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The Board of Governors of the Federal Reserve System’s (“Federal Reserve”) issued revised guidance on May 4, 2020, with respect to the Primary Market Corporate Credit Facility (“PMCCF”) and noted that it expects the PMCCF to be operational sometime early this month.[1] The revised guidance clarifies two substantive issues with respect to the application of the PMCCF’s issuer requirements.

First, the revised guidance clarifies the extent to which U.S. subsidiaries may participate under the PMCCF in light of the requirement that issuers have “significant operations in and a majority of its employees based in the United States” (the “U.S. Requirements”). Previous guidance on the matter was silent as to whether U.S. subsidiaries would be eligible to participate in the PMCCF and, if eligible, how such entities would be evaluated under the U.S. Requirements (e.g., application of employee and operations on a consolidated basis, whether use of funds would be restricted to U.S. operations, etc.).

Second, the revised guidance clarifies the extent to which the PMCCF restriction that issuers not “have received specific support pursuant to the [Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”)] or any subsequent federal legislation” applies to issuers generally. Previous guidance did not provide additional detail as to what constitutes “specific support” under the CARES Act (e.g., support under Title IV programs, tax relief, participation in the Paycheck Protection Program, etc.).

This revised guidance confirms that U.S. subsidiaries can participate in the PMCCF, and provides additional gloss on eligibility requirements under the U.S. Requirements and the “no specific support” under the CARES Act condition. For additional background and information regarding the PMCCF and its requirements, please see our previous alerts, available here and here.

The revised guidance provides several avenues by which a U.S. subsidiary issuer may participate in the PMCCF:

Test 1 (A or B): S. Subsidiary Whose Sole Purpose to Issue Debt. If the sole purpose of the U.S. subsidiary issuer is to issue corporate debt, eligibility will depend on the contemplated distribution of PMCCF proceeds, based on the satisfaction of one of the two following tests:
1. If 95 percent or more of the proceeds from the PMCCF are transferred to another corporate affiliate (a “Primary Corporate Beneficiary”) for use in its operations, the Primary Corporate Beneficiary, on a consolidated basis with its consolidated subsidiaries, must satisfy the U.S. Requirements.
2. If there is no Primary Corporate Beneficiary, at least 95 percent of the proceeds of the PMCCF must go to corporate affiliates, each of which, on a consolidated basis with its consolidated subsidiaries, satisfy the U.S. Requirements.
Test 2: Other U.S. Subsidiary Issuers. If the U.S. subsidiary issuer is not a subsidiary whose sole purpose is to issue debt, it may participate in the PMCCF so long as it, on a consolidated basis with its consolidated subsidiaries, satisfies the U.S. Requirements. Use of PMCCF proceeds by issuers satisfying Test #2 does not appear to be restricted to solely U.S. entities or operations and may be directed to non-U.S. operations and non-U.S. affiliates so long as the U.S. subsidiary issuer otherwise satisfies the consolidation test noted above. If the U.S. subsidiary does have a direct or indirect non-U.S. parent or intermediate holding company, please see #4 below. If the U.S. subsidiary’s only purpose is to issue debt, the requirements under Test #1(A) or #1(B) must be met.

With respect to the abovementioned tests, we note the following additional takeaways:

Upstream Entities: Upstream entities and sister affiliates of a U.S. subsidiary issuer will not be considered if the U.S. subsidiary issuer, with its consolidated downstream group, satisfies the U.S. Requirements.
Downstream Entities: Guidance does not appear to restrict participation in the PMCCF if a downstream consolidated subsidiary of the U.S. subsidiary issuer is not itself a U.S. entity, so long as the consolidated group satisfies the U.S. Requirements.
Creating/Identifying a New U.S. Subsidiary Issuer: Guidance explicitly provides that corporates may create a new entity or identify an existing entity as an issuer and may rely on the ratings history of any U.S. affiliate that is guaranteeing the issuance. Participating issuers under the PMCCF are subject to a participation threshold that may not exceed 130% of the issuer’s maximum outstanding bonds and loans on any day between March 22, 2019 and March 22, 2020. U.S. subsidiary issuers participating in the PMCCF and relying on an affiliate guarantee would be subject to the 130% threshold, calculated with respect to its top-tier parent’s issuances on a consolidated basis.[2]
U.S. Subsidiary of a Non-U.S. Parent: A U.S. subsidiary issuer of a non-U.S. company may participate if it otherwise satisfies the U.S. Requirements, but will be restricted in the use of its PMCCF proceeds. The U.S. subsidiary must covenant that PMCCF proceeds are used only for the benefit of the U.S. subsidiary issuer, its consolidated U.S. subsidiaries, and other affiliates that are U.S. businesses, and not for the benefit of its non-U.S. affiliates.[3]
Significant Operations Requirement: The revised guidance provides a non-exhaustive list of examples that would satisfy the “significant operations” component of the U.S. Requirements. The U.S. subsidiary issuer would qualify as having “significant operations” in the U.S. if, as reflected in its most recent audited financial statements, it has greater than 50% of its:
1. Consolidated assets in the U.S.; or
2. Annual consolidated net income generated in the U.S.; or
3. Annual consolidated net operating revenues generated in the U.S.; or
4. Annual consolidated operating expenses (excluding interest expense and any other expenses associated with debt service) generated in the U.S.
“Specific Support” Requirement: Eligibility under the PMCCF also requires issuers not to have “received specific support pursuant to the CARES Act or any subsequent federal legislation.” The revised guidance clarifies this restriction by stating that an issuer is not eligible if “it has received a loan, loan guarantee, or other investment from the Treasury Department under section 4003(b)(1)-(3).” In addition, the revised guidance states that an issuer may use tax credits or tax relief in the CARES Act and still participate in the PMCCF.

Conclusion

Revised guidance under the PMCCF provides a path to eligibility for certain U.S. subsidiaries of corporates and manufacturers with substantial overseas operations. It does so without requiring consolidated, parent level calculations. While the guidance helpfully clarifies these structural issues and the substantive requirements thereunder, the guidance does not address the administrative aspects of the PMCCF (e.g., application forms, dates, procedures) other than through a general statement that the PMCCF will purchase eligible assets soon this month. We will continue to monitor developments with respect to the PMCCF, including when additional guidance on the application process for the PMCCF is released.

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[1] The PMCCF term sheet has not been updated.

[2] The maximum amount of instruments that may be purchased by the PMCCF and Secondary Market Corporate Credit Facility (“SMCCF”) with respect to an issuer may not exceed 1.5% of the combined size of the PMCCF and SMCCF, currently sized at $750 billion. Measurement of the 1.5% threshold will be at the time of purchase of the bond or portion of loan syndication.

[3] The revised guidance also notes that U.S. branches or agencies of non-U.S. banks may participate as eligible sellers under the SMCCF provided that they otherwise satisfy the U.S. Requirements.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding developments related to the COVID-19 pandemic. For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team or its Capital Markets or Financial Institutions practice groups, the Gibson Dunn lawyer with whom you usually work, or the following authors:

Authors: Michael D. Bopp, Andrew L. Fabens, Arthur S. Long and James O. Springer

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])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

New York partner Akiva Shapiro and associates Doran Satanove and Lee Crain are the authors of “COVID-19 News Defamation Claims Are Unlikely To Succeed,” [PDF] published by Law360 on May 4, 2020.

Gibson Dunn’s lawyers regularly counsel clients on issues raised by the COVID-19 pandemic, and we are working with many of our clients on their response to COVID-19. The following is a round-up of today’s client alerts on this topic prepared by the Gibson Dunn team. Our lawyers are available to assist with any questions you may have regarding developments related to the outbreak. As always, for additional information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, or any member of the firm’s Coronavirus (COVID-19) Response Team.

GLOBAL OVERVIEW

The Future Fund – a Venture into the Unknown for the UK Government

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.
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In recent weeks, legal commentators have predicted that employers will face an “explosion” of employee lawsuits for tort claims relating to the COVID-19 pandemic. As non-essential businesses begin to develop plans for reopening—and essential businesses continue to navigate the unprecedented challenge of remaining operational during a pandemic—employers worry that one wrong step might expose them to sweeping legal liability. Perhaps most concerning for employers is the specter of class action lawsuits alleging that unsafe workplaces have caused employees to contract COVID-19 or left them at heightened risk of exposure, which the U.S. Chamber of Commerce considers to be possibly the “largest area of concern for the overall business community.”
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COVID-19 and Personal Injury Tort Liability: Preliminary Considerations for Businesses

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, and some fear that a wave of litigation in the wake of the pandemic will threaten economic recovery. Plaintiffs have claimed that defendants failed to properly warn others of the presence of a COVID-19 outbreak, and failed to take reasonable steps to prevent the virus from spreading. Some plaintiffs have even claimed that businesses that do not take sufficient precautions create a public nuisance, 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. And others have called for legislation to provide liability protections across many industries. Here, we preview just a few of the issues likely to shape the scope of liability in personal injury actions related to COVID-19.
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Coronavirus: Private Equity Investing in a Distressed Environment

For private equity funds, the current Covid-19 pandemic – while providing unprecedented challenges for many portfolio companies – will also present some unique investment opportunities to invest in distressed businesses.

In a distressed context, there are four principal strategies to achieve ownership: a negotiated distressed sale conducted outside of a formal insolvency process; a negotiated sale through a pre-packaged insolvency procedure, such as a scheme of arrangement; a purchase out of a judicial insolvency process, such as a scheme of arrangement, administration or liquidation; and a loan-to-own strategic purchase of debt as a path to obtaining control. This article discusses these strategies below and introduces the key issues, opportunities and obstacles associated with each of them. Originally published by IFLR on April 23, 2020.
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The U.S. Department of Commerce, Bureau of Industry and Security (“BIS”) is moving forward with long-anticipated efforts to further restrict trade in a large number of sensitive technologies. Though the rules ostensibly apply to a number of countries, they are particularly focused on China and, as such, will have a significant impact on global supply chains that link the United States and China for years to come. While aspects of the new rules reflect the United States’ longstanding restrictions on exports in support of the Chinese military, they also advance several more recent Trump Administration national security and foreign policy priorities.

With broad Congressional support, the Trump Administration has significantly expanded restrictions on all facets of trade with China over the last several years. Using a wide array of tools, the U.S. Government has (1) increased its scrutiny of Chinese investment in the United States and associated technology transfers to China under the Committee on Foreign Investment in the United States’ (“CFIUS”) review process, (2) discouraged the import of Chinese goods through the imposition of new tariffs, (3) prohibited U.S. Government procurement of telecommunications and security technology from several major Chinese companies, and (4) engaged in efforts to dissuade U.S. allies from partnering with Huawei and other Chinese telecommunications providers in the development and deployment of 5G networks. The Departments of Justice and Commerce have also brought sweeping enforcement actions against some of China’s most significant companies, which combine criminal and civil enforcement with potent export controls, such as the BIS’s sweeping export restrictions on Huawei and many of its affiliates.

BIS’s actions this past week further expand U.S. export controls in an effort to address the U.S. government’s increasing concerns regarding overlap between China’s economic and military programs.

Expanding Restrictions on Exports for Military End Uses or to Military End Users

BIS’s announced rule changes are only the latest steps in a series of moves set in motion by the enactment of the Export Controls Reform Act of 2018 (“ECRA”). Through ECRA, Congress expressed concern about the strength of U.S. trade controls concerning China, and required an interagency review of the U.S. arms embargo and controls on exports of dual use items for military end uses and end users. The regulatory changes stemming from this review were due to be released in May 2019, but were likely delayed as BIS officials juggled other ECRA and Administration priorities, including the identification of new controls on emerging and foundational technologies and weighing how new rules focused on military end users would impact the broader U.S.-China trade dispute and the Trump administration’s on-again-off-again trade negotiations with China.

The United States has had a decades-long embargo in place on the export of military items to China. The United States last expanded these restrictions in 2007 to prohibit the export to China of certain dual-use items—items with both civil and military applications—that are intended for a “military end use.” In the most substantial change announced this past week, BIS is imposing strict new licensing requirements, effective June 29, 2020, on the export of an expanded list of dual-use items when those items are exported for military end uses or end users in China, Russia, and Venezuela.

Specifically, the new rule strengthens the controls on exports to these jurisdictions by:

Expanding the definition of “military end uses” for which exports must be authorized;
Adding a new license requirement for exports to Chinese “military end users”;
Expanding the list of products to which these license requirements apply; and
Broadening the reporting requirement for exports to China, Russia, and Venezuela.

Expanding Military End Uses Subject to Control

Exporters of certain goods, software, or technology that are subject to the Export Administration Regulations (“EAR”)[1] currently require a license from BIS to provide those items to China, Russia, or Venezuela if the exporters know or have reason to know that the items are intended, entirely or in part, for a “military end use” in those countries. Under this license requirement, “military end use” is defined to include the “use,” “development,” or “production” of certain military items. An export is considered to be for the “use” of a military item if the export is for the operation, installation, maintenance, repair, overhaul and refurbishing of the military item. The exported item must perform all six functions in order to be considered a “use” item subject to the military end use restriction.

The new rule expands the definition of “military end use” in two important ways. Where the current formulation only captures items exported for the purpose of using, developing, or producing military items, the revised rule also captures items that merely “support or contribute to” those functions. The revised rule also effectively broadens the definition of “use.” Rather than requiring that an item perform all six previously listed functions, an item that supports or contributes to any one of those functions will now be subject to the military end use license requirement. For example, a repair part for a military item that might not have required a license under the previous formulation (perhaps because it was not also required for the military item’s installation) would be subject to the updated license requirement.

Restricting Exports to Chinese Military End Users

Under the current regulations, exports to military end users in Russia and Venezuela are subject to a specific license requirement. The revised rule will also require licenses for exports of covered items to Chinese military end users.

Military end users covered by this license requirement not only include national armed services, police, and intelligence services, but also include “any person or entity whose actions or functions are intended to support ‘military end uses.’” Taken together with the newly broadened definition of “military end uses,” this restriction could apply to a significant number of private entities in China, even those that are engaged largely in civilian activities. For example, a manufacturing company that has a single, unrelated contract with a military entity could be considered a “military end user” subject to these strict licensing requirements. Given that applications for BIS licenses to export covered items for military end uses or end users face a presumption of denial, this restriction could have a significant impact on large swaths of the Chinese economy, where the U.S. government has indicated its concerns about military-civilian collaboration in Chinese industry.

Expanding the List of Covered Items

The updated rule also expands the category of goods, software, or technology that require a license for military end use or end user exports. The current license requirement applies to a relatively limited set of items specifically described in a supplement to the rule. The revised rule will expand the scope of the item categories already listed and add many new categories of covered items—including goods, technology, and software relating to materials processing, electronics, telecommunications, information security, sensors and lasers, and propulsion.

Many of the new items are currently subject to some of the EAR’s most permissive controls and, at this time, do not generally require a license for export to China, Russia, or Venezuela. For example, mass market encryption items—a category which includes many types of software that incorporate or call on common encryption functionality—are not currently subject to the military end use restrictions but will be added pursuant to this week’s revision.

Broadening the Reporting Requirement

BIS will also be requiring exporters to report more often and to provide more data on items provided to China, Russia, or Venezuela.

Under the current rules, exporters are not required to provide Electronic Export Information (“EEI”) for shipments valued under $2,500. Exporters also are not required to provide the Export Control Classification Number (“ECCN”) for shipments of items that are only controlled for export because of antiterrorism concerns—the most permissive and most frequently applied category of control on the EAR’s list of items controlled for export.

Under the new rules, there will be no value threshold. EEI will generally be required for all shipments to China, Russia, or Venezuela, regardless of value. Moreover, exporters will be required to provide the ECCNs for all items exported to China, Russia, or Venezuela, regardless of the reason for control.

In announcing this change, Commerce Secretary Wilbur Ross noted that “[c]ertain entities in China, Russia, and Venezuela have sought to circumvent America’s export controls, and undermine American interests in general.” Secretary Ross vowed that the United States would “remain vigilant to ensure U.S. technology does not get into the wrong hands.” This amendment to the EEI reporting requirements is designed to ensure that BIS and other U.S. Government trade enforcement agencies have increased visibility into shipments to jurisdictions of significant concern.

Removing the License Exception for Civilian End Uses

BIS also announced that it will remove License Exception Civil End Users (“CIV”) from Part 740 of the EAR. This exception currently allows eligible items controlled only for National Security (NS) reasons to be exported or reexported without a license for civil end users and civil end uses in countries included in Country Group D:1, excluding North Korea. NS controls are BIS’s second most frequently applied type of control, applying to a wide range of items listed in all categories of the Commerce Control List (“CCL”). Country Group D:1 identifies countries of national security concern for which the Commerce Department will review proposed exports for potential contribution to the destination country’s military capability. D:1 countries include China, Russia, Ukraine, and Venezuela, among others.

By removing License Exception CIV, the Commerce Department will now require a license for the export of items subject to the EAR and controlled for NS reasons to D:1 countries. As with the expansion of the military end use/end user license requirements described above, the Commerce Department has stated that the reason for the removal of License Exception CIV is the increasing integration of civilian and military technological development pursued by countries identified in Country Group D:1, making it difficult for exporters or the U.S. government to be sufficiently assured that U.S.-origin items exported for apparent civil end uses will not actually also be used to enhance the military capacity contrary to U.S. national security interests.

Proposing the Expansion of License Requirements for Reexports

The third change is a proposed amendment to the EAR’s License Exception Additional Permissive Reexports (“APR”). License Exception APR currently allows the unlicensed reexport (the export of a U.S.-origin item from one non-U.S. country to another non-U.S. country) of an item subject to the EAR from trusted allies with similar export control regimes (i.e., listed in Country Group A:1, and Hong Kong) to countries presenting national security concerns (i.e., Country Group D:1, except North Korea). To be eligible for the exception, the reexport must also be consistent with the export licensing policy of the reexporting country and the item must be subject to only a subset of other controls (i.e., controlled only for antiterrorism, national security, or regional security reasons), among other limitations. The reexporting countries identified in Country Group A:1 include those countries that are participants with the United States in the Wassenaar Arrangement, a multilateral consortium that develops export controls on conventional weapons and dual-use items and underlies much of the U.S. export control regime. BIS’s proposed amendment would remove this portion of the license exception.

The Commerce Department explained that it has proposed this amendment because of concerns regarding variations in how the United States and its international partners, including those in Country Group A:1, perceive the threat caused by the policy of civil-military technological integration pursued by D:1 countries. Due to these disparities, reexports under License Exception APR have occurred that would not have been licensed by BIS if the export had taken place directly from the United States.

This proposed rule change echoes recent changes affecting the scope of investment reviews by CFIUS, by which the United States has similarly sought to incentivize foreign allies to harmonize their national security-related measures with those of the United States. In the new CFIUS rules implemented in February and previously described here, the Committee will require “excepted foreign states” to ensure their national security-based foreign investment review process meets requirements established by CFIUS in order to retain their excepted status.

How Will the New Rules Impact U.S.-China Trade and Global Supply Chains?

The removal of the CIV license exception, the imposition of new controls on military end uses and military end users in China, and the proposed modification of the APR license exception, taken together, will have significant and far-reaching impacts on U.S.-China trade and global supply chains that include many kinds of U.S. origin commodities, software and technology.

Upstream Suppliers to Chinese Companies

For upstream suppliers to Chinese companies (and their Russian and Venezuelan counterparts), enhanced due diligence to determine whether items to be supplied are destined to military end users or will be put to military end uses will become the norm. Not only will exporters, reexporters, and those transferring items subject to export controls need to better know their proposed customers and how their customers intend to use their products through front-end diligence, if possible military end use and end user concerns are identified, exporters can expect BIS to ask probing follow-up questions regarding customers and end users identified in license applications.

The diligence required to monitor for military end use will not end with the sale of many items. Especially for products that are provided with aftermarket service or warranties, companies will need to consider how to train those business personnel with continued contacts with Chinese, Russian and Venezuelan counterparties to monitor for potential diversion to military end use. Moreover, diligence will not necessarily be limited to the supply of items to subject to the EAR to China, Russia and Venezuela. For example, to the extent China-owned companies or joint ventures in Europe or elsewhere place orders for items subject to the EAR, BIS’s new diligence and licensing requirements will apply to those transactions as well.

License Application Processing and Delay

The removal of License Exception CIV and proposed changes to License Exception APR will also introduce new trade compliance resource burdens on companies that continue to do business with China and delays and uncertainty into supplier transactions and relationships. Companies that have made significant use of CIV in the past will now need to allocate additional labor to the preparation of license applications, and many non-U.S. companies that source items from U.S. suppliers will need to devote resources to learning how to prepare and file re-export and transfer license requests with BIS. Even if BIS has developed a plan to increase the staffing available to process these license applications, the interagency review of license applications can easily introduce months of delay to planned transactions. Especially for companies that have shifted to just-in-time production models, delays of even a few days can scuttle proposed business. Global suppliers may be faced with the hard choice of continuing to source commodities, technology and software from the U.S. for products destined for China and D:1 country markets, or switching out U.S. for non-U.S. content in order to avoid this type of supply chain disruption.

Downstream Customers of Chinese Companies

At least in the short term, BIS’s rule changes are also likely to have an impact on companies that source products from Chinese suppliers. To the extent the Chinese suppliers might be identified as military end users, or may not provide the kinds of information that will be required to continue receiving items subject to the EAR under a license requirement, these suppliers may lose access to key commodities, software and technology that they require for their own products. Until Chinese suppliers design-out U.S.-origin content or provide their U.S. suppliers with the additional information required to obtain licenses for their supply transactions, their own customers are likely to experience delay and disruption in their receipt of items with U.S.-controlled content.

Fragmentation of Non-U.S. Export Control Regimes and Trade Relationships

Although BIS’s proposed changes to the APR license exception are still only proposed, the frequent use by the Trump Administration of other trade tools to leverage changes by U.S. trade partners in other areas of trade policy provides a glimpse of the potentially divergent paths that responses to this sort of selective leveraging might take. In essence, the changes to the APR rules will force other Wassenaar Arrangement countries to decide whether to impose more stringent licensing requirements on proposed reexports to China, or impose new transaction costs on their own companies associated with supply transactions that could now require transaction-by-transaction licensing. Depending on the strength (and dependence) of their own trade ties with China or other D:1 countries, these countries may be more or less willing to follow the United States’ lead toward stricter trade controls. Over time, this could lead to greater fragmentation in the international trade system and a realignment of global trade in the sensitive technologies current licensed by APR both toward and away from the United States and China. Especially given the longer-term impacts that APR may have on U.S., EU, UK, and other Wassenaar Arrangement participants’ trade arrangements with the U.S., companies straddling the trade controls regimes of these countries should consider providing comments to BIS’ proposed rule, which are due by June 29, 2020.

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[1] Including all items located in the United States, all U.S. origin items wherever located, foreign-made items incorporating, bundled with, or comingled with any amount of certain controlled content or more than a minimal amount of other controlled U.S.-origin content, and certain foreign-made items that are direct products of U.S. technology or software.

The following Gibson Dunn lawyers assisted in preparing this client update: Judith Alison Lee, Chris Timura, R.L. Pratt, Samantha Sewall, Laura Cole and Josh Suo Zhang.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the above developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s International Trade practice group:

United States:
Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, [email protected])
Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, [email protected])
Jose W. Fernandez – New York (+1 212-351-2376, [email protected])
Marcellus A. McRae – Los Angeles (+1 213-229-7675, [email protected])
Adam M. Smith – Washington, D.C. (+1 202-887-3547, [email protected])
Stephanie L. Connor – Washington, D.C. (+1 202-955-8586, [email protected])
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, [email protected])
Ben K. Belair – Washington, D.C. (+1 202-887-3743, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, [email protected])
Laura R. Cole – Washington, D.C. (+1 202-887-3787, [email protected])
R.L. Pratt – Washington, D.C. (+1 202-887-3785, [email protected])
Samantha Sewall – Washington, D.C. (+1 202-887-3509, [email protected])
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, [email protected])
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, [email protected])
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, [email protected])

Europe:
Peter Alexiadis – Brussels (+32 2 554 72 00, [email protected])
Nicolas Autet – Paris (+33 1 56 43 13 00, [email protected])
Attila Borsos – Brussels (+32 2 554 72 10, [email protected])
Patrick Doris – London (+44 (0)207 071 4276, [email protected])
Sacha Harber-Kelly – London (+44 20 7071 4205, [email protected])
Penny Madden – London (+44 (0)20 7071 4226, [email protected])
Steve Melrose – London (+44 (0)20 7071 4219, [email protected])
Benno Schwarz – Munich (+49 89 189 33 110, [email protected])
Michael Walther – Munich (+49 89 189 33-180, [email protected])
Richard W. Roeder – Munich (+49 89 189 33-160, [email protected])

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.

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])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

I. Overview

In recent weeks, legal commentators have predicted that employers will face an “explosion” of employee lawsuits for tort claims relating to the COVID-19 pandemic.[1] As non-essential businesses begin to develop plans for reopening—and essential businesses continue to navigate the unprecedented challenge of remaining operational during a pandemic—employers worry that one wrong step might expose them to sweeping legal liability. Perhaps most concerning for employers is the specter of class action lawsuits alleging that unsafe workplaces have caused employees to contract COVID-19 or left them at heightened risk of exposure, which the U.S. Chamber of Commerce considers to be possibly the “largest area of concern for the overall business community.”[2]

While many employee lawsuits can be expected, employers likely have statutory defenses that mitigate the risk of liability in these lawsuits. Specifically, assuming COVID-19 is a covered occupational disease or injury, most tort claims for monetary damages filed by employees against their employers should be barred by applicable workers’ compensation statutes. Employers should, however, be aware of the limitations and exceptions under applicable workers’ compensation statutes. Those statutes vary state by state, and while a 50-state survey is beyond the scope of this alert, we focus here on relevant principles from the workers’ compensation statutory schemes in three of the most populous states: New York, California and Texas.

In addition, while beyond the scope of this alert, there are many inherent challenges for employees to adequately allege or prove causation in these COVID-19 exposure cases.[3] Proof of causation will necessarily require an individualized examination of workplace interactions and alternative sources of exposure; in light of the risks of contraction virtually anywhere—from restaurants, to elevators, to mass transit—the employee’s ability to sufficiently identify the workplace as the source of exposure defies credulity in most circumstances. And, that individualized assessment of causation and the myriad sources of exposure to COVID-19 likely would doom any putative class action as well.[4] It is important to note that, given these causation challenges, some states have already proposed or enacted legislation providing a presumption of causation that certain first responders contracted COVID-19 if exposed in the course of their employment.

Any “explosion” of COVID-19 exposure suits will impose substantial costs on employers in defending these lawsuits, even if they are meritless. For that reason, both the U.S. Chamber of Commerce and Senate Majority Leader Mitch McConnell have called for federal legislation to shield businesses from exposure liability.[5]

II. Recently Filed Workplace Safety Lawsuits

A number of lawsuits seeking relief for alleged exposure to COVID-19 have already been filed by employees against employer-defendants.[6] Wrongful death claims have also been filed against decedents’ employers for deaths related to COVID-19 infections allegedly contracted in the workplace. In another suit, a group of employees seeks to recover damages against a temporary staffing agency for allegedly misleading nurses to work in unsafe environments and providing negligent care.[7] While many of these suits allege negligence and breaches of various standards of care, some employees, such as unionized employees, seek damages or injunctive relief based on breach of contract theories.[8]

In addition, a number of suits do not seek compensatory damages, but instead seek injunctive relief from employers to ensure a safe working environment.[9] While such cases may not raise the same financial exposure for employers, they can be disruptive and burdensome to businesses, which could be forced to defend company policies in court or be subjected to injunctions mandating specific and expensive workplace protocols.

Based on a survey of these and other recently filed cases, the potential theories of liability against employers include: (1) failure to properly screen employees for COVID-19; (2) failure to protect employees from other symptomatic (or asymptomatic) persons; (3) failure to cleanse and sanitize the workspace; (4) failure to provide personal protective equipment; (5) failure to implement a social distancing policy; (6) failure to implement a telework or work-from-home policy; and/or (7) failure to implement various government guidelines.[10]

While some complaints allege that employers have a freestanding duty to take some or all of the above steps, the tort claims are often tied to alleged violations by the employer of federal and state recommendations, mandates, guidelines, and regulations regarding employee safety. For example, the Occupational Safety and Health Administration (“OSHA”), like many other government agencies, has posted recommendations and guidance applicable in certain settings to the COVID-19 health crisis. OSHA has also identified what it considers to be relevant pre-existing OSHA standards and regulations applicable to the COVID-19 pandemic on its website.[11] These standards include: (1) OSHA’s Personal Protective Equipment (PPE) standards; (2) the General Duty Clause, requiring employers to furnish “employment and a place of employment, which are free from recognized hazards that are causing or are likely to cause death or serious physical harm”; and (3) the Recordkeeping and Reporting Occupational Injuries and Illness Requirement.[12] Employers should pay careful attention to applicable federal and state standards and recommendations as appropriate to best protect their employees, to avoid the risk of regulatory investigations or actions, and to minimize the risk that violations of these standards be used as evidence of negligence.[13]

III. Protections for Employers Under Workers’ Compensation Statutes

A. Scope of Workers’ Compensation

Although a number of lawsuits have been filed against employers for exposure to COVID-19, most lawsuits for monetary damages relating to workplace-contracted illness should be barred by the applicable state’s workers’ compensation statute if COVID-19 is considered an occupational injury or illness. Even if it meets this definition, however, plaintiffs in recent suits are exploring a variety of creative approaches in an effort to circumvent the usual workers’ compensation bar on such claims.

Workers’ compensation is a state-operated insurance scheme designed to allow workers to be compensated for injuries suffered in the course of employment through an administrative process without regard to fault. In New York, employees can receive workers’ compensation for “accidental injuries arising out of and in the course of employment and such disease or infection as may naturally and unavoidably result therefrom,”[14] or for occupational diseases, which are diseases “resulting from the nature of employment and contracted therein.”[15] Thus, mere exposure to the COVID-19 virus without infection would not result in a compensable workers’ compensation claim. However, a mental injury caused by psychic trauma “is generally compensable to the same extent as a physical injury,”[16] and plaintiffs may claim that the risk from exposure resulted in such trauma.

But even a disease that is not considered to be an occupational disease under New York law may constitute an accidental injury covered by workers’ compensation if the “inception of the disease [is] assignable to a determinate or single act, identified in space or time” and is also “assignable to something catastrophic or extraordinary.”[17] The New York Court of Appeals has upheld compensation awards for a tuberculosis infection based on a correctional officer’s exposure to a sick inmate[18] and aggravated bronchial asthma based on exposure to excessive amounts of secondhand cigarette smoke.[19]

In contrast to New York, some workers’ compensation statutes define occupational diseases to exclude ailments like the flu or common cold. In Texas, for example, an occupational disease includes “a disease or infection that naturally results from the work-related disease,” but “does not include an ordinary disease of life to which the general public is exposed outside of employment unless that disease is an incident to a compensable injury or occupational disease.”[20] It remains to be seen whether COVID-19 will be considered an ordinary disease of life. Moreover, despite this ordinary disease exception, Texas courts have allowed “recovery for pneumonia, tuberculosis, and other respiratory diseases which follow as the result of sudden, accidental inhalation of heavy volumes and concentrations of noxious gases . . . or other foreign substances which cause damage to the lungs,” even as they have rejected recovery for “illnesses like cold, sore throat, and pneumonia” from exposure to the elements clearly traceable to work conditions.[21] And to the extent that an employee attempts to avoid the workers’ compensation bar by arguing that COVID-19 is a common disease of life, such an argument would make causation difficult to establish in a lawsuit attempting to hold an employer liable for an infection.

In California, an illness is not an occupational disease solely because it was contracted after exposure at work; the illness “must be one commonly regarded as natural to, inhering in, an incident and concomitant of, the work in question.”[22] While not a model of clarity, it is generally understood that “if the employment subjects the employee to an increased risk [of contracting the disease] compared to that of the general public, the injury is compensable.”[23]

These are fact-specific standards, and courts have yet to decide whether COVID-19 is covered by applicable workers’ compensation statutes. Employers should be mindful of the possibility that, as a result, states may issue more specific guidance or legislate with respect to the availability of workers’ compensation to employees who contract COVID-19. Some states have already proposed or enacted legislation providing a presumption of workers’ compensation coverage for certain categories of workers who contract COVID-19. For example, Alaska has passed a law stating that infected firefighters, medical first responders, and peace officers are “conclusively presumed to have contracted an occupational disease” if exposed to COVID-19 in the course of their employment.[24] Minnesota has similarly passed a presumptive occupational disease law for COVID-19 infections by health care workers, law enforcement officers, and child care providers to first responders and health care workers.[25] Wisconsin has passed a law stating that a first responder’s injury caused by COVID-19 after the employee was exposed to someone with a confirmed case of COVID-19 in the course of employment is presumed to be an injury caused by employment.[26]

On the administrative front, some state agencies have issued sweeping pronouncements ensuring that first responders who contract COVID-19 are presumptively covered by workers’ compensation.[27] By contrast, some states like New York have been more incremental in their guidance. The Chair of New York’s Workers’ Compensation Board has issued guidance encouraging employees who develop COVID-19 during the course of their employment to file claims, and further encouraging insurance carriers to issue payments pursuant to New York Workers Compensation Law § 21-a—which allows payment of a claim without an initial admission of liability—instead of disputing the claim. [28] The California Department of Insurance, meanwhile, has scheduled a public hearing to entertain a regulatory filing from the Workers’ Compensation Insurance Rating Bureau of California (WCIRB), a nonprofit association of insurers, that would exclude COVID-19 claims from an employer’s experience rating.[29]

B. The Workers’ Compensation Bar

To the extent that COVID-19 is considered an occupational injury covered by the workers’ compensation statutes, any tort claim for compensatory damages asserted directly by an employee against her employer, either in an individual capacity or on behalf of a class of employees, is likely to be barred.

Designed to ease the process for dealing with workplace injuries by providing compensation without a liability finding, workers’ compensation is generally the exclusive remedy to an injured employee—meaning that the employee cannot maintain a separate, private tort suit against an employer based on a workplace injury. With some limited exceptions, most employers are required to provide their employees with workers’ compensation coverage.[30] Texas, however, does not require employers to provide workers’ compensation coverage.[31] Texas employers who do not provide coverage, “non-subscribers,” are subject to personal injury lawsuits for workplace injuries and do not benefit from typical tort defenses such as assumption of the risk, contributory negligence, and co-worker negligence.[32]

In New York, an employer’s liability under the workers’ compensation law is “exclusive and in place of any other liability” to an employee, the employee’s representative, or any person otherwise entitled to recover damages, contribution, or indemnity on account of an employee’s injury or death.[33] This exclusive remedy bar also applies when an “employee is injured or killed by the negligence or wrong of another in the same employ . . . .”[34] The exclusive remedy bar also prevents recovery by an employee who has received workers’ compensation benefits from a general employer, but then seeks to recover from a special employer to whom the employee was assigned to work by the general employer.[35] This might be relevant, for example, where a business (the special employer) retains dedicated contractors (such as a cleaning staff) that the business controls but are procured through a separate company (the general employer) in charge of hiring and payroll. The exclusive remedy bar can also be raised as a defense to claims brought on behalf of a putative class of employees.[36]

Some plaintiffs may attempt to avoid the workers’ compensation bar by asserting claims on behalf of the public at large, such as the public nuisance claim asserted in one recent COVID-19-exposure lawsuit.[37] Some courts, however, have concluded that such a claim is an improper effort to circumvent the workers’ compensation bar.[38] And there are other challenges employees would face in asserting a public nuisance claim. “A public nuisance is a violation against the State,”[39] so to bring a private action to abate a public nuisance, the person seeking relief must suffer special injury beyond that suffered by the community at large; this injury must be different in kind, rather than different only in degree.[40] An employee may have difficulty in showing such special injury distinct from the risk to the community in a COVID-19-related lawsuit.[41]

IV. Limits of the Workers’ Compensation Bar

Although workers’ compensation schemes generally establish exclusive remedies for employee injury and illness claims against employers, each jurisdiction has particular exceptions that allow workers to maintain individual tort suits against employers. For example, a common exception to the exclusive remedy rule is an employer’s intentional conduct toward employees. In addition, while the bar generally protects employers from liability for direct employee claims, employers may face exposure from claims brought by third parties whom the employee sues, as well as from nonemployees (such as independent contractors and vendors) or customers who enter the workplace.

A. Exceptions for Intentional Torts/Fraudulent Concealment

In New York, the “exclusive remedy doctrine bars an employee from bringing a negligence- or gross negligence-based claim against an employer and the employer’s agent.”[42] One narrow exception to the workers’ compensation bar applies when an employer commits an intentional tort: “[w]hen it has been determined that a plaintiff’s injury is the result of an intentional and deliberate act by the defendant or someone acting on his behalf, the defendant is not entitled to such immunity.”[43] To establish an intentional tort, “the conduct must be engaged in with the desire to bring about the consequences of the act; a mere knowledge and appreciation of a risk is not the same as the intent to cause injury[.]”[44] As such, an employer’s failure to warn of dangers in the workplace will not be considered an intentional tort,[45] and it will be very difficult for an employee to establish that an employer deliberately exposed him or her to COVID-19 with an intention to infect the employee.

While New York has a narrow exception to the exclusive remedy doctrine, other states have broader exceptions that may be implicated in COVID-19 lawsuits. In California, for example, an employee may overcome the exclusive remedy bar 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[.]”[46] This exception refers to an employer’s concealment of knowledge that an employee has contracted a disease from conditions of work.[47] However, “conflating knowledge of exposure with knowledge of injury . . . is insufficient to support a [concealment] claim as a matter of law.”[48]

And in Texas, gross negligence is an exception to the worker’s compensation bar where suit is brought by the surviving spouse or heirs of an employee who suffers a fatal workplace injury.[49] But gross negligence is not sufficient to allow an employee himself to maintain a separate tort suit.[50] As a result, there is the possibility of tort suits being brought by surviving spouses in Texas, even if COVID-19 were considered an occupational injury covered by Texas’s workers’ compensation statutes.

B. Lack of Coverage for Third-Party Suits

Although New York’s exclusive remedy provision prevents direct tort suits by employees against their employers, there are additional litigation risks involving third parties of which employers must be aware.

An employer may be liable for contribution or indemnity to a third party for any “grave injuries” sustained by an employee for which the third party is held liable, with “grave injury” defined as death, permanent loss of use or amputation of a body part, blindness, and deafness.[51] This may arise where, for example, an employee sues the owner of the property where the employer’s offices are located and then the property owner impleads the employer for indemnity or contribution.[52] Workers’ compensation laws would not bar tenants’ employees from asserting tort claims against the property owners; in the COVID-19 context, such lawsuits may attempt to impose liability for a property owner’s failure to inspect, clean, or sterilize a building and failure to implement procedures to prevent the spread of COVID-19. Property owners that are or should be aware of dangerous conditions in communal spaces such as lobbies, stairwells, or elevators, but fail to exercise reasonable care to prevent injuries in those spaces, may be subject to suit.[53]

Additionally, non-employees, such as independent contractors,[54] are not covered by workers’ compensation and would thus not be subject to the workers’ compensation bar. But, as noted previously, certain workers who are loaned to a “special” employer from a separate “general” employer to perform on behalf of the special employer and subject to the special employer’s control are covered by workers’ compensation and are barred from asserting tort suits against whichever employer was not responsible for workers’ compensation coverage.[55] Employers should evaluate whether dedicated contractors, such as a cleaning staff retained from another employer, are special employees subject to the exclusive remedy bar.

* * *

In sum, while the applicability of workers’ compensation statutes to COVID-19-related claims varies from state to state—and can quickly change even within those states, as legislators and regulators continue to respond to the pandemic—there is good reason to believe that, assuming COVID-19 is a covered occupational disease, most employers will be able to rely on workers’ compensation statutes to avoid direct liability to employees for monetary damages.

Employers should nevertheless take affirmative steps now to protect their employees and minimize their potential liability. To that end, the best factual defense to any potential employee or class action lawsuit alleging claims related to COVID-19 exposure is to develop appropriate procedures to address the risk of COVID-19 in the workplace,[56] paying attention to applicable guidance from OSHA, the CDC and state or local officials. Such preventative steps may help evidence that an employer satisfied any alleged duty of reasonable care,[57] and may also help discourage lawsuits seeking prospective relief. Moreover, alleged failures to address COVID-19-related risks can subject employers to scrutiny by regulators.[58]

____________________

[1] See, e.g., Amanda Bronstad, Lawyers Predict a ‘Huge Explosion’ in Worker Class Actions Over COVID-19, Law.com (Apr. 16, 2020), https://www.law.com/2020/04/16/lawyers-predict-a-huge-explosion-in-worker-class-actions-over-covid-19/.

[2] U.S. Chamber of Commerce, “Implementing a National Return to Work Plan” (Apr. 13, 2020), available at https://www.uschamber.com/coronavirus/implementing-national-return-to-work-plan?utm_source=email&utm_medium=enl&utm_campaign=laboroflaw&utm_‌content‌=20200416&utm_term=law#liability.

[3] Gibson Dunn has discussed standard of care and causation issues related to COVID-19-based lawsuits in more depth in a separate Client Alert. See Gibson Dunn’s May 4, 2020 Client Alert, COVID-19 and Personal Injury Tort Liability: Preliminary Considerations for Businesses, available at https://www.gibsondunn.com/covid-19-and-personal-injury-tort-liability-preliminary-considerations-for-businesses.

[4] See, e.g., In re Methyl Tertiary Butyl Ether (“MTBE”) Prods. Liab. Litig., 209 F.R.D. 323, 349 (S.D.N.Y. 2002) (noting that “[Federal Rule of Civil Procedure] 23(b)(3) requires that common issues predominate,” and aggregating examples where courts denied class certification because of individualized issues of fact).

[5] Andrew Kragie, McConnell Wants Broad Liability Shield in Next COVID-19 Bill, Law360 (Apr. 27, 2020), https://www.law360.com/articles/1267837/; U.S. Chamber of Commerce, “Implementing a National Return to Work Plan” (Apr. 13, 2020), available at https://www.uschamber.com/coronavirus/implementing-national-return-to-work-plan?utm_source=email&utm_medium=enl&utm_campaign=laboroflaw&utm_‌content‌=20200416&utm_term=law#liability.

[6] In addition to COVID-19 exposure claims, employers are facing and will likely continue to face claims under the WARN Act and wage and hour, discrimination, leave, whistleblower protection and other laws relating to actions taken in response to the pandemic.

[7] Allen v. Krucial Staffing, LLC, No. 20-cv-2859 (S.D.N.Y. Apr. 6, 2020).

[8] N.Y. State Nurses Ass’n v. Montefiore Med. Ctr., No. 20-cv-03122 (S.D.N.Y. Apr. 20, 2020). On May 1, 2020, the district court dismissed the New York State Nurses Association’s claim, finding that the court did not have subject-matter jurisdiction to grant injunctive relief pending the parties’ arbitration. See id. at ECF No. 33.

[9] See, e.g., Rural Cmty. Workers Ass’n v. Smithfield Foods, Inc., No. 5:20-cv-06063 (W.D. Mo. Apr. 23, 2020) (asserting a public nuisance claim and seeking declaratory and injunctive relief against an essential business for alleged failure to comply with basic health and safety standards); Corr. Officers’ Benevolent Ass’n, Inc. v. City of New York, No. 704991/2020 (N.Y. Sup. Ct. Queens Cty. Apr. 2, 2020) (correction officers’ seeking injunctive relief); N.Y. State Nurses Ass’n v. Montefiore Med. Ctr., No. 20-cv-03122 (S.D.N.Y. Apr. 20, 2020) (nurses’ union seeking injunctive relief).

[10] See supra notes 7–10.

[11] See OSHA, COVID-19 Standards, https://www.osha.gov/SLTC/covid-19/standards.html; Guidance on Preparing Workplaces for COVID-19, OSHA 3990-03 2020, https://www.osha.gov/Publications/OSHA3990.pdf.

[12] See, e.g., OSHA, Enforcement Guidance for Recording Cases of Coronavirus Disease 2019 (COVID-19), https://www.osha.gov/memos/2020-04-10/enforcement-guidance-recording-cases-coronavirus-disease-2019-covid-19.

[13] See, e.g., Albrecht v. Balt. & Ohio R. Co., 808 F.2d 329, 332 (4th Cir. 1987) (“In a negligence action, regulations promulgated under . . . [OSHA] provide evidence of the standard of care exacted of employers, but they neither create an implied cause of action nor establish negligence per se.”); Ries v. Nat’l RR Passenger Corp., 960 F.2d 1156, 1164 (3d Cir. 1992) (“[V]iolation of the OSHA regulation was properly admissible as evidence of Amtrak’s negligence”).

[14] N.Y. Workers’ Comp. § 2(7).

[15] N.Y. Workers’ Comp. §§ 2(15), 3(2-30).

[16] DePaoli v. Great A & P Tea Co., 725 N.E.2d 1089, 1090 (N.Y. 2000) (citing Wolfe v. Sibley, Lindsay & Curr Co., 330 N.E.2d 603, 606 (N.Y. 1975) (“[P]sychological or nervous injury precipitated by psychic trauma is compensable to the same extent as physical injury.”); see also Kraus v. Wegmans Food Mkts., Inc., 67 N.Y.S.3d 702, 706 (3d Dep’t 2017) (“For a mental injury premised on work-related stress to be compensable, ‘a claimant must demonstrate that the stress that caused the claimed mental injury was greater than that which other similarly situated workers experienced in the normal work environment.’”) (citation omitted).

[17] Lerner v. Rump Bros., 149 N.E. 334, 335 (N.Y. 1925).

[18] Middleton v. Coxsackie Corr. Facility, 341 N.E.2d 527, 531 (N.Y. 1975).

[19] Johannesen v. New York City Dep’t of Hous. Pres. & Dev., 638 N.E.2d 981 (N.Y. 1994).

[20] Tex. Lab. Code Ann. § 401.011(34).

[21] Bewley v. Texas Employers Ins. Ass’n, 568 S.W.2d 208, 210 (Tex. Civ. App. 1978).

[22] See LaTourette v. W.C.A.B., 951 P.2d 1184, 1189 (Cal. 1998) (citation omitted).

[23] Id. at 654 (citation omitted); see also S. Coast Framing, Inc. v. Workers’ Comp. Appeals Bd., 61 Cal. 4th 291, 301, 349 P.3d 141, 148 (2015) (“[I]t [is] enough that ‘ the employee’s risk of contracting the disease by virtue of the employment must be materially greater than that of the general public.’”) (citation omitted).

[24] Alaska Enrolled SB241 § 15, akleg.gov/PDF/31/Bills/SB0241Z.pdf.

[25] Minn. Stats. § 176.011(15)(f), https://www.revisor.mn.gov/laws/2020/0/72/laws.0.1.0#laws.0.1.0.

[26] Wis. Stat. § 102.03(6), https://docs.legis.wisconsin.gov/statutes/statutes/102.pdf.

[27] For example, the Illinois Workers Compensation Commission issued an Emergency Amendment that provides that an occupational disease or incapacity from exposure to COVID-19 “will be rebuttably presumed” to have arisen out of and in the course of a COVID-19 first responder or front-line worker’s employment and will be “rebuttably presumed” to be causally connected to that employment. 50 Ill. Adm. Code 9030, Amended by emergency rulemaking at 44 Ill. Reg. ______, effective April 16, 2020, for a maximum of 150 days, https://www2.illinois.gov/sites/iwcc/news/Documents/15APR20-Notice_of_Emergency_Amendments_CORRECTED-clean-50IAC9030_70.pdf

[28] Letter from Chair Rodriguez to Carriers and Payers of Workers’ Compensation, Apr. 15, 2020, http://www.wcb.ny.gov/content/main/TheBoard/WCB_COVID19_LtrtoCarriers.pdf.

[29] See Workers’ Compensation Insurance Rating Board, Hearing Date Set for July 1, 2020 Special Regulatory Filing (Apr. 21, 2020), https://www.wcirb.com/news/hearing-date-set-july-1-2020-special-regulatory-filing.

[30] For example, domestic workers working fewer than forty hours a week, members of the clergy, and municipal employees whose municipalities have not elected to participate in workers’ compensation are not covered. See N.Y. Workers’ Comp. § 3.

[31] Office of the Commissioner Representing Employers, Texas Workforce Commission, Especially for Texas Employers, Workers’ Compensation, available at https://www.twc.texas.gov/news/efte/workers_compensation.html.

[32] Id.

[33] N.Y. Workers’ Comp. § 11.

[34] N.Y. Workers’ Comp. § 29(6).

[35] Thompson v. Grumman Aerospace Corp., 585 N.E.2d 355 (N.Y. 1991).

[36] See In re Agent Orange Prod. Liab. Litig., 818 F.2d 210, 214 (2d Cir. 1987) (“Dismissal of all personal injury and related wrongful death claims against the Regents was required because the Hawaiian compensation statute provides the exclusive remedy against fellow employees for work-related injuries.”).

[37] See Rural Cmty. Workers Ass’n, supra note 10.

[38] Acevedo v. Consol. Edison Co. of New York, 596 N.Y.S.2d 68, 71 (1st Dep’t 1993).

[39] 532 Madison Ave. Gourmet Foods, Inc. v. Finlandia Ctr., Inc., 750 N.E.2d 1097, 1104 (N.Y. 2001).

[40] Agoglia v. Benepe, 924 N.Y.S.2d 428, 432 (2d Dep’t 2011); see also Trujillo v. Ametek, Inc., No. 3:15-CV-1394-GPC-BGS, 2015 WL 7313408, at *7 (S.D. Cal. Nov. 18, 2015) (“The general rule is that public nuisance actions must be brought by government officials. . . . However, a private party may bring a public nuisance action where the nuisance is ‘specially injurious’ to the private party, beyond the harm caused by the nuisance to the general public.”).

[41] See, e.g., Burns Jackson Miller Summit & Spitzer v. Lindner, 451 N.E.2d 459, 468–69 (N.Y. 1983) (dismissing nuisance claim by law firms seeking lost profit damages resulting from closure of transit system because harms caused by closure were so widespread all businesses suffered similar damage); Venuto v. Owens-Corning Fiberglass Corp., 22 Cal. App. 3d 116, 123–24 (1971) (rejecting public nuisance claim brought by plaintiffs who claimed that air pollution from a fiberglass manufacturing plant aggravated their respiratory disorders).

[42] Lauria v. Donahue, 438 F. Supp. 2d 131, 141 (E.D.N.Y. 2006).

[43] Id.; see also Gagliardi v. Trapp, 633 N.Y.S.2d 387, 388 (2d Dep’t 1995) (“[T]he defendants’ conduct amounted, at most, to gross negligence or reckless conduct. The plaintiff’s remedy for such a wrong is that provided in the Workers’ Compensation Law.”).

[44] Pereira v. St. Joseph’s Cemetery, 864 N.Y.S.2d 491, 492 (2d Dep’t 2008) (citations omitted).

[45] Forjan v. Leprino Foods, Inc., 209 F. App’x 8, 10 (2d Cir. 2006) (citing Acevedo, N.Y.S.2d at 68 (exception did not apply where employer had sent workers to clean up after an explosion without warning them of toxic asbestos); Briggs v. Pymm Thermometer Corp., 537 N.Y.S.2d 553 (2d Dep’t 1989) (exception did not apply where employer concealed and/or misrepresented the risk of toxic exposure to mercury, cleaning fluids and solvents).

[46] Cal. Lab. Code § 3602.

[47] Foster v. Xerox Corp., 707 P.2d 858 (Cal. 1985); see also Johns-Manville Prod. Corp. v. Superior Court, 612 P.2d 948 (Cal. 1980) (pre-dating the enactment of Cal Lab. Code § 3602) (“[I]f the complaint alleged only that plaintiff contracted the disease because defendant knew and concealed from him that his health was endangered by asbestos in the work environment, failed to supply adequate protective devices to avoid disease, and violated governmental regulations relating to dust levels at the plant, plaintiff’s only remedy would be to prosecute his claim under the workers’ compensation law.”).

[48] Rodriguez v. United Airlines, Inc., 5 F. Supp. 3d 1131, 1138-39 (N.D. Cal. 2013).

[49] Tex. Lab. Code Ann. § 408.001(b).

[50] Arnold v. Renken & Kuentz Transp. Co., 936 S.W.2d 57, 58 (Tex. App. 1996).

[51] N.Y. Workers’ Comp. § 11.

[52] See, e.g., Rubeis v. Aqua Club Inc., 821 N.E.2d 530 (N.Y. 2004) (allowing impleaded third-party complaints and awards against employers upon determining that plaintiffs had suffered from grave injuries).

[53] See, e.g., DiVetri v. ABM Janitorial Serv., Inc., 990 N.Y.S.2d 496, 496 (1st Dep’t 2014) (finding that owner of office building and the janitorial company contracted by the office building could be liable for the dangerous condition in the lobby that caused the plaintiff to slip and injure herself); Pintor v. 122 Water Realty, LLC, 933 N.Y.S.2d 679, 679 (1st Dep’t 2011).

[54] Commissioners of State Ins. Fund v. Fox Run Farms, Inc., 600 N.Y.S.2d 239, 239 (1st Dep’t 1993) (“[I]independent contractors are not employees covered by the Workers’ Compensation Law.”).

[55] Thompson v. Grumman Aerospace Corp., 585 N.E.2d 355 (N.Y. 1991).

[56] In a previous alert, Gibson Dunn outlined issues for companies to consider in implementing responses to COVID-19. See Gibson Dunn’s March 16, 2020 Client Alert, U.S. Employment Law Considerations for Companies Responding to COVID-19, available at https://www.gibsondunn.com/us-employment-law-considerations-for-companies-responding-to-covid-19/. Gibson Dunn has also outlined issues for companies to consider in planning how to bring employees back to work. See Gibson Dunn’s April 30, 2020 Webcast, Returning to Work: Health, Employment and Privacy Considerations and Constraints as Businesses Resume Post-Quarantine Operations in the U.S., available at https://www.gibsondunn.com/webcast-returning-to-work-health-employment-and-privacy-considerations-and-constraints-as-businesses-resume-post-quarantine-operations-in-the-u-s/.

[57] See supra Section II. There have also been calls to create specific safe-harbor provisions for businesses that comply with such guidelines. See, e.g., U.S. Chamber of Commerce, “Implementing a National Return to Work Plan” (Apr. 13, 2020), available at https://www.uschamber.com/coronavirus/implementing-national-return-to-work-plan?utm_source=email&utm_medium=enl&utm_campaign=laboroflaw&utm_‌content‌=20200416&utm_term=law#liability.

[58] See Rachel Abrams, Spectrum Employees Are Getting Sick Amid Debate Over Working From Home, The New York Times (Apr. 21, 2020), https://www.nytimes.com/2020/04/21/business/spectrum-employees-coronavirus.html.

This client update was prepared by Avi Weitzman, Lauren Elliot, Gabrielle Levin, Steven Spriggs*, Declan Conroy, Nina Meyer and Clifford Hwang.

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 Labor and Employment Group, or the following authors:

Avi Weitzman – New York (+1 212-351-2465, [email protected])
Lauren Elliot – New York (+1 212-351-3848, [email protected])
Gabrielle Levin – New York (+1 212-351-3901, [email protected])

* Not admitted to practice in New York; currently practicing under the supervision of Gibson, Dunn & Crutcher LLP.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

M&A practitioners are well aware of the several standards of review applied by Delaware courts in evaluating whether directors have complied with their fiduciary duties in the context of M&A transactions. Because the standard applied will often have a significant effect on the outcome of such evaluation, establishing processes to secure a more favorable standard of review is a significant part of Delaware M&A practice. The chart below identifies fact patterns common to Delaware M&A and provides a preliminary assessment of the likely standard of review applicable to transactions fitting such fact patterns. However, because the Delaware courts evaluate each transaction in light of the transaction’s particular set of facts and circumstances, and due to the evolving nature of the law in this area, this chart should not be treated as a definitive statement of the standard of review applicable to any particular transaction.

No.	Facts	Likely Standard of Review[2]
1.	Fully independent and disinterested [3] board of directors; no controlling stockholder [4]	Business judgment [5]
2.	Majority of board is independent and disinterested; no controlling stockholder	Business judgment [6]
3.	Board is evenly split between directors who are independent and disinterested and directors who are not independent and disinterested; no controlling stockholder	Entire fairness [7] Business judgment if transaction is approved by a properly functioning special committee [8] or a fully-informed, uncoerced stockholder vote [9]
4.	Majority of board is not independent and disinterested; no controlling stockholder	Entire fairness [10] Business judgment if transaction is approved by a properly functioning special committee [11] or a fully-informed, uncoerced stockholder vote [12]
5.	None of the board members is independent and disinterested; no controlling stockholder	Entire fairness [13] Business judgment if transaction is approved by a fully-informed, uncoerced stockholder vote [14]
6.	Transaction with a controlling stockholder where majority of the board is independent and disinterested	Entire fairness, but either (a) a properly functioning special committee or (b) approval of a majority of the minority will shift the burden of proof to the plaintiff [15] Business judgment if both (a) a properly functioning special committee and (b) approval of a majority of the minority [16]
7.	Transaction with a controlling stockholder where a majority of the board is not independent and disinterested	Entire fairness, but either (a) a properly functioning special committee or (b) approval of a majority of the minority will shift the burden of proof to the plaintiff [17] Business judgment if both (a) a properly functioning special committee and (b) approval of a majority of the minority [18]
8.	Controlling stockholder; majority of the board is independent and disinterested with respect to the controlling stockholder; controlling stockholder is not the counterparty in the transaction; and controlling stockholder is treated the same as other stockholders	Business judgment [19]
9.	Controlling stockholder; majority of the board is not independent and disinterested with respect to the controlling stockholder; controlling stockholder is not the counterparty in the transaction; and controlling stockholder is treated the same as other stockholders	Business judgment [20]
10.	Controlling stockholder; majority of the board is independent and disinterested with respect to the controlling stockholder; controlling stockholder is not the counterparty in the transaction; and controlling stockholder receives different treatment in the transaction than other stockholders	Entire fairness, but either (a) a properly functioning special committee [21] or (b) approval of a majority of the minority will shift the burden of proof to the plaintiff [22] Business judgment if both (a) a properly functioning special committee and (b) approval a of majority of the minority [23]
11.	Controlling stockholder; majority of the board is not independent and disinterested with respect to the controlling stockholder; controlling stockholder is not the counterparty in the transaction; and controlling stockholder receives different treatment in the transaction than other stockholders	Entire fairness, but either (a) a properly functioning special committee [24] or (b) approval of a majority of the minority will shift the burden of proof to the plaintiff [25] Business judgment if both (a) a properly functioning special committee and (b) approval of a majority of the minority [26]

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[1] This report updates our report, “Determining the Likely Standard of Review Applicable to Board Decisions in Delaware M&A Transactions,” as originally published on November 18, 2014 and updated on February 8, 2016 and April 12, 2017.

[2] Assumes duty of care is discharged. In addition to the standards of review identified in this chart, a transaction is subject to enhanced judicial scrutiny under Revlon, Inc. v. Macandrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986) “when a company embarks on a transaction — on its own initiative or in response to an unsolicited offer — that will result in a change of control.” Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 242 (Del. 2009). However, under the so-called Corwin doctrine, if a transaction (other than a transaction in which a controlling stockholder extracts personal benefits) has been ratified by a vote of a “fully informed, uncoerced majority of the disinterested stockholders,” it will be subject to business judgment review even if Revlon would otherwise apply. Corwin v. KKR Financial Holdings LLC, 125 A.3d 304, 305–06 (Del. 2015); see also, e.g., Morrison v. Berry, 191 A.3d 268, 274 (Del. 2018) (explaining the Corwin doctrine).

[3] “Independence means that a director’s decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences.” Aronson v. Lewis, 473 A.2d 805, 816 (Del. 1984), overruled in part on other grounds by Brehm v. Eisner, 746 A.2d. 244, 254 (Del. 2000). “Such extraneous considerations or influences may exist when the challenged director is controlled by another.” Orman v. Cullman, 794 A.2d 5, 24 (Del. Ch. 2002). Thus, a “lack of independence can be shown when a plaintiff pleads facts that establish that the directors are beholden to [the controlling person] or so under [that person’s] influence that [the directors’] discretion would be sterilized.” Id. (first alteration in original) (internal quotation marks omitted). “Put differently, a director is not independent if particularized facts support a reasonable inference that she would be more willing to risk her reputation than risk the relationship with the [controlling] person.” Sciabacucchi v. Liberty Broadband Corp., 2018 WL 3599997, at *11 (Del. Ch. 2018). Disinterestedness means that “directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally.” Id. at 23.

[4] A stockholder is a controlling stockholder under Delaware law where the stockholder (1) owns more than 50% of the voting power of a corporation or (2) exercises control over the business affairs of the corporation. Kahn v. Lynch Commc’ns Sys. (Kahn I), 638 A.2d 1110, 1113–14 (Del. 1994). When evaluating whether a stockholder exercises the requisite control, Delaware courts will evaluate whether the stockholder controlled the board “such that the directors . . . could not freely exercise their judgment” with respect to a transaction. In re KKR Fin. Holdings LLC S’holder Litig., 101 A.3d 980, 993 (Del. Ch. 2014); see also In re Crimson Exploration Inc. S’holder Litig., 2014 WL 5449419, at *10–*12 (Del. Ch. Oct. 24, 2014) (analyzing Delaware case law concerning controlling stockholders). “A group of stockholders, none of whom individually qualifies as a controlling stockholder, may collectively be considered a control group that is analogous, for standard of review purposes, to a controlling stockholder.” Frank v. Elgamal, 2014 WL 957550, at *18 (Del. Ch. Mar. 10, 2014). However, “[a] plaintiff must provide that the group of stockholders ‘was connected in some legally significant way—e.g., by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.’” In re Nine Systems Corp. Shareholders Litigation, 2014 WL 4383127 (Del. Ch. Sept. 4, 2014).

[5] See In re Trados Inc. S’holder Litig., 73 A.3d 17, 36 (Del. Ch. 2013) (explaining that the business judgment rule applies to decisions by board members who are “disinterested and independent”); see also In re PLX Technology Inc. S’holders Litig., 2018 WL 5018535, at *30–*31 (Del. Ch. 2018).

[6] The business judgment rule is generally the applicable standard of review where a majority of the board is disinterested and independent. See Cinerama, Inc. v. Technicolor, 663 A.2d 1156, 1170 (Del. 1995). Nonetheless, a transaction must be “approved by a majority consisting of the disinterested directors” in order for the business judgment rule to apply. See Aronson v. Lewis, 473 A.2d at 812, overruled in part on other grounds by Brehm v. Eisner, 746 A.2d. at 254; see also In re Trados Inc., 73 A.3d at 44 (“To obtain review under the entire fairness test, the stockholder plaintiff must prove that there were not enough independent and disinterested individuals among the directors making the challenged decision to comprise a board majority. . . . To determine whether directors approving the transaction comprised a disinterested and independent board majority, the court conducts a director-by-director analysis.”); Chaffin v. GNI Group, Inc., No. 16211-NC, 1999 WL 721569, at *5–*6 (Del. Ch. Sept. 3, 1999) (holding that where a board had three independent and disinterested members and two interested members, and the board approved a merger by a vote of 4-1, with one of the independent and disinterested directors voting against the merger, the merger approval “was one vote short of the required disinterested majority”).

[7] “A board that is evenly divided between conflicted and non-conflicted members is not considered independent and disinterested.” Gentile v. Rossette, No. 20213-VCN, 2010 WL 2171613, at *7 n.36 (Del. Ch. May 28, 2010); see also Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, 845 A.2d 1040, 1046 n.8 (Del. 2004). “[T]he business judgment rule has no application” to a merger transaction that is “not approved by a majority consisting of the disinterested directors,” Aronson v. Lewis, 473 A.2d at 812, overruled in part on other grounds by Brehm v. Eisner, 746 A.2d. at 254, and where the business judgment rule has been “rebut[ted]” this “lead[s] to the application of the entire fairness standard,” In re Crimson Exploration Inc., 2014 WL 5449419, at *20; see also In re PLX Technology Inc., Litig., No. 9880-VCL, 2018 WL 5018535, at *30 (explaining that the entire fairness test applies to director decision-making when “directors making the decision did not comprise a disinterested and independent board majority”).

[8] “[I]n the instant context, where there is no controlling stockholder but the board is conflicted…a fully constituted, adequately authorized, and independent special committee can cleanse such a transaction…remov[ing] the malign influence of the self-interested directors, and thus should result in business judgement review”. Salladay v. Lev, 2020 WL 954032, at *9 (Del. Ch. Feb. 27, 2020) (also noting the special committee must be formed ab initio and “prior to substantive economic negotiations, which include valuation and price discussions if such discussions set the field of play for the economic negotiations to come”). However, the Delaware Supreme Court has not definitively resolved the question of which standard of review applies when a special committee approves a transaction and there is no controlling stockholder because there is some precedent that could be read to suggest that a properly functioning special committee does no more than shift the burden of the proof to the plaintiff, see In re Tele-Commc’ns, Inc. S’holders Litig., No. 16470, 2005 WL 3642727, at *8 (Del. Ch. Dec. 21, 2005), although the better reading of this precedent may be that it involved a controlling stockholder, see In re John Q. Hammons Hotels Inc. S’holder Litig., No. 758-CC, 2009 WL 3165613, at *11 (Del. Ch. Oct. 2, 2009) (interpreting In re Tele-Commc’ns as having involved a controlling stockholder).

[9] See Corwin, 125 A.3d 304 (holding that, in the absence of a controlling stockholder, an uncoerced, informed stockholder vote causes the application of the business judgment standard of review even where enhanced scrutiny would otherwise apply); see also Vice Chancellor J. Travis Laster, The Effect of Stockholder Approval on Enhanced Scrutiny, 40 Wm. Mitchell L. Rev. 1443 (2014) (providing substantial discussion of the interplay between stockholder approval and the standard of review prior to the decision in Corwin). Note, however, that the failure to disclose all material information to stockholders can prevent a stockholder vote from being fully informed, and would thus prevent the vote from “ratifying” the transaction. See Chen v. Howard-Anderson, 87 A.3d 648, 669 (Del. Ch. 2014) (noting that, even if defendants had argued that the stockholder vote ratified the challenged transaction, “disclosure deficiencies” would undermine the vote and render the ratification ineffective); In re Saba Software, Inc. S’holder Litig., No. 10697-VCS, slip op. at 20–23 (Del. Ch. Mar. 31, 2017) (concluding that material omissions from a proxy statement “undermined the stockholder approval”); see also Morrison v. Berry, 191 A.3d at 274–75 (overturning a decision applying the ratification doctrine, stating “stockholders cannot possibly protect themselves when left to a vote on an existential question in the life of a corporation based on materially incomplete or misleading information”).

[10] See In re Trados Inc., 73 A.3d at 45 (holding that entire fairness was the applicable standard of review in scrutinizing a board’s approval of a merger where “the plaintiff proved at trial that six of the seven . . . directors were not disinterested and independent”); In re Tele-Commc’ns, Inc., 2009 WL 3165613, at *6–*8 (explaining that an “entire fairness analysis” is required whenever “evidence in the record suggests that a majority of the board of directors were interested in the transaction” and providing several examples).

[11] See note 8, supra.

[12] See note 9, supra.

[13] See In re PNB Holding Co., 2006 WL 2403999, at *12–*15 (concluding that all of the members of the board were interested and that entire fairness was the standard of review, recognizing that stockholder approval for the merger was accordingly “the only basis for the defendants to escape entire fairness review,” but ultimately concluding that “[b]ecause a majority of the minority did not vote for the Merger, the directors cannot look to our law’s cleansing mechanism of ratification to avoid entire fairness review”).

[14] See note 9, supra.

[15] See Kahn I, 638 A.2d at 1117 (the “standard of judicial review in examining the propriety of an interested cash-out merger transaction by a controlling or dominating shareholder is entire fairness. . . . However, an approval of the transaction by an independent committee of directors or an informed majority of minority shareholders shifts the burden of proof . . . to the challenging shareholder-plaintiff.”).

[16] The detailed requirements for the business judgment review to apply to a controlling-stockholder transaction are set forth in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) as follows: “(i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.” Id. at 645. See also Flood v. Synutra International, Inc., 195 A.3d 754 (Del. 2018) (clarifying that “so long as the controller conditions its offer on [the approval of both a Special Committee and a majority of the minority stockholders] at the germination stage of the Special Committee process, when it is selecting its advisors, establishing is method of proceeding, beginning its due diligence, and has not commenced substantive negotiations with the controller, the purpose of the pre-condition requirement of MFW is satisfied.”).

[17] Kahn I, 638 A.2d at 1117.

[18] See note 16, supra.

[19] See In re Synthes, Inc. S’holder Litigation, 50 A.3d 1022, 1046 (Del. Ch. 2012) (applying business judgment review despite pled facts that a majority of the board was not independent with respect to the controlling stockholder because the controlling stockholder “received equal treatment in the Merger”).

[20] “Entire fairness is not triggered solely because a company has a controlling stockholder. The controller also must engage in a conflicted transaction.” In re Crimson Exploration Inc., 2014 WL 5449419, at *12. A conflicted transaction exists if the controlling stockholder is the counterparty to, or otherwise “stands on both sides of,” the transaction. Gamco Asset Mgmt. Inc. v. iHeartMedia Inc., No. 12312-VCS, 2016 WL 6892802, at *15 (Del. Ch. Nov. 23, 2016). A conflicted transaction also exists if the controlling stockholder receives different treatment or “competes with the common stockholders for consideration” in the transaction. Id. In some cases, such as when a controlling stockholder receives disparate consideration, it is relatively simple to conclude that the controlling stockholder was not treated the same as other stockholders. See In re Delphi Fin. Grp. S’holder Litig., No. 7144-VCG, 2012 WL 729232, at *3 (Del. Ch. Mar. 6, 2012) (controlling stockholder negotiated a substantial premium for his shares); In re Tele-Commc’ns, Inc., 2005 WL 3642727, at *6–*8 (controlling stockholder received more valuable high-vote stock). In other cases, however, where the controlling stockholder receives a unique benefit (other than disparate consideration) or a continuing stake in the acquiring entity, the question is more complex. Compare New Jersey Carpenters Pension Fund v. infoGROUP, Inc., No. 5334-VCN, 2011 WL 4825888, at *9–*11 (Del. Ch. Sept. 30, 2011) (controlling stockholder received “desperately needed liquidity”), and In re John Q. Hammons Hotels Inc. S’holder Litig., 2009 WL 3165613, at *1 (controlling stockholder received “an array of private benefits” including a continuing stake in the acquiring entity), with Larkin v. Shah, No. 10918-VCS, 2016 WL 4485447, at *15 (Del. Ch. Aug. 25, 2016) (rejecting plaintiffs’ assertion that a venture capital firm’s desire to exit its investment was a hurried attempt to sell the company and extract a unique benefit).

[21] See In re John Q. Hammons Hotels Inc. S’holder Litig., No. 758-CC, 2011 WL 227634, at *2 (Del. Ch. Jan. 14, 2011) (“[P]laintiffs bear the ultimate burden to show the transaction was unfair given the undisputed evidence that the transaction was approved by an independent and disinterested special committee of directors.”).

[22] Although we have not identified any Delaware cases explicitly addressing the effect on the standard of review of approval by a majority of the minority stockholders in this factual scenario, it would be reasonable to conclude that the reasoning of Kahn I, 638 A.2d 1110, would apply.

[23] See In re John Q. Hammons Hotels Inc. S’holder Litig., 2009 WL 3165613, at *12 (in transaction where controlling stockholder receives different consideration than minority stockholders, “business judgment would be the applicable standard of review if the transaction were (1) recommended by a disinterested and independent special committee, and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders”).

[24] In re Tele-Commc’ns, Inc., 2005 WL 3642727, at *8 (explaining that because of the directors’ interested status “[t]he initial burden of proof rests upon the director defendants to demonstrate . . . fairness,” but further explaining that “[r]atification by a majority of disinterested directors, generally serving on a special committee, can have the effect of shifting the burden onto the plaintiff shareholders to demonstrate that the transaction in question was unfair. In order to shift the burden, defendants must establish that the special committee was truly independent, fully informed, and had the freedom to negotiate at arm’s length.”).

[25] See note 22, supra.

[26] See note 23, supra.

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

Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work or the authors of this alert:

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Mergers and Acquisitions Group:
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The Hong Kong Competition Tribunal (“Tribunal”) has issued its first decision on cartel fines in Competition Commission v W. Hing Construction Company Limited and Others (“Competition Commission v W. Hing”).[1] This decision is important because it sets out the methodology that the Tribunal will follow when imposing fines on undertakings in breach of the prohibition on cartel conduct.

The Tribunal has, by and large, followed the approach recommended by the Hong Kong Competition Commission (“Commission”). However, the facts of the case did not require the Tribunal to fully address all of the relevant factors for the calculation of a fine in the cartel context. Also, it is unclear how the framework adopted by the Tribunal would apply in case of fines on individuals. Further guidance from the Commission would therefore be welcome.

In addition, the facts did not require the Tribunal to assess a Commission recommendation on fine reductions under the Commission’s Cooperation and Settlement Policy. However, the Tribunal recognized the strong public interest in facilitating the kind of cooperation envisaged in the Commission’s leniency programme and it is therefore likely that the Tribunal will follow the Commission’s recommended reductions for cooperation.

1. Background

The Hong Kong Competition Ordinance (“Ordinance”) prohibits cartel conduct under its “First Conduct Rule.” The Commission can commence proceedings for violations of the First Conduct Rule before the Tribunal, which can impose pecuniary penalties of up to 10% of an undertaking’s total gross revenues generated in Hong Kong for the duration of the contravention (capped at three years). The Commission has recently brought major changes to its leniency programme (see https://www.gibsondunn.com/hong-kong-competition-commission-brings-major-changes-to-leniency-program/).

The Commission has initiated proceedings before the Tribunal for several cartel cases. The Competition Commission v W. Hing case concerned market sharing practices among decoration contractors in relation to a housing estate. The Tribunal decided on 17 May 2019 that the practices amounted to an infringement of the First Conduct Rule. In a subsequent decision on 29 April 2020, the Tribunal issued its decision on the amount of the fines to be imposed on the cartel participants.

2. Methodology for Fine Calculation

The Tribunal has adopted a methodology that is similar to the approaches taken by the UK and the EU. In particular, the Tribunal set out a four-step approach in calculating the fine: (1) determining the base amount; (2) making adjustments for aggravating, mitigating and other factors; (3) applying the statutory cap; and (4) applying any fine reductions based on cooperation or an inability to pay.

2.1 Step One: Determining the Base Amount

The base amount reflects the nature and extent of the conduct constituting the contravention, which is one of the mandatory considerations that the Tribunal must take into account in determining the amount of fine. The starting point is the “value of sales,” namely the undertaking’s sales directly or indirectly related to the contravention in the relevant geographic area within Hong Kong in the financial year in question. This is a different concept from the turnover of the undertaking, as the value of sales refers not to the revenues from all of the undertaking’s activities, but only from the affected commerce. In this case, the value of sales was calculated based on each defendant’s work orders and invoices issued for renovation works on the housing estate in question.

The next step is to identify the “gravity percentage,” which reflects the gravity and blameworthiness of the conduct. The Tribunal agreed with the Commission’s suggestion that the range of 15% to 30% would be appropriate for serious anti-competitive conduct and applied a percentage of 24%.

Finally, the amount is multiplied by the number of years of the undertaking’s participation in the contravention to reflect the temporal extent of the conduct in question. The Tribunal applied a multiplier of 1 although the cartel only lasted for 5 months.

2.2 Step Two: Making Adjustments for Aggravating, Mitigating and Other Factors

As provided by the Ordinance, the Tribunal must also take into account (1) aggravating circumstances; (2) mitigating circumstances; and (3) whether the person in question has previously been found to have contravened the Ordinance.

The Tribunal did not discuss the aggravating circumstances in detail as they were not relevant in the present case. Some of the aggravating circumstances suggested by the Commission include where the undertaking acted as a leader in the contravention, or where the anti-competitive practice is reflective of widespread industry practice such that there is a need for general deterrence.

On the other hand, the Commission suggested that mitigating circumstances may include where there was a genuine uncertainty as to the lawfulness of the conduct in question, where an undertaking had limited participation in the contravention, or where an undertaking has taken steps to ensure genuine compliance with the Ordinance, although there is no indication in the judgment as to whether this is a reference to pre-investigation/contravention steps or post-investigation remedial measures, or both.

Where there is a previous contravention, the Tribunal indicated that an increase in the amount of penalty would be imposed, having regard to the number of previous contraventions, the time lag between the previous and current contraventions, whether any of the individuals involved in the previous contravention are connected with the current contravention and the nature of the previous contravention. However, these factors were not relevant in the Competition Commission v W. Hing case.

The Tribunal added that proportionality is relevant throughout the process of assessment, in particular to give “an overall sense check” to ensure that the amount would be a just and proportionate penalty for the contravention by the undertaking in the circumstances.

2.3 Step Three: Applying the Statutory Cap

Section 93(3) of the Ordinance imposes a ceiling which a penalty may not exceed, namely 10% of the undertaking’s turnover for each year in which the contravention occurred, or where the contravention occurred in more than three years, 10% of the turnover of the undertaking for the three years in which the contravention occurred that saw the highest, second highest and third highest turnover.

The Tribunal rejected the argument that the statutory cap should be viewed as the “maximum sentence” to be reserved for a case that is the worst case of its kind that can be realistically envisaged. In finding that the statutory cap is more akin to a jurisdictional limit than provisions stipulating the maximum amount of fine, the Tribunal explained that the limit is applied only towards the end of the process of assessment so as to ensure that the maximum is not exceeded, and not treated as part of the general considerations in arriving at the amount of the penalty in the first place.

2.4 Step Four: Applying Cooperation Reduction and Considering Plea of Inability to Pay

Step Four involves the application of fine reductions to reflect cooperation with the Commission and, in exceptional cases, the undertaking’s inability to pay the penalty.

Under the Commission’s Leniency Policy, the first undertaking to report its participation in a cartel will obtain full immunity from possible fines. Other cartel participants can still obtain a reduction of the possible fine under the Commission’s Cooperation and Settlement Policy. In exchange for their cooperation, the Commission will agree to apply a discount to the pecuniary penalty that it would recommend to the Tribunal. Where an undertaking indicates its willingness to cooperate with the Commission before the commencement of any Tribunal proceedings against it, it may receive a discount of up to 50% depending on the order in which undertakings express their interest to cooperate. In particular, the Commission may recommend a discount between 35% and 50% in favour of the first undertaking after the immunity applicant to express its interest to cooperate (see https://www.gibsondunn.com/cartel-leniency-in-hong-kong/).

While the Tribunal did not fully consider the weight to be placed on the Commission’s recommendation of a reduction of penalty as none of the defendants in the case claimed a cooperation reduction, the Tribunal indicated that it would give due consideration to any such recommendations if raised by the Commission. In particular, the Tribunal acknowledged that there is strong public interest in facilitating the kind of cooperation and settlement envisaged in the Commission’s leniency and cooperation policies. Such arrangements enable the Commission to carry out its investigations more efficiently, conserve resources and give early redress to any harmful conduct.

Finally, the Tribunal held that the cooperation reduction should be dealt with after applying the statutory cap to ensure that there would still be a real benefit for someone to offer cooperation even if the pecuniary penalty would already be limited by the statutory cap.

With regard to an undertaking’s inability to pay, the Tribunal stated that a reduction of penalty on account of inability to pay should be an exceptional measure, having regard to the effect on the undertaking’s viability and supported by clear and compelling evidence.

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[1] Competition Commission v W. Hing Construction Company Limited and Others [2020] HKCT 1. A copy of the judgment is available at: https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=127610&currpage=T.

The following Gibson Dunn lawyers assisted in the preparation of this client update: Sébastien Evrard and Bonnie Tong.

Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Antitrust and Competition Practice Group, or the following lawyers in the firm’s Hong Kong office:

Sébastien Evrard (+852 2214 3798, [email protected])
Kelly Austin (+852 2214 3788, [email protected])
Emily Seo (+852 2214 3725, [email protected])
Bonnie Tong (+852 2214 3762, [email protected])

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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.

____________________

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])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

The COVID-19 pandemic is undoubtedly the biggest public health crisis of our times. Like many other countries, the UK Government has exercised broad powers and passed new laws that impact how we do business and interact as a society.

To address the pandemic, the Government announced several sweeping regulations and ushered through the Coronavirus Act 2020. These actions have a broad impact on law, public policy and daily life, impacting areas including health, social welfare, commerce, trade, competition, employment and the free movement of people.

Join our team of Gibson Dunn London lawyers, led by partner and former Lord Chancellor Charlie Falconer QC, for a discussion of these changes and to answer your questions on how they will affect British businesses and community, including the impact on new and ongoing business relationships.

In this webinar we will cover:

Governance – key issues for boards
HMRC’s response to tax residence and cross-border employment tax matters
Commercial real estate update – challenges or opportunities?

We want to hear from you about the impacts the current measures and conditions are having on your business and the legal issues you are facing. We therefore welcome suggested topics, as well as questions in advance of each webinar, to ensure that we can address issues relevant to your business.

PANELISTS:

Charlie Falconer QC: An English qualified barrister and Gibson Dunn partner. Former UK Lord Chancellor and first Secretary of State for Justice, he spent 25 years as a commercial barrister, and became a QC in 1991.

Matt Aleksic: An associate in the Litigation and International Arbitration practice groups of Gibson Dunn. Experience in a wide range of disputes, including commercial litigation, international arbitration and investigations.

Lucy Conway: An associate in the Mergers and Acquisitions practice group of Gibson Dunn. Ms. Conway advises on a broad range of UK and international cross-border corporate finance transactions, including mergers and acquisitions, joint ventures, initial public offerings (IPOs) and secondary fundraisings.

Benjamin Fryer: A partner in the Tax practice group. Mr. Fryer advises on a wide range of domestic and cross-border matters and transactions, including in relation to banking, capital markets, corporate finance, corporate reorganisations, debt restructuring, mergers and acquisitions, private equity, real estate and structured finance.

Richard Sen: An associate in the London Real Estate practice group of Gibson Dunn. Mr. Sen advises on asset and corporate acquisitions and disposals, joint venture arrangements, real estate financing, high profile development work and commercial leasing transactions.

It is expected that, from the end of 2021, London Interbank Offered Rates (“LIBORs”), which are used as reference rates in the loan, bond and derivatives markets, will cease to be published. Instead, these rates will be replaced with alternative ‘nearly risk free’ rates (“RFRs”). A different RFR will be available for each currency in which LIBOR is offered (as to which, see the table below). Similar reforms of other benchmarks (e.g. EONIA) are also being undertaken.

	Existing benchmark	Alternative RFR
	GBP LIBOR	Reformed Sterling Overnight Index Average (SONIA)
	USD LIBOR	Secured Overnight Financing Rate (SOFR)
	JPY LIBOR	Tokyo Overnight Average Rate (TONAR)
	CHF LIBOR	Swiss Average Rate Overnight (SARON)
	EUR LIBOR	Euro Short-Term Rate (€STER)

Contracts referencing LIBORs with a term beyond 2021 (so-called ‘legacy’ contracts) will therefore need to be amended, to transition to RFRs. This transition may have tax implications. On 19 March 2020, the UK tax authority, HM Revenue & Customs (“HMRC”), published draft guidance setting out its views on certain of the potential UK tax issues arising as a result of transition. Simultaneously, it launched a consultation inviting taxpayers to comment on the draft guidance, and identify any other tax issues arising from benchmark reform.

Overall, HMRC has taken a sensible approach, and its draft guidance will give some comfort to affected taxpayers. However, there is some remaining uncertainty due to omissions from the draft guidance, the subjective judgement required by certain aspects of the draft guidance, and the likely timing of final guidance. In addition, certain tax issues arising from benchmark reform may call for legislative responses (if HMRC is inclined to offer relief). Comments are now invited by 28 August 2020 (following a deferral from the original 28 May 2020 deadline).

Background

This transition to RFRs will not be implemented through legislation, and will instead be market-led. This means that taxpayers that are party to legacy contracts will need to amend them. Practically speaking:

Interest provisions may be amended directly; or
Existing “fallback provisions”, which contemplate a method for calculating interest if LIBOR is temporarily unavailable, may be amended to provide for the transition to RFRs on (or before) LIBOR’s permanent cessation.

For derivatives, ISDA favours the latter approach, and will be publishing a “protocol” to the ISDA Master Agreement which parties can choose to apply to their legacy contracts. For loan agreements, the LMA has published draft provisions, although amendments would need to be agreed between all parties. (For some syndicated loans, majority lender consent may be sufficient.) For bonds, the process is, as a practical matter, likely to be more complicated, as typically, the consent of between 90% and 100% of noteholders must be obtained via a consent-solicitation process.

Amendments will not simply involve replacing references to LIBOR with the applicable RFR. This is because RFRs differ from LIBORs in two key ways: they are overnight, rather than term rates, and they do not contain a credit-spread. Therefore, in addition to replacing the relevant LIBOR, adjustments will be needed to minimise changes to the existing economics:

RFRs will need to be compounded over the relevant interest period; and
To prevent value-transfer, it will be necessary to either (i) add an adjustment-spread to the interest rate or (ii) make a one-off equalisation payment (a “one-off payment”), to compensate for the lower future return.

Over the past year, in sterling bond, loan and derivatives markets, a consensus generally seems to have formed regarding preferences for these proposed adjustments. The table below provides a broad overview, based on responses to consultations from regulatory and trade bodies, and (limited) reported transactions:

	Term	Spread
Bond	RFR compounded in arrears (over “observation period” 5 business days ahead of interest period)	Forward spreads between LIBOR and RFR
Derivatives	RFR compounded in arrears (over “observation period” 2 business days ahead of interest period)	Mean spread between LIBOR and RFR over 5 year look-back period
Loan	RFR compounded in arrears (No consensus on observation period)	Mean spread between LIBOR and RFR over 5 year look-back period

Two points, which may impact the tax consequences of benchmark reform, are worth noting:

As between different kinds of instrument (e.g. derivatives, loans etc.), there is divergence on technical aspects of the proposed adjustment calculations. The sterling-market approach may also differ from that taken with other currencies.
Spread-adjustments based on historical spreads between LIBORs and RFRs (which is seemingly the favoured approach) will result in some value-transfer between counterparties.

The consultation and draft guidance

Following engagement with stakeholders, HMRC has launched a consultation and issued draft guidance regarding the potential UK tax implications of benchmark reform.

The consultation identifies statutory references to LIBOR (such as lease discounting provisions), and asks for views on an appropriate replacement. More substantively, however, it calls for (a) the identification of wider UK tax issues arising from benchmark reform, and (b) views on HMRC’s draft guidance (which addresses many of the potential problems HMRC is already aware of).

On the whole, HMRC has taken a pragmatic and sensible approach in the draft guidance. Nevertheless, (a) their position on certain issues may cause difficulties and (b) there are some points on which they have remained silent.

Tax consequences arising from accounting implications

Amendments to legacy contracts may result in debits and credits being recognised in taxpayers’ profit and loss statement (“P&L”). Generally, amendments may impact (a) the measurement and recognition of financial instruments and (b) (where relevant) hedge accounting. Accounting standards bodies propose to offer some relief, to minimise the accounting implications of benchmark reform. However, they have stopped short of offering full relief. A (non-accountant’s) high-level overview of possible accounting impacts, and proposed IASB reliefs (published on 9 April) is set out below:

	Possible accounting implication	Proposed IASB relief for changes required by benchmark reform
Measurement and recognition	Fair value: Value transfer recognised via change in fair value	No relief proposed
Measurement and recognition	Amortised cost: · Possible derecognition if “significant modification”; · Otherwise, carrying amount recalculated, with gain / loss immediately recognised in P&L	Broadly (subject to certain conditions): · No derecognition; · No immediate change in carrying value / gain or loss recognised in P&L. Instead, effective interest rate updated
Hedge accounting	· Discontinuation; or · Increased hedge-ineffectiveness	· Broadly (subject to certain conditions), no discontinuation; · No relief for increased hedge ineffectiveness

Generally, amounts recognised in a taxpayer’s P&L would be brought into account for UK tax purposes pursuant to the loan relationship rules and / or the derivative contracts rules (at Parts 5 and 7 of the Corporation Tax Act 2009), as applicable. HMRC’s draft guidance suggests that there will be no tax relief for these accounting debits and credits.

Broadly, potential tax volatility arising from fair value accounting of hedging instruments is managed in one of two ways: hedge accounting, or the ‘disregard regulations’ (SI 2004/3256). In very high-level terms:

Where hedge accounting is applied, to the extent that a hedge is effective, fair value gains and losses will generally be kept off P&L (and hence not taxed) until settlement of the hedge.
The disregard regulations (which taxpayers must elect into) allow the hedge to be taxed on an ‘appropriate accruals basis’, so that fair value gains and losses would not generally be brought into account for tax purposes.

For taxpayers who have taken the latter approach, the draft guidance confirms that (notwithstanding amendments to give effect to benchmark reform), the disregard regulations will continue to apply, provided an intention to hedge remains. However, for taxpayers relying on hedge accounting, benchmark reform may have a greater impact (as to which, see further below).

Tax consequences arising from fact of amendment

One key tax concern is that amendments giving effect to benchmark reform could be considered sufficiently material to give rise to a new instrument. If so:

Grandfathering relied upon could fall away;
Tax clearances obtained might need to be refreshed;
A stamp duty reserve tax (“SDRT”) charge could apply for instruments in clearing or depositary receipt systems; and
Reporting obligations could be triggered e.g. under DAC6 (the new EU reporting regime for certain cross border arrangements).

The draft guidance confirms that amendments stemming from transition would “normally be viewed as a variation” rather than the creation of a new instrument”. However, this is dependent on “the economics of the transaction [remaining] mostly the same” (emphasis added). Continued reliance on clearances is subject to stricter conditions, e.g. that amendments “not [affect] the economics of the transaction”.

Tax consequences arising from difference in interest rate

Spread-adjustments

Many UK tax provisions require a contract’s terms to be compared against market-standards. For example, taxpayers may need to consider whether:

The terms are arm’s length for transfer pricing purposes;
The interest rate is more than a reasonable commercial return, to assess whether:
1. interest payments may be treated as distributions;
2. a loan is a “normal commercial loan” (e.g. to test whether lenders may be “equity-holders” for the purposes of applying group relief provisions and/or whether it is a qualifying corporate bond (“QCB”) for capital gains tax (“CGT”) purposes); and
3. the stamp duty/SDRT loan capital exemption may apply.

A question arises as to whether, for these purposes, amended terms must be re-tested by reference to prevailing rates at the time of amendment. Given the commercial desire to broadly preserve existing economics, and the time which may have elapsed since the contract was entered into, if this was necessary, these tests may well be failed. Helpfully, the draft guidance generally considers that these provisions can continue to be applied by reference to the position when the contract was originally entered into (although the “normal commercial loan” test is not expressly referred to). However, as this outcome is dependent on amendments being treated as mere variations to existing contracts, the tax treatment again hinges (indirectly) on the economic impact of the amendments.

One-off payments

The draft guidance provides some helpful confirmations regarding the UK tax treatment of one-off payments:

Such payments will generally be taxable/deductible for corporation tax purposes (as applicable), provided corresponding debits and credits are recognised in P&L; and
For withholding tax purposes:
- payment by borrowers under loans will be treated as interest; but
- payments by lenders or under derivatives will not attract withholding (because, respectively, they will not constitute annual payments, or the withholding tax exemption for derivative contracts will apply).

Some key potential issues

Economic qualifiers

The helpful position which HMRC has generally taken in the draft guidance is, in some instances, qualified by reference to the economic impact of amendments – with the level of value-transfer which is tolerable seeming to vary depending on context. For example, continued reliance on existing clearances requires “no change in economics”, whereas for amendments to qualify as variations, the economics must remain “mostly the same”.

Benchmark reform constitutes an exceptional event. The need for amendment is not being driven by voluntary commercial forces, but rather by regulatory will, and market-standards (which seem to be moving to a position where some level of value-transfer is unavoidable) may leave taxpayers with little choice regarding the extent to which the economics are ultimately altered. If the above qualifications are ultimately retained, the tax impact of amendments required by benchmark reform will depend on subjective judgments. This introduces uncertainty, which risks impeding the wider transition process. In contrast, when assessing whether grandfathering is preserved for example, HMRC proposes to look at the purpose of the amendment – “HMRC would normally expect [grandfathering] to continue where amendments are made for the purpose of responding to benchmark reform”. The potential tax implications of amendment would be significantly simplified if, across the board, this was the sole criterion applied by HMRC.

Form-over-substance

In a departure from recent themes, the draft guidance indicates that HMRC may, in this context, take a form-over-substance approach, with tax treatment dependent on the manner in which amendments are executed. It notes that “the intention of the parties, and how this is reflected in the legal documents, will be significant factors in determining whether the changes constitute an amendment to an existing financial instrument, or as the redemption and replacement of an existing financial instrument with a new financial instrument”. Where, for example, a legacy trade referencing LIBOR is rebooked on the same terms (except to the extent necessary to give effect to benchmark reform), questions may arise as to whether HMRC would characterise that as an “amendment”.

If continuity of tax treatment is dependent on a particular amendment process being followed, this risks creating an additional burden for taxpayers. This is particularly true for financial institutions, who will be faced with huge volumes of contracts requiring amendment – but without the benefit of operational flexibility. Again, an approach which looks to the purpose of amendment, rather than the manner in which it is effected, would significantly lighten the potential burdens created by benchmark reform.

CGT not addressed

The draft guidance is silent on whether amendments may trigger disposals (or part-disposals) for CGT purposes. It is directed towards businesses, and addresses both the corporation tax position (discussed above) and income tax position (noting that “where a financial instrument is taken out for the purposes of a trade or property business, the tax treatment will generally follow the accounting treatment.”) However, legacy contracts may (a) constitute capital asset/liabilities for businesses, and/or (b) be held by individuals (e.g. floating-rate bonds issued into retail-markets).

If a contract is a QCB, a disposal would, in any event, be exempt from CGT. However, clarity as to whether amendments to non-QCBs and other capital instruments would trigger a disposal would be helpful. This is not only relevant to taxpayers subject to CGT. Regulators are encouraging financial institutions to begin discussing amendments with counterparties, and issuers of floating-rate notes may be considering consent-solicitation processes to amend such notes. If (where relevant) financial institutions/issuers are unable to provide clarity regarding the CGT implications of amendment, there is a risk that these processes may be impeded.

Timing

HMRC had originally called for comments on the draft guidance, and responses to the consultation, by 28 May. As a result of the COVID-19 pandemic, this has been delayed until 28 August 2020. HMRC are also considering constituting a working-group. Engagement with stakeholders is certainly welcome, and typically, enhanced opportunity for taxpayers to respond to a consultation is a positive outcome. However, both points raise timing concerns. Notwithstanding the ultimate deadline of year-end 2021 for the discontinuation of LIBOR, timing is of the essence. It is the aim of the Sterling Working Group on RFRs that the ‘stock of LIBOR-referencing contracts [should be] reduced significantly’ by the end of Q1 2021, and there is substantial (and growing) regulator pressure for market participants to transition to RFRs. On 22 April, Bloomberg (which has been chosen by ISDA as the “adjustment services vendor” to calculate and publish benchmark reform adjustments for legacy over the counter derivatives) substantially progressed the path to amendment by publishing a “rulebook”, setting out proposed amendment terms. These factors mean that amendment processes are likely to begin in earnest in the coming weeks and months. In the absence of final guidance from HMRC in the near future, there is a real risk that, due to these wider forces, taxpayers may end up having to amend legacy contracts without certainty regarding HMRC’s position on the tax implications of doing so. Given that taxpayers have neither chosen, nor can avoid, benchmark reform, this would be regrettable.

Potential accounting issues

The draft guidance notes that “projects are ongoing to decide if amendments to International Financial Reporting Standards (IFRS) and UK Generally Accepted Accounting Practice (UK GAAP) are needed to address accounting issues that arise because of the restructuring of contracts as a consequence of benchmark reform”.

Based on current IASB proposals, for instruments accounted for on fair value basis, any value transfer on transition is likely to result in some debits and credits being recognised in P&L. Where there is an increase in value and credits are recognised, (based on the current UK guidance) it is expected that such credits would be taxable. However, where there is a decrease in value and the recognition of debits results in an overall loss for the period, the UK tax position may be complicated by quantitative restrictions on the use of carry-forward losses. If losses realised in the period in which the transition takes place were carried forward, then (subject to a £5 million annual allowance) corporates could only offset them against 50% of profits in any subsequent year. For banks, the figure is limited to 25% of profits.

Moreover, the lack of (complete) alignment between adjustments to categories of financial instruments may be a cause of concern for taxpayers that are party to hedges and apply hedge accounting. Any differences in amendments made to hedging, and hedged, instruments may result in increased hedge ineffectiveness going forward. It appears (based on current proposals) that the IASB does not intend to offer relief to address this – with the result that, going forward, changes in market value would, to the extent of such ineffectiveness, be recognised in P&L and taxed. As above, this may be more than a mere timing point; if the impact cannot be off-set over the instrument’s term due to restrictions on loss carry-forwards, there may be a real tax cost. Moreover, (in the absence of a concession from HMRC) it would not be possible to circumvent the tax impact of increased hedge ineffectiveness by electing into the disregard regulations, as elections cannot be made in respect of existing agreements.

If the proposed scope of IASB relief is not expanded to address the above accounting impacts, it remains to be seen whether HMRC would be willing to step in. The above issues are not addressed in the draft guidance. However, that is largely unsurprising. If HMRC considered it appropriate to offer relief addressing the above issues, a legislative fix would likely be required.

Conclusion

The draft guidance is largely helpful and will go some way in providing comfort to UK taxpayers impacted by benchmark reform. However, it does not offer a complete solution.

Based on the current draft:

To minimise the tax implications of transition, UK taxpayers would need to (i) curtail value-transfers, and (ii) (where relevant) align amendments to hedging, and hedged, instruments. However, depending on where market-standards crystallise and whether different counterparties are involved, practically-speaking, both matters may be outside a taxpayer’s control.
Taxpayers face uncertainty due to (i) omissions from the draft guidance, (ii) the subjective-judgment inherent in certain aspects of the draft guidance and (iii) the likely timing of final guidance.

These factors risk putting taxpayers’ understandable desire for tax-neutrality and certainty at odds with both commercial drivers, and regulatory time-tables.

Moreover, if the scope of IASB relief remains as currently proposed, there may be circumstances where taxpayers may wish to call for legislative action to limit the tax impact of transition.

This client alert is based on an article by certain of the authors published in Tax Journal on 21 April 2020.

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 Tax Practice Group or the authors:

Sandy Bhogal – London (+44 (0) 20 7071 4266, [email protected])
Ben Fryer – London (+44 (0)20 7071 4232, [email protected])
Bridget English – London (+44 (0)20 7071 4228, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On April 30, 2020, the California Supreme Court issued a long-awaited opinion in Nationwide Biweekly Administration Inc. v. Superior Court, No. S250057, ___ Cal.5th ___ regarding whether civil actions brought by governmental entities on behalf of the People, seeking statutory penalties under the Unfair Competition Law, Business and Professions Code §§ 17200 et seq. (“UCL”), and False Advertising Law (“FAL”), Business and Professions Code §§ 17500 et seq., must be tried to a jury. A unanimous Court held that there is no right to a jury trial for causes of action brought under the UCL, regardless of the relief sought. A majority of the Court held the same as to the FAL.

The discussion below provides a brief overview of the UCL and FAL, analyzes the California Supreme Court’s decision in Nationwide Biweekly, and identifies some of the unresolved questions left open by Nationwide Biweekly.

I. Overview of the UCL and FAL

The UCL permits both private parties and public prosecutors to bring suits to combat “unfair competition,” which is defined broadly to include “any unlawful, unfair or fraudulent business act or practice.” (Bus. & Prof. Code, § 17200.) While the potential application of the statute is exceedingly broad, it provides few—yet powerful—remedies. Private plaintiffs may obtain an injunction and restitution of money or property acquired by means of unfair competition. (Id., § 17203.) Public prosecutors may obtain these remedies as well as civil penalties up to $2,500 per violation, plus up to an additional $2,500 for each violation against an elderly or disabled person. (Id., §§ 17203, 17206.1.)

The FAL protects consumers from “false or deceptive advertising.” (People v. Super. Ct. (Olson) (1979) 96 Cal.App.3d 181, 190; Bus. & Prof. Code, § 17500.) Like the UCL, the FAL can be used by either private plaintiffs or public prosecutors, and authorizes injunctive relief, restitution, and (for public prosecutors) civil penalties. (Bus. & Prof. Code, §§ 17535, 17536.)

As these remedies are equitable in nature, they are awarded by the court. (See id., § 17203 [court may order injunctive relief or restitution]; id., § 17206, subd. (b) [“The court shall impose a civil penalty for each violation of this chapter.”]; id., § 17536.) Accordingly, courts have regularly stricken jury demands in UCL cases and required parties to try their case to the court. (See Real Party in Interest’s Opening Brief on the Merits (Dec. 18, 2018) Nationwide Biweekly Administration, Inc. v. Super. Ct., No. S250047, 2018 WL 7108369, at pp. 45-46 [compiling cases denying jury trial right in UCL actions].)

Some courts and commentators have observed that this practice stands in tension with the broad scope of the UCL, which can be used to target business practices that violate any law—civil or criminal—including laws that would provide for a right to trial by jury if the claim were brought directly. For example, if a public prosecutor chose to pursue a predicate violation in a criminal proceeding, the defendant would be entitled to trial by jury, a higher standard of proof, and a host of other protections that are absent when prosecutors elect to try the case as a civil UCL action instead. Furthermore, claims asserting “fraudulent” and “unfair” business practices often involve fact-intensive inquiries of the kind that, in other contexts, are left to a jury.

Finally, even when civil penalties are imposed for enforcement purposes, they may still have a compensatory or punitive aspect, and appear akin to money damages. (See Kizer v. County of San Mateo (1991) 53 Cal.3d 139, 147-148 [explaining that although civil penalties “may have a punitive or deterrent aspect, their primary purpose is to secure obedience to statues and regulations”].) Civil penalty awards can also be substantial, raising due process questions about the constitutional limits on awards. (See, e.g., City and County of San Francisco v. Sainez (2000) 77 Cal.App.4th 1302, 1321 [holding 28% net-worth penalty not constitutionally impermissible against due process challenge]; Cal. Const., art. I, § 17.) Because the penalties can be so large as to reach the outer bounds of what is constitutionally permissible, due process arguably suggests they should be determined by a jury. (See Kennedy v. Mendoza-Martinez (1964) 372 U.S. 144, 164-165 [statutory remedies which “are essentially penal in character” should not be imposed without due process “safeguard[]” of trial by jury]; State v. Altus Finance (2005) 36 Cal.4th 1284, 1308 [explaining “[c]ivil penalties . . . are designed to penalize a defendant”].)

Nationwide Biweekly presented two of these concerns—predicate violations of laws that require fact-intensive inquiries regarding deceptive advertising, and public prosecutors seeking considerable sums in civil penalties—while denying the defendant a trial by jury. The Supreme Court’s decision addresses each of these concerns, ruling their application in the UCL and FAL contexts weigh against a state constitutional right to a jury trial.

II. Procedural Background of Nationwide Biweekly

The California Department of Business Oversight and several district attorney’s offices acting on behalf of the People sued Nationwide Biweekly Administration Inc., its subsidiary Loan Payment Administration LLC, and its owner Daniel Lipsky (collectively, “Nationwide”) under the UCL, FAL, and other state laws, for false and misleading advertising and for operating without a license. The government sought to enjoin the allegedly unlawful practices, restitution of all money wrongfully acquired from California consumers, and civil penalties of up to $2,500 for each violation of the UCL. The defendants demanded a jury trial, and the trial court struck the demand on the government’s motion.

Nationwide ultimately petitioned the Supreme Court for review, and the Supreme Court directed the Court of Appeal to issue an order to “show cause why defendant does not have a right to a jury trial where the government seeks to enforce the civil penalties authorized” under the UCL. The Court of Appeal then granted Nationwide’s peremptory writ of mandate, and, in a published opinion, crafted a narrow right to trial by jury: only to decide the question of liability, and only when the government seeks civil penalties. The Court of Appeal determined it would still decide the amount of civil penalties and other remedies to be awarded.

The public-prosecutor plaintiffs filed a petition for review of the Court of Appeal’s decision, which the Supreme Court granted on September 19, 2018.

The question presented was: “Is there a right to a jury trial in a civil action brought by the People, acting through representative governmental agencies, pursuant to the Unfair Competition Law (Bus. & Prof. Code, § 17200, et seq.) or the False Advertising Law (Bus. & Prof. Code, § 17500, et seq.), because the People seek statutory penalties, among other forms of relief?”

The California Attorney General and the California District Attorneys Association, both of which have “longstanding” practices of trying UCL cases “before the bench,” submitted amicus curiae briefs in support of the governmental entities and against a right to trial by jury.

III. The Supreme Court’s Decision

Chief Justice Cantil-Sakauye authored the opinion of the Court in which Justices Chin, Corrigan, and Groban joined. Justice Kruger filed a separate opinion concurring in the judgment; Justices Liu and Cuéllar joined in Justice Kruger’s separate concurrence. All seven Justices agreed that all UCL cases must be tried to the court, not a jury, and that in this case, the FAL claim should also be tried to the court. Collectively, the two opinions spanned 92 pages.

A. Chief Justice Cantil-Sakauye’s Majority Opinion Speaks In Broad Terms.

In a majority opinion authored by Chief Justice Cantil-Sakauye (joined by Justices Chin, Corrigan, and Groban), the California Supreme Court reversed the Court of Appeal and held that there is no right to a jury trial for causes of action under the UCL or FAL, whether brought by a private party or a public prosecutor, and regardless of the relief sought. (Nationwide Biweekly Administration, Inc. v. Super. Ct. (Apr. 30, 2020, S250057) ___ Cal.5th ___ [p. 61].) The Court “express[ed] no opinion” on whether the “jury trial right applies to other statutory causes of action that authorize both injunctive relief and civil penalties.” (Id., at [p. 4].)

First, the Court held that the UCL provides no statutory right to a jury trial because the purpose and legislative history of the UCL “convincingly establish that the Legislature intended” UCL claims to be tried to the court, “exercising the traditional flexible discretion and judicial expertise of a court of equity, . . . including when civil penalties as well as injunctive relief and restitution are sought.” (Id., at [p. 10].) In arriving at that determination, the Court highlighted many of the significant UCL cases that have been decided during the “more than 80-year history” of the statute. (Id., at [pp. 17-24].) Likewise, after examining seminal FAL decisions, the Court concluded that there was no statutory right to a jury trial because, “as with the UCL, the Legislature intended that the civil cause of action embodied in the FAL would be tried by a court of equity rather than by a jury.” (Id., at [p. 39].)

Second, the Court decided that there is no constitutional right to trial by jury in UCL and FAL cases because the “gist” of an action under the UCL or FAL is equitable, not legal, in nature. (Id., at [p. 52] [applying “gist of the action” standard outlined in C&K Engineering Contractors v. Amber Steel Co. (1978) 23 Cal.3d 1].) The Court first considered the nature of the remedies provided by the UCL, finding “the bulk of the remedies”—specifically, restitution and injunctive relief—are “clearly equitable in nature.” (Id., at [p. 59].) As for the civil penalty remedy available to public prosecutors, the majority found that even that remedy, under the circumstances, is equitable in nature because the UCL’s penalties, “unlike the classic legal remedy of damages, are noncompensatory in nature” and are used to fund further enforcement. (Id., at [p. 60].) The Court also reasoned that the exercise of calculating the amount of a civil penalty under the UCL and FAL invoked equitable principles, as the “court is afforded broad discretion to consider a nonexclusive list of factors”—an assessment “typically undertaken by a court and not a jury.” (Id., at [pp. 59-60].) After finding the remedies afforded were more equitable in nature than legal, the Court examined the nature of the UCL and FAL claims themselves. The “expansive and broadly worded” standards to be applied in determining whether contested business practices were unlawful “call for the exercise of the flexibility and judicial expertise and experience that was traditionally applied by a court of equity.” (Id., at [p. 60].) The Court then concluded that UCL and FAL actions “are equitable either when brought by a private party seeking only an injunction, restitution, or other equitable relief or when brought by the Attorney General, a district attorney, or other governmental official seeking not only injunctive relief and restitution but also civil penalties.” (Id., at [pp. 52-53, 61].) There is no right to a jury trial for any actions brought under the UCL or FAL. (Id., at [pp. 53, 61].)

B. Justice Kruger Arrives at the Same Conclusion by a “Somewhat Different—and Narrower—Path.”

In her separate concurrence, Justice Kruger (joined by Justices Liu and Cuéllar) expressed a preference for deciding the issue on the facts of the case before her and by weighing the relative importance of the remedies sought. Finding that the case was at too early a procedural stage to do so, Justice Kruger took a “broader look” at the UCL, and agreed with the majority that, because “liability under the UCL inherently rests on equitable considerations . . . of a sort that only the trial court can effectively weigh and determine,” the “gist” of a UCL action is equitable and there is no right to trial by jury. (Nationwide Biweekly Administration, Inc., supra, ___ Cal.5th ___ [conc. opn. of Kruger, J.], at [p. 4].)

However, Justice Kruger disagreed with the majority’s analysis of the FAL. She contended that unlike the UCL, “nothing about the nature of liability determination under the FAL” implicates the “inherently equitable judgment uniquely suited to a court.” (Id., at [pp. 6-7, 12].) Unlike the UCL, determining liability under the FAL does not require weighing the equities such as the competing harms and benefits or the parties’ and public’s interests, and instead requires only findings of fact as to whether the public is likely to be deceived—a task more suited to a jury. Nonetheless, she concurred in the judgment, reasoning that on the facts of this case, the FAL claim was “inherently intertwined” with the UCL claim because the same questions that would decide FAL liability would be decided by the court for UCL liability. (Id., at [p. 13].) As a result, the FAL causes of action in this case are “predominantly equitable in character,” and do not therefore trigger the right to trial by jury. (Id., at [pp. 12-13].)

As Justice Kruger recognized, where UCL and FAL claims are pleaded together, there is no procedural benefit to separating out FAL issues for a jury trial. (Id., at [pp. 13-14].) Regardless of how a jury decided a FAL claim, the court would retain the power to nullify that verdict in two ways: first, by ruling in the opposite manner for the same conduct on the UCL claim; second, by retaining the ultimate authority and discretion to craft remedies for any FAL and UCL violations that may be found. (Ibid.) In such cases, the court will effectively determine the ultimate outcome.

IV. Practical Implications and Unanswered Questions

A. Forum Selection and Severability of Issues That May Be Tried to a Jury.

As the tide of UCL claims brought by private plaintiffs and public prosecutors continues to rise, the existence and extent of a right to try some or all claims to a jury now depends on whether a defendant litigates in state or federal court. UCL defendants should assess at the outset of litigation whether a jury or bench trial on eligible claims would be preferable, as that determination may affect strategic considerations, including forum selection, removal or remand, and bifurcation: the outcome may be different depending on the venue.

In federal court, “the court may order a separate trial of one or more separate issues [or] claims” for “convenience, to avoid prejudice, or to expedite and economize,” so long as it does not impinge on the right to trial by jury. (Fed. R. Civ. P. 42, subd. (b).) Accordingly, where a case presents both legal and equitable claims that do not overlap, the court may bifurcate and “regulate the order of the trial.” (Danjaq LLC v. Sony Corp. (9th Cir. 2001) 263 F.3d 942, 962.) But if the legal and equitable issues or evidence overlap, the legal claims must be resolved before the court addresses the equitable issues. (Id.; Nationwide Biweekly Administration, Inc., supra, ___ Cal.5th ___ , at [p. 68] [citing Tull v. United States (1987) 481 U.S. 412, 425].)

In California, however, where there are both legal and equitable issues, the court may decide to try the equitable issues first. (See Nationwide Biweekly Administration, Inc., supra, ___ Cal.5th ___ , at [p. 44]; Raedeke v. Gibraltar Savings & Loan Assn. (1974) 10 Cal.3d 665, 696; see Orange County Water Dist. v. Alcoa Global Fasteners, Inc. (2017) 12 Cal.App.5th 252, 354 [in cases with both equitable and legal claims, the equitable claims “could, and in many cases should” be tried first].) If the California court’s determination of those issues also resolves all the legal questions, there could be no need for a jury. But where the equitable issues do not determine the outcome of the legal issues, there may still be a right to trial by jury on those legal questions. (Nationwide Biweekly Administration, Inc., supra, ___ Cal.5th ___ , at [p. 43].)

Accordingly, Nationwide’s holding adds an additional layer to consider with respect to forum selection, because the opportunity for and scope of a jury trial may vary depending on whether the case is tried in state or federal court.

B. Application to Other Statutory Schemes That Provide for Civil Penalties and Injunctive Relief.

While the Court held there was no right to a jury trial under the UCL, both the majority and concurring opinions made clear they were not passing upon other statutory schemes that provide for civil penalties and injunctive relief. The Court’s analysis nonetheless provides a useful guide for understanding which statutory schemes are more likely to come with a jury-trial right.

In Nationwide Biweekly, the Court held the civil penalties under the UCL and FAL were equitable in nature because the amount awarded as well as liability itself were determined based on equitable considerations. In assessing the amount of the civil penalty to be imposed under either the UCL or the FAL, the court has “broad discretion to consider a nonexclusive list of factors,” such as “the relative seriousness of the defendant’s conduct and the potential deterrent effect of such penalties.” (Id., at [pp. 59-60].) This type of “qualitative evaluation and weighing of factors is typically undertaken by a court and not a jury.” (Ibid.) This made the remedy more equitable in nature, despite its resemblance to the classic legal remedy of money damages.

But this may not hold true as to all civil penalties authorized by other statutory schemes. Indeed, other statutory schemes, such as those providing for statutorily prescribed penalties not implicating the exercise of a judge’s discretion, or those that evince a clear legislative purpose to be punitive rather than restitutionary, may be considered “legal” in nature. Additionally, if the liability inquiry does not require as complex a balancing of factors as the UCL often does, the “gist of the action” could conceivably be deemed “legal” rather than equitable, potentially triggering the right to trial by jury.

C. The Right to Trial by Jury Under the Sixth and Seventh Amendments to the United States Constitution.

The Court also declined to address whether the United States Constitution’s Sixth and Seventh Amendments provide an independent constitutional right to trial by jury. The Court deemed the issue waived, ruling that Nationwide had not advanced this argument in the Court of Appeal. (Id., at [p. 73, fn. 25].)

The Court did, however, conclude that the Court of Appeal erred in relying on the U.S. Supreme Court’s decision in Tull v. United States (1987) 481 U.S. 412. First, the majority held that Tull “rested exclusively” on construing the right to trial by jury under the Seventh Amendment, which applies only to trials in federal—not state—court. (Id., at [p. 66].) The majority also noted the “significant differences in the manner in which the federal and California constitutional civil jury trial provisions have been interpreted and applied,” as well as the difference in statutory standards, given the “type of equitable discretion” that must be exercised under the UCL and FAL. (Id. at [pp. 72-73].)

D. Importance of a Statement of Decision To Aid Appellate Review.

Writing for the majority, Chief Justice Cantil-Sakauye noted that an “additional significant benefit” of trying UCL claims to a court, rather than a jury, is that a court must issue “a statement of decision explaining the factual and legal basis for its decision” if requested to do so. (Id., at [p. 23].) Such a statement of decision differs, of course, from the kind of verdict forms filled out by juries. Appellate review of detailed statements of decision, “in turn, promotes the creation of a cumulative body of precedent that improves the consistency of future determinations under the UCL and provides needed guidance to companies” regarding acceptable business practices. (Id., at [pp. 23-24].) As the UCL and FAL have no clear boundaries, and in fact are “expanding” to cover “new facts and relations,” the majority found any potential for overreach better tempered by the transparency a court judgment would provide. (Id., at [pp. 16, 23-24].) Justice Kruger, on the other hand, found this reasoning “unpersuasive” as a basis to narrow the civil jury trial right enshrined in the California Constitution. (Nationwide Biweekly Administration, Inc., supra, ___ Cal.5th ___ [conc. opn. of Kruger, J.], at [p. 11].)

The Court’s decision underscores the importance of proactively crafting a statement of decision that will be advantageous for purposes of appellate review.

V. Conclusion

Nationwide Biweekly forcefully confirms the decades of Court of Appeal precedent holding that UCL (and some FAL) claims are to be decided by judges, rather than juries, and raises a number of strategic considerations to consider in litigating against such claims.

For more information, please feel free to contact the Gibson Dunn lawyer with whom you usually work or any of the following attorneys listed below.

Theodore J. Boutrous, Jr. – Los Angeles (+1 213-229-7000, [email protected])
Daniel M. Kolkey – San Francisco (+1 415-393-8420, [email protected])
Julian W. Poon – Los Angeles (+1 213-229-7758, [email protected])
Michael Holecek – Los Angeles (+1 213-229-7018, [email protected])
Victoria L. Weatherford – San Francisco (+1 415-393-8265, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

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Federal Reserve Announces Revisions To And Expansion Of The Main Street Lending Programs

On April 9, 2020, we published an alert on the Board of Governors of the Federal Reserve System’s (“Federal Reserve”) announcement that it was creating two loan facilities, the Main Street New Loan Facility (“MSNLF”) and the Main Street Expanded Loan Facility (“MSELF”), pursuant to the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”). Yesterday, the Federal Reserve announced key changes to those Facilities, including the creation of a third program, the Main Street Priority Loan Facility (“MSPLF,” together with the MSNLF and MSELF, the “Main Street Lending Programs”), which is meant to extend assistance to more highly leveraged companies and those with lower earnings in 2019.
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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. 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.
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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.

_________________________

[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.

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.

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

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).

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.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Yesterday, the Federal Reserve announced key changes to those Facilities, including the creation of a third program, the Main Street Priority Loan Facility (“MSPLF,” together with the MSNLF and MSELF, the “Main Street Lending Programs”), which is meant to extend assistance to more highly leveraged companies and those with lower earnings in 2019.

Key takeaways from the Federal Reserve’s announcement include:

Creating a New Facility for More Leveraged Borrowers: The MSPLF is a new lending facility with less restrictive leverage requirements than the MSNLF, requiring the maximum loan size to be the lesser of $25 million or six times adjusted 2019 earnings before interest, taxes, depreciation, and amortization (“EBITDA”); as compared to the MSNLF, which establishes a maximum of four times adjusted 2019 EBITDA.
Increasing Scope of Eligible Borrowers: The revised terms sheets for the Main Street Lending Programs modify certain borrower eligibility tests to make more borrowers eligible. They raise the maximum employee cap from 10,000 to 15,000 and the maximum annual revenue cap from $2.5 billion to $5.0 billion.
Clarification on Eligible Borrowers: Under the additional guidance on eligible borrowers, it appears that U.S. subsidiaries of foreign businesses or U.S. businesses owned by non-U.S. persons can participate in the Main Street Lending Programs.
SBA Affiliation Rules: When determining the number of employees for purposes of the Main Street Lending Programs, the SBA Affiliation Rules apply. These rules are discussed in prior alerts available here and here.
Decreasing Minimum Loan Size: Under the MSNLF, minimum loan size has been reduced from $1 million to $500,000. Similarly, the newly created MSPLF will require only a minimum of $500,000 to be borrowed.
Increasing Maximum Loan Size in MSELF: The minimum borrowable amount required under the MSELF has been increased to $10 million from $1 million. The maximum amount borrowable under the MSELF has been increased to the lesser of (a) $200 million that is pari passu in priority and equivalent in security with the MSELF loan (increased from $150 million), (b) 35% of outstanding and undrawn available debt (increased from 30% and adding the priority and security requirements), or (c) six times 2019 adjusted EBITDA (unchanged from previous guidance).
No “Specific Support”: Similar to other Federal Reserve programs, all three Main Street Lending Programs now require that the borrower “has not received specific support pursuant to the [CARES Act].” Accompanying guidance clarified that “specific support” does not include participation in the Paycheck Protection Program, but it does include support pursuant to Section 4003(b)(1)-(3) of the CARES Act, which provides funding to specific industries—namely, passenger and cargo air carriers and businesses critical to national security.
Prior Existence: Eligible borrowers must have existed prior to March 13, 2020, and not be “ineligible business[es].”[1]

The following requirements, although substantively unchanged from April 9 guidance, will apply to all three Main Street Lending Programs:

Only One Program May Be Selected: As required under previous guidance, borrowers may only participate in one Main Street Lending Program or the Primary Market Corporate Credit Facility (“PMCCF”). Borrowers may not participate in both a Main Street Lending Program and the PMCCF.
Compensation, Dividend, and Buy-Back Restrictions Apply: Compensation, stock repurchase, and capital distribution restrictions under Section 4003(c)(3)(A)(ii) of the CARES Act continue to apply.
No Forgiveness: Loans remain unforgivable.
Program Size: The overall aggregate size of the Main Street Lending Programs remains unchanged at $600 billion.
Application Process: There will be an application process run by lenders. The guidance instructs potential borrowers to contact lenders to see if the lender plans to participate in the Main Street Lending Programs and to request additional information. The official launch date of the Main Street Lending Programs, however, has not yet been announced.

The chart below details changes to key terms under the MSNLF and MSELF, as well as the features of the MSPLF.

Main Street Lending Programs
	MSNLF		MSELF		MSPLF
Version	Old Terms (April 9)[2]	New Terms (April 30)[3]	Old Terms (April 9)[4]	New Terms (April 30)[5]	New Program (April 30)[6]
Revenue Cap	$2.5 billion	Either $5 billion or 15,000 employees[7]	$2.5 billion	Either $5 billion or 15,000 employees[8]	Either $5 billion or 15,000 employees
Employee Cap	10,000	Either $5 billion or 15,000 employees[7]	10,000	Either $5 billion or 15,000 employees[8]	Either $5 billion or 15,000 employees
Term	4 years	4 years	4 years	4 years	4 years
Minimum Loan Size	$1,000,000	$500,000	$1,000,000	$10,000,000	$500,000
Maximum Loan Size	Lesser of $25M or 4x 2019 adjusted EBITDA	Lesser of $25M or 4x 2019 adjusted EBITDA	Lesser of $150M, 30% of outstanding and undrawn available debt, or 6x 2019 adjusted EBITDA	Lesser of $200M, 35% of outstanding and undrawn available debt that is pari passu with other debt and equivalent in secured status, or 6x 2019 adjusted EBITDA	Lesser of $25M or 6x 2019 adjusted EBITDA
Risk Retention	5%	5%	5%	5%	15%
Payment (year one deferred for all)	Post-Year 1 unspecified	Years 2-4: 33.33% each year	Post-Year 1 unspecified	Years 2-4: 15%, 15%, 70%	Years 2-4: 15%, 15%, 70%
Rate	Secured Overnight Financing Rate (“SOFR”) + 250–400 basis points	LIBOR + 3%	Secured Overnight Financing Rate (“SOFR”) + 250–400 basis points	LIBOR + 3	LIBOR + 3%

Main Street Priority Loan Facility

The new MSPLF is similar in concept and terms to the MSNLF and MSELF. As noted above, it is an additional avenue of relief for certain higher-leveraged borrowers. Differences from the MSNLF include:

Lender Participation: Under the MSNLF and MSELF, the Special Purchase Vehicle (“SPV”), which the Federal Reserve and Treasury will capitalize, will purchase 95% of the interest in MSNLF and MSELF loans. Under the MSPLF, however, the SPV will purchase only 85%, and require lenders to retain the remaining 15%;
Loan Size Calculation: The maximum loan size under the MSPLF is capped at the lesser of $25 million and six times adjusted 2019 EBITDA (as compared to the lesser of $25 million or four times adjusted 2019 EBITDA under the MSNLF);
Loan Amortization: Rather than the standard one-third amortization rate for years two through four under the MSNLF, loans under the MSPLF will be amortized at 15% for years two and three, with a final balloon payment of 70% due in year four;
Loan Subordination: MSPLF loans must be senior to or pari passu, both in terms of priority and security, with the other debt instruments of the borrower (excluding mortgage debt). This is the same for an upsized tranche under the MSELF. MSNLF loans, however, must only be senior to or pari passu in terms of priority (but not security) with the other debt instruments of the borrower (inclusive of mortgage debt);
Loan Refinancing: MSPLF loans allow for the borrower to refinance its existing debt at the time of origination of the MSPLF loan, provided that the MSPLF lender is not also the holder of the refinanced debt. Such refinancing is not permitted under the MSNLF.

Main Street New Loan Facility

The key changes to the MSNLF are as follows:

Minimum Loan Size Decrease: Minimum loan size changed from $1 million to $500,000;
Additional Guidance on Eligible Businesses: The guidance clarifies that an eligible business is any of the following: an entity that is organized for profit as a partnership; a limited liability company; a corporation; an association; a trust; a cooperative; a joint venture with no more than 49 percent participation by foreign business entities; or (with limited exceptions) a tribal business concern as defined in 15 U.S.C 657a(b)(2)(C);
Ineligible Businesses: A number of businesses are ineligible to participate, including (but not limited to) non-profit businesses, and financial businesses primarily engaged in the business of lending, such as banks, finance companies, and factors (but pawn shops, although engaged in lending, may qualify in some circumstances);
Eligible Lenders: The additional guidance provides that eligible lenders include a “U.S. branch or agency of a foreign bank,” a “U.S. intermediate holding company of a foreign banking organization,” or a “U.S. subsidiary of” any entity that otherwise meets the definition of eligible lender; currently, nonbank financial institutions are not considered eligible lenders;
Financial Condition Assessment: Lenders are now expected to conduct an assessment of each potential borrower’s financial condition at the time of the potential borrower’s application;
Solvency Certification: A borrower must certify that it has a reasonable basis to believe that, as of the date of origination of the loan and after giving effect to such loan, it has the ability to meet its financial obligations for at least the next 90 days and does not expect to file for bankruptcy during that time period;
Adjusted EBITDA Certification: Lenders must certify that the methodology used to generate a borrower’s 2019 adjusted EBITDA is the same as previously used;
LIBOR Pricing: Pricing for the loans will be based on LIBOR, not SOFR as originally proposed. Guidance explains that this change is intended to facilitate timely originations as lenders continue to prepare to transition from LIBOR to alternative reference rates”; and
Retained Interest: Lenders must retain their 5% portion of the loan until it matures or the SPV sells all of its 95% participation, whichever comes first.

Main Street Expanded Loan Facility

Largely the same new features apply to the MSELF as apply to the MSNLF, including: (i) additional guidance on eligible and ineligible business; (ii) more targeted guidance on eligible lenders; (iii) the financial condition assessment; (iv) additional solvency certifications; (v) the adjusted EBITDA certification; and (vi) LIBOR pricing.

The April 30 guidance also includes some new features unique to the MSELF:

Requirements on Loan Being Upsized: The upsized tranche must be senior to or pari passu with, in terms of priority and security, the borrower’s other loans or debt instruments, other than mortgage debt;
Additional Loan Requirements: The upsized tranche must:
- Be a term loan originated on or before April 24, 2020, and that has a remaining maturity of at least 18 months (taking into account any adjustments made to the maturity of the loan after April 24, 2020, including at the time of upsizing); and
- Have principal amortization of 15% at the end of the second year, 15% at the end of the third year, and balloon payment of 70% at maturity at the end of the fourth year;
Eligible Lender Requirements: The lender must be one of the lenders that holds an interest in the underlying loan at the date of upsizing. Additionally, the lender must:
- Retain its 5% portion of the upsized tranche of the loan until the upsized tranche of the loan matures or the SPV sells all of its 95% participation, whichever comes first; and
- Retain its interest in the underlying loan until the underlying eligible loan matures, the upsized tranche of the eligible loan matures, or the SPV sells all of its 95% participation, whichever comes first.

Conclusion

Despite some broadening at the margins, the Federal Reserve’s actions do not transform the fundamental nature of the Main Street Lending Programs. The requirements of a financial assessment of the borrower, and solvency and adjusted EBITDA certifications, will focus the Programs on firms that have not incurred very significant amounts of leverage. Borrowers will also be required to comply with the CARES Act restrictions on stock repurchases and dividends, and the statute’s executive compensation limitations. We will continue to monitor developments with respect to these Programs, including when additional guidance on the application process for the Main Street Lending Programs is released.

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[1] For more information regarding the PPP and “ineligible business” standard, please see 13 CFR 120.110(b)-(j) and (m)-(s) and our discussion of the implementing regulations of the PPP, available at https://www.gibsondunn.com/analysis-of-small-business-administration-memorandum-on-affiliation-rules-and-faqs-on-paycheck-protection-program/.

[2] MSNLF (April 9): https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200409a7.pdf

[3] MSNLF (April 30): https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200430a1.pdf

[4] MSELF (April 9): https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200409a4.pdf

[5] MSELF (April 30): https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200430a3.pdf

[6] MSPLF (April 30): https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200430a2.pdf

[7] Borrower only needs to satisfy the revenue or employee test, but not both as previously required under April 9 guidance.

[8] Borrower only needs to satisfy the revenue or employee test, but not both as previously required under April 9 guidance.

Michael D. Bopp, Arthur S. Long, Roscoe Jones, Jr.*, James O. Springer and Luke Sullivan

* Not admitted to practice in Washington, D.C.; currently practicing under the supervision of 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 businesses plan to resume or expand operations in a post-quarantine COVID-19 world, they face a complex, and sometimes conflicting, patchwork of public health, employment, and privacy considerations requiring them simultaneously to:

Develop, implement, and continue to evaluate infection control programs—including PPE use, cleaning and disinfection protocols, social distancing and hand hygiene programs, and return to work policies—to reduce illness and transmission risk and keep up with evolving community health and industry standards.
Evaluate, implement, and document enhanced worker screening and contact tracing programs to identify, respond to, and understand the root cause of worker illnesses.
Implement screening and other programs with an eye to privacy, balancing the need to collect information with applicable and potentially conflicting privacy obligations arising under state constitutional and common law; statutes including the California Consumer Privacy Act, California’s Confidentiality of Medical Information Act, the Illinois Biometric Information Privacy Act, and various tracking and data breach statutes; and evolving general privacy principles of transparency, data minimization, confidentiality, and data security.
Remain compliant with wage and hour obligations in a “new normal” of altered work schedules and arrangements and new activities ancillary to workers’ regular shifts that may include PPE use, additional personal hygiene steps, or employee screening requirements.
Navigate the framework of federal and state employment law protecting employee rights, including those protecting potentially higher risk workers based on age or disability, worker health and safety obligations, and paid and unpaid leave rights, and be prepared to respond to employee concerns (and potential reluctance to work) while remaining sensitive to whistle-blower, anti-retaliation, worker speech.

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PANELISTS:

Karl Nelson is a Gibson Dunn partner who advises and represents employers across the country in connection with employment law compliance and litigation, including with respect to fair employment practices, benefits issues, worker health and safety, whistle-blower claims, and collective bargaining rights and obligations. He has been actively involved as part of the firm’s COVID-19 Response Team in guiding clients across a range of industries in responding to the recent health crisis.

Katherine V.A. Smith is a partner in Gibson Dunn’s Los Angeles office whose practice focuses on high stakes employment litigation matters such as wage and hour class actions, representative actions brought under the California Private Attorney General Act (“PAGA”), whistleblower retaliation cases, and executive disputes. In addition to litigation, Ms. Smith also dedicates a significant portion of her practice to advising employers on nearly all aspects of employment law, including those arising from the COVID-19 crisis.

Alexander H. Southwell is a nationally-recognized technology investigations lawyer and counselor, serving as global Co-Chair of Gibson, Dunn & Crutcher’s Privacy, Cybersecurity, and Consumer Protection Practice Group. He represents a wide-range of leading companies, counseling on privacy, information technology, data breach, theft of trade secrets and intellectual property, computer fraud, national security, and network and data security issues, including handling investigations, enforcement defense, and litigation. Recently, he has focused on advising clients on cybersecurity and privacy issues relating to COVID-19 crisis management programs and has led a number of COVID-related pro bono projects.

Cassandra Gaedt-Sheckter is a senior associate in Gibson Dunn’s Palo Alto office who focuses on cutting-edge privacy law compliance concerns for clients in a broad range of industries, including relating to federal, state, and international privacy and cybersecurity laws, and representing companies in technology-related privacy class action and IP litigation matters. She is a leader of the firm’s CCPA Task Force, and has been particularly dedicated in recent months to advising clients on privacy and cybersecurity issues relating to businesses’ implementation of COVID-19 crisis management and prevention programs.

Dr. Christopher Kuhlman is a board certified toxicologist (DABT) and industrial hygienist (CIH) with CTEH. Dr. Kuhlman specializes in toxicology, risk assessment, toxicity evaluations, and emergency response toxicology. Recently, he has been working with employers around to globe to meet the ongoing challenges of the outbreak of COVID-19.

New York partner Reed Brodsky and associate Michael Nadler are the authors of “Pandemic May Prompt Legislative Action On Court Deadlines,” [PDF] published by Law360 on April 30, 2020.

Hong Kong partners Michael Nicklin, Paul Boltz and Scott Jalowayski are the authors of “Coronavirus: Private equity investing in a distressed environment,” [PDF] published by International Financial Law Review on April 23, 2020.

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