update as of closing of the expert restructuring opinion pursuant to standard IDW S 6 already obtained at signing should eliminate any remaining grounds for the insolvency administrator to justify a contestation based on intent.
- Furthermore, if the purchaser succeeds in structuring the performance of the agreement as a so-called “cash deal” (§ 142 InsO – Bargeschäft), the contestation rights of the insolvency administrator to challenge performance actions are excluded per se, with the exception of disadvantaging creditors with intent (§ 133 para. 3 InsO). In order to qualify a transaction as a cash deal, the parties must exchange performances of equivalent worth directly, i.e. in close temporal proximity. Since the exchanged performance must be objectively of equivalent value, absolute deal certainty can ultimately only be obtained by way of a valuation expert opinion. However, a competitive auction process or, if applicable, a fairness opinion might also provide meaningful indications in this regard.
The necessary temporal link permits staggered closing actions or implementation steps only to a very limited extent, even though strictly simultaneous performance (Zug-um-Zug) is not mandatory but recommended. Purchase price retention amounts to secure potential claims for breaches of representations and warranties, purchase price adjustment clauses and, especially, earn-out provisions should be avoided. If the purchaser wants to agree on and implement a “cash deal” within the meaning of insolvency law, he should, as a precaution, also consider not to include a conditional assignment of share title already in the Acquisition Agreement.
- Finally, specific issues arise if the seller also concludes further ancillary agreements either with the purchaser or the target at the closing, such as lease or tenure agreements (Miet- oder Pachtverträge), license agreements, supply agreements, transitional services agreements or the like, which, in turn, are subject to separate contestation rights.
- Unlike in the case of the insolvency administrator’s election right to either reject or continue to perform under pending contracts, the insolvency administrator cannot be forced into a timely decision on his potential contestation right. This causes considerable uncertainty for the purchaser (whilst giving the insolvency administrator strong leverage in negotiations) since the contestation right is only limited by the regular three year time limitation period under German law.
In summary, reducing the risk of possible subsequent contestation requires some effort on the part of the purchaser. In addition to a fairness opinion and an expert analysis of the insolvency status, a restructuring expert opinion in accordance with standard IDW S 6 may also be well-advised, but the purchaser will have to rely on the cooperation of the seller in this regard. The respective mutual performance actions should, in an ideal case, be agreed upon and implemented as a cash deal with a simultaneous exchange of performance actions. At least on a literal reading of the wording, the purchaser could also rely on COVInsAG to make performance actions taken during the transitional period contestation-proof if a positive expert restructuring opinion exists.
2. COVID-19 and M&A-Transactions in Germany
2.1. Acquisition Agreements in the Pre-Closing Phase
Whereas the start of 2020 was still characterized by lively M&A activities, the German market was taken by surprise in March by the speed and massive impact of the COVID-19 pandemic. For the majority of investors and companies, measures to stabilize sales and liquidity were and are still the focus of attention.
In this situation, a share purchase agreement (the “Acquisition Agreement“) already signed but not yet closed may represent a welcome influx of liquidity for the seller, while the same agreement may now be viewed as a drain on liquidity by the buyer which might no longer be welcome. Various contractual and legal provisions may play a role in this dilemma, which are outlined below and may also serve as guidelines for negotiations of Acquisition Agreements in the near future.
2.1.1 Provisions in the Acquisition Agreement
a) Termination Clauses
The respective Acquisition Agreement usually provides for a termination provision which, in principle, allows both parties to terminate the agreement if the transaction has not been completed (closing) by a certain long stop date. Also, further provisions, which frequently are agreed and allow unilateral termination before the long stop date has occurred, usually require that the closing has become impossible due to the definitive frustration of a closing condition. Not least because deal certainty is regularly a priority for both parties to an Acquisition Agreement, it seems fair to expect that a general right of termination or a termination due to the effects of COVID-19 can only in rare cases be based on the agreed upon regular termination provisions. However, even if the conditions for terminating the Acquisition Agreement are met, the actual exercise of this right will require careful review of whether such termination would, in turn, result in an obligation to pay any pre-agreed contractual penalties, break-up fees or damages to the counterparty.
b) Specific Closing Conditions: Merger Clearance and Material Adverse Change
(i) Merger Clearance
If a contractual termination right in the Acquisition Agreement is tied to the failure of closing occurring within a certain agreed-upon timeframe, the necessary analysis must consider, first and foremost, the specific closing conditions agreed in each individual case. One of the key closing conditions in this context regularly is obtaining merger clearance by the specifically named anti-trust authorities. The impact of the COVID-19 pandemic on the work of these anti-trust authorities varies greatly from jurisdiction to jurisdiction.[5] In the case of M&A transactions that have been signed but have not yet closed, the contract parties would, thus, be well-advised to examine in each case whether the originally envisaged time frame is (still) sufficient, whether and which complications and delays are possible and what measures could or even must be taken to further ongoing proceedings. Where appropriate, it is recommended to enter into timely discussions on the potential adjustment of the long stop date.
If no amicable agreement can be reached in this respect, further questions under contract law could arise: This is so because, irrespective of any statutory obligations to adjust or modify the contract (see below on § 313 of the German Civil Code (Bürgerliches Gesetzbuch, BGB), there may be contractual provisions in the Acquisition Agreement which could conceivably result in an obligation of a contracting party to agree to an adjustment of the contract. In practice, there are some cases, for instance, where a general mutual obligation to cooperate and facilitate the closing is included in the Acquisition Agreement or the severability clause provides for an obligation to agree on a fair commercial solution if unforeseen or unforeseeable contractual gaps or omissions later become apparent. Whether such provisions indeed lead to a contractual adjustment obligation of a contracting party can only be assessed on the basis of the individual provision in the relevant Acquisition Agreements.
(ii) Material Adverse Change
Another contractual provision in the Acquisition Agreement, which may lead to either a contract adjustment, potential compensation payments or even to the termination of the Acquisition Agreement, depending on the substance of the clause in question, are so-called Material Adverse Effect (MAE) or Material Adverse Change (MAC) clauses. Essentially, these are clauses which – if agreed as a closing condition or as a right of rescission – provide for a closing reservation to address the occurrence of unforeseen, material adverse developments of the target company’s business (so-called Business or Target MAC) between signing and closing, or, less frequently, with regard to the industry in which the target company operates (so-called Market MAC), which have a value-diminishing long-term impact on the target company. If such an adverse development occurs or exists, the purchaser does not have to close or complete the transaction.
Under the seller-friendly M&A market conditions prevalent in recent years, the inclusion of such clauses has become more rare. However, if the Acquisition Agreement contains a MAC clause, the issue of its interpretation will likely come more into focus now. Whether the COVID-19 pandemic and its consequences actually constitute a material adverse change event must be carefully determined on the basis of the specifically agreed clause and the details and spheres of knowledge of the parties at the time of entering into the Acquisition Agreement. Even if the MAC clause does not contain any specific wording regarding the inclusion or exclusion of epidemics or pandemics, this is only the starting point for such an analysis.
In a second step, the agreed upon exclusions then need to be assessed: In particular, it may be required to clarify whether the frequently used exclusion of general or industry-specific negative market developments is applicable here, and then again whether there might be a counter-exception in case the target company is disproportionately affected by these developments.
A further issue that needs reviewing in the specific MAC clause is the exact reference point in time for, and probability threshold of, the MAC event occurring. There will also be cases where – depending on the industry – certain adverse effects are (partly) becoming apparent already now, but have not yet (fully) materialized. In such scenarios, the outcome will depend on whether the wording of the clause only covers disadvantages that have already occurred or also – already foreseeable – future consequences.
It is also crucial by which criteria the materiality of an event is to be measured. In some cases, the parties agree on specific thresholds (e.g., a reduction of EBITDA by x%). If such materiality criterion is not defined in greater detail, this must be assessed by interpreting the agreement with specific focus on the target company.
Finally, even if a MAC event has occurred, the contractual consequences provided for in the agreement must be clarified. Withdrawal from the Acquisition Agreement or a refusal to close the deal may only be the ultima ratio. It would also be conceivable to negotiate in good faith on the adaptation of the Acquisition Agreement to the changed commercial circumstances.
2.1.2 Statutory Provisions on the refusal to Perform or the Adaptation of the Agreement
The issue whether the parties to an Acquisition Agreement may also rely on the statutory provisions in view of the COVID-19 pandemic is likely to be a matter of increasing activity for (arbitration) tribunals in the near future: In particular, the legal instruments in the event of a disruption to the basis of the transaction (Störung der Geschäftsgrundlage) pursuant to § 313 BGB are likely to be at the forefront. These rules allow the adaptation of the contract or, in case of impossibility or unreasonableness of such adaptation, the rescission of the contract, if the parties’ mutual conceptions on which the agreement was based have changed to such an extent that one party cannot reasonably be expected to adhere to the unchanged contract. With the COVID-19 pandemic, the various restrictive governmental measures to combat the spread of the virus, but also, in turn, specific governmental stabilization and support measures and, in many cases, the grave effects thereof on the business of the target company, its profitability and the assumptions in the business plan, may be seen, at a first glance, as such momentous changes arising from the COVID-19 pandemic without either of the parties having been in a position to foresee such impact or be held responsible for the consequences. However, even if the manifold economic effects resulting from the outbreak of the pandemic seem to be a textbook example of a disruption of the contractual performance obligations, the legal significance of such disruption must be analyzed in a differentiated manner and on the basis of the specific contractual agreements.
In the Acquisition Agreement, the parties often agree on specific comprehensive exclusions of the statutory provisions, which may in certain cases also include the – generally negotiable – provision in § 313 BGB. However, even if such an exclusion is not expressly provided for, it may, for example, follow from a past effective date, on which the (economic) transfer of risk is deemed to occur, that any risks which materialize after such date have to be borne by the purchaser. The conclusion may be similar in the case of a MAC clause contained in the Acquisition Agreement. As specific expression of the intentions of the parties, such concrete agreements must, in principle, be given priority and can, as a specifically agreed contractual distribution of risk, override or exclude the application of § 313 BGB even for unforeseen circumstances. All of this does not per se exclude a possible adjustment of the contract due to disruption of the basis of the transaction, as any contractual provision (including an exclusion) could also have been affected by the parties’ underlying fundamental misconceptions. In any case, however, the hurdles to be overcome would then be significantly higher and require a comprehensive evaluation of the wording and spirit of the Acquisition Agreement.
If these initial hurdles can be overcome, the second step is to examine whether there has been, taking into account the circumstances of the individual case, such a momentous change in the parties’ underlying conceptions of the agreement that adherence to the contract would be unreasonable. Here, similar considerations will then play a role as discussed above when assessing the application and interpretation of MAC clauses (see above under Section 2.1.1, lit. b), (ii)), i.e. what did the parties know at the time of signing the Acquisition Agreement, do the contractual provisions as agreed entail a certain distribution of risk between the parties, how significant are the changes for the subject matter of the contract and how significant would the consequences of an application of § 313 BGB be for the parties.
To make matters worse, there is another major factor of uncertainty: It is currently completely unclear how COVID-19 and its consequences will pan out (internationally) in purely factual terms. The length of the restrictions in the individual countries, possible further waves of outbreaks, economic catch-up effects, government support and economic stimulus programs and the concrete effects on the respective target companies – these and many other aspects will only reveal themselves fully in the future. In any case, the individual allocation of risk between the parties of future Acquisition Agreements is likely to play a greater role again in the respective contract negotiations going forward – also with a view to possible further COVID-19 “waves”.
2.2 Purchase Price Mechanics and Evaluation Matters
When predicting the development of the M&A market in the near and medium term future, COVID-19 and the economic effects of the pandemic will be one of the central issues in determining the value of a company and, thus, also the purchase price. The discussions are likely to focus on the question whether the fair enterprise value can be justified on the basis of normalized EBITDA, taking into account or excluding the effects of the COVID-19 pandemic, among other things. However, this is also likely to play a major role in the case of already concluded Acquisition Agreements with earn-out or staggered payment regulations or in connection with management incentive schemes or bonus arrangements. In these cases, EBITDA is also regularly used as a benchmark and specific rules are agreed on to determine it.
With regard to the two main approaches for determining the purchase price, the following considerations are fundamental: If the parties have agreed on a so-called fixed purchase price (locked-box approach), this should basically be exactly that, a definitive purchase price which is typically not subject to any later adjustment. The purchase price is determined by reference to an economic reference date and the risk of changes in value transfers to the purchaser on such date. In principle, there is no mechanism for some kind of value clarification regarding the underlying valuation assumptions. Instead, the purchaser is protected against changes in value after the reference date until the closing date by means of positive and negative covenants and guarantees (ring-fencing), which are essentially related to the conduct of the business in the ordinary course.
As far as variable purchase prices are concerned, there are ultimately many different approaches to agreeing such a variable purchase price. In the first instance, the reference values agreed on by the parties for determining the purchase price and the influence of the COVID-19 pandemic on these values must be taken into account. Under the so-called closing accounts method, which is often used in this regard, the parties generally agree on a fixed enterprise value, which is typically not subject to adjustments. Only the reconciliation bridge to the equity value is based on a subsequent adjustment of cash, debt and (normalized) working capital positions in the so-called closing accounts prepared by reference to the agreed economic effective date. It follows that COVID-19 effects are therefore only recorded under this method to the extent that they affect the aforementioned reference values. The extent to which changes are then to be reflected depends on the principles laid down for the preparation of the closing date accounts (including the degree to which any value-enhancing facts are taken into account), it being understood that the parties regulate the granularity of these principles to varying degrees. A particularly thorough and careful assessment of the provisions in the Acquisition Agreement is required in this regard, which should not only include the necessary legal analysis but also cover the commercial and economic evaluation and accounting methods to be applied.
The questions raised in this context are also likely to feature prominently when interpreting agreed clauses on purchase price components payable only in the future, as in the case of earn-outs or other staggered payment arrangements, if these are related to key company benchmark figures (and not, for example, to the realization of future minimum exit sale proceeds). Here, too, the payment of the additional purchase price components is linked to certain economic reference values, the determination of which is governed by the individual agreement regarding the applicable (accounting) provisions. The parties would, therefore, be well-advised also with regard to already existing earn-out regimes to monitor the likely effects of the COVID-19 pandemic on the company’s key benchmark figures at this early stage and consider their evaluation impact and suitable accounting treatment as well as their potential scope for manoeuver under the specific, individually agreed upon provisions.
3. W&I Insurance in Times of COVID-19
Among the consequences of the COVID-19 pandemic have been certain new trends and challenges in the private equity and M&A arena, including W&I insurances. Even though there are no current indications that W&I insurances will generally become unavailable in transactions, COVID-19 certainly has an influence on the insurer’s risk assessments and the details of the insurance policies that are on offer.
3.1 Potential Impact of COVID-19 on the Future Scope of W&I Insurance
At the moment, there is no market trend that insurers are generally re-considering the scope of the guarantees and representations and warranties that can be insured. Having said that, to insure certain, previously customary and coverable representations and warranties in new policies not concluded prior to the occurrence of the COVID-19 pandemic will now and in future be subject to a more detailed insurance assessment (see below under lit. b) regarding the consequences for the underwriting process). This, in particular, concerns guarantees which are related to a contractually defined reference or balance sheet date and the absence of material disadvantageous deteriorations regarding the target entities or their business operations since then, as well as guarantees that refer to an adequate level of insurance coverage of the sold business operations – it being understood, for instance, that, depending on the business model, the question whether and under which circumstances a particular business interruption insurance policy provides “adequate” insurance coverage may well have been affected and modified by the COVID-19 pandemic. A further focus is likely to be on guarantees regarding compliance with all (material) laws and regulations, in particular on health and safety, and on customer and supplier relationships. With a view to the scope of damages covered, several insurers currently exclude any and all damages that are caused by and arise from the pandemic in their entirety. Other insurers are willing not to insist on such a blanket exclusion of damages and negotiate modified, specifically defined and tailored damage exclusions. This means that in these Corona times the selection of the W&I insurer and the ensuing negotiation of the actual W&I policy have gained added practical relevance and are more important than ever before, especially since the contractual provisions agreed on in the transaction documentation with the purchaser might in many cases allow recourse to the seller for certain uninsurable risks.
3.2 Impact on the Underwriting Process
It is nothing new that the insurers have always put special emphasis on the topics most critical for the insurance’s potential liability during the underwriting process. If the purchaser’s due diligence exercise on such specific risk topics is not sufficiently thorough from an insurer’s perspective, the policy will usually contain corresponding exclusions of insurance coverage. Furthermore, an exclusion from insurance coverage of all known problematic issues and risks, which had been identified in the course of the due diligence process by the purchaser or which arose and were identified in the time window between the signing and the closing of the transaction, was customary in the past already.
Currently, this conclusion is of particular and increased relevance for the potential impact and consequences of the COVID-19 crisis on the business operations of a company undergoing a sales process and the corresponding catalogue of guarantees contained in the sale and transfer agreement: It depends on the nature of the business sector and the industry of the sold business how strict the insurer’s parameters for this evaluation will be and whether they may differ to a significant degree – reflecting the fact that not all enterprises are affected by the current crisis in the same manner, relative to the nature and structure of their business, their geographic footprint, potential interdependencies in their production procedures and supply chain, the consequences of the pandemic for their customers, suppliers and staff, and, of course, the existence of any liquidity or balance sheet reserves and buffers. As far as (material) customer and supply agreements are concerned, it is especially pertinent whether such contracts – based on the respective applicable law – may be terminated or modified based on force majeure or an undue change of the underlying common commercial understanding of the parties (Änderung der Geschäftsgrundlage) or whether there may, at least, be a (temporary) defense of withholding or delaying performance (Leistungsverweigerungsrecht). Another point of special importance for the insurers is the question how the parties deal in the transaction documentation with the particular further transaction risks potentially triggered by the COVID-19 crisis in the time between signing and closing, e.g. by way of relevant closing conditions, specific termination rights prior to closing or the inclusion of a specially-tailored MAC clause. We are under the general impression that the insurers have a current market expectation that the parties should normally agree on express provisions in their sale and transfer agreements dealing with the potential COVID-19 risks: This means that the insured party should therefore examine and assess the impact and consequences of COVID-19 on the business operations of the target extra-thoroughly and with specific care to put themselves in a position where they can negotiate with the insurer on a solid factual basis on a successful, moderate exclusion of such risks rather than being hit with a blanket exclusion of all COVID-19-related risks.
3.3 Special Case: Occurrence of the Pandemic between Signing and Closing
The above considerations apply to those cases where the negotiation and conclusion of the insurance policy and its terms are completed subsequent to the occurrence of the COVID-19 pandemic. The second, also practically relevant scenario concerns cases where the signing of the transaction (and, thus, the insurance policy) predate COVID-19 but the closing only occurs thereafter. W&I insurances regularly provide for the disclosure of new facts and circumstances, which arose in the time period between signing and closing and which result in breaches of guarantees and representations and warranties, and then exclude them from insurance coverage, at least, for such guarantees which are repeated at closing (so-called bring-down). The details and scope of such additional disclosure is, in particular, stipulated in the insurance policy negotiated between the insurer and the insured party and is normally limited to facts and circumstances occurring between signing and closing which would result in a breach of a guarantee as of the closing date had they been left undisclosed. Irrespective of such underlying contractual agreement, however, certain insurers have already requested blanket disclosure of all abstract consequences of COVID-19 for the transaction and have asked for a description of the concrete measures the target has taken in order to mitigate the impact of the pandemic or the purchaser’s assessment of the changed business case of the target entities or have enquired whether the parties may have settled on modified transaction parameters to address the crisis. Normally, such questions are likely designed to allow an argument that the corresponding consequences and adaptations identified can then be excluded from coverage as a disclosed known risk. The parties should therefore take the utmost care to limit such disclosure in terms of its content and scope strictly to the contractually agreed degree and not make any further-reaching, sweeping written or oral generalizations on the target entities or the transaction vis-à-vis the insurer so that their W&I policy is not compromised unduly. However, the insured party must, in turn, also take care that it does not fall short in fulfilling its contractually agreed disclosure and information obligations, because a breach of such obligations could also result in a loss of insurance coverage.
3.4 Outlook
COVID-19 places new and difficult challenges and demands on both the insurers and the insured party when it comes to structuring M&A procedures and developing tailor-made, risk-appropriate W&I solutions. It nevertheless is to be expected that the W&I insurance will continue to remain a practical and valuable tool for the purchaser to ensure adequate coverage for damages caused by breaches of contractual guarantees or representations and warranties – irrespective of their bargaining power in the sales process and the solvency position of the seller. Taking into account the expected shift of the M&A markets towards an even more buyer-friendly market climate, potential purchasers will be well-advised to evaluate the suitable liability recourse structure for the time after closing (e.g. seller’s liability, W&I insurance or a mixture of both) with particular emphasis in each individual case on the potential exclusions of insurance coverage that can be expected under new W&I policies. There is, at least, some good news in the short term for the potential insured party, however, in that the current decrease in the number of M&A transactions during times of crisis could easily result in a trend towards lower insurance premiums in the immediate short term.
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[1] We have already covered various reactions by the German and European lawmakers and administration, which are particularly relevant to corporate law and the transaction business in Germany, in our Client Update of April 14, 2020, available in English and German at: https://www.gibsondunn.com/corporate-ma-in-times-of-the-corona-crisis-current-legal-developments-for-german-business/.
[2] In this context, also see: https://www.gibsondunn.com/whatever-it-takes-german-parliament-passes-far-reaching-legal-measures-in-response-to-the-covid-19-pandemic/, under section II.2, as well as with further analysis in this regard https://www.gibsondunn.com/european-and-german-programs-counteracting-liquidity-shortfalls-and-relaxations-in-german-insolvency-law/.
[3] The temporal application of these provisions may be extended by way of governmental regulation until 31 March 2021.
[4] Regarding the potential extension option, please see above footnote 3.
[5] Reference is again made to: https://www.gibsondunn.com/corporate-ma-in-times-of-the-corona-crisis-current-legal-developments-for-german-business/, see Section 4 (Anti-Trust and Merger Control in Times of COVID-19), available in German and in English.
The following Gibson Dunn lawyers assisted in preparing this client update: Lutz Englisch, Birgit Friedl, Marcus Geiss, Sonja Ruttmann and Dennis Seifarth.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. The two German offices of Gibson Dunn in Munich and Frankfurt bring together lawyers with extensive knowledge of corporate, financing and restructuring, tax, labor, real estate, antitrust, intellectual property law and extensive compliance / white collar crime and litigation experience. The German offices are comprised of seasoned lawyers with a breadth of experience who have assisted clients in various industries and in jurisdictions around the world. Our German lawyers work closely with the firm’s practice groups in other jurisdictions to provide cutting-edge legal advice and guidance in the most complex transactions and legal matters. For further information, please contact the Gibson Dunn lawyer with whom you work or any of the following members of the German offices:
General Corporate, Corporate Transactions and Capital Markets
Lutz Englisch (+49 89 189 33 150, lenglisch@gibsondunn.com)
Markus Nauheim (+49 89 189 33 122, mnauheim@gibsondunn.com)
Ferdinand Fromholzer (+49 89 189 33 121, ffromholzer@gibsondunn.com)
Dirk Oberbracht (+49 69 247 411 510, doberbracht@gibsondunn.com)
Wilhelm Reinhardt (+49 69 247 411 520, wreinhardt@gibsondunn.com)
Birgit Friedl (+49 89 189 33 180, bfriedl@gibsondunn.com)
Silke Beiter (+49 89 189 33 121, sbeiter@gibsondunn.com)
Annekatrin Pelster (+49 69 247 411 521, apelster@gibsondunn.com)
Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com)
Sonja Ruttmann (+49 89 189 33 150, sruttmann@gibsondunn.com)
Dennis Seifarth (+49 89 189 33 150, dseifarth@gibsondunn.com)
Finance, Restructuring and Insolvency
Sebastian Schoon (+49 89 189 33 160, sschoon@gibsondunn.com)
Birgit Friedl (+49 89 189 33 180, bfriedl@gibsondunn.com)
Alexander Klein (+49 69 247 411 518, aklein@gibsondunn.com)
Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com)
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As COVID-19 continues to spread throughout the globe, the ultimate effect on businesses and financial markets remains uncertain. At the same time, certain risks and disruptions to operations and performance have materialized, and investment advisers should consider their disclosure obligations and determine appropriate steps in communicating evolving circumstances to investors. This alert offers practical guidance for the managers of private equity and real estate funds weighing such considerations.
Interim and Proactive Disclosure to Existing Investors
In evaluating disclosure obligations to existing investors regarding the ongoing and potential impacts of COVID-19, investment advisers should distinguish between effects that relate to the following:
- a fund’s financial performance (e.g. disruptions to a portfolio company’s business); and
- an investment adviser’s ability to manage a fund (e.g. a diminished capacity to source, diligence or complete deals due to work-from-home or other limitations).
Fund’s Financial Performance: Contractual obligations in existing fund documents and side letters typically address the timing and form of reporting and/or notice obligations relating to changes in a fund’s financial performance. Interim disclosure regarding fund performance or risks to performance may also be appropriate if investors have ongoing or impending investment decisions in connection with a fund, such as for open-ended funds.
In providing normal course or interim fund performance disclosure, investment advisers should consider whether to include specific COVID-19 disclaimers to indicate that future performance remains uncertain and prior period results may have been obtained in an environment that differs materially from the current economic climate. Funds that are actively marketing to prospective investors and/or seeking additional commitments from existing investors must take into account additional disclosure considerations; please see our related alert “COVID-19: Fundraising Considerations for Private Investment Fund Sponsors” for additional information.
Investment Adviser Operations: Changes to an investment adviser’s own operational abilities and performance implicate a deeper set of fiduciary and regulatory considerations, even before running into typical contractual guardrails (e.g. key person and time commitment clauses applicable to senior personnel). Timely disclosure of any material disruptions to operations is important, but investment advisers would be well served to communicate the state of the firm and any risks to their own operations to investors proactively during the crisis.
Oral Versus Written Disclosure
Investment advisers may reasonably differ in their approach to communicating information to investors, subject to any contractual notice or reporting obligations. Phone conversations with investors can be appropriate (and are often preferred from an investor relations perspective), provided that messaging remains consistent, is supported by underlying facts and avoids selective disclosure (as further discussed below). Alternatively, written communications offer uniformity, precision in message and provide a documentary record for regulatory and compliance purposes.
Avoid Selective Disclosure
Investment advisers should take care to ensure that messaging remains consistent and complete across the investor base. Selective disclosure to certain limited partners risks not only running afoul of partnership agreement or side letter provisions, but also undermining the adequacy of disclosure made to other investors.
Consider Categorizing Investment Risk Levels
SEC Chairman Jay Clayton and William Hinman, Director of the Division of Corporate Finance, released a joint statement encouraging “companies strive to provide, and update and supplement, as much forward-looking information as is practicable” and noted “that we would not expect good faith attempts to provide appropriately framed forward-looking information to be second guessed by the SEC.”[1] Although directed to public companies, this guidance offers insight into the SEC’s expectations around disclosure during the COVID-19 crisis, and the message appears intended to encourage forward-looking disclosure even in the face of uncertainty.
In light of this message, each investment adviser should consider categorizing the level of investment risk and volatility associated with COVID-19 across its portfolio and communicating its analysis to investors, in particular for funds with multi-sector investment strategies. Advisers should weigh the value of this enhanced disclosure against the risk attendant in forecasting performance, and any such disclosure should be appropriately qualified.
Responding to Investor Inquiries
Existing investors and prospective investors have begun to, and will continue to, make inquiries regarding the impact of COVID-19 on fund performance and operations. Preparing a script and drafting form responses (e.g. an FAQ) in anticipation of such inquiries is the surest route to achieve accuracy and conformity in communications. Consider also having a dedicated compliance member tasked with reviewing communications for COVID-19-related disclosure.
Keep Records of Communications and Supporting Materials
As noted in our March 26, 2020 alert “SEC Enforcement Focus on Fallout from COVID-19: Insights for Public Companies and Investment Advisers During a Crisis”, prior periods of market volatility have been typically followed or accompanied by heightened SEC investigative risk. Investment advisers should maintain contemporaneous records of communications with investors regarding the crisis and any supporting materials, with a view towards a post hoc assessment by the SEC of actions taken during this time. For oral communications, calendaring calls and maintaining an internal written summary of conversations may be appropriate.
LP or Limited Partner Advisory Committee Notices
A detailed review of fund documents and side letters should be undertaken to assess potential notice requirements. Adhering to such requirements is particularly important during this period of heightened scrutiny.
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[1] Public Statement, “The Importance of Disclosure – For Investors, Markets and Our Fight Against COVID-19, Public Statement” (April 8, 2020), available at, https://www.sec.gov/news/public-statement/statement-clayton-hinman
Gibson Dunn lawyers regularly counsel clients on the issues raised in this alert, and we are working with many of our clients on their response to COVID-19. Please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Investment Funds Practice Group, or the authors:
C. William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com)
Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com)
Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com)
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com)
John Fadely – Hong Kong (+852 2214 3810, jfadely@gibsondunn.com)
Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com)
Nicholas C. Duvall – Washington, D.C. (+1 202-887-3781, nduvall@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On May 7, 2020, New York Governor Andrew Cuomo announced that the state’s moratorium on residential and commercial COVID-19-related evictions will be extended through August 20 and that new rent relief measures will be imposed.
Executive Order 202.8, which established the eviction moratorium, was signed by Governor Cuomo on March 20, 2020. Among other measures, the order placed a stay on all residential and commercial evictions. This provision of the order, which was set to expire next month, will be extended an additional 60 days through August 20.
In addition to extending the eviction moratorium, Governor Cuomo announced two additional measures to protect renters. First, the state is banning late payments or fees for missed rent payments during the eviction moratorium period. Second, the state will allow renters facing COVID-19-related hardships to use their security deposit in place of rent payments. During his May 7, 2020 daily press briefing, Governor Cuomo stated that renters will be required to repay the deposit “over a prolonged period of time.”
A press release announcing these measures was published on May 7, 2020. At this time, no new Executive Order has been issued.
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Gibson Dunn’s lawyers are available to assist with any questions you may have regarding developments related to the COVID-19 outbreak. For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team, or the following authors:
Mylan Denerstein – New York (+1 212.351.3850, mdenerstein@gibsondunn.com)
Andrew A. Lance – New York (:+1 212.351.3871, alance@gibsondunn.com)
Emily Black – New York (+1 212.351.6319, eblack@gibsondunn.com)
Stella Cernak – New York (+1 212.351.3898, scernak@gibsondunn.com)
Doran Satanove – New York (+1 212.351.4098, dsatanove@gibsondunn.com)
© 2020 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.