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The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime

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James Schwartz*

The derivatives market was seen as having contributed substantially to the financial crisis of 2007–08.[1] This led to efforts to regulate derivatives in many of the countries in which their use was commonplace.[2] Historically, the swaps market consisted primarily of bilateral transactions agreed upon by telephone or electronic messages, which, in the absence of any reporting or clearing requirement, remained known only to the two principals.[3] At a September 2009 summit in Pittsburgh, however, G-20 leaders agreed in concept to wholesale reforms.[4] These reforms included the requirements that by the end of 2012, “all standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms[] where appropriate,” “cleared through [a] central counterpart[y]” standing between the two original parties, and “reported to [a] trade repositor[y].”[5]

The G-20’s original timeframe did not hold, and today, almost a year after the G-20’s 2012 year-end target date, implementation of the contemplated reforms remains problematic.[6] Many of the delays reflect issues on the national level—mainly that the derivatives market is large, complex, and not especially familiar to many policymakers. However, beyond the need for action at the national level, the regulation of the swaps market, in which transactions between counterparties in wide-ranging jurisdictions have long been routine, requires international coordination and cooperation. If this were lacking, the consequences could include regulatory arbitrage, outsized compliance costs for, or incomplete compliance by, market participants, the fracturing of liquidity among different jurisdictions, and perhaps even political tensions.

The most aggressive regulator of the swaps market to date has been the U.S. Commodity Futures Trading Commission (CFTC), the primary U.S. regulator of derivatives. The CFTC is empowered to regulate the swaps market under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[7] The CFTC’s rules are significantly closer to being implemented than those of many regulators outside the U.S.[8] As a result of the CFTC’s guidance regarding the extraterritorial application of its regulations[9] and the timeframe that the CFTC has set for implementation of that guidance, December 21 of this year may be a key date for many market participants.[10] On that day, according to the CFTC’s current timetable, many of the CFTC’s rules may become applicable to many transactions involving U.S. counterparties acting through non-U.S. offices or non-U.S. swap dealers registered with the CFTC by reason of their substantial U.S.-facing swap activities.[11]

Under the terms of the CFTC exemptive order issued on July 22, 2013, many such market participants are exempted from compliance with a number of the CFTC’s rules until the earlier of December 21, 2013 or thirty days following the issuance of an applicable substituted compliance determination.[12] As detailed below, a substituted compliance determination is an assessment by the CFTC that the relevant foreign jurisdiction’s rules are sufficiently comprehensive and comparable to the CFTC’s own rules to be followed in lieu of the CFTC’s rules.[13]

The CFTC’s timeframe, and the uncertain prospects of such substituted compliance determinations,[14] have put many market participants in an uncomfortable position. Because foreign swaps regulations are generally in a less advanced state than the CFTC’s own rules, the extent to which substituted compliance determinations may even be possible by December 21 is not entirely clear. Where the corresponding non-U.S. rules are in place, it is unclear whether the CFTC will actually make substituted compliance determinations related to those rules. Where the corresponding foreign rules are not yet in place, these could come into effect shortly after December 21. If the CFTC on December 21 requires compliance with U.S. rules, this could mean that market participants will be required to comply with both sets of rules. Moreover, the CFTC’s cross-border guidance contemplates requirement-by-requirement determinations on comparability of non-U.S. swaps regulatory regimes.[15] This mix-and-match approach makes it likely that many market participants will be required to comply both with certain (as yet unspecified) elements of the CFTC’s rules and certain (as yet unspecified) elements of non-U.S. regulatory regimes.

Issues in the cross-border market brought about by the CFTC’s mandatory clearing requirement, which went into effect on October 9 of this year for many market participants,[16] indicate that a significant delay in substituted compliance determinations could be the worst outcome for the U.S. swaps market. Upon the CFTC’s clearing requirement becoming effective, the absence of a substituted compliance determination with respect to clearing prompted certain non-U.S. market participants to avoid dealing with U.S. swap dealers.[17] This has moved swap trading activities with non-U.S. market participants into non-U.S. affiliates.[18] A further, related concern that may be limiting trading by swap dealers through their non-U.S. branches, in the absence of a substituted compliance determination, is that if transactions entered into by such branches are subject to mandatory clearing, they may soon also be subject to U.S. rules which in certain cases will likely require execution on a swap execution facility.[19]

The CFTC’s approach to cross-border matters is complex and nuanced. It divides the CFTC’s requirements into two separate categories: Transaction-Level Requirements and Entity-Level Requirements.[20] It then splits each of these categories into two subcategories.[21] The Transaction-Level requirements are split into Category A Transaction-Level Requirements (which include clearing and swap processing, trade execution, swap trading relationship documentation, and real-time public reporting of swap data) and Category B Transaction-Level Requirements (which consist of the CFTC’s external business conduct standards).[22] Similarly, the Entity-Level Requirements are divided into First Category Entity-Level Requirements (which include capital adequacy, chief compliance officer, risk management, and most swap data recordkeeping) and Second Category Entity-Level Requirements (which include, among others, swap data repository reporting and reporting for large traders of swaps linked to certain commodities).[23]

The CFTC’s regime, with respect to the Transaction-Level Requirements, may be summarized—albeit in a vastly simplified manner—as a continuum.[24] At one end of the spectrum such requirements will apply to swaps involving a CFTC-registered swap dealer (whether or not a U.S. Person[25]) acting through a U.S. branch or a U.S. Person other than a swap dealer.[26] Contrariwise, at the other end of the spectrum, such requirements will not apply (unless one party is a swap dealer acting through a U.S. branch[27] or a U.S. Person[28]) to swaps involving a party that is not a U.S. Person and not otherwise linked to the U.S. as a “guaranteed affiliate”[29] or an “affiliate conduit.”[30] With respect to swaps that do not fall at either end of the spectrum, such as swaps involving a CFTC-registered swap dealer acting through a non-U.S. branch, a substituted compliance determination is possible in relation to many such requirements.[31] With respect to the Entity-Level Requirements, for U.S. dealers, such requirements will apply, and for non-U.S. CFTC-registered swap dealers, substituted compliance determinations will be possible for many such requirements.[32]

On its face, this approach has a certain logic to it—the more closely linked to the U.S. a counterparty or transaction is, the more likely it is that the CFTC’s rules or similar rules, by way of substituted compliance, should apply. In practice, however, the approach seems likely to cause significant issues in the absence of substantial and close coordination among regulators—which, to date, does not appear overly abundant.[33]

These issues can be illustrated using the first cross-border example above, a transaction involving a U.S. swap dealer acting through a U.S. branch. If the swap were transacted between, for example, the New York head office of a U.S. swap dealer and the Paris head office of a French swap dealer, the EU’s rules should presumably govern the transaction to the same extent the U.S. rules do. If the EU were to take a position parallel to that of the CFTC and require the application of the EU’s rules to a transaction involving an EU swap dealer, the transaction would be governed by both U.S. and EU rules. Any material differences between these two sets of rules could be a significant issue for the parties to such a transaction and, by extension, for the swaps market as a whole.

Even in this relatively straightforward case, some understanding among relevant regulators with regard to cross-border swaps would seem highly desirable. The genius of the CFTC’s approach is that, by implementing its rules first and, by means of substituted compliance determinations, setting a bar for other regulators to reach, it has claimed the power to shape significantly discussions in foreign jurisdictions regarding the substance of swaps regulations. On the other hand, by making its own rules without agreements from other regulators and then delaying compliance dates, the CFTC is putting pressure on other regulators to fall into line to avoid causing conflict.[34] Given the need for cooperation, this approach seems incongruous and even slightly imperious.[35] There is a distinct lack of an institutional framework for making international regulatory swaps determinations,[36] in the absence of which the CFTC contemplates that foreign regulators, industry groups and even individual market participants may request a substituted compliance determination.[37]

Even for requirements in which substituted compliance is possible, the CFTC’s guidance is unclear. It offers scant insight into whether the CFTC will in fact make a substituted compliance determination, and, if it does make such a determination, what conditions it may impose on market participants seeking to rely on such determination. In order for a party to a swap to substitute compliance with the requirements of a non-U.S. jurisdiction for compliance with the CFTC’s own requirements, the CFTC must determine that the foreign jurisdiction’s requirements “are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the Entity- and Transaction-Level Requirements.”[38] However, they need not be “identical requirements to those established under the Dodd-Frank Act.” [39] In cases where the CFTC does not find foreign laws and regulations to merit substituted compliance, the relevant non-U.S. Person or foreign branch of a U.S. Person “may be required to comply” with the applicable CFTC regulations.[40]

The CFTC may consider both swap-specific regulations of the relevant foreign regulator and other provisions that may “achieve comparable and comprehensive regulatory objectives as the Dodd-Frank Act requirements, but on a more general, entity-wide, or prudential, basis.”[41] Moreover, the CFTC may vary its approach depending on the particular foreign jurisdiction.[42] In certain cases it may seek to influence the contents of foreign regulations by “coordinating with the foreign regulators in developing appropriate regulatory changes or new regulations, particularly where changes or new regulations already are being considered or proposed by the foreign regulators or legislative bodies.”[43] In other cases, the CFTC “may include conditions that take into account timing and other issues related to coordinating the implementation of reform efforts across jurisdictions”[44] or otherwise “include in its substituted compliance determination a description of the means by which certain swaps market participants can achieve substituted compliance within the construct of the foreign regulatory regime.”[45]

The CFTC does not intend to make substituted compliance determination with respect to foreign regulations as a whole, but instead with respect to particular foreign regulations.[46] Partly because “many foreign jurisdictions” are in the process of implementing derivatives market reforms “in an incremental manner,” a “comparability analysis will be based on a comparison of specific foreign requirements against specific” provisions of the Dodd-Frank Act and CFTC regulations for each of the categories of regulatory obligations for which substituted compliance may be available.[47] As a result, the swap counterparties to whom substituted compliance may apply will likely be expected to comply with a mixture of U.S. and non-U.S. regulations.

At the same time, however, the CFTC, somewhat puzzlingly, has stated that it expects to “rely upon an outcomes-based approach to determine whether these requirements achieve the same regulatory objectives of the Dodd-Frank Act.”[48] In this context, “outcomes-based” is often understood to refer not to what regulations state, but instead to the actual consequences that they cause.[49] It is not clear why an outcomes-based approach would necessitate a requirement-by-requirement review such as the CFTC contemplates. The SEC, in contrast to the CFTC, stated in its proposed cross-border rules that it would not focus on “a rule-by-rule comparison” but instead “on regulatory outcomes” with a “holistic approach.”[50]

If the CFTC guidance regarding substituted compliance sounds vague enough to support whatever ad hoc arrangement the regulator believes is warranted in any particular case, perhaps that is exactly the point. A commitment to the substituted compliance regime did not prevent the CFTC from agreeing to another approach entirely just days before the release of its cross-border guidance.[51] In one of the relatively few concrete signs of cooperation with foreign regulators, the CFTC and EU authorities agreed in July of 2013 to an understanding known as the “path forward.”[52] In that understanding, they agreed to a “stricter-rule-applies” approach with regard to mandatory clearing, one of the fundamental reforms sought by the G-20.[53] This approach, not referenced in the CFTC’s cross-border guidance, would be applicable “where exemptions from mandatory clearing would exist in one jurisdiction but not in the other.”[54] Although this approach may indeed “prevent loopholes and any potential for regulatory arbitrage,”[55]imposing stricter regulations on cross-border swap transactions than on transactions undertaken in a single jurisdiction would seem not to promote a liquid international market.

In the longer run, it seems likely that the swaps regulations of the major jurisdictions will converge. For the foreseeable future, however, both before and after December 21, questions will continue to abound, and the swaps market will continue to be burdened by regulatory uncertainty. As it was the G-20 process that delineated and put in process the swaps market reforms in G-20 member nations, international bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board could likely play a productive role in minimizing confusion and disruption and in bringing much needed clarity to the swaps market.[56]

 

Preferred citation: James Schwartz, The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime, 4 Harv. Bus. L. Rev. Online 52 (2013), https://journals.law.harvard.edu/hblr//?p=3676.

* Of Counsel, Morrison & Foerster LLP.

[1] See, e.g., Colin Barr, Geithner to Rein in Derivatives, CNNMoney (May 13, 2009), http://money.cnn.com/2009/05/13/news/derivatives.fortune/.

[2] See, e.g., G-20, Leaders’ Statement: The Pittsburgh Summit (September 24–25, 2009) [hereinafter Leaders’ Statement], available at http://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.

[3] See, e.g., Randall Dodd, Derivative Study Center, The Structure of OTC Derivatives Markets 2 (2002), http://www.financialpolicy.org/dscotcstructure.pdf.

[4] See Leaders’ Statement, supra note 2.

[5] Leaders’ Statement, supra note 2.

[6] See, e.g., James K. Jackson & Rena S. Miller, Cong. Research Serv., Comparing G-20 Reform of the Over-the-Counter Derivatives Markets (2013), http://www.fas.org/sgp/crs/misc/R42961.pdf.

[7] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 701–74, 124 Stat. 1376, 1641–802 (2010) (codified as amended in scattered sections of 7, 12 and 15 U.S.C. (2012)). The Dodd-Frank Act permits the U.S. Commodity Futures Trading Commission (CFTC) to exercise authority with respect to activities outside of the United States if those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States” or “contravene such rules or regulations as the [CFTC] may prescribe [] as are necessary or appropriate to prevent the evasion of any provision of [the Dodd-Frank Act]”. Id. at § 722(d) (codified at 7 U.S.C. § 2(1)). Title VII of the Dodd-Frank Act gives the CFTC jurisdiction over “swaps” and the U.S. Securities and Exchange Commission (SEC) jurisdiction over “security-based swaps.” Id. at §§ 722(a), 761(a) (codified at 7 U.S.C. § 2(a)(1), 15 U.S.C. § 78c(a)). The Dodd-Frank Act defines each term, id. at §§ 721(a), 722(a), and a joint rulemaking by the CFTC and the SEC has further defined them. See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208 (Aug. 13, 2012) (to be codified at 17 C.F.R. pts. 1, 230, 240, and 241). Unlike the CFTC, the SEC has not yet finalized its rules regarding extraterritoriality, and its proposed cross-border rules are outside the scope of this article. See Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249). More broadly, in contrast with the CFTC, the SEC has finalized few of its rulemakings under the Dodd-Frank Act, and has postponed the application of many provisions that would treat security-based swaps as “securities” or would otherwise subject security-based swaps to the Dodd-Frank Act. See Extension of Exemptions for Security-Based Swaps, 78 Fed. Reg. 7,654 (February 4, 2013); Order Extending Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection With the Revision of the Definition of “Security” to Encompass Security-Based Swaps, and Request for Comment, 78 Fed. Reg. 10,218 (February 13, 2013); Temporary Exemptions and Other Temporary Relief, Together With Information on Compliance Dates for New Provisions of the Securities Exchange Act of 1934 Applicable to Security-Based Swaps, 76 Fed. Reg. 36,287 (June 22, 2011).

[8] As the CFTC has noted, “many foreign jurisdictions have been implementing OTC derivatives reforms in an incremental manner,” and “because many jurisdictions are in the process of finalizing and implementing their derivatives reforms incrementally,” the CFTC’s determinations, discussed infra text accompanying notes 38–50, as to which foreign rules are sufficiently comprehensive and comparable to the CFTC’s own rules “may need to take into account the timing of regulatory reforms that have been proposed or finalized, but not yet implemented.” Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,343–44 (July 26, 2013) (to be codified at 17 C.F.R. § 1). For an analysis of one area in which there is a significant difference in timing between U.S. rules and analogous foreign rules, see James E. Schwartz, Marissa N. Golden & Robert J. Dilworth, First Steps on the Path Forward, 32 Int’l Fin. L. Rev. 36, 36–37 (2013), available at http://www.iflr.com/Article/3247985/The-path-forward-for-EU-US-derivatives-regulation.html (analyzing the status of the trade execution mandate in the U.S. and the EU, and noting that while the CFTC’s mandate will be in effect shortly, the EU’s is not expected to be in place until possibly as late as 2016).

[9] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292.

[10] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 43,785, 43,794–95 (July 22, 2013) (stating that numerous requirements for certain non-U.S. market participants and certain non-U.S. branches of U.S. swap dealers will go into effect on the earlier of December 21, 2013 or 30 days after the issuance of an applicable substituted compliance determination).

[11] See id.

[12] See id.

[13] See id. at 43,789.

[14] Even close followers of regulatory matters could be forgiven for not recognizing the words “substituted compliance” when the CFTC used and defined the term in its 2012 proposed interpretive guidance regarding cross-border matters. See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41214, 41229 (proposed July 12, 2012). The term appears to have its origins in a seminal 2007 article in the Harvard International Law Journal, in which the authors argued that foreign stock exchanges and broker-dealers should be able to provide services in the United States “based on their compliance with substantively comparable foreign securities regulations and laws and supervision by a foreign securities regulator with oversight powers and a regulatory and enforcement philosophy substantively similar to the SEC’s,” instead of based on compliance with U.S. securities regulations and SEC supervision. Ethiopis Tafara & Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, 48 Harv. Int’l L.J. 31, 32 (2007). Although the SEC signed a “mutual recognition agreement” with Australian regulators in 2008, it apparently shelved its plans to increase mutual recognition activities shortly thereafter, driven partly by the financial crisis. See Jerry Ellig & Houman B. Shadab, Talking the Talk, or Walking the Walk? Outcome-Based Regulation of Transnational Investment, 41 N.Y.U. J. Int’l L. & Pol. 265, 268 (2009).

[15] See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. at 41,229.

[16] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 43,794.

[17] See, e.g., Anish Puaar, EU Firms Forced to Take Action to Avoid US Clearing Rules, Financial News (October 10, 2013), http://www.efinancialnews.com/story/2013-10-10/eu-firms-forced-to-take-action-to-avoid-us-clearing-rules?ea9c8a2de0ee111045601ab04d673622 (“[S]ome European buyside firms are not prepared to clear their swap trades, leading them to either switch to US banks’ European entities or stop trading with them altogether.”).

[18] See id.

[19] The Dodd-Frank Act amended the Commodity Exchange Act, 7 U.S.C. §§ 1–27f (2012), to provide that swaps that the CFTC subjects to mandatory clearing must be executed on either a swap execution facility or a designated contract market, unless no swap execution facility or designated contract market makes the swap available to trade. See Dodd-Frank Act at § 723(a)(8); 7 U.S.C. § 2(h)(8). Mandatory execution on a swap execution facility for certain transactions is expected to commence in the near future, as swap execution facilities have started submitting “made available to trade” determinations, which the CFTC will consider pursuant to its rules. See Process for a Designated Contract Market or Swap Execution Facility To Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act, 78 Fed. Reg. 33,606 (June 4, 2013) (to be codified at C.F.R. pts. 37 and 38); Provisions Common to Registered Entities, 76 Fed. Reg 44,776, 44,793-96 (July 27, 2011) (to be codified at C.F.R. pt. 40); Silla Brush, Javelin Files to Trade Interest-Rate Swaps, Spurring Sef Shift, Bloomberg (October 19, 2013), http://www.bloomberg.com/news/2013-10-19/javelin-files-to-trade-interest-rate-swaps-spurring-sef-shift.html.

[20] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,331–40 (July 26, 2013) (to be codified at 17 C.F.R. § 1).

[21] See id. at 45,335–36.

[22] See id. at 45,336.

[23] See id. at 45,335–36.

[24] See id. at 45,369 apps. D & E.

[25] The CFTC’s cross-border guidance defines a U.S. Person “generally to include, but not be limited to: (i) Any natural person who is a resident of the United States; (ii) any estate of a decedent who was a resident of the United States at the time of death; (iii) any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of enterprise similar to any of the foregoing (other than an entity described in prongs (iv) or (v), below) (a ‘legal entity’), in each case that is organized or incorporated under the laws of a state or other jurisdiction in the United States or having its principal place of business in the United States; (iv) any pension plan for the employees, officers or principals of a legal entity described in prong (iii), unless the pension plan is primarily for foreign employees of such entity; (v) any trust governed by the laws of a state or other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) any commodity pool, pooled account, investment fund, or other collective investment vehicle that is not described in prong (iii) and that is majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v), except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons; (vii) any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) that is directly or indirectly majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v) and in which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity; and (viii) any individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in prong (i), (ii), (iii), (iv), (v), (vi), or (vii).” Id. at 45,316–17.

[26] See id. at 45,369 apps. D & E.

[27] See id. at 45,350 n.513.

[28] See id. at 45,369 apps. D & E.

[29] A “guaranteed affiliate” is a “non-U.S. person that is an affiliate of a U.S. person and that is guaranteed by a U.S. person.” Id. at 45,318.

[30] See id. at 45,369 apps. D & E. The CFTC has not precisely defined “affiliate conduit” but has stated that certain factors are relevant to the consideration of whether a non-U.S. Person constitutes an affiliate conduit. See id. at 45,369 app. D n.1. Such factors include “whether (i) the non-U.S. person is majority-owned, directly or indirectly, by a U.S. person; (ii) the non-U.S. person controls, is controlled by, or is under common control with the U.S. person; (iii) the non-U.S. person, in the regular course of business, engages in swaps with non-U.S. third party(ies) for the purpose of hedging or mitigating risks faced by, or to take positions on behalf of, its U.S. affiliate(s), and enters into offsetting swaps or other arrangements with such U.S. affiliate(s) in order to transfer the risks and benefits of such swaps with third-party(ies) to its U.S. affiliates; and (iv) the financial results of the non-U.S. person are included in the consolidated financial statements of the U.S. person.” Id.

[31] See id. at 45,369 app. D. Substituted compliance does not apply with respect to the external business conduct rules that constitute the Category B Transaction-Level Requirements. See id. at 45,369 app. E. This may be partly because such rules, which require dealers in certain transactions to provide pre-trade and daily mid-market marks, and, upon request, scenario analyses, are not expected to have analogs in many non-U.S. jurisdictions. See Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg. 9,734 (February 17, 2012) (to be codified at 17 C.F.R. pts. 4 and 23).

[32] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations,78 Fed. Reg. at 45,368.

[33] Even with regard to the EU, one of the only foreign regulators with which the CFTC has appeared to have tangibly productive discussions, see infra n.51–53 and accompanying text, the lack of a detailed agreement between regulators is reportedly harming the negotiation of a U.S.-EU free trade agreement. Luke Baker & Stephen Adler, Derivatives Dispute Harming EU-U.S. Free-Trade Talks, Reuters (October 29, 2013), http://uk.reuters.com/article/2013/10/29/uk-eu-us-regulation-idUKBRE99S0G220131029.

[34] See Edward F. Greene & Ilona Potiha, Issues in the Extraterritorial Application of Dodd-Frank’s Derivatives and Clearing Rules, the Impact on Global Markets and the Inevitability of Cross-Border and US Domestic Coordination, 8 Cap. Mkts. L.J. 338, 353 (2013).

[35] See id.

[36] See id. at 386.

[37] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 45,344.

[38] Id. at 45,342.

[39] Id. at 45,342–43. “In evaluating whether a particular category of foreign regulatory requirement(s) is comparable and comprehensive to the applicable requirement(s) under the [Commodity Exchange Act] and Commission regulations, the Commission will take into consideration all relevant factors, including but not limited to, the comprehensiveness of those requirement(s), the scope and objectives of the relevant regulatory requirement(s), the comprehensiveness of the foreign regulator’s supervisory compliance program, as well as the home jurisdiction’s authority to support and enforce its oversight of the registrant.” Id. at 45,343.

[40] Id. at 45,344.

[41] Id. at 45,343.

[42] See id.

[43] Id. at 45,343–44.

[44] Id. at 45,343.

[45] Id. at 45,344.

[46] See id. at 45,343.

[47] Id. at 45,343–44.

[48] Id. at 45,342.

[49] See Ellig & Shadab, supra note 14, at 282 (“Outcomes are the actual benefits created, or harms avoided, for citizens. . . . [R]egulations issued are outputs that may affect outcomes, but they are not outcomes.”).

[50] Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968, 30,975 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249).

[51] See Press Release, U.S. Commodity Future Trading Commission, The European Commission and the CFTC Reach a Common Path Forward on Derivatives (July 11, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.

[52] Id.

[53] Id.

[54] Id.

[55] Id.

[56] See Greene & Potiha, supra note 34, at 385–92.

By

The Regulatory Challenge Of Distributed Generation

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David B. Raskin*   

I.   Introduction

Recent published reports point toward a growing conviction that the demand for utility service from the U.S. electric grid may soon decline, perhaps substantially, due to the expanding use of distributed generation.[1] One report prepared by a division of Citigroup describes the improving economics of distributed solar power, which the authors expect will continue.[2] A second Citigroup report projects reductions in the demand for utility service in developed markets of up to fifty percent by 2050.[3] Favorable projections for distributed generation, however, depend on assumptions about technological change that may turn out to be overstated, and even if distributed generation grows substantially, millions of homes and businesses will continue to rely on the electric grid for many decades.[4]

Germany has gone further to promote distributed generation[5] than any other industrialized nation, and its experience provides a cautionary tale. More than a decade after Germany initiated its Energiewende,[6] the average residential price for electricity is almost 36 cents per kWh,[7] and rates are projected to rise another thirty to fifty percent in the next ten years.[8] Without a change in policy, German residential electric rates may therefore approach 50 cents per kWh by the end of this decade. In contrast, the average residential rate in the U.S. is approximately 12.5 cents per kWh.[9] Because the average U.S. residence uses approximately 1,000 kWh of electricity per month,[10] the current German rate would be equivalent to an average household tax of $3,000 per year. Rates anywhere near the levels being experienced in Germany would be unacceptable in the U.S.[11]

Even with extraordinarily high and increasing electric rates, aggregate carbon dioxide emissions by the German electric sector are rising.[12] In contrast, U.S. emissions are falling even though renewables constitute a much smaller percentage of the electric energy mix in the U.S.[13] The stability of the German grid is also being put at risk: it has relied more heavily on variable, renewable generation at the same time that grid resources capable of rapidly balancing supply and demand have been shutting down due to anomalous market price signals.[14] Energiewende has also taken a toll on the utility companies that may have to make the grid investments to fix these operating problems. Equity values for Germany’s biggest utilities have fallen by fifty percent or more over the past three years.[15]

While Germany struggles with Energiewende, the growth of distributed generation in the U.S. is being fueled by a controversial regulatory practice known as net metering. If distributed generation comes to play a significant role, the loss of demand for service from the grid may eventually make it difficult for the owners of grid assets to recover their costs, creating what the utility industry calls “stranded costs.” This Article explores the debate over net metering and then turns to the longer-term prospect of having to address potential stranded costs produced by the expanded use of distributed generation.

II.   Net Metering: The Current Battlefield

Most renewable generation in the U.S. is subsidized through investment or production tax credits.[16] This Article focuses on an additional subsidy to distributed renewable generation alone that exists as a result of “net metering” as applied in about forty states. Under net metering, retail customers (including commercial and industrial customers) can offset their electricity purchases from the grid with energy generated behind the retail meter, such as from rooftop solar panels. In most of the states that allow net metering, the credit equals the bundled retail rate. The credit applies not only to foregone consumption but also—with limited exceptions—to the energy generated from behind the meter in excess of the customer’s own use and delivered to the utility.[17]

Net metering therefore values the energy produced by distributed generators at the bundled retail rate for electricity. The bundled retail rate includes, in addition to the cost of producing electric energy, the costs associated with investment in and operation of transmission and distribution facilities and other costs incurred to ensure reliability and fund public policy initiatives endorsed by utility regulators. As noted above, the average residential price of electricity (the average bundled rate) is currently around 12.5 cents per kWh.[18] According to published data as of November 2013, the market price of energy from grid-connected[19] generators is averaging, in most locations, between 2 and 3 cents per kWh during off-peak periods and between 4 and 5 cents per kWh during on-peak periods.[20] Recent sales of grid-connected renewable energy have been priced near or below 3 cents per kWh.[21] Therefore, net metering allows the owners of distributed generation to effectively sell their energy at prices between two and six times the market price for energy.

Grid-connected renewable generators are paid the much lower market price for their energy, so the issue is not, as advocates of distributed generation allege, merely about promoting “clean” energy. A grid-connected solar generator at the same location as a distributed solar generator receives a fraction of the compensation for providing energy using similar—and equally clean—technology.[22] Grid-scale solar generation is actually more efficient, so net metering provides a huge subsidy to a less efficient form of renewable energy.

Utilities point out that the differential is paid by other retail customers. Because virtually all retail service is billed based on energy usage, net metering causes a re-allocation of transmission, distribution, and reliability costs to those customers who do not own distributed generation. Yet, the owners of distributed generation continue to rely on utility service from the grid for back-up and supplemental energy (for example, at night and when it is cloudy). Presently, the use of distributed generation in the U.S. is sufficiently limited that the cost-shifting effects are minor. However, subsidies this large can induce rapid changes. A report recently issued by the California Public Utilities Commission forecasts that net metering will cost the State $1.1 billion per year in 2020.[23] It also finds that the average net metering customer in California has an income almost twice the state’s average, [24] confirming claims that net metering entails a wealth transfer from low- to high-income consumers.

Net metering raises a number of legal issues that are just beginning to be explored. The definition of “net metering service” in the Energy Policy Act of 2005 indicates that Congress did not endorse the subsidy described above.[25] Section 111(d)(11) of the Public Utility Regulatory Policies Act (PURPA)[26] was added in 2005 to a list of retail ratemaking practices that state utility commissions are required to evaluate for use in their jurisdictions. This provision defines “net metering service” as follows:

Net Metering – Each electric utility shall make available upon request net metering service to any electric consumer that the electric utility serves. For purposes of this paragraph, the term “net metering service” means service to an electric consumer under which electric energy generated by that electric consumer from an eligible on-site generating facility and delivered to the local distribution facilities may be used to offset energy provided by the electric utility to the electric consumer during the applicable billing period.[27]

Under this definition, “electric energy” generated by a retail customer’s on-site facility may be used to offset “energy” provided by the utility. The language strongly implies that Congress meant only to ensure that consumers would receive an appropriate credit for the energy supplied from on-site generation and not a credit based on the bundled retail rate that includes costs associated with transmission, distribution, and reliability. If this is correct, net metering as applied in most states is inconsistent with this part of PURPA.[28]

In 2002, the Supreme Court of Ohio addressed this very issue in connection with interpreting Ohio legislation that required public utilities to offer net metering.[29] In that case, FirstEnergy proposed a net metering regime under which net metered customers would receive a credit for energy supplied from on-site generation based on the unbundled generation component of the retail rate.[30] This proposal was rejected by the Ohio Public Utilities Commission, which directed that FirstEnergy offer a credit based on the full bundled retail rate.[31] The Ohio Supreme Court held that FirstEnergy had correctly applied statutory language requiring utilities to provide a credit for the “electricity” produced by on-site generators by offering to credit only the generation component of the retail rate.[32] The Court found that FirstEnergy was correct in contending that a net meter customer “does not provide transmission, distribution or ancillary services,” and therefore the term “electricity” in the statute did not require a credit for the costs associated with these other unbundled services.[33]

Net metering also appears to be inconsistent with provisions of PURPA that were designed to protect electric consumers from cross-subsidization. Under PURPA, utilities are required to purchase energy from qualifying “small power production” facilities that meet eligibility standards established in the law.[34] Under FERC regulations, retail customers that own on-site generators with a maximum net generating capacity of less than 1 MW are permitted to self-implement PURPA’s mandatory purchase requirement without any notification to or approval from FERC.[35] Most retail customers using net metering rely on the mandatory purchase requirement to require their host utilities to purchase their energy.[36] Absent the PURPA requirement, utilities would generally have no obligation to buy energy from distributed generators because the Federal Power Act[37] (the law that applies in the absence of PURPA) does not obligate utilities to purchase energy at wholesale.[38]

PURPA, however, while requiring utilities to buy, also caps the price paid to qualifying facilities at the purchasing utility’s “avoided cost,” which is defined as the cost of energy that would have been supplied from the utility’s own system if the energy had not been supplied by the qualifying facility.[39] Because net metering compensates owners for the energy supplied from distributed generation at the utility’s bundled retail rate, this practice would appear to violate the avoided cost rate cap that is based on the cost of energy alone.

The FERC, however, permits net meter customers to avoid this price cap. The FERC holds that unless a retail customer with on-site generation is a net supplier of energy to the grid over the state retail billing period (almost always one month), no sale takes place under PURPA or the Federal Power Act, even if there are substantial deliveries of energy to the grid during the month.[40] In the absence of a “sale” to the utility, FERC deems that no mandatory purchase of energy is taking place under PURPA and the avoided cost price cap does not apply.[41]

The FERC’s theory, that the existence of a “sale” can be determined by netting metered inflows and outflows over the course of a month, was recently rejected in two appellate cases involving FERC’s use of this same theory to determine whether a retail sale has occurred when generators acquire energy for station service purposes, the mirror image of the net metering situation.[42] In these two cases, the D.C. Court of Appeals held that netting could not be used to determine whether a sale has taken place and that there is a sale whenever energy is delivered from the generator to the utility and vice versa.[43] The FERC’s disclaimers of jurisdiction in MidAmerican and SunEdison may therefore be subject to a renewed challenge, which, if successful, would require net metering rules to be changed at the state level.

This same “netting” theory allows FERC to avoid facing the fact that the prices inherent in net metering are discriminatory. The Federal Power Act prohibits charges for wholesale energy that are “unduly discriminatory,”[44] but this prohibition only applies if there is a FERC-jurisdictional wholesale transaction. MidAmerican Energy and SunEdison therefore provide a rationale for FERC to avoid addressing the huge differential between the prices paid to distributed and grid-connected generators for the energy they supply.

From both economic and environmental perspectives, energy from distributed generation is no more beneficial than other forms of renewable generation. Energy available to meet electric load, whether generated behind the retail meter or from grid-connected generation, provides equivalent value to the electric system. Therefore, the price discrimination inherent in net metering cannot be justified based on differences in the value of the services offered. If anything, distributed solar is less valuable than most energy from grid-connected generators because the energy output of solar facilities varies uncontrollably. Consequently, utilities must have sufficient grid-connected capacity on hand to supply the entire load when solar generation is non-productive. For the same reason, retail customers with distributed generation require access to grid-supplied energy up to their full load at unpredictable times.[45] Indeed, solar generation has a pernicious effect on energy markets because energy from solar generators tends to suppress energy market prices during peak-load periods, providing less revenue for grid-connected generation and falsely signaling to the market that grid-connected generation that is needed for reliability is no longer economic.[46]

In conclusion, net metering as currently practiced in most states provides a huge subsidy to distributed generators over and above the tax subsidy provided to all renewable generation, discriminates against all forms of grid-connected generation (including renewables), forces an inappropriate re-allocation of the costs of the grid to remaining (and disproportionately lower income) customers, and sends a faulty price signal that can cause under-investment in (or early shut down of) grid-connected generation that is needed for real-time balancing purposes and to meet peak demands. These same problems—in larger scale—are among the primary causes of Germany’s growing dysfunction.

III.   The Return of Stranded Costs

Broadly speaking, the current dispute over net metering is about managing the growth of distributed generation during the period when growth is being fueled by subsidies. If projections such as those made by Citigroup are correct, the cost of energy from distributed generation will decline, eventually making it competitive with energy from the grid without subsidies, and the pace of growth will accelerate. At some point, distributed generation could be married to behind-the-meter storage capability, permitting customers to disconnect from the grid or significantly limit their use of utility service. Investments in distributed generation combined with storage should expand rapidly when and if the combined cost of distributed energy and storage reaches parity with the cost of bundled service from the grid.

In this scenario, as the demand for service from the grid declines and utilities need to recover the cost of the grid from a smaller customer base, utilities will have to respond by filing to raise rates. While this is occurring, a large body of customers will remain dependent on electricity from the grid for a considerable period of time since many customers may not have the resources to install distributed generators and others may choose to take their electric service from the grid.

Even as this possible transition approaches, billions of dollars of grid investments are being made, mostly in response to regulatory mandates.[47] As the use of distributed generation grows, investors in grid assets will demand that regulators provide assurance that their investments will be recoverable over time with a reasonable return. Otherwise, the cost of capital will rise, exacerbating the problem of rising rates during the transition, and in a worst case making it impossible for utilities to raise the capital needed to serve remaining customers and compensate investors for their prior investments in the grid.

Around the turn of the century, the utility industry faced the prospect that investments in generation might be unrecoverable. In those jurisdictions that permitted “retail choice” of electricity suppliers, utility generation was unbundled and re-priced to market. This competitive transformation produced debates over whether utilities were entitled to recover the costs associated with prior generation investments from departing customers when sunk costs exceeded the revenues recoverable at market prices. The differential was known as “stranded costs.”

Utilities argued that they were entitled by law to recover their stranded costs pursuant to an implicit bargain with the government under which utilities had assumed an obligation to serve the public in return for assurance that they would be compensated for their prudent investments made to meet that obligation. Along with many scholars, utilities argued that the law recognized this “regulatory compact” and that failure to permit the recovery of stranded costs represented an unconstitutional taking of utility property.[48] Others argued that no such legal right exists and that allowing utilities to recover their stranded costs would be inconsistent with the transition to competition.[49]

In the states that endorsed retail choice, legislative or regulatory compromises were reached in which utilities recovered most of their stranded costs. The underlying legal question was never resolved decisively in the courts. The stranded cost issue will be different in the context of utility loss of demand to distributed generation. In this context, stranded cost issues will not appear at one point in time (such as a legislative determination to permit retail customer choice) but will emerge gradually as utilities and regulators respond to reductions in aggregate demand for utility service. The stranded cost issue may also include stranded investment in transmission and distribution assets as well as generation. Further, stranded cost recovery will have to be addressed in the context of a declining utility customer base that may ultimately become too small to support recovery. In the last round of stranded costs, customers changing power suppliers remained as transmission and distribution customers of the utility and stranded costs could be recovered in the rates for these unbundled services.

A.  Cost Recovery for Regulated Assets

Assuming distributed generation becomes economical without subsidies, retail customers will be making independent decisions about whether to reduce or jettison utility service, and these decisions will occur over time as the relative economics of grid-produced and distributed electricity change. The stranded cost issue is therefore likely to arise in individual rate proceedings as utilities file to increase their rates to offset the effects of declining demand and regulators respond by requiring offsetting cost reductions to cabin these rate increases to remaining captive customers. As this process unfolds, history teaches that there will be disputes over the prudence of past utility expenditures and over whether particular assets remain “used and useful” and thus eligible for cost recovery.

The Supreme Court’s decision in Duquesne Light Co. v. Barasch holds that a utility’s Constitutional right to recover its costs to serve the public is not infringed by regulatory decisions disallowing individual items of cost.[50] An unlawful “taking” occurs only when the overall level of rates produces insufficient revenue to satisfy the “end-result” test established in FPC v. Hope Natural Gas Co.[51] Hope held that overall rate levels “which enable a company to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risk assumed . . . ” are sufficient to pass Constitutional muster.[52] The Hope test is fairly subjective and may not produce rates that are attractive to investors. Duquesne suggests that stranded cost issues will have to be addressed through rate litigation, which means the availability of relief to distressed utilities may be delayed.[53] Without legislation, moreover, the remaining customer base will eventually become too small, forcing utilities to try and convince regulators to permit them to charge exit fees to departing customers. For these reasons, substantial pressure will arise to resolve stranded cost recovery issues through legislation. Legislative fixes will be a hard sell politically, but legislators may be convinced to act in order to prevent important energy policy issues from being decided in the courts.[54]

In determining which facilities remain used and useful, regulators will have to balance reliability and environmental effects as well as economics. They will also have to address complex competing interests. For example, utilities supply power using a combination of owned generation and purchases in the form of FERC-jurisdictional power purchase agreements (PPAs), most of which are the product of regulatory mandates. Federal law protects FERC-jurisdictional PPAs by requiring state regulators to pass through the costs incurred by utility buyers in their retail rates.[55] But this “trapped cost” protection will be a two-edged sword for utilities that face premature retirement of their own generation while continuing to pay third parties for purchased power. FERC may therefore face a host of contract termination disputes. The transition will be made more difficult by the fact that most utility-owned generation is subject to state regulation, PPAs are regulated by FERC, and substantial generation is publicly owned and not subject to traditional rate regulation.

Generation cost recovery is likely to be under pressure before transmission and distribution. For the most part, the electric delivery system operates as an integrated network, and it will be difficult to identify specific assets that are no longer required as demand declines. Nonetheless, a substantial portion of the cost of electricity consists of investments in transmission and distribution, and a regulator under pressure to reduce rates would eventually have to pay attention to the cost of these facilities. Stranded transmission and distribution cost issues will play out simultaneously at FERC (which regulates most unbundled transmission) and in state proceedings (for bundled transmission and local distribution) unless Congress changes jurisdictional responsibilities.[56]

Disputes will likely arise over which assets should be targeted for early retirement. The interstate transmission grid, for example, is an integrated network of facilities owned by a large number of entities.[57] One can imagine a form of competition among transmission asset owners to protect their assets and avoid stranded costs. Most publicly-owned transmission is not subject to FERC or state jurisdiction, which will further complicate the process.

As this process unfolds, utility investors will be watching. As cost recovery uncertainty rises, debt and equity investors will demand higher returns, making it more expensive to maintain a reliable grid and putting further upward pressure on utility rates. At some point, the risks could be large enough that investors will not provide capital on acceptable commercial and regulatory terms, and investment in the grid will become problematic, even as many consumers continue to rely on it.

B.  Unregulated Generation

In regions where utilities have already divested their generation to merchant power producers, capacity and energy is transacted in wholesale markets under the control of RTOs, subject to overarching FERC regulation. Market forces will therefore play a significant role in determining which generators survive as demand declines. The owners of unregulated generation have assumed the market risk and are much less likely to have valid stranded cost claims.

But electricity markets will only provide a partial solution. With recent reductions in natural gas costs and flat demand, grid-connected generation is already under considerable economic pressure, and regulators are being asked to approve additional revenue streams to support reliability and new investment. In response to disputes over market rules, regulators are making critical decisions on the economic margin. Therefore, even where generation is subject to market forces, the future portends complex regulatory disputes over how wholesale markets should be organized to respond to reductions in the demand for energy from the grid. At the core of these disputes, an enduring tension will exist between economics, reliability, and fairness.

IV.   Conclusion

Once a sizable number of customers have invested in distributed generation in response to the subsidies afforded under net metering, changing the economic rules will be difficult, both because some customers will have relied on subsidies to make their investments and others will want the same opportunities as their neighbors. Policymakers therefore should not long defer addressing the consequences of providing these subsidies in order to promote distributed generation over other alternatives. What may appear politically attractive in its early stages can quickly become a regulatory and political quagmire, as the Germans are learning. The U.S. will not countenance electric rates anywhere close to German levels, nor an electric system that is not reliable. Over the long term, any required unwinding of the utility-owned grid due to distributed generation will be extraordinarily complex and will raise many novel and intractable legal and policy issues.

 

 

Preferred citation: David B. Raskin, The Regulatory Challenge of Distributed Generation, 4 Harv. Bus. L. Rev. Online 38 (2013), https://journals.law.harvard.edu/hblr//?p=3673.

* David Raskin is a partner in the Washington, DC office of Steptoe & Johnson LLP. He has represented stakeholders in the electric power industry for more than thirty years. During this time, he has been involved in most of the significant federal regulatory initiatives designed to increase competition in the electric industry and has assisted clients in managing the unprecedented changes that have occurred in recent decades.

[1] E.g., Diane Cardwell, On Rooftops, a Rival for Utilities, N.Y. Times, July 26, 2013, http://www.nytimes.com/2013/07/27/business/energy-environment/utilities-confront-fresh-threat-do-it-yourself-power.html; Peter Kind, Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business, Edison Electric Institute (Jan. 2013), www.eei.org/ourissues/finance/Documents/disruptivechallenges.pdf‎.

[2] Citi Research, Rising Sun: Implications for US Utilities (Aug. 8, 2013), http://www.wecc.biz/committees/BOD/TEPPC/SPSG/Lists/Events/Attachments/706/CITI-Rising%20Sun%20Implications%20for%20US%20Utilities.pdf.

[3] Jason Channell et al., Energy Darwinism: The Evolution of the Energy Industry, Citi Global Perspectives & Solutions 73-75 (Oct. 2013), https://ir.citi.com/Jb89SJMmf%2BsAVK2AKa3QE5EJwb4fvI5UUplD0ICiGOOk0NV2CqNI%2FPDLJqxidz2VAXXAXFB6fOY%3D.

[4] Even if Citi’s aggressive prediction of fifty percent demand reduction by 2015 turns out to be accurate, that prediction leaves fifty percent of electric load dependent on grid service.

[5] In this Article, references to “distributed generation” refer to energy sources located behind the retail meter or connected to a micro grid, where the intent is to remove some load or demand from the system of integrated electric generation, transmission, and distributed facilities that comprise what is referred to in this Article as the “grid.”

[6] Energiewende, or energy transformation, is the product of the German Renewable Energy Act of 2000 (Erneuerbare-Energien-Gesetz) that put in place substantial subsidies for distributed generation and grid-connected renewables. See General Information: Transformation of Our Energy System, Ger. Fed. Ministry for the Env’t, Nature Conservation and Nuclear Safety, www.bmu.de/P118-1/ (last visited Nov. 24, 2013).

[7] Jesse Morris, How Germany’s Solar Evolution Impacts America, Earth Techling (Oct. 12, 2013), http://www.earthtechling.com/2013/10/how-germanys-solar-evolution-impacts-america. Ironically, this article laments the fact that the German feed-in tariff rate for distributed solar is only 20 cents per kWh, well below the full retail rate.

[8] Institute for Energy Research, Germany’s Energy Policy: Man-Made Crisis Now Costing Billions (Oct. 30, 2012), http://www.instituteforenergyenergy research.org/10/20/2012. Many Germans claim they can no longer afford to buy electricity. Germany’s Energy Poverty: How Electricity Became a Luxury Good, Spiegel Online Int’l (Sept. 4, 2013), http://www.spiegel.de/international/germany/high-costs-and-errors-of-german-transition-to-renewable-energy-a-920288.html.

[9] Energy Info. Admin., Table 5.6.A. Average Retail Price of Electricity to Ultimate Customers by End-Use Sector, (Nov. 20, 2013), http://www.eia.gov/electricity/monthly/epm_table_grapher.cfm?t=epmt_5_6_a.

[10] Energy Info. Admin., How Much Electricity Does an American Home Use?, http://www.eia.gov/tools/faqs/faq.cfm?id=97&t=3 (last updated Mar. 19, 2013).

[11] Germany’s Environment Minister, Peter Altmaier, has acknowledged that Germany has overdone the subsidies and needs to cut them back. Diarmaid Williams, Altmaier says German energy transition could cost $1.34trn, Power Energy International (Feb. 21, 2013), http://www.powerengineeringint.com/articles/2013/02/Altmaier-says-German-energy-transition-could-cost-134trn.html; Minister Altmaier: EEG Cuts Needed—or Energiewende Costs Will Reach Trillion Euro Mark by 2040, German Energy Blog (Feb. 20, 2013), http://www.germanenergyblog.de/?p=12278.

[12] Spiegel Online Int’l, supra note 8; Max Luke, Jessica Lovering & Alex Trembath, Trash, Trees and Taxes: The Cost of Germany’s Energiewende, Energy Collective (Sept. 16, 2013), http://theenergycollective.com/maxluke/274041/trash-trees-and-taxes.

[13] An environmental critique of Energiewende can be found in Will Boisvert, Green Energy Bust in Germany, Dissent (2013), http://www.dissentmagazine.org/article/green-energy-bust-in-germany.

[14] Tilting at Windmills, Economist, June 15, 2013, available at http://www.economist.com/news/special-report/21579149-germanys-energiewende-bodes-ill-countrys-european-leadership-tilting-windmills.

[15] How to Lose Half a Trillion Euros, Economist, October 12, 2013, available at http://www.economist.com/news/briefing/21587782-europes-electricity-providers-face-existential-threat-how-lose-half-trillion-euro.

[16] German subsidies primarily take the form of “feed in tariffs” that guarantee minimum per kWh payments to those employing favored technologies, which are paid out of a pool funded by consumers. See Stefan Nicola, German Industry Wants End of Feed-in Tariff on Rising Power Cost, Bloomberg (Sep 19, 2013, 5:53 AM), http://www.bloomberg.com/news/2013-09-19/german-industry-wants-end-of-feed-in-tariff-on-rising-power-cost.html.

[17] As discussed below, the Federal Energy Regulatory Commission (FERC) has disclaimed jurisdiction over energy supplied from behind-the-meter distributed generation so long as the customer does not supply more excess energy than it acquires from the grid over the course of a monthly retail billing period.

[18] Energy Info. Admin., Table 5.6.A, supra note 9.

[19] This Article refers to generators that are connected on the utility side of the customer meter as “grid-connected generation” for ease of reference. This is a misnomer, however, because all generation, including generation located on a retail customer’s property on the customer side of the meter, is connected to and part of the electric grid. Electricity does not recognize the difference in location; at all times sufficient energy must be supplied to meet the aggregate demand of all users, and the system must be kept in precise balance (supply equaling demand) in order to prevent outages and serious damage to facilities.

[20] See Platts, Megawatt Daily, at 2-10 (November 27, 2013).

[21] American Wind Energy Association, The Cost of Wind Energy in the U.S., http://www.awea.org/Resources/Content.aspx?ItemNumber=5547 (last visited Nov. 24, 2013).

[22] The analysts at Citi put it succinctly: “While residential solar has the advantage of competing against higher residential electricity prices, merchant utility scale solar must compete against wholesale power prices.” Citi Research, supra note 2 at 21.

[23] See Cal. Pub. Utils. Comm’n, California Net Energy Metering (NEM) Draft Cost-Effectiveness Evaluation (2013), available at http://www.cpuc.ca.gov/NR/rdonlyres/BD9EAD36-7648-430B-A692-8760FA186861/0/CPUCNEMDraftReport92613.pdf.

[24] Id. at 110.

[25] Energy Policy Act of 2005, Pub. L. No.109-58, sec. 1251, § 111(d), 119 Stat. 962 (codified as amended at 16 U.S.C. 2621(d)(11)).

[26] See id.; Pub. Util. Reg. Policies Act of 1978, Pub. L. No. 95-617, § 111(d), 92 Stat. 3117, 3142-43 (codified as amended at 16 U.S.C. § 2621(d)(10)(E)(11) (2006)).

[27] Energy Policy Act § 111(d); 16 U.S.C. § 2621(d)(10)(E)(11).

[28] Congress also did not define what it meant by “delivered to the local distribution facilities” in this provision. It may have intended the energy credit to apply only to energy in excess of the customer’s on-site use, or it may have intended that all energy produced on-site be treated as energy provided to the grid because all such energy substitutes energy that would otherwise be supplied from the grid. Either way, the definition provides only for an energy credit, which is not what occurs in most jurisdictions.

[29] FirstEnergy Corp. v. Pub. Utils. Comm’n of Ohio, 768 N.E.2d 648 (Ohio 2002).

[30] Id. at 650.

[31] Id.

[32] Id. at 652.

[33] Id.

[34] Pub. Util. Reg. Policies Act § 210 (codified at 16 U.S.C. § 824a-3(a) (2006)). FERC regulations refer to these as “qualifying facilities.” 18 C.F.R. § 292.101(b)(1).

[35] 18 C.F.R. § 292.203(d) (2010).

[36] See Stephanie Watson, How Net Metering Works, How Stuff Works, http://science.howstuffworks.com/environmental/green-science/net-metering2.htm (last visited Nov. 24, 2013).

[37] 16 U.S.C §§ 791a-825r.

[38] From the earliest days of Federal Power Act jurisprudence, courts have emphasized that wholesale power transactions under the Federal Power Act are voluntary. Fed. Power Comm’n v. Sierra Pac. Power Co., 350 U.S. 348 (1956). In organized Regional Transmission Organization (RTO) markets, any generator that signs a service agreement with RTO is permitted to bid its energy into the market and, if dispatched, gets paid the locational marginal cost of energy, even if the generator does not have a contract with a specific buyer.

[39] Am. Paper Inst. v. Am. Elec. Power Serv. Corp., 461 U.S. 402, 404 (1983).

[40] See MidAmerican Energy Co., 94 F.E.R.C. P 61,340 (2001); Sun Edison LLC, 129 F.E.R.C. P 6,1146 (2009).

[41] Id.

[42] See S. Cal. Edison Co. v. FERC, 603 F.3d 996 (D.C. Cir. 2010); Calpine Corp. v. FERC, 702 F.3d 41 (D.C. Cir. 2012).

[43] See S. Cal Edison Co. 603 F.3d at 1000-01; Calpine Corp. 702 F.3d at 45.

[44] 16 U.S.C. § 824e(a).

[45] California is attempting to overcome this issue by requiring utilities to purchase storage capacity using new technologies to help balance supply and demand. Order Instituting Rulemaking Pursuant to Assembly Bill 2514 to Consider the Adoption of Procurement Targets for Viable and Cost-Effective Energy (published October 17, 2013), Cal. Pub. Utils. Comm’n, 2013 Cal. PUC LEXIS 569, available at http://docs.cpuc.ca.gov/PublishedDocs/Published/G000/M078/K912/78912194.PDF. Whether these alternative technologies will become available in sufficient quantities and at a reasonable cost to replace balancing generation from the grid, and how long this may take, is unknown.

[46] The Economist notes: “Renewables can depress wholesale prices, e.g. when the sun creates a midday jolt. This discourages investors in the flexible, gas-powered generation needed to provide backup for windless, cloudy days.” Energiewinde, Economist, July 28, 2012, at 3. Citi Research, noting that solar production causes lower utilization rates for conventional generation plants, concludes: “This would in a perfect economic world lead to the closure of some higher heat rate gas plants, but the problem of course is that much of this generation capacity needs to remain to cover lost generation on less sunny days and at night, and through the winter . . . .” Citi Research, supra note 2, at 17.

[47] For example, the electric industry is investing significant sums in response to state laws imposing renewable portfolio standards. Large additional investments are being made to modernize the transmission and distribution systems and incorporate so-called “smart grid” technologies. One utility executive recently noted that half the existing transmission grid is more than fifty years old, so sizable investments to sustain it are inevitable. Lisa Barton, IHS The Energy Daily, September 26, 2013, at 14. Several northeastern states are requiring utilities to invest in “hardening” their systems in response to recent storm-related outages. See Diana Cardwell et al., Hurricane Sandy Alters Utilities’ Calculus on Upgrades, N.Y. Times, Dec. 28, 2012, at B1. Since 2005, the utility industry has also been subject to mandatory reliability standards approved by the FERC that require significant ongoing investments in the grid. 16 U.S.C. § 824o (2005).

[48] See, e.g., J. Gregory Sidak & Daniel F. Spulber, Deregulatory Takings and Breach of the Regulatory Contract, 71 N.Y.U. L. Rev. 851 (1996).

[49] See, e.g., Susan Rose-Ackerman & Jim Rossi, Disentangling Deregulatory Takings, 86 Va. L. Rev. 1436 (2000).

[50] 488 U.S. 299, 314-15 (1989) [hereinafter Duquesne].

[51] 320 U.S. 591, 602-03 (1944) [hereinafter Hope].

[52] Id. at 605.

[53] The takings issue will recur if demand declines further over time. If demand declines after rates have been set, utilities will once again under-recover their costs, forcing them to file for another round of rate increases to offset the effect of the loss of load since the prior rate case. Utilities will be playing

“catch-up” to get the revenues needed to recover their costs and attract investment.

[54] Assuming much of the utility industry will have moved into other business lines, including distributed generation, legislators could be less inclined to provide full stranded cost relief in these circumstances.

[55] See Nantahala Power & Light Co. v. Thornburg, 476 U.S. 953, 970 (1986); Entergy La., Inc. v. La. Pub. Serv. Comm’n, 539 U.S. 39, 48 (2003).

[56] In Texas, the Public Utility Commission of Texas (PUCT) regulates all of these functions. In other states where retail rates remain bundled, states will have most of the control over this process for both transmission and distribution assets, unless the FERC chooses (or is forced) to assume jurisdiction over interstate transmission costs that are bundled into retail rates pursuant to the Supreme Court’s opinion in New York v. FERC, 535 U.S. 1 (2002).

[57] FERC has recently decided that more entities should be eligible to build and own transmission facilities. Transmission Planning and Cost Allocation by Transmission Owning and Operating Public Utilities, Order No. 1000, FERC Stats. & Regs. ¶ 31,323 (2011), order on reh’g, Order No. 1000-A, 139 FERC ¶ 61,132, order on reh’g, Order No. 1000-B, 141 FERC ¶ 61,044 (2012), appeal docketed, S.C. Pub. Serv. Auth. v. FERC, No. 12-1232 (D.C. Cir. 2012).

 

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Investing in U.S. Pipeline Infrastructure: Could the Proposed Master Limited Partnerships Parity Act Spur New Investment?

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Linda E. Carlisle, Daniel A. Hagan and Jane E. Rueger*

The so-called “shale revolution” has upset traditional notions of supply and demand centers for natural gas and crude oil. Demand centers in the Northeast traditionally needed to import natural gas or oil from distant supply centers, such as Texas or Louisiana. However, major plays located near these demand centers, such as the Marcellus shale, are causing directional flows on existing pipelines to change. In addition, these plays have spurred the need for additional pipeline infrastructure development to transport crude oil and natural gas liquids from major shale plays in the Northeast and the Midwest to processing and manufacturing facilities that currently exist or are under development in Texas and Louisiana.

This Article explores combining the traditional oil and gas pipeline structure with solar electric generation to: (1) increase the return on pipeline investments by making the income from a solar electric generation business available to pipeline operators; and (2) lower the cost of operating the pipeline. After a brief overview of the current state of U.S. pipeline infrastructure, this Article describes the structure generally used for current pipeline investment and pending legislation, which would make the structure available to solar electric generation businesses. The Article then explores the potential benefits of combining solar generation and pipeline transportation businesses if the pending legislation passes.

Overview of the Current State of U.S. Pipeline Infrastructure

The past decade has brought sweeping change to the oil and gas industry in the United States. Technological developments in drilling and hydraulic fracturing have allowed extraction of large volumes of shale gas and tight oil that were previously economically infeasible to produce. With respect to natural gas, tight oil and shale gas accounted for forty percent of the total U.S. natural gas produced in 2012.[1] The U.S. Energy Information Administration (EIA) projects natural gas production in the United States will increase from 23.0 trillion cubic feet in 2011 to 33.1 trillion cubic feet by 2040, a forty-four percent increase almost entirely due to projected growth in shale gas production.[2] As of June 2013, EIA ranks the United States fourth in the world with respect to volume of technically recoverable shale gas resources[3] and projects that the United States may become a net exporter of natural gas in years to come.[4] Crude oil production has similarly increased; EIA ranks the United States second in the world with respect to volume of technically recoverable shale oil,[5] and crude oil production from tight plays accounted for nearly all 847,000 barrels per day increase in production in 2012 compared with 2011.[6] This is by far the largest growth in crude oil production in any country.[7]

Development of the infrastructure necessary to fully utilize the wealth of shale oil and gas reserves in the United States has been slow to materialize. Pipelines, particularly large diameter, long-distance interstate pipelines, are very expensive to build. By some recent estimates, onshore pipeline construction costs in the United States can be an average cost-per-mile of $3.1 million.[8] A recently proposed interstate natural gas pipeline is expected to cost approximately $3 billion to build.[9] Moreover, pipelines have a long construction lead-time: it often takes years to work through planning, siting, and obtaining regulatory approvals, prior to beginning construction. Developers have often found it difficult to attract the kind of long-term firm commitments that are necessary to support investment in pipeline infrastructure. Pipelines also face competition from railroads for the crude oil and natural gas liquids transportation business because building new rail is cheaper, and existing rail beds give more delivery point options than pipelines.

Moreover, not all investments in the pipeline transportation business have been successful. For example, the Rockies Express Pipeline (REX), completed in 2009 at a cost of about $6.2 billion, was built to deliver natural gas from Colorado and Wyoming to demand centers as far east as Ohio.[10] The subsequent development of economically recoverable shale gas reserves in the Marcellus and Utica regions has upended REX’s value proposition such that it has operated at a load factor of only sixty-six percent in 2013.[11] This resulted in bond ratings agencies questioning REX’s ability to maintain earnings after its anchor shippers’ contracts expire in 2019, absent timely action to enter into new contracts.[12] Current anchor shippers vigorously oppose entering into new contracts for shale gas shipments from east to west, making REX’s future prospects uncertain.[13]

Master Limited Partnerships[14] Today and the Master Limited Partnerships Parity Act[15]

Master limited partnerships (MLPs) are publicly traded businesses that are taxed as partnerships.[16] A U.S. business entity that is taxed as a partnership, unlike a corporation, is a “pass-through entity” for federal income tax purposes.[17] This means that the partnership does not pay tax as an entity, but rather each partner is allocated his share of partnership income, gain, deductions, losses, and credits annually and pays tax on his distributable share of partnership income regardless of whether the partnership makes any cash distributions to its partners. As a result, there is only a single level of federal income tax (at the partner level) on the income of a partnership. This is in stark contrast to the two levels of tax imposed on the income of a corporation (for a corporation, the income is taxed when earned by the corporation[18] and then again when it is distributed in the form of a dividend to its shareholders).[19]

In 1987, Congress limited the types of businesses that would be taxed as partnerships if they were “publicly traded” out of concern that the widespread use of publicly traded partnerships would erode the corporate tax base.[20] Partnership status, however, was retained for businesses that had traditionally been conducted in partnership form, such as businesses involved in oil and gas exploration and production.[21]

To qualify for MLP status, a business entity that otherwise would be treated as a partnership for federal income tax purposes and whose interests are “publicly traded” must satisfy a “qualifying income” test, which requires ninety percent or more of the gross income of the partnership to be “qualifying income.”[22] Qualifying income includes: (i) passive income such as interest, dividends, and gains from the disposition of property that generates such passive income; (ii) rents and gains from real property; (iii) income and gains from the exploration, development, mining, production, processing, refining, transportation, or marketing of minerals and natural resources; and (iv) income and gains from transactions in commodities in the case of partnerships that buy and sell such commodities as a principal business activity.[23]

MLPs combine the benefits of public corporations whose interests are readily bought and sold on established securities markets and the tax benefits of partnerships, which are not subject to the federal corporate income tax. Such favorable tax treatment allows MLPs to access capital at a lower cost than business entities taxed as corporations. This makes the MLP structure particularly attractive to the capital-intensive pipeline infrastructure transportation business.

In 2008, Congress expanded the definition of qualifying income to include transportation and storage of certain renewable and alternative fuels, such as ethanol and biodiesel, as well as industrial-source carbon dioxide.[24] Income from alternative or renewable energy generation businesses, however, continues to be excluded from qualifying income status.

Legislation has been introduced in the House of Representatives[25] and in the Senate[26] that would expand the definition of qualifying income to allow alternative or renewable energy projects access to the MLP structure. Under the “Master Limited Partnerships Parity Act,” the definition of qualifying income would be expanded to include income from clean energy resources and infrastructure businesses. Qualifying income would include income from renewable energy projects such as wind power, closed and open loop biomass, geothermal, solar, municipal solid waste, hydropower, marine and hydrokinetic, and fuel cells. The legislation would also expand the definition of qualifying income to include income from certain clean energy technologies, including the production, storage, and transportation of renewable fuels, electricity storage, carbon capture and storage, waste heat power production, and energy-efficient building technology.

Opportunities for Solar Generation: Pipeline Infrastructure Synergies

Passage of the Master Limited Partnerships Parity Act could lead to some interesting opportunities and synergies for solar generation and pipeline infrastructure businesses that could begin to address the economic hurdles to pipeline infrastructure development. The Master Limited Partnerships Parity Act would allow a single MLP to be in the pipeline transportation business and the renewable electric generation business because both businesses would generate “qualifying income” that would allow the entity to benefit from favorable tax treatment as a partnership. The solar generation business would give the pipeline operator an additional revenue source from the sale of power, either through bilateral sales, wholesale sales into power markets, or sales under the Public Utility Regulatory Policies Act (PURPA).[27] In addition, the operational costs of the pipeline business would be reduced. For example, while pipeline compressor stations can vary widely by design, they typically incur fuel costs and often emit greenhouse gases and NOx,which imposes additional construction and maintenance costs due to the equipment necessary to meet local or federal emissions limits.[28] As compressor stations are usually spaced approximately every fifty to one hundred miles along a pipeline route,[29] these costs can be significant on long interstate pipelines. Using electricity from solar assets to power compressor operations offers the opportunity to reduce the overall cost of operating the pipeline. Although solar generation only produces power during the day, electric storage devices would allow such power to be used to serve nighttime compressor operations.

Moreover, pipeline companies have right-of-way and permitting institutional knowledge that is readily transferrable to the siting and permitting of solar generation. In the process of constructing a pipeline, pipeline companies must acquire rights-of-way from local landowners along the entire route of the pipeline, including appurtenant parcels for placement of compressor stations that can reach seventy acres each (including the compressor site and additional acreage for sound buffering).[30] Pipeline companies are also familiar with state and local processes for environmental and similar permits. These areas of institutional knowledge are equally relevant to the solar generating facility siting and permitting process.

Infrastructure development related to the shale boom is a complex problem without a single, simple solution. But within every problem lies opportunity, and the beneficial combination of pipeline and solar infrastructure is one potential opportunity that could start to address the need to incentivize investment in pipeline infrastructure in the current economic climate.

 

Preferred citation: Linda E. Carlisle, Daniel A. Hagan & Jane E. Rueger, Investing in U.S. Pipeline Infrastructure: Could the Proposed Master Limited Partnership Parity Act Spur New Investment?, 4 Harv. Bus. L. Rev. Online 32 (2013), https://journals.law.harvard.edu/hblr//?p=3645.

* Linda E. Carlisle is a Partner in the Tax Group of White & Case LLP. Daniel A. Hagan is a Partner, and Jane E. Rueger is a Counsel, in the Energy Markets and Regulatory Group of White & Case LLP. All are based in White & Case LLP’s Washington, D.C. office. The opinions expressed are those of the authors and do not necessarily reflect the views of the authors’ law firm or its clients.

[1] Energy Info. Admin., Technically Recoverable Shale Oil and Shale Gas Resources: An Assessment of 137 Shale Formations in 41 Countries Outside the United States [hereinafter EIA 2013 Assessment], (June 13, 2013), at 11, http://www.eia.gov/analysis/studies/worldshalegas.

[2] See Energy Info. Admin., Energy in Brief: What Is Shale Gas and Why Is It Important?, (Dec. 5, 2012), http://www.eia.gov/energy_in_brief/article/about_shale_gas.cfm?src=home-f2.

[3] EIA 2013 Assessment, supra note 1, at 10.

[4] Energy Info. Admin., Annual Energy Outlook 2013, (Apr. 2013), at 2, http://www.eia.gov/forecasts/aeo/chapter_executive_summary.cfm.

[5] EIA 2013 Assessment, supra note 1, at 10.

[6] Id. at 12.

[7] Id.

[8] Christopher E. Smith, Worldwide Pipeline Construction: Crude, Products Plans Push 2013 Construction Sharply Higher, Oil & Gas J, (Feb. 4, 2013), http://www.ogj.com/articles/print/volume-111/issue-02/special-report–worldwide-pipeline-construction/worldwide-pipeline-construction-crude-products.html.

[9] Bill Faries & Mike Lee, Spectra Wins $3 Billion Interstate Florida Gas Pipeline, Bloomberg News, (July 26, 2013), http://www.bloomberg.com/news/2013-07-26/spectra-wins-3-billion-interstate-florida-gas-pipeline.html.

[10] Kinder Morgan Energy Partners, Current Report (Form 8-K, Ex. 99.1) at 128 (June 12, 2009).

[11] Peter Behr, Rockies Express shippers fight a proposed change in gas flows, EnergyWire, (July 26, 2013), http://www.eenews.net/stories/1059985120. Load factor refers to customers’ actual utilization of a pipeline’s capacity compared to its maximum capacity.

[12] Id.

[13] See id.

[14] For federal tax purposes, master limited partnerships include both limited partnerships and limited liability companies.

[15] S. 795, 113th Cong. (2013); H.R. 1696, 113th Cong. (2013).

[16] See I.R.C. § 7704(c)(1) (2012).

[17] See id. § 701.

[18] See id. § 11.

[19] See id. § 61(a)(7).

[20] H.R. Rep. No. 100-391, pt. 2, at 1064 (1987), reprinted in 1987 U.S.C.C.A.N. 2313-378, 2313-680.

[21] Id. at 2313-683.

[22] I.R.C. § 7704(c)(2) (2012).

[23] See id. § 7704(d).

[24] See id. § 7704(d)(1)(e).

[25] H.R. 1696, 113th Cong. (2013).

[26] S. 795, 113th Cong. (2013).

[27] PURPA was enacted in 1978 with the intent to spur development of more efficient and renewable generating facilities developed and owned by entities independent from incumbent franchised utilities. See Fed. Energy Regulatory Comm’n, What is a Qualifying Facility? http://www.ferc.gov/industries/electric/gen-info/qual-fac/what-is.asp (last visited Nov. 23, 2013). To that end, PURPA established a new class of generating facilities called qualifying facilities that receive special rate and regulatory treatment. See id. One type of qualifying facility, the small power production facility (SPP QF), is a generating facility of eighty-megawatts or less that uses, as a primary energy source, renewable (hydro, wind, or solar), biomass, waste, or geothermal resources. See id. Facilities that meet the size and fuel requirements to be SPP QFs and file a simple self-certification form with the Federal Energy Regulation Commission enjoy numerous rate and regulatory benefits. See Fed. Energy Regulatory Comm’n, What Are the Benefits of QF Status?

http://www ferc.gov/industries/electric/gen-info/qual-fac/benefits.asp (last visited Nov. 23, 2013).

[28] Ranier Kurz et al., Gas Compressor Station Economic Optimization, Int’l J. of Rotating Machinery, Vol. 2012, available at http://www.hindawi.com/journals/ijrm/2012/715017/.

[29] Energy Info. Admin., Natural Gas Compressor Stations on the Interstate Pipeline Network: Developments Since 1996 (Nov. 2007),

http://www.eia.gov/pub/oil_gas/natural_gas/analysis_publications/ngcompressor/ngcompressor.pdf.

[30] See, e.g., 240 No. 7 Pipeline & Gas J., Millennium Touts Completion of Minisink Compressor Station, (July 2013), http://www.pipelineandgasjournal.com/millennium-touts-completion-minisink-compressor-station.

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Brazilian Private Equity Funds (FIPs): A DNA Change in Brazilian M&A Deals

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José Carlos Junqueira Sampaio Meirelles*

Caio Carlos Cruz Ferreira Silva†

I.  M&A ACTIVITY AND THE PRIVATE EQUITY SCENARIO IN BRAZIL

Brazil has become a preferred destination for private equity[1] investments from all over the globe.[2] The country’s recently achieved investment-grade[3] status was perhaps the missing push needed to put Brazil on the radar of private equity investors and in the mainstream of international business transactions.[4]

The longstanding efforts undertaken in Brazil to reconcile sustainable growth with sound economic policies and reliable legal and regulatory frameworks have helped steer the country out of one of the worst global economic downturns, drawing yet more attention to its promising and underexplored market as an attractive alternative for investors. Mindful of these developments and related opportunities, private equity investors have been deploying substantial funds in Brazil, fueling an unprecedented flow of countrywide M&A activity.[5] The number of private equity deals that have taken place in M&A arena has increased by roughly 168% since 2007,[6] and private equity investors have rapidly developed into one of the driving forces behind business ventures across a variety of industries.[7]

The above data helps put in perspective the rising magnitude of private equity investments in the Brazilian M&A context, a trend that is expected to be further amplified going forward.[8] The data also suggests that private equity investments exert a high degree of influence in the transformation of several sectors in the Brazilian economy, primarily by fostering the reallocation of assets and capital among entities and the reorganization of domestic businesses in pursuit of efficiency and profitability.

From a legal standpoint, the intensification of private equity activity has prompted investors and governmental authorities to come up with creative transactional structures and regulatory approaches to facilitate private equity ventures, while coping with the demands and challenges of an increasingly competitive market. The result of this interaction has been instrumental in reshaping the Brazilian M&A landscape.

M&A deal structures[9] and market players in Brazil have evolved over the past ten years,[10] and private equity sponsors catalyzed several of these changes.[11] This Article, however, focuses on one specific change: most M&A deals in Brazil involving private equity players have been undergoing an important DNA change stemming from the increasing use of the Brazilian Private Equity Fund (Fundo de Investimento em Participações (FIP)) on the buy-side and the sell-side of these transactions.

Unlike U.S. corporate law, Brazilian law does not provide for limited liability partnerships (LLPs) or limited partnerships (LPs), and until recently private equity investments in Brazil were predominantly structured through holding companies. These classic private equity transactions—formally implemented either through direct acquisitions/investments or via local holdings incorporated as a limited liability company (sociedade limitada[12]) or a corporation (sociedade por ações (S.A.)[13])—are now gradually making way for structures involving domestic investment funds[14] as the vehicle to acquire or invest in, hold, and manage portfolio companies until divestment is completed.

The most popular private equity vehicle in the Brazilian M&A practice is by far the FIP, whose structure bears some similarity to the partnership fund model generally adopted in the U.S. and in Europe. The Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários (CVM)[15]) introduced FIPs to Brazil through Rule No. 391 (CVM Rule 391/03), issued on July 16, 2003.[16]

By laying down the legal and regulatory grounds for the establishment of an investment conduit that local and foreign investors formerly lacked when sponsoring private equity ventures in Brazil, CVM Rule 391/03 largely contributed to a rapid expansion of FIPs in M&A deals.[17] More importantly, investments and exit strategies successfully implemented by FIPs since 2004 created an encouraging track record that helped Brazilian private equity-backed M&A transactions achieve high priority on the agendas of institutional investors.

The regulatory flexibility and generally favorable tax regime accorded to FIPs make FIPs a unique and powerful tool for structuring M&A transactions involving targets in Brazil. Additionally, investors can utilize FIPs for fundraising, deal financing, and implementing exit strategies, as applicable CVM regulations allow the placement of their units in the market. This Article illustrates the many ways in which private equity-backed M&A deals have undergone a DNA change in Brazil, derived—to a large extent—from the rise of FIPs as a common vehicle in such transactions.

II.  THE BRAZILIAN PRIVATE EQUITY FUND (FIP)

CVM Rule 391/03 is the core regulation applicable to FIPs.[18]The self-contained and investor-friendly legal regime applicable to FIPs makes FIPs the preferred and most flexible private equity vehicle in Brazil. The adaptability of the FIP allows investors to contractually stipulate the most suitable set of governance and operational rules that will govern the FIP itself and their legal interaction as owners of the vehicle. These rules are customarily amalgamated in the FIP’s charter, investment commitment agreements, quotaholders agreements,[19] and a variety of service contracts,[20] which regulate matters bearing on investment policy, decision-making procedures, capital commitments and calls, issuance and placement of units (quotas), distribution of proceeds, investment and divestment periods, minimum net equity requirements, management and performance fees, and liquidation, among others.

2.1. Form and Ownership Structure

The FIP is, in essence, a collective investment vehicle formed as a condominium,[21] allowing co-ownership of assets to be exercised among investors. FIPs can only operate in Brazil upon registration with the CVM, and FIPs, along with their securities (quotas) and investors (quotaholders), are subject to the CVM’s oversight. The FIP must be organized as a closed-end[22] condominium consisting of an un-personified pool of assets managed and represented by an administrator[23] registered with the CVM.

The FIP form can be especially attractive to private equity investors seeking lower individual exposure to risks through the gathering of funds by an investor pool and asset diversification.[24] The FIP can also provide its owners with a platform for centralized professional management of target companies with the requisite market and financial skills that otherwise would not be available to investors acting individually or through subsidiaries.[25] Additionally, Brazilian law requires the FIP to obtain a federal taxpayer number and to book the transactions it engages in on its own name and on its own behalf.[26]

2.2. Ownership Rights and Quotas

Equity units known as “quotas” represent the ownership interest rights of the FIP’s investors, or quotaholders.[27] Each quota in an FIP corresponds to a ratable share of the portfolio assets held under joint ownership by the quotaholders.[28] Thus, the value of each quota is calculated as the division of the net equity of the FIP by the number of outstanding quotas. Each quota carries one vote in the quotaholders’ general meeting,[29] unless the organizational documents of the FIP admit classes of quotas with different voting rights.[30]

2.3. Permitted Investments

The FIP’s investment objectives primarily comprise the acquisition of stock, debentures, subscription warranties, or other securities convertible into or exchangeable for stock issued by publicly held (listed) or closely held corporations in Brazil, whose management must be actively monitored by the FIP. The remaining portion of the FIP’s portfolio can consist of liquid fixed-income instruments and other financial assets, mainly for cash management purposes.

The FIP’s charter must establish the eligibility criteria[31] that apply to publicly held companies that the FIP invests in. These companies are also subject to the minimum set of corporate governance standards imposed by CVM Rule 391/03. Closely held companies that the FIP invests in have to comply with certain minimum governance guidelines such as (a) the establishment of a unified one-year term of office for the entire board of directors (no staggered boards); (b) annual audit of their financial statements; (c) disclosure of related-party agreements, shareholders’ agreements, stock option plans, and share buyback plans; and (d) the obligation to adhere to certain differentiated levels of corporate governance practices in case the company goes public.[32]

Investments by the FIP in either closely or publicly held companies are not subject to minimum revenue or net worth requirements. There are no mandatory concentration or diversification requirements that apply to the allocation of the FIP’s portfolio in equity investments, except if otherwise defined in the FIP’s charter. The FIP can concentrate its entire net equity in a single target or distribute its investments in as many targets as decided on by the FIP’s quotaholders or investment committee. Further, there are no restrictions on the number of FIPs that can invest in a single company.

2.4. Investment Restrictions

The FIP cannot invest in derivatives, except for hedging purposes. Furthermore, only the invested companies that make up the FIP’s portfolio may hold direct ownership in real estate assets, not the FIP itself. Consequently, when FIPs are used to structure real estate investments, the invested companies held by the FIP are generally the ones either directly holding the real estate assets or investing in Special Purpose Companies (SPCs), which will then hold the real estate assets.[33] FIPs are not permitted to invest overseas.[34] Further investment restrictions include the prohibition from soliciting or contracting loans (except under very specific limited circumstances) and providing guarantees (except when approved by a qualified majority of 2/3 or more of the quotaholders in a general meeting and as expressly permitted by the fund’s bylaws).[35] These restrictions constrain the FIP’s ability to raise debt in the market to fund acquisitions or investments.[36] Nonetheless, holding companies or SPCs that the FIP invests in can be used as vehicles in leveraged acquisitions of, or investments in, target companies.

2.5. Special Purpose Companies (SPCs)

While companies in which the FIP invests must be publicly or closely held corporations, prevailing regulations impose no restrictions as to the type of business organization of the SPCs that can be held by target companies (S.A.s) directly owned by the FIP. As Figure 1 depicts, the FIP can use these SPCs—through target companies—to channel private equity investments in equity participations and assets that would otherwise not be permitted at the FIP level,[37] which creates liability-shields for the FIP’s quotaholders.[38]

 Image 1, Section 2.5

Peculiarities pertaining to target or asset acquisitions, costs, time, tax efficiencies, and regulatory implications may be some of the motivations that lead corporate planners to adopt multiple corporate layers under an FIP, like the ones exemplified in Figure 1.

2.6. Eligible Investors

The risks associated with private equity investments generally make such investments unsuitable for the general public. As for FIPs specifically, typical risks involve: (a) illiquidity of the securities and assets making up the FIP’s portfolio (as opposed to other investments in more liquid asset classes); (b) concentration in securities issued by only a few target companies or by target companies pertaining to given industries or sectors; (c) failure to comply with the investment policy due to the lack of eligible targets; (d) other risks particularly related to the target companies, including a spectrum of business, financial, and legal risks and contingencies; (e) risks related to the management and operation of the FIP; and (f) market and credit risks.[39] CVM Rule 391/03 acknowledges these risks concern and limits investment eligibility in FIPs to investors whose financial capabilities and sophistication enable them to make informed investment decisions.[40] CVM Rule 391/03 also sets at R$100,000 (approximately US$43,000 as of November 2013) the minimum capital commitment in the FIP per quotaholder.[41] Hence, only “qualified investors” as defined by the CVM, can acquire the quotas of an FIP.[42] This target investor restriction gives private equity investors great latitude to structure FIPs and regulate their operation according to the rules suited for each particular deal or set of deals.

Among local qualified investors, pension funds have been one of the most active players in the domestic private equity scenario.[43] Non-resident investors must make the required investment in accordance with the rules of Resolution No. 2,689, issued by the National Monetary Council (CMN) on January 26, 2000 (CMN Resolution 2,689/00),[44] which apply in addition to the prerequisites of CVM Rule 391/03. CMN Resolution 2,689/00 basically allows non-resident private equity investors to remit funds into Brazil to subscribe for and pay in FIPs’ quotas and repatriate their capital abroad.[45]

2.7. Active Participation in the Management of Target

CVM Rule 391/03 requires the FIP to actively participate in the invested companies’ strategic policies and management, notably by appointing members to their boards of directors.[46] The requirement to actively participate in the decision-making process of the target companies and influence their strategy and management is one of the core features that make FIPs especially attractive to private equity investors. Whatever form the FIP investment in a target company takes,[47] under CVM Rule 391/01, the FIP must retain some degree of effective influence in the invested companies’ strategic decisions.

In order to satisfy the investment eligibility test, the FIP may: (a) hold stocks that are part of the controlling block of the invested company; (b) enter into shareholders’ agreements granting it decision powers over the invested company; or (c) enter into other agreements or arrangements that ensure the FIP’s actual influence on the strategic policy and management of the invested company (agreements or arrangements of this sort can entail, for example, veto rights and supermajority quorums).

2.8. Management and Governance

In contrast to the partnership structure of many U.S. private equity funds, the administration, portfolio management, and distribution of equity interests of an FIP are not performed by a general partner but rather by an independent legal entity accredited with the CVM to engage in securities portfolio administration activities: the so-called FIP administrator (administrador).[48] The administrator is responsible for the legal representation of the FIP as well as for managing the FIP’s routine activities, which include paying fees, receiving dividends and interest, preparing financial statements and reports, signing shareholders’ agreements of companies in which the FIP is a shareholder, providing reports and information to investors, in addition to other activities established in the FIP’s charter or determined by the quotaholders’ general meeting.

The quotaholders who attend the general meeting are the key decision-makers in an FIP and have exclusive authority over key matters such as the amendment of the charter, the removal of the administrator, the merger or liquidation of the FIP, the issuance and distribution of new quotas, the extension of the duration of the FIP, and the operation of the committees and administrative bodies of the FIP. Resolutions of the general meeting generally require a majority vote of the attendees, unless a supermajority vote is mandated by CVM Rule 391/03 or by the FIP’s charter.

Certain FIPs also have internal committees and boards to enrich their decision-making processes and to ensure informed decisions regarding the FIP’s investments and divestitures.[49] More complex FIPs might also have advisory boards and technical committees to advise on matters pertaining to the industry or sector of each target company.[50]

2.9. Distributions and Dividends, and Investment and Divestment Periods

While investors of mutual funds organized as open-end mutual condominia can have their quotas redeemed at any time, quotaholders of closed-end mutual funds like FIPs are only entitled to redeem their quotas at the end of the FIP’s term, and thus remain locked-in for the entire term of the FIP. Nevertheless, the FIP is allowed to make recurring distributions (amortizações) to its quotaholders during the term of the FIP. An FIP may divest itself of one or more of its portfolio companies and distribute the sales proceeds to its quotaholders without having to wait until the termination of the FIP. It may also reinvest such proceeds in other targets, subject to the applicable provisions of the FIP’s charter.[51] Additionally, if the FIP’s charter allows its quotaholders to receive dividends from companies in which the FIP has invested, such dividends may be distributed directly by the target company to the FIP’s quotaholders, ratably according to their respective ownership interests in the FIP.

Quotaholders also have the right to terminate the FIP at any time by qualified majority voting at a meeting, even during the investment period. This right is usually exercised by quotaholders when the FIP has disposed of all of the securities and assets in its portfolio before the end of the FIP’s term of duration or in situations where the FIP has not been able to find eligible target investments.

2.10. FIP Registration and Reporting Requirements

FIPs must be registered with the CVM in order to operate and are subject to continued scrutiny by the CVM.[52] The CVM imposes flexible and relatively simple conditions for registration of FIPs. When an investment channels through an FIP, the CVM requires that the FIP regularly report information about its financial standing and performance, including general information about its portfolio. Other than these CVM reporting requirements, there are no disclosure obligations affecting private equity investments, except for the Central Bank of Brazil’s reporting requirements, which are applicable to foreign investments entering Brazil, and the disclosure requirements that may be imposed by local antitrust authorities. However, if the company is or becomes listed, it must then comply with several disclosure and publicity requirements under Brazilian law.[53]

2.11. Offering of Quotas

The distribution of FIPs’ quotas is considered a public offering of securities under Brazilian securities laws and regulations[54] and, as such, is subject to prior registration with the CVM. If an FIP’s quotas are to be distributed to the public, the requirements set forth in CVM Rule No. 400, of December 29, 2003 are triggered.[55] Nonetheless, under Rule No. 476, issued by the CVM on January 16, 2009 (CVM Rule 476/09),[56] a fast-track procedure applies to certain restricted placements.[57]

2.12. Taxation of FIP and its Quotaholders

FIPs are generally exempt from income tax on the gains derived from their financial investments because of the FIP’s characterization as a condominium under Brazilian law. In contrast, Brazilian tax law does not treat the Brazilian target companies in which the FIP invests as tax-transparent and instead taxes them as independent entities. The fact that the FIP itself is per se exempt from taxation on acquisitions and divestitures makes it a very attractive vehicle for private equity investment. Further, the tax treatment accorded to non-resident quotaholders of FIPs give them an extra incentive to employ such vehicles.

Dividends received by the FIP and repaid to its quotaholders are currently not subject to the Brazilian withholding income tax (WHT). Interest on net equity[58] received by the FIP and repaid to quotaholders as well as other payments made to FIP’s quotaholders domiciled in Brazil are subject to WHT at the rate of fifteen percent.[59] However, WHT assessed on the income earned by non-resident investors arising from an interest in an FIP as well as upon repatriation of the capital originally invested in the FIP are currently subject to a zero percent rate,[60] provided that certain conditions are met.[61] This exemption partly explains why foreign private equity feeder funds and other non-resident investors usually treat FIPs as the preferred vehicles for private equity investments in Brazil.

Savings from a zero reduction on the WHT levied on income distributions made by the FIP may be crucial to determining the economic advisability of an M&A transaction and allow private equity investors to maximize the value-capturing potential of certain opportunities.[62] As the FIP itself is a tax neutral entity (pass-through vehicle), even resident investors take this factor into consideration when structuring M&A deals, with the intent to defer taxes at least for the term of the FIP.

2.13. FIP Structure

 Image 2, Section 2.13

Figure 2 shows a standard FIP structure and the payment flows typically carried out among transaction participants, as enumerated below:

1.  FIP issues quotas to Qualified Investors;

2.  Qualified Investors subscribe and pay quotas to the FIP;

3.  During the investment period, the FIP invests the amounts raised through the offering of its quotas in securities of one or more target companies;

4.  The remaining net equity of the FIP is invested in other assets and securities authorized under the FIP’s charter;

5.  Proceeds arising from payments of dividends and interest on equity by target companies, sales of other assets and securities comprising the FIP’s portfolio, and other distributions are disbursed to the FIP normally following the expiration of the FIP’s investment period; and

6.  The FIP makes distributions to quotaholders.

III.  CONCLUSION

Brazil has become a preferential stop for private equity sponsors seeking high returns from investments in local target companies. The surge of private equity investments carried out in Brazil over the past decade had two major ramifications. First, it powered an unmatched flow of M&A activity across nearly all business sectors of the Brazilian economy. Second, it fostered a revamp of the legal and regulatory framework of private equity-backed ventures in Brazil.

From a legal perspective, the measures that Brazilian authorities adopted primarily focused on making available to local dealmakers cutting-edge tools, features, strategies, and structures that private equity sponsors and conduits generally employ in the international M&A arena. In this context, FIPs came to light in 2003, in a clear attempt to facilitate private equity investments and to adapt to an increasingly competitive market for transnational business combinations. CVM Rule 391/03 tailored FIPs so as to meet such demands, not surprisingly making them the most successful private equity vehicle in Brazil.

As FIPs gain prominence, the classic private equity investment model[63] that prevailed until the late 1990s is rapidly losing ground in Brazil, as are the tools, features, strategies, and structures associated with this deal wave. The benefits of FIPs outweigh corporate-based structures by encompassing more flexibility, less bureaucracy, lower transaction costs, and more tax efficiencies. Moreover, FIPs can also provide synergies as domestic hubs of private equity investments in a diversified portfolio of target companies and can finance such undertakings through the placement of quotas.

The foregoing scenario converges in what this Article claims to be a DNA change in Brazilian M&A deals. Part II addressed the role that FIPs are playing in this process and highlighted the regulatory stability and structuring possibilities introduced by CVM Rule 391/03 that are largely contributing to a swift expansion of such conduits in the Brazilian M&A practice.[64] Some of the distinguishing features of FIPs discussed in Part II also support the conclusion that their widespread use is reshaping the Brazilian M&A landscape. As the roster of reasons supporting this proposition is extensive, it suffices to recapitulate here that the adaptability of FIPs to a wide range of transactional circumstances and requirements, coupled with the favored tax regime accorded both to the fund itself and to its quotaholders, increasingly make FIPs the most suitable structuring option for private equity-sponsored M&A deals in Brazil.

Taking advantage of the investor-friendly legal and regulatory regime accorded to FIPs, private equity investors have found in the FIP form great latitude to engage in domestic M&A transactions. Moreover, private equity investors are now able to influence the management of target companies according to the rules that they consider more suitable for each given deal. This DNA change in Brazilian M&A deals has optimized the investment landscape to the benefit of the investor. In sum, the ongoing boom of M&A transactions involving private equity sponsorship through FIPs means that M&A practitioners should familiarize themselves with FIP structures so as to stay ahead of the legal curve in the rapidly evolving Brazilian investment landscape.

 

 

Preferred citation: José Carlos Junqueira Sampaio Meirelles & Caio Carlos Cruz Ferreira Silva, Brazilian Private Equity Funds (FIPs): A DNA Change in Brazilian M&A Deals, 4 Harv. Bus. L. Rev. Online 15 (2013), https://journals.law.harvard.edu/hblr//?p=3636.

* José Carlos Junqueira Sampaio Meirelles: Corporate Partner, Pinheiro Neto Advogados; Adjunct Professor of the University of Illinois; Guest Faculty Member of Duke University School of Law; LL.B., University of São Paulo Law School, 1986; LL.M., University of Illinois, 1989.

† Caio Carlos Cruz Ferreira Silva: Corporate Senior Associate, Pinheiro Neto Advogados; LL.B., University of São Paulo Law School, 2003; LL.M. in International Law, University of São Paulo Law School, 2007; LL.M., Harvard Law School, 2011.

[1] In this Article, references to private equity are used in accordance with the broad definition in article 2 of CVM Rule 391/03, a rule issued by the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários (CVM)) introducing the Brazilian version of private equity funds. See infra Part II. Under this definition, private equity includes any acquisition of, or investment in, securities of a Brazilian publicly or closely held corporation with the purpose of actively participating in its decision-making process and influencing its capital structure, management, and operations through the adoption of value-enhancing strategic policies.

[2] See, e.g., Guillermo Parra-Bernal, Big private equity eyes Brazil for tasty deals, Reuters (Dec. 16, 2009), available at http://www.reuters.com/article/2009/12/16/us-brazil-privateequity-analysis-idUSTRE5BF2DL20091216; Spencer Ante, Brazil: The next hotbed of venture capital and private equity, Businessweek.com (Jun. 29. 2009), http://www.businessweek.com/the_thread/techbeat/archives/2009/06/brazil_the_next_hotbed_of_venture_capital_and_private_equity.html; Mike Dorning, U.S. Loses No. 1 to Brazil-China-India Market in Investor Poll, Bloomberg (Sep. 21, 2010), http://www.bloomberg.com/news/2010-09-21/u-s-loses-no-1-to-brazil-china-india-market-in-global-poll-on-investing.html.

[3] In general, “investment grade” refers to a classification assigned by rating agencies to entities that are deemed capable of paying off their debt.

[4] Since September 2009, when Moody’s updated Brazilian government debt’s rating to the investment grade category, Brazil’s investment-grade status has been recognized by all the three major rating agencies. Standard & Poor’s and Fitch Ratings elevated Brazil’s rating to investment-grade in April and May 2008, respectively. Brazil is also rated investment-grade by the Canadian rating agency Dominion Bond Rating Service and by the Japanese agencies Rating and Investment Information and Japan Credit Rating Agency. See Public Debt Strategic Planning Department – Investors Relations, Brazil Becomes Investment Grade by Moody’s, Brazilian Treasury (Tesouro Nacional) (2009), available at http://www3.tesouro.fazenda.gov.br/english/hp/downloads/Nota_Investment_Grade.pdf.

[5] In a recent study on mergers and acquisitions in Brazil, PricewaterhouseCoopers reported an average of 384 announced transactions per year from 2002–2005, while the yearly average for 2006–2009 soared to 646 transactions. The yearly average further increased to 773 transactions announced from 2010–2012. See Mergers and Acquisitions in Brazil, PricewaterhouseCoopers (Dec. 2012), http://www.pwc.com.br/pt/publicacoes/servicos/assets/fusoes-aquisicoes/mea-in-brazil-december.pdf. In 2009, Brazil hosted 79 of the 176 private equity transactions that took place in Latin America, channeling US$2 billion of the US$3.27 billion invested by private equity funds in the region. See Orlando Fernández, Private equity in Latin America, Private Law Company (PLC) (Sep. 21, 2010), available at http://crossborder.practicallaw.com/9-503-3821. Following this trend, in 2012, private equity and venture capital firms invested US$7.9 billion in Latin America, according to the Latin American Private Equity and Venture Capital Association. See Vinod Sreeharsha, Private Equity and Venture Capital Investments Rise in Latin America, The New York Times, DealBook (March 5, 2013), http://dealbook.nytimes.com/2013/03/05/private-equity-and-venture-capital-investments-rise-in-latin-america. Accounting for US$5.7 billion of the total channeled to the region, Brazil stands out as the country attracting the most money in Latin America. Id.

[6] See Mergers and Acquisitions in Brazil, PricewaterhouseCoopers, supra note 5.

[7] These industries include food and beverages, real estate, information technology, health, education, energy, infrastructure, logistics, oil and gas, mining, reforestation and consumer products, among others.

[8] Other factors supporting this trend include the steady improvement of local macroeconomic conditions and the overall investment climate, the rising liquidity of the Brazilian capital market, and the investment gap that exists in pivotal areas such as infrastructure, energy, health and education. See Rodrigo B. Feitosa, Fabio Terepins & Hermano Kemps, Brazilian Private Equity: Moving Centre Stage, INSEAD (Faculty & Research Working Paper, 2011), available at http://www.insead.edu/facultyresearch/research/doc.cfm?did=48210.

[9] See infra the remainder of Part I for a description of typical deal structures and corporate entities more commonly employed in the context of private equity transactions carried out over the last decade.

[10] Economies of scope and scale—other than those typically sought in M&A combinations—have become even more far reaching through arrangements permitting the management centralization of many targets and assets under a single investment conduit, putting the capital of its investors and the expertise of its service providers to the service of several companies, industries, and sectors. Exit strategies otherwise impracticable have become feasible through public or private offerings of securities due to a functional regulatory framework and an evolving capital market, which is capable of providing investors with liquidity to sell their stakes either through initial public offers (IPOs) or secondary offers. See Leonardo L. Ribeiro, Antonio Gledson de Carvalho & Claudio V. Furtado, Private Equity and Venture Capital in an Emerging Economy: Evidence from Brazil, 8–9 (Working Paper, 2006), available at http://ssrn.com/abstract=912523. Nine out of the sixteen Brazilian companies that went public on the São Paulo Stock Exchange (BM&FBOVESPA) between 2004 and 2005 were financed by private equity or venture capital investors. Id. at 8.

[11] Among such innovations, it is worth highlighting a set of measures enhancing governance standards and transparency in the Brazilian capital markets, including the protection of minority shareholders by means of a reduction of the proportion of preferred non-voting stock that may be issued in relation to common voting stock, tag-along rights to minority common stockholders at a price equal to eighty percent of the price paid to the controllers in case of a sale of control, the regulation of going private tender offers affecting takeovers and unsolicited bids, as well as the adoption of voluntary listing levels on BM&FBOVESPA (Nível 1, Nível 2 and Novo Mercado), imposing on companies listed in such segments more stringent corporate governance standards than those required by Brazilian Corporation Law.

[12] The sociedade limitada is the type of Brazilian business organization that most closely mirrors the limited liability companies, limited partnerships, and closely held companies under U.S. and U.K. laws. They are currently the most common company form in the country, especially due to the flexibility accorded to the structuring of this type of business entity and the relatively low level of legal requirements and formalities to which it is subject under Brazilian law. For more information on limitadas, see Pinheiro Neto Advogados, Doing Business in Brazil, Vol. 1, Chapter 2, F (2010).

[13] The sociedade por ações (S.A.) is the type of Brazilian business organization that is similar to corporations and joint-stock companies under U.S. and U.K. laws. An S.A. can be publicly or privately held. A publicly held S.A. and its securities must be registered with the CVM, and its securities can be traded on the stock exchange or on regulated over-the-counter markets. The securities of a closely held company are not available to the general public. For more information on S.A.s, see Pinheiro Neto Advogados, Doing Business in Brazil, Vol. 1, Chapter 2, G (2010).

[14] The Brazilian regulatory framework encompasses a profusion of investment fund categories, each tailored to carry out investments in a particular asset class. As far as private equity investment is concerned, the equity funds that can be used are typically FIPs, Venture Capital Investment Funds (Fundos de Investimento em Empresas Emergentes (FIEEs), focused on start-ups and small targets) and Stock Investment Funds (Fundos de Investimento em Ações, rarely adopted in part on account of regulatory constraints on portfolio composition).

[15] Similar to the U.S. Securities and Exchange Commission, the Comissão de Valores Mobiliários (CVM) is a federal agency linked to the Ministry of Finance that is in charge of the regulation, development, control, and supervision of securities markets in Brazil, including FIPs, their investors, and quotas.

[16] Instrução CVM [CVM Rule] No. 391, de 16 de julho de 2003, Diário Oficial da União [D.O.U.] de 18.7.2003 (Braz.), as amended, [hereinafter CVM Rule 391/03].

[17] As of December 31, 2012, there were 517 FIPs registered with the CVM, with a combined net equity of approximately US$53.5 billion. See CVM’s Register of FIP’s Net Equity (Cadastro de Patrimônio Líquido de FIP) (Mar. 2013), available at http://cvmweb.cvm.gov.br/SWB/Sistemas/SCW/CPublica/ListaPLFdoExcvFech/CPublicaListaPlFdoExcvFech.aspx?TPPartic=73. Nine out of the 517 FIPs currently registered with the CVM were under liquidation. Compared to FIPs, the use of Mutual Investment Funds in Innovative Emerging Companies (Fundos Mútuos de Investimento em Empresas Emergentes Inovadoras (FMIEEs)) is infrequent. As of the same date, only thirty-four FMIEEs were registered with the CVM (two of which were currently under liquidation), with an aggregated net equity of US$376.3 million. See CVM Register of FMIEE’s Net Equity (Cadastro de Patrimônio Líquido de FMIEE) (Mar. 2013), available at http://cvmweb.cvm.gov.br/SWB/Sistemas/SCW/CPublica/ListaPLFdoExcvFech/CPublicaListaPlFdoExcvFech.aspx?TPPartic=72.

[18] FIPs are also governed by a specific regulation, Instrução CVM [CVM Rule] No. 409, de 18 de agosto de 2004, D.O.U de 24.8.2004 (Braz.), as amended (CVM Rule 409/04), which provides for the creation, management, operation, and disclosure of most Brazilian investment funds. This rule applies to FIPs on a supplementary basis, when its provisions do not contravene CVM Rule 391/03. FIPs are subject to Brazilian securities statutes but not to the Brazilian Corporation Law (Lei [Law] No. 6,404, de 15 de dezembro de 1976, D.O.U. de 17.12.1976, as amended).

[19] FIPs held by more than one group of related investors or used as a conduit to implement joint ventures or associations between private equity investors and other strategic partners are often subject to quotaholders’ agreements that regulate the participation of investors in the definition of the strategies and management policy of the FIP, including matters like the exercise of voting rights or control power, preemption rights, and purchase and sale of quotas at the FIP level.

[20] These service contracts include administration and portfolio management agreements, depository or custody agreements, and agreements with consultants, advisors, and industry experts hired by the FIP.

[21] Under Brazilian law, a condominium can be defined as a joint property (in rem) right exercised by two or more persons over a certain asset or pool of assets, each holder (a co-owner or condômino) owning a pro rata fraction of such asset. The condominium itself has no legal personality apart from that of its owners, and the Brazilian Civil Code (Lei [Law] No. 10,406, de 10 de janeiro de 2002, D.O.U. de 11.1.2002 (Braz.), as amended) sets forth its central legal tenets. Statutes and regulations have elaborated on the legal concept of condominium to develop various legal structures, such as joint ownership of common areas of residential and commercial buildings and, most importantly for the purposes of this Article, quotas (securities) of mutual funds regulated by the CVM. For a further discussion of FIP’s quotas, see infra section 2.2.

[22] A mutual fund can be formed either as an open-end condominium, in which quotaholders can redeem their units at any time, or as a closed-end condominium, in which units can only be redeemed at the end of the funds’ term, except in the case of liquidation of the fund. However, distributions can generally be made to quotaholders throughout the term of the fund and pursuant to its organizational documents. See infra section 2.9.

[23] See infra section 2.8.

[24] An FIP can be funded either publicly or privately, at the beginning of its operations or during its term of duration, and in a single offering or a series of offerings. The mix of alternatives available for FIP capitalization is further described in section 2.11.

[25] This feature is especially important in FIPs that invest in multiple target companies in the same industry, allowing quotaholders to benefit from economies of scale and scope that a centralized management structure and FIP-related efficiencies can provide.

[26] While the FIP is an un-personified entity under Brazilian civil law, tax regulations require the FIP to be registered with the National Register of Legal Entities (Cadastro Nacional da Pessoa Jurídica (CNPJ)).

[27] Resembling a limited partner (LP) in a U.S. partnership, the quotaholder of an FIP is the equity owner (co-owner) of a unit (quota) representing a fraction of the FIP’s net equity. According to the legal concept of condominium under Brazilian law, quotaholders of the FIP are not entitled to ownership rights over the securities and assets in its portfolio, but rather to the appropriate proportion of the total assets comprising the FIP’s portfolio and available for distribution.

[28] Section 2.9 discusses how FIP’s quotaholders are remunerated for their investment and the types of distributions they are entitled to receive from the FIP. FIPs having a sole quotaholder (exclusive FIPs) are also permitted, provided that such quotaholder is a qualified investor. See infra section 2.6.

[29] See infra section 2.8.

[30] If the FIP issues more than one class of quotas, each class can have distinct voting rights as defined by the FIP’s charter. This possibility allows the FIP to accommodate in its ownership base investors with contrasting profiles and interests, changing their level of involvement in the FIP’s governance and activities as particular deal circumstances may demand. Additionally, the FIP can attach to each class of quotas different economic rights, but exclusively in connection with the administration and performance fees relevant to each class and respective calculation bases. Consequently, the issuance of classes of quotas establishing different remuneration criteria among quotaholders of distinct classes is not permitted, which grants quotaholders an undivided right in the portfolio securities and assets of the FIP.

[31] Frequently, such criteria are specified based either on those required under the voluntary listing levels on the São Paulo Stock Exchange (BM&FBOVESPA, Nível 1, Nível 2 and Novo Mercado) or the minimum corporate governance standards imposed on closely held companies by CVM Rule 391/03.

[32] See CVM Rule 391/03.

[33] See infra section 2.5 and Figure 1 (FIPs, Target Companies and SPCs).

[34] According to article 35, item VI(a) of CVM Rule 391/03, all companies comprising the FIP’s portfolios must be incorporated and headquartered in Brazil. Despite the growing internationalization of M&A transactions and the demand from local institutional investors for such flexibility, the CVM has not changed this rule.

[35] See art. 35, items II e III, of CVM Rule 391/03.

[36] This differs from the leveraged buyout structures that are common in private equity-sponsored M&A deals in the U.S.

[37] See supra section 2.4.

[38] Under Brazilian Corporation Law, the liability of an FIP with respect to an SPC or any other invested target company is generally limited to the unpaid portion of the issuance price of such SPC’s or target company’s shares (that is, the portion subscribed for but not yet paid in by the FIP). Once the FIP pays in the shares of the SPC or the target company, the FIP and its quotaholders are no longer responsible for any liabilities in connection with companies held in its portfolio, except in very limited circumstances. These limited circumstances include, for example, liabilities associated with acts perpetrated with fault or willful misconduct and in violation of the law or the target companies’ organizational documents, and instances where the application of the disregard of legal entity doctrine can be applied under Brazilian law.

[39] Additionally, equity losses incurred by the FIP’s quotaholders are not limited to the subscribed capital, meaning that they may be called to make extraordinary capital contributions to the FIP in cases where the assets available are not sufficient to fulfill liabilities arising from target companies.

[40] See CVM Rule 391/03.

[41] See id.

[42] The definition of “qualified investors” includes the following investors: (a) financial institutions; (b) insurance companies and special savings companies (sociedades de capitalização); (c) open- and closed-end pension funds; (d) individuals or legal entities with financial investments that hold financial investments in excess of R$300,000 (roughly US$130,000) and that attest in writing their status as qualified investors; (e) investment funds exclusively targeted to qualified investors; (f) portfolio managers and securities consultants authorized by the CVM, in relation to their own funds; and (f) social security regimes instated by the Federal Government, States, Federal District or Municipalities. See CVM Rule 409/04, art. 109.

[43] Pension funds became one of the most active players in the domestic private equity scenario mainly after the National Monetary Council (CMN) recognized private equity as a separate asset class and allowed closed pension funds (Entidades Fechadas de Previdência Complementar) to invest up to twenty percent of their portfolios in quotas of FIPs. See Resolução CMN [CMN Resolution] No. 3.792, de 24 de setembro de 2009, D.O.U. de 28.9.2009 (Braz.), as amended.

[44] See Resolução CMN [CMN Resolution] No. 2.689, de 26 de janeiro de 2000, D.O.U. de 27.1.2000 (Braz.), as amended.

[45] For the purpose of foreign capital registration with the Central Bank of Brazil, the FIP must be registered with the CVM, and its quotas must be tradable either on the stock exchange or organized over-the-counter market. See art. 6 of CMN Resolution 2,689/00.

[46] See CVM Rule 391/03.

[47] Forms that the investment may take include a control acquisition, minority participation, or joint venture, inter alia.

[48] The functions of both the FIP’s administrator and portfolio manager (gestor de carteira) may be performed by the same legal entity. Alternatively, the FIP’s administrator may retain an equally qualified third party to manage the portfolio of the FIP. The administrator and the portfolio manager can be held liable for losses borne by the quotaholders if they act with fault or in violation of the law, the CVM rules, or the FIP’s charter.

[49] These internal bodies are more relevant in FIP structures where the investors have a passive or secondary role in defining investment policies. As a result, in many instances investors prefer to entrust the details of portfolio management of an FIP to groups of private equity professionals, business developers, industry experts or technicians who are also empowered to follow up on the performance of the FIP’s investment portfolio and the administrator’s activities vis-à-vis its obligations to the FIP.

[50] Supervisory boards have become more common in the FIP business due to the rules recently introduced by the Governance and Best Practices Code for Private Equity Funds (FIPs) and Emerging Companies Investment Funds (FIEEs), which state that such boards are to oversee investment decisions made by the investment committee whenever conflicts of interest arise between quotaholders and the FIP’s administrator or portfolio manager.

[51] Normally, distributions occur only after the expiration of the investment period defined in the FIP’s charter. The investment period often goes from the inception of the FIP until two or three years after, and during this period FIP is expected to undertake investments and deploy funds in target companies in fulfillment of its investment policy. Distributions may also be made in kind, such as in assets, rights, or securities, as long as the relevant distribution rules have been previously agreed upon and are stipulated in the FIP’s charter.

[52] Registration is generally granted within five business days from the filing of the proper documentation with the CVM.

[53] See Instrução CVM [CVM Rule] No. 400, de 29 de dezembro de 2003, D.O.U. de 9.1.2004 (Braz.), as amended.

[54] See, e.g., art. 26 of CVM Rule 391/03.

[55] In this case, the FIP must submit the CVM filing, along with a detailed prospectus, notices, and marketing materials for underwriters and offering participants to use in the public offering, as well as statements signed by the FIP’s administrator and the offering’s underwriter in connection with the legality of the offering and the truthfulness of the information then provided to the public. See Instrução CVM [CVM Rule] No. 400, de 29 de dezembro de 2003, D.O.U. de 9.1.2004 (Braz.), as amended.

[56] See Instrução CVM [CVM Rule] No. 476, de 16 de janeiro de 2009, D.O.U. de 19.1.2009 (Braz.).

[57] In restricted placements, a maximum of fifty potential investors are initially approached and no more than twenty investors ultimately subscribe quotas of the FIP. See art. 3, item I, of CVM Rule 476/09. Moreover, the FIP’s quotas offered under CVM Rule 476/09 are subject to a ninety-day lock-up, which begins with their subscription or acquisition by the respective investor, see art. 13 of CVM Rule 476/09, and the FIP cannot carry out another public offer of quotas within four months from the date of termination of the last offer, unless such new offer is submitted for registration by the CVM. See art. 9, of CVM Rule 476/09.

[58] Under Brazilian law, interest on equity (juros sobre capital próprio) is essentially a tax-deductible payment, made by corporations to their shareholders, of a notional interest rate calculated by the application of a long-term interest rate over the company’s capital stock.

[59] See art. 25 of Instrução Normativa [Rule] No. 1,022, de 5 de abril de 2010, D.O.U de 7.4.2010 (Braz.), as amended, and art. 2 of Lei [Law] No.11,312, de 27 de junho de 2006, D.O.U de 28.6.2006 (Braz.) (Law 11,312/2006).

[60] See art. 3 of Law 11,312/2006.

[61] In order to enjoy such tax benefits, the following conditions must be met: (a) the FIP’s quotaholder cannot hold—individually or jointly with related persons—quotas representing forty percent or more of all the FIP’s quotas or forty percent or more of the total income of the FIP; (b) the FIP cannot hold in its portfolio debt securities exceeding five percent of the FIP’s net equity; and (c) the foreign investor cannot be resident or domiciled in a country defined by Brazilian law as a tax haven jurisdiction (a country where income is not taxed or subject to taxation at a maximum rate lower than twenty percent). See id.

[62] From a deal perspective, a positive side effect of this mutually beneficial “increase in the pie” is to induce private equity investors—as owners and controllers of the FIP—to take a more risk-seeking approach towards the closing of M&A transactions in Brazil that would otherwise not be feasible.

[63] See supra Part I.

[64] The investments and exit strategies successfully implemented by FIPs since 2004 likewise created an encouraging track record that stimulated the propagation of FIPs among foreign institutional investors seeking opportunities in emerging markets.

By

The Equity Façade of SEC Disgorgement

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Russell G. Ryan*

In its civil law enforcement cases under the federal securities laws, the Securities and Exchange Commission (SEC) routinely seeks disgorgement of ill-gotten gains, and courts routinely grant it.[1] The SEC commonly describes disgorgement as an equitable remedy,[2] and courts similarly begin their disgorgement analyses by assuming as axiomatic the equitable nature of disgorgement.[3]

But what if that premise is wrong? What if disgorgement is an equitable remedy only some of the time? What if in many cases it is actually a remedy at law, or even a punitive remedy? And what if in some cases the very label of disgorgement is a misnomer?

This Article attempts to answer these critical but largely overlooked questions. It begins with a brief summary of the history and context of disgorgement among the various SEC enforcement remedies.[4] It then explains why disgorgement in SEC cases is often not a remedy in equity at all, but rather a classic remedy at law in the form of a personal liability to pay a sum of money—independent of whether the defendant still possesses the tainted profits, or ever possessed them at all.[5] Finally, the Article explores the potential legal and statutory ramifications of removing the façade of equity from the disgorgement remedy.[6]

Disgorgement in Context

In carrying out its law enforcement role, the SEC is statutorily empowered to pursue a wide range of remedies against securities law violators. These remedies include injunctions,[7] administrative cease-and-desist orders,[8] monetary penalties,[9] and various forms of bars and suspensions.[10] The SEC can unilaterally order some of these remedies through administrative proceedings, while others are available only if the SEC files a lawsuit and obtains an order or judgment from a federal district court.[11]

Congress has never explicitly included disgorgement among the remedies the SEC can seek in federal court.[12] Despite this silence, the SEC has been seeking disgorgement for decades, and courts have been granting it for nearly as long.[13] Courts initially held that disgorgement—or “restitution,” as some courts and commentators labeled it early on—was a remedy ancillary to the court’s statutory power to order equitable injunctive relief.[14] Over time, courts came to accept as a truism the notion that disgorgement is inherently an ancillary equitable remedy.[15]

Significantly, most of the seminal SEC disgorgement cases were decided before Congress first empowered the agency in 1990 to seek monetary penalties against securities law violators.[16] Until then, the temptation for the SEC to request and the courts to grant disgorgement based on questionable theories was understandable, lest securities law violators appear to avoid punishment by suffering a mere injunction against future wrongdoing without any accompanying monetary sanctions. Today, however, there are no compelling reasons to stretch disgorgement beyond its limits.[17] In recent decades, Congress has granted the SEC and the courts a vast array of options to impose harsh monetary and other sanctions against wrongdoers in virtually all kinds of securities cases, regardless of whether disgorgement is available as an additional remedy.[18] Indeed, with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, the SEC can now administratively impose severe financial penalties, subject to only limited and deferential after-the-fact review by a federal court of appeals.[19]

More importantly for purposes of this Article, SEC disgorgement law developed mostly before the Supreme Court’s 2002 decision in Great-West Life & Annuity Insurance Co. v. Knudson.[20] As discussed at length below, Great-West articulated the Court’s most recent and authoritative teaching on whether and under what circumstances a restitutionary remedy constitutes equitable relief, as opposed to legal relief, in the context of a federal statute that explicitly allows the former but not the latter.[21] Great-West is especially significant because, within months after it was decided, Congress added a similar provision for equitable relief to the federal securities laws as part of the Sarbanes-Oxley Act of 2002.[22] Although that provision did not explicitly mention disgorgement, the widespread assumption that disgorgement was invariably a form of equitable relief has since emboldened the SEC and courts to cite it as statutory authority for ordering disgorgement.[23] Still, whether the power to order disgorgement derives from a district court’s inherent equitable powers or from the explicit statutory authority of Sarbanes-Oxley—or both—it can lawfully be ordered only if it in fact constitutes equitable relief rather than legal relief.

Courts have also given the SEC substantial procedural and evidentiary advantages in disgorgement cases based on the premise that it is an equitable remedy. For example, the SEC is required to proffer only a “reasonable approximation” of the alleged ill-gotten gains, at which point the evidentiary burden shifts to the defendant to disprove the SEC’s calculation.[24] Based on the presumption that disgorgement is an inherently equitable remedy, courts also generally hold that defendants facing SEC disgorgement claims enjoy neither the protection of any statute of limitations[25] nor the right to a jury trial.[26] Courts have also accepted the SEC’s position that a disgorgement order is enforceable through contempt sanctions[27] and is not a debt that triggers the protections normally afforded to judgment debtors under the Federal Debt Collection Procedures Act.[28] All of these advantages, however, would presumably be swept aside in any given case if the disgorgement sought by the SEC were determined not to be an equitable remedy.

The Equity Façade and the Disgorgement Misnomer

As noted at the outset of this Article, the SEC and the courts have commonly described disgorgement as an equitable remedy, designed to deprive wrongdoers of unjust enrichment and to deter others from violating the securities laws.[29] It is also generally acknowledged that disgorgement cannot be used punitively, and thus must be limited to an amount causally connected to the alleged wrongdoing.[30] Beyond that, however, any resemblance to a truly equitable remedy largely disappears in most cases. For example, the SEC and the courts generally say that disgorgement can be ordered even against defendants who no longer possess or have access to the tainted profits, or never possessed them at all.[31] They further say that a defendant can be held jointly and severally liable for other people’s gains as long as the participants were closely related or had collaborated in their scheme.[32] These attributes call into question whether the label of equity accurately describes disgorgement.

In determining whether SEC disgorgement claims seek truly equitable relief, the starting point should be the Supreme Court’s analysis in Great-West,[33] which interpreted the phrase “equitable relief” in Section 502(a)(3) of the Employee Retirement Income Security Act of 1974.[34] The plaintiffs were an insurer and a company-sponsored employee health plan seeking reimbursement of funds previously paid to a beneficiary after an auto accident.[35] They claimed that certain agreements entitled them to reimbursement from the proceeds of a settlement the beneficiary later recovered from a third-party tortfeasor.[36] In a 5-4 decision, the Supreme Court rejected several alternative attempts to classify the requested monetary relief as equitable rather than legal.[37] Most relevant for present purposes, the Court rejected the argument that the plaintiffs were seeking equitable restitution.[38]

The Court acknowledged that some forms of restitution are equitable in nature but emphasized that others are available only at law.[39] The Court quoted earlier precedent holding that “equitable relief,” as used in the statute at issue, “must refer to ‘those categories of relief that were typically available in equity.’”[40] The Court then distinguished between “restitution at law” and “restitution in equity,” holding that only the latter fell within the court’s equitable powers.[41]

The Court’s description of “restitution at law” fittingly captures the essence of the disgorgement remedy typically sought by the SEC:

In cases in which the plaintiff “could not assert title or right to possession of particular property, but in which nevertheless he might be able to show just grounds for recovering money to pay for some benefit the defendant had received from him,” the plaintiff had a right to restitution at law through an action derived from the common law-writ of assumpsit. In such cases, the plaintiff’s claim was considered legal because he sought “to obtain a judgment imposing a merely personal liability upon the defendant to pay a sum of money.”[42]

The Court then distinguished the separate concept of restitution in equity:

In contrast, a plaintiff could seek restitution in equity, ordinarily in the form of a constructive trust or an equitable lien, where money or property identified as belonging in good conscience to the plaintiff could clearly be traced to particular funds or property in the defendant’s possession. A court of equity could then order a defendant to transfer title (in the case of the constructive trust) or to give a security interest (in the case of the equitable lien) to a plaintiff who was, in the eyes of equity, the true owner. But where “the property [sought to be recovered] or its proceeds have been dissipated so that no product remains, [the plaintiff’s] claim is only that of a general creditor,” and the plaintiff “cannot enforce a constructive trust of or an equitable lien upon other property of the [defendant].” Thus, for restitution to lie in equity, the action generally must seek not to impose personal liability on the defendant, but to restore to the plaintiff particular funds or property in the defendant’s possession.[43]

Because the plaintiffs in Great-West sought to impose the kind of personal monetary liability described by the Court as legal restitution, the Court held that the remedy was beyond the district court’s equitable powers.[44]

Many SEC disgorgement orders do not fit within Great-West’s description of equitable relief because the defendant does not possess the allegedly illicit gains that flowed from the securities law violation, and thus the disgorgement seems most akin to a personal liability to pay a substitutionary sum of money approximating the illicit gains. Common examples include insider-trading cases in which tippers are ordered to disgorge not only their own profits but also those of their tippees.[45] Other cases involve defendants who have spent, squandered, or transferred their ill-gotten gains before being caught by the SEC, yet are still ordered to disgorge what they no longer possess.[46] In these cases, courts often rely in part on the concept of joint and several liability,[47] a dubious approach for reasons that exceed the scope of this Article.[48] In any event, the so-called disgorgement does not purport to order specific performance, a constructive trust, or an equitable lien over specific funds or property derived from the alleged wrongdoing, all of which would, of course, be impossible. Instead, courts simply require the defendant to pay a substitutionary sum of money calculated as an approximation of ill-gotten gains the defendant does not possess. Not surprisingly, the SEC’s collection rate in these cases is dismal.[49]

In ordering disgorgement, courts typically consider it irrelevant that the defendant no longer possesses the ill-gotten gains,[50] which seems incompatible with Great-West. One influential example is the D.C. Circuit’s opinion in SEC v. Banner Fund International.[51] Rejecting the defendant’s claim that he no longer had access to his illicit gains, and thus could not disgorge them, the court asserted that the defendant’s approach would create a “monstrous doctrine” and lead to “absurd results,” because it might incentivize securities law violators to spend or transfer their tainted profits before getting caught.[52] In hindsight, however, this aspect of Banner Fund cannot be squared with the Supreme Court’s Great-West opinion two years later.

Like most disgorgement decisions, Banner Fund assumed that disgorgement is an inherently equitable remedy. But the court’s literal language and rationale, when read in contrast with the Supreme Court’s subsequent opinion in Great-West, leaves little doubt that Banner Fund was actually describing a legal remedy rather than an equitable one:

The SEC in turn contends that . . . the disgorgement order imposes an obligation upon [the defendant] personally, which he may satisfy using his own assets. Because disgorgement is an equitable obligation to return a sum equal to the amount wrongfully obtained, rather than a requirement to replevy a specific asset, we reject [the defendant’s] challenge and affirm the district court.

. . . As the SEC points out, the requirement of a causal relationship between a wrongful act and the property to be disgorged does not imply that a court may order a malefactor to disgorge only the actual property obtained by means of his wrongful act. Rather, the causal connection required is between the amount by which the defendant was unjustly enriched and the amount he can be required to disgorge. To hold, as [defendant] maintains, that a court may order a defendant to disgorge only the actual assets unjustly received would lead to absurd results. . . .

. . . [A]n order to disgorge establishes a personal liability, which the defendant must satisfy regardless whether he retains the selfsame proceeds of his wrongdoing.[53]

Banner Fund flatly rejected the notion that disgorgement requires current possession of, or access to, the “actual property” representing the ill-gotten gains; the court instead explicitly equated disgorgement with the mere payment of a sum of money “equal to the amount wrongfully obtained.”[54] Two years later in Great-West, however, the Supreme Court made clear that the kind of remedy described in Banner Fund (and similar cases) is actually a legal one rather than an equitable one.[55] Specifically, Banner Fund’s literal description of disgorgement as imposing a “personal liability” to pay “a sum equal to the amount wrongfully obtained,” rather than an obligation to return “the actual assets wrongfully received,” eerily presaged the nearly verbatim language Great-West later used to describe restitution at law.[56] Moreover, contrary to what Banner Fund incorrectly assumed, whether a defendant “retains the selfsame proceeds from his wrongdoing” is not only relevant to the distinction between equitable and legal remedies that seek the repayment of money, it is largely dispositive under Great-West.[57]

Indeed, in cases like Banner Fund, the very label of disgorgement is a misnomer. The federal securities laws do not define the terms “disgorge” or “disgorgement,” but in common parlance they mean to eject or discharge the contents of something.[58] These terms presuppose that the contents remain extant in order to be disgorged. In the securities law context, true disgorgement should similarly mean that the defendant in fact possesses or at least has access to the asset being disgorged. Otherwise, calling the remedy “disgorgement” is akin to a doctor advising an emaciated patient to disgorge last year’s Thanksgiving dinner. When the order makes no pretense of requiring the actual disgorgement of anything the defendant possesses or has access to, it is neither disgorgement nor an exercise of equitable power. It is a mere personal liability to pay a money judgment—the quintessence of a remedy at law.

Additionally, disgorgement fails Great-West’s test for equitable relief in several other ways. First, disgorgement is a relatively modern concept, particularly in the context of law enforcement. It does not appear to have even been known to historical courts of chancery, much less typically granted by them, the key determinant of equitable relief under Great-West.[59] Indeed, disgorgement was not known, contemplated, or typically awarded even when Congress enacted the federal securities laws. One commentator found “only 11 cases in federal and state case law that were published between 1800 and 1960 that use the term ‘disgorgement’ in any context.”[60] The Government Accounting Office has likewise reported that “[t]he use of the disgorgement sanction in securities law violation cases is a relatively recent phenomenon,” and that “[d]isgorgement was first ordered in a securities law violation case in 1970.”[61] The closest historical antecedent to modern disgorgement is probably restitution, which as previously noted was the label some early disgorgement cases used,[62] and which was the very remedy the Supreme Court analyzed in Great-West.

Moreover, the federal securities laws explicitly include disgorgement among the many remedies the SEC is empowered to order administratively without ever seeking the imprimatur of a federal court sitting in either law or equity.[63] By explicitly authorizing disgorgement as an administrative remedy, capable of being ordered by an independent executive branch agency carrying out its law enforcement functions, Congress must have recognized that disgorgement is not invariably a remedy in equity. It seems highly doubtful that Congress would—or constitutionally could, consistent with separation of powers—bestow one of the core judicial powers of an Article III court of equity upon a law enforcement agency of the executive branch.[64]

To be sure, some disgorgement might fairly be characterized as equitable under Great-West. For example, the SEC sometimes moves with alacrity to preserve suspected ill-gotten funds through a temporary restraining order, a preliminary asset freeze, the appointment of a receiver, a voluntary agreement, or otherwise. Sometimes the ill-gotten gains remain extant and identifiable even in the absence of affirmative steps by the SEC to preserve them. If and when the SEC obtains a disgorgement order in these types of cases, there is a specific pool of money that can be turned over to the SEC. Not coincidentally (and not insignificantly), in these cases the SEC has a relatively high success rate in collecting the resulting disgorgement judgments.[65] But these cases, based on the author’s two decades of anecdotal experience on both sides of SEC enforcement cases, represent a small fraction of SEC disgorgement cases.[66]

Potential Ramifications

If the above analysis is correct—if disgorgement is often not an equitable remedy in SEC enforcement cases but rather a legal remedy akin to a simple money judgment—there would be several practical ramifications for SEC enforcement.

First, whenever disgorgement is legal rather than equitable, the SEC has no lawful power to seek it in federal court proceedings, and the courts have no lawful power to award it. Being purely a creature of statute, the SEC can lawfully seek in court only those remedies Congress has authorized it to seek, and disgorgement at law is not among those remedies.[67] Likewise, being courts of limited jurisdiction, federal courts can lawfully impose only those remedies at law that Congress has authorized in the relevant statutes.[68] As discussed above, ever since disgorgement was first accepted as a lawful remedy in SEC enforcement, the only plausible sources of authority cited to support it are either the courts’ inherent power to grant equitable remedies ancillary to their explicit statutory power to grant injunctive relief[69] or the recent statutory provision for “equitable relief” added by Sarbanes-Oxley.[70] If and when disgorgement is not in fact an equitable remedy, neither source of lawful authority is available.

Second, notwithstanding the colorful warnings of Banner Fund and other cases, the resulting partial demise of disgorgement would not raise an alarm in the realm of SEC enforcement. As previously discussed, the SEC has a vast arsenal of other equitable and punitive remedies to address securities law violations even in cases where disgorgement is unavailable or inappropriate.[71] Violators are also subject to potential criminal prosecution[72] as well as money damage awards in private lawsuits.[73] In short, securities law violators do not get off scot-free simply because the SEC cannot seek disgorgement in a particular case.

Moreover, even under a strict adherence to the principles of Great-West, the SEC would have several options to deprive securities law violators of the profits caused by their violations. As previously noted, the agency often moves swiftly to preserve tainted profits—through court orders, voluntary agreements, or otherwise—before those profits can be transferred or dissipated, and in other cases the funds remain available even without any affirmative steps being taken to preserve them.[74] In such cases, the court could presumably order truly equitable disgorgement consistent with Great-West.[75] As also previously noted, whenever the SEC finds a securities law violation it can order disgorgement from the violator administratively, without having to go to court at all (although subject to deferential judicial review).[76] The SEC can also ask federal courts, when imposing statutory penalties against a defendant, to calculate that penalty as an amount equal to “the gross amount of pecuniary gain to [the] defendant as a result of the violation.”[77] Of course, if these remedies are insufficient, the SEC can always seek help from Congress, which has accommodated similar requests in recent decades.[78]

To be sure, if courts began acknowledging that some SEC disgorgement demands seek legal rather than equitable relief—yet concluded they could still award it (or the SEC prevailed upon Congress to authorize disgorgement at law by statute)—the distinction between legal and equitable disgorgement would affect a host of collateral issues and rights affecting SEC disgorgement defendants. For example, based largely on the premise that SEC disgorgement claims seek inherently equitable relief, courts have generally denied defendants the repose of any statute of limitations[79] and the right to a jury trial.[80] For similar reasons, courts have allowed the SEC to enforce disgorgement judgments through contempt sanctions (including incarceration) rather than limiting the agency to the writ of execution normally used to enforce money judgments.[81] One federal circuit has even held that an SEC disgorgement order is not a “debt” owed to the government that triggers the protections ordinarily afforded under the Federal Debt Collection Act.[82] Removing the façade of equity would severely undermine the prevailing approach to all of these issues.[83]

Conclusion

The prevailing notion that SEC disgorgement is an inherently equitable remedy ought to be thoughtfully revisited. Courts award the SEC billions of dollars in disgorgement each year, yet in many cases the premise of equity seems squarely at odds with the Supreme Court’s analysis of restitution in Great-West. Given the amounts at stake in these cases, as well as the significant procedural disadvantages a defendant confronts when a court acts in equity rather than at law, the long-standing premise of equity warrants a higher degree of skepticism and scrutiny than it has received thus far.

 

Preferred citation: Russell G. Ryan, The Equity Façade of SEC Disgorgement, 4 Harv. Bus. L. Rev. Online 1 (2013), https://journals.law.harvard.edu/hblr//?p=3528.

* Russell G. Ryan, a former Assistant Director of the SEC’s Division of Enforcement, is a partner in the Washington, D.C., office of King & Spalding LLP. Mr. Ryan represented the petitioner in Cahill v. SEC, 133 S. Ct. 28 (2012) (denying certiorari), and in related proceedings in the lower courts, certain opinions from which are cited in this Article.

[1] The Securities and Exchange Commission (SEC) has secured more than $1.8 billion in aggregate disgorgement orders in each of its four most recent fiscal years—far more than the agency has been awarded in statutory penalties over the same period. See Secs. & Exch. Comm’n, Select SEC and Market Data, Fiscal 2012, 2 tbl. 1, available at www.sec.gov/about/secstats2012.pdf ($2.1 billion in disgorgement and $1 billion in penalties); Secs. & Exch. Comm’n, Select SEC and Market Data, Fiscal 2011, 2 tbl. 1, available at www.sec.gov/about/secstats2011.pdf ($1.9 billion in disgorgement and $928 million in penalties); Secs. & Exch. Comm’n, Select SEC and Market Data, Fiscal 2010, 2 tbl. 1, available at www.sec.gov/about/secstats2010.pdf ($1.8 billion in disgorgement and $1 billion in penalties); Secs. & Exch. Comm’n, Select SEC and Market Data, Fiscal 2009, 2 tbl. 1, available at www.sec.gov/about/secstats2009.pdf ($2.1 billion in disgorgement and $345 million in penalties).

[2] As an example, in a recent case the SEC asserted this premise in the second sentence of the argument section of its brief. Brief of the Secs. & Exch. Comm’n, Appellee at 15, SEC v. Whittemore, 659 F.3d 1 (D.C. Cir. 2011) (No. 10-5321) (quoting SEC v. First City Fin. Corp., 890 F.2d 1215, 1230 (D.C. Cir. 1989)). Similarly, in a report on disgorgement submitted by the agency to Congress, the second sentence of the SEC’s background discussion of disgorgement stated: “Disgorgement is a well-established, equitable remedy applied by federal district courts and is designed to deprive defendants of ‘ill-gotten gains.’” Secs. & Exch. Comm’n, Report Pursuant to Section 308(c) of the Sarbanes Oxley Act of 2002, 2­–3 (2003) [hereinafter SEC Disgorgement Report], available at www.sec.gov/news/studies/sox308creport.pdf.

[3] See infra notes 15 & 29 and accompanying text. A recent Lexis search of cases in which the SEC was a named party and the opinion contained the exact phrase “disgorgement is an equitable remedy” returned 81 hits. Moreover, this author’s routine weekly electronic search and review of new court opinions issued in SEC enforcement cases has revealed dozens of opinions each year in which courts begin their disgorgement analysis with the assumed premise that disgorgement is equitable. For several recent examples, see SEC v. O’Meally, 2013 U.S. Dist. LEXIS 33487, at *7 (S.D.N.Y. March 11, 2013) (“Disgorgement is a form of equitable relief.”); SEC v. Murray, 2013 U.S. Dist. LEXIS 32460, at *4 (E.D.N.Y. March 6, 2013) (“Once the district court has found federal securities law violations, it has broad equitable power to fashion appropriate remedies, including ordering that culpable defendants disgorge their profits.”); SEC v. Art Intellect, Inc., 2013 U.S. Dist. LEXIS 32132, at *69 (D. Utah March 6, 2013) (“Actions for disgorgement of improper profits are equitable in nature, because the purpose of disgorgement is to prevent unjust enrichment.”).

[4] See infra notes 7–28 and accompanying text.

[5] See infra notes 29­–66 and accompanying text.

[6] See infra notes 67–83 and accompanying text.

[7] See, e.g., Securities Act of 1933 § 20(b), 15 U.S.C. § 77t(b) (2012); Securities Exchange Act of 1934 § 21(d)(1), 15 U.S.C. § 78u(d)(1).

[8] See, e.g., 15 U.S.C. §§ 77h-1(a), 78u-3(a).

[9] See, e.g., 15 U.S.C. §§ 77t(d), 78u(d)(3), 78u-1 to -2.

[10] See, e.g., 15 U.S.C. § 77h-1(f), 77t(e) (bars and suspensions from service as public company officer or director); 15 U.S.C. § 78u(d)(2), 78u-3(f) (same): 15 U.S.C. § 78o(b)(4), (b)(6) (bars and suspensions from service as or association with broker-dealers); Investment Advisers Act of 1940 § 203(e), (f), 15 U.S.C. § 80b-3(e) to (f) (2012) (bars and suspensions from service as or association with investment advisers).

[11] Compare 15 U.S.C. §§ 77h-1, 78u-2 to -3 (administrative remedies) with 15 U.S.C. §§ 77t, 78u, 78u-1(federal court remedies).

[12] This is not merely a legislative oversight, as Congress has explicitly empowered the SEC to order disgorgement administratively without having to go to court at all. See, e.g., 15 U.S.C. §§ 77h-1(e),78u-2(e), -3(e). As noted by one commentator, the legislative history of these provisions “makes clear that Congress assumed that disgorgement was already available as a remedy in judicial proceedings.” Barbara Black, Should the SEC Be a Collection Agency for Defrauded Investors?, 63 Bus. Law. 317, 321 (2008) (citing S. Rep. No. 101-337, at 8 (1990)). In practice, for reasons that exceed the scope of this article, the SEC rarely uses administrative proceedings to pursue contested disgorgement claims, preferring instead to file and litigate such claims in federal court. Nevertheless, the fact that Congress has explicitly granted the SEC, an independent executive branch agency, the power to order disgorgement administratively as part of its law enforcement functions, weighs heavily against any presumption that disgorgement is a remedy in equity. See infra notes 63–64 and accompanying text.

[13] The SEC first sought and obtained disgorgement in SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 92–94 (S.D.N.Y. 1970); aff’d in part and rev’d in part, 446 F.2d 1301, 1307–08 (2d Cir. 1971), and has done so innumerable times since. See generally John D. Ellsworth, Disgorgement in Securities Fraud Actions Brought by the SEC, 1977 Duke L.J. 641, 641–42 n.3 (1977); SEC Disgorgement Report, supra note 2, at 3 n.3 (citing cases).

[14] See, e.g., SEC v. First City Fin. Corp., 890 F.2d 1215, 1230 (D.C. Cir. 1989) (holding that because the Exchange Act does not restrict the equitable remedies of district courts, disgorgement is available “simply because the relevant provisions . . . vest jurisdiction in the federal courts”); SEC v. Manor Nursing Ctrs., Inc., 458 F.2d 1082, 1103–04 (2d Cir. 1972); Texas Gulf Sulphur, 446 F.2d at 1307–08.

[15] See, e.g., SEC v. Wang, 944 F.2d 80, 85 (2d Cir. 1991) (“The disgorgement remedy [the district court judge] approved in this case is, by its very nature, an equitable remedy . . . .” (emphasis added)); First City Fin, 890 F.2d at 1230 (“Disgorgement is an equitable remedy . . . .”); SEC v. Certain Unknown Purchasers of Common Stock of and Call Options for Common Stock of Santa Fe Int’l Corp., 817 F.2d 1018, 1020 (2d Cir. 1987) (“The disgorgement remedy approved by the district court in this case is, by its nature, an equitable remedy.” (emphasis added)).

[16] See infra note 18.

[17] See generally John K. Robinson, A Reconsideration of the Disgorgement Remedy in Tipper-Tippee Insider Trading Cases, 62 Geo. Wash. L. Rev. 432 (1994).

[18] See, e.g., Securities Enforcement Remedies and Penny Stock Reform Act, Pub. L. No 101-429, secs. 101, 202, §§ 20(d), 21B, 104 Stat. 931, 932­–33, 937–38 (1990) (codified in relevant part at 15 U.S.C. §§ 77t, 78u-2) (authorizing the SEC to seek, and courts to impose, among other things, monetary penalties, officer-director bars, and penny-stock bars against any violator and authorizing the SEC to impose monetary penalties and other sanctions administratively against persons and entities in SEC-regulated industries); Sarbanes-Oxley Act, Pub. L. 107-204, §§ 305, 603, 807, 1105 and 1106, 116 Stat. 745, 778–79, 794–95, 804, 809–10 (2002) (codified in relevant part at 15 U.S.C. § 78u(d)(2), 78u(d)(6), 78u-3(f), 78ff(a), & 18 U.S.C. § 1348) (lowering the SEC’s burden of proof to obtain officer-director bars; authorizing the SEC to impose such bars administratively and without court approval; authorizing the SEC to obtain penny-stock bars in federal court cases; adding new criminal penalties for securities fraud involving public companies; and increasing maximum penalty amounts for violations generally).

[19] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, sec. 929P, § 308, 124 Stat. 1376 (2010). SEC administrative sanctions are set aside by courts only if “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” See 5 U.S.C. § 706(2)(A); KPMG, LLP v. SEC, 289 F.3d 109, 121 (D.C. Cir. 2002); Graham v. SEC, 222 F.3d 994, 999–1000 (D.C. Cir. 2000); accord VanCook v. SEC, 653 F.3d 130, 137 (2d Cir. 2011) (holding that the SEC’s choice of administrative sanction disturbed only if “unwarranted in law or without justification in fact”).

[20] 534 U.S. 204 (2002).

[21] See infra notes 34–44 and accompanying text.

[22] Sarbanes-Oxley Act § 305(b), codified at 15 U.S.C. § 78u(d)(5).  The amendment inserted a new subsection (5) into Section 21(d) of the Securities Exchange Act of 1934, providing that “[i]n any action or proceeding brought or instituted by the Commission under any provision of the securities laws, the Commission may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.” Id.

[23] E.g., SEC v. Whittemore, 659 F.3d 1, 4 (D.C. Cir. 2011).

[24] E.g., id. at 7; SEC v. Happ, 392 F.3d 12, 31 (1st Cir. 2004); SEC v. First City Fin. Corp., 890 F.2d 1215, 1231–32 (D.C. Cir. 1989) (citing cases from other circuits).

[25] See, e.g., Riordan v. SEC, 627 F.3d 1230, 1234 (D.C. Cir. 2010); SEC v. Rind, 991 F.2d 1486, 1492–93 (9th Cir. 1993); SEC v. Gabelli, 2010 U.S. Dist. LEXIS 27613, at *12–13 (S.D.N.Y. 2010).

[26] See, e.g., Rind, 991 F.2d at 1493; SEC v. Commonwealth Chem. Sec., Inc., 574 F.2d 90, 94-96 (2d Cir. 1978).

[27] See, e.g., SEC v. Huffman, 996 F.2d 800, 803 (5th Cir. 1993) (holding that a disgorgement order is enforceable by contempt because it is “more like a continuing injunction in the public interest than a debt” (citing Pierce v. Vision Investments, Inc., 779 F.2d 302, 307–08 (5th Cir. 1986))); SEC v. Goldfarb, 2012 U.S. Dist. LEXIS 85628, at *10–17 (N.D. Cal. 2012) (contempt available). But see SEC v. New Futures Trading Int’l Corp., 2012 U.S. Dist. LEXIS 55557, at *5–6 (D.N.H. 2012) (striking provision in SEC’s standard settlement template purporting to allow the agency to enforce the disgorgement provision through contempt sanctions).

[28] See, e.g., Huffman, 996 F.2d at 802–03.

[29] E.g., SEC v. First Pac. Bancorp, 142 F.3d 1186, 1191 (9th Cir. 1998); SEC v. Hughes Capital Corp., 124 F.3d 449, 455 (3d Cir. 1997) (quoting First City Fin., 890 F.2d at 1230).

[30] E.g., First City Fin., 890 F.2d at 1231 (citing cases from other circuits).

[31] See, e.g., SEC v. Whittemore, 659 F.3d 1, 9–10 (D.C. Cir. 2011) (quoting SEC v. Banner Fund Int’l, 211 F.3d 602, 617 (D.C. Cir. 2000) and Platforms Wireless, 617 F.3d at 1098); SEC v. Benson, 657 F. Supp. 1122, 1134 (S.D.N.Y 1987).

[32] E.g., Whittemore, 659 F.3d at 10–12; SEC v. Calvo, 378 F.3d 1211, 1215–16 (11th Cir. 2004); Hughes Capital, 124 F.3d at 455.

[33] 534 U.S. 204.

[34] 29 U.S.C. § 1132(a)(3).

[35] See Great-West, 534 U.S. at 207–08.

[36] Id.

[37] Id. at 210–20.

[38] Id. at 212–18.

[39] Id. at 212­–14.

[40] Id. at 210 (quoting Mertens v. Hewitt Assocs., 508 U.S. 248, 256 (1993)).

[41] Id. at 212–14.

[42] Id. at 213 (citations omitted) (quoting 1 Dan B. Dobbs, Law of Remedies: Damages-Equity-Restitution § 4.2(1), at 571 (2d ed. 1992); Restatement of Restitution § 160 cmt. a (1936)).

[43] Id. at 213–14 (alterations in original) (second & third emphases added) (citations omitted) (quoting Restatement of Restitution § 215 cmt. a (1936)). In footnoted dictum, the Court noted “a limited exception for an accounting for profits,” a remedy not at issue in that case. Great-West, 534 U.S. at 214 n.2. “If, for example, a plaintiff is entitled to a constructive trust on particular property held by the defendant, he may also recover profits produced by the defendant’s use of that property, even if he cannot identify a particular res containing the profits sought to be recovered.” Id. In the context of SEC enforcement, this remedy is most closely akin to the prejudgment interest that is routinely awarded on top of a lawfully ordered disgorgement award.

[44] Id. at 214.

[45] See, e.g., SEC v. Clark, 915 F.2d 439, 453–54 (9th Cir. 1990); SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 89 (S.D.N.Y. 1970). For a strong articulation and analysis of the illogic of ordering disgorgement from non-trading tippers, see John K. Robinson, supra note 17, at 432.

[46] See, e.g., SEC v. Whittemore, 659 F.3d 1, 9–12 (D.C. Cir. 2011).

[47] E.g., Whittemore, 659 F.3d at 10–12; SEC v. Calvo, 378 F.3d 1211, 1215–16 (11th Cir. 2011); SEC v. Hughes Capital Corp., 124 F.3d 449, 455 (3d Cir. 1997).

[48] In short, applying a tort-damage theory like joint and several liability to a purportedly equitable law enforcement remedy is the jurisprudential equivalent of forcing a square peg into a round hole. Unlike a private plaintiff, the SEC is not an injured victim suing to recover for compensable loss, injury, or damages that it has suffered. Cf. Gabelli v. SEC, 133 S. Ct. 1216, 1218 (2013) (noting that as a law enforcement agency, the SEC is “a different kind of plaintiff” seeking “a different kind of relief”). Although the SEC often sues to remedy misconduct that resulted in investor losses, the purpose of disgorgement is not to compensate those losses but rather to deprive the wrongdoer of his ill-gotten gains. See, e.g., Zacharias v. SEC, 569 F.3d 458, 471 (D.C. Cir. 2009) (quoting earlier cases). Thus, the disgorgement amount can be higher or lower than the damages sustained by those injured by the wrongdoing, and indeed the very question of whether anyone suffered a loss is “irrelevant” to the appropriateness and calculation of any disgorgement award. Id. Moreover, allowing the SEC the expediency of joint and several liability introduces risks of unfairness, favoritism, and the arbitrary exercise of prosecutorial discretion, because many securities fraud cases present more than one potential defendant, and the ability to hold any one of them jointly and severally liable for everyone else’s gains presents the SEC with disquieting incentives when picking and choosing who among them it will charge.

[49] See SEC Disgorgement Report, supra note 2, at 20–21; U.S. Gov’t Accountability Office, GAO-02-771, SEC Enforcement: More Actions Needed to Improve Oversight of Disgorgement Collections 12–14 (2002), available at www.gao.gov/new.items/d02771.pdf.

[50] See SEC v. Banner Fund Int’l, 211 F.3d 602, 617 (D.C. Cir. 2000) (noting that a contrary rule would lead to “absurd results”); SEC v. Whittemore, 691 F. Supp. 2d 198, 207 (D.D.C. 2010) (holding that whether a defendant retained the funds is “not germane” and how she spent them is “irrelevant”); SEC v. Benson, 657 F. Supp. 1122, 1134 (S.D.N.Y. 1987) (noting that the manner in which defendants “chose to spend” their gains is “irrelevant” to disgorgement).

[51] 211 F.3d 602.

[52] Id. at 617.

[53] Id. (emphasis added).

[54] Id.

[55] Great-West, 534 U.S. at 213.

[56] Banner Fund, 211 F.3d at 617.

[57] Supporters of prevailing SEC disgorgement law might cite by analogy to the Second Circuit’s opinion in FTC v. Bronson Partners, LLC, 654 F.3d 359 (2d Cir. 2011). However, Bronson was interpreting the Federal Trade Commission Act and is otherwise distinguishable. The relevant statute in Bronson, unlike the Exchange Act and the statute at issue in Great-West, was silent regarding the kinds of relief a court could award beyond injunctions. Id. at 365 (quoting statute). Bronson relied heavily on Porter v. Warner Holding Co., 328 U.S. 395 (1946), to suggest that this statutory silence gave courts almost limitless power to award monetary relief ancillary to a statutory injunction. 654 F.3d at 365–66.  The relevant section of the Exchange Act, however, is noticeably different from the statutes in Porter and Bronson, and for practical purposes is identical to the statute in Great-West. Whereas Porter involved a statute that granted courts power to issue any “other order” in addition to injunctions, and Bronson involved a statute that was silent on the matter, both the Exchange Act and the statute in Great-West empower courts to issue injunctions plus other “equitable relief.” As Great-West made clear, the qualifier “equitable” would be meaningless if not read to limit the available remedies to those in equity. 534 U.S. at 209–10. Moreover, the fact that Congress added this phrase to the Exchange Act in 2002, just months after Great-West interpreted the identical phrase in another federal statute, strongly suggests that the phrase should have the same import as it did in Great-West. Additionally, the appellant in Bronson did not argue the specific point raised in this article, as both the parties and the court appear to have simply assumed that disgorgement (unlike restitution) is equitable; the dispute ultimately centered on how disgorgement should be calculated and whether “equitable tracing” rules should apply. 654 F.3d at 372–75. Finally, Bronson’s literal description of disgorgement—like that in Banner Fund—actually echoes the themes articulated in Great-West to describe what an equitable remedy is not. Id. at 373–74 (noting that the disgorgement plaintiff “does not claim any entitlement to particular property” or “priority over the other creditors of the defendant,” but “asks only to have a judgment for the amount of [the] ill-gotten gains, which . . . will simply permit [the plaintiff] to share with other creditors on an equal basis”).

[58] See, e.g., Merriam-Webster’s Collegiate Dictionary 332 (10th ed. 1993).

[59] See Great-West, 534 U.S. at 211.

[60] See George P. Roach, A Default Rule of Omnipotence: Implied Jurisdiction and Exaggerated Remedies in Equity for Federal Agencies, 12 Fordham J. Corp. & Fin. L. 1, 47 n.175 (2007).

[61] U.S. Gov’t Accountability Office, GAO/GGD-94-188, Securities Enforcement: Improvements Needed in SEC Controls Over Disgorgement Cases 2, n.3 (August 1994) (citing SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77 (S.D.N.Y. 1970)), available at www.gao.gov/assets/230/220095.pdf.

[62] See generally SEC v. First Pac. Bancorp, 142 F.2d 1186, 1192–93 (9th Cir. 1998) (declining to “engage in a rather scholastic argument about whether restitution and disgorgement are really just about the same thing” and citing cases going both ways on the point). But see SEC Disgorgement Report, supra note 2, at 2–3 (acknowledging that courts at times use the terms disgorgement and restitution interchangeably, but arguing that they are distinct concepts).

[63] See, e.g., 15 U.S.C. § 78u-2(e), -3(e). Like other administratively ordered sanctions, an administrative disgorgement order is subject only to limited and deferential review by a court of appeals, and thus will be set aside only if “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” See supra note 19 and cases cited therein. For reasons beyond the scope of this article, the SEC rarely brings contested disgorgement claims in administrative proceedings, preferring instead to pursue them in federal court.

[64] Even Article I courts—which are at least courts of some kind rather than law enforcement agencies of the executive branch—have been held to lack general equitable powers. See, e.g., Bowen v. Massachusetts, 487 U.S. 879, 905 (1988) (federal Court of Claims lacks equitable powers of a district court); Comm’r v. McCoy, 484 U.S. 3, 7 (1987) (Tax Court lacks general equitable powers); cf. Comm’r v. Gooch Milling & Elevator Co., 320 U.S. 418, 420–21 (1943) (Board of Tax Appeals, an executive branch administrative predecessor of the Tax Court, lacks equity jurisdiction).

[65] See SEC Disgorgement Report, supra note 2, at 1, 9, 22.

[66] The author recently argued the relevance of Great-West to SEC disgorgement on behalf of a client in a petition for an en banc rehearing in the D.C. Circuit and a subsequent petition for certiorari in the Supreme Court, but both petitions were denied without comment. See SEC v. Whittemore, No. 05-cv-00869 (D.C. Cir. Dec. 22, 2011) (unpublished order denying rehearing en banc); cert. denied, 133 S. Ct. 28 (2012). Only two district court opinions appear to have squarely considered the relevance of Great-West to SEC disgorgement, and both ruled in the SEC’s favor. SEC v. DiBella, 409 F. Supp. 2d 122, 132–33 (D. Conn. 2006); SEC v. Buntrock, 2004 U.S. Dist. LEXIS 9495, at *6–9 (N.D. Ill. May 25, 2004). However, both cases examined the issue in the context of a motion to strike, and neither appeared to have involved a scenario where the illicit gains had been transferred to other parties as part of the relevant scheme and thus were no longer available to disgorge. Moreover, as one commentator has noted, Buntrock essentially “assume[d] away the issue” and thus “failed to undertake the analysis established in Great-West” and even “flout[ed] the Supreme Court’s message in Great-West.” See Roach, supra note 60, at 48.

[67] See, e.g., Am. Bus Ass’n v. Slater, 231 F.3d 1, 8 (D.C. Cir. 2000) (Sentelle, J., concurring) (“Congress’s failure to grant an agency a given power is not an ambiguity as to whether that power has, in fact, been granted. On the contrary, and as this Court persistently has recognized, a statutory silence on the granting of a power is a denial of that power to the agency.”).

[68] See, e.g., Kokkonen v. Guardian Life Ins. Co. of Am., 511 U.S. 375, 377 (1994) (holding that federal courts, being courts of “limited jurisdiction,” “possess only that power authorized by Constitution and statute, [] which is not to be expanded by judicial decree” (internal citation omitted)).

[69] See supra notes 13–15 and accompanying text.

[70] See supra notes 22–23 and accompanying text.

[71] See supra notes 18 & 19 and accompanying text.

[72] See 15 U.S.C. §§ 77x, 78ff.

[73] See Janus Capital Grp., Inc. v. First Derivative Traders, 31 S. Ct. 2296, 2301 (2011) (acknowledging private right of action under section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 thereunder).

[74] See supra note 65 and accompanying text.

[75] Cf. Sereboff v. Mid Atl. Med. Servs., Inc., 547 U.S. 356, 362–63 (2006) (distinguishing Great-West where plaintiff sought recovery of “specifically identifiable” funds that were “within the possession and control” of the defendant because the parties had previously stipulated the funds would be set aside and preserved pending final determination of the merits of the lawsuit).

[76] See supra notes 12 (citing relevant statutes) and 19 (describing standard of review for SEC administrative sanctions and citing cases).

[77] See, e.g., 15 U.S.C. § 78u(d)(3)(B).

[78] See supra notes 18 & 19 and accompanying text.

[79] See supra note 25.

[80] See supra note 26.

[81] See supra note 27. Compare Fed. R. Civ. P. 69(a)(1) (enforcement of money judgment is through writ of execution) with Fed. R. Civ. P. 70(e) (contempt available for failure to obey judgment for a specific act).

[82] See, e.g., Huffman, 996 F.2d 800, 802–03 (5th Cir. 1993).

[83] The SEC’s ability to obtain an equitable preliminary asset freeze at the start of an enforcement case would also be doubtful whenever the SEC could not identify the specific assets representing the fruits of the securities law violation because the Supreme Court has held that such preliminary equitable remedies are not available to secure assets prior to trial where a plaintiff seeks only legal relief in the form of a money judgment. See Grupo Mexicano v. Alliance Bond Fund, 527 U.S. 308, 321 (1999); SEC v. ETS Payphones, Inc., 408 F.3d 727, 734 (11th Cir. 2005) (distinguishing Grupo Mexicano on the ground that disgorgement is an equitable remedy).

 

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Why Are Foreign Investments in Domestic Energy Projects Now Under CFIUS Scrutiny?

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Stephen Heifetz and Michael Gershberg*

Until recently, the Committee on Foreign Investment in the United States (CFIUS or the Committee) rarely affected domestic energy projects. That has changed, and CFIUS now actively reviews and sometimes alters transactions that result in foreign control of U.S. energy companies. In just the past several months, CFIUS has blocked an acquisition of Oregon wind farm projects (the Ralls/Terna case),[1] reportedly imposed conditions on the acquisition of a large oil and gas company (the CNOOC/Nexen case),[2] and approved an acquisition of a high-tech battery manufacturer only after the deal was restructured to carve out its government contracting business (the Wanxiang/A123 case).[3]

There are three primary drivers behind this recent scrutiny. The first is the rise of China—on the one hand as a trading and investment partner, and on the other hand, as a perceived security threat. Each of the three CFIUS cases referenced above concerned Chinese investments in domestic energy projects.[4] The second driver is U.S. government concern about the vulnerability of U.S. infrastructure, particularly to a cyber attack on U.S. networked systems, such as energy grids and other energy-related assets. The third driver is a change in the balance among the agencies that comprise CFIUS. In particular, the Department of Defense has sought aggressively to use the Committee’s authority to keep potential foreign adversaries far away from U.S. security facilities, while the more trade-oriented agencies have been weakened in CFIUS deliberations.[5]

CFIUS Background

CFIUS is an interagency committee chaired by the Department of Treasury.[6] Its mandate is to review foreign investments in U.S. businesses to ensure that such investments do not adversely affect national security.[7] More specifically, CFIUS reviews transactions that result in foreign “control” of U.S. businesses where that foreign control may affect national security.[8]

Though the Committee often reviews more than one hundred cases per year,[9] it typically sees potential security implications in only a dozen or so.[10] In those cases, CFIUS generally protects against possible adverse effects by obtaining commitments from the foreign investor. These commitments, which take the form of a “risk mitigation agreement,” may include such requirements as the use of specified vetting procedures for key employees or restrictions on foreign access to sensitive technology or facilities.[11] When CFIUS cannot mitigate the risk presented by a transaction through an agreement, its recourse is to recommend that the President block the transaction.[12] The President is authorized to “take such action for such time as the President considers appropriate to suspend or prohibit any covered transaction that threatens to impair the national security of the United States.”[13] CFIUS recommendations to the President are very rare, usually no more than one or two per year.[14] In those rare cases, if the parties do not voluntarily withdraw the transaction, the President is likely to follow the Committee’s recommendations to preclude foreign control of the U.S. business. Transacting parties have forced a Presidential decision only twice in the Committee’s history, and in both cases the President exercised his authority to block the transaction.[15]

However, there is a significant benefit to undergoing CFIUS review from the perspective of the transacting parties. If CFIUS approves the deal, as it does in the vast majority of cases, then the deal is insulated from executive branch interference on national security grounds.[16]

The CFIUS process is nominally voluntary. There is no requirement that parties conducting transactions involving foreign entities notify CFIUS, even when those transactions result in foreign control or clearly involve assets relevant to national security.[17] However, the Committee monitors a wide range of transactions, primarily through open media sources. If a “non-notified transaction” is of interest to CFIUS, the Committee will offer the parties the opportunity to submit a notification.[18] In the event that transacting parties ignore the “voluntary” submission request, CFIUS has authority to initiate a review of a transaction on its own.[19] A notice filed by the parties will invariably put the transaction in a better light than if the parties refuse to submit a notice and the Committee undertakes a review on its own accord.

The Committee’s attention to non-notified transactions, which has grown over the last few years, incentivizes transacting parties to err on the side of voluntarily notifying CFIUS for several reasons. First, when CFIUS requests a notification in the absence of a voluntary notice, the parties begin the CFIUS process with an air of distrust. These transactions receive additional scrutiny—both because CFIUS already has decided that the transaction may raise national security concerns and because CFIUS generally is suspicious that the parties deliberately sought to avoid review. Second, because CFIUS generally requests notice only after the transaction has closed, there is greater commercial risk if CIFIUS rejects the deal or if it imposes burdensome conditions. There is no opportunity in such cases for the parties to restructure the transaction in a way that helps address the Committee’s concerns. Third, there is greater risk that CFIUS will reject a non-notified transaction or impose very burdensome conditions, because CFIUS often finds it more difficult to mitigate national security risks after a transaction has closed.

The current state of affairs with regard to CFIUS regulation can be summarized as follows: CFIUS has significant power over foreign investments in U.S. companies, and provides strong incentives for transacting parties to voluntarily submit to a review. Considering this background, we can identify several factors that have driven recent Committee attention to domestic energy projects.[20]

The Rise of China

China’s emergence as a world power has been accompanied by concerns about Chinese espionage directed at the United States. For example, an October 2012 report by the U.S. House Permanent Select Committee on Intelligence alleged that investments by Chinese telecommunications equipment companies Huawei and ZTE presented significant national security risks.[21] A February 2013 report by the security company Mandiant Corporation alleged that the Chinese government sponsored cyber espionage.[22] In March 2013, the U.S. National Security Advisor alleged that Chinese entities are the sources of “sophisticated, targeted theft of confidential business information and proprietary technologies through cyber intrusions emanating from China on an unprecedented scale.”[23] In addition, the U.S. Government has recently accused the Chinese military of launching cyber attacks against U.S. government and private networks.[24]

At the same time, the flow of Chinese direct investment into the U.S.—one indicator of the U.S.-China economic relationship—has been growing rapidly, from $129 million in 2006, to $1.9 billion in 2009, to $6.5 billion in 2012.[25] This trend has resulted in more instances of Chinese investment in U.S. energy projects and companies. With China joining the United States as the world’s biggest consumers of energy,[26] the development of energy projects should be an arena for extensive investment and collaboration between the two world powers. In fact, in President Obama’s first year in office, the Administration announced multiple cooperative energy development measures with China and there have been regular follow-on efforts.[27]

Yet extensive collaboration also can give rise to conflict, leading the U.S. to view China as a strategic threat as well as a partner. This threat has led CFIUS to closely examine recent Chinese investment in U.S. energy projects. Such transactions present concerns such as U.S. energy security, China’s ability to infiltrate U.S. power systems, the transfer of key technology to China, and the proximity of foreign-controlled projects to sensitive military facilities.

Infrastructure Vulnerability

In recent years, the energy sector has become a focus of national security concerns, along with traditional security-related areas such as defense, telecommunications, and high technology. As the power grid is increasingly reliant on electronic systems, energy projects are now a main point of vulnerability to the United States. Other energy projects may present national security implications for reasons of energy independence or the valuable technology involved. Accordingly, the 2007 amendments to the CFIUS statute stressed the importance of the energy sector.[28] Among the list of factors CFIUS must consider in its proceedings are “the potential national security-related effects on United States critical infrastructure, including major energy assets,” and “the long-term projection of United States requirements for sources of energy and other critical resources and material.”[29]

The CFIUS cases referenced at the outset of this article—Ralls/Terna, CNOOC/Nexen, and Wanxiang/A123—all involved Chinese investments in energy companies that, from the perspective of CFIUS, represented potential national security vulnerabilities.[30] The acquisition by Chinese-owned Ralls Corp. of assets from Greek-owned Terna concerned wind farm projects that would connect to a regional electric grid and that were near a Department of Defense flight facility.[31] The CNOOC acquisition of Canadian energy company Nexen involved oil platforms in the Gulf of Mexico that the Department of Defense viewed as strategic locations.[32] Wanxiang’s purchase of A123, a high-tech battery manufacturer, stalled until the parties decided that Wanxiang would not acquire A123’s defense-related business.[33]

In other words, CFIUS viewed many of the assets at issue as potentially exploitable to the detriment of U.S. security. Coupled with U.S. concern about China as an espionage threat and source of cyber attacks, each case presented a combustible mixture. Fortunately, CFIUS ultimately approved the CNOOC/Nexen and Wanxiang/A123 cases in early 2013.[34] However, in both cases the parties reportedly had to undertake substantial commitments to ensure CFIUS approval. In CNOOC/Nexen, CNOOC apparently was obligated to agree to a broad range of security measures concerning Nexen’s oil platform assets in the Gulf of Mexico.[35] In Wanxiang/A123, Wanxiang agreed to carve out pieces of A123’s business that were of importance to the U.S. government.[36] On the other hand, the President blocked the Ralls/Terna deal in September 2012 because, due to the proximity to U.S. defense facilities, the President found that the Chinese owners “might take action that threatens to impair the national security of the United States.”[37]

Changing Balance Within CFIUS

CFIUS decisions ultimately are made by individual representatives from the separate agencies that comprise the Committee. These individuals—bright, dedicated, and committed to the national interest—discuss each CFIUS case among themselves.[38] They gather in person at least once each week and continue their dialog through emails and by phone. These individuals each bring to bear their own experiences, knowledge, and interests. They also are obligated to represent the views of their agencies, and act consistently with their agencies’ missions, while serving on CFIUS.[39]

For example, a cyber attack that shuts down a city’s power would concern personnel at the Department of Homeland Security more than personnel at the Office of the United States Trade Representative (USTR). Conversely, if the United States enters into a counterproductive trade dispute, it would directly affect personnel at USTR much more than at the Department of Homeland Security. In addition, the relevant personnel are held accountable by pressure and potential fallout—from inside their agencies, Congress, and the press—if their areas of expertise lead to a compromise of national security. That is not to say that concerns are strictly limited in this way, but it is a rough approximation of how representatives from each of the agencies behave. An additional layer of complexity results from the varied views on an issue shaped by Committee members’ personal experience and the agency positions for which they advocate.

Accordingly, representatives from the more security-focused agencies—the Departments of Homeland Security, Justice, and Defense—typically are more hawkish in Committee deliberations than are representatives from other agencies. On the other hand, representatives from the Departments of State and Commerce and USTR are often focused on commercial, trade, and diplomatic interests. In the past, this latter group generally defended these interests strongly. In CFIUS deliberations they argued in favor of approving deals that the hawkish agencies sought to scuttle or burden with conditions. In their view, the trade or diplomatic benefits of international commercial transactions and an open investment environment outweighed many concerns raised by the security agencies.

Recently, however, the trade-oriented agencies have been more muted in CFIUS deliberations. This change may be a function of the particular individuals involved in the deliberations (since the cast of individuals changes over time), or a function of policy concerns at their agencies. The State Department, for example, recently has been playing a critical role on U.S. policy vis-à-vis Iran. That may make some bureaucracies within the State Department more hawkish, which may in turn create different incentives for the State Department’s CFIUS representatives. By many accounts, the representatives from the trade-oriented agencies recently appear less inclined to challenge their security-focused counterparts.

The Department of Energy plays a unique role in CFIUS because it has an interest in security, trade, and the promotion of renewable energy. Yet in recent cases involving Chinese investments in U.S. energy projects—where the Department of Energy could potentially play a leading role—its trade and environmental interests were insufficient for it actively to challenge the security-focused agencies.

At the same time, the Department of Defense, in particular, has leveraged CFIUS authority as a way to keep potential foreign adversaries away from U.S. government security facilities.[40] Defense representatives on the Committee have argued aggressively that any advantage that a potential foreign adversary might gain from U.S. investment—for example, by acquiring a company with access to an important network that could be used for a cyber attack—must be nullified. The result is occasionally the scuttling of the deal entirely, either voluntarily by the parties or by Presidential order as in the Ralls/Terna case.[41]

Conclusion

With counter-arguments from trade-oriented agencies now muted or absent, the hawkish agencies are determining CFIUS outcomes in cases where there are security concerns. The rise of China has brought increased Chinese investment in the United States, including energy-related investments. With this investment, however, have come security concerns, particularly regarding Chinese espionage. Coupled with concerns about infrastructure vulnerability, these dynamics have given rise to an increased number of difficult CFIUS cases that have involved domestic energy projects.

 

Preferred citation: Stephen Heifetz & Michael Gershberg, Why Are Foreign Investments in Domestic Energy Projects Now Under CFIUS Scrutiny?, 3 Harv. Bus. L. Rev. Online 203 (2013), https://journals.law.harvard.edu/hblr//?p=3356.

* Stephen Heifetz and Michael Gershberg are members of Steptoe & Johnson LLP’s International Regulation and Compliance Practice in Washington, D.C. Mr. Heifetz represented the Department of Homeland Security on CFIUS from 2006–10. This Article draws from the authors’ personal experience with CFIUS.

[1] See Regarding the Acquisition of Four U.S. Wind Farm Project Companies by Ralls Corporation, 77 Fed. Reg. 60,281 (Oct. 3, 2012).

[2] Roberta Rampton & Scott Haggett, CNOOC-Nexen Deal Wins U.S. Approval, Its Last Hurdle, Reuters, Feb. 12, 2013, available at http://www.reuters.com/article/2013/02/12/us-nexen-cnooc-idUSBRE91B0SU20130212. CFIUS proceedings are related documents are kept strictly confidential pursuant to statutory requirement. See 50 U.S.C. app. § 2170(c) (2012). Therefore, with few exceptions, there is no official public information on the results of CFIUS proceedings. However, details of newsworthy cases are often reported in the press.

[3] Michael Bathon, Wanxiang Wins U.S. Approval to Buy Battery Maker A123, Bloomberg (Jan. 30, 2013), http://www.bloomberg.com/news/2013-01-29/wanxiang-wins-cfius-approval-to-buy-bankrupt-battery-maker-a123.html.

[4] See Andrew Zajac, Ralls Sues to Void U.S. Wind-Farm Purchase Obama Blocked, Bloomberg (Jan. 29, 2013), http://www.bloomberg.com/news/2013-01-29/ralls-sues-to-void-u-s-wind-farm-purchase-obama-blocked.html; Rampton & Haggett, supra note 2; Bathon, supra note 3.

[5] The authors’ discussion of the Committee’s changing balance draws from personal experience.

[6] See 50 U.S.C. app. § 2170(k). The agencies statutorily charged with CFIUS obligations are the Departments of Treasury, Homeland Security, Commerce, Defense, State, Justice, Energy, Labor (as a non-voting member), and the Office of the Director of National Intelligence (also a non-voting member). Id. In addition, by executive order, the Office of the United States Trade Representative (USTR) and the Office of Science and Technology Policy both regularly participate in the Committee. See Exec. Order No. 13,456 § 3(b), 73 Fed. Reg. 4677, 4677 (Jan. 23, 2008).

[7] See 50 U.S.C. app. § 2170(k).

[8] CFIUS regulations define “control” of a U.S. business quite loosely—virtually any foreign ability to cause a company to act (or not to act) in a particular manner constitutes foreign control. See 31 C.F.R. § 800.204 (2012). However, at least “control” is defined. Whether a transaction may affect national security, though subject to a statutory “factors test,” is virtually indefinable. See 50 U.S.C. app. § 2170(f). The amorphous quality of the national security inquiry is underscored by the last statutory factor: “such other factors as the President or the Committee may determine to be appropriate.” Id. § 2170(f)(11).

[9] See Comm. on Foreign Inv. in the U.S., Annual Report to Congress CY 2011 2 (Dec. 2012), http://www.treasury.gov/resource-center/international/foreign-investment/Documents/2012%20CFIUS%20Annual%20Report%20PUBLIC.pdf.

[10] See id. at 18 (“From 2009 through 2011, 22 cases (eight percent) resulted in the use of legally binding mitigation measures.”).

[11] These commitments are embodied in risk mitigation agreements between the government and the acquiring parties. See 50 U.S.C. app. § 2170(l)(1) (authorizing mitigation agreements).

[12] See Exec. Order No. 13,456 § 6(c), 73 Fed. Reg. 4677, 4678–79 (Jan. 23, 2008).

[13] 50 U.S.C. app. § 2170(d)(1).

[14] See generally Comm. on Foreign Inv. in the U.S., supra note 9, at 3 (indicating that “there were no transactions that resulted in a Presidential decision”).

[15] In October 2012, the President blocked Ralls’ acquisition of Oregon wind farm projects. See Regarding the Acquisition of Four U.S. Wind Farm Project Companies by Ralls Corporation, 77 Fed. Reg. 60,281 (Oct. 3, 2012). In February 1990, the President blocked China National Aero-Technology Import and Export Corporation’s acquisition of aircraft parts manufacturer MAMCO Manufacturing, Inc. See Order Pursuant to Section 721 of the Defense Production Act of 1950, 55 Fed. Reg. 3935 (Feb. 6, 1990).

[16] See 50 U.S.C. app. § 2170(b)(1)(D). See also Edward M. Graham & David M. Marchick, U.S. National Security and Foreign Direct Investment 33–58 (2006).

[17] A “notice” to CFIUS initiates the CFIUS review process. See 31 C.F.R. § 800.401 (2012). Notices are virtually always submitted jointly by the parties to the transaction that is subject to CFIUS review because the regulations require submission of information related to both parties.

[18] Id. § 800.401(b).

[19] Id. § 800.401(c).

[20] While the Committee’s attention to domestic energy projects has been limited until recently, one notable exception was the Chinese National Offshore Oil Corporation’s (CNOOC) proposed acquisition of Unocal Oil Company in 2005. See Francesco Guerrera, CNOOC at Odds with Congress over Unocal Deal, Fin. Times (July 26, 2005), http://www.ft.com/intl/cms/s/0/07ca91da-fdfc-11d9-a289-00000e2511c8.html. CNOOC withdrew its bid for Unocal, as well as its CFIUS notice, amid U.S. political pressure. See Ben White, Chinese Drop Bid To Buy U.S. Oil Firm, Wash. Post (Aug. 3, 2005), http://www.washingtonpost.com/wp-dyn/content/article/2005/08/02/AR2005080200404.html. The House of Representatives enacted a non-binding resolution opposing the transaction and stating that CNOOC’s planned acquisition of Unocal “would threaten to impair the national security of the United States.” See H.R. Res. 344, 109th Cong. (2005). A bill was introduced in the Senate to prohibit the sale and the House passed an amendment to an appropriations bill that would have prohibited CFIUS from approving the deal. See S. Res. 1412, 109th Cong. (2005); H.R. Res. 3058, 109th Cong. (2005).

[21] See U.S. House of Representatives Permanent Select Comm. on Intelligence, 112th Cong., Investigative Report on the U.S. National Security Issues Posed by Chinese Telecommunications Companies Huawei and ZTE 44–46 (Oct. 8, 2012), available at http://intelligence.house.gov/sites/intelligence.house.gov/files/documents/Huawei-ZTE%20Investigative%20Report%20%28FINAL%29.pdf.

[22] Mandiant, APT1: Exposing One of China’s Cyber Espionage Units (Feb. 2013), http://intelreport.mandiant.com/Mandiant_APT1_Report.pdf.

[23] Thomas Donilon, Nat’l Sec. Advisor to President Obama, The United States and the Asia-Pacific in 2013 (Mar. 11, 2013) (transcript available at http://asiasociety.org/new-york/complete-transcript-thomas-donilon-asia-society-new-york).

[24] David E. Sanger, U.S. Blames China’s Military Directly for Cyberattacks, N.Y. Times (May 6, 2013) http://www.nytimes.com/2013/05/07/world/asia/us-accuses-chinas-military-in-cyberattacks.html?pagewanted=all&_r=0 (citing U.S. Department of Defense report on Military and Security Developments Involving the People’s Republic of China).

[25] See Chinese Investment Monitor, Rhodium Group, http://rhg.com/interactive/china-investment-monitor (last visited Apr. 20, 2013).

[26] Spencer Swartz & Shai Oster, China Tops U.S. in Energy Use, Wall St. J. (July 18, 2010), http://online.wsj.com/article/SB10001424052748703720504575376712353150310.html.

[27] See, e.g., U.S. Dep’t of Energy, U.S.-China Clean Energy Cooperation (Jan. 2011), available at http://energy.gov/sites/prod/files/USChinaCleanEnergy_0.PDF.

[28] Foreign Investment and National Security Act of 2007, Pub. L. No. 110-49, 121 Stat. 246 (2007).

[29] Id. § 4.

[30] See Zajac, supra note 4; Rampton & Haggett, supra note 2; Bathon, supra note 3.

[31] See Helene Cooper, Obama Orders Chinese Company to End Investment at Sites Near Drone Base, N.Y. Times, Sept. 29, 2012, at A16, available at http://www.nytimes.com/2012/09/29/us/politics/chinese-company-ordered-to-give-up-stake-in-wind-farms-near-navy-base.html.

[32] See Sara Forden & Rebecca Penty, Nexen Rigs Near U.S. Military Base May be Issue in CNOOC Review, Fin. Post (Dec. 12, 2006), http://business.financialpost.com/2012/12/06/nexen-rigs-near-u-s-military-base-may-be-issue-in-cnooc-review/?__lsa=a706-0039.

[33] Erin Ailworth, A123 Deal Hangs on Secretive Federal Panel, Bos. Globe (Jan. 9, 2013), http://www.bostonglobe.com/business/2013/01/09/deal-hangs-secretive-federal-panel/92R7hEpT6Jrgdsod9txw8M/story.html.

[34] See Rampton & Haggett, supra note 2; Bathon, supra note 3.

[35] See Rebecca Penty & Sara Forden, CNOOC Said to Cede Control of Nexen’s U.S. Gulf Assets, Bloomberg (Mar. 1, 2013), http://www.bloomberg.com/news/2013-03-01/cnooc-said-to-cede-control-of-nexen-s-u-s-gulf-assets.html.

[36] See Bathon, supra note 3.

[37] Regarding the Acquisition of Four U.S. Wind Farm Project Companies by Ralls Corporation, 77 Fed. Reg. 60,281, 60,281 (Oct. 3, 2012).

[38] The authors’ discussion of the Committee’s changing balance draws from practical experience.

[39] While the day-to-day CFIUS participants represent the views of their agencies, certain actions require the approval of high-level political appointees. See 50 U.S.C. app. § 2170(b)(1)(F), (b)(2)(D)(ii), (b)(3)(C)(iv)(II).

[40] See, e.g., Memorandum from Davis Graham & Stubbs LLP & Reed Smith LLP to Nw. Non-Ferrous Int’l Co. & Firstgold Corp. (Dec. 14, 2009), available at http://graphics8.nytimes.com/packages/images/nytint/docs/memo-regarding-the-sale-of-firstgold-corp/original.pdf.

[41] Regarding the Acquisition of Four U.S. Wind Farm Project Companies by Ralls Corporation, 77 Fed. Reg. at 60,281.