By Allison L. Kierman, DLA Piper LLP

It is now standard practice that every litigation should begin with the institution of a litigation hold. Companies have created their own procedures and forms to aid with the institution of such litigation holds. Although a company may be entirely correct about the underlying merits of a dispute, it could find that its position in litigation (and the judge’s opinion of a company) has been compromised by the failure to take steps to preserve potentially discoverable information.

The obligation to issue a litigation hold is widely known and is the subject of significant judicial opinions, scholarly articles, and continuing legal education seminars, among other things. Nonetheless, parties are routinely found negligent, and sometimes grossly negligent, by failing to properly issue and implement a litigation hold. Indeed, litigation holds have been at issue in more than 100 cases since the beginning of 2012. These cases include important instructions and reminders on how to avoid sanctions for failure to properly implement litigation holds.

Ten Tips for Proper
Litigation Hold Policies

1. Pre-litigation optimism shouldn’t impede hold. Sometimes companies and in-house counsel wait to issue a litigation hold until after pre-litigation settlement and dispute resolution fails or until the business people have reached an impasse. The hope and optimism that a dispute will not rise to the level of litigation is an insufficient basis to wait to issue a litigation hold. Litigation holds should be issued as soon as the business relationship sours. Courts are now finding that litigation holds should be issued from the first instance in which the company has notice that a dispute is brewing. This notice may occur years before any actual litigation is filed. Nonetheless, courts have been consistent in stating that waiting until a complaint has been filed to issue a litigation hold is too late. Companies are encouraged to be proactive in issuing litigation holds and preserving all potentially discoverable information.

2. Subpoenas, government investigations get holds.Traditionally, litigation holds were only issued at the onset of a filed complaint. Companies should consider taking a more conservative approach and should issue a litigation hold when they receive a third-party subpoena or when they are under investigation by a governmental entity. The theory behind such approach is that third-party subpoenas and governmental investigations are leading to actual litigation more now than ever. If a company produces a document in response to a third-party subpoena and is later joined to an action, the company is expected to have preserved all relevant documents as the company was on notice of the dispute at least as of the time of the subpoena.

3. Gauge employee compliance with holds. It is insufficient to simply issue a litigation hold and assume employees have and/or will comply. Courts are increasingly contemptuous of what they consider lackadaisical attitudes toward document preservation. A California judge in a 2012 case issued sanctions for defendants’ spoliation of evidence in part because defendant failed to take “any steps to ensure its employees actually complied with the [litigation hold] notice.” Companies should undertake specific actions to measure and ensure employee compliance with the litigation hold. Such compliance actions could include: (a) conducting interviews before issuing the litigation hold to ensure all relevant data is captured and subject to the litigation hold; (b) conducting periodic interviews of those on the litigation hold to ensure the individuals are complying with the litigation hold and that relevant data is being preserved as required; (c) gathering and copying employees’ files as they exist at the time of the litigation hold, including paper files, without waiting for written discovery to commence; (d) taking mirror images of employees’ email and hard drives; (e) requiring employees to periodically acknowledge that they have received and are abiding by the litigation hold; and (f) monitoring and interviewing those subject to the litigation hold periodically to ensure all relevant data is preserved.

4. Send to all possible witnesses. Traditionally, litigation holds were sent to key custodians for preservation of those custodians’ data. Many of these litigation holds ask the key custodians to forward the litigation hold on to other individuals that may have knowledge of the dispute. This passive form of gathering information regarding possible company witnesses and those with documents relevant to the dispute is insufficient. In Yelton v. PHI Inc., et al., 2012 BL 2070622012 WL 3441826 (E.D. La. Aug. 14, 2012), a court sanctioned one of the defendants for failure to issue a litigation hold for one of that defendant’s key witnesses. As part of its sanctions award in one recent case, a California court found defendants’ issuance of a litigation hold to only three employees insufficient. To ensure compliance with litigation hold requirements, companies should interview key custodians and compile a complete and thorough list of all knowledgeable employees and those employees who may be called as a witness at any deposition, hearing, or trial of the disputed matter. Each of these individuals should receive the litigation hold. In particular, each employee who would be listed on any disclosure or witness list should receive the litigation hold. As the litigation proceeds over time, companies should be vigilant in re-issuing litigation holds to new employees and newly-discovered employees with knowledge.

5. Include social media. Many companies prohibit employee use of social media while at work. Such policies may or may not be effective. Regardless, it is indisputable that use of social media has exploded in recent years. Many employees post to social media websites information regarding where they work, travel for work, and how they feel about their work, employer, and other employees, among other things. Employees also contact and message others through social media websites. Such information and messages may be relevant in litigation and should be encompassed in a litigation hold. Employment-related cases more frequently involve social media than other types of disputes. The U.S. District Court for the Eastern District of New York has stated that “there is no dispute that social media information may be a source of relevant information that is discoverable.” Reid v. Ingerman Smith LLP, CV 2012-0307 ILG MDG, 2012 BL 3397442012 WL 6720752 (E.D.N.Y. Dec. 27, 2012). Social media data is not generally privileged or protected by common law or civil law notions of privacy. Tompkins v. Detroit Metro. Airport, 278 F.R.D. 387, 388 (E.D. Mich. 2012). The Tompkins court did find, however, that “the Defendant does not have a generalized right to rummage at will through information that Plaintiff has limited from public view. Rather, … there must be a threshold showing that the requested information is reasonably calculated to lead to the discovery of admissible evidence.”

6. Don’t forget paper documents. Litigation holds are most commonly used to halt routine electronic destruction of electronic data. It should not be forgotten that document preservation efforts began with paper documents. Litigation holds should encompass all types of paper documents and files and handwritten notes and companies must make efforts to gather all relevant paper documents. In a 2012 decision issued by the Eastern District of New York, one defendant was sanctioned because that defendant did not retain copies of handwritten notes on documents relevant to the litigation. Conducting witness interviews in conjunction with issuing a litigation hold will help companies collect relevant paper documents that may be missed in a collection of electronic data. As courts have noted, collection of a document electronically does not always excuse the collection of a paper document, especially where the paper document is similar but not duplicative of the electronic document.

7. Don’t forget image files, proprietary software. Among the data to be preserved, litigation holds should encompass TIFF, PDF, JPEG, PNG, GIF, and other image files, as well as documents created and maintained using proprietary software. It is more common that companies are obligated to produce information in its native form. A necessary corollary to preserving data in its native form is preserving the software that allows access to information in its native form, including proprietary software. Companies may be obligated to allow the opposing party in litigation to run or access the proprietary software in order to view information in its native form. The privacy protections associated with such discovery will necessarily need to be taken into consideration during the course of litigation but failure to preserve will not be an adequate defense to avoid production of relevant information.

8. Consider employing a forensic specialist. Companies are obligated to preserve all forms of electronic and paper documents, in all types of media (e.g., USB drives, handheld devices, and cloud storage), and data kept by the company and by employees personally (e.g., at home and on personal mobile devices). This obligation on companies can be enormous and burdensome. To aid in corporate accountability, companies are now more often employing forensic specialists to assist in document preservation, collection, and review efforts. Such efforts are particularly helpful in uncovering “missing” data. Indeed, in a March 2013 decision issued by the Western District of New York, the court noted that according to a forensic expert’s testimony “whenever a USB device is plugged into a computer, the computer’s operating system records the connection.” As a result, defendants’ forensic expert uncovered six missing USB devices from plaintiffs’ document production. Plaintiffs’ failure to disclose and produce such USB devices was considered willful spoliation by the Court.

9. Keep detailed records of holds. Generally, litigation holds are not discoverable. However, after a court has found spoliation has occurred, information regarding the implementation of litigation holds is discoverable. Additionally, courts are more frequently requiring parties to disclose information regarding litigation holds. Indeed, in Roberts v. Los Alamos Nat. Sec. LLC, 2012 BL 2023642012 WL 3262455 (W.D.N.Y. Aug. 8, 2012), the court ordered counsel to file an affidavit of a party employee with direct knowledge of the party’s document and email retention system stating: (a) the document/email retention policy used; (b) the dates of emails “reasonably accessible” for production in the litigation; (c) the back up or legacy system, if any, used to preserve or archive emails that are no longer “reasonably accessible” and whether responsive documents or data may potentially be found on such back up or legacy systems; (d) whether accessing archived or back up emails would be unduly burdensome or costly and why; and (e) the date when a litigation hold or document preservation notice was put in place and either a copy of or a description of the preservation or litigation hold utilized. Companies should consider developing a template litigation hold form to catalogue information regarding the date(s) a litigation hold was issued, employees to whom the litigation hold was issued, and any action taken to gather the relevant employees’ files, among similar related matters.

10. Be cautious. Companies should be cautious and conservative in issuing litigation holds and preserving documents. In Mangione v. Jacobs, 950 N.Y.S.2d 457 (N.Y. Sup. Ct. 2012), a New York court found that a plaintiff who had a pending personal injury action committed spoliation by undergoing non-emergency and non-life-threatening surgery before defendant had the opportunity to perform an independent medical examination. Efforts to thwart the discovery of relevant data are likely to be met with skepticism and hostility from the court (and the opposing party).

Conclusion

In 2003, the decision in Zubulake v. UBS Warburg LLC, 220 F.R.D. 212 (S.D.N.Y. 2003), set the standard for obligations to preserve and produce electronic documents in litigation. In the 10 years since that landmark case, sanctions awards for failure to comply with Zubulake and its progeny have exploded and spoliation motions are now common in litigation.

The tips listed above are but a few important reminders of the litigation hold requirements and the current legal standards for preservation of documentary evidence. Companies should consider reviewing their current litigation hold policies and procedures. It may be necessary for companies to revise their litigation hold policies to stay abreast of the current legal landscape regarding document preservation requirements.

Allison Kierman is a litigation associate with the law firm of DLA Piper LLP (US). Ms. Kierman practices in the area of commercial litigation and routinely provides advice to clients on a variety of regulatory and compliance matters.

© 2013 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.

Disclaimer
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

By Jennifer E. Eller, Groom Law Group

Thousands of times each year, fiduciaries of plans covered by the Employee Retirement Income Security Act and service providers receive an unexpected letter or phone call from the Department of Labor noticing an investigation “to determine whether any person has violated or is about to violate” any provision of Title I of ERISA. Knowing how the DOL investigation process works and what to expect if you are investigated can greatly ease the strain and lower the cost of having the federal government take particular interest in your ERISA plans.1

DOL’s Investigative and Enforcement Authority

The DOL’s Employee Benefit Security Administration (EBSA) Office of Enforcement has more than 300 investigators working out of 10 regional offices across the country. Under ERISA, the DOL has powers to investigate ERISA violations, including the power to subpoena books and records and compel witnesses to testify under oath. The DOL is one of the federal agencies with independent litigation authority—the Solicitor of Labor has litigation responsibility with respect to EBSA investigations.

ERISA empowers (and in some cases, requires) the DOL to assess civil penalties against a fiduciary who breaches his duties under ERISA or commits a violation of any of ERISA’s fiduciary responsibility provisions and against any person who knowingly participates in such a breach or violation. In addition to assessing penalties, the DOL may bring civil litigation against fiduciaries for breach of ERISA duties.

During fiscal year 2012 (October 1, 2011 – September 30, 2012) EBSA closed 3,566 civil investigations. Of these, 2,570 (72.1 percent) resulted in monetary recoveries totaling $1.27 billion. These recoveries included $911 million in prohibited transaction corrections, $188 million in plan assets restored to plans, and $12.2 million in voluntary fiduciary correction program filings. The Solicitor of Labor filed 100 civil lawsuits (out of 218 referred).

Why EBSA Investigates

With responsibility for over 700,000 retirement plans and approximately 2.3 million health plans, EBSA regional offices can investigate only a small fraction of plans. As a result, roughly 25 percent of investigations are opened based on participant complaints. During the fiscal year ending Sept. 30, 2012, EBSA fielded over 240,000 inquiries from plan participants, and these inquiries led to the opening of 814 new investigations.

In addition to participant complaints, EBSA has focused its enforcement resources in certain areas, and has developed a set of National Enforcement Projects—areas on which each EBSA Regional Office focuses investigative resources. These include:

• Contributory Plans Criminal Project
• Health Benefit Security Project (primarily MEWAs)
• Consultant/Adviser Project
• Sponsors in Bankruptcy (REACT)
• ESOPs
• Non-Filer Enforcement Program
• Late Filer Enforcement Program
• On-Site Reviews of Audit Work Papers
• Desk Reviews of Form 5500s

Investigative Process

A substantial amount of information about EBSA’s investigative process is available on the agency’s website. This information includes the EBSA Enforcement Manual, and numerous form documents, including subpoenas, reports, checklists and sample closing letters which are used by investigators during investigations.

Please note: the EBSA Enforcement Manual includes a statement of purpose, which provides that the manual is intended solely for use of EBSA employees and does not limit or restrict the agency in any way. Nor is the enforcement manual intended to interpret the law, provide guidance to or confer rights on persons outside the DOL. Nevertheless, the enforcement manual and other materials and information on EBSA’s website can be very useful in gaining insight about the DOL’s investigative process.

Initial Contact and Information Request

A typical investigation begins with a letter (or a preliminary phone call followed by a letter) from the EBSA Regional Office conducting the investigation. The letter includes a case number, names the entity under investigation, outlines the DOL’s investigative authority and includes a request for documents. The letter also should describe the time period covered by the request for documents. Often, the letter will request that documents responsive to the information request be provided as of a certain date—usually within a matter of weeks from the date of the initial letter.

For plan sponsors under investigation, the DOL may review areas such as:

• Bonding
• Employer contributions
• Reporting and disclosure
• Loans (including participant loans, employer loans and ESOP loans)
• Employer securities/real property
• Missing participants/unclaimed benefits
• Receivables
• Income/earnings
• Fees and expenses
• Investments (including securities, stocks, bonds, mortgages, and alternative investments)
• Blackout procedures

The records requested by the DOL may include some or all of the following:

• Plan and trust documents
• SPD / SAR / SMM
• Meeting minutes, resolutions and correspondence
• Benefits statements
• Participant disclosure documents
• Service provider agreements
• Investment documents (e.g., collective fund, partnership and joint venture documents)
• COBRA notices
• Fiduciary liability insurance
• Fidelity bond
• Insurance contracts
• Forms 5500 and attachments (including financial statements)
• Appraisals/valuations
• Participant records

Document requests that the DOL issues to entities that provide services to ERISA-covered plans may ask for similar information, and may also seek client lists and client specific information, as well as internal audits and information on products and services provided to ERISA plan clients.

Upon receiving an investigation letter, consideration needs to be given to the initial scope of the investigation. Information requests can cover a limited data set, or be very broad. Typical information requests can range from a few items to dozens of separate requests for documents and information. Often, information requests ask for all documents (e.g., correspondence, agreements, policies, procedures, guidelines and manuals, etc.) regarding a certain subject. In addition to the breadth of the document request, consider the time period covered by the request.

Identifying and collecting documents requested by the EBSA investigator can take significant time. By coordinating with the investigator at the outset of the investigation it may be possible to narrow, or at least prioritize, the requested information. It is often helpful to have an initial conversation regarding the precise scope of the issue or subject of the investigation, the time period under review, the priority of documents for production, and specific entities, lines of business or geographic areas covered.

It is also important to establish a point of contact for the investigator. Typically, the contact person is an in-house or outside lawyer, who serves as the conduit of all information exchanged with the DOL, and coordinates the process.

Interview Process

While the DOL has the authority to notice depositions, most DOL investigations involve voluntary interviews with persons the investigator believes to have information relevant to the investigation. According to the EBSA Enforcement Manual, the objectives of an interview include, “to develop credible information that is relevant and material to the investigation and to ascertain the interviewee’s version of the facts.”

Before beginning an interview, DOL investigators are required to identify themselves and to show their official credentials when asked (most do this as a matter of course). Investigators also are supposed to inform interviewees that if the investigator discovers information involving violations of laws other than ERISA, EBSA will refer the matter to another relevant agency (including the U.S. Department of Justice). The initial formality of the interview process can come as a surprise to some interviewees, as can the scope and range of the questions asked.

Investigators are trained in interview techniques, such as how to develop a line of questions, how to frame questions, and how to use different questioning techniques to elicit information. For instance, when posing a series of questions designed to bring out description of an event or incident, the EBSA Enforcement Manual encourages investigators to “begin with questions not likely to cause hostility.” The manual reminds investigators that “almost every subject/interviewee possesses more information than he/she initially admits knowing.” Investigators are also instructed by the manual to “conduct interviews in a courteous manner, free of personal prejudice or preconceived notions as to the culpability of the interviewee, and without making any threats or promises whatsoever to elicit any information.”

DOL investigators will typically take notes during an interview. Once the investigator has completed the interviews, he or she will use the notes from each interview to create a Report of Interview (“ROI”). The ROI will be maintained in the case file, as will the investigator’s notes from the interview.

Closing the Investigation

Once the investigator has gathered and analyzed the necessary information, the EBSA regional office must decide whether to take any further action. For certain matters, such as those involving a lengthy proposed correction of a violation, potential fraud or criminal misconduct, the removal of a fiduciary, or particularly novel or complex violation or violations of other laws, EBSA will generally not seek “voluntary compliance.” Rather, the agency will refer those cases to the solicitor’s office or other appropriate entity.

The vast majority of EBSA investigations are resolved without litigation. In these cases, the closing of an investigation, like the opening of an investigation, takes place with a letter. EBSA regional offices issue a number of types of closing letters. Where the investigation detected no ERISA violations, a letter closing the investigation and indicating that no further action will be taken is usually provided.

When any potential violations that are identified in the investigation are de minimis or have been adequately corrected, the closing letter may note the potential violations, but will also state that no further action will be taken. EBSA may also choose to refer a potential violation to the Internal Revenue Service. Under these circumstances, the IRS may impose excise taxes, if applicable.

To the extent EBSA concludes an investigation and determines that violations of ERISA may have occurred, the regional office may issue a “Voluntary Compliance Letter” (VC letter). A sample VC letter is available on the EBSA website. In general, the letter:

• Provides a description of facts identified during the investigation and the Department’s position with respect to violations that may have occurred based on the Department’s understanding of the facts;
• Invites discussion regarding correction of the identified potential violations;
• Advises that without correction, the matter may be referred to the Solicitor of Labor for possible legal action;
• Advises that the Secretary of Labor may furnish information to parties affected by the investigation and notes that the target of the investigation remains subject to suit by private parties, even if the Secretary takes no further action; and
• Discusses the Secretary of Labor’s rights and obligations with respect to assessing civil penalties.

While ultimate resolutions of an investigation vary, one important thing to be aware of is that EBSA will likely issue a press release regarding any settlement with EBSA following an investigation. The EBSA Enforcement Manual provides a brief description of the process utilized by the agency in issuing press releases. Press releases are also archived on the DOL website.

Conclusion

Knowing what to expect from a DOL investigation is a necessary step in preparing for one. Thinking about the process the DOL might use, and the likely areas of focus during an investigation can also help identify areas of legal and operational compliance where additional effort might be warranted. After all, the time to identify and fix problems is before the DOL comes calling.

Jennifer E. Eller is a principal with the Groom Law Group, Chartered working primarily in the firm’s fiduciary practice group. She helps plan fiduciaries, sponsors, service providers, and financial institutions think strategically about fiduciary governance and ERISA compliance issues.

© 2013 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.

Disclaimer
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

By Carolyn P. Meade, Moore & Van Allen PLLC

Recognizing the role of small business in economic growth, certain U.S. states are speeding access to capital for local companies by authorizing equity-based crowdfunding. While most states await implementation of the federal Jumpstart Our Business Startups Act (the “JOBS Act”) (P.L. 112-106) enacted April 5, 2012, or actively caution investors against equity-based crowdfunding,1 two states have instead embraced this new form of fundraising and two additional states are currently considering authorizing legislation. Leading this movement, Georgia and Kansas in 2012 adopted new securities exemptions which permit Georgia-based and Kansas-based companies, respectively, to advertise to the public their need for investment and to raise money from state citizens.2 Similar legislation is now pending in both North Carolina and the state of Washington.3 Title III of the JOBS Act, coupled with Title II of the JOBS Act, which will lift the prohibition on general advertising of an offering, should enable equity crowdfunding on a national scale, but federal implementation is trailing state efforts, and the law itself imposes significant requirements on the businesses that would seek to take advantage of this new fundraising approach. This article therefore examines the more business-friendly approaches Georgia, Kansas, North Carolina and Washington (for purposes of this article, the “Crowdfunding States”) are piloting or considering now.

Crowdfunding – the concept of raising money through small contributions from a large number of investors – can provide access to capital to new business ventures which are too small to be of interest to angel investors and venture capitalists. Equity-based crowdfunding describes the action of raising money from a large number of investors who, in exchange, receive equity in the company raising those funds. For businesses, and a nation that experienced the capital freeze that accompanied the recent recession, crowdfunding provides a new avenue for a capital raise outside of the traditional financial markets.

Permitted Investment

Where current state and federal securities regulations in practice limit small equity raises to accredited investors – persons making more than $200,000 per year or whose net worth is at least $1,000,000 – new Crowdfunding State exemptions allow entities formed in-state to offer the opportunity to invest to any citizen in the state. Furthermore, that investment may, but does not have to, be offered through an intermediary website (similar to Kickstarter or Indiegogo but for equity-based funding instead of donor-funding). In most cases, even if the offering is through such a website, the website does not have to register with, or wait for pre-clearance from, the State.

State legislatures in Crowdfunding States have intentionally limited requirements for new start-ups and provided access to the in-state “crowd” in the hopes that capital access will help industry grow in-state. Acknowledging that those initiatives mean less information may be available to an investor pool that now includes less sophisticated persons, the implementing states have adopted investment caps, setting as a matter of public policy the amount an individual should be entitled to put at risk. The maximum permitted investment by an individual who is not an accredited investor is $10,000 in Georgia, $1,000 in Kansas and, as legislation is currently drafted, $2,000 in each of North Carolina and Washington.4 The bills pending in North Carolina and Washington would require a plain English statement of risk be signed by each funder: “I acknowledge that I am investing in a high-risk, speculative business venture, that I may lose all of my investment and that I can afford the loss of my investment.”

In contrast to Georgia, Kansas, North Carolina and Washington, the proposed regulations for the federal JOBS Act would require the offering entity (through the intermediary used for the offering, discussed below) to determine how much an intended funder could invest. This means determining the income or net worth of prospective investors and ensuring that those investors do not exceed the allowable limits of their investments. The formula is complex: An investor whose annual income or net worth is less than $100,000 per year could invest the greater of $2,000 or 5 percent of his or her income or net worth. For investors whose income or net worth each year is $100,000 or more, the permitted investment would increase to 10 percent of annual income or net worth.

As alluded in the preceding paragraph, the proposed JOBS Act regulations would permit a crowd-funded offering to be made only through an intermediary website or a registered broker and, in the first case, only through those websites previously certified and approved by the Securities and Exchange Commission (“SEC”). The website (or broker) hosting the offering would, in turn, have to (i) conduct a background and securities enforcement regulatory history check on each officer, director and person holding more than 20 percent of the outstanding equity of the issuer, (ii) deliver to each participant investor education information, (iii) receive from each investor a statement acknowledging risk of loss and (iv) ensure that offering proceeds go to the issuer only when the aggregate raised capital is at least equal to the target offering amount.

Offering Size

Using either the federal JOBS Act exemption or one of the Crowdfunding State exemptions, an offering entity may raise up to $1,000,000 in any 12 month period; of course, in the case of the Crowdfunding State provisions, those funds could come only from state citizens. North Carolina’s proposed “Jump Start Our Business Start-Ups Act” would go one step further for more established businesses; entities with audited GAAP (generally accepted accounting principles) financials for the prior year of operations would be entitled to raise up to $2,000,000 in any 12 month period.

Required Paperwork

Another hallmark of most of the Crowdfunding State exemptions is the minimal burden imposed on new entities in terms of required filings with the state securities commission.5 In Georgia and Kansas, and, if pending legislation passes, in North Carolina and Washington, an offering may begin without notice to the state securities commissioner. A one page notice does have to be submitted to the securities commissioner before any general solicitation or the 25th sale of the security, whichever comes first. Furthermore, the issuer does not have to provide audited financials, removing the barrier to a securities raise that would otherwise exist for many brand new businesses. Post-offering reporting requirements are frequent but flexible, allowing companies to point investors to a website that includes management comments and quarterly (unaudited) financials.

The federal JOBS Act exemption is less user-friendly. A business wishing to issue securities using this exemption would have to provide an offering memorandum or prospectus to the SEC, investors, and the broker or funding portal used for the offering. That offering memorandum must include, depending on offering size, certified, reviewed or audited financials.6 Additional required information for the offering memorandum (or to be distributed by the broker or funding portal to potential investors) would include:

• the name, legal status, physical address and website address of the issuer;
• the names of the issuer’s directors and officers and each person holding more than 20% of its shares;
• a description of the issuer’s business and anticipated business plan;
• a description of the financial condition of the issuer;
• if the target offering is for more than $100,000, reviewed or audited financial statements;
• if the target offering is for $100,000 or less, certified financial statements and the issuer’s most recent income tax returns (if any);
• regardless of offering size, a description of the purpose and intended use of the proceeds of the offering;
• the target offering amount, the deadline to reach the target offering amount and periodically, updates on progress towards that target;
• the price to the public for the securities (or the method for determining that price); and
• a description of the ownership and capitalization of issuer.

As noted previously, the broker or funding portal through which the new equity would be offered would have to be one registered with the SEC. No issuance could commence without that initial registration step. Following the offering, the issuing entity would have to file with the SEC and provide to investors annual reports containing the results of operations and its financial statements.

Access to Capital

Once implemented or enacted, both the federal and state crowdfunding exemptions will offer businesses a new way to raise capital. However, the business that chooses to take advantage of the federal exemption is likely to be more established and therefore different from the in-state issuer who avails itself of, for example, Georgia’s “Invest Georgia” exemption. True start-ups and “Mom and Pop” businesses may be forced to look at intrastate offerings if only because they cannot produce the financial statements, income tax returns and more fulsome information necessary to be eligible to take advantage of the federal exemption. Lessons learned in both approaches may drive further changes in this new securities space.

The chart on the following pages highlights the key terms of the federal JOBS Act Exemption and the Crowdfunding State exemptions summarized here. Please keep in mind that the North Carolina and Washington exemptions have yet to be enacted and thus may change during the process of consideration.

By Bill Capps and Rob Steinberg, Jeffer, Mangels, Butler & Mitchell LP

The heightened focus on corporate governance by regulators, stock exchanges, and investors over the past decade has made periodic evaluation of members of a board of directors increasingly important. A robust program of evaluation of individual board members, as well as that of the whole board of directors and committees of the board, can assist in protecting shareholders against board entrenchment and, when combined with training and continuing education (which will be discussed at the end of this article) can play a critical role in assisting in the ongoing improvement of performance by individual board members and the entire board.

Whether we are thinking about public companies, private companies, or nonprofits, each is faced with considering the evaluation process. Public companies, of course, may be required to do this by regulators, institutional investors, or their exchange listings. However, private companies and non-profits will have their own reasons for maintaining an ongoing program of evaluation.

What does an evaluation process look like in the case of individual board members?

1. What is being measured?

Typically, the evaluation is intended to measure “board competencies.” These are the range of characteristics the board members are supposed to possess. Evaluation can happen in the process of selecting a board member or in considering whether or not to re-nominate the board member. Think of the competencies as a checklist for the perfect director.

The sought after “competencies” will vary from company to company but here are some examples:

— Basic knowledge (examples are knowledge of a specific industry, the company, and its executive team; knowledge of risks specific to the company or its industry; knowledge of board responsibilities);

— Technical and analytical skills (examples are financial and accounting expertise, transactional savvy, and demonstrated individual decision making);

— “Soft” inter-personal skills (examples are contributions to group decision making, tolerance of opposing positions, professionalism, and communication skills);

— Professional reputation;

— Community service;

— Diversity enhancement (adding women or disadvantaged minorities);

— In the case of non-profits, passion for the subject matter and ability to “give or get” (i.e. contribute money or find contributions).

2. Who is doing the evaluation?

Typically, there is either a specific corporate governance committee or a committee charged with the nomination or re-nomination of board members. In some companies, this might be handled by an executive committee. This function is sometimes wholly or partially “farmed out” by the responsible committee to independent consultants. An example of such a resource is http://www.corpgov.deloitte.com/site/us/ (the so-called Center for Corporate Governance maintained by Deloitte). Of course, such a resource is more appropriate in a public company where the stakes (and requirements of third parties) may be greater.

A problem with a large board of directors is that it is difficult to tell in a large setting whether or not a particular director has defective performance. That means the intelligence gathering about a director’s performance has to be distributed so that the evaluating committee learns facts from (a) other individual board members, (b) the chair or members of committees on which the board member serves (because in that smaller group, defective performance is more noticeable), or (c) the member himself through self evaluation. (Self evaluation is typically used to identify areas of training that a director identifies as being useful to him.)

Understandably, directors are often reluctant to disclose defective performance of their peers. This no doubt results from among other things the personal relationships of the directors, fear of retaliation and a general desire not to get involved. The company must emphasize that the first duty that it is owed by a director is the duty to the company and not to fellow directors. Perhaps this can be further ameliorated by emphasizing positive aspects of identifying personal development opportunities for directors themselves.

Clearly, in the case of “minor” problems with a given director’s performance, counseling among board members may be done without necessarily raising the perceived problem to the level of the committee.

3. Keeping track of evaluations.

A sensitive subject is whether or not and how the committee keeps track of evaluations. There is not one written test that can effectively measure director capability and performance. The hard data points (e.g. attendance at meetings and committee meetings) are few and, as a result, board members often rely on questionnaires that frame possible issues but leave the opportunity for open-ended responses. One fear is that written evaluations might be fodder for lawyers in the event of litigation or dispute. Although the nomination of directors is not protected by the myriad of laws relating to employment discrimination, this boundary can be blurred where a director works for the company.

Another fear is that putting evaluation materials in writing tends to concretize matters which are probably less defined. For example, a committee chair might want to inform a committee member that he was disappointed with his preparation for or contribution to a meeting without necessarily creating a writing which overly emphasizes the problem.

Another issue is the problem of intellectual honesty. Directors must have the courage to stand behind their criticism of other directors, as painful as this may be. Otherwise, the director being criticized may believe that he is being singled out unfairly for personal or other reasons not related to his performance.

4. Additional considerations.

One issue about which directors should be educated (which makes the evaluation process easier) is the concept that their service is for the benefit of the company and not themselves. This emphasizes that the directorship is not a lifetime sinecure. Directorship is based on the needs of the company. So, for example, a director may have perfectly fine performance but if the company at that time requires a different skill set (e.g. cybersecurity experience, marketing expertise), the director may not be re-nominated.

Typically, other techniques are used to “refresh” boards of directors. These include term limits, mandatory retirement at certain ages, changes in job responsibility (someone who became a director because he was the CEO of a strategic partner or customer who has now left the employ of the strategic partner or customer). In some cases, an “advisory” or “president’s” board may be an appropriate way to continue to have the capability of a former board member who simply lacks the time or energy for a full board position.

5. The “ecosystem” of training providers and opportunities.

Orientation and continuing education of directors is encouraged under NYSE listing rules, and also encouraged by many institutional investors and investor organizations. These factors together with the perceived enhancement of director performance that results has engendered a robust “ecosystem” of training providers for boards and individual directors. More reputable examples are described below, but, as in many areas of training, some providers seem to be more about colorful certificates and titles than useful information. Accordingly, directors should be careful to assure that training programs are appropriate.

Business schools at major universities provide not only training but “certification” of training. The three day immersion in board best practices offered by the UCLA Anderson School of Management is typical. Another example is the directors’ consortium which also provides three days of training in corporate governance at Chicago Booth, Dartmouth Tuck, and Stanford business schools.

In addition, the National Association of Corporate Directors (“NACD”), a non-profit association generally recognized as a leading provider of board education for directors, offers a variety of board programs. NACD’s current topics offered as board programs are typical for training programs offered by other providers and include:

Director Professionalism;

Audit Committee: Improving Quality, Independence and Performance;

Board Effectiveness: Improving Communication and Decision Making;

Fiduciary Responsibility;

Financial Statements: Fundamental Questions Every Director Should Ask;

Role of the Board in Corporate Strategy and Risk;

Role of the Nominating & Governance Committee: Raising the Bar;

Directors and Officers Liability: Update;

Role of the Board in Crisis: Preparation, Response, Communications, and Post-Crisis Evaluation;

Role of the Board in Mergers and Acquisitions;

Technology: Increased Risk for Board and Leaders;

China: Opportunities and Risks.

Of course, the topics above are generally applicable to most companies. Specialized training is often available for specific industries. For example, an insurance company will offer training in its industry or regulatory topics. In addition, a director who perceives himself or herself as affiliated with a particular group (e.g. women, minority groups) may find training specific to that group. The training can be very narrowly defined indeed (women on boards of insurance companies; see the IICF Women in Insurance Global Conference held recently in New York). Some companies will have sufficient in-house capability to design their own programs and do not need the imprimatur of an outside training organization.

There is no doubt board and board member evaluation and training will continue to play an important role in corporate governance. Lawyers will be helpful advisors to their clients if they can help the company navigate its way through this landscape.

Bill Capps chairs the Corporate Department of Jeffer, Mangels, Butler & Mitchell LP, a law firm with offices in San Francisco, Los Angeles and Irvine. Rob Steinberg is a senior partner specializing in public companies and mergers and acquisitions.

© 2013 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.

Disclaimer
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

By Joel H. Levitin, Cahill Gordon & Reindel LLP and Michael R. Carney, McKool Smith, P.C.

I. Introduction

Many finance lawyers believe that a creditor is entitled to assert the full face amount of its claim against a guarantor in bankruptcy, without having to reduce such claim to reflect any partial payments by the primary obligor on the underlying debt.1 Thus, there is a traditional notion in bankruptcy practice that a creditor is entitled to receive a distribution from the guarantor based on the full face amount of its debt, potentially obtaining a recovery in excess of those received by other holders of claims with the same priority of payment that have received partial payments from the debtor.

Consider two creditors of a debtor that will pay 50% of amounts owed to its creditors, one with a $100 guaranty claim and the other with a $100 non-guaranty claim, where the holder of the guaranty claim received a partial payment of $50 from the primary obligor, and the other claimholder was paid $50 on its claim by the debtor, prior to bankruptcy. Under the conventional view, the holder of the guaranty claim would be allowed to assert a claim of $100, despite the $50 payment, entitling it to recover an additional $50 from the debtor’s estate for a total of $100 in full satisfaction of its claim. In contrast, the other creditor, whose claim has the same priority, would be required to reduce its claim by the $50 payment, recovering only $25 on its remaining claim of $50, for a total of $75. If the claim against the guarantor were limited to the $50 remaining amount unpaid, however, it would receive only an additional $25 distribution from the debtor’s estate, like other similarly-situated creditors with net unpaid claims of $50.

The U.S. Supreme Court’s 1935 decision in Ivanhoe Building & Loan Association of Newark, N.J. v. Orr2 is cited in support of the accepted position. However, Ivanhoe is not necessarily definitive on the issue, and other decisions offer a potential departure from the traditional view. As explained in greater detail below, it is at least arguable that a creditor should not be required to reduce its claim for guaranteed debt by the amount paid by the primary obligor.

II. The Traditional View of Guaranty Claims in Bankruptcy

In Ivanhoe, the Supreme Court held that a creditor was entitled to an allowed claim for the full amount of a mortgage bond under which the debtor was obligated, notwithstanding that such creditor’s claim already had been satisfied in part by a recovery through foreclosure on the mortgaged property then owned by a third party.3The Ivanhoe decision rests upon an interpretation of the defined term “secured creditor” under Bankruptcy Act §1(23) and makes no reference to applicable non-bankruptcy law.4

Bankruptcy Act §1(23) (as in effect in 1935) provided that a

By John Breaux and Trent Lott, Patton Boggs

Congress and the administration can still achieve the first major overhaul of our nation’s tax laws in nearly 30 years; such reform could occur with or without an agreement to enact fundamental entitlement spending reform.

While challenges remain, none are intractable—most are matters of degree. Let us look at the fundamentals and draw some conclusions as to how Congress and the administration might be able to get to “yes.”

Consensus on the Need for Reform Exists;
Differences Persist but Are Smaller
Than Many Think

Tax reform is inherently difficult to achieve as tax writers must grapple with the substance and politics of once-in-a-generation reform. For example: How much base broadening should there be? What should the tax distribution tables after reform look like? How to ensure U.S.-based multinationals can compete on a level playing field with their competitors, while at the same time ensuring the corporate tax base is not eroded?

These are all weighty issues about which much has been written. As a starting point, however, it is critical to note that there is broad bipartisan consensus among senior tax writers and the president that the Internal Revenue Code should be overhauled. Members and staff have already done much of the important work hearing from stakeholders and sorting through issues. The analytical work is well under way, and rather than succumbing to “analysis paralysis” principals must now begin to make difficult political decisions.

Of course, the single biggest stumbling block to tax reform is the absence of agreement between the parties on whether reform should be revenue neutral with all of the increased revenues that result from base broadening utilized to offset the cost of lower rates (as many congressional Republicans advocate), or used for deficit reduction purposes (the approach sought by President Obama and many congressional Democrats). Even here, a closer look at the differences leads us to believe that the perceived gap between the parties is not as great as many think, and could be easily bridged were both parties to measure revenue from a reasonable starting point.

Revenue Differences:
The Root of the Problem

A look at differing fiscal year 2014 budget proposals lays bare the different political perspectives, which appear daunting.

The party-line House Republican budget proposal calls for a simpler tax code with just two individual tax rates (10 percent and 25 percent), plus elimination of the alternative minimum tax. The legislative blueprint also calls for a 25 percent corporate rate while transitioning to a more competitive system of taxing the foreign earnings of U.S.-based multinationals. All of this would be done on a revenue-neutral basis, through enacting significant base-broadening measures.

The Senate Democrats’ FY 2014 budget proposal, also passed on a party-line vote, offers a very different vision: it pursues tax reform for the chief purpose of raising roughly $1 trillion in new revenue (over 10 years) from upper-income individuals and large corporations, rather than lowering rates in a revenue-neutral manner.

In the middle we have the president’s FY 2014 budget proposal, which asks for revenue-neutral business tax reform while simultaneously seeking to increase revenue to the tune of roughly $1 trillion (over 10 years) for the purposes of deficit reduction. However, the president’s public statements have been clear: While $1 trillion may be his preferred approach, he is open to a deficit reduction agreement that includes about $600 billion in tax increases on upper-income individuals. He includes in his budget $582 billion of such revenue raisers—a limitation on the use of itemized deductions and implementation of the so-called Buffett rule, a minimum tax on individuals with income exceeding $1 million.

Over and above this, the president includes about $400 billion in additional taxes, $100 billion of which comes from applying a chain-weighted consumer price index to the indexing of tax provisions for inflation. Of note, the president also includes several entitlement spending reductions in his budget as well (including a chained CPI for calculating Social Security cost of living adjustments).

There Is More Common Ground
Than Meets the Eye

Observers of the political jujitsu in Washington may believe that Republicans and Democrats are incapable of agreeing on anything. However, while there has been much discussion and political controversy over how to achieve tax reform, somewhat lost in the discourse is the degree to which overlap between the political parties exists.

Business tax reform is an excellent case in point: President Obama and congressional Republicans and Democrats alike believe revenues raised should be utilized to pay for substantially lowering the 35 percent corporate rate. While details differ a bit (the president proposes a 28 percent corporate rate, with lower rates for manufacturers, while Ways and Means Committee Chairman Dave Camp (R-Mich.) proposes 25 percent for all U.S. businesses), these differences can be bridged.

So too can differences with respect to taxation of U.S. companies doing business overseas—moving toward a territorial-type system with protections for the U.S. tax base gives both sides a good measure of what they want, while transitioning the United States away from our antiquated and anti-competitive international tax rules. And, Republicans and Democrats alike will insist that “passthrough” entities do not get left behind, both for sound policy and parochial reasons.

Reforming the tax code for non-business individual income is a bit trickier, as congressional Republicans want to apply the same principles of business tax reform to the taxation of individuals, meaning they want revenue-neutral reform with sharply lower rates and a greatly expanded tax base. To do this, they are willing to take on sacred cows, including the mortgage interest deduction.

The differences with the president here are twofold. First, as noted, the president has insisted upon increasing net revenue by $600 billion (over 10 years), all of which is harnessed on upper-income taxpayers by virtue of further limiting their tax preferences. Second, revenue differences aside, the president appears reluctant to endorse base-broadening for lower rates even if a fixed sum of revenue is applied to deficit reduction. Thus, his version of individual reform is largely to keep rates where they are while raising the effective rate of tax for some individuals (and providing some incentives for small businesses like increased expensing of investments).

Still, we believe most of these differences can be bridged. One way is obvious: Fast-track tax and entitlement reform through a process agreed to that would round out a “grand bargain” on deficit reduction. This would require Republicans and Democrats to agree to specified new tax revenue and entitlement spending reductions, each totaling in the hundreds of billions of dollars. If past is prologue, this is unlikely to occur.

While more than $3 trillion in deficit reduction has occurred since the beginning of 2011, all of this has occurred as a result of reluctant dealmaking at the precipice of looming fiscal crisis, with one party holding all of the cards. Each side has won a round or two, but attempts to do deficit reduction on a bipartisan basis have failed each time. Such talks could always be resurrected in the context of raising the debt ceiling later in 2013, but there is a lot of pessimism about the potential for success currently.

However, the point is this: If a “grand bargain” does not materialize, there are at least two other solutions that could be considered.

(1) Enact Business Tax Reform Only

One plausible path forward is for Congress and the president to focus on revenue-neutral tax reform for businesses only, which is where most agreement exists, while “agreeing to disagree” about non-business individual reform.

Such reform would need to lower rates substantially for both businesses chartered as C corporations and passthrough entities, but would not lower rates or decrease tax preferences for non-business income. It would also provide tax writers with the important opportunity to transition from our antiquated system of taxing business income on a worldwide basis. This has the effect of trapping profits overseas, which is a result no one should like.

In this scenario, congressional Republicans would agree to defer their desire to lower rates for non-business individual income, and the president would agree to punt the battle to raise taxes again on “upper-income individuals.” And, while focused on business tax reform, important but noncontroversial individual items (such as taxpayer simplification and taxpayer protection provisions) could be included as well.

Many Republicans would prefer to go further of course, and many Democrats may oppose this on the grounds that it cedes their best chance for “new revenue” for the duration of this Congress, and, perhaps, the remainder of the Obama administration. But the rationale for this sort of compromise is clear: The parties put aside their differences and focus on what is achievable.

The politics should work too: While Republicans would generally prefer to “broaden the base,” on the individual side, one can infer that significant reductions to tax preferences for a broad swath of taxpayers (such as the exclusions for employer-provided health care and municipal bond interest, and the deductions for state and local taxes and mortgage interest) would be necessary to achieve their goals. These are the thorniest issues to tackle politically, and also happen to be the provisions that President Obama suggests should be pared back for upper-income taxpayers (the resulting revenue to be used for deficit reduction). And taxpayers who benefit most from these preferences tend to reside in the higher tax (and higher cost) “blue” states like New York, California, and Illinois.

(2) Adopt a Realistic Baseline
From Which to Measure Revenue Changes

As mentioned, the key to tax reform is an agreement on revenue. President Obama wants $600 billion in statically scored revenue, and congressional Republicans are determined to give him none. But are they really that far apart? Part of the answer may depend upon what revenue baseline they are using to measure proposed changes.

If they adopt a “current policy” baseline, as both parties have done in the recent past, policymakers will find they are closer to an agreement on revenue than at first meets the eye.

Using a current policy baseline is not new. Over the past several years, while the political parties have differed in their policy goals (in particular the appropriate level of taxation of upper-income individuals) they have more or less agreed to use a realistic baseline as a common starting point for measuring revenue changes. They should do so again here.

Current Law or Current Policy?

First, some background: Until the fiscal cliff deal produced the American Taxpayer Relief Act (ATRA; Pub. L. No. 112-240) on Jan. 1, there was a $4 trillion-plus disparity between how official scorekeepers (the Joint Committee on Taxation and the Congressional Budget Office) and how the administration and most elected officials measured the “score” (or cost) of tax policy proposals. This enormous gap in assumptions resulted from the fact that the major individual tax cut provisions enacted and extended over the last 12 years were subject to automatic sunset, and thus not deemed to be “permanent” for official scorekeeping purposes.

Official scorekeepers measure the cost (or score) of any proposed tax changes relative to revenue expected to be collected under a “current law” baseline. Unlike official scorekeepers, who are bound to measure against a current law baseline, the administration and most lawmakers (on both sides of the aisle) assumed “current tax policy” would be extended permanently and used that baseline to measure the cost or savings of particular tax proposals.

By way of example, all Obama administration budget requests and deficit reduction plans have utilized an adjusted (current policy) baseline to measure the cost of tax policy proposals. For example, in the FY 2013 budget proposal a baseline shift of $4.5 trillion allowed the administration to measure the cost of making the Bush tax cuts permanent for income below $250,000 (while allowing the Bush rates to expire for income above that) at $850 billion in new revenue. Compare this to JCT, which, utilizing a current law baseline, scored the president’s tax proposals as a net tax cut of $3 trillion.

As the administration put it, “An important step in addressing the Nation’s fiscal problems is to be upfront about them and to establish a baseline that provides a realistic measure of the deficit outlook before new policies are enacted. This Budget does so by adjusting the [Budget Enforcement Act] baseline to reflect the true cost of extending major tax policies that are scheduled to expire but that are likely to be extended.”

Quite so. Following this line of reasoning, during consideration of ATRA both parties used numbers that suggest they were comparing the effects of policy proposals to a current policy baseline. Therefore, for Republicans and Democrats alike, the fiscal cliff deal amounted to a roughly $620 billion tax increase (compared to current policy) even as JCT scored the bill as a $4 trillion tax cut (compared to what was then current law).

Baselines Post-ATRA

Employing a realistic baseline continues to be important. Much of the disparity between current law and current policy baselines was mooted by ATRA, which made most of the Bush tax cuts permanent in law while also permanently indexing the parameters of the alternative minimum tax exemption. This narrowed the gap between the two baselines by roughly $4 trillion. But post-ATRA a current law baseline still overestimates revenues the government can expect to collect by hundreds of billions of dollars over the next 10 years; a realistic baseline could be used to unlock a deal on tax reform where both sides achieve their goals.

One need look no further than the president’s own FY 2014 budget proposal for evidence of this. As in past years, it uses an adjusted baseline for purposes of scoring the cost of its proposals. While the adjusted baseline has narrowed considerably given passage of ATRA, the administration continues to employ a $161 billion baseline change by assuming permanence of several provisions that were extended for five years in ATRA and are, thus, not permanent in law:

• the American Opportunity tax credit;
• the earned income tax credit expansions; and
• the child tax credit expansion.

Permanence of these provisions in the adjusted baseline allows the administration to assert that they have no cost, reflecting a more realistic baseline.

This makes sense, as far as it goes. But unfortunately the budget request does not capture all relevant provisions that should be included in the realistic baseline.

For example, there are still a number of business, individual, and energy tax “extender” provisions, as well as accelerated cost recovery through bonus depreciation and small business expensing, that are reauthorized annually. Most of these provisions have been on the books, extended without interruption, for a decade or longer. In reality, it is unlikely that Congress will allow these provisions to expire, at least outside of tax reform. Taken together, they account for hundreds of billions of dollars over a 10-year period but are not considered part of permanent tax law. Thus, under a “current law” baseline, their repeal counts for nothing. That makes getting to a revenue agreement much more difficult.

A Path Forward

Congressional tax writers should build upon the example the president has set in his FY 2014 budget by assuming permanence of all long-standing provisions that are subject to sunset on a year-to-year basis. While Congress may (and should) make some of these provisions permanent during tax reform, it is inevitable that many of them will be jettisoned for base broadening purposes, thus raising significant revenue that has currently been lost in the tax reform discussion.

With this common starting point, both sides will find that they are not that far apart from rate-lowering tax reform that raises some revenue for deficit reduction. They can then move beyond political jujitsu and onto the real work of tax reform.

Former Sen. Trent Lott is senior counsel at Patton Boggs, where he provides strategic advice, consulting, and lobbying to clients on a wide range of public policy matters, including tax and financial services, defense and homeland security, energy, transportation, and communications.

A former Senate majority leader, Senate Republican whip, and House Republican whip, Sen. Lott is one of a handful of officials to have held elected leadership positions in both the House and Senate. During his 16 years in the House and 19 years in the Senate, he worked closely with seven presidential administrations and was regarded as a savvy coalition builder and dealmaker.

Former Sen. John Breaux is senior counsel at Patton Boggs, where he provides strategic advice to the firm’s attorneys and clients on a wide range of public policy matters, with a particular focus on the areas of tax, health care, and energy law.

Sen. Breaux led a long and distinguished career in the U.S. Congress. He was elected to the House in 1972 at the age of 28—at the time of his election he was the youngest member of Congress. Sen. Breaux was a widely recognized bipartisan leader in the Senate, and in 1993 was appointed by his Democratic colleagues to the post of chief deputy whip, a position he held until his retirement. Following his retirement from the Senate, Sen. Breaux co-chaired President George W. Bush’s Advisory Panel on Tax Reform.

© 2013 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.

Disclaimer
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

By Timothy R. Dudderar and Justin Morse, Potter Anderson & Corroon

In a recent decision from the Delaware Court of Chancery, Vice Chancellor J. Travis Laster provided what seems to be an important step towards reconciling two strands of Delaware law, addressing the distinction between direct and derivative claims, that have been in subtle conflict for years. That decision, Carsanaro v. Bloodhound Technologies, Inc.,1 has already been recognized as an important development in the law governing the relationship between company founders and venture capitalists.2 The Vice Chancellor held that cashed-out stockholders had standing to bring direct, as opposed to derivative, claims alleging that a group of venture capital funds with majority representation on the Board inequitably diluted plaintiffs’ equity stake before ultimately selling the company. In addition to expanding the breadth of stockholder rights to bring direct actions, Carsanaro is notable as an apparent step toward reconciling the accepted test under Delaware law for distinguishing between direct and derivative claims with one line of cases that has stubbornly stood outside of its ambit. It bears emphasis, however, that Carsanaro is only one step towards such reconciliation, and it remains to be seen whether Delaware law will continue down its path.

‘Tooley’ and Development
Of the Delaware Standard

The standards for distinguishing derivative from direct claims under Delaware law were substantially clarified in the Delaware Supreme Court’s 2004 decision in Tooley v. Donaldson, Lufkin & Jenrette, Inc.3 Prior to Tooley, there existed “no standard test … applied in all cases to determine whether a given claim is derivative or direct.” 4 Frequently, however, Delaware courts in the pre-Tooley era applied the so-called “special injury” test, according to which a plaintiff could only bring direct claims if it suffered a “special injury,” defined as “a wrong suffered by plaintiff that was not suffered by all stockholders generally or … [a] wrong [that] involves a contractual right of the stockholders, such as the right to vote.” 5 In Tooley, the Delaware Supreme Court disapproved of the special injury test, together with the related “concept that a claim is necessarily derivative if it affects all stockholders equally.” 6 Rather than looking to whether a plaintiff could plead a special injury, the Delaware Supreme Court in Tooley ruled that the classification of claims as direct or derivative “must turn solely on the following questions: (1) who suffered the alleged harm … ; and (2) who would receive the benefit of any recovery or other remedy … .” 7

‘Gentile v. Rossette’ and
The Lingering Application
Of the ‘Special Injury’ Test

Although simple on its face, the two-part Tooley test has not brought a complete end to uncertainty, and close calls on the direct/derivative distinction continue to arise. In 2006, the Delaware Supreme Court provided some clarification in Gentile v. Rossette,8 which involved allegations that defendants inequitably diluted—or, in the terminology adopted by Gentile, transferred or expropriated—stockholders’ economic interest and voting power when a chief executive officer and controlling stockholder received stock from the corporation in exchange for forgiving debts of allegedly lesser value.9 In Gentile, the Delaware Supreme Court ruled that, under certain circumstances, claims for dilution or expropriation may be brought either directly or derivatively. Specifically, the Gentile court held that either type of action may be brought where:

(1) a stockholder having majority or effective control causes the corporation to issue ‘excessive’ shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders.10

In arriving at its decision, the court cited and applied Tooley, which it had issued just two years before. Yet, while acknowledging that Tooley provided the exclusive test for determining whether a claim is derivative or direct, the Delaware Supreme Court also appears to have been influenced by pre-Tooley authority that Tooley itself criticized. First, the Delaware Supreme Court noted in its analysis that claims for “corporate overpayment” (a category it characterized as including expropriation) are typically treated as “exclusively derivative.” 11 In describing the justification for viewing dilution claims as derivative and, importantly, in affirming that such a classification comports with Tooley, the Delaware Supreme Court stated in terms reminiscent of the special injury test:

any dilution in value of the corporation’s stock is merely the unavoidable result (from an accounting standpoint) of the reduction in the value of the entire corporate entity, of which each share of equity represents an equal fraction. In the eyes of the law, such equal “injury” to the shares resulting from a corporate overpayment is not viewed as, or equated with, harm to specific shareholders individually.12

Similarly, in explaining why claims involving expropriation undertaken specifically by a controlling stockholder may be brought directly, the Delaware Supreme Court explained that under such conditions, “the public shareholders are harmed, uniquely and individually, to the same extent that the controlling shareholder is (correspondingly) benefited.” 13 Such statements appear to be indistinguishable from “the concept that a claim is necessarily derivative if it affects all stockholders equally,” 14 of which Tooley disapproved. Despite never using the term “special injury,” then, Gentile relied on the core assumption of the special injury test: that a stockholder may bring a direct action where it is harmed by being treated differently from other stockholders. Thus, it appears that Gentile, likely not intentionally, re-introduced the concept of special injury, at least with respect to a (potentially limited) subset of wrongful dilution claims.

The influence of the special injury test, or at least the reasoning behind it, is also apparent from decisions cited by the Gentile court to justify direct standing, each of which was decided before Tooley, and, more importantly, relied on the special injury test. Although the Delaware Supreme Court most directly relied on Turner v. Bernstein,15 that decision derived its relevant conclusions from another case also cited in Gentile: In re Tri-Star Pictures, Inc.16 Tri-Star, in turn, involved challenges by former stockholders of Tri-Star Pictures, Inc. to transactions through which the Coca-Cola Company exchanged overvalued assets for Tri-Star stock, with the result that Coca-Cola obtained a majority position while the percentage owned by the minority correspondingly decreased. The Delaware Supreme Court in Tri-Star described application of the special injury test as “well settled,” and held based on that test that plaintiffs could bring direct claims because they had suffered harms stemming from loss of economic interest and voting power not suffered by Coca-Cola.17

Although Tri-Star relied on the special injury test, and although Tooley disapproved of that test in the period between Tri-Star and Gentile, the Delaware Supreme Court’s holding in Tri-Star can be traced directly forward in time to Gentile. Notably, Gentile summarized Tri-Star in a way that did not include the words “special injury” but nevertheless preserved the reasoning of that test:

By Brian D. Hector, Morgan Lewis

Beginning in 2013, long-term capital gains tax rates increased from 15 percent to 20 percent. Additionally, certain provisions of the new health care reform have imposed a new 3.8 percent tax on capital gains for certain high-income individuals in 2013, bringing the capital gains tax rate to 23.8 percent, which amounts to a 60 percent increase.

With the capital gains tax rate increase, a business owner stands to lose a greater portion of the wealth that he or she has worked hard over decades to accumulate when the owner sells his or her business. Moreover, if a selling business owner lives in a state with high state income tax rates, such as California or New York, the owner would be subject to an additional 8 percent to 13 percent tax above the federal capital gains rate. Thus, for the business owner who sells his or her business in 2013, the collective tax increases could wipe out as much as 30 percent to 35 percent of the wealth that the owner worked hard to accumulate for retirement, regardless of whether the owner’s stock is redeemed or sold to a third party. Further, beyond tax considerations, an outside sale may prevent the owner from (i) transferring control of the business to the owner’s children or the company’s current management, and (ii) ensuring job security for its loyal long-term workers.

ESOP Tax Advantage

There is a way to help a selling business owner eliminate the impending tax blow and at the same time unlock substantial liquid assets—an employee stock ownership plan (ESOP). An ESOP is a qualified retirement plan designed to invest primarily in company stock. As a tax-qualified plan, the stock owned by the ESOP is held in a tax-exempt trust, and the ESOP must comply with certain requirements under the Internal Revenue Code (Code). Because of its special tax features, an ESOP allows a business owner to sell his or her stock and diversify wealth on a tax-favorable basis, while retaining control of the business. An ESOP also provides a way for the owner’s children or current management to eventually take control of the business and provides retirement benefits to employees in the form of an ownership stake, which various studies have shown enhances business productivity and better retains employees.

The selling business owner can choose, with proper planning, to avoid the capital gains tax on the stock sold to an ESOP, as long as certain requirements under Section 1042 of the Code (1042 Transaction) are met. Some of the primary requirements include:

1. the stock must be C corporation stock and the selling shareholder must have held the stock for at least three years,
2. the ESOP must own at least 30 percent of the stock of the corporation after the stock is sold to the ESOP, and
3. the sale proceeds must be invested in “qualified replacement property” within a certain time frame.

The chart below illustrates the tax savings of an ESOP sale versus the more conventional sale of stock to a third-party buyer, in both 2012 and in 2013. The 2013 federal long-term capital gains tax rate reflects the increase to 23.8 percent.

As the illustration shows, the tax savings from an ESOP transaction were significant in 2012 at then-current capital gains tax rates. However, the tax savings in 2013 are even more substantial due to the fact that capital gains tax rates increased by 60 percent. Further, this ESOP savings comparison only shows the federal tax savings. There would also be a substantial savings at the state tax level as well. For example, California has a 13.3 percent income tax rate for transactions over $1 million. Accordingly, if the owner in the above example is a California resident, that owner would save $9,275,000 if the owner sold to an ESOP, at a combined rate of 37.1 percent (23.8 percent federal + 13.3 percent California).

Additional ESOP Tax Advantages

While the potential tax savings to the shareholder in a 1042 Transaction is one of the most significant current advantages due to the increase in tax rates, it is also important to consider the tax savings that an ongoing ESOP can provide for a corporation.

Contribution Deduction for ESOPs

Code Section 404(a)(3) provides that the deduction amount for company contributions to a stock bonus or profit-sharing plan is limited to 25 percent of the participants’ compensation. However, Section 404(a)(9) sets forth special deduction rules for C corporation contributions to an ESOP that are used to repay principal and interest on a loan that was used to acquire the shares (ESOP Loan). An employer’s deductions for contributions paid to an ESOP to repay only the principal on an ESOP Loan used to acquire stock can equal up to 25 percent of the ESOP participants’ compensation. In addition, there is no limit on the employer’s deduction for contributions to an ESOP that are used to pay interest on an ESOP Loan.

Also, it is important to note that, in certain rulings, the Internal Revenue Service has stated that because Code Section 404(a)(9) provides different authority from Code Section 404(a)(3) to allow for an ESOP Loan contribution deduction, a C corporation that sponsors both a leveraged ESOP and a separate qualified defined contribution plan (such as a 401(k) plan), may take (a) a deduction up to 25 percent of compensation for contributions used to make principal repayments on an ESOP Loan, (b) an unlimited deduction for the contribution to the ESOP used to pay down the interest on the ESOP Loan, and (c) an additional deduction of up to 25 percent of compensation for a contribution to another defined contribution plan, all in the same year.

Deduction of Employer Dividend Payments

C corporations may deduct dividends, pursuant to Code Section 404(k), paid on stock held by an ESOP maintained by the corporation, provided that the dividends paid are:

1. paid in cash directly or through the ESOP to its participants or their beneficiaries;
2. reinvested in stock, if participants have been given the election to receive the dividends in cash; or
3. used to repay an ESOP Loan.

This deduction for dividends paid on stock held by an ESOP can be a useful mechanism for increasing the amount of stock that may be placed in an ESOP.

An ESOP offers unique tax advantages, not only to a selling business owner undergoing a business transition, but also as an ongoing tax-advantageous employee benefit plan that has been proven to motivate employees while conferring a great reward on long-term employees. The ESOP is becoming more and more recognized as a transition tool to be seriously considered by the many business owners who are approaching retirement age and find that much of their wealth is tied up in their businesses.

Brian D. Hector (bhector@morganlewis.com) is a partner in Morgan Lewis‘s Employee Benefits and Executive Compensation Practice and chair of the ESOP Task Force. He is resident in the firm’s Chicago office.

© 2013 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.

Disclaimer
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

By Mitchell A. Lowenthal and Ari D. MacKinnon, Cleary Gottlieb Steen & Hamilton LLP

The right of shareholders to inspect corporate books and records occupies an important—though sometimes overlooked—place in corporate democracy and in shareholder litigation.

The basic premise underlying inspection rights is that shareholders—as owners of the corporate enterprise—have a legally cognizable interest in accessing certain information relevant to their financial investment in the corporation.1 Nonetheless, the separation of share ownership from management control is one of the foundational principles of corporate law and, thus, a shareholder’s inspection rights necessarily must be limited in deference to the basic principle that a corporation’s board of directors, not its shareholders, is charged with managing the affairs of the corporation.2

Shareholder inspection rights have come to the forefront in several recent Delaware derivative lawsuits, in which the Delaware Court of Chancery has strongly encouraged shareholders of Delaware companies to avail themselves of shareholder inspection rights before bringing derivative actions, including so-called Caremark3claims for failure to adequately oversee and monitor alleged corporate wrongdoing.4

Although the Delaware Supreme Court recently rejected the most far-reaching implications of these Chancery Court decisions, holding that there is no “irrebuttable presumption” that shareholders who bring Caremark claims without first exercising their inspection rights will provide inadequate representation to shareholders generally, the court also acknowledged the “fast filer” problem, directed that remedies for that problem be aimed at counsel, and cited cases in which it had previously emphasized the importance of issuing pre-suit inspection demands.5

Delaware courts encourage shareholder plaintiffs to exercise their inspection rights before filing plenary suits in order to (a) dissuade the filing of derivative actions that cannot satisfy applicable demand futility or wrongful refusal of demand standards or fail to state a claim, and (b) improve the quality of any plenary litigation that is brought (including by enabling the plaintiff to plead demand futility or wrongful refusal with the required particularity and to plead the necessary factual link between any corporate “trauma” that is the basis of the claim and the fiduciaries who are the subject of the suit).6

Reinforcing these objectives, Delaware courts generally preclude the filing of books and records actions after a derivative complainant has filed a plenary action, requiring the complainant to defend his pleading based upon the allegations contained therein, without further enhancement through a post-suit inspection demand.7

New York law, too, grants inspection rights to shareholders under the common law and by statute.8 New York courts have grappled with inspection rights in the past and likely will continue to confront them in future litigation, especially if the trend in Delaware to encourage shareholders to employ their inspection rights carries over to New York, as it should.

Given the important position that shareholder inspection rights occupy in safeguarding shareholders’ financial interests and informing shareholder legal action, and the at least equally important policy that gives primacy to the board of directors in deciding whether a corporation should pursue causes of action (and if so, how), shareholders and corporate management alike should be aware of these rights.

Accordingly, this article seeks to shed light on the scope of New York shareholder inspection rights, as well as the procedures for exercising and enforcing them.

I. Procedure for Exercising, Enforcing Inspection Rights

In order to exercise the common-law or statutory right of inspection, a shareholder of a New York corporation must make a demand upon the board of directors seeking specific books and records.9

Neither the common law nor the BCL specifies the necessary content of such an inspection demand. Nonetheless, a corporation may condition a shareholder’s exercise of his statutory right of inspection upon the submission of an affidavit attesting that “inspection is not desired for a purpose which is in the interest of a business or object other than the business of the corporation and that he has not within five years sold or offered for sale any list of shareholders of any corporation of any type or kind.”10

Although the case law does not expressly hold that the common-law right may be conditioned upon the submission of such an affidavit, a New York court might so rule, as the common-law and statutory rights often are analyzed apiece.11

Once an inspection demand has been made upon a corporation, the corporation generally must endeavor to respond to that demand within a reasonable period of time.12 Further, in the event that the corporation denies a shareholder’s inspection demand, the shareholder may seek judicial relief, usually in the form of a petition for a writ of mandamus pursuant to Article 78 of the Civil Practice Law and Rules.13

New York courts have not explicitly confronted arguments regarding whether shareholder inspection rights may be enforced contemporaneously with the filing of derivative claims.14 The Delaware courts, however, have explicitly held that inspection rights may not be enforced at the same time that a shareholder is prosecuting a derivative claim.

Substantial policy and practical concerns support this result. First, a derivative complainant affirms that he has sufficient information to bring a lawsuit by filing that suit, and a request to inspect corporate books and records contradicts that affirmation.15

Second, shareholders elect the board to manage the corporation’s affairs, including whether to bring litigation, and that responsibility should not be displaced unless a shareholder complainant has in hand a factual basis for seeking to do so.16 The corporation (and all of its shareholders) should not be put to the expense of addressing derivative action litigation if the complainant requires access to books and records in order to determine whether it can satisfy the threshold requirements with respect to demand futility or wrongful refusal.17

Third, once a shareholder complainant commences a derivative action, any discovery available in that action should be governed by the applicable rules of civil procedure, such as the CPLR, rather than the BCL.18

Further, requiring potential complainants to seek access to books and records before commencing plenary actions may both weed out cases that should not be filed, and improve those that should be.19

II. Threshold Requirements for Enforcing Inspection Rights

There are two principal substantive prerequisites to the enforcement of common-law and statutory shareholder inspection rights in New York: (1) shareholder status at the time of the inspection request; and (2) good faith and a proper purpose in making the inspection request.

Shareholder Status

An individual is entitled to exercise common-law and statutory inspection rights only if he is a shareholder at the time of his inspection request. Accordingly, although there is no express requirement that shareholder status be proved through any particular means, a corporation nevertheless may require reasonable proof of shareholder status before granting access to corporate books and records.21

Good Faith and Proper Purpose

Under the common law of New York and by statute, a shareholder is entitled to exercise his inspection rights only if he acts in good faith and with a proper purpose.22 Thus, a corporation may deny a shareholder’s inspection demand if it determines that the shareholder is not acting in good faith or otherwise does not have a proper purpose. Further, if a shareholder subsequently brings suit to enforce his common-law or statutory inspection rights, a court may order that inspection be granted only if it determines that the shareholder is acting in good faith and has a proper purpose.23

Significantly, when a shareholder brings suit to enforce the common-law right of access, he has the burden of “plead[ing] and prov[ing] that inspection is desired for a proper purpose,”24 whereas when the shareholder asserts the statutory right of access, the corporation bears the burden of “showing an improper purpose or bad faith.”25 In either event, if there is a question of fact as to whether the shareholder seeks to exercise his inspection rights in good faith and has a proper purpose, the court must hold a hearing to adjudicate that issue.26

There is scant case law on the meaning of good faith in the context of shareholder inspection rights,27 as most of the jurisprudence focuses upon the “proper purpose” requirement. In this respect, common-law and statutory inspection rights exist principally to permit shareholders reasonably to “protect their financial interests in a corporation by inspecting its books and records.”28 Thus, whether an individual shareholder has a “proper purpose” in seeking inspection turns on a fact-specific inquiry into whether he is reasonably seeking to safeguard his investment.

Although the “proper purpose” inquiry necessarily is fact intensive, the case law provides some guidance on shareholder purposes that may be deemed sufficiently connected to safeguarding shareholder financial interests as to ground an inspection demand.

Generally, proper shareholder purposes may “include, among others, efforts to ascertain the financial condition of the corporation, to learn the propriety of dividend distribution, to calculate the value of stock, to investigate management’s conduct, and to obtain information in aid of legitimate litigation.”29

On the other hand, improper purposes embrace “those which are inimical to the corporation, for example, to discover business secrets to aid a competitor of the corporation, to secure prospects for personal business, to find technical defects in corporate transactions to institute ‘strike suits,’ and to locate information to pursue one’s own social or political goals.”30

In line with this general guidance, New York courts regularly permit inspection for purposes of valuing shareholdings, especially in the context of closely held corporations.31 There also is support for the use of shareholder inspection rights to obtain a shareholder list for purposes of preparing a tender offer or proxy filing.32

The investigation of possible corporate mismanagement and the preparation of shareholder litigation also may constitute proper inspection purposes under certain circumstances, although the case law is more limited and more nuanced on this point.

New York courts do not require conclusive proof of wrongdoing before allowing a shareholder to inspect books and records in order to investigate management conduct or prepare for litigation.33 Nonetheless, New York courts have made clear that they will not permit shareholder inspection rights to be used as fishing expeditions.34

Further, conclusory allegations of corporate mismanagement or wrongdoing fail to provide a sufficient foundation for the exercise of shareholder inspection rights.35 Therefore, it seems reasonable to conclude that New York courts, like their Delaware counterparts, generally will require a showing of some concrete reasonable basis to infer that wrongdoing has occurred before allowing a shareholder inspection predicated solely on allegations of mismanagement or wrongdoing.36

In addition, a shareholder possesses a proper purpose for conducting an inspection only if the inspection is reasonably calculated to advance that proper purpose.37 In other words, a shareholder is not entitled to inspect books and records merely because he states a purpose that, in the abstract, may be proper where, for example, that purpose cannot be advanced through inspection.38

III. Scope of Inspection Rights

The statutory and common-law rights of inspection provide access to distinct, though partly overlapping, corporate books and records.

Beginning with the statutory right, BCL § 624 narrowly delineates the books and records available to shareholders. In particular, subsection (b) permits a shareholder to examine the “minutes of the proceedings of [the corporation's] shareholders and record of shareholders and to make extracts therefrom for any purpose reasonably related to such person’s interest as a shareholder.”39 Subsection (e) allows a shareholder to obtain “an annual balance sheet and profit and loss statement for the [corporation's] preceding fiscal year, and, if any interim balance sheet or profit and loss statement has been distributed to its shareholders or otherwise made available to the public, the most recent such interim balance sheet or profit and loss statement.”40

Other records may be obtained (if at all) only through reliance on the common-law right of access.

In delimiting the scope of the common-law right of inspection, courts generally hold that a shareholder is entitled to access only those books and records that are “relevant and necessary” to his “proper purpose.”41Accordingly, the shareholder’s purpose in seeking access is the primary guidepost in determining the books and records that the shareholder is entitled to review. Therefore, the scope of materials available through the exercise of common-law inspection rights generally is much narrower than the scope of materials available through disclosure in the context of litigation.42

Finally, a corporation is entitled to withhold documents based on the attorney-client and work-product privileges.43 Moreover, where the documents to be inspected include potentially sensitive materials, a corporation may be entitled to a protective order restricting the dissemination or use of such materials.44

IV. Conclusion

Shareholder inspection rights provide an important tool for shareholders to obtain information regarding their financial stake in the corporation and to exercise their share ownership rights on a more informed basis. Given the separation of ownership and management embodied by the New York corporate form, such inspection rights are of course not without their reasonable limitations.

It behooves shareholders and corporations alike to be fully aware of the scope and content of shareholder inspection rights. Such awareness may permit shareholders to enhance their ability to make reasonably informed investment decisions, while also allowing corporations to process inspection demands efficiently.

Mitchell A. Lowenthal is a partner of Cleary Gottlieb Steen & Hamilton LLP, resident in the firm’s New York office. Mr. Lowenthal’s practice focuses on the prosecution and defense of disputes arising out of significant capital markets events and M&A transactions.

Ari D. MacKinnon is an associate of Cleary Gottlieb Steen & Hamilton LLP, resident in the firm’s New York office. Mr. MacKinnon’s practice focuses on litigation.

© 2013 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.

Disclaimer
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

After a flurry of legislative and administrative initiatives over the past six months to strengthen privacy protections in the telecommunications, internet, and credit-related sectors, China’s legislature now appears to be setting its sights on crafting broader consumer privacy protections. On April 28, the National People’s Congress (NPC) released for public consultation draft amendments to the Law on the Protection of the Rights and Interests of Consumers (“Consumer Protection Law”).¹ If approved, these amendments would be the biggest amendments made to the Consumer Protection Law since its adoption in 1994.

In addition, efforts continue to strengthen protections in the telecommunications and internet sectors, particularly with respect to the use of mobile devices, sending spam text messages, and the collection of personal information in the education context. The Decision on Reinforcing the Protection of Network Information (“Decision”), issued by the Standing Committee of the NPC Dec. 28, 2012, set the stage for the Ministry of Industry and Information Technology (MIIT) to issue draft implementing rules that, if approved, would require telecommunications business operators and internet information service providers to fulfill privacy-related obligations such as notice, consent, and data security.² Since then, MIIT continues to issue new rules, opinions, and initiatives that address specific issues raised by the Decision. Most recently, MIIT has issued in final form new rules that regulate the collection of personal information through mobile devices and has launched an initiative to crack down on spam text messages. MIIT also has issued opinions that prohibit telecommunications companies from illegally collecting personal information of students and teachers and sending them materials without their consent.

Consumer Protection Law Highlights

The draft amendments to the Consumer Protection Law would clarify that consumers have a right to privacy, dignity, and respect for ethnic customs and practices, and to have their personal information such as name and image protected when purchasing or using a good or receiving a service. A business operator who infringes these rights would have to cease such infringement, rehabilitate the user’s reputation, take actions to mitigate negative effects, apologize, and indemnify the user for losses. In addition to civil liabilities, governing authorities and penalties specified in relevant laws and regulations would apply. If the laws and regulations were silent, industrial and commercial authorities or other relevant administrative authorities could order rectification and based on the circumstances, impose one or more of the following penalties: a warning, confiscation of unlawful income, or a fine of more than one times and less than 10 times the unlawful income. Where there is no unlawful income, a fine of less than ¥500,000 (about $81,584) would have to be imposed. Where laws and regulations were seriously violated, the business operator would have to be ordered to cease business until the problem had been rectified, or have its business license revoked.

Other privacy law principles incorporated into the draft include:

• The collection and use of consumers’ personal information would have to be on the basis of informed consent, and consumers would have to be notified about the purpose, method, and scope of the data collection.
• Business operators would have to adhere to the principles of legality, legitimacy, and necessity when collecting or using consumers’ personal information.
• Business operators would have to adopt rules and regulations governing their collection and use of the personal information that is made publicly available.
• Business operators and their staff would be required to keep consumers’ personal information in strict confidence and could not divulge, tamper with, or damage such information, and could not sell or illegally provide such information to third parties. Business operators would have to adopt technological and other measures as necessary to secure the safety of the information, and prevent it from being divulged, damaged, or lost. In the event that personal information had or could be divulged, damaged, or lost, the business operator would have to immediately take remedial actions.
• Without a consumer’s consent or request or if a consumer had expressly refused, business operators could not send electronic commercial information to the consumer.

The deadline for feedback and comments to the draft Consumer Protection Law was May 31. Public consultation is an increasingly important part of the legislative process. Once the Commission of Legislative Affairs of the Standing Committee of the NPC has received comments, there could well be relatively significant changes to the draft. Some commentators are predicting the law will be finalized by year-end, but predictions can be difficult.

Sector-Specific Initiatives

The following provides an overview of recent initiatives in the telecommunications, internet, and credit-related sectors.

• Circular on Strengthening the Administration of Network Access of Mobile Intelligent Terminals(Issued April 11; effective Nov. 1, 2013).³ This circular will prohibit production enterprises from pre-installing application software with a feature to collect or amend users’ personal information in “mobile smart terminals” (a term that includes mobile handsets, tablets, and other mobile devices that can access public communications networks) without expressly indicating or asking for consent from such users. The circular will also prohibit production enterprises from pre-installing other software that may infringe upon the safety of users’ personal information or endanger the safety of the network and its information.
• Circular on Carrying out a Special Operation for Cracking Down on Spam Text Messages (Issued and effective April 7, 2013).⁴ A special operation to crack down on spam text messages will last from April 2013 to December 2013. Based on the relevant work plan, the MIIT will draft the Provisions for Administration of Text Message Communication Services and amend relevant technology standards. Basic telecommunications service providers are required to upgrade their spam message disposal platforms and standardize the subscription and cancellation of commercial text messages. Without the informed consent of subscribers, or if a subscriber has expressly refused, telecommunications enterprises may not send commercial text messages to subscribers. However, these regulations, like the regulations for email advertising,⁵ do not distinguish clearly between spam messages and reasonable commercial communications. The MIIT regulations also call for the establishment of a mechanism to enable the discovery, reporting, disposal, and monitoring of spam text messages.
• Opinions on Further Regulating the Market Operation Activities of Telecommunications Operation Enterprises in Campus Telecommunications Businesses (Issued and effective April 3, 2013).⁶ Under these opinions, telecommunications enterprises are prohibited from illegally obtaining personal information of teachers, students, or their parents. Without the consent of teachers, students, or their parents, telecommunications enterprises may not mail subscriber identity module (SIM) cards or business materials to them.
• Information Security Guidelines for Protection of Personal Information Within Information Systems for Public and Commercial Services (Issued and effective Feb. 1, 2013).⁷ The guidelines, issued as a ‘‘national standard’’ under China’s GB (‘‘guobiao’’) standardization system, encompass the full range of obligations found under most omnibus data protection laws and encompass all of the Fair Information Principles as well as some additional obligations. Although these guidelines are not mandatory, they will serve as an important reference for companies seeking to develop best practices in order to comply with existing People’s Republic of China legal provisions that pertain to data privacy.
• Credit Reporting Regulations (Approved in December 2012 and effective March 15, 2013).⁸ The regulations impose a number of obligations upon credit reporting agencies (CRAs) and other entities with regard to their collection and use of personal information in the course of their business operations.