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.

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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 ([email protected]), Richard Mark ([email protected]), Doran Satanove ([email protected]), and Amanda First ([email protected])

© 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.

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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 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, [email protected])
Lee R. Crain – New York (+1 212-351-2454, [email protected])
Grace E. Hart – New York (+1 212-351-6372, [email protected])
Jason Bressler – New York (+1 212-351-6204, [email protected])

© 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.

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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, [email protected])
Markus Nauheim (+49 89 189 33 122, [email protected])
Ferdinand Fromholzer (+49 89 189 33 121, [email protected])
Dirk Oberbracht (+49 69 247 411 510, [email protected])
Wilhelm Reinhardt (+49 69 247 411 520, [email protected])
Birgit Friedl (+49 89 189 33 180, [email protected])
Silke Beiter (+49 89 189 33 121, [email protected])
Annekatrin Pelster (+49 69 247 411 521, [email protected])
Marcus Geiss (+49 89 189 33 122, [email protected])
Sonja Ruttmann (+49 89 189 33 150, [email protected])
Dennis Seifarth (+49 89 189 33 150, [email protected])

Finance, Restructuring and Insolvency
Sebastian Schoon (+49 89 189 33 160, [email protected])
Birgit Friedl (+49 89 189 33 180, [email protected])
Alexander Klein (+49 69 247 411 518, [email protected])
Marcus Geiss (+49 89 189 33 122, [email protected])

© 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.

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:

1. a fund’s financial performance (e.g. disruptions to a portfolio company’s business); and
2. 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

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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, [email protected])
Shukie Grossman – New York (+1 212-351-2369, [email protected])
Edward D. Sopher – New York (+1 212-351-3918, [email protected])
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, [email protected])
John Fadely – Hong Kong (+852 2214 3810, [email protected])
Mark K. Schonfeld – New York (+1 212-351-2433, [email protected])
Nicholas C. Duvall – Washington, D.C. (+1 202-887-3781, [email protected])

© 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.

___________________________

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, [email protected])
Andrew A. Lance – New York (:+1 212.351.3871, [email protected])
Emily Black – New York (+1 212.351.6319, [email protected])
Stella Cernak – New York (+1 212.351.3898, [email protected])
Doran Satanove – New York (+1 212.351.4098, [email protected])

© 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.

As the COVID-19 global pandemic continues to devastate economies, trading prices for many bank loans have fallen significantly.  Private equity sponsors are looking at debt buybacks as a potential opportunity to de-lever their portfolio companies at a significant discount.  This client alert highlights some of the critical issues for private equity sponsors when considering these opportunities.

Debt Buybacks: Loan Documentation in the Asia-Pacific Region

Compared to the US and European markets, it is much harder to make generalisations about loan documentation in the Asia-Pacific region as many countries within the region have distinct approaches to loan documentation.  However, it is fair to say that where the loan documents contemplate debt buybacks at all they most typically follow (with a few negotiated points) the Loan Market Association (“LMA“) options of permitting debt buybacks by the borrower provided that specific processes and conditions are followed (and by sponsors and affiliates subject to disenfranchisement provisions (discussed below)).  There are exceptions to this, particularly in the context of US-style Term Loan B facilities which typically permit debt buybacks subject to certain conditions and similar Dutch auction processes; however, they also often allow open market purchases without prescription as to the process.  Additionally, there are many loan agreements in the Asia-Pacific region that do not contemplate debt buybacks at all.  The LMA’s standard form also provides an option for debt buybacks to be expressly prohibited, but this is rarely seen in practice.

Liquidity Considerations 

When considering debt buybacks, a threshold issue to address is who will purchase the debt and how will they fund the purchase.  For borrowers (or other companies within the borrowing group) considering a debt buyback, they must first be comfortable that they have sufficient liquidity to continue to meet their debts as they fall due after giving effect to the cash outlay required to effect the purchase.  Where there would be insufficient liquidity, sponsors can consider either funding the purchase through the injection of new equity or subordinated debt or making the purchase directly themselves, through an affiliate or an unrestricted subsidiary.

We have also seen purchases of unfunded commitments where the purchaser is paid to assume the unfunded commitments (note that the LMA standard form does not provide an option for the purchase of revolving loans or other unfunded commitments).  These situations require special consideration as they can create additional issues; for example, whether the purchaser is sufficiently credit-worthy to fund future drawdowns, and in the case of buybacks by the sponsor, the potential conflicts for sponsor directors of whether to drawdown on such facilities where it would be prudent for the company to do so but there is a significant risk that the sponsor would not make a full recovery.  In some purchases of unfunded commitments, sponsors/companies have used the proceeds received by them for the purchase to fund further buybacks of funded debt.

LMA Debt Buyback Processes 

Where debt buybacks by a member of the group are to be permitted, the LMA has proposed certain conditions that must be satisfied before the borrower can effect a debt buyback.  These conditions are:

(i)    the borrower makes the purchase (often negotiated to include other members of the restricted group);

(ii)   the consideration for the purchase is below par;

(iii)  no default is continuing at the time of the purchase (sometimes this standard is negotiated to event of default);

(iv)  the consideration is funded from retained excess cash (with an option to restrict this to the immediately preceding financial year), or new equity/subordinated debt (this condition is often negotiated also to permit funding from (a) excluded disposal proceeds, excluded insurance proceeds, excluded acquisition proceeds and excluded IPO proceeds; (b) permitted financial indebtedness; (c) cumulative retained cash; (d) any overfunding amounts; and (e) cash and cash equivalents to the extent that it could be used to fund certain (highly negotiated) permitted payments); and

(v)  the purchase is implemented using either the solicitation process or the open order process.

The solicitation process provides for the parent to approach all of the relevant term loan lenders to enable them to offer to sell an amount of their participation to the relevant borrower.  Any lender wishing to sell provides details of the amount of the participation that they want to sell and the price at which they are willing to sell.  The parent has no obligation to accept any of the offers from the lenders. However, if it agrees to any such proposals, it must do so in inverse order of the price offered (with the lowest price being accepted first). If two or more offers to sell a particular term facility at the same price are received, such offers may only be accepted on a pro rata basis.

The open order process provides for the parent (on behalf of the relevant borrower) setting out to each of the lenders of a particular facility the aggregate amount of such facility it is willing to purchase and the price at which it is willing to buy.  The lenders then notify the parent if they are willing to sell on such terms.  If the aggregate amount which lenders are willing to sell exceeds the aggregate amount that the parent had notified the relevant borrower it was willing to purchase, then such offers shall be accepted on a pro rata basis.

In respect of a debt purchase transaction complying with the LMA conditions:

(i)    the relevant portion of the term loan to which it relates are extinguished, and any related repayment instalments will be reduced pro rata accordingly;

(ii)   the borrower shall be deemed to be a permitted transferee;

(iii)  the extinguishment of any portion of any such loan shall not constitute a prepayment of the facilities;

(iv)   no member of the group shall be in breach of the general undertakings as a result of such purchase;

(v)    the provisions relating to sharing among the finance parties shall not apply; and

(vi)   no amendment or waiver approved by the requisite lenders before the extinguishment shall be affected by such extinguishment.

The LMA debt buyback provisions are drafted widely and apply not only to purchases by way of assignment or transfer but also to sub-participations and any other agreement or arrangement having an economic effect substantially similar to a sub-participation.  This is to safeguard against such methods being employed to circumvent restrictions relating to assignments or transfers.

There are also obligations on any sponsor affiliate who enters into a debt purchase transaction (whether as the direct purchaser of the loan or as a participant) to notify the agent by no later than 5.00 pm on the business day following entry into such transaction.  The agent is then obliged to disclose this to the other lenders.

Tax 

Depending on the jurisdiction, extinguishment of debt can create taxable income on the amount of the cancellation of debt.  For this reason, sponsors often negotiate for debt buybacks to be permitted by any member of the group (rather than only the relevant borrower).  Tax advice should be obtained before entering into a debt buyback to address this and other issues such as ensuring that the lender is in a favourable tax jurisdiction for withholding tax purposes.

Disenfranchisement 

Where the loan documentation contemplates debt buyback transactions, purchases by the sponsor are typically permitted without following the solicitation or open order processes but subject to certain conditions.  These include:

• in determining whether any applicable lender thresholds have been met to approve any consent, waiver, amendment or other vote under the finance documents the commitment of the sponsor shall be deemed to be zero and the sponsor shall be deemed not to be a lender;
• the sponsor shall not attend or participate in any lender meeting or conference call or be entitled to receive any such agenda or minutes of such meeting or call unless the agent otherwise agrees; and
• in its capacity as a lender the sponsor shall not be entitled to receive any report or other documents prepared on behalf of or at the instructions of the agent or any lenders.

These conditions also apply to affiliates (broadly defined) of the sponsor unless they have been established for at least [6] months solely for the purpose of making, purchasing or investing in loans or debt securities and are managed or controlled independently from all other trusts, funds or other entities managed or controlled by the sponsor.  Sponsors will typically expressly carve-out any existing affiliated bona-fide credit funds.  Again, the drafting is broad to also capture transactions effected by way of sub-participation and any other agreement or arrangement having an economic effect substantially similar to a sub-participation.  Typically in the Asia-Pacific region there is no cap on the amount of the commitments which can be held by the sponsor or its affiliates. An exception to this is found in US-style term loan B facilities which typically have caps of 20-30% of the term loan commitments. The disenfranchisement provisions can typically be amended with majority lender consent (66.66% in most deals in the Asia-Pacific region) and in some cases we have seen sponsors purchase a majority stake but require the selling lenders to consent to the removal of such restrictions as a condition precedent to the buyback becoming effective.  In such circumstances the sponsor then has the ability to strip the covenants and, depending on the documentation, may have the ability to restructure its acquired debt as super-priority. 

Equitable Subordination

Sponsors should also consider whether there is a risk that the purchased debt could be subject to equitable subordination.  Equitable subordination is a doctrine that enables the court to lower the priority of a creditor claim to that of equity.  It can have the effect of converting certain senior secured claims into claims that rank pari passu with other unsecured claims (or in some jurisdictions even behind unsecured creditor claims and treated as equity). It is not a universal doctrine; for example, there is no doctrine of equitable subordination under English, Hong Kong or Singapore law and often where the doctrine does exist it is used sparingly by the courts and cases often have elements of inequitable conduct, breach of fiduciary duty, fraud, illegality or undercapitalisation.  However, this is not always the case and in some jurisdictions all shareholder loans are automatically ranked behind all unsecured creditor claims.

Regulatory Issues 

Another issue to be considered on a case-by-case basis is whether there are any applicable regulatory issues; for example, is the potential purchaser required to be a licensed lender under applicable laws and regulations?  Similarly, consideration should be given to whether any rules relating to material nonpublic information, insider trading or analogous rules apply – typically, in the case of loans (as opposed to bonds) they do not apply; however, this should be confirmed before entering into the transaction.

Equity Cure 

How debt buybacks impact the financial covenants turns on the drafting in the loan document and the purchaser.  Typically, intra-restricted group debt is excluded from the covenant calculations, but if the debt is purchased by an affiliate outside of the restricted group it will not benefit in this way.  In many loan agreements in Asia, equity cures can be added to EBITDA.  In these cases, can a debt purchase by the sponsor be contributed to the borrower and added to EBITDA? In some cases it can but more often the equity contribution must be received in cash – in which case the sponsor can contribute the cash to the borrower group to increase EBITDA and the borrower or another member of the restricted group can effect the debt buyback.  In such circumstances, can the borrower also claim the benefit of the reduction in debt thereby gaining a double benefit?  Often there are restrictions around this. However, it is not unusual that the cure amount added to EBITDA cannot be used to reduce net debt with respect to the test period in which the cure was made but may be included in subsequent test periods.

During the great recession where the agreements typically didn’t contemplate debt buybacks there were examples of some very aggressive positions taken by sponsors, including where they: (i) contributed the purchase price to the group which was deemed to be added to EBITDA as a cure amount; (ii) deducted the face amount of the debt purchased from net debt; and (iii) the amount of the discount to face value being added back to EBITDA as a one-off item to obtain a triple benefit for covenant purposes.

Key issues to consider when the Loan Agreement is silent on Debt Buybacks 

Where the loan agreement is silent on debt buybacks, in addition to the liquidity, tax, equitable subordination and regulatory issues, it is necessary to consider a number of other issues.

First, is the proposed purchaser a permitted transferee? Careful analysis of the loan document and the specific facts regarding the potential purchaser are required here as to the scope of permitted transferees.  In the Asia-Pacific region, in many cases, even where the loan agreement does not follow the LMA, the permitted transferee language tracks the LMA position and permits transfers to “another bank or financial institution or to a trust, fund or other entity which is regularly engaged in or established for the purpose of making, purchasing or investing in loans, securities or other financial assets”.  This is extremely wide and from an English law perspective a relatively low threshold to meet.  In fact, even where the language is limited to “another bank or financial institution”, under English law this is still a relatively low bar as the Court of Appeal decision in The Argo Fund Ltd v Essar Steel [2006] held that “the terms ‘financial institution’ meant an entity having a legally recognised form or being, which carried on its business in accordance with the laws of its place of creation and whose business concerned commercial finance”.  In a number of jurisdictions in Asia-Pacific such as Hong Kong, Singapore and Australia this may be persuasive; however, this must always be considered in the context of the applicable governing law of the loan agreement.

Second, if the potential purchaser is a permitted transferee, whether there are any other contractual restrictions in the finance documents; for example, the holding company undertaking in the loan agreement or where the debt will not be extinguished, restrictions in the intercreditor agreement requiring such debt to be unsecured and subordinated?

Third, does the buyback constitute a prepayment?  Where the debt is purchased by an entity other than the borrower (another member of the group or a sponsor affiliate) the debt will clearly continue to exist and the purchase cannot be characterised as a prepayment.  However, the position may be less clear where the buyback is by the borrower of its own debt.  Again, this needs to be considered under the applicable governing law.  From an English law perspective there is case law that a party cannot contract with itself (as it cannot sue itself) and is argued that by extension, a party cannot owe a debt to itself and therefore a buyback by the borrower may cause the debt to be automatically extinguished.  This position is not settled under English law in the loan buyback context. Section 61 of the Bills of Exchange Act 1882 states “When the acceptor of a bill is or becomes the holder of it at or after its maturity, in his own right, the bill is discharged”. This provides an argument that an unmatured debt can be held by that debtor.  However, it is fair to say that the more widely held market view is that under English law a buyback by the borrower of its own debt triggers an automatic extinguishment.  The relevance of this issue is that if the extinguishment constitutes a prepayment, the provisions relating to prepayments would apply and the sharing among finance parties provisions would also likely apply.  Whether such an extinguishment could be recharacterised as prepayment has not been settled as a matter of English law.  However, the more widely held market view is that under English law, the extinguishment resulting from a borrower buyback would not constitute a prepayment. Therefore the prepayment provisions should not apply.

If the buyback is by the borrower and the debt extinguished, then the borrower is not a lender and would have no right to vote or receive information.  However, if the buyback is by another member of the group or an affiliate and the debt is not waived or forgiven then, typically, absent any contractual disenfranchisement, the purchaser will be able to vote, attend lender meetings and receive lender information on the same basis as it would if it was an unrelated party.

Where there are contractual impediments to a debt buyback in a loan agreement which is otherwise silent on debt buybacks (for example, the potential purchaser not being a permitted transferee), it may be possible to structure around such restrictions through a sub-participation, total return swap or similar arrangement.  Note, however, that while it may be possible to confer voting discretion on the sub-participant, such methods will not usually assist the borrower from a financial covenant perspective.

How We Can Help

Reviewing the finance documents to understand the potential options available to buyback debt is a complicated task.  Each case will need to be examined based on the particular facts and the specific drafting (or lack of drafting on the issue) in the finance documents.  We have extensive experience in guiding sponsors and their portfolio companies through successful debt buybacks both in circumstances where there are processes prescribed by the finance documents and where the finance documents do not contemplate debt buybacks at all.  Gibson Dunn’s global finance team is available to answer your questions and assist in evaluating your finance documents to identify any potential issues and work with you on the best strategy to address them.

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Gibson Dunn’s 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 in the firm’s Global Finance or Private Equity practice groups, or the authors:

Michael Nicklin – Hong Kong (+852 2214 3809, [email protected])
Jamie Thomas – Singapore (+65 6507.3609, [email protected])

 

© 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.

 

As governments contemplate lifting COVID-19 restrictions, businesses looking to reopen their doors face numerous questions about the legal risks of operating in the midst of a pandemic.  Some of the most pressing concerns include identifying the precautions needed to avoid transmission of the virus to employees, customers, or others in proximity to their operations and the potential for liability if individuals become severely ill or die from a COVID-19 infection.  Personal injury claims based on COVID-19 are already being filed against businesses in courts across the country,[1] and some fear that a wave of litigation in the wake of the pandemic will threaten economic recovery.[2]  Plaintiffs have claimed that defendants failed to properly warn others of the presence of a COVID-19 outbreak,[3] and failed to take reasonable steps to prevent the virus from spreading.[4]  Some plaintiffs have even claimed that businesses that do not take sufficient precautions create a public nuisance,[5] which strategy echoes efforts by the plaintiffs’ bar to assert public nuisance claims in other contexts, such as opioid, tobacco, and environmental litigation.  Indeed, the potential for a high volume of lawsuits has prompted nursing homes to seek executive orders granting immunity from negligence claims involving COVID-19.[6]  And others have called for legislation to provide liability protections across many industries.[7]^, [8]

Here, we preview just a few of the issues likely to shape the scope of liability in personal injury actions related to COVID-19.

Standard of Care

A plaintiff asserting a personal injury tort claim generally must prove that the defendant breached a duty of care owed to the plaintiff.  Businesses owe their employees, customers, and others with whom they interact a duty to exercise the level of care that would be exercised by a reasonably prudent person under the same or similar circumstances to avoid or minimize the risk of foreseeable harm.  This duty may include warning of dangerous conditions and taking reasonable steps to minimize the risks presented by known hazards.

Courts recognize a general obligation of “one who has a contagious disease” to “take the necessary steps to prevent the spread of the disease.”[9]  The “necessary steps” depend on the circumstances.  As one court explained, “[t]he degree of diligence required to prevent exposing another to a contagious or infectious disease depends upon the character of the disease and the danger of communicating it to others.”[10]  In that case, the court reversed dismissal of a complaint alleging that the defendant, who owned a two-family residence and occupied one of the units, was negligent in failing to warn the other family that she had tuberculosis and in failing to avoid close personal contact.  A similar duty may extend to others who have some relationship with the sick person and knowledge of their condition, and are thus in the best position to prevent the spread of the disease.  For example, a physician whose patient receives an HIV-contaminated blood transfusion has been found to owe a duty of care to the patient’s future, unidentified sexual partners to inform the patient of the potential for HIV transmission.[11]

In the context of COVID-19, the applicable standard of care is an open issue, and various plausible scenarios present particular challenges.  For example, while it seems uncontroversial to ask symptomatic employees to stay home, to what extent should that employee’s potential contacts within the workplace be similarly restricted even if they have not manifested any symptoms?  How long should sick employees remain away after recovering, especially when COVID-19 infection, which resembles other common illnesses, has not been confirmed by a positive test result?  And given the current limitations on access to reliable testing, are businesses obligated to take affirmative steps to detect sick employees and customers?[12]  How much certainty is needed before a duty arises to warn other employees and customers about the potential infection?  The level of precautions a business can reasonably take has implications not only for personal injury liability, but also, as noted above, for nuisance claims arguing that insufficient protective measures in the workplace threaten the entire community.

Guidance from public health agencies, such as that recently issued for employers by CDC[13]^, [14] and OSHA,[15] will have an important role in shaping the standard of care.[16]  Businesses should monitor current guidance from state and federal agencies and act with that guidance in mind.  Acting consistently with guidance from public health authorities or other governmental authorities is likely to benefit a defendant faced with personal injury tort claims.  Conversely, a defendant that has not followed public health authority guidance is likely to see that same guidance asserted by future tort plaintiffs as the basis for a standard of care that plaintiffs will argue was breached.[17]  However, since current guidance is subject to change, is typically presented at a high level of generality, and often leaves details to the discretion of the employer based on circumstances, businesses should not assume compliance with agency guidelines necessarily provides a safe harbor against tort liability just as compliance with statutory and regulatory obligations generally does not bar tort claims.

Additional sources of information on the standard of care include trade association guidance and common practice in the industry.  After all, “[c]ourts will not lightly presume an entire industry negligent.”[18]  Thus, it is advisable to be aware of the measures similarly situated businesses have adopted to mitigate the spread and risks associated with COVID-19 in considering the reasonableness of measures for your business.

The contours of the standard of care will also continue to solidify as scientific understanding of the virus—and the nature of the risks it presents—grows.  Relevant factors include the means and likelihood of transmission at various stages of infection and the risk of serious illness or death upon infection.  These characteristics of COVID-19, which inform whether it is reasonable to take very stringent precautions, remain poorly understood, though research is advancing rapidly.

Causation

A personal injury tort plaintiff must also prove that the defendant’s breach of the duty of care proximately caused the claimed injury.  Here, plaintiffs are likely to face challenges.  COVID-19 is already widespread and highly contagious, and symptoms may not develop for several days after infection; indeed, some may be infected and infectious without any symptoms at all.  As a result, many people who become sick could have difficulty establishing by a preponderance of the evidence where and when they contracted the virus. This was true in the case of a nurse whose estate claimed she had been negligently exposed to H1N1 when she was asked to care for suspected H1N1 patients without an N95 mask, contrary to CDC guidance.  The court found that given the absence of evidence that the nurse actually treated an H1N1 positive patient and the fact that the virus was present in the community at large, the plaintiff’s claim of causation did not rise above the level of speculation.[19]  In a case involving Valley Fever, which is caused by a soil fungus common in the San Joaquin Valley of Central California, causation could not be proved beyond a mere possibility, as opposed to a reasonable medical probability, “[g]iven that over one-third of the population in the San Joaquin Valley tests positive for exposure to the fungus, and due to the great number of reasons for soil disturbance.”[20]

COVID-19 presents similar causation issues, although cases arising in nursing homes, prisons, and other locations in which residents, or plaintiffs, had little contact with the outside world during the likely period of infection present a possible exception.  These dynamics also could change once the initial wave of COVID-19 cases subsides and it becomes more feasible to trace the origins of individual outbreaks.

Workers’ Compensation Exclusivity

Many injuries sustained in the workplace are redressed exclusively through the states’ workers’ compensation systems,[21] which generally provide for more streamlined resolution of claims and cap recoveries for certain injuries.  Not all workplace injuries are subject to workers’ compensation exclusivity, however, and the scope of exceptions varies from state to state.  In California, for example, exclusivity does not apply where the employee’s injury is aggravated by the employer’s “fraudulent concealment” of the existence of the injury and its connection with the employment.[22]

For infectious diseases, workers’ compensation is generally available only where the job subjects the employee to a heightened risk of contracting the disease as compared to the general public.[23]  A healthcare worker who contracts COVID-19 after treating infected patients presents a straightforward example of an occupational disease, but application of the rule is less clear for workers whose jobs merely require regular interaction with the general public, since the general public itself is the source of the worker’s risk.  Concerns about the volume of workers’ compensation claims and the difficulty of demonstrating a causal connection to the workplace have motivated some states to adopt presumptive eligibility measures for certain classes of employees, including law enforcement, healthcare, and other essential workers.[24]

* * *

In sum, COVID-19 personal injury lawsuits have already made an appearance, and the volume of this litigation is likely to grow as businesses reopen and Americans increasingly encounter the virus in their workplaces, crowded venues, and interactions in business centers.  Businesses and employers face uncertainty regarding the undeveloped standard of care for COVID-19 personal injury claims, but should frequently have reasonable causation defenses under traditional principles of tort law.  Further, the extent to which the workers’ compensation system will absorb employees’ claims against their employers may depend on the risks of infection specific to the employee’s job and exceptions to workers’ compensation exclusivity that vary from state to state.  For a more comprehensive review of workers’ compensation issues raised by the COVID-19 pandemic, please refer to the Gibson Dunn Labor and Employment practice group client alert entitled, “Employer Liability and Defenses From Suit for COVID-19-Related Exposures in the Workplace.”

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[1] Daniel Wiessner, Estate of Walmart worker who died from COVID-19 sues for wrongful death, Reuters, Apr. 7, 2020.

[2] Editorial Board, Stopping a Lawsuit Epidemic, Wall St. J., Apr. 23, 2020.

[3] Tim Reid, Seattle-area nursing home hit with wrongful death lawsuit over coronavirus death, Reuters, Apr. 10, 2020.

[4] See Wiessner, supra note 1.

[5] Noam Scheiber and Michael Corkery, Smithfield Meat Plant Conditions Assailed as Public Nuisance,  N.Y. Times, Apr. 24, 2020.

[6] Marau Dolan, Harriet Ryan, and Anita Chabria, Nursing homes want to be held harmless for death toll.  Here’s why Newsom may help them, L.A. Times, Apr. 23, 2020.

[7] Evan Greenberg, What Won’t Cure Corona: Lawsuits, Wall St. J., Apr. 21, 2020.

[8] Natalie Andrews, Mitch McConnell Wants to Shield Companies From Liability in Coronavirus-Related Suits, Wall St. J., Apr. 28, 2020.

[9] Mussivand v. David, 544 N.E.2d 265, 269 (Ohio 1989) (collecting cases).

[10] Earle v. Kuklo, 98 A.2d 107, 109 (N.J. Super. Ct. App. Div. 1953) (quoting 25 Am. Jur., Health, § 45).

[11] Reisner v. Regents of University of Cal., 31 Cal. App. 4th 1195, 1198-99 (1995).

[12] Compare, Bogard’s Administrator v. Illinois Cent. R. Co., 139 S.W. 855, 857 (Ky. 1911) (rejecting argument that railroad had an affirmative duty to maintain the capability to diagnose measles in a passenger who allegedly spread the disease to plaintiff’s child), with In re September 11 Litigation, 280 F. Supp. 2d 279, 293-94 (S.D.N.Y. 2003) (recognizing a duty of airlines to screen passengers for contraband that could be used to hijack the airplane).

[13] Centers for Disease Control and Prevention, Interim Guidance for Business and Employers to Plan and Respond to Coronavirus Disease 2019 (COVID-19).

[14] Centers for Disease Control and Prevention, Implementing Safety Practices for Critical Infrastructure Workers Who May Have Had Exposure to a Person with Suspected or Confirmed COVID-19.

[15] Occupational Safety and Health Administration, Guidance on Preparing Workplaces for COVID-19.

[16] See, e.g., In re City of New York, 522 F.3d 279, 285-86 (2d Cir. 2008) (“Governmental safety regulations can . . . shed light on the appropriate standard of care.”); Rolick v. Collins Pine Co., 975 F.2d 1009, 1014 (3d Cir. 1992) (holding OSHA regulations were relevant to the standard of care).

[17] See, e.g., Ebaseh-Onofa v. McAllen Hospitals, L.P., No. 13-14-00319-CV, 2015 WL 2452701, at *6 (Tex. Ct. App., May 21, 2015) (noting plaintiff’s argument in lawsuit based on nurse’s death from H1N1 that the standard of care was determined by CDC’s purported requirement that healthcare workers use N95 masks when treating patients suspected of having the virus).

[18] See In re City of New York, 522 F.3d at 285.

[19] See Ebaseh-Onofa, 2015 WL 2452701, at *7.

[20] See, e.g., Miranda v. Bomel Construction Co., Inc., 187 Cal. App. 4th 1326, 1336 (Cal. Ct. App. 2010).

[21] See, e.g., Cal. Labor Code § 3602(a); 19 Del. Code § 2304.

[22] Cal. Labor Code § 3602(b)(2).

[23] See, e.g., Bethlehem Steel Co. v. Industrial Accident Commission, 21 Cal.2d 742, 744 (Cal. 1943).

[24] Russell Gold and Leslie Scism, States Aim to Expand Workers’ Compensation for COVID-19, Wall St. J., Apr. 28, 2020.

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Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. 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 its Environmental Litigation and Mass Tort practice group, or the following authors:

Daniel W. Nelson – Washington, D.C. (+1 202-887-3687, [email protected])
Patrick W. Dennis – Los Angeles (+1 213-229-7568, [email protected])
Alexander P. Swanson – Los Angeles (+1 213-229-7907, [email protected])

© 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 20 April 2020, the UK Government announced the launch of an investment fund intended to deliver up to £500 million of investment and liquidity to high-growth companies impacted by the Covid-19 pandemic (the “Future Fund”). The Future Fund will provide UK-based companies with convertible loans ranging from £125,000 to £5 million, provided that the amount loaned by the UK Government is matched by third party investors. The UK Government’s total commitment to the Future Fund is £250 million. This new form of support is an important step in providing liquidity and investment to innovative high-growth companies as they are typically loss-making and thus ineligible to access financial support through the Coronavirus Business Interruption Loan Scheme (the “CBILS”) during the Covid-19 pandemic.

A term sheet issued by the UK Government sets out the primary terms on which convertible loans will be provided. The main points of the term sheet are considered in further detail below. In summary, the convertible loans are provided on market standard terms for high risk-assets. The UK Government’s funding must be matched by one or more investors (each a “matched investor”) for a company to be able to access the scheme. The loans will automatically convert into equity on the company’s next qualifying funding round (i.e. where the company raises equity capital for an amount at least equal to the total funding of the bridge finance), or at the end of the loan if the debt has not been repaid. The use of convertible loans rather than direct equity investments means that funds can be provided to a company without requiring a prior valuation, making them more cost and time efficient. They also provide a higher return for investors with the additional benefit of an equity ‘kicker’ through the conversion mechanism, which makes them suitable for high-growth but also less-certain business propositions.

Eligibility

In order to participate in the scheme, a business must be an unlisted UK registered private company that has raised at least £250,000 in equity investment from third party investors in the last five years. The company is also required to have a substantial economic presence in the UK, which is generally being interpreted as having the company’s headquarters and/or production or trading facilities located in the UK. Unlike the CBILS and some of the UK Government’s other support schemes, there is, however, no requirement to demonstrate that the company is struggling as a result of the COVID-19 pandemic. The Future Fund is set to open in mid-May and close to applications in September 2020. Funding will not be available through the Future Fund in respect of recently closed funding rounds.

Use of capital

The funding can solely be used for working capital purposes and cannot be used to repay any borrowings, declare or pay any dividends or bonus payments or, in respect of the UK Government’s portion of the funding, pay any advisory or placement fees or bonuses to external advisers.

Terms of the convertible loans

Term

The convertible loans have a term of three years. This presents issues for venture capital trusts and certain venture capital investment funds as they are typically restricted from holding convertible loan securities that have a minimum term of less than five years. This may make finding matched investors difficult for some venture capital portfolio companies, meaning they would need to seek additional matched investors from outside of their current group of investors.

Interest rate

Although the initiative, which has been drawn up with the British Business Bank, may provide a much needed boost to certain start-ups, the terms of the convertible loans make this program equivalent to the UK Government investing tax payer money in high-risk, non-investment grade bonds. These investments are accordingly on the riskier end of the spectrum and this is reflected in the terms that the UK Government is prepared to provide for the funding. With the current market uncertainty, the high yield bond market is currently offering yields of between 8-10%, up from approximately 3.5% in early March. The term sheet issued by the UK Government provides that it shall receive a minimum of 8% per annum (non-compounding) interest to be paid on the maturity of the loan, although, the interest rate shall be higher if a higher rate is agreed by the company and a matched investor. While this interest rate is commensurate with interest rates for convertible loans issued to venture capital and angel investors, it is intended to reflect the high-risk nature of  the investment and reward an investor accordingly.

Discount rate

To compensate for the higher risk categorisation, the convertible loans will automatically convert to equity at the next qualifying funding round, with an option to convert on a non-qualifying funding round. A “qualifying funding round” is a funding round where the company in raises at least the same amount in equity investment as that raised by the UK Government’s bridge finance.

On conversion, a minimum discount of 20% applies which, as with the interest rate, shall be higher if a higher discount is agreed by the company and a matched investor. As an example, if the Future Fund provides a £1 million convertible loan to Company A, and in a future fundraising, Company A raises equity finance at £1 per share from a new investor, the loan will automatically convert into 1.25 million shares (equivalent to £0.80 per share). The conversion discount applies only to the principal amount outstanding under the loan and not to any accrued interest, which shall convert at the price of the funding round without the discount.

Repayment and redemption premium

To further offset the risk of the investment and encourage the companies to seek additional equity investment, the convertible loans carry a redemption premium of 100%. On maturity of the loan, if the majority of the matched investors prefer not to convert into equity at the discount rate to the price set by the most recent funding round of the company, they shall be entitled to receive a premium of 100% in addition to the outstanding amount of the loan, plus the accrued interest. Following the above example, the investors in Company A would be entitled to receive £2.24 million from Company A at the end of a three year term, which is equivalent to an internal rate of return of approximately 30%. Redemption premiums are normally only acceptable for high risk investments as, from the company’s perspective, the loan can become a very expensive form of finance if the investors do not convert into equity prior to or at maturity of the loan.

The term sheet issued by the UK Government does not provide for the option of early repayment prior to the next funding round and specifically provides that the UK Government’s portion of the loan shall automatically convert into equity unless it specifically requests repayment. This indicates that the UK Government does not intend for this to be merely bridge financing and wishes to participate in the potential equity upside.

While the interest rate, discount rate and redemption premium attached to the convertible loans may be considered market standard for some venture capital firms investing in high risk enterprises in a stable economy, these terms illustrate a high-level of risk that the UK Government is willing to take with tax payers’ money in order to provide liquidity to businesses that may otherwise fail. As the scheme is reliant on the involvement and investment decisions of the matched investors, it is open to the risk of poor judgment by less successful investors and floundering companies that are willing to take on exceptionally expensive debt as a last resort.

Other terms

The UK Government is to receive limited corporate governance rights during the term of the loan and as a shareholder following conversion of the loan into equity. The term sheet contains a ‘Most Favoured Nation’ provision whereby, if the company issues further convertible loan instruments to new or existing investors on terms which are more favourable than those of the scheme, those terms will apply to the convertible loans provided by the Future Fund. There is also a negative pledge which prohibits the issuing company from creating any indebtedness that is senior to the convertible loan other than any bona fide senior indebtedness from a person that is not an existing shareholder or a matched investor.

International equivalents

The UK Government is not the only state government currently willing to invest in high risk assets. On 9 April, the U.S. Federal Reserved announced plans that, as part of its quantitative easing package, it was going to expand its ETF (exchange traded funds) buying program to include credit that has recently been downgraded to BB-/Ba3 (i.e. junk). However, the program is not open to all struggling companies and is aimed at those who have been recently impacted by the COVID-19 pandemic as the Federal Reserve is only permitted to invest in corporates that were listed as investment grade as recently as 22 March 2020.

The French government is also providing a comprehensive support plan for start-ups with financing and liquidity measures representing €4 billion euros. Only €80 million of this is to be available as bridge financing to start-ups that were in the process of raising investment and is aimed to be step-in measure to assist those entities where an investor has pulled out since the start of the crisis. This is in stark contrast to the £250 million to be provided by the Future Fund to any high-growth company that meets the criteria set out above.  The majority of the support from the French government is being provided through early payments of certain tax credits, worth €1.5 billion, and public guarantees over cash-flow costs, worth €2 billion. Germany has also implemented a special support program to provide up to €2 billion to start-ups who have a market value of more than €50 million and plans to work through venture capital firms who will distribute the support to businesses who are struggling as a result of the crisis. The minimum market capital requirement means that it is likely that these funds will be distributed to more established businesses, rather than fledgling entities who would struggle to survive in a normal socio-economic environment. It could be said therefore, that the Future Fund, when compared to positions taken by the governments of other leading economies, represents an investment in innovation and entrepreneurship in the UK.

Response of the VC community

The response to the concept of the Future Fund amongst venture capital firms and industry bodies has been overwhelmingly positive and it is seen as a big success for the Venture capital industry. Many feel that this level of investment in high-growth companies indicates that the UK Government recognises the immense value that the start-up industry provides to the economy as a whole. However, concerns have been raised about the detail of the plan. As the matched funding has to be provided through use of convertible loans, investors will not be eligible for EIS (enterprise investment scheme) relief, which applies only to new share issuances and provides income tax and capital gains tax relief to the holders of the shares. As referenced above, venture capital trusts (“VCT”) will generally be unable to participate in the scheme as a matched investor as (i) they are only able to hold convertible loans that have a minimum term of five years (whereas the convertible loans under the Future Fund have a maximum term of three years); and (ii) the loans held by a VCT can have an annual return of no more than 10% (which given the redemption premium is not the case with the convertible loans). Industry bodies such as the British Private Equity and Venture Capital Association have been engaging in ongoing discussions with the UK Government and hope to be able to iron out some of these issues in the coming weeks before the Future Fund launches.

Conclusion

The scheme is unprecedented and represents a bold move by the UK Government to provide support to the start-up industry. However, it also raises a number of questions, such as: (i) should the UK Government be providing tax payer support to high-risk fledgling entities backed by venture capital firms; and (ii) should state support to struggling companies be provided on such one-sided terms? While the intent of the governments of Germany and France is similar to that of the UK, the risk profile of their support programs appears at first glance to be markedly different. Rather than protecting and facilitating the growth of the UK’s tech industry, which may be better served through cash-flow relief measures, tax credits and loans on favourable terms, the terms of the convertible loans detailed above, particularly the lack of an early repayment option and the automatic conversion of the UK Government’s loan to equity, provides for the possibility of large upsides in the long-run but entails taking on considerable risk. This could leave the program open to being misused by entities that either were already struggling or are not yet sufficiently established and who are willing to take on expensive debt that they will be unable to repay. Additionally, the scheme will only work to the extent that there is sufficient participation by venture capital firms who are prepared to provide the matched funding and are prepared to have the UK Government as a co-shareholder.

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This client update was prepared by Jeremy Kenley, James R. Howe, Amar Madhani and Ciarán Deeny.

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. In the UK, the contact details of the authors and other key practice group lawyers are as follows:

The Authors:

Jeremy Kenley – London, M&A, Private Equity & Real Estate (+44 (0)20 7071 4255, [email protected])
James R. Howe – London, Private Equity (+44 (0)20 7071 4214, [email protected])
Amar Madhani – London, Private Equity and Real Estate (+44 (0)20 7071 4229, [email protected])
Ciarán Deeny – London, M&A and Private Equity (+44 (0)20 7071 4248, [email protected])

London Key Contacts:

Sandy Bhogal – London, Tax (+44 (0)20 7071 4266, [email protected])
Thomas M. Budd – London, Finance (+44 (0)20 7071 4234, [email protected])
Gregory A. Campbell – London, Restructuring and Finance (+44 (0)20 7071 4236, [email protected])
Ben Fryer – London, Tax (+44 (0)20 7071 4232, [email protected])
Christopher Haynes – London, Corporate (+44 (0)20 7071 4238, [email protected])
Anna Howell – London, Energy, Oil & Gas (+44 (0)20 7070 9241, [email protected])
Michelle M. Kirschner – London, Financial Institutions (+44 (0)20 7071 4212, [email protected])
Selina S. Sagayam – London, Corporate (+44 (0)20 7071 4264, [email protected])
Alan A. Samson – London, Real Estate & Real Estate Finance (+44 (0)20 7071 4222, [email protected])
Mark Sperotto – London, Private Equity (+44 (0)20 7071 4291, [email protected])
Nick Tomlinson – London, Private Equity (+44 (0)20 7071 4272, [email protected])
Jeffrey M. Trinklein – London, Tax (+44 (0)20 7071 4264, [email protected])

© 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 pandemic has resulted in unprecedented governmental actions at the federal, state, and local levels.  Those actions have raised substantial constitutional questions.  In previous alerts, we discussed the constitutional implications of various proposed legislative and executive actions in response to COVID-19, including under the Takings, Contracts, Due Process, and Equal Protection Clauses of the U.S. Constitution.[1]  Here, we flag additional business-related constitutional questions raised by the government’s restrictions on travel, with a particular focus on the extent of a state’s authority to impose restrictions on out-of-state visitors and to restrict interstate travel.  As governments continue to take swift and often unprecedented action in response to the pandemic, additional novel constitutional challenges are likely to arise.

As COVID-19 has spread, some state and local governments have erected checkpoints at which they stop, order quarantine of, and even turn away travelers arriving from states with substantial community spread of the virus.[2]  Other states have barred short-term rentals to individuals arriving from out of state, making it impractical to travel to those locations.[3]  And all over the country, states and localities have imposed significant restrictions on their own citizens’ ability to travel even within the state or locality.  While some state quarantine restrictions provide broad exceptions for travelers engaging in commerce, others do not, and in the latter group of states businesses may find routine commercial activity—e.g., interstate transport of goods and employee business travel—far more difficult to conduct.[4]

These and similar restrictions implicate the constitutional right to travel.  That right—whose textual source has long remained “elusive”[5]—“embraces at least three different components[:]  the right of a citizen of one State to enter and to leave another State, the right to be treated as a welcome visitor rather than an unfriendly alien when temporarily present in the second State, and, for those travelers who elect to become permanent residents, the right to be treated like other citizens of that State.”  Saenz v. Roe, 526 U.S. 489, 500 (1999).  Under Supreme Court precedent, the right to travel is typically applied to an individual who wishes to travel—not necessarily to goods she wishes to transport.  But since commercial transport today depends in large part upon the movement of people—from the truck driver to the pilot—restraints on an individual’s right to travel necessarily inhibit the transport of goods.

State laws implicate the right to travel where, inter alia, they deter, intend to impede, or utilize classifications that punish interstate travel.  Soto-Lopez, 476 U.S. at 903.  And a law that burdens the right to travel is unconstitutional “[a]bsent a compelling state interest.”  Dunn v. Blumstein, 405 U.S. 330, 342 (1972).[6]  In keeping with the right’s multifaceted nature, courts have relied on it to invalidate state restrictions in a variety of contexts.  See, e.g., Soto-Lopez, 476 U.S. at 911 (invalidating New York restriction of civil service preference to veterans entering armed forces while living in state); Mem’l Hosp. v. Maricopa Cty., 415 U.S. 250 (1974) (invalidating Arizona 1-year residency requirement for receiving nonemergency hospitalization or medical care); Crandall v. Nevada, 6 Wall. 35 (1868) (invalidating Nevada tax imposed on individuals leaving state by railroad, coach, or other vehicle transporting passengers for hire).

Quarantine and travel restrictions may also raise related questions under the dormant Commerce Clause, which is more often litigated in the commercial context.  Although the Commerce Clause “is framed as a positive grant of power to Congress,” the Supreme Court has “long held that this Clause also prohibits state laws that unduly restrict interstate commerce.”  Tenn. Wine & Spirits Retailers Ass’n v. Thomas, 139 S. Ct. 2449, 2459 (2019).[7]  If a state law affirmatively discriminates against interstate transactions, it is presumptively invalid, passing constitutional muster only if its “purpose could not be served as well by available nondiscriminatory means.”  See Maine v. Taylor, 477 U.S. 131, 138 (1986); see also Granholm v. Herald, 544 U.S. 460 (2005).  If a law is nondiscriminatory, courts require that the law’s benefits to the state exceed its burden on interstate commerce.  See Taylor, 477 U.S. at 138.  But the dormant Commerce Clause doctrine admits two exceptions:  (i) state laws authorized by valid federal laws, and (ii) states acting as “market participants,” which covers distribution of state benefits and the actions of state-owned businesses.  See Ne. Bancorp v. Bd. of Governors of Fed. Reserve Sys., 472 U.S. 159, 174 (1985); White v. Mass. Council of Constr. Emp’rs, 460 U.S. 204, 206–08 (1983).[8]  Dormant Commerce Clause analysis is often fact-intensive, especially when the balancing test for nondiscriminatory laws is applied.  See Pike v. Bruce Church, 397 U.S. 137, 139–42 (1970).

The more restrictive dormant Commerce Clause standard may well apply in the COVID-19 context, where certain quarantine requirements appear facially discriminatory by applying only to out-of-state travelers.  As a result, such requirements would be presumed invalid unless there are no available nondiscriminatory means that can advance its purposes.  While a high threshold, this test is not a death knell for the travel restrictions.  The Supreme Court and other courts have upheld discriminatory laws at times, with significant deference to the factual findings of lower courts.  See Taylor, 477 U.S. at 141, 146–48 (upholding Maine restriction on importation of out-of-state baitfish, finding no “clear[] err[or]” in the district court’s factual findings regarding the effects of baitfish parasites and non-native species on Maine’s wild fish population); see also Shepherd v. State Dep’t of Fish & Game, 897 P.2d 33, 41–43 (Alaska 1995) (holding that requirements giving hunting preferences to Alaska residents adequately promoted state interest in “conserving scarce wildlife resources for Alaska residents”).

Any challenge under either the right to travel or the dormant Commerce Clause would likely be evaluated based on the breadth and severity of the restrictions on travel, the difference (if any) on the treatment of in-state and out-of-state residents, the exigencies and public health needs faced by the geographic area at issue, the impact on interstate commerce of the restrictions challenged, the feasibility and efficacy of alternative, narrower constraints on movement that just as successfully combat the spread of the virus, and whether quarantine requirements and other restrictions are properly calibrated to achieve their public-health objectives.  In addressing these issues, courts may also consider whether states are acting pursuant to federal law and, where it is the federal government that is acting, whether it is acting pursuant to the Spending Clause.  See U.S. Const. art. I, § 8, cl. 1.

In evaluating challenges under both the right to travel and the dormant Commerce Clause doctrines, courts will look to the limited precedent arising in the context of quarantines.  In cases that generally pre-date modern jurisprudence on the right to travel and the dormant Commerce Clause, the U.S. Supreme Court has upheld quarantines—particularly those imposed pursuant to states’ police powers—for public health reasons.  In Compagnie Francaise de Navigation a Vapeur v. Board of Health of State of Louisiana, 186 U.S. 380 (1902), for example, the Court upheld a New Orleans ordinance prohibiting all domestic and foreign travelers—regardless of health status—from entering the city because of a yellow fever outbreak, noting that it was “not an open question” that state quarantine laws are constitutional, even where they affect interstate commerce.  Id. at 387.  On the other hand, some courts have rejected quarantine measures when imposed against individuals for whom the state had no reasonable basis to suspect individual infection or exposure to the disease.  See, e.g., In re Smith, 40 N.E. 497, 499 (N.Y. 1895) (rejecting Brooklyn quarantine of individuals who had refused smallpox vaccination as overbroad under New York health law which, because it affected “the liberty of the person,” was to be “construed strictly,” without explicitly referencing the right to travel).

In the event that states’ quarantine requirements in response to COVID-19 face constitutional challenges, courts may be called upon to reconcile these lines of precedent—weighing the fundamental right to free travel and entitlement to equal treatment for out-of-state citizens against the compelling need to prevent the spread of contagion.  Courts will likely also consider precedent recognizing the states’ well-established “police power” in addressing public health crises.  See, e.g., Jacobson v. Massachusetts, 197 U.S. 11, 38 (1905) (upholding state’s mandatory vaccination during smallpox outbreak); Phillips v. City of New York, 775 F.3d 538, 542 (2d Cir. 2015) (relying on Jacobson in rejecting substantive due process and free exercise challenges to New York mandatory school vaccination requirement).  Courts may likewise consider the fact that quarantines necessarily require establishing boundaries, which logically may be drawn using existing state or municipal borders.

Furthermore, in an environment in which states have adopted divergent approaches to quarantines and similar restrictions, courts may bear important principles of federalism in mind.  Nearly a century ago, Justice Brandeis lauded the states as “laborator[ies]” for “novel social and economic experiments,” New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932)—a famous phrase that may sound more literal than metaphorical today.  While the Constitution guarantees liberty in interstate travel and trade, it also seeks to protect the autonomy and creativity of the individual states.  And those principles may well conflict if, for instance, one state determines that more restrictive quarantine measures are appropriate than a sister state.  Resolution of any such conflict may require, as with many issues related to COVID-19, a challenging balance of individual liberty and federalism interests.

 As federal, state, and local governments continue to restrict the movement of people and goods in response to COVID-19, it is unclear whether their actions will be challenged under the constitutional provisions outlined above, much less how those challenges would fare in court.  Nonetheless, constitutional constraints on governmental action remain significant.  Even in these unprecedented times, all levels of government must make sure to implement responses that grant proper deference to the principles and precedent underlying the constitutional provisions discussed above.

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  [1]  See Constitutional Implications of Government Regulation and Actions in Response to the COVID-19 Pandemic (Mar. 27, 2020), https://www.gibsondunn.com/constitutional-implications-of-government-regulations-and-actions-in-response-to-the-covid-19-pandemic/; Constitutional Implications of Rent- and Mortgage-Relief Legislation Enacted in Response to the COVID-19 Pandemic (Apr. 15, 2020), https://www.gibsondunn.com/constitutional-implications-of-rent-and-mortgage-relief-legislation-enacted-in-response-to-the-covid-19-pandemic/; New York Governor v. New York City Mayor:  Who Has the Last Word on New York City’s Business Shutdown? (Apr. 18, 2020), https://www.gibsondunn.com/new-york-governor-v-new-york-city-mayor-who-has-the-last-word-on-new-york-citys-business-shutdown/.

  [2]  See, e.g., Fla. Exec. Order No. 20-86 (Mar. 27, 2020) (directing establishment of road checkpoints and mandating self-quarantine for travelers from states with substantial community spread of COVID-19), available at https://www.flgov.com/wp-content/uploads/orders/2020/EO_20-86.pdf; R.I. Exec Order No. 20-12 (Mar. 26, 2020), (requiring travelers from New York to self-quarantine for 14 days), available at http://www.governor.ri.gov/documents/orders/Executive-Order-20-12.pdf; see also Joe Barrett, Tourist Towns Say, ‘Please Stay Away,’ During Coronavirus Lockdowns, Wall St. J., Apr. 6, 2020 (discussing Florida Keys ban on visitors but not property owners, and Cape Cod petition to turn away visitors and nonresident homeowners from bridges that provide the only road access to the area), https://www.wsj.com/articles/tourist-towns-say-please-stay-away-during-coronavirus-lockdowns-11586165401?.

  [3]  See, e.g., Fla. Exec. Order No. 20-87 (Mar. 27, 2020) (suspending certain vacation rentals on the basis that “vacation rentals and third-party platforms advertising vacation rentals in Florida present attractive lodging destinations for individuals coming into Florida”), available at https://www.flgov.com/wp-content/uploads/orders/2020/EO_20-87.pdf.

  [4]  Compare, e.g., Fla. Exec. Order No. 20-86 (exempting “persons involved in any commercial activity” from self-quarantine requirement), with Second Supplementary Proclamation – COVID-19, Office of the Governor, State of Hawaii (Mar. 21, 2020) (exempting only “persons performing emergency response or critical infrastructure functions who have been exempted by the Director of Emergency Management” from Hawaii out-of-state self-quarantine requirement), available at https://governor.hawaii.gov/wp-content/uploads/2020/03/2003152-ATG_Second-Supplementary-Proclamation-for-COVID-19-signed.pdf.

  [5]  Attorney Gen. of N.Y. v. Soto-Lopez, 476 U.S. 898, 902 (1986).  The right to travel “has been variously assigned to the Privileges and Immunities Clause of Art. IV, to the Commerce Clause, and to the Privileges and Immunities Clause of the Fourteenth Amendment.”  Id. (citations omitted); see also Jones v. Helms, 452 U.S. 412, 418 (1981) (“Although the textual source of this right has been the subject of debate, its fundamental nature has consistently been recognized by this Court.”).  The Supreme Court has also stated that the right is “part of the ‘liberty’ protected by the Due Process Clause of the Fourteenth Amendment.”  City of Chicago v. Morales, 527 U.S. 41, 53 (1999) (plurality opinion).

  [6]  The Supreme Court has distinguished the constitutional right to interstate travel from the freedom to travel abroad; the former is “virtually unqualified,” while the latter is “no more than an aspect of the ‘liberty’ protected by the Due Process Clause [and] can be regulated within the bounds of due process.”  Haig v. Agee, 453 U.S. 280, 306–07 (1981) (quoting Califano v. Aznavorian, 439 U.S. 170, 176 (1978)).

  [7]  In recent years, “some Members of the [Supreme] Court have authored vigorous and thoughtful critiques” of the dormant Commerce Clause.  Tenn. Wine, 139 S. Ct. at 2460 (collecting opinions of Justices Gorsuch, Scalia, and Thomas).  “But,” the Court noted last term, “the proposition that the Commerce Clause by its own force restricts state protectionism is deeply rooted in our case law.”  Id.

  [8]  Where governmental actions are challenged on a basis other than the dormant Commerce Clause (e.g., the Due Process Clause), other considerations may of course be relevant to an analysis of the action’s constitutionality.

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Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. 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 its Appellate or Public Policy practice groups, or the following authors:

Akiva Shapiro – New York (+1 212.351.3830 , [email protected])
Avi Weitzman – New York (+1 212-351-2465, [email protected])
Patrick Hayden – New York (+1 212.351.5235, [email protected])
Alex Bruhn* – New York (+1 212.351.6375, [email protected])
Jason Bressler – New York (+1 212.351.6204, [email protected])
Parker W. Knight III* – New York (+1 212.351.2350, [email protected])

* Not admitted to practice in New York; 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.

On Thursday, April 30, 2020, the Internal Revenue Service (the “IRS”) issued Notice 2020-32 (the “Notice”).[1]  The Notice clarifies that, in the IRS’s view, expenses funded using the p

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roceeds of Small Business Administration (“SBA”) loans extended pursuant to the Paycheck Protection Program are not deductible if the loan is forgiven.

Paycheck Protection Program Background

The Paycheck Protection Program was created by the Coronavirus Aid, Relief, and Economic Security Act, Pub. L. 116–136 (116th Cong.) (Mar. 27, 2020) (the “CARES Act”), and significantly expands SBA loan availability for certain businesses.[2]

Under Section 1106(b) of the CARES Act, if certain conditions are satisfied, recipients of these new SBA loans are eligible for loan forgiveness in an amount equal to the qualifying payroll costs, mortgage interest payments, rent, and utilities incurred or paid by the recipient during the eight weeks following the origination of the loan.[3]

Tax Treatment of SBA Loan Forgiveness and Associated Deductions

In general, when a loan is forgiven, the borrower includes the forgiven amount in gross income.  Section 1106(i) of the CARES Act modifies this rule by excluding from income any forgiven SBA loan amount that otherwise would be includible in the gross income of the recipient.  The CARES Act is silent, however, about whether expenses funded with the proceeds of those loans are deductible for federal income tax purposes.

The Notice, which is the first guidance to specifically address the issue, provides that although ordinary and necessary expenses incurred in carrying on a trade or business generally are deductible, no deduction is available for expenses that are funded out of the proceeds of a forgiven SBA loan, reasoning that allowing such a deduction would confer an improper double tax benefit (a deduction for the expenses paid with the forgiven loan proceeds and no income inclusion from the amount of the loan forgiven).

The Notice clearly sets forth the IRS’s position regarding the non-deductibility of expenses funded using the proceeds of Paycheck Protection Program loans that are forgiven.  It is worth observing, however, that the applicable law supporting the position taken in the Notice is not entirely clear, and the Notice does not address every practical scenario that might be confronted by a taxpayer who receives a loan under the Paycheck Protection Program.[4]  For example, the Notice does not consider situations in which the related expense is incurred in a different taxable year than the taxable year in which the forgiveness of the debt is anticipated or occurs, or whether (or how) a taxpayer can determine with certainty that debt will be forgiven, particularly in light of the fact that the CARES Act requirements continue to be subject to additional regulatory refinements.

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[1]      The Notice is available on the IRS website at https://www.irs.gov/pub/irs-drop/n-20-32.pdf.

[2]     CARES Act section 1102.  For additional details about the Paycheck Protection Program 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; and Small Business Administration Publishes Additional Interim Final Rules and New Guidance Related to PPP Loan Eligibility and Accessibility.

[3]      CARES Act section 1106(b).

[4]   Virginia Blanton, Michael Q. Cannon & Jennifer A. Fitzgerald, Double Tax Benefits in the CARES Act, 167 Tax Notes Fed. 423 (2020).

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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, any member of the firm’s Tax Practice Group or its Coronavirus (COVID-19) Response Team, or the following authors:

Michael Q. Cannon – Dallas (+1 214-698-3232, [email protected])
Virginia Blanton* – Washington, D.C. (+1 202-887-3587, [email protected])

Please also feel free to contact any of the following leaders and members of the Tax group:

Jeffrey M. Trinklein – Co-Chair, London/New York (+44 (0)20 7071 4224 /+1 212-351-2344), [email protected])
David Sinak – Co-Chair, Dallas (+1 214-698-3107, [email protected])
James Chenoweth – Houston (+1 346-718-6718, [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
Eric B. Sloan – New York (+1 212-351-2340, [email protected])
Edward S. Wei – New York (+1 212-351-3925, [email protected])
Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, [email protected])
Daniel A. Zygielbaum – Washington, D.C. (+1 202-887-3768, [email protected])
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Paul S. Issler – Los Angeles (+1 213-229-7763, [email protected])
Lorna Wilson – Los Angeles (+1 213-229-7547, [email protected])
Scott Knutson – Orange County (+1 949-451-3961, [email protected])

* 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.

I.  Overview

The coronavirus pandemic (“COVID-19”) has had far-reaching implications on virtually every aspect of the global economy, and the private equity industry has faced its share of challenges.  As investment advisers and private equity fund managers navigate this uncertain terrain, many have identified alternative types of investments, including private investments in public equity (“PIPEs”) and various types of debt investments, as promising alternatives to their existing funds’ original investment strategies.  With private equity firms holding an estimated $2 trillion of ‘dry powder’ and companies in dire need of capital, it should come as no surprise that, since late March, companies have raised approximately $8 billion from private equity funds in PIPE transactions, as sponsors eye dividends and an eventual equity stake in lieu of a more customary control investment approach.[1]  This client alert identifies a number of issues fund managers should consider as they evaluate opportunities outside of their existing funds’ primary investment focuses.

II.  Investment Program

     A.  Investment Objective

Fund managers should first evaluate whether the relevant disclosure and partnership agreement language is flexible enough to permit alternative investment types. This evaluation should focus on whether the fund’s investment objective is sufficiently broad to accommodate the desired types of alternative investment strategies (such as a carve-out to allow the fund to invest in “other assets,” or similar language).  Any fund manager that pursues alternative investments for a fund that fall outside of the fund’s primary investment strategy should consider whether the current disclosure documents adequately discuss the risks inherent in such types of investments, or whether such disclosure should be supplemented.

     B.  Investment Restrictions

Sponsors should also be mindful of applicable investment limitations, whether contained in the partnership agreement or in investor side letters.  These provisions are often drafted to allow the fund’s limited partner advisory committee (“LPAC”) or limited partners to waive the restrictions on a case-by-case basis, and fund managers should consider whether to request such a waiver in light of other requests they may be making (e.g., waivers of the requirement to hold an annual meeting, extensions of fundraising and investment periods, etc.) and how they can make their requests more appealing by, for instance, including a time limitation that stresses the unique nature of the opportunity being pursued and assures the investors that the drift in investment objective will be temporary in nature.

Of particular concern to fund managers in this respect will be restrictions in investing in marketable securities, or otherwise investing in publicly traded securities in the open market.  While these restrictions would typically apply to investments in publically traded debt, they generally would not apply to investments in PIPEs, as such transactions do not involve open market purchases.

Should the fund’s documentation permit the sponsor to pursue alternative investments, the sponsor may wish to consider whether any of its existing portfolio companies would benefit from a debt investment (including a bridge financing) as a means of providing working capital.  Before pursuing such opportunities, however, sponsors should carefully review the fund’s governing documents to ensure that there are no relevant restrictions (e.g., a cap on follow-on investments or a requirement that they must be in the form of equity).

     C.  Alternative Vehicles and Supplemental Fundraises

The creation of annex or ancillary investment vehicles may provide relief to a fund manager that is not necessarily restricted from investing in PIPEs or other alternative investment strategies in an existing fund, but the existing fund is near the end of its investment period or has limited available capital (even taking into consideration recycling mechanisms and scope to complete follow-on investments).

1. 1. Co-Investment Vehicles

To the extent that a fund lacks the flexibility to pursue a compelling opportunistic investment strategy (whether due to fund-level investment restrictions or a lack of sufficient capital) and is unable to (or otherwise does not wish to) seek relief from its LPAC or limited partners, the fund manager may wish to consider allocating the remainder of the targeted investment to a newly formed co-investment vehicle.  This approach has the benefit of allowing the fund to take only as much of the targeted investment as the fund manager deems appropriate (due to capacity constraints, investment restrictions, or other factors). The approach has the additional advantage of allowing the fund manager to raise additional capital relatively quickly (particularly to the extent the manager has an established form of co-investment agreement and has completed co-investments with its existing limited partners in the past).  Sponsors should of course first evaluate whether the fund documents (including investor side letters) permit the formation of a co-investment vehicle and whether they obligate the sponsor to offer co-investment opportunities to specific investors.

1. 2. Annex Funds

To assist in raising additional capital, fund managers may also wish to consider forming an annex fund, which is a newly formed fund vehicle intended to supplement the existing fund’s investment program.  Annex funds are typically first offered to the existing fund’s investors on a pro rata basis.  Investors who already subscribed are then offered their pro rata share of any unclaimed capacity, and any remaining capacity can then be offered to outside investors.  Management fees and carried interest are typically heavily reduced (or, in the case of management fees, eliminated entirely).

1. 3. Independent Investment Vehicles

Even if the fund documentation permits the manager to pursue its desired type of alternative investments, the manager may wish to create a completely independent investment vehicle focused on such alternative investments.  While this approach should allow the manager to achieve economics that are not obtainable in the co-investment or annex fund contexts, establishing a standalone investment vehicle has a longer time horizon than the alternatives discussed above. This approach also presents the most risk, particularly in the current uncertain fundraising climate where travel and the ability to conduct onsite due-diligence with prospective investors may be drastically curtailed.

1. 4. Supplemental Fundraises

Finally, to the extent practicable, sponsors may wish to consider conducting a supplemental fundraise within the sponsor’s existing fund.  Assuming that there is no outer limit on the period during which the sponsor may accept new investor commitments (or the limited partners or LPAC have agreed to an extension of such period), the sponsor may allow existing investors to increase their capital commitments (or, potentially, allow a select number of new investors to join the fund).  While this may allow the sponsor to maintain the core economics of the existing fund and to raise new capital quickly, it involves a number of important questions that must be addressed, including whether the increasing (or new) investors will be able to dilute existing investors in existing investments.

Under any of these approaches, sponsors will likely want to raise capital in an accelerated timeframe in order to capitalize on the applicable opportunities.  Accordingly, we recommend that interested managers immediately begin preparing highly tailored marketing presentations that provide detailed overviews of the relevant opportunities and schedule virtual conferences with lead investors in order to address any questions or concerns. Sponsors should also be mindful that an effective ancillary vehicle will not simply duplicate the primary fund’s terms, but rather adjust them in a manner that reflects the relevant facts in order to minimize investor negotiation and proceed quickly to closing.  Additionally, even if a sponsor is not looking into alternative investments and is not preparing for a traditional fundraise, we encourage a careful review of the existing fund’s terms and structure in order to be prepared to quickly return to market as desirable opportunities arise, given the current uncertainty in the market.

The formation of annex or ancillary investment vehicles requires careful consideration of a number of potential hurdles, as discussed more fully in Part III below.

III.  Time and Attention and Related Considerations

     A.  Time and Attention; Key Person

Before forming a new investment vehicle to pursue alternative investment strategies, a fund manager should analyze a number of provisions in its existing funds’ governing documents.  Chief among these are the key persons’ time commitment covenants, which are often heavily negotiated and should be analyzed carefully if the fund’s key persons are expected to play significant roles in the new investment vehicle.  For example, a key person essentially would be precluded from involvement in the new investment vehicle if an existing fund’s partnership agreement requires that the key person devote “substantially all” of his or her business time and attention to the fund’s affairs.  However, a key person clause that only requires a “reasonably necessary” amount of time offers more latitude, particularly in a scenario where, for example, the existing fund only has enough dry powder to make one additional investment. Sponsors should also consider their fiduciary responsibilities when evaluating time and attention and key person obligations to a fund.  Time commitment requirements typically are customized so these analyses tend to be highly fact-specific.  We are very familiar with helping fund managers analyze the relevant considerations.

     B.  Successor Fund Restrictions

Sponsors should also consider whether and to what extent successor fund restrictions may limit flexibility to establish a new vehicle.  Many partnership agreements restrict fund managers from forming new vehicles with investment strategies that are “substantially similar” to the current fund’s investment strategy, until the current fund deploys a specified amount of capital or reaches the end of its investment period.  This of course requires careful consideration of how the documents describe each fund’s investment objective, as discussed in Part II above.  Co-investment vehicles are often specifically carved out from the definition of “successor funds” (i.e. permitted), but annex funds typically are not.  In many cases, a fund’s LPAC has the explicit ability to waive this restriction, which may be the most efficient option for managers interested in setting up an annex fund (or a co-investment vehicle, to the extent it is not already carved out).

     C.  Allocation of Investment Opportunities

Finally, fund managers should be mindful of potential conflicts of interest and restrictions that may arise when allocating investment opportunities among the manager’s various funds and clients. A fund’s partnership agreement may require that the fund manager allocate to the fund any investment opportunities that fall within its investment mandate (subject to exceptions), regardless of whether such opportunities were primarily envisioned when the fund was created.  Managers should seek to articulate a clear rule that identifies investment opportunities that fall outside of an existing fund’s investment objective and that can be allocated to a new vehicle.  Deal allocation provisions may create substantial hurdles for managers looking to create new fund vehicles to pursue alternative investment types. Managers must carefully analyze the existing fund’s deal allocation requirements, including a review of both the existing fund’s partnership agreement and disclosure documentation and the manager’s allocation policy.  Similar issues may arise when allocating an investment between the existing fund and a co-investment or annex fund.

IV.  Conclusion

COVID-19 has created a tremendous amount of uncertainty in the global economy, causing many private equity fund managers to pursue new, attractive opportunities outside of their traditional investment objectives.  Such managers should carefully review their funds’ governing documents and disclosure materials to determine whether and to what extent it is possible to pursue such opportunities.  Sponsors should also maintain an open dialogue with limited partners and clearly communicate the desired strategy in a concise, focused manner, including a consideration of the various tools at the sponsor’s disposal, as outlined above.

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   [1]   Crystal Tse and Liana Baker, Buffett-Goldman Redux: Buyout Shops Fight for Lifeline Deals, Bloomberg (Apr. 27, 2020).

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Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above. For further information, please contact the Gibson Dunn lawyer with whom you usually work, or the following authors:

Shukie Grossman – New York (+1 212-351-2369, [email protected])
Edward D. Sopher – New York (+1 212-351-3918, [email protected])
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, [email protected])
William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, [email protected])
Robert Harrington – New York (+1 212-351-2608, [email protected])

© 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.

 

Despite pressure from U.S. and non-U.S. officials to ease sanctions on Iran in response to COVID-19, the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) to date has not made substantial changes to the longstanding legal authorizations for humanitarian trade.  Nonetheless, OFAC has in recent weeks published unprecedented guidance for those who may find themselves facing challenges to comply with OFAC’s reporting requirements in light of the pandemic, acknowledging that some businesses may be forced to reallocate sanctions compliance resources to other functions.  While this is far from the substantial changes called for by some, it nonetheless indicates OFAC’s willingness to respond to the crisis with some measure of understanding for the new realities faced by many businesses affected by the pandemic.

Analysis of Recent Economic and Trade Sanctions Developments in Response to COVID-19

The COVID-19 crisis has intensified longstanding controversy over the role of economic and trade sanctions in the context of international humanitarian efforts.  OFAC has in recent weeks taken unprecedented actions in this area—including offering a unique position concerning the possible reallocation of compliance resources away from sanctions matters.  We provide below a summary of recent actions and public statements by senior U.S. and non-U.S. officials related to sanctions in the context of the response to COVID-19 and our reflections on what to expect in the short term.

Both before and after the United States’ participation in the Iran Nuclear Deal, the scope of activities related to Iran undertaken by non-U.S. persons that could result in U.S. secondary sanctions was and remains broad.  As a result, many foreign financial institutions, manufacturers, and others have simply decided to restrict business related to Iran, regardless of whether the business would otherwise be authorized under the U.S. Iran sanctions.  This widespread over-compliance with OFAC’s rules both within and outside of the United States has placed a significant practical restrain on humanitarian trade with Iran.

In response to the COVID-19 pandemic, the United Nations High Commissioner for Human Rights and the High Representative of the European Union for Foreign Affairs intensified calls on the United States to ease sanctions on Iran in response to that country’s particularly severe outbreak of the novel coronavirus.

OFAC initially responded with the addition of a new Frequently Asked Question directing attention to existing authorizations and exemptions for humanitarian trade with Iran.  The FAQ described the general scope of the existing authorizations for trade in agricultural commodities, medicine, and medical devices with Iran, subject to limitations related to restricted parties and payment mechanisms.

Political pressure continued to mount, as current and former senior U.S. officials and diplomats, including former Secretary of State Madeleine Albright and Vice President Joe Biden, issued public statements urging OFAC to expand existing authorizations.  Proposals for action included expanding the list of items eligible for the general authorization for trade in medicine and medical devices with Iran; issuing “comfort letters” to non-U.S. banks asked to facilitate humanitarian trade; adding staffing and resources to OFAC to accelerate the licensing process for medical items subject to a licensing requirement; offering updates on the operationalization of the Swiss Humanitarian Trade Arrangement; and expressing support for humanitarian trade facilitated by Europe’s INSTEX arrangement.

In apparent response to these public requests, OFAC has taken several steps that, while novel in certain respects, fall short of the changes that others have called for.

First, on April 16, OFAC issued a “Fact Sheet” summarizing the existing authorizations and exemptions for humanitarian trade and other assistance provided in response to COVID-19 with respect to all of the comprehensively sanctioned jurisdictions, namely Iran, Venezuela, North Korea, Syria, Cuba, and the Crimea region of Ukraine.  Although no new authorizations were included in this document, the Fact Sheet is a helpful resource for industry, as it is the most complete collection published by OFAC to date of the various legal provisions applicable to humanitarian trade.

On the other hand, the length and detail of the Fact Sheet itself demonstrate the significant complexity and compliance resources needed to effectively use the existing authorizations for humanitarian trade.  Particularly with respect to Iran, the number of restricted parties, including Iranian financial institutions and medical facilities that may be connected to restricted entities such as the Islamic Revolutionary Guard Corp-Qods Force, can make sales or donations of medical supplies to Iran complicated and risky.  In addition, U.S. banks are not permitted to maintain direct correspondent relationships with banks in Iran, requiring all payments even for authorized trade to be routed through third-country banks in order to reach the United States.

Further, the Fact Sheet does not cover licensing requirements that apply to some exports of medical supplies from the United States to comprehensively sanctioned jurisdictions administered by the U.S. Department of Commerce.

Second, on April 20, OFAC issued an unusual public statement in which it appeared to provide limited leniency for persons subject to reporting requirements or who have received requests for information under an administrative subpoena with respect to challenges arising from the COVID-19 emergency.  OFAC acknowledged that the pandemic crisis has caused “technical and resource challenges” for organizations.  OFAC stated:

Accordingly, if a business facing technical and resource challenges caused by the COVID-19 pandemic chooses, as part of its risk-based approach to sanctions compliance, to account for such challenges by temporarily reallocating sanctions compliance resources consistent with that approach, OFAC will evaluate this as a factor in determining the appropriate administrative response to an apparent violation that occurs during this period.  OFAC will address these issues on a case-by-case basis.

OFAC has not previously made any similar statement appearing to accommodate the choice by a regulated organization to reassign resources away from sanctions compliance.

We note that this public statement by OFAC does not authorize any apparent violation of the existing sanctions rules.  It merely refers to OFAC’s assessment of an organization’s risk-based compliance procedures in the context of an administrative enforcement action.  Therefore, rather than indicate any departure by OFAC from the existing requirements with respect to sanctions compliance, this rather unprecedented statement may indicate the unusual amount of pressure that OFAC finds itself under to justify its maintenance of the status quo.

In the short term, we expect that OFAC will continue to resist calls to dramatically change the scope of existing authorizations for humanitarian trade.  Press releases by the U.S. Department of State and the U.S. Department of the Treasury have offered public justification for OFAC’s position.  OFAC has also indicated in recent calls and panel discussions that it does not anticipate issuing new general licenses.  That said, we will continue to monitor this ongoing controversy as the unusual present circumstances may yet lead to unpredictable results.

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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 pandemic.  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 its International Trade Practice Group, or the authors:

Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, [email protected])
Adam M. Smith – Washington, D.C. (+1 202-887-3547, [email protected])
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, [email protected])
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, [email protected])
Samantha Sewall – Washington, D.C. (+1 202-887-3509, [email protected])

© 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.

 

To Our Clients and Friends:

In the last week, as the U.S. Small Business Administration (“SBA”) prepared for additional Paycheck Protection Program (the “Program” or “PPP”) funding and began accepting—for the second time—applications from participating lenders, the SBA issued a series of new guidance materials related to Program eligibility, fund accessibility, and loan amount calculations.

With an additional $349 billion in funding to PPP under the Paycheck Protection Program and Health Care Enhancement Act (the “PPP and Health Care Enhancement Act”), the Program, established by the Coronavirus, Aid, Relief, and Economic Security (“CARES”) Act, is set to provide a total of $659 billion to help small businesses impacted by COVID-19 with funds to pay eight weeks of payroll and other eligible costs.  The PPP and Health Care Enhancement Act, which was enacted into law on April 24, 2020, and primarily designed to replenish funds for the Program, did not substantially change the overall structure of the Program.  The new law did, however, set aside $60 billion in funding for “community financial institutions” to serve underserved small businesses and nonprofit organizations[1] and directed the SBA to allow agricultural enterprises[2] to apply for Economic Injury Disaster Loans.  With the additional funds Congress provided in the PPP and Health Care Enhancement Act, the SBA started accepting PPP applications from lenders again on April 27, 2020.

This client alert, the sixth in a series of alerts regarding the Program,[3] will address the SBA’s (1) Fourth Interim Rule (the “Fourth IFR”), which speaks to, among other topics, the eligibility (or ineligibility) of private equity firms, hedge funds, and the gaming industry to participate in the Program; (2) certification that a PPP loan is needed in order to support ongoing operations; (3) Fifth Interim Final Rule (the “Fifth IFR”), acknowledging a disparity in treatment under the maximum loan calculation under the CARES Act for seasonal employers and Sixth Interim Final Rule (the “Sixth IFR”) on disbursements; (4) guidance on how to calculate maximum loan amounts and related payroll documentation requirements; and (5) guidance on how to calculate the number of employees under employee-based size standards for eligibility.

Thematically, much of the new guidance is cautionary in nature; warning public, private equity-held, and other businesses with access to liquidity that PPP loans are not for them.  Adding teeth to those warnings the Treasury Department also announced that all PPP loans of more than $2 million will be audited.

The Fourth Interim Final Rule

Under the Fourth IFR, hedge funds and private equity firms are explicitly prohibited from receiving a PPP loan because they are “primarily engaged in investment or speculation.”  This rule is consistent with prior restrictions on Section 7(a) loans identified in 13 CFR §120.110 and described in SBA’s Standard Operating Procedure (SOP) 50 10, which prohibited loans to “speculative businesses” for the “sole purpose of purchasing and holding an item until the market price increases” or “[e]ngaging in a risky business for the chance of an unusually large profit.”  Prior to the Fourth IFR “speculative” businesses included those “[d]ealing in stocks, bonds, commodity futures, and other financial instruments.”[4]

The Fourth IFR acknowledges, however, that a portfolio company of a private equity fund may still be eligible for a PPP loan and concludes that “[t]he affiliation rules apply to private equity-owned businesses in the same manner as any other business subject to outside ownership or control.”  The acknowledgment comes with a cautionary note:  that borrowers should “carefully review” the PPP loan application certifications, including that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.”

The Fourth IFR also contains the following additional clarifying provisions:

• Government-Owned Hospitals. Hospitals otherwise eligible to receive a PPP loan are not determined ineligible because of ownership by state or local government if the hospital receives less than 50% of its funding from state or local government sources, exclusive of Medicaid.
• Legal Gaming Activities. Businesses that receive legal gaming revenues are eligible for PPP loans.  In a shift from the SBA’s Third Interim Rule, the Fourth IFR states that 13 CFR 120.110(g) (providing that businesses deriving more than one-third of gross annual revenue from legal gambling activities are ineligible for SBA loans) is inapplicable to PPP loans.  Businesses that receive illegal gaming revenues remain ineligible.
• Employee Stock Ownership Plans. Participation in an ESOP (as defined in 15 U.S.C. § 632(q)(6)) does not result in an affiliation between the business and the ESOP.
• Bankruptcy Proceedings. An applicant is ineligible for PPP loans if it, or its owner, is the debtor in a bankruptcy proceeding at the time of the application or any time before the loan is disbursed.

Borrower Certification Safe Harbor

In the SBA’s FAQ, the SBA reiterates that “all borrowers must assess their economic need for a PPP loan under the standard established by the CARES Act and the PPP regulations at the time of the loan application.”  Regardless of eligibility requirements, borrowers must certify in good faith that the PPP loan request is necessary even though the CARES Act suspended the ordinary requirement that borrowers must be unable to obtain credit elsewhere.  Specifically, the guidance states that borrowers need to consider “their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business,” when certifying that the PPP loan request is necessary to ongoing operations.

The guidance concluded that it is “unlikely” a public company “with substantial market value and access to capital markets will be able to make the required certification in good faith, “ and cautioned that such companies should be prepared to demonstrate to the SBA, upon request, the basis for its certification.  In addition, yesterday, Secretary of the Treasury Steven Mnuchin said that the government will audit any PPP loans above $2 million.

Notably, the Fourth IFR establishes a form of amnesty by allowing “borrowers [to] promptly repay PPP loan funds that the borrower obtained based on a misunderstanding or misapplication of the required certification standard.”  Under the Fourth IFR, any borrower that applied prior to April 23, 2020 and repays the loan in full by May 7, 2020 “will be deemed by SBA to have made the required certification in good faith.”

The Fifth and Sixth Interim Final Rules

On April 27, 2020, the SBA issued the Fifth Interim Final Rule (available here) to provide seasonal employers with an alternative method to calculate their maximum loan amount.  In doing so, the Fifth IFR stated that without the rule, “many summer seasonal businesses would be unable to obtain funding on terms commensurate with those available to winter and spring seasonal businesses.”  Under Section 1102 of the CARES Act, a seasonal employer may determine its maximum loan amount by reference to the employer’s average total monthly payments for payroll during “the 12-week period beginning February 15, 2019, or at the election of the eligible [borrower], March 1, 2019, and ending June 30, 2019.”  The Fifth IFR allows seasonal employers to calculate the maximum loan amount using any consecutive 12 week period between May 1, 2019 and September 15, 2019.  The Rule also clarifies that if a seasonal business was not fully operating or dormant as of February 15, 2020, it is still eligible to receive a PPP loan.

The Sixth Interim Final Rule, posted on April 28, 2020 and available here, provides that lenders must make a one-time, full disbursement of the PPP loan within ten calendar days of loan approval (defined as when the loan is assigned an SBA loan number).  Loan approvals will be cancelled for any loans that are not disbursed because of a borrower’s failure to provide required loan documentation, including a promissory note, within 20 calendar days of loan approval.  The Sixth IFR provides for transition rules for those loans that have received an SBA loan number prior to the posting of the Sixth IFR but are not yet fully disbursed.

Maximum Loan Calculation and Payroll Documentation Requirements

In addition, on April 24, 2020, the SBA provided guidance (available here) to assist businesses in calculating their payroll costs for determining the maximum possible PPP loan amount.  Under the guidance, the SBA outlines the methodology potential borrowers should use to calculate the maximum amount they can borrow, as well as the documentation the borrower should provide to substantiate the loan amount.  A table summarizing the required documentation as articulated in the guidance is below.

The SBA guidance reminds borrowers that, under most circumstances, “PPP loan forgiveness amounts will depend, in part, on the total amount spent during the eight-week period following the first disbursement of the PPP loan.”

Records from a retirement administrator, or a health insurance company or third-party administrator for a self-insured plan can be used to demonstrate employers retirement and health insurance contributions.

Supporting Documentation Requirements

No.	Eligible Borrower	2019 Documentation	2020 Documentation
1.	Self-employed with no employees	IRS Form 1040 Schedule C. IRS Form 1099-MISC detailing nonemployee compensation received (box 7), invoice, bank statement, or book of record establishing you were self-employed in 2019.	Invoice, bank statement, or book of record establishing operation on February 15, 2020.
2.	Self-employed with employees	IRS Form 1040 Schedule C. IRS Form 941[1], or IRS Form W-2s, IRS Form W-3, or payroll processor reports, including quarterly and annual tax reports. State quarterly wage unemployment insurance tax reporting form from each quarter (or equivalent payroll processor records or IRS Wage and Tax Statements). Documentation of any retirement or health insurance contributions.	Payroll statement or similar documentation from the pay period that covered February 15, 2020.
3.	Self-employed farmers	IRS Form 1040 Schedule 1 and Schedule F.
4.	Partnerships without employees	IRS Form 1065 (including K-1s).	Invoice, bank statement, or book of record establishing the partnership was in operation on February 15, 2020.
5.	Partnerships with employees	IRS Form 1065 (including K-1s). IRS Form 941, or IRS Form W-2s, IRS Form W-3, or payroll processor reports, including quarterly and annual tax reports. State quarterly wage unemployment insurance tax reporting form from each quarter (or equivalent payroll processor records or IRS Wage and Tax Statements). Documentation of any retirement or health insurance contributions.	Payroll statement or similar documentation from the pay period that covered February 15, 2020.
6.	S Corporations or C Corporations	IRS Form 941, or IRS Form W-2s, IRS Form W-3, or payroll processor reports, including quarterly and annual tax reports.  State quarterly wage unemployment insurance tax reporting form from each quarter (or equivalent payroll processor records or IRS Wage and Tax Statements) Filed business tax return (IRS Form 1120 or IRS 1120-S) or other documentation of any retirement and health insurance contributions.	Payroll statement or similar documentation from the pay period that covered February 15, 2020.
7.	Eligible Non-Profit Organizations	IRS Form 941, or IRS Form W-2s, IRS Form W-3, or payroll processor reports, including quarterly and annual tax reports. State quarterly wage unemployment insurance tax reporting form from each quarter (or equivalent payroll processor records or IRS Wage and Tax Statements) IRS Form 990 or other documentation of any retirement and health insurance contributions	Payroll statement or similar documentation from the pay period that covered February 15, 2020.

Employee-Based Size Standards and Definitions

In guidance issued on April 26, 2020 (available here), the SBA reiterated that under the 500-employee or other applicable employee-based threshold, the term “employee” under the CARES Act includes “individuals employed on a full-time, part-time, or other basis.”  Although this is consistent with the original text of the CARES Act, the guidance confirms that a part-time employee working 10 hours per week should be counted the same as a full-time employee for purposes of loan eligibility.  In contrast, the guidance acknowledges, to determine the extent of any reduction in the loan forgiveness amount in the event of a reduction in headcount, the CARES Act uses the standard of “full-time equivalent employees.”

Although the CARES Act and related guidance issued to date do not define the term in the context of the Program, Title II of the CARES Act defines “full-time employee” by referencing the Internal Revenue Code, 26 U.S.C. § 4980H, which defines the term as “an employee who is employed on average at least 30 hours of service per week.”  In addition, the Internal Revenue Service defines “full-time equivalent employee” as “a combination of employees, each of whom individually is not a full-time employee, but who, in combination, are equivalent to a full-time employee.”  Absent further guidance, these definitions may be instructive.

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   [1]   A search tool for identifying all eligible lenders is available on the SBA website here.

   [2]   Existing law defines “agricultural enterprises” to mean “small business concerns engaged in the production of food and fiber, ranching, raising of livestock, aquaculture, and all other farming and agricultural-related industries.”

   [3]   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, and Analysis of Small Business Administration Memorandum on Affiliation Rules and FAQs on Paycheck Protection Program.

   [4]   See SBA’s Standard Operating Procedure (SOP) 50 10.

   [5]   Very small businesses that file an annual IRS Form 944 instead of quarterly IRS Form 941 should provide IRS Form 944.

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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, [email protected])
Roscoe Jones, Jr.* – Washington, D.C. (+1 202-887-3530, [email protected])
Alisa Babitz – Washington, D.C. (+1 202-887-3720, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, [email protected])
Alexander Orr – Washington, D.C. (+1 202-887-3565, [email protected])
William Lawrence – Washington, D.C. (+1 202-887-3654, [email protected])
Samantha Ostrom – Washington, D.C. (+1 202-955-8249, [email protected])

* 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.

First, we hope you and your families are staying safe in the midst of this COVID-19 pandemic.

As you navigate through the implications of the pandemic on your business, below is a high level list of some of the key issues to consider with respect to one or more events or consequences caused by the COVID-19 pandemic (“COVID-19 Event”) in reviewing your project agreements and financing documents.

1. Impact of a COVID-19 Event under Project Agreements/Commercial Contracts (e.g., Concession Agreements, Offtake Agreements, Construction Contracts, Supply Contracts, O&M Agreements, etc.)
   1. Relief Event/Compensation Event/Force Majeure Event – Determine whether the COVID-19 Event would qualify as a relief event, compensation event or force majeure event under the contract, what notices are required and the extent of relief available.Consider also if there are applicable “you snooze you lose” time frames that should be adhered to and if, in order to avoid missing any deadlines, a tolling agreement should be entered into.  Discuss if there are strategic reasons to prefer entering into a tolling agreement versus filing relief event, compensation event and/or force majeure event notices with the counterparty (particularly with government entities/grantors).  Finally, you should be familiar with, and proactively manage upfront, any contractual obligation to mitigate the impact of the COVID-19 Event in your (or your counterparty’s) business.

Here is a 4-step checklist and flow chart on force majeure relief under US law: https://www.gibsondunn.com/force-majeure-clauses-a-4-step-checklist-and-flowchart; and under English law: https://www.gibsondunn.com/english-law-force-majeure-clauses-a-4-step-checklist-flowchart. While the cases are primarily based on US and English law, respectively, a similar analysis would generally be undertaken under the governing law of the relevant contract.

We suggest reviewing whether and how relief events, compensation events and force majeure relief can be claimed both by your entities and your contract counterparties.

1. 2. COVID-19 Event (whether or not it qualifies as a Relief Event, Compensation Event or Force Majeure Event) Implications on:
      1. Revenue – Analyse how the COVID-19 Event would impact your revenue stream under the contract and under any applicable business interruption or other insurance.
      2. Payment Obligation – Determine how the amount and timing of your payment obligations to counterparties would be affected by the COVID-19 Event.
      3. Schedule – Assess the impact of the COVID-19 Event on any milestone with a specific deadline or any other time-bound undertaking (e.g., completion date, commercial operations date, delivery date); review corresponding forecasts and expectations.
      4. Contract Enforceability – Assess the potential implications of the COVID-19 Event on enforceability and defences available under the applicable contract law principles (e.g., impossibility, frustration, impracticability).
      5. Ability to Perform Obligations – Analyse whether the relevant entity will continue to be able to meet its obligations. Considerations include having an appropriate business continuity plan (i.e.,  Does it take into account pandemics?  Are there work-from-home arrangements, back-up plans if employees get sick, alternative sites for required back-office equipment?  Are you experiencing supply chain disruptions that could impact construction or operation?).
      6. Non-Compliance Points / Liquidated Damages / Events of Default / Termination – Analyse whether the COVID-19 Event could potentially lead to a default and trigger a termination event under the contract or result in the assessment of non-compliance points or liquidated damages.
      7. Insurance – Determine whether insurance would cover any or all of your losses arising from the COVID-19 Event.
2. Financing Agreements
   1. Representations & Warranties[1]
      1. “No Default” – Determine whether the COVID-19 Event would trigger actual or potential defaults by the borrower and/or the relevant contractcounterparties under the borrower’s material contracts.  On occasion, this representation may also include defaults under the financing agreements.
      2. Insolvency/Bankruptcy/Inability to Pay Debts Generally When Due – Consider whether the COVID-19 Event would trigger a breach of this representation, which would also depend on the laws of the jurisdiction applicable to the subject entity/ies (including any recent pronouncements, relief measures, moratoria and the like by government entities in response to the pandemic).
      3. No Proceedings – Consider whether the relevant entity is or would be subject to litigation, disputes, claims, and the like, both actual or threatened, as a result of the COVID-19 Event, including any disputes relating to the availability of force majeure relief and labor-related disputes.
      4. MAC – Check whether the COVID-19 Event would lead to a “material adverse change” usually from the latest audited financials, or depending on the formulation, have/would/is reasonably likely to have a material adverse effect on the business, financials, operations, or prospects of the company or key contract counterparties. Note that this is a rapidly evolving area of the law in various jurisdictions and so it is prudent to check with counsel.
   2. Covenants
      1. Information Covenants – Check what notice requirements will be triggered to the granting entity, lenders, trustees, bondholders and otherwise (e.g., force majeure claims, material litigation/disputes, potential or actual defaults under commercial contracts, potential delays in milestones, events that could have a material adverse effect, etc.). If the company has bonds that are publicly listed, are any reporting obligations triggered?  Are voluntary disclosures recommended?  In addition, certain deliverables such as financial statements (and any related audit review) may be delayed due the impact of the COVID-19 Event on both the company and the auditors.
      2. Financial Covenants and Ratio-based Distribution Tests – Review the calculation of the financial ratios both as maintenance covenants and dividend blocks (particularly for projected figures), and determine whether they are likely to be breached and how any such breach can be mitigated (e.g., equity cure, prepayments, tap into revolvers or additional facility). Note that previously contemplated dividend payments may now be delayed or prohibited.
      3. Other Covenants – Determine whether any of the other covenants would be triggered as result of the COVID-19 Event, including with respect to acts or omissions vis-à-vis counterparties under commercial contracts (e.g., enforcing rights and remedies under material contracts, not settling claims without lender consent), obligations to meet construction deadlines, meeting requirements, operating standards, etc.
      4. Reserve Accounts – To the extent that the relevant entity will experience liquidity issues, consider whether it will be able to meet any reserve account requirements. Determine also whether any failure to meet such reserve account requirements would result in a default and what mitigation measures are available.
      5. Distributions – In addition to determining the implications of the COVID 19 Event on the distribution test, consider if dividend policies should be revisited in terms of potential liquidity needs.
   3. Drawstop Events

To the extent that the facility has not yet been fully drawn, a breach of representations and warranties or covenants (as described above), or the occurrence of an event of default or potential default (as described below), may prohibit subsequent draws.  The implications of the COVID-19 Event on the borrower’s ability to make further borrowings and the consequences thereof on its business should be carefully reviewed.

1. 4. Events of Default/Potential Default

The list of events of default should be reviewed to see whether any of them would be triggered by the COVID-19 Event, including by a prolonged occurrence thereof.  Some examples include:

1. 1. 1. Misrepresentation and Covenant-Related Defaults – Consider whether a breach of representations or failure to meet financial or other covenants as described above would result in a default.
      2. Failure to Meet Certain Milestones – If the borrower or a contract counterparty is required to achieve certain milestones by a date certain, e.g., commercial operations date or construction completion date, a delay resulting from a COVID-19 Event may trigger a default. Note that where such milestone in the financing agreement is not tied to the definition under the relevant commercial contract (e.g., concession agreement, construction contract, etc.), then the borrower would not be entitled to the same force majeure relief under the financing agreements as in the relevant commercial contract.
      3. MAC – In cases where the financing agreement includes a “Material Adverse Change/Effect” event of default (including through repeating representations), the formulation should be reviewed to see whether the COVID-19 Event would trigger such default.
      4. Audit Qualification – Determine whether the COVID-19 Event would lead to a qualification in the auditor’s report, and if so, whether such qualification would trigger a default.
      5. Payment-Related Defaults – Consider whether liquidity issues will result in difficulty meeting payment obligations, and whether waivers or extensions related to upcoming payments are required.

There may be other issues to consider given the specifics of your business and contractual arrangements.  While this alert has been drafted to cover projects in a variety of jurisdictions globally and in all cases at a high level, we would be happy to help you on specific issues with respect to your projects in the respective geographies covered hereby.  Should you have any questions please feel free to contact us.

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[1]   Under some loan agreements, representations and warranties are repeated periodically.  If these representations and warranties have already been made and do not need to be repeated, it is likely that there would be a corresponding formulation in the Covenant or Event of Default section so the same analysis would apply.

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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.

Gibson Dunn regularly counsels clients on issues raised by this pandemic in the commercial context. For additional information, please contact the Gibson Dunn lawyer with whom you usually work or the authors:

Tomer Pinkusiewicz – New York (+1 212-351-2630, [email protected])

Patricia Tan Openshaw – Hong Kong (+852 2214-3868, [email protected])

Anita Girdhari – New York (+1 212-351-5362, [email protected])

Cristina Uy-Tioco – Hong Kong (+852 2214-3818, [email protected])

 

© 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 briefing covers steps sponsors should consider taking when fundraising in the current environment.

Investor Sentiment

Investor interest in private investment funds is generally expected to remain subdued in the months ahead.  Based on recent industry surveys:

• a majority of surveyed investors are generally open for business or are at least in the market to “re-up” with existing sponsor relationships;
• many investors plan to reduce, or are considering reducing, new fund commitments this year;
• a minority of investors are proceeding only with investment opportunities that were in progress prior to the pandemic or are pausing investments for the time being;
• fundraising is expected to be quite difficult for debut sponsors and sponsors with whom an investor has no pre-existing relationship;
• travel restrictions and social distancing measures are key practical barriers hampering investors from meeting in person with sponsors and conducting on-site diligence, which is contributing to a stronger preference for re-ups;
• some investors have liquidity concerns given the prospect of smaller distributions and accelerated drawdowns by some sponsors, including to pay down balances under subscription lines; and
• due to the public markets “denominator effect,” institutional investors with less flexible portfolio allocation requirements (e.g., pension funds) may need to scale back their alternative investment programs.

These trends may become especially challenging for less established sponsors throughout 2020 and into 2021.  Sponsors currently or soon to be fundraising should plan to be proactive in communicating with investors about the impact of the pandemic on their investments and operations.

Offering Materials

Sponsors should update disclosures in fund offering materials to ensure their continued accuracy, including:

• Market/industry outlook. Discussion regarding the relevant market or industry may need to be revised to account for material changes in market conditions and expectations.
• Track record. Discussion of predecessor fund performance should include disclaimers that prior performance was achieved in different market circumstances.  Any detailed financial information should be accompanied by an explanation of any material changes since the relevant measurement dates.
• Case studies. Sponsors should revisit whether particular case studies are appropriate under current market conditions and may need to include additional disclaimers or omit such case studies from the offering materials.
• Risk factors. Risk factors should be revised to reflect the foreseeable impact of the pandemic (including macro-level and fund-specific risks), as well as other future pandemics or similar disruptions.

Investor Due Diligence

Given investor scrutiny of the impact of the COVID-19 pandemic, sponsors should consider preparing standard responses to potential inquiries, including:

• Existing portfolios. What have been the adverse effects on predecessor funds’ portfolios, and what steps has the sponsor been taking in response?  Is there an expanded need for follow-on investments or bridge financings with respect to existing portfolio companies under stress from the pandemic?
• Pipeline concerns. What is the expected impact on the sponsor’s investment pipeline and ability to deploy capital given travel restrictions that are affecting the ability to conduct onsite research with respect to potential investments, potential changes in cost and availability of financing, risk of deal-level MAC clauses being triggered, and potential delays in closing transactions because of COVID-19 mitigation policies?
• Valuation methodology. Should portfolio investments be revalued, or do recent market disruptions make publicly traded share valuations less indicative of fair market value than they normally would be?  Any changes with respect to valuation methodology and assumptions need to be clearly disclosed to and discussed with investors.
• Business continuity plans and disaster recovery plans. Do the sponsor’s business continuity and disaster recovery plans, both for itself and its portfolio companies, take account of disruptions from this and potentially from other pandemics?
• ESG and COVID-19-related community service. How are the sponsor and its portfolio companies helping those most affected by the pandemic?
• Information use. Given office closures and work-from-home arrangements, do the sponsor’s IT policies and infrastructure relating to cybersecurity, data privacy and confidentiality meet current challenges, such as affording staff remote VPN access and defending against increased phishing attempts, the emerging videoconference hacking trend, etc.?
• Reporting.  Does the sponsor have a plan to minimize any potential delays in providing financial reports, including potential delays by portfolio companies in providing information necessary for the sponsor’s funds to complete their financial reports?

Closings

As the fundraising pace is expected to slow over the next several months, sponsors should consider:

• Fundraising period. While there are pros and cons, it may be suitable for some sponsors to seek a longer fundraising period (e.g., 18 months instead of 12 months) from the outset rather than having to seek a fundraising period extension later.
• Rolling closings. As prospective investors may be subject to disparate constraints and timelines for when they can subscribe, sponsors should consider holding smaller, more frequent closings than usual in order to secure capital as it becomes available in 2020 and into 2021.
• Dry closings. Making the initial closing a dry closing (i.e., delaying the commencement of the investment period and the management fee) may provide a time buffer allowing greater flexibility in extending first closing benefits to investors making commitments across a wider initial closing window.

Regulatory Considerations

For marketing efforts into non-U.S. jurisdictions that require regulatory filings or approvals to comply with local private placement rules, sponsors should build in extra time for pre-closing steps.  Regulators may be less responsive (or temporarily unresponsive) during the pandemic and could remain backlogged after resuming operations.

Sponsors must consider where prospective investors are physically located in assessing which jurisdiction’s rules will apply to an offering.  In particular, as a result of the COVID-19 pandemic, high net worth individuals may not be located in the country where they normally reside.

Communications with Existing Investors

Finally, given expected increased reliance on re-ups in any fundraising process, sponsors should be providing clear, meaningful and more frequent portfolio updates to maintain trust and maximize investor goodwill.

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Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above. For further information, please contact the Gibson Dunn lawyer with whom you usually work, or the following authors:

John Fadely – Hong Kong (+852 2214-3810, [email protected])
Bill Thomas – Washington, D.C. (+1 202-887-3735, [email protected])
Kevin Heilenday – Washington, D.C. (+1 202-887-3507, [email protected])
Alicia Shi – Hong Kong (+852 2214-3745, [email protected])
Kobe Chow – Hong Kong (+852 2214-3769, [email protected])

The rapid spread of the COVID-19 pandemic, and stringent government orders regulating the movement and gathering of people issued in response, continues to raise concerns about parties’ abilities to comply with contractual terms across a variety of industries.  As discussed previously here, force majeure clauses may address parties’ obligations under such circumstances.  Even without force majeure clauses, depending on the circumstances parties may seek to invalidate contracts or delay performance under the common law based on COVID-19.  To assist in considering such issues, we have prepared the following overview.  As the analysis of the applicability of any of the doctrines below is fact-specific and fact-intensive, this overview is intended only as a starting point.  We encourage you to reach out to your Gibson Dunn contact to discuss specific questions or issues that may arise.

Impossibility of Performance 

The doctrine of impossibility is available where performance of a contract is rendered objectively impossible.[1]  In assessing whether impossibility of performance applies to your situation and your contract, it is useful first to determine whether the jurisdiction applicable to your contract or dispute has codified the doctrine.  As in California, the statutory language might provide guidance to or place limitations on its applicability.[2]

A party seeking to invoke the impossibility doctrine under common law must show that the impossibility was produced by an unanticipated event and the event could not have been foreseen or guarded against in the contract.[3]  Courts have held that impossibility of performance during times of emergency or disaster has generally excused performance on the basis of governing law, governmental regulations, or the disruption of transportation or communication networks.  However, the economic consequences of those events do not necessarily permit a claim of impossibility.

A handful of cases from the early 20th century which discuss epidemics in connection with school closures and resulting performance failures under teacher contracts are divided on whether performance was excused.[4]  Federal courts have excused performance for impossibility where, in times of war, manufacturers prioritized governmental orders issued under the Defense Production Act.[5]  In the wake of the September 11, 2001 terrorist attacks, courts excused performance resulting from the effective lockdown of communications in New York City.[6]

In New York, the doctrine is narrowly construed and is limited to specific circumstances, including “the destruction of the means of performance by an act of God, vis major, or by law.”[7]  Thus, it will be necessary to evaluate the impact of any governmental orders relating to COVID-19, or any applicable court orders, to assess their impact on any given contract.  The First Appellate Division of New York previously found that performance of music recording and management contracts was objectively impossible after a court ordered that the parties could not have any contact with each other.[8]  There, the means of performance was made impossible by operation of law—the court’s order that the parties cease contact.

By contrast, historically, performance has not been excused where the impossibility or difficulty was caused “only by financial difficulty or economic hardship, even to the extent of insolvency or bankruptcy.”[9]  Certain New York courts have rejected claims of impossibility related to an economic downturn with the explanation that “the risk of changing economic conditions or a decline in a contracting party’s finances is part and parcel of virtually every contract.”[10]

Commercial Impracticability of Performance

As with impossibility, the doctrine of commercial impracticability may also be available where performance is rendered impracticable.  The treatment and availability of commercial impracticability varies significantly across states, with some treating it as its own standalone defense and others including it under the umbrella of the impossibility defense.[11]  But regardless of the form it takes, many states that recognize commercial impracticability as a defense have adopted the Restatement (Second) of Contracts Section 261, or similar language, which provides that a party’s duty to perform under a contract is excused where “performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made.”[12]  Looking to Section 261 for guidance, one Hawaii court found that fear and uncertainty in the aftermath of the September 11, 2001, by themselves, were insufficient grounds for showing impracticability.[13]

As in the case of the doctrine of impossibility, the impracticability at issue must be the product of unforeseen events.  In general, mere economic loss or hardship is insufficient to render performance impracticable because courts generally treat it as foreseeable.[14]  However, in some circumstances the defense may be available where performance “can only be done at an excessive and unreasonable cost.”[15]

The Uniform Commercial Code, which has been adopted as law in most states, covers commercial contracts, including contracts related to the sale and leasing of goods, commercial paper, banking transactions, letters of credit, auctions and liquidations of assets, storage and bailment of goods, securities, financial assets and secured transactions.  For a transaction governed by the UCC, the defense of commercial impracticability may apply where performance “has been made impracticable by the occurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was made.”[16]   

Frustration of Purpose

The doctrine of frustration of purpose may be available where “a change in circumstances makes one party’s performance virtually worthless to the other,” thereby frustrating the principal purpose in making the contract.[17]  Whether or not frustration of purpose applies depends on the precise wording of the contract but, in any event, the frustration itself must be “substantial.”[18]  Or, in other words, “the frustrated purpose must be so completely the basis of the contract that, as both parties understood, without it, the transaction would have made little sense.”[19]

Similar to the doctrines of impossibility and impracticability, frustration of purpose is applied narrowly and is limited to instances where the event rendering the contract valueless is unforeseeable.[20]  It has been most commonly applied by courts upon the death or incapacity of a person necessary for performance, the destruction or deterioration of a thing necessary for performance, or a change in the law that prevents a person from performing.[21]

Moreover, as with the doctrine of impossibility, frustration of purpose does not usually apply merely “because it becomes more economically difficult to perform.”[22]  For example, a New York federal district court rejected an argument that losses prevented the defendant from being able to pay the plaintiff because “[t]he application of the frustration of purpose doctrine in such circumstances would ‘place in jeopardy all commercial contracts.’”[23]  

Consequences of Successful Defense 

If one of the above defenses were deemed to apply, the duties of the party asserting the defense may be discharged.[24]  However, if impossible or impracticable performance were temporary in duration, these doctrines generally would excuse performance only for so long as the disabling condition persisted.  In addition, if performance were excused, courts could potentially grant quantum meruit claims of the counterparty, in order to equitably adjust for gains and losses sustained by the parties.  This could require the excused party to reimburse the counterparty for expenses incurred in expectation of the performance.[25]

We expect all of these doctrines to be tested in the context of the COVID-19 pandemic and the associated governmentally mandated shutdowns and other actions.  We will continue to monitor developments in this regard and are available to discuss if you have any questions.

   [1]   See Kel Kim Corp. v. Central Mkts., 70 N.Y.2d 900, 902 (1987).

   [2]   For example, under the California Civil Code, performance is excused when a party “is prevented or delayed by an irresistible, superhuman cause, or by the act of public enemies of this state or of the United States, unless the parties have expressly agreed to the contrary.”  Cal. Civ. Code § 1511(2).

   [3]   Kel Kim Corp., 70 N.Y.2d at 902; see also, e.g., Citadel Builders, LLC v. Transcon. Realty Inv’rs, Inc., 2007 WL 1805666, at *4 (E.D. La. June 22, 2007) (noting that although hurricanes are foreseeable events in New Orleans during the summer, impossibility defense was available because Hurricane Katrina and her aftermath “devastated th[e] area in ways beyond what anyone predicted”); Gregg School Tp., Morgan Cty. v. Hinshaw, 76 Ind. App. 503 (Ind. App. Ct. 1921) (performance excused due to legally mandated school closure related to Spanish Influenza).

   [4]   Phelps v. School District No. 109, Wayne County, 302 Ill. 193, 198 (1922) rejected the defense on the basis that the closure had been foreseeable.  Gregg School Tp., Morgan County, 76 Ind. App. 503, however, excused performance because the law of the land (which allowed closure of schools) was part of every contract.

   [5]   Eastern Air Lines, Inc. v. McDonnell Douglas Corp., 532 F.2d 957, 996 (5th Cir. 1976); U.S. for Use and Benefit of Caldwell Foundry & Mach. Co. v. Texas Const. Co., 224 F.2d 289, 293 (5th Cir. 1955).

   [6]   See, e.g., Bush v. Protravel Int’l, Inc., 192 Misc.2d 743, 750 (N.Y. Civ. Ct. 2002) (acknowledging impossibility defense may be available where communications and transportation networks damaged by September 11, 2001 terrorist attack in New York City).

   [7]   Kolodin v. Valenti, 115 A.D.3d 197, 200 (N.Y. App. Div. 1st Dep’t 2014).

   [8]   Id.

   [9]   407 E. 61st Garage, Inc. v. Savoy Fifth Ave. Corp., 23 N.Y.2d 275, 281 (N.Y. 1968); see also Stasyszyn v. Sutton E. Assocs., 161 A.D.2d 269, 271 (N.Y. App. Div. 1st Dep’t 1990) (absent an express contingency clause “compliance is required even where the economic distress is attributable to the imposition of governmental rules and regulations” rendering performance more costly “or the inability to secure financing”).

  [10]   Route 6 Outparcels, LLC v. Ruby Tuesday, Inc., 27 Misc. 3d 1222(A) (N.Y. Sup. Ct. Albany Cty. 2010), aff’d, 88 A.D.3d 1224 (N.Y. App. Div. 3d Dep’t 2011); Urban Archaeology Ltd. v. 207 E. 57th St. LLC, 68 A.D.3d 562, 562 (N.Y. App. Div. 1st Dep’t 2009) (doctrine not available because “economic downturn could have been foreseen or guarded against in the [contract]”).

  [11]   Courts in New York and California both treat impracticability as a form of the impossibility defense.  See Axginc Corp. v. Plaza Automall, Ltd., 2017 WL 11504930, at *8 (E.D.N.Y. Feb. 21, 2017), aff’d, 759 F. App’x 26, 29 (2d Cir. 2018) (New York courts do not recognize “commercial impracticability as a separate defense to the doctrine of impossibility; rather, impracticability is treated as a type of impossibility and construed in the same restricted manner.”); Emelianenko v. Affliction Clothing, 2011 WL 13176615, at *28 (C.D. Cal. June 7, 2011) (“The enlargement of the meaning of ‘impossibility’ as a defense [] to include ‘impracticability’ is now generally recognized.”).

  [12]   E.g., LECG, LLC v. Unni, 2014 WL 2186734, at *6 (N.D. Cal. May 23, 2014), aff’d, 667 F. App’x 614 (9th Cir. 2016) (California); Waddy v. Riggleman, 216 W. Va. 250, 258 (W. Va. 2004) (West Virginia); Tractebel Energy Mktg., Inc. v. E.I. Du Pont De Nemours & Co., 118 S.W.3d 60, 65 (Tex. App. 14th Dist. 2003) (Texas); Step Plan Servs., Inc. v. Koresko, 12 A.3d 401, 414 (Pa. Super. Ct. 2010) (Pennsylvania).

  [13]   OWBR LLC v. Clear Channel Comm’cs, Inc., 266 F. Supp. 2d 1214, 1222 (D. Haw. 2003) (analyzing impracticability doctrine in context of contract containing force majeure provision).

  [14]   See, e.g., Karl Wendt Farm Equip. Co. v. Int’l Harvester Co., 931 F.2d 1112, 1117 (6th Cir. 1991) (dramatic downturn in farm equipment market causing defendant to go out of business did not excuse unilateral termination of its dealership agreements due to commercial impracticability).

  [15]   Emelianenko, 2011 WL 13176615, at *28; see also City of Vernon v. City of Los Angeles, 45 Cal.2d 710, 720 (1955).

  [16]   U.C.C. § 2-615(a); see also, e.g., Cal. Com. Code § 2615 (codifying language of U.C.C. § 2-615).

  [17]   PPF Safeguard, LLC v. BCR Safeguard Holding, LLC, 85 A.D.3d 506, 508 (N.Y. App. Div. 1st Dep’t 2011) (citing Restatement (Second) of Contracts § 265 (1981)).  The Restatement (Second) of Contracts § 265 provides that “[w]here, after a contract is made, a party’s principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his remaining duties to render performance are discharged, unless the language or the circumstances indicate the contrary.”  The Restatement commentary further explains that Section 265 requires that (1) the purpose that is frustrated was a “principal purpose” in making the contract, such that without it the transaction “would make little sense”; (2) the frustration is substantial; and (3) the non-occurrence of the frustrating event was a basic assumption on which the contract was made.  Restatement (Second) of Contracts § 265, cmt. a.

  [18]   Crown IT Servs., Inc. v. Koval-Olsen, 11 A.D.3d 263, 265 (N.Y. App. Div. 1st Dep’t 2004).

  [19]   Id.

  [20]   Crown IT Servs., 11 A.D.3d at 265; A + E Television Networks, LLC v. Wish Factory Inc., 2016 WL 8136110, at *12 (S.D.N.Y. Mar. 11, 2016); Warner v. Kaplan, 71 A.D.3d 1, 6 (N.Y. App. Div. 1st Dep’t 2009) (frustration of purpose “is not available where the event which prevented performance was foreseeable and provision could have been made for its occurrence”).

  [21]   Bayou Place Ltd. P’ship v. Alleppo’s Grill, Inc., 2020 WL 1235010, at *8 (D. Md. Mar. 13, 2020); see also Warner, 71 A.D.3d at 6.

  [22]   A + E Television Networks, 2016 WL 8136110, at *13.

  [23]   Id. (quoting 407 E. 61st Garage, Inc., 23 N.Y.2d at 282).

  [24]   In the event that a court rejects such defenses, a party found to be in breach of a contract may still raise the counterparty’s failure to mitigate its damages as an alternative defense or option for reducing any prospective damages award.  See U.S. Bank Nat. Ass’n v. Ables & Hall Builders, 696 F. Supp. 2d 428, 440-41 (S.D.N.Y. 2010) (“In a breach of contract action, a plaintiff ordinarily has a duty to mitigate the damages that he incurs. If the plaintiff fails to mitigate his damages, the defendant cannot be charged with them.”).

  [25]   D & A Structural Contractors Inc. v. Unger, 25 Misc.3d 1211(A) (N.Y. Sup. Ct. Nassau Cty. 2009).

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Gibson Dunn’s lawyers are available to assist with questions you may have regarding developments related to the COVID-19 outbreak.  We regularly counsel clients on issues raised by this pandemic in the commercial context.  For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team, the Gibson Dunn attorney with whom you work, or the following authors:

AUTHORS: Shireen Barday, Mary Beth Maloney, Rahim Moloo, Hannah Kirshner, and Robert Banerjea

© 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 our client alert of 27 March 2020, we provided an overview of the financial support made available by the UK Government to: (i) investment grade businesses through the Covid Corporate Finance Facility (the “CCFF”); and (ii) small and medium sized enterprises (“SMEs”) through the Coronavirus Business Interruption Loan Scheme (the “CBILS”).  In our client alert of 6 April 2020, we gave a brief overview of the measures that have been taken in the UK to support businesses and highlighted in that alert that the CBILS was being extended to larger business with an annual revenue of between £45 million and £500 million.

In this client alert we summarise: (i) the announcement of details on the Coronavirus Large Business Interruption Loan Scheme (the “CLBILS”); and (ii) the announcement of a new funding scheme for innovative companies that are facing financing difficulties due to the COVID-19 pandemic (the “Innovation and Development Scheme”).

See also the Gibson Dunn Coronavirus (COVID-19) Resource Centre for more resources on the response to COVID-19.

Background to the CLBILS

Design Flaws with the CBILS and Pressure from Industry

Whilst the UK Government announced a package of measures worth approximately £330 billion in mid-March 2020, in recent days, the UK Government has come under pressure to ensure that all UK businesses are able to access the financial and liquidity support measures that have been made available. As at close of business on 13 April 2020, UK Finance (the industry body for the banking and finance sector in the UK) reported that of 28,461 applications made to lenders to access the CBILS, only 6,016 loans had been approved with total lending reaching £1.1 billion. Further, it has become clear that the CCFF would only be available to a select number of investment grade companies in the UK that already had a commercial paper issuance programme or those that would otherwise meet the criteria for such a programme.

Criticism of the CBILS have been growing since its launch. Industry bodies, including the British Private Equity and Venture Capital Association (the “BVCA”) have been reporting a number of structural issues with the scheme that meant large business and portfolio companies of private equity firms were not able to access much needed financial support. This is supported by the views of our private equity clients, whose portfolio companies have encountered difficulties in accessing the scheme. Some of the issues identified have been:

• Process and Timing: Difficulties with access to the scheme and the process for approving applications has had a significant impact on the liquidity position of a number of companies.
• Eligibility Criteria:
  • Companies and industry bodies have been reporting that banks are only lending to those companies that are credit-worthy with a strong balance sheet (i.e. those companies with retained profits/equity capital and low leverage). This is because lenders retain a 20% exposure to loans advanced under the CBILS. This has prevented many venture capital backed companies and innovative tech and healthcare companies that are not typically profitable from accessing much-needed financial support.
  • Importantly for our clients, guidance from the British Business Bank to lenders also provided that companies that are majority-owned by a private equity firm would not be eligible to participate in the CBILS in circumstances where additional equity funding is available to be provided by the private equity firm.
  • Lenders have also been aggregating the annual revenues of private equity firm’s majority-owned portfolio companies to determine whether a single portfolio company is eligible for a CBILS loan, which had the effect of excluding the large majority of portfolio companies backed by mid to large-cap private equity firms (estimated by the BVCA to be 750+ companies).
• Level of Funding: When the CLBILS was initially announced on 3 April 2020, it was suggested that the scheme would provide £25 million of funding to businesses with an annual revenue of between £45 million and £500 million. For larger companies with an annual revenue of £500 million, a loan of £25 million would represent just over half of a business’ revenue for a month. The concern expressed is that if the current low levels of economic activity prevail for a significant period into the summer months, the loans available would not provide a sufficient liquidity buffer, even with the other support measures available, to prevent many companies from going out of business.

In the context of the growing criticism of the design flaws with the CBILS and the lack of access to the CCFF, the UK Government was forced to act by launching: (i) the CLBILS to provide genuine support to the majority of medium to large-sized UK businesses, and (ii) the Innovation and Development Scheme to support innovative development and research companies, including those backed by venture capital firms.

Regulatory Pressure

On 15 April 2020, the Financial Conduct Authority (FCA) published a “Dear CEO” letter setting out its expectations of banks, in relation to lending to SMEs.

In the letter to banks, the FCA reminded them that the priority is ensuring that the benefit of the package of measures introduced by the Government, including the CBILS, is passed through to businesses as soon as possible. The FCA also highlighted that responsibility for these specific lending activities should be allocated to one or more Senior Managers.

In the letter, the FCA also stated that a new small business unit has been established. This will, amongst other things, gather intelligence about the treatment of SMEs during the crisis. There is, therefore, a clear prospect of future enforcement action being taken by the FCA against banks where it does not consider that its expectations have been met. The pressure on commercial lending institutions to deliver the UK Government’s schemes and provide access to liquidity has, therefore, been increasing.

The Coronavirus Large Business Interruption Loan Scheme

On 3 April 2020, the UK Chancellor of the Exchequer, Rishi Sunak MP, announced that support would be provided to larger businesses in the UK (i.e. those with an annual revenue of in excess of £45 million) through the CLBILS. There followed an announcement on 16 April 2020, which set out the scope of the CLBILS, a scope broader than that initially announced on 3 April 2020. The UK Government has sought to design the CLBILS to support those businesses that hitherto had been unable to access funding through the CBILS or that had been ineligible to obtain funding through the CCFF. The CLBILS launched on Monday, 20 April 2020, and the key details of the scheme are as follows:

• Businesses with UK-based business activity and annual revenue of more than £45 million are eligible.
• Businesses with an annual revenue of between £45 million and £250 million will be able to access to up to £25 million of loans and businesses with an annual revenue of more than £250 million will have access to up to £50 million of loans.
• The UK Government will guarantee 80% of each loan but unlike the CBILS, the UK Government will not cover the first twelve months of interest.
• The business needs to have a borrowing proposal which the lender would consider viable, that will enable the business to trade out of any short-term to medium-term difficulty caused by the COVID-19 pandemic.
• The business should be able to self-certify that it has been adversely impacted by the COVID-19 pandemic.
• The business should not have received a facility under the CCFF.
• Majority-owned portfolio companies of private equity firms will now be able to access the scheme following updated guidance to lenders, as such companies’ annual revenues will be assessed on a standalone basis (i.e. there will be no grouping of all of a private equity firm’s portfolio companies’ annual revenues).
• Personal guarantees will not be permitted for loans of up to £250,000.
• The scheme will be available through a series of accredited lenders, that will be listed on the British Business Bank website.
• Credit institutions, insurers, reinsurers, building societies, public sector bodies, grant-funded further education establishments and state-funded schools are not eligible to participate in the scheme.

As a result of pressure from UK-businesses, the CLBILS appears to address some of the key issues relating to eligibility and levels of funding that had been identified with the CBILS. Large businesses now have access to up to £50 million of funding (depending on annual revenues) and companies that are not eligible to access the CCFF may still able to access the loans under the CLBILS. Importantly for the private equity industry, it also appears as though revenue-grouping for portfolio companies has been abolished together with the exclusion from the schemes of companies that are majority-owned by private equity firms.

However, one key point to note is that it appears as though businesses will need to still be credit-worthy with a viable business plan to access finance under the CLBILS. The decision on credit-worthiness remains in the hands of a business’ lenders and so businesses which maintain a high leverage levels may continue to be excluded.

The Innovation and Development Scheme

On 20 April 2020, the Chancellor of the Exchequer announced the establishment of a new Future Fund to support the UK’s innovative businesses currently affected by the Covid-19 pandemic, together with other measures to support businesses driving innovation in the UK. In total, the package announced represents £1.25 billion of additional funding through: (i) a £500 million investment fund for high-growth companies impacted by the Covid-19 pandemic, delivered in partnership between UK Government and the private-sector (the “Future Fund”); and (ii) £750 million of grants and loans to SMEs focussing on research and development.

The Future Fund

In an unprecedented step, the Future Fund will make convertible loans of between £125,000 and £5 million available to high-growth innovative businesses in the UK. The Fund will be delivered by the British Business Bank and will provide UK-based companies with funding from the UK Government. Private investors will be obliged to match the UK Government funding amount for companies to participate. These loans will automatically convert into equity on the company’s next qualifying funding round, or at the end of the loan if they are not repaid, meaning the UK Government will become a shareholder in these companies.

To be eligible, a business must be an unlisted UK registered company that has previously raised at least £250,000 in equity investment from third party investors in the last five years.

The UK Government has also published a term sheet which sets out the terms of the convertible loans provided under the Future Fund here.

The UK Government’s initial commitment to the Future Fund will be £250 million, with the Future Fund due to open for applications in May 2020 and run until September 2020. The UK Government has announced that it will keep the scale of its investment in the Future Fund under review.

Grants and Loans for Research and Development

£750 million of targeted support will be made available for research and development intensive SMEs. The grants and loans will be provided through existing schemes of the UK’s national innovation agency, Innovate UK.

Innovate UK, will accelerate up to £200 million of grant and loan payments for its 2,500 existing Innovate UK customers on an opt-in basis. An extra £550 million will also be made available to increase support for existing customers and £175,000 of support will be offered to around 1,200 firms not currently in receipt of Innovate UK funding. It has been announced that the first payments will be made by mid-May.

Conclusions

We are in unprecedented times in the United Kingdom, as is the case for many leading economies globally. The UK State (and accordingly, the UK taxpayer) is being asked to underwrite British business for it to survive during the COVID-19 pandemic. The UK Government is having to make policy announcements an almost daily basis in a very fluid situation and then rush to provide guidance and infrastructure for policy to be delivered. This has led to much criticism but the new measures appear to be designed to plug the design flaws in the initial schemes that were adopted in the early days of the developing COVID-19 crisis.

However, it remains to be seen whether the new schemes and updated guidance will enable lenders to speed up processes for approving loans and funding businesses at a time when the liquidity squeeze is being keenly felt. Central to the loan approval processes is the issue that the UK Government is guaranteeing only 80% of the exposure for lenders under the schemes with 20% of the residual risk carried by commercial lenders. In the current economic environment and prevailing macro-economic uncertainty, some lenders are discouraged from approving the loans under the schemes where they carry such residual risk. It is considered likely that further measures may need to be enacted, including having the UK Government or the Bank of England step in to guarantee 100% of the loans issued under the schemes to enable lenders to have the confidence in lending to British business. In these unprecedented times, it will remain to be seen whether further unprecedented measures are needed or whether the UK Government’s latest schemes will provide sufficient funding and liquidity for UK Business to survive what is fast-turning into a global economic crisis.

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This client update was prepared by Tom Budd, Greg Campbell, Michelle Kirschner, Mark Sperotto, Attila Borsos, Amar Madhani and Martin Coombes.

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. In the UK, the contact details of the authors and other key practice group lawyers are as follows:

The Authors:
Thomas M. Budd – London, Finance (+44 (0)20 7071 4234, [email protected])
Gregory A. Campbell – London, Restructuring and Finance (+44 (0)20 7071 4236, [email protected])
Michelle M. Kirschner – London, Financial Institutions (+44 (0)20 7071 4212, [email protected])
Mark Sperotto – London, Private Equity (+44 (0)20 7071 4291, [email protected])
Attila Borsos – Brussels, Antitrust (+32 2 554 72 11, [email protected])
Amar Madhani – London, Private Equity and Real Estate (+44 (0)20 7071 4229, [email protected])
Martin Coombes – London, Financial Institutions (+44 (0)20 7071 4258, [email protected])

London Key Contacts:
Sandy Bhogal – London, Tax (+44 (0)20 7071 4266, [email protected])
Thomas M. Budd – London, Finance (+44 (0)20 7071 4234, [email protected])
James A. Cox – London, Employment (+44 (0)20 7071 4250, [email protected])
Patrick Doris – London, Litigation & Data Protection (+44 (0)20 7071 4276, [email protected])
Ben Fryer – London, Tax (+44 (0)20 7071 4232, [email protected])
Christopher Haynes – London, Corporate (+44 (0)20 7071 4238, [email protected])
James R. Howe – London, Private Equity (+44 (0)20 7071 4214, [email protected])
Anna Howell – London, Energy, Oil & Gas (+44 (0)20 7070 9241, [email protected])
Charles Falconer, QC – London, Litigation (+44 (0)20 7071 4270, [email protected])
Jeremy Kenley – London, M&A, Private Equity & Real Estate (+44 (0)20 7071 4255, [email protected])
Penny Madden, QC – London, Arbitration (+44 (0)20 7071 4226, [email protected])
Ali Nikpay – London, Antitrust (+44 (0)20 7071 4273, [email protected])
Philip Rocher – London, Litigation (+44 (0)20 7071 4202, [email protected])
Selina S. Sagayam – London, Corporate (+44 (0)20 7071 4264, [email protected])
Alan A. Samson – London, Real Estate & Real Estate Finance (+44 (0)20 7071 4222, [email protected])
Jeffrey M. Trinklein – London, Tax (+44 (0)20 7071 4264, [email protected])

© 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 the early stages of the coronavirus (COVID-19) pandemic, U.S. financial regulators have issued a flurry of guidance.  This Alert analyzes select guidance from regulators to date on three key issues:  (1) the additional planning that financial institutions should undertake going forward, (2) how financial institutions should adjust day-to-day banking operations during coronavirus, including complying with their Bank Secrecy Act/anti-money laundering (“BSA/AML”) obligations, and (3) how COVID-19 affects oversight of financial institutions, including supervisory priorities and deadlines.[1]

Key U.S. financial regulators presently appear focused on ensuring safety, soundness, and liquidity, but are acting with flexibility given the operational challenges facing, and the increased demands imposed on, U.S. financial institutions.  We will continue to monitor developments, including whether regulators maintain this approach over the long term with respect to any COVID-19 performance gaps, as well as potential supervisory and enforcement options.

1. Planning

In the initial response to coronavirus, financial regulators have issued guidance regarding how financial institutions should plan for pandemics, the financial risks posed by them, and the specific areas of responsibility for boards of directors and senior management.

Pandemic Planning and Preparedness

FFIEC, on behalf of its member agencies, issued an update to earlier guidance on how federally regulated banks and credit unions should plan and prepare for a pandemic.[2]  The new guidance explains the pandemic-related information that needs to be included in a financial institution’s business continuity plan.  Specifically, the plan should include, among other things, a preventative plan to reduce the impact of a pandemic, a documented strategy for scaling a response to pandemic efforts, and a comprehensive framework of facilities, as well as testing and oversight of the program.  This planning should be accompanied by a business impact analysis of the potential effects of a pandemic and appropriate risk assessment and management.

DFS issued guidance requiring “New York State Regulated Institutions” to submit a report describing their pandemic preparedness.[3]  The term “New York State Regulated Institutions” is not defined and appears to apply broadly to all DFS-regulated entities.  The report must describe the financial institution’s “plan of preparedness to manage the risk of disruption to its services and operations.”  The report is required to cover, “at a minimum,” preventative measures to mitigate the risk of operational disruption, a documented strategy addressing the impact of the outbreak in stages, an assessment of all facilities, an assessment of potential increased cyberattacks and fraud, an assessment of the preparedness of critical outside-party service providers and suppliers, employee protection strategies, and development of a communications plan, as well as testing and governance.  And, on cybersecurity specifically, DFS issued additional guidance instructing regulated entities to “assess” and “address” a number of cybersecurity risks posed by working arrangements adopted during the pandemic, including ensuring secure connections, configuring remote working video and audio conferencing applications to limit unauthorized access, revisiting phishing training and testing “at the earliest practical opportunity,” and coordinating with critical third-party vendors to determine how they are adequately addressing new risks.[4]

Financial Risk Planning

DFS issued another piece of guidance requiring the same “New York State Regulated Institutions” to submit a second report regarding assurance relating to the financial risks from COVID-19.[5]  The report must “describ[e] the institution’s plan regarding managing the potential financial risk” arising from coronavirus.  Specifically, the plan must include an assessment of: (i) the credit risk ratings of the customers, counterparties and business sectors impacted by coronavirus; (ii) the credit exposure to customers, counterparties and business sectors impacted by coronavirus arising from lending, trading, investing, hedging and other financial transactions; (iii) the scope and the size of credits adversely impacted by coronavirus that currently are in, or potentially may move to, non-performing/delinquent status; (iv) the valuation of assets and investments that may be, or have been, impacted by coronavirus; (v) the overall impact of coronavirus on earnings, profits, capital, and liquidity; and (vi) reasonable and prudent steps to assist those adversely impacted by coronavirus.

2. Banking Practices During an Emergency

Financial regulators have also issued guidance on how financial institutions should conduct  operations during this pandemic.  Three key issues the guidance has covered are remote work arrangements, providing payment relief to customers, and complying with BSA/AML obligations.

Remote Work Arrangements

As explained in a recent Gibson Dunn alert, the Department of Homeland Security’s Cybersecurity and Infrastructure Security Agency (“CISA”) issued updated guidance outlining which employees in the financial services sector, among others, are considered essential.[6]  In the financial services sector, this includes employees needed to process transactions, maintain orderly market operations, and provide business, commercial, and consumer access to bank and non-bank financial services and lending services.  These workers “should be encouraged to work remotely when possible” but, if remote work is not possible, financial institutions should use strategies such as offsetting shift hours and social distancing to reduce the likelihood of the spread of COVID-19.

The FRB, OCC, and Treasury Department have all issued statements recognizing the CISA classifications.[7]  The FRB, for example, advises that supervised financial institutions should provide essential employees and contractors with a letter explaining that the identified worker is an essential critical infrastructure worker who needs to be allowed access to their place of work.[8]  DFS has issued guidance permitting employees to work from home,[9] and FINRA has temporarily suspended the requirement to maintain updated Form U4 information for registered persons who are temporarily working in alternate locations due to COVID-19.[10]  DFS has also issued guidance providing that New York State-chartered institutions may conduct meetings by teleconference or videoconference during the declared Disaster Emergency and 60 days thereafter.[11]

Lending, Borrower Accommodation, and Customer Assistance

The U.S. financial regulators have also issued extensive guidance encouraging financial institutions to assist consumers that may be struggling financially due to COVID-19.  The FDIC and OCC issued similar guidance, which is consistent with the FRB’s pre-existing guidance regarding responses to major disasters or emergencies, encouraging financial institutions to try to  provide relief to customers affected by the pandemic.[12]  The FRB, FDIC, NCUA, OCC, and CFPB issued a joint statement encouraging banks, savings associations, and credit unions to offer responsible small-dollar loans to both consumers and small business.[13]

The guidance from all these regulators generally follows a similar pattern of (1) acknowledging the likely financial hardship for individuals and small businesses due to the pandemic; (2) encouraging financial institutions to do their part to alleviate the adverse impact caused by COVID-19; and (3) providing suggested measures that financial institutions may take to do so.  Examples of suggested measures include offering payment accommodations, waiving overdraft and ATM fees, easing credit terms for new loans, waiving late fees for loan balances and credit card balances, increasing ATM daily cash withdrawal limits, waiving early withdrawal penalties on time deposits, and increasing credit card limits for creditworthy customers.  The FRB, DFS, the FDIC, and OCC also provided assurances that prudent efforts to modify the terms on existing loans for affected customers will not be subject to examiner criticism.[14]

Although the above guidance is voluntary, some consumer relief guidance is not optional.  DFS promulgated regulations requiring banks to grant 90-day forbearances on residential mortgages for borrowers that are suffering financial hardship as a result of the COVID-19 pandemic and also to waive ATM, overdraft, and credit card late payment fees.  Those regulations were previously summarized by Gibson Dunn here.

Bank Secrecy Act Compliance

U.S. regulators, notably FinCEN, have issued a number of pieces of guidance on how financial institutions should continue to comply with their BSA/AML obligations during the pandemic.

FinCEN issued guidance stating that compliance with the BSA “remains crucial to protecting our national security by combating money laundering and related crimes, including terrorism and its financing,” and, as such, “FinCEN expects financial institutions to continue following a risk-based approach” and “diligently adhere to their BSA obligations.”[15] At the same time, FinCEN “recognizes that certain regulatory timing requirements with regard to BSA filings may be challenging during the COVID-19 pandemic and that there may be some reasonable delays in compliance.”  Nevertheless, financial institutions are advised to “contact FinCEN and their functional regulator as soon as practicable [regarding] concern[s] about any potential delays in [their] ability to file required Bank Secrecy Act (BSA) reports.”[16]  To that end, FinCEN has created a new mechanism to contact the agency through its website for COVID-19-related issues.[17]  Such communications “are strongly encouraged but not required.”[18]  FinCEN also encourages financial institutions to contact their regulators or examiners “as soon as practicable if a financial institution has BSA compliance concerns because of the COVID-19 pandemic.”

The OCC has issued guidance supporting FinCEN’s approach to BSA/AML compliance, stating that it “encourages all banks to follow a risk-based approach to managing their BSA compliance programs.”[19]  Specifically, “[w]hen evaluating a bank’s BSA compliance program, the OCC will consider the actions taken by banks to protect and assist employees, customers, and others in response to the COVID-19 pandemic, including any reasonable delays in BSA report filings, beneficial ownership verification or re-verification requirements, and other risk management processes.”[20] Again, banks are encouraged to contact examiners if they anticipate delays.

At a more granular level, FinCEN has also issued guidance regarding filing SARs for COVID-19-related activity and complying with beneficial ownership obligations when dispensing loans under the Paycheck Protection Program (“PPP”).  As financial institutions continue to monitor transactions in compliance with their obligations under the Bank Secrecy Act and relevant anti-money laundering laws, FinCEN has specifically identified various COVID-19-related scams that may occur, including companies selling unapproved or misbranded products making false health claims and bad actors soliciting donations or stealing personal information by impersonating health-related government agencies, international organizations, or healthcare organizations.[21]  In the event that financial institutions detect any of these typologies or suspect suspicious transactions linked to COVID-19, they are asked to enter “COVID19” in Field 2 of the Suspicious Activity Report (“SAR”) template.

Regarding loans issued under the PPP, analyzed in detail in a separate Gibson Dunn client alert, FinCEN issued guidance clarifying that if PPP loans are being made to existing customers and their necessary information was previously verified, it does not need to be re-verified for FinCEN Rule CDD purposes.[22]  As for new customers, FinCEN clarified that, for all natural persons with a 20% or greater ownership stake in the applicant business, collection of their owner name, title, ownership percentage, TIN, address, and date of birth will be deemed to satisfy applicable BSA requirements and FinCEN regulations governing the collection of beneficial ownership information.

Relief on CECL Implementation

Even before the effects of the pandemic began to make themselves felt, the new current expected credit losses (“CECL”) methodology promulgated by the Financial Accounting Standards Board concerned many banking institutions, which feared pro-cyclical effects on credit loss allowances, and ultimately, reductions to capital.  In 2019, U.S. banking regulators modified their capital rules to permit banks to phase in over a period of three years the day-one effects of the transition to CECL, to smooth out those effects over time.

On March 27, 2020, the U.S. regulators issued an interim final rule that provided alternative relief, by permitting banking organizations to phase-in over a period of five years the effects of the transition to CECL that occur during the first two years of implementation.  Under this approach, no effects of CECL implementation will be recognized for the first two years; banking organizations will phase in the effects over years three through five.[23]  In addition, Section 4014 of the CARES Act provides banking organizations with the option not to comply with CECL until the earlier of the end of 2020 or the end of the COVID-19 emergency.[24]  On March 31, 2020, the banking regulators issued a statement to the effect that the regulatory relief and Section 4014 are not mutually exclusive; a banking organization that elects to use the statutory relief may also elect the regulatory capital relief after the expiration of the statutory relief period.  The two-year period in the regulatory relief would be reduced by the number of quarters that the banking organization made use of the statutory relief.[25]

3. Supervisory Priorities and Deadlines

U.S. financial regulators have also provided guidance on how COVID-19 will affect examination priorities and reporting deadlines.

Regarding examinations, the FRB released guidance stating that it “is reducing its focus on examinations and inspections at this time” and that “[a]ny examination activities will be conducted off-site until normal operations are resumed.”[26]  For supervised institutions with less than $100 billion in assets, the FRB intends to cease all regular examination activity unless there is an urgent need, or it is critical for consumer protection.  The FRB intends to reassess its approach in the last week of April.  Supervisors are also focusing efforts to ensure that supervisory findings are still relevant and appropriately prioritized in light of changing circumstances.  And, as noted above, the FRB, DFS, the FDIC, and OCC have provided assurances that prudent efforts to modify the terms on existing loans for affected customers will not be subject to examiner criticism.

Regulators have also extended various reporting and submission deadlines.  A selected list of reporting deadlines that have been extended to date is included in the table below.  Please consult the website of your financial regulators to confirm current deadlines and extensions.  In general, if a financial institution will not be able to meet a submission deadline as a result of COVID-19, the best practice is to contact your financial institution’s regulator.[27]

Table 1 – Deadlines Extended by U.S. Financial Regulators

Agency	Task	Extension / Deadline
FDIC	Q1 2020 Regulatory Report Filings	30-day grace period[28]
FDIC	Reports of Condition and Income (Call Report) due March 31, 2020	30-day grace period
FinCEN	FIN-2020-R001 ruling on CTR filing obligations when reporting transactions involving sole proprietorships and entities operating under a “doing business as” (DBA) name	Indefinitely
FRB	Deadline for remediating existing supervisory findings unless the FRB notifies the institution otherwise	90 days
FRB	Revised Control Framework for determining when one company controls another company for purposes of the Bank Holding Company Act and Home Owners’ Loan Act	Effective date delayed six months, until September 30, 2020[29]
FINRA	Comment Period for Regulatory Notice 20-05	May 31, 2020
FINRA	Comment Period for Regulatory Notice 20-04	May 15, 2020
FINRA	Annual Reports	10-day extension for reports related to fiscal years ending January 2020 through March 2020
FINRA	FOCUS Reports	10-day extension for FOCUS reports related to periods ending in February 2020 through April 2020
FINRA	· Rule 3120 Report · Rule 3130 Certification	Deadlines that fall between March 1 and May 1, 2020 are extended until May 31, 2020
FINRA	Fingerprinting requirements for FINRA members and employees	Temporary exemption until May 30, 2020
FINRA	Timeframe for individuals designated as principals under FINRA Rule 1210.04 prior to February 2, 2020 to pass appropriate examination(s)	Extended to May 31, 2020
NY DFS	Annual stockholder meetings	Institutions will have seven months instead of four months from the beginning of an institution’s fiscal year end if the prior deadline for the stockholder meeting occurs during the disaster emergency
NY DFS	· Annual reports and comparative statements of commercial banks · Annual reports of licensed lenders · Quarterly reports of budget planners · Audited financial statements of budget planners · Annual reports and audited financial statements of check cashers · Certifications of compliance with cybersecurity requirements · Transaction monitoring and filtering · Volume of operation reports · Volume of servicing reports · Quarterly financial statements of virtual currency licensees · Annual reports of student loan servicers	45-day extension

 

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   [1]   This alert covers select guidance issued by the Federal Reserve Board (“FRB”), the Federal Financial Institutions Examination Council (“FFIEC”), the New York Department of Financial Services (“DFS”), the Office of the Comptroller of the Currency (“OCC”), the Financial Industry Regulatory Authority (“FINRA”), the Federal Deposit Insurance Corporation (“FDIC”), and the Financial Crimes Enforcement Network (“FinCEN”).  It does not cover every COVID-19-related guidance issued by these regulators nor does it discuss guidance issued by the U.S. Department of Justice, the Securities and Exchange Commission, or state financial regulators other than DFS.

   [2]   Federal Financial Institutions Examination Council, Interagency Statement on Pandemic Planning (Mar. 6, 2020), https://www.ffiec.gov/press/pr030620.htm.  The member agencies of the FFIEC are the FRB, FDIC, OCC, and the National Credit Union Administration (“NCUA”) and the Consumer Financial Protection Bureau (“CFPB”).

   [3]   N.Y. Dep’t of Fin. Servs., Re: Guidance to New York State Regulated Institutions and Request for Assurance of Operational Preparedness Relating to the Outbreak of the Novel Coronavirus (Mar. 10, 2020), https://www.dfs.ny.gov/industry_guidance/industry_letters/il20200310_risk_coronavirus.

   [4]   N.Y. Dep’t of Fin. Servs., Re: Guidance to Department of Financial Services (“DFS”) Regulated Entities Regarding Cybersecurity Awareness During COVID-19 Pandemic (Apr. 13, 2020), https://www.dfs.ny.gov/industry_guidance/industry_letters/il20200413_covid19_cybersecurity_awareness.

   [5]   N.Y. Dep’t of Fin. Servs., Re: Guidance to New York State Regulated Institutions and Request for Assurance Relating to Potential Financial Risk Arising from the Outbreak of the Novel Coronavirus (Mar. 10, 2020), https://www.dfs.ny.gov/industry_guidance/industry_letters/il20200310_financial_risk_coronavirus.

   [6]   Cybersecurity and Infrastructure Security Agency (CISA) of the Dep’t of Homeland Security, Memorandum on Identification of Essential Critical Infrastructure Workers During COVID-19 Response (Apr. 17, 2020), https://www.cisa.gov/publication/guidance-essential-critical-infrastructure-workforce.

   [7]   For example, the Treasury Department also includes “key third-party providers who deliver core services” in its definition of essential financial services sector workers.  U.S. Department of the Treasury, Memorandum: Financial Services Sector Essential Critical Infrastructure Workers (Mar. 22, 2020), https://www.aba.com/-/media/documents/incident-response/Financial-Services-Sector-Essential-Critical-Infrastructure-Workers.pdf.

   [8]   Bd. of Governors of the Fed. Reserve Sys., SR 20-6: Identification of Essential Critical Infrastructure Workers in the Financial Services Sector During the COVID-19 Response (Mar. 27, 2020), https://www.federalreserve.gov/supervisionreg/srletters/sr2006.htm.

   [9]   N.Y. Dep’t of Fin. Servs., Order (Mar. 12, 2020), https://www.dfs.ny.gov/system/files/documents/2020/03/ea20200312_covid19_relief_order.pdf.

  [10]   Financial Industry Regulatory Authority, Regulatory Notice 20-08: Pandemic-Related Business Continuity Planning, Guidance and Regulatory Relief, https://www.finra.org/rules-guidance/notices/20-08.

  [11]   N.Y. Dep’t of Fin. Servs., Order (Apr. 16, 2020), https://www.dfs.ny.gov/system/files/documents/2020/04/ea200416_banking_order_re_virtual_and_stockholder_meetings_due_to_c_19.pdf.

  [12]   Fed. Deposit Ins. Corp., Regulatory Relief: Working with Customers Affected by the Coronavirus, FIL-17-2020 (Mar. 13, 2020), https://www.fdic.gov/news/news/financial/2020/fil20017.html; Office of the Comptroller of the Currency, Pandemic Planning: Working With Customers Affected by Coronavirus and Regulatory Assistance (Mar. 13, 2020), https://www.occ.treas.gov/news-issuances/bulletins/2020/bulletin-2020-15.html; Bd. of Governors of the Fed. Reserve Sys., SR 13-6 / CA 13-3: Supervisory Practices Regarding Banking Organizations and their Borrowers and Other Customers Affected by a Major Disaster or Emergency (Mar. 29, 2013), https://www.federalreserve.gov/supervisionreg/srletters/sr1306.htm.

  [13]   Joint Statement Encouraging Responsible Small-Dollar Lending in Response to COVID-19 (Mar. 26, 2020), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200326a1.pdf.  This March 26 guidance follows a March 19 joint statement from the Federal Reserve, FDIC, and OCC stating that the agencies will look favorably on retail banking and lending activities that meet the needs of small businesses and farms, in connection with the Community Reinvestment Act.  See Office of the Comptroller of the Currency, Pandemic Planning: Joint Statement on CRA Consideration for Activities in Response to COVID-19 (Mar. 19, 2020), https://www.occ.gov/news-issuances/bulletins/2020/bulletin-2020-19.html.

  [14]   In the FDIC’s “Frequently Asked Questions for Financial Institutions Affected by the Coronavirus Disease 2019,” the FDIC stated that it would be acceptable for a bank to offer borrowers affected by COVID-19 payment accommodations, such as allowing borrowers to defer or skip some payments or extending the payment due date.  See Fed. Deposit Ins. Corp., Frequently Asked Questions for Financial Institutions Affected by the Coronavirus Disease 2019 (Referred to as COVID-19) – As of April 15, 2020, https://www.fdic.gov/coronavirus/faq-fi.pdf.  Additionally, on April 7, 2020, the FRB, the CFPB, the FDIC, NCUA, and OCC issued an updated statement “encouraging financial institutions to work prudently with borrowers” affected by COVID-19 and providing additional information regarding loan modifications.  Specifically, the agencies “encourage financial institutions to work prudently with borrowers” and “will not criticize institutions for working with borrowers in a safe and sound manner[] and will not direct supervised institutions to automatically categorize all COVID-19-related modifications as TDRs (troubled debt restructurings).”  Bd. of Governors of the Fed. Reserve Sys. et al., Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus (Revised) (Apr. 7, 2020), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200407a1.pdf.

  [15]   Financial Crimes Enforcement Network, Press Release, The Financial Crimes Enforcement Network Provides Further Information to Financial Institutions in Response to the Coronavirus Disease 2019 (COVID-19) Pandemic (Apr. 3, 2020), https://www.fincen.gov/news/news-releases/financial-crimes-enforcement-network-provides-further-information-financial.

  [16]   Financial Crimes Enforcement Network, The Financial Crimes Enforcement Network (FinCEN) Encourages Financial Institutions to Communicate Concerns Related to the Coronavirus Disease 2019 (COVID-19) and to Remain Alert to Related Illicit Financial Activity (Mar. 16, 2020), https://www.fincen.gov/news/news-releases/financial-crimes-enforcement-network-fincen-encourages-financial-institutions.

  [17]   Specifically, parties are advised to go to https://www.fincen.gov/contact and select “COVID19” in the “Subject” drop down menu.

  [18]   Financial Crimes Enforcement Network, Press Release, The Financial Crimes Enforcement Network Provides Further Information to Financial Institutions in Response to the Coronavirus Disease 2019 (COVID-19) Pandemic (Apr. 3, 2020), https://www.fincen.gov/news/news-releases/financial-crimes-enforcement-network-provides-further-information-financial.

  [19]   Office of the Comptroller of the Currency, Bank Secrecy Act/Anti-Money Laundering: OCC Supports FinCEN’s Regulatory Relief and Risk-Based Approach for Financial Institution Compliance in Response to COVID-19 (Apr. 7, 2020), https://www.occ.treas.gov/news-issuances/bulletins/2020/bulletin-2020-34.html.

  [20]   Id.

  [21]   Financial Crimes Enforcement Network, Press Release, The Financial Crimes Enforcement Network (FinCEN) Encourages Financial Institutions to Communicate Concerns Related to the Coronavirus Disease 2019 (COVID-19) and to Remain Alert to Related Illicit Financial Activity (Mar. 16, 2020), https://www.fincen.gov/news/news-releases/financial-crimes-enforcement-network-fincen-encourages-financial-institutions.

  [22]   Financial Crimes Enforcement Network, Press Release, Paycheck Protection Program Frequently Asked Questions (FAQs) (Apr. 13, 2020), https://www.fincen.gov/news/news-releases/paycheck-protection-program-frequently-asked-questions.

  [23]   Joint Press Release: Agencies Announce Two Actions to Support Lending to Households and Businesses (Mar. 27, 2020), https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200327a.htm.

  [24]   Coronavirus Aid, Relief, and Economic Security Act § 4014, Pub. L. No. 116-136, 134 Stat. 281 (Mar. 27, 2020).

  [25]   Joint Statement on the Interaction of Regulatory Capital Rule: Revised Transition of the CECL Methodology for Allowances with Section 4014 of the Coronavirus Aid, Relief, and Economic Security Act (Mar. 31, 2020), https://www.fdic.gov/news/news/financial/2020/fil20032a.pdf.

  [26]   Bd. of Governors of the Fed. Reserve Sys., Federal Reserve Statement on Supervisory Activities (Mar. 24, 2020), https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200324a1.pdf.

  [27]   The Federal Reserve, for example, has explicitly stated it does not expect to take supervisory action against a banking organization that takes reasonable and prudent steps to comply with the Board’s reporting requirements but is unable to do so in these difficult times.  See Bd. of Governors of the Fed. Reserve Sys., SR 13-6 / CA 13-3: Supervisory Practices Regarding Banking Organizations and their Borrowers and Other Customers Affected by a Major Disaster or Emergency (Mar. 29, 2013), https://www.federalreserve.gov/supervisionreg/srletters/sr1306.htm.

  [28]   FDIC-supervised institutions are encouraged to contact the FDIC in advance of the official filing date if they anticipate a delayed submission.

  [29]   For more information on the Federal Reserve’s Revised Control Framework, see our previously published client alert on this topic, available at https://www.gibsondunn.com/federal-reserve-new-control-framework-somewhat-greater-opportunities-for-minority-investments/.

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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 consult the firm’s Coronavirus (COVID-19) Resource Center.  Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Financial Institutions Group, or the authors.

The following Gibson Dunn lawyers assisted in preparing this client alert:  Matthew Biben, Stephanie Brooker, Joel Cohen, Kendall Day, Mylan Denerstein, Arthur Long, Adam Smith, Joseph Warin, Linda Noonan, Chris Jones, Susanna Schuemann, and Tory Roberts.

*Mr. Jones and Ms. Schuemann are admitted only in New York and Washington, D.C.  Ms. Roberts is admitted only in California.  All are practicing under the supervision of Principals of the Firm.

© 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.

After more than one month of widespread measures to fight the Coronavirus,[1] we can observe the first enforcement actions throughout Europe for alleged misconduct illustrating the wide spectrum of issues facing enforcement agencies. For instance, on April 2, 2020, the Public Prosecutor’s Office of Braunschweig announced that it is investigating the COVID-19-related deaths of elderly people in a nursing home in Wolfsburg/Germany under the suspicion of negligent homicide.[2] Sadly, twenty-two people had died as a consequence of the infection with the virus. According to the allegations the hygienic measures taken to protect the inhabitants from contagion were insufficient and a prohibition to allow third party visits to the inhabitants was ordered too late.  On the other end of the spectrum, courts in the United Kingdom and the Netherlands have recently sentenced defendants for assault/threatening to custodial sentences because they coughed/threatened to cough at policemen.[3]

These are drastic cases, but they illustrate that with the proceeding of the COVID-19 crisis new exposure arises for business leaders and compliance officers alike.

The changing enforcement and risk landscape is partly a result of the quick adjustment of enforcement agencies to the “new normal” under restrictive measures stipulated through a series of ad hoc regulations that dramatically change the way businesses and their employees used to operate a few weeks ago.

1.  Sources of liability and exposure

Businesses, whether run by individuals or by companies, have a responsibility to appropriately protect their employees, customers, and business partners from dangers deriving from business operations. The COVID-19 pandemic should remind managers of this fundamental obligation when running the business during the current crisis. Given the dynamic of the situation, this might involve a series of measures to be taken or adjusted ad hoc, that in the short or mid-term have potentially substantial impact on the way the business is run or even may have to discontinue the business.

Under German law, liability can be of criminal, regulatory or civil law nature:

• Individual managers may be held criminally responsible, if they fail to comply with required safety standards that cause bodily harm of others (e.g. for negligent bodily harm or negligent killing), or be held liable for regulatory/criminal offenses if they fail to comply with official orders and regulations based (e.g. orders under the Infectious Diseases Protection Act, IfSG[4]). They can also be held responsible and fined with a fine of up to €10 million for committing a regulatory offense if they fail to duly oversee their employees and therefore facilitate or enable that they commit offenses;
• Companies and partnerships can be held administratively responsible and fined, if an offense was committed by a representative of the company/partnership, e.g. a board member, or a person having managing responsibilities (Leitungsperson) and as a result thereof, (i) duties incumbent on the business have been violated, or (ii) the business has been enriched or (iii) was intended to be enriched. In addition, any economic gain derived from the violation may be subject to disgorgement;
• Finally, individual managers as well as companies/partnerships represented by them may be held responsible under civil law for damages if as a result of their business decisions other people, including employees, suffer bodily harm.

2.  Attributing criminal responsibility to management for business decisions in situations of crisis

If employees, customers, or business partners become infected with the virus due to poor organizational and safety standards, it is conceivable that managers can be held responsible for not having prevented the infection. This does not only apply to a single executive board member responsible for occupational health and safety. Rather, in the current situation, every board member needs to have these issues in mind.

The German Federal Court of Justice held in a famous judgment^[5] that the entire board can be made criminally responsible for bodily harm, no matter whether the individual board member was internally responsible for health and safety matters. In that particular case, the board members of a company were convicted for dangerously inflicting bodily harm on customers because they unanimously decided to refrain from a recall of a shoe leather spray that was detrimental to health when used.[6]

The court, by invoking principles of company law, set out the following:

“The principles of general responsibility and general competency of the management attach if for a particular reason, such as in situations of crisis and exception, the enterprise as a whole is concerned. In such a situation, the entire management is called upon to act.”^[7]

When neglected or inadequate safety and health measures can lead to a potentially fatal infection of employees, business partners and customers, as in the current COVID-19 pandemic, it is an exceptional situation that affects the entire company. Therefore, the current crisis triggers the general responsibility of the entire management meaning that business leaders must feel responsible that adequate organizational measures be taken to prevent harm to both employees and third parties such as customers, visitors and business partners. It is therefore recommendable to Compliance Officers to put such measures on the agenda of the entire board and make members aware of their duties to inform themselves, to decide on adequate measures and to ascertain their implementation.

3.  Holding the business responsible for offences of its business leaders

As set out above, companies and partnerships can be held administratively responsible and fined, if an offense was committed by a representative of the company/partnership, e.g. a board member, or a person having managing responsibilities (Leitungsperson) and as a result thereof, (i) duties incumbent on the legal entity have been violated, or (ii) the legal entity has been enriched or (iii) was intended to be enriched.

For instance, if a company hires employees, it is a duty incumbent to the company that runs the business to protect its employees from dangers arising at the workplace. In contrast, a mere break of a curfew by a manager outside of the business cannot lead to fining the company because observing a curfew is a duty that entirely attaches to the individual.

4.  Creating civil liability exposure

In addition, individual managers as well as companies/partnerships represented by them may be held responsible as joint obligors under civil law for damages if as a result of their business decisions other people suffer bodily harm. For instance, if a company were to sell  a protective mask that due to its composition is knowingly harmful to the customers making use of it.

Such liability usually arises under sec. 280(1), 241(2), 823(1) and/or (2) of the German Civil Code if an offense that serves to protect individual interests is committed (e.g. negligent bodily harm). In the case of  employees, civil liability can also arise on the basis of employment law but will often be excluded due to the provisions of the mandatory accident insurance (sec. 104  Social Code VII).

The amount to be compensated under German civil law does not include punitive damages that is known in other jurisdictions, but is calculated as the difference between the victims hypothetical financial situation had the event causing the damage not occurred and its real financial situation, supplemented by a sum for non-material damage for pain and suffering.

5.  Special Recommendations by Public Authorities in re COVID-19

Apart from special requirements for particular businesses that may require specific instructions relating to the operation of the business (e.g. dealing with customers and business partners), as a minimum measure, we would recommend implementing and controlling the effective use and application of the workplace-related recommendations by public authorities.

Adhering to such recommendations would, absent more specific circumstances mandating more stringent measures, allow management to show that it did not act negligently and would further demonstrate compliance with its general obligation set out in Sec. 4 Work Protection Act (ArbSchG) stipulating that work must be organized in such a way that risks to physical and mental health are avoided and minimized.

In this regard, we deem the following recommendations as particularly useful which are targeted at the need of employers:

• Recommendations by the Federal Center for Health Education (BzGA): https://www.infektionsschutz.de/fileadmin/infektionsschutz.de/Downloads/Infoblatt-Arbeitgeber-Coronavirus.pdf (in German; last visited April 20, 2020);
• Recommendations by the World Health Organization: https://www.who.int/docs/default-source/coronaviruse/getting-workplace-ready-for-covid-19.pdf?sfvrsn=359a81e7_6 (in English, last visited April 20, 2020);
• The Robert Koch Institute^[8] has published specific information with respect to the prevention of infections in nursing homes and hospitals: https://www.rki.de/DE/Content/InfAZ/N/Neuartiges_Coronavirus/nCoV.html (in German, last visited April 20, 2020);
• Lastly, the Federal Ministry of Health has put together a website with hotlines, podcasts and useful links for many topics affected by COVID-19: https://www.bundesgesundheitsministerium.de/coronavirus.html#c17634 (mostly in German, partly in further languages including English, last visited April 20, 2020).

Additional helpful guidance can often be found for members on the websites of the respective industry associations. These are more specific to the specific industry requirements relevant from case to case.

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    [1]   See in this regard, https://www.gibsondunn.com/covid-19-german-infectious-diseases-protection-act-what-makes-you-stay-at-home/ (last visited April 20, 2020).

   [2]   https://www.sueddeutsche.de/gesundheit/gesundheit-wolfsburg-corona-tode-in-seniorenheim-staatsanwaltschaft-ermittelt-dpa.urn-newsml-dpa-com-20090101-200402-99-565664 (in German, last visited April 20, 2020).

   [3]   https://www.sueddeutsche.de/panorama/coronavirus-grossbritannien-polizei-1.4866309 (in German, last visited April 20, 2020).

   [4]   See in this regard, https://www.gibsondunn.com/covid-19-german-infectious-diseases-protection-act-what-makes-you-stay-at-home/ (last visited April 20, 2020).

   [5]   See Federal Court of Justice, Judgment of July, 6, 1990, 2 StR 549/89.

   [6]   The defendants were sentenced to fines and imprisonment (up to 18 months) with probation.

   [7]   Our translation, the original quote has the following wording: „Doch greift der Grundsatz der Generalverantwortung und Allzuständigkeit der Geschäftsleitung ein, wo – wie etwa in Krisen- und Ausnahmesituationen – aus besonderem Anlaß das Unternehmen als Ganzes betroffen ist; dann ist die Geschäftsführung insgesamt zum Handeln berufen […].“ Federal Court of Justice, Judgment of July 6, 1990, 2 StR 549/89, para. 51.

   [8]   For the role of the Robert Koch Institute, see https://www.gibsondunn.com/covid-19-german-infectious-diseases-protection-act-what-makes-you-stay-at-home/ (last visited April 20, 2020).

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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 in Germany:

Authors:  Benno Schwarz, Ralf van Ermingen-Marbach and Andreas Dürr

© 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.