Harvard Business Law Review (HBLR)

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New Margin Requirements for Uncleared Swaps

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Craig Stein & Paul N. Watterson, Jr.*

One of the fundamental changes that the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”)[1] made in the financial markets has been to force most over-the-counter swap transactions onto exchanges and impose regulations on transactions that remain uncleared by a central counterparty.  At the same time, laws and regulations adopted by the European Commission and other nations have imposed similar, but by no means identical, requirements on swap markets outside the United States.  This article reviews one aspect of these changes in the over-the-counter swap markets:  the new margin requirements for uncleared swaps.  Because margin for uncleared swaps has to date been set by each dealer in negotiations with individual customers, the transition to margin requirements imposed by regulators is likely to be difficult.  There have also been predictions that the discrepancies between the margin requirements proposed by U.S. regulators and those proposed by regulators outside the U.S. will result in fragmentation of the uncleared swap markets.

I.          Background

The Dodd-Frank Act, enacted on July 21, 2010,[2] requires swap dealers, major swap participants, security-based swap dealers and major security-based swap participants (each, a “swap entity” and, collectively, “swap entities”) to register with the Commodity Futures Trading Commission (“CFTC”) or the Securities and Exchange Commission (“SEC”).[3]  The Dodd-Frank Act also requires the Office of the Comptroller of the Currency Treasury (“OCC”), the Board of Governors of the Federal Reserve System (“Board”), the Federal Deposit Insurance Corporation (“FDIC”), the Farm Credit Administration (“FCA”) and the Federal Housing Finance Agency (“FHFA”) (collectively, “the Prudential Regulators”) to adopt joint rules for swap entities under their respective jurisdictions imposing initial and variation margin requirements on all swaps not cleared by a central counterparty (“CCP”).[4]  The Dodd-Frank Act also requires the CFTC and the SEC separately to adopt rules imposing margin requirements for swap entities for which there is no Prudential Regulator.[5]

In April 2011, the CFTC proposed rules to implement the foregoing provisions of the Dodd-Frank Act,[6] and two weeks later the Prudential Regulators proposed substantially similar rules.[7] The SEC is not expected to propose similar rules for security-based swaps until next year.  Before these rules became effective, in July 2012, the Basel Committee on Banking Supervision (“BCBS”) and the board of the International Organization of Securities Commissions (“IOSCO”) proposed an international framework for margin requirements on uncleared swaps with the goal of creating an international standard for uncleared swaps.[8]  This international framework, finalized in September 2013[9], articulates eight key principles for uncleared swaps margin rules:[10]

  1. Appropriate margining practices should be in place with respect to all uncleared derivative transactions;
  2. Financial firms and systemically important non-financial entities (covered entities) that engage in non-centrally cleared derivatives must exchange initial and variation margins;
  3. The methodologies for calculating initial and variation margins should be consistent across covered entities and ensure that all counterparty risk exposures are covered with a high degree of confidence;
  4. To ensure that collateral will generate proceeds sufficient to protect against losses in the event of a counterparty default, collateral should be highly liquid and should, after accounting for an appropriate haircut, be able to hold its value in a time of financial stress;
  5. Initial margin should be exchanged on a gross basis and held in such a way as to ensure that: (a) the margin collected is immediately available to the collecting party in the event of the counterparty’s default; and (b) the collected margin is subject to arrangements that fully protect the posting party;
  6. Requirements for transactions between affiliates are left to the national supervisors;
  7. Requirements for margining uncleared swaps should be consistent and not duplicative across jurisdictions; and
  8. Margin requirements should be phased in over an appropriate period of time.

In September and October 2014, the CFTC[11] and the Prudential Regulators[12] re-proposed rules for margin requirements for uncleared swaps (the “CFTC Proposal” and the “PR Proposal,” respectively).  In reproposing the rules, the regulators clearly took into account the BCBS/IOSCO framework, but nonetheless there are important discrepancies between the proposed rules and the framework.

II.         Scope of Coverage

The BCBS/IOSCO framework applies to all uncleared OTC derivatives.[13]  The PR Proposal imposes initial and variation margin requirements on prudentially regulated swap entities such as registered swap dealers that are U.S. or foreign banks (“PR Covered Swap Entities”) entering into uncleared swaps and security-based swaps with the types of counterparties discussed below.[14] PR Covered Swap Entities would be required to post and collect initial and variation margin when facing these counterparties even if the counterparties themselves are not subject to regulation under the Dodd-Frank Act.[15]  The Prudential Regulators are proposing to adopt what they refer to as a risk-based approach.[16]

The CFTC Proposal imposes initial and variation margin requirements on swap dealers and major swap participants that are not regulated by a Prudential Regulator, such as registered swap dealers that are not U.S. or foreign banks (“CFTC Covered Swap Entities”).[17]  The CFTC Proposal generally applies only to uncleared swaps.  However, deliverable foreign exchange forwards and foreign exchange swaps are not considered swaps under the Commodity Exchange Act as amended by the Dodd-Frank Act for purposes of uncleared swap margin requirements, as determined by the U.S. Department of Treasury in 2012.[18] As a result, PR Covered Swap Entities may be required to pay variation margin for foreign exchange forwards and foreign exchange swaps while CFTC Covered Swap Entities will not be required to pay it.[19]

III.        Counterparties

Both the PR Proposal and the CFTC Proposal distinguish among four different types of swap counterparties:

  1. Counterparties that are themselves PR Covered Swap Entities;
  2. Counterparties that are financial end users with a material swaps exposure;
  3. Counterparties that are financial end users without a material swaps exposure; and
  4. All other counterparties.[20]

The PR Proposal provides a list of entities that would qualify as financial end users[21] as well as a list of entities excluded from that definition.[22]  It is not consistent with the definition of a “financial entity” in Section 2(h) of the Commodity Exchange Act[23], which on its own is likely to cause confusion in the markets. In addition, the enactment of the Business Risk Mitigation and Price Stabilization Act of 2015 (the “RMPS Act”) on January 13, 2015 appears to have heightened the significance of such confusion.  By way of background, the RMPS Act amends sections 731 and 764 of the Dodd-Frank Act to provide that rules with respect to initial and variation margin requirements adopted by the CFTC, the SEC and the Prudential Regulators will not be applicable to entities that qualify for the end-user exception to the mandatory clearing requirement set forth in section 2(h)(7)(A) of the Commodity Exchange Act and corresponding section 3C(g)(1) of the Securities Exchange Act.  This statutory exemption  is available to any entity that: (i) is not a financial entity; (ii) uses swaps to hedge or mitigate commercial risk; and (iii) notifies the CFTC regarding the manner in which it generally meets its financial obligations in respect of uncleared swaps.  The “is not a financial entity” condition is with reference to the definition of “financial entity” set forth in section 2(h)(7)(C) of the CEA.  However, in an attempt to avoid difficulties experienced in determining which market participants should qualify as “financial entities” pursuant to the statutory language, the CFTC and the Prudential Regulators sought in the PR Proposal and the CFTC Proposal to provide clarity about whether particular entities would be subject to the margin rules by including in the reproposed rules the alternative concept of “financial end user.”  But at the time of this writing, considering that the RMPS Act specifically refers to “financial entity” instead of “financial end user”, it is unclear whether the CFTC and the Prudential Regulators will continue to rely in the final rules on the current definition of “financial end user” or will instead conform to the statutory definition of “financial entity”.

Under the PR Proposal, financial end users include banks; credit unions; broker-dealers, investment advisers, CPOs, CTAs or FCMs; investment funds, including a private fund under Section 202(a) of the Investment Advisers Act; investment vehicles operating in reliance on Section 3(c)(5)(C) or Rule 3a-7 of the 1940 Act; and insurance companies.[24]  “Financial end user” is defined in the CFTC Proposal in substantially the same way as in the PR Proposal[25], but there are slight differences.

In the PR Proposal and the CFTC Proposal, “material swaps exposure” is defined to mean that a counterparty has a consolidated average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps with all other counterparties for June through August of the previous year that exceeds $3 billion.[26]

The definition of financial end users is so broad that it will require exceptions to be made, either in the final rules or in no-action letters, in order to avoid unintended disruptions of markets.  For example, it includes securitization vehicles[27], and these entities do not currently post margin on uncleared swaps and in most cases are prohibited by their transaction documents and rating agency criteria from doing so.  Structured finance transactions where the swap counterparty is either secured by a senior claim on pledged collateral held by a special purpose vehicle or is otherwise entitled to a senior priority claim on the assets of the special purpose vehicle do not pose systemic risk to the broader market.  Such credit support arrangements protect swap counterparties without the use of initial margin or variation margin as required under the proposed rules.

IV.         Margin Requirements by Counterparty

PR Covered Swap Entities must collect and post a minimum amount of initial margin when entering into an uncleared swap with any other PR Covered Swap Entity and with any financial end user that has a material swaps exposure.[28]  Variation margin requirements would apply to swap transactions where a PR Covered Swap Entity enters into a trade with another PR Covered Swap Entity or a financial end user (regardless of whether the financial end user has a material swaps exposure).[29]  A PR Covered Swap Entity may make its own credit judgment about whether to collect initial margin or variation margin from other types of counterparties based on the credit risk posed by the counterparty and the risks of such swaps or security-based swaps.[30]

The CFTC Proposal requires CFTC Covered Swap Entities to post and collect initial margin for uncleared swaps from any counterparty that is a CFTC Covered Swap Entity or financial end user with material swaps exposure.[31]  A CFTC Covered Swap Entity must post and collect variation margin in transactions with another CFTC Covered Swap Entity or a financial end user (regardless of whether the counterparty has material swaps exposure).[32]  There is no requirement for CFTC Covered Swap Entities to exchange margin with non-financial end users.  However, CFTC Covered Swap Entities are permitted to agree to initial and variation margin requirements and thresholds with such non-financial end users.

This aspect of the proposed rules represents a departure from the BCBS/IOSCO framework, under which initial margin is not required to be posted or collected by entities with an average daily aggregate notional amount of uncleared swaps below approximately $11 billion.[33]

V.          Initial Margin Calculation Methodology

For initial margin, the PR Proposal would require a PR Covered Swap Entity to calculate its minimum initial margin requirement in one of two ways.  It may use a standardized margin schedule set forth in the PR Proposal, or it may use an internal margin model that satisfies criteria set forth in the PR Proposal and has been approved by the Prudential Regulator.[34]  Like the PR Proposal, the CFTC Proposal permits CFTC Covered Swap Entities to calculate initial margin by using either a risk-based model or a standardized table method.[35]

In their comment letters, many swap market participants argued that each covered swap entity should be permitted to use its proprietary initial margin model, rather than being required by the proposed rules to use a model from a vendor or clearing organization or a model that has been approved by the Prudential Regulators.[36]

VI.         Calculating Variation Margin

Unlike the PR Proposal, the CFTC Proposal requires control mechanisms for the calculation of variation margin.[37]  A CFTC Covered Swap Entity must create and maintain documentation setting forth its calculation methodology to allow the counterparty, the CFTC and any Prudential Regulator to calculate a reasonable approximation of the margin requirement independently.[38]  It is also required to evaluate the reliability of its data sources at least annually and make adjustments, as appropriate.[39]  In addition, the CFTC Proposal requires a CFTC Covered Swap Entity to have in place alternative methods for determining the value of an uncleared swap in the event of the unavailability of any input required to value a swap, and the CFTC may at any time require a CFTC Covered Swap Entity to provide further data or analysis concerning the methodology or data source used to value a swap for variation margin purposes.[40]

VII.        Thresholds

Under the PR Proposal, initial margin must be posted and collected on a daily basis (with the collection and posting of initial margin beginning no later than the business day following the day of entry into the swap) in response to changes in portfolio composition or other factors that would change the required initial margin amounts.[41]  PR Covered Swap Entities are permitted to adopt a maximum initial margin threshold of $65 million, below which they need not collect or post initial margin from or to other PR Covered Swap Entities or financial end users with material swaps exposure.[42]  The threshold would be applied on a consolidated basis and would apply both to the consolidated PR Covered Swap Entity as well as to the consolidated counterparty.[43]  With respect to variation margin, no threshold amounts would be permitted; but a minimum transfer amount of $650,000 is permitted (the minimum transfer amount applies to all margin posted, initial and variation margin combined).[44]  Variation margin also would be required to be posted and collected on a daily basis.[45]

The CFTC Proposal, like the PR Proposal, permits a CFTC Covered Swap Entity to reduce the amount of initial margin by a threshold amount that is established by the CFTC Covered Swap Entity but that may be no greater than $65 million.[46]  The initial margin threshold amount must be applied on a consolidated basis.  Initial margin must be posted and collected on a daily basis commencing on or before the business day after execution of an uncleared swap.[47]

Swap market participants have objected to these standardized thresholds, arguing that instead the rules should permit each covered swap entity to determine the relevant thresholds for its counterparties, subject to regulatory review.[48]

VIII.       Eligible Collateral

Although the BCBS/IOSCO framework does not distinguish between forms of initial and variation margin collateral[49], the proposed rules permit a wide variety of securities to be delivered as initial margin while restricting variation margin to cash.  Under the PR Proposal, eligible collateral is limited to high-quality assets that are expected to remain liquid and retain their value, after accounting for an appropriate risk-based haircut.  Eligible collateral for variation margin is limited to cash in U.S. dollars or the currency in which payment obligations under the swap are required to be settled.[50]  Eligible collateral for initial margin includes cash, U.S. treasuries and agencies, certain foreign government debt securities, certain corporate debt securities, certain listed equities or gold.[51]  The value of any eligible collateral that is collected and held to satisfy initial margin requirements is subject to the haircuts described in the PR Proposal.[52]  A PR Covered Swap Entity is required to monitor the market value and eligibility of all collateral to satisfy the initial margin requirements.[53]  To the extent that the market value of such collateral has declined or if it is no longer eligible collateral, the PR Covered Swap Entity must promptly collect additional eligible collateral.[54]

The list of eligible collateral (including haircuts) in the CFTC Proposal is substantially the same as in the PR Proposal.[55]  CFTC Covered Swap Entities also are required to monitor the market value and eligibility of all collateral collected to satisfy initial margin requirements.

This is another aspect of the proposed rules where swap market participants have commented that the rules should permit covered swap entities to determine eligible collateral and relevant haircuts for such collateral, subject to regulatory review.[56]

IX.         Custodial Agreements and Segregation

Under the PR Proposal, initial margin must be segregated at custodians that are not affiliates of the PR Covered Swap Entity or the counterparty.[57] On the other hand, variation margin is not required to be segregated at an independent third-party custodian.[58]  The segregation requirement applies only to the minimum amount of initial margin that a PR Covered Swap Entity is required to collect from a swap entity or a financial end user with material swaps exposure; however, it applies to all collateral (other than variation margin) that the PR Covered Swap Entity posts to any counterparty.[59]  The custodial agreement must prohibit rehypothecating, repledging, reusing or otherwise transferring any of the funds the third-party custodian holds.[60]  Substitution of collateral and reinvestment of posted collateral is permitted.[61]  Unlike initial margin, variation margin may be rehypothecated by the recipient.[62]

Similar to the PR Proposal, the CFTC Proposal requires any initial margin posted by a CFTC Covered Swap Entity, and the initial margin that is required to be collected by a CFTC Covered Swap Entity, to be held by an independent third-party custodian.[63]  The CFTC Proposal, like the PR Proposal, requires the custodian agreement to limit rehypothecation and to permit substitution and reinvestment of collateral.

Under the BCBS/IOSCO framework, the customer has the option to segregate initial margin[64] and the customer may consent to rehypothecation.[65]  The PR Proposal and the CFTC Proposal are therefore more restrictive than the BCBS/IOSCO framework since under the PR Proposal and the CFTC Proposal segregation is required and rehypothecation is prohibited.

In comment letters swap market participants have expressed a desire to continue the current practice, which these segregation requirements would ban, of allowing parties to agree that the custodian for their margin will be an affiliate of either counterparty.[66]

X.          Interaffiliate Swaps

The PR Proposal and the CFTC Proposal do not provide an exemption from these margin requirements for uncleared swap transactions between affiliates.  The BCBS/IOSCO framework left the decision to national supervisors[67], so if national supervisors outside the United States provide an exemption, it could place U.S. entities at a competitive disadvantage.

The exemption of inter-affiliate swaps is an issue that swap market participants, particularly global financial entities that have historically used back-to-back swaps to consolidate and manage market risk exposures centrally at a single affiliate, have consistently (and almost universally) requested.[68]  The generally expressed rationale for such an exemption is that inter-affiliate swaps do not increase systemic risk because losses on a trade that accrue to one affiliate are equally offset by gains to the affiliate on the other side of the trade, resulting in a net wash for the consolidated entities.  So posting of collateral for inter-affiliate swaps is not necessary to control systemic risk.

XI.         Netting and Treatment of Legacy Trades

Under the PR Proposal and the CFTC Proposal, the margin amounts posted and received for transactions made under an eligible master netting agreement could be fully netted.  While the margin requirements would not be applicable to trades entered into prior to the effective date of the new rules, if such “legacy” trades were made under the same master netting agreement as new trades made after the effective date, such legacy trades would be required to satisfy the new margin requirements.[69]

The proposal by the U.S. regulators to condition grandfathering of legacy trades on the documentation of those swaps under separate eligible master netting agreements from new swaps, would increase credit risk and systemic risk by reducing the netting of trades.[70]  Cross-product portfolio margining arrangements across cleared and uncleared swaps and other non-derivative products remain a critical issue for market participants.[71]

XII.        Trading Documentation

The PR Proposal requires the trading agreements between a PR Covered Swap Entity and a counterparty that is either another PR Covered Swap Entity or a financial end user to include credit support provisions that meet the requirements of the rule.[72]  Such credit support arrangements must specify the methods, procedures, rules and inputs for determining the value of each swap and contain dispute resolution procedures.[73]  In contrast, the CFTC Proposal requires CFTC Covered Swap Entities to enter into trading agreements that contain such credit support provisions with all uncleared swap counterparties, including non-financial end users.[74]

CFTC rules and regulations already require swap trading documentation to include methods, procedures, rules and inputs for swap valuation and a valuation dispute resolution process and disclosure of the methodology and assumptions used to prepare the daily mark.[75]  The proposed rules are duplicative and impose additional documentation requirements related to valuation that are unnecessary and will be burdensome for swap market participants.

XIII.       Effective Dates

If the proposed rules are implemented, as currently drafted, PR Covered Swap Entities and CFTC Covered Swap Entities will need to comply with the margin requirements for swaps entered into on or after December 1, 2015 with respect to variation margin.[76] For initial margin the compliance date is December 1, 2015 if both the PR Covered Swap Entity (and its affiliates) or the CFTC Covered Swap Entity (and its affiliates), as applicable, and the counterparty (and its affiliates) have an average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps for June through August 2015 that exceeds $4 trillion.[77]  However, if a party has a lower volume of uncleared swap and foreign exchange trading, the effective date is deferred to December 1, 2016, if for June through August 2016 such volume exceeds $3 trillion; December 1, 2017, if for June through August 2017 it exceeds $2 trillion; and December 1, 2018, if for June through August 2018 it exceeds $1 trillion.[78]  The new requirements will become effective for all counterparties on December 1, 2019.[79]

It is unlikely that the final rules will be finalized before mid-2015.  As a result, market participants will have very little time before the December 1, 2015 deadline to put the necessary legal, operational, risk management and technology in place to implement these new regulations.  A deferral of the proposed effective dates is needed to provide additional time after the finalization of the rules is necessary to ensure a smooth and efficient implementation of the rules.

However, on March 18, 2015 the BCBS and IOSCO jointly announced that the implementation schedule set forth in the international framework was being extended by nine months.  In addition, the requirement to exchange variation margin was made subject to a six month phase-in period.[80]  The U.S. regulators have not yet officially followed suit, but CFTC Commissioner Timothy Massad has been quoted as stating that the CFTC is also considering pushing back its implementation timeline by a matter of months.[81]

XIV.        Extraterritoriality

The PR Proposal excludes any foreign non-cleared swap or foreign non-cleared security-based swap of a foreign covered swap entity.[82]  A “foreign non-cleared swap” is an uncleared swap of a foreign covered swap entity where neither the counterparty nor any guarantor of either party is:  (1) organized under the laws of the United States or any state (including a U.S. branch, agency or subsidiary of a foreign bank); (2) a branch or office of an entity organized under the laws of the United States or any state; or (3) a PR Covered Swap Entity controlled by an entity organized under the laws of the United States or any state.[83] A “foreign covered swap entity” is a PR Covered Swap Entity that is not:  (1) organized under the laws of the United States or any state (including a U.S. branch, agency or subsidiary of a foreign bank); (2) a branch or office of an entity organized under the laws of the United States or any state; or (3) a PR Covered Swap Entity controlled by an entity organized under the laws of the United States or any state.[84]  In addition to the foregoing exclusion, the PR Proposal would permit “substituted compliance”:  Foreign covered swap entities could meet the requirements of the rule by complying with the requirements of a non-U.S. regulator in the event that a comparability determination is made by the Prudential Regulators, provided that the covered swap entity’s obligations under the swap are not guaranteed by a U.S. entity.[85]

Unlike the PR Proposal, the CFTC Proposal does not include exemptions to its margin requirements for transactions outside the United States markets.  The CFTC Proposal includes an advance notice of proposed rulemaking and asks for public comment on alternative approaches including:  (1) application of the rules according to the PR Proposal; or (2) application of the uncleared swap margin CFTC rules according to the “transaction-level requirements” of the CFTC’s earlier cross-border guidance or the “entity-level requirements.”[86]

One issue on which all swap market participants agree is “harmonization”:  margin rules should be consistent across different jurisdictions and within the United States or, at a minimum, require a transaction to comply with only one jurisdiction’s rules where such harmony is lacking.[87]  In the U.S., the SEC has yet to re-propose its rules on margin.  And with respect to the CFTC Proposal, there has been no determination to permit substituted compliance for non-U.S. margin rules that are consistent with the BCBS/IOSCO framework.  Substituted compliance is necessary to avoid having margin rules from two different jurisdictions with inconsistent requirements applying simultaneously to the same collateral transfer.

Swap market participants have argued that swaps between non-U.S. covered swap entities and non-U.S. counterparties should not be subject to the U.S. margin rules, even if such entities are affiliated with U.S. companies.[88]  The definition of what is a “non-U.S.” entity is also crucial:  non-U.S. covered swap entities should include non-U.S. branches, offices, subsidiaries and other non-U.S. affiliates of U.S. entities, and non-U.S. counterparties should include non-U.S. funds or other entities with a U.S. advisor and non-U.S. entities guaranteed by a U.S. entity.

XV.         Impact of Re-Proposed Margin Rules

Margin requirements today are established through bilateral negotiations between a dealer and its counterparty, and two-way margining is not current market practice for many participants in the swap market.  As a result, market participants will be required to make changes in longstanding business practices as well as significant investments to improve their collateral infrastructure. Collateral account control agreements with third-party custodians will need to be negotiated. Systems will need to be updated to support the new margin calculations, and reporting capabilities will need to be enhanced to track collateral.

Mandatory margin requirements are expected to lead to higher costs and reduced liquidity for uncleared swaps.  Since initial margin will not be permitted to be rehypothecated, industry participants will need a consistent supply of eligible collateral, which may result in a shortage of, and possibly a squeeze on, eligible collateral.  Counterparties may be increasingly reliant on transformation services if this shortage of eligible assets develops; dealers providing transformation services will lend eligible collateral to counterparties for a fee.

In addition, risk may also increase as the cost of customizing risk management tools will increase, causing counterparties to use more standardized swaps, which are less tailored to reduce the specific risks to which counterparties are exposed.  Risk will concentrate at central counterparty clearing houses as trades move away from the more expensive uncleared swaps market.  Such concentration at the central counterparties may have adverse consequences if risk management is not improved at central counterparties.  If the margin requirements for uncleared swaps become too costly, the markets for uncleared swaps may become disrupted and no longer viable, thereby adversely affecting the ability of market participants to manage risk effectively.

XVI.        Conclusion

ISDA estimates that as much as $1 trillion of new collateral may need to be posted if the rules for margin for uncleared swaps proposed by the CFTC and Prudential Regulators are adopted.[89]  This increased collateral demand would have a significant impact on financial markets.  While most swap market participants generally support measures to reduce risk in the swaps markets and incentivize clearing of swaps, many have expressed concerns that the proposed rules will have unintended consequences that will increase systemic risk and disrupt these markets.  The rules need to appropriately address the particular risks posed by uncleared swap transactions.  As currently proposed, the margin rules for uncleared swaps may be too costly and punitive.  If the market for uncleared swaps loses its viability, market participants will not be able to manage risk effectively.  Market participants need a well-functioning market for uncleared swaps in order to meet their trading and risk management needs, which often require the customized transactions which exchanges cannot by their nature offer.

 

Preferred citation: Craig Stein & Paul N. Watterson, Jr., New Margin Requirements for Uncleared Swaps, 5 Harv. Bus. L. Rev. Online 114 (2015), https://journals.law.harvard.edu/hblr//?p=4029.

* Craig Stein is a partner and co-head of the Structured Finance & Derivatives Group at Schulte Roth & Zabel LLP.  His practice focuses on swaps and other derivative products, including credit- and fund-linked derivatives, prime brokerage and customer trading agreements, and structured finance and asset-backed transactions.  Paul N. Watterson, Jr. is a partner and co-head of the Structured Finance & Derivatives Group at Schulte Roth & Zabel LLP.  He concentrates his practice on structured product and derivative transactions, the formation and representation of credit funds, and capital markets regulation.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Public L. No. 111-203, 124 Stat. 1376 (2010).

[2] Id.

[3] See 7 U.S.C. § 6s(a) (2012); 15 U.S.C. § 78o-10(a).

[4] See 7 U.S.C. § 6s(e)(2)(A)(ii); 15 U.S.C. § 78o-10(e)(2)(A)(ii).

[5] See 7 U.S.C. § 6s(e)(2)(B)(ii); 15 U.S.C. § 78o-10(e)(2)(B)(ii).

[6] Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23,732 (Apr. 28, 2011).

[7] Margin and Capital Requirements for Covered Swap Entities, 76 Fed. Reg. 27,564 (May 11, 2011).

[8] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Consultative Document: Margin requirements for non-centrally-cleared derivatives (2012).

[9] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives (2014).

[10] See id. at 5.

[11] Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,898 (Oct. 3, 2014).

[12] Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,348 (Sept. 24, 2014).

[13] Except, the Framework does not apply for physically settled foreign exchange forwards and swaps. See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 7 (2014).

[14] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,350.

[15] See id. at 57,354.

[16] See id.

[17] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,902.

[18] Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 77 Fed. Reg. 69,694 (Nov. 20, 2012).

[19] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,351.

[20] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,398; Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,926.

[21] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,360.

[22] See id. at 57,362.

[23] See 7 U.S.C. § 2(h)(7)(C)(i).

[24] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,390.

[25] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,926.

[26] See id. at 59,927 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,391.

[27] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,903 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,361.

[28] See Margin and Capital Requirements for Covered Swap Entities,79 Fed. Reg. at 57,391.

[29] See id. at 57,392.

[30] See id. at 57,391,  57,392.

[31] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,928.

[32] See id.

[33] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 10 (March 2014).

[34] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,393.

[35] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,929.

[36] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); SIFMA Comment Letter addressed to Prudential Regulators (March 12, 2014).

[37] See 79 Fed. Reg. at 59,931.

[38] Id.

[39] Id.

[40] Id.

[41] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,391.

[42] See id. at 57,390.

[43] See id. at 57,366.

[44] See id. at 57,392.

[45] See id.

[46] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,927 (defining initial margin threshold amount).

[47] See id. at 59,928.

[48] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (July 11, 2011); ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); SIFMA Asset Management Group Comment Letter addressed to the CFTC (September 28, 2012).

[49] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 17 (March 2014).

[50] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,392.

[51] See id.

[52] See id.

[53] See id.

[54] See id.

[55] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,931.

[56] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012).

[57] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,393.

[58] Seeid. at 57,356.

[59] See id. at 57,393.

[60] See id.

[61] See id.

[62] See id.

[63] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932.

[64] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 20 (March 2014).

[65] See id. at 21.

[66] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012); ISDA Comment Letter addressed to the Prudential Regulators (November 24, 2014); Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[67] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 22 (March 2014).

[68] See e.g. SIFMA Comment Letter addressed to the Prudential Regulators (March 12, 2014); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012).

[69] See Margin and Capital Requirements for Covered Swap Entities,79 Fed. Reg. at 57,392.

[70] See Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[71] See e.g. Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 26, 2012); Managed Funds Association Comment Letter addressed to the CFTC (July 11, 2011); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012).

[72] See Margin and Capital Requirements for Covered Swap Entities,79 Fed. Reg. at 57,395.

[73] See id. at 57,382.

[74] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932.

[75] See, e.g., 17 CFR 23.504.

[76] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,388.

[77] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,389.

[78] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,388.

[79] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,389.

[80] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 24 (2015)
available at  http://www.bis.org/bcbs/publ/d317.pdf.

[81] Philip Stafford, Hopes quashed of two-year delay for new swaps rules, Financial Times (Mar. 11, 2015), http://www.ft.com/intl/cms/s/0/15a8496e-c80e-11e4-8210-00144feab7de.html?siteedition=intl#axzz3UYwoM5Rn.

[82] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,395.

[83] See id.

[84] See id.

[85] See id.

[86] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,916.

[87] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (July 11, 2011); SIFMA Asset Management Group Comment Letter addressed to the Prudential Regulators (November 26, 2012); Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[88] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (July 11, 2011); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012); ISDA / SIFMA Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[89] ISDA/ SIFMA Joint Comment Letter addressed to the Prudential Regulators (July 6, 2011).

By

Why The Lack of Interest in Interest? Another Look at Preferences and Secured Creditors

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Samuel D. Krawiecz*

I.          Introduction

The Bankruptcy Code (sometimes referred to herein as the Code) disallows preferential payments made to creditors.[1] Bankruptcy preference law “ha[s] been hailed as ‘the single greatest contribution of the Bankruptcy Act to the field of commercial law.’”[2] Preference law is “designed to prohibit insolvent debtors, on the eve of filing for bankruptcy, from paying off their debts held by ‘preferred’ creditors—those creditors whom the soon-to-be bankrupts wish to favor.”[3] One purpose the preference provisions serve is that of “facilitat[ing] the prime bankruptcy policy of equality of distribution among creditors of the debtor.”[4] The other purpose of preference law is to discourage creditors “from racing to the courthouse to dismember the debtor during his slide into bankruptcy.”[5] This gives the debtor an opportunity to rescue his business and remove it from insolvency.[6]

The preference rule has five elements.[7] The payment must be (1) a transfer to a creditor, (2) for the benefit of an antecedent debt, (3) while the debtor was insolvent, (4) within ninety days of the filing of the petition (unless the creditor is an insider), and (5) the payment must “enable[] such creditor to receive more than such creditor would receive” in a Chapter 7 liquidation.[8] This Article will analyze how the fifth and last element is applied, particularly with regard to fully secured creditors.

II.         The Hypothetical Liquidation Test

The fifth element is sometimes called the “hypothetical liquidation test.”[9] The full text of paragraph 547(b)(5) reads:

[T]he trustee may avoid any transfer of an interest of the debtor in property . . .
(5) that enables such creditor to receive more than such creditor would receive if—
(A) the case were a case under chapter 7 of this title;
(B) the transfer had not been made; and
(C) such creditor received payment of such debt to the extent provided by the provisions of this title.[10]

A court must “construct a hypothetical chapter 7 case and determine what the creditor would have received if the case proceeded under chapter 7.”[11]

A.         Secured v. Unsecured Creditors

Generally, an unsecured creditor receiving a prepetition payment will have received more than in a chapter 7 liquidation.[12] This is true because, in a typical bankruptcy, the distribution made to unsecured creditors is less than 100% of their outstanding debt. Therefore, “any payment . . . will enable [an unsecured] creditor to receive more than” in a liquidation.[13]

The opposite rule holds true for secured creditors.[14] Prepetition payments to a fully secured creditor “generally ‘will not be considered preferential because the creditor would not receive more than in a chapter 7 liquidation.’”[15] This rule seems appropriate because the underlying rationale for preference law “appl[ies] to a lesser degree to creditors with fully secured claims.”[16] The fairness rationale does not apply in the case of a fully secured creditor because a fully secured creditor “is not required to share with other creditors on a pro rata basis” due to his security interest and there is less fear of a fully secured creditor “dismember[ing] a financially unsound debtor” because he is certain of his payment to the extent of his security interest.[17]

B.       Application of the Hypothetical Liquidation Test

When applying the hypothetical liquidation test, courts construct a counterfactual in which (1) there was a Chapter 7 liquidation proceeding, (2) the transfer was not made, and (3) the debtor’s debt was discharged pursuant to the Bankruptcy Code.[18] The court then estimates how much the creditor would receive in the hypothetical case, which I will refer to as Scenario B, for the debt that was repaid with the allegedly preferential payment.[19] If this amount is lower than the amount of the prepetition payment, what we will call Scenario A, then the fifth prong of the preference analysis is satisfied.[20]

The hypothetical is not “conducted in a vacuum.”[21] For example, when a creditor has a contract with the debtor, a court must estimate whether the contract would be assumed or rejected before concluding whether the prepetition payment benefitted the creditor.[22] When making this assessment, courts do not mechanically construct and apply a Chapter 7 liquidation model, but take into account the “actual facts of the case.”[23] The hypothetical “assume[s] that [all] persons would act in a commercially reasonable and businesslike manner.”[24]

III.      Post-Petition Interest and the Hypothetical Liquidation Test: Why Secured Creditors Are Usually “Preferenced”

Although courts consider issues such as liquidation costs and contract assumption, they do not consider post-petition interest when performing the hypothetical liquidation test.[25] For example, consider the effect of post-petition interest[26] on a fully secured creditor with a $1 million debt, a $1 million security interest in the debtor, and the ability to receive a semi-annual interest rate of 4%. In Scenario A, he receives a $1 million cash payment on January 1 and the debtor files for bankruptcy on February 1 of the same year. Because the money is in the creditor’s hands and not subject to the automatic stay, he will employ this cash and receive a semi-annual interest rate of 4%. This will result in him earning forty thousand dollars every six months.

In Scenario B, a court would hypothesize either that the money was returned before February 1 or never paid to the creditor and the debtor then files for Chapter 7 on February 1. The creditor will then submit a claim for $1 million. However, even though he is fully secured, he will not receive interest until the conclusion of the Chapter 7 proceedings. In a liquidation proceeding with “extensive or complex litigation”, the case can take years.[27] Supposing it takes half a year, he will receive $1 million in six months’ time in Scenario B; in Scenario A, he will have $1.04 million.[28]

Another way of analyzing this is by comparing the present value of the payments in Scenario A and B.  In Scenario A, the payment is today and the present value would therefore equal the payment, or one million dollars.  In Scenario B, supposing the Chapter 7 takes six months, the present value of the million dollars is only $961,538.[29]  Secured creditors seem to “flunk” the hypothetical liquidation test. This analysis runs counter to the legal dogma that secured creditors are not preferenced by prepetition payments.[30]

A.         This Analysis Fits with the Statutory Text of Bankruptcy Code § 547(b)

The statutory language of the hypothetical liquidation test requires only that the prepetition payment “enable” the creditor “to receive more” than in hypothetical liquidation.[31] The term enable indicates that the analysis should encompass more than the prepetition payment itself. If Congress meant to limit the court’s consideration to the actual payment, it could have stated “(5) that is greater than such creditor would receive if . . . ” Additionally, the text of § 547 does not require that the benefit from the preference derive from the debtor themselves.[32]

B.         This Analysis Follows the “Not Conducted in a Vacuum” and “Commercially Reasonable and Businesslike Manner” Approaches Taken by Courts

Preference case law also supports a contextual approach to constructing the hypothetical liquidation.[33] In In re LCO Enterprises,[34] the question of whether a creditor benefitted from a prepetition payment depended on whether the creditor’s contract with the debtor would be assumed or rejected in Scenario B.[35] If assumed, the debtor would be obligated to cure any default,[36] the creditor would therefore be paid in full, and the payment would not be a preference.[37] In the actual facts of that case, the contract was assumed but the question the court was considering was whether that fact should affect the hypothetical test.[38]

The court began its analysis by invoking the Supreme Court’s ruling in Palmer Clay Products Co. v. Brown[39] that:

The preferential effect of the payment must be determined “not by what the situation would have been if the debtor’s assets had been liquidated and distributed among his creditors at the time the alleged preferential payment was made, but by the actual effect of the payment as determined when bankruptcy results.”[40]

This principle was applied in In re Tenna Corp.[41] to disregard a post-petition development of a super-priority in constructing the hypothetical liquidation.[42] Both cases seem to indicate that in a hypothetical liquidation, the court can only look at events as of the day of the filing.[43]

Despite this, the court in In re LCO Enterprises stressed that “the hypothetical liquidation . . . should not . . . be conducted in a vacuum,”[44] and that it “must be based on the actual facts of the case.”[45] The court therefore ruled that, because the contract was assumed, there was a legal obligation on the debtor to repay the debt in full and therefore there was no benefit to the creditor due to the prepetition payment.[46]

Just as a court can consider post-petition events such as a contract assumption,[47] so too it can consider the length of a hypothetical liquidation in determining the amount that would be received in that proceeding, relative to what a prepetition payment “enabled” a creditor to receive.

C.         Applying Preference Law to Payments to Secured Creditors Fits with the Rationale for Preference Law

Allowing secured creditors to receive prepetition payments and ignoring the practical benefits accruing to them due to the time value of money runs counter to the policy rationales underlying preference law. These reasons are described in the legislative history of section 547:

The purpose of the preference section is two-fold. First, by permitting the trustee to avoid prebankruptcy transfers that occur within a short period before bankruptcy, creditors are discouraged from racing to the courthouse to dismember the debtor during his slide into bankruptcy. The protection thus afforded the debtor often enables him to work his way out of a difficult financial situation through cooperation with all of his creditors. Second, and more important, the preference provisions facilitate the prime bankruptcy policy of equality of distribution among creditors of the debtor. Any creditor that received a greater payment than others of his class is required to disgorge so that all may share equally.[48]

Payments to secured creditors should be avoided pursuant to both of these reasons.

1.         The dismemberment fear

As noted in In re Fuel Oil Supply & Terminaling, Inc., there is an incentive, albeit reduced, even for secured creditors to obtain prepetition payments due to the time value of money.[49] If a bank has knowledge that a debtor is having financial difficulties and may need to enter bankruptcy, there is a very real incentive for them to try to force the debtor to use whatever cash is available to pay their debts. Their alternative, in the real world, is to wait for the conclusion of a Chapter 11 proceeding. Although Congress is attempting to shorten the duration of Chapter 11 cases by limiting the period of exclusivity for debtors to file plans of reorganization,[50] even a secured creditor must fear that his money will be tied up for the duration of the proceedings. If there are many creditors, the case can take a long time.[51] Thus, the first rationale for preferences applies to secured creditors as well.

2.         The fairness concern

Additionally, fairness should dictate that payments to secured creditors are avoidable preferences. First, as the Ninth Circuit formulated the fairness argument, preference law was meant to “prohibit insolvent debtors, on the eve of filing for bankruptcy, from paying off their debts held by ‘preferred’ creditors—those creditors whom the soon-to-be bankrupts wish to favor.”[52] Given the interest of a creditor in avoiding having his money tied up in a bankruptcy, this consideration is very real even for secured creditors. Supposing a debtor has several secured creditors with claims of one million dollars, and the debtor has only one million in cash, he can favor a “preferred” creditor by paying them the cash and allowing them to avoid waiting out the ensuing bankruptcy.

Additionally, there is a fairness concern that prepetition payment to a secured creditor will result in less money for the other creditors, secured or otherwise. Allowing the debtor to keep its cash means that the debtor, and not the secured creditor, will capture the benefit of the time value of money. This value can be obtained either by lending out the money, or, as is more likely, if the debtor needs the cash to operate in bankruptcy, keeping its cash allows the debtor to avoid obtaining expensive debtor-in-possession financing. Thus, avoiding prepetition payments for secured creditors “facilitate[s] the prime bankruptcy policy of equality of distribution among creditors of the debtor.”[53]

IV.         Conclusion

Current case law clearly holds that payments made to a secured creditor are not voidable because the creditor was guaranteed to be repaid that amount, due to his security. However, this does not account for the real world practicality that receiving a prepetition payment is greatly beneficial to the secured creditor as it allows him to receive interest on that money during the pendency of the Chapter 11 proceedings.

The statutory text seems to allow for this consideration, as it states that a prepetition payment need only “enable” the creditor to receive more. Additionally, current bankruptcy doctrine has other instances where courts create a hypothetical scenario (such as would need to be created to account for post-petition interest) in analyzing if a creditor is better off.[54]

The underlying preference law rationale militates for such a rule as well. Allowing secured creditors to keep prepetition payments will lead to such creditors rushing the debtor and actually causing a filing, which is precisely the result preference law was meant to prevent.

 

Preferred citation: Samuel D. Krawiecz, Why The Lack of Interest in Interest? Another Look at Preferences and Secured Creditors, 5 Harv. Bus. L. Rev. Online 107 (2015), https://journals.law.harvard.edu/hblr//?p=4024.

* J.D., Harvard Law School, 2015. I am especially grateful to Professor Mark J. Roe for his thoughtful guidance and feedback.

[1] See 11 U.S.C. § 547 (2012).

[2] Isaac Nutovic, The Bankruptcy Preference Laws: Interpreting Code Sections 547(c)(2, 550(a)(1), and 546(a)(1), 41 Bus. Law. 175, 175 (1985) (quoting Maclachlan, Bankruptcy 284 (1956)).

[3] In re Taylor, 599 F.3d 880, 888 (9th Cir. 2010).

[4] Union Bank v. Wolas, 502 U.S. 151, 161 (1991) (quoting H.R. Rep. No. 95-595, at 177–78 (1977), reprinted in 1978 U.S.C.C.N. 5963, 6138).

[5] Union Bank, 502 U.S. at 161 (quoting H.R. Rep. No. 95-595, at 177–78 (1977), reprinted in 1978 U.S.C.C.N. 5963, 6138).

[6] See Union Bank, 502 U.S. at 161.

[7] See 11 U.S.C. § 547(b) (2012).

[8] See id.

[9] E.g., In re Friedman’s Inc., 738 F.3d 547, 555–56 (3d Cir. 2013).

[10] 11 U.S.C. § 547(b)(5).

[11] In re LCO Enters., 12 F.3d 938, 941 (9th Cir. 1993).

[12] See e.g., In re Powerine Oil Co., 59 F.3d 969, 972 (9th Cir. 1995).

[13] Id. This is because for the portion of debt that is paid prepetition, the unsecured creditor is being repaid at rate of 100%, as opposed to during a bankruptcy where unsecured creditors receive less than 100% for the entirety of their loan.

[14] See id.

[15] Id. (quoting 4 Collier on Bankruptcy ¶ 547.08, at 547–45 (Lawrence P. King ed., 15th ed. 1995)).

[16] See In re Fuel Oil Supply & Terminaling, Inc., 837 F.2d 224, 227 (5th Cir. 1988).

[17] See id.

[18] See e.g., In re Friedman’s, 738 F.3d at 556; In re Smith’s Home Furnishings, Inc., 265 F.3d 959, 963 (9th Cir. 2001).

[19] See In re Smith’s Home Furnishings 265 F.3d at 963.

[20] See id.

[21] In re LCO, 12 F.3d at 942.

[22] See id. at 941.

[23] See id. at 942–43.

[24] See In re ML & Assocs., Inc., 301 B.R. 195, 202 (Bankr. N.D. Tex. 2003).

[25] See e.g., In re LCO Enters., 12 F.3d at 942–44;  In re ML & Assocs., 301 B.R.  at 202–03. But see In re Fuel Oil Supply & Terminaling, Inc., 837 F.2d at 227 n.10 (noting that a fully secured creditor’s incentive to obtain prepetition payments is merely “reduced” but still present, partly because he “forgoes earning interest on the retained collateral during bankruptcy”).

[26] This argument applies only to the interest that could be earned after the filing. With regard to the interest between the preference and the filing though, there is no argument to say that there is a benefit. This is because the creditor’s claim is accruing interest even in Scenario B, which means that on the day of the filing, there is no difference between Scenarios A and B. In both cases, he will have a right to the one million dollars with its accompanying interest for January 1st through February 1st.

[27] See William J. Factor, When is Chapter 7 the Best Option for Liquidating a Business?, in Chapter 7 Commercial Bankruptcy Strategies 91, 97 (2010), available at 2010 WL 895211 (noting that “it can take longer than a decade to administer a case involving extensive or complex litigation claims”).

[28] This is equal to the one million dollars paid prepetition and an additional forty thousand dollars earned as interest over six months (1,000,000 x 1.04).

[29] This is equal to one million divided by 1.04.

[30] See e.g., In re Smith’s, 265 F.3d at 964.

[31] 11 U.S.C. § 547(b)(5).

[32] See id.

[33] A contextual approach, as opposed to a mechanical one, is crucial to this analysis. Most of the cases cited use this approach when constructing Scenario B (for example, by assessing if a contract will be assumed) while in this Essay’s analysis the main effect is in Scenario A. Just as courts look beyond the petition date when constructing Scenario B, this analysis looks at the length of the proceedings after the petition date to either discount the payment in Scenario B or to calculate interest that can be earned in Scenario A.

[34] 12 F.3d 938 (9th Cir. 1993).

[35] See id. at 941.

[36] See id. (citing 11 U.S.C. § 365(b)).

[37] See In re LCO Enters., 12 F.3d  at 941.

[38] See id. at 942.

[39] 297 U.S. 227 (1936).

[40] In re LCO Enters., 12 F.3d at 942 (quoting Palmer Clay, 297 U.S. at 229).

[41] 801 F.2d 819 (6th Cir. 1986).

[42] See id. at 823.

[43] See In re LCO, 12 F.3d at 942.

[44] See id. (quoting In re LCO Enters., 137 B.R. 955, 959 (B.A.P. 9th Cir. 1992)).

[45] See In re LCO, 12 F.3d at 940.

[46] See id. at 942.

[47] See id.

[48] H.R. Rep. No. 95-595, at 177–78 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6138.

[49] 837 F.2d at 227 n.10.

[50] See Bankruptcy Abuse Protection and Consumer Protection Act of 2005 § 411, 11 U.S.C. § 1121(d)(2) (2012).

[51] See M. Todd Henderson, Paying CEOs in Bankruptcy: Executive Compensation When Agency Costs are Low, 101 Nw. U. L. Rev. 1543, 1607 n.327 (“The average time a firm spends in Chapter 11 is about 18 months.”).

[52] In re Taylor, 599 F.3d at 888.

[53] H.R. Rep. No. 95-595, at 177–78 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6138.

[54] See supra, note 18.

By

The Sarbanes Oxley Privilege For Public Company Accounting Oversight Board Materials: Its Implications For SEC Enforcement Proceedings

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Andrew J. Morris*

I.         Introduction

In 2002, a wave of high-profile accounting scandals led Congress to pass the Sarbanes-Oxley Act—“SOX.”[1] In SOX, Congress created the Public Company Accounting Oversight Board—the “PCAOB”—and charged it to oversee the auditors of public companies.[2] The PCAOB soon began inspecting accounting firms. According to knowledgeable commentators, these inspections have significantly improved the audits of public-company financial statements.[3]

Recent developments, however, threaten to undermine one of the critical foundations of the PCAOB oversight program: the “SOX privilege.” This statutory privilege ensures that the details of PCAOB inspections and investigations remain confidential.[4] The threat to this privilege arises when the PCAOB shares information with other regulators, including the Securities and Exchange Commission (“SEC” or the “Commission”). SOX permits this sharing, but only on the express condition that the receiving regulator must preserve the SOX privilege.[5] SOX makes this condition quite plain, stating that regulators who accept privileged information from the PCAOB “shall maintain such information as confidential and privileged.”[6]

The problem is that some private litigants, some SEC staff, and at least one court do not read this simple mandate to mean what it says. They find it counterintuitive—and therefore hard to accept—that a statute would restrict the SEC’s use of information it obtains from the PCAOB. This resistance to the statutory language is apparent in Securities & Exchange Commission v. Goldstone, 301 F.R.D. 593 (D.N.M. 2014), the first judicial opinion on the issue. In Goldstone, the United States District Court for the District of New Mexico concluded that when the SEC brings enforcement actions, it can disclose privileged information received from the PCAOB.[7]

This article explains how Goldstone misreads SOX. Part I briefly outlines why the privilege is critical to the success of the PCAOB’s inspection regime, and Part II sketches its statutory basis. Part III explains how Goldstone undermines the SOX privilege and, in turn, threatens to weaken the entire PCAOB oversight regime. Part III then shows that Goldstone creates practical problems for the PCAOB, for the auditing profession it oversees, and paradoxically, for the SEC itself. Finally, Part IV suggests that, in order to resolve these issues, the SEC should adopt a formal policy relating to PCAOB materials that acknowledges the full force of the SOX privilege and establishes internal procedures for working with materials covered by the privilege.

II.         The SOX Privilege Provides Confidentiality That Is Critical to the PCAOB’s Successful Inspection Regime

A.          The Effectiveness of the PCAOB’s Predecessor Was Hampered by the Absence of a Privilege Protecting Its Inspections

During the hearings that led Congress to pass SOX, several prominent witnesses criticized the audit regulator at the time (the predecessor to the PCAOB) as “ineffective.”[8] One reason for this ineffectiveness, according to the regulator itself, was its inability to shield its oversight process from private litigants who wanted information for lawsuits against accounting firms.[9]

The SEC, after conducting its own study of audit regulation, also concluded that confidentiality was important to effective oversight. It wrote at the time that auditing firms “may be less forthcoming in responding to [an auditing regulator] inquiry if they believe that the information they provide will be made public or made available to private litigants.”[10] It also warned that a failure to ensure confidentiality could harm audit quality, injure accounting firms unfairly, and harm the shareholders of the companies involved.[11]

B.          The Privilege Created by SOX Enables the PCAOB to Conduct Inspections That Are Effective Because They Are Cooperative Rather Than Adversarial

Congress provided this confidentiality when it passed SOX and established an improved oversight regime. The cornerstone of this regime is the PCAOB’s inspection program,[12] which examines accounting firms responsible for auditing 98 percent of U.S. market capitalization.[13] This program relies on a process that is cooperative rather than adversarial, and the SOX privilege is critical to maintaining a cooperative, frank exchange of information between the regulator, and the regulated.

Each inspection involves extensive dialog between the PCAOB and the inspected firm.[14] In a typical inspection, the PCAOB inspectors select a sample of the firm’s audit engagements, review audit workpapers and other materials, talk to auditors and other firm representatives, and then provide criticisms and suggestions.[15] The inspectors and the firm then exchange oral and written comments, typically in several informal rounds.[16] Often the firm agrees to make auditing changes proposed by the inspectors.[17] Ultimately the PCAOB issues a final inspection report, which the firm can ask the SEC to review.[18]

Congress specifically chose this interactive and constructive process.[19] As the PCAOB has explained, SOX “reflects a legislative policy choice favoring the correction of quality control problems over the exposure of them.”[20] For this reason, it “generally seeks, in its inspection program, to encourage constructive engagement, rather than to put firms in a position where they will perceive that their self-interest is better served by an adversarial and confrontational posture.”[21]

Accounting firms can safely participate in this “constructive engagement” only if they know that their compromises with the PCAOB will remain confidential and, therefore, will not be cited against them as evidence that audit work was inadequate.[22] The SOX privilege provides the necessary confidentiality by shielding PCAOB inspection and enforcement details from disclosure to third parties (with a narrow exception that is described below).[23]

The privilege thus gives auditors an incentive to accept the PCAOB’s comments and adjust audit procedures to address them. Because the SOX privilege permits auditors to agree with PCAOB inspectors without fear of incurring liability, it is a linchpin of the cooperative regulatory scheme.

According to the PCAOB, this guarantee of confidentiality has contributed to the effectiveness of the inspection program.[24] By 2007, the PCAOB reported that it was increasingly able to “foster improvement in audit quality through the on-site dialogue the inspection process allows for, in addition to more formal findings in inspection reports and other oversight actions.”[25] The PCAOB also reported that firms have routinely agreed to “perform[] missed or additional auditing procedures” on specific audits, and to make changes “to the firm’s internal quality control processes and systems.”[26] It concluded that “the effectiveness and the efficiency of the Board’s programs are enhanced when firms opt for constructive engagement rather than an adversarial approach.”[27]

III.        SOX Expressly Requires the SEC to Preserve the Privilege When It Receives Privileged Material from the PCAOB

A.          Subparagraph (A) Of Section 105(b)(5) Establishes The SOX Privilege

Congress established the SOX privilege in SOX Section 105(b)(5).[28] Subparagraph 105(b)(5)(A), titled “Confidentiality,” sets out the privilege’s basic elements.[29] Subparagraph (A) begins with a carve-out (“Except as provided in subparagraphs (B) and (C) . . . .”),[30] which excludes material that the PCAOB passes along to other regulators. This material is governed by Subparagraphs (B) and (C), which are discussed in Part II.B below. [31]

Subparagraph (A) then identifies the broad range of material it does govern: “all documents and information prepared or received by or specifically for the Board, and deliberations of the Board and its employees and agents, in connection with an inspection . . . or with an investigation.”[32]

The subparagraph next describes the protection provided by the privilege: The SOX privilege shields the governed material from “civil discovery or other legal process” and from introduction into evidence.[33] It then identifies the broad range of forums where the privilege applies: “any proceeding in any Federal or State court or administrative agency.”[34]

Finally, Subparagraph (A) says how the privilege can be terminated.[35] It states that information remains privileged “unless and until presented in connection with a public proceeding or released in accordance with [SOX Section 105(c)].”[36] That subsection, titled “Disciplinary procedures,” addresses disciplinary PCAOB proceedings against auditors.[37]

B.          Subparagraph (B) Permits the PCAOB to Share Privileged Information with Other Regulators—But Only on the Express Condition That Those Regulators Preserve the Privilege

Next in SOX Section 105(b)(5), subparagraphs (B) and (C) govern the material carved out of subparagraph (A). They permit the PCAOB to share information with regulators in the United States (Subparagraph (B)) and elsewhere (Subparagraph (C)).[38]

Subparagraph (B), titled “Availability to Government agencies,” authorizes the PCAOB to share privileged material with “(i) [T]he Commission; [and] (ii) [other enumerated regulators, including] the Attorney General of the United States[,] State attorneys general, . . . state regulatory authorit[ies]; and [certain] self-regulatory organization[s] . . . .”[39] Crucially, however, it requires that those entities “maintain such information as confidential and privileged.”[40] This is the provision that binds the SEC to preserve the privilege for material it receives from the PCAOB.

IV.         The Court in SEC v. Goldstone Erred When It Held that the SEC Can Disclose Privileged Material Received from the PCAOB

In sum, SOX Section 105 permits the PCAOB to share privileged material with other regulators, but only on the condition that those regulators “maintain such information as confidential and privileged.”[41] The statutory language and structure are simple. Yet the one judicial opinion on the issue, SEC v. Goldstone, declines to enforce the statute as written.

A.          The Court Overrode SOX’s Plain Language to Create an Exception to the Mandate that the SEC “Shall Maintain” the Privilege

1.          The Goldstone Court’s Reading of the Statute

Goldstone was an SEC enforcement action against several officers of a registrant.[42] During the litigation’s discovery phase, the officers demanded that the SEC produce documents it had previously received from the PCAOB.[43] The PCAOB had generated these documents when it had investigated the registrant’s auditor.[44] Then, under the authority granted to it under Subparagraph (B) of SOX Section 105(b)(5), the PCAOB had transmitted the documents to the SEC during the SEC’s investigation of the registrant’s management.[45] When these documents were created, they were covered by the SOX privilege—a point not disputed by any party in Goldstone.[46]

The Goldstone defendants moved to compel the SEC to produce this material, arguing that it no longer was privileged.[47] They contended that the SEC had relied on the material when it drafted its complaint;[48] the defendants then pointed to the clause at the end of SOX Section 105(b)(5)(A) providing that the privilege is terminated if material is “presented in connection with a public proceeding.”[49] The defendants argued that the SEC had “presented” the material “in connection with a public proceeding” by relying on it to draft the complaint in the enforcement case. [50] The SEC opposed the defendants’ motion, in particular contending that it had not relied on the documents when it drafted the complaint in this case.[51]

The registrant’s auditor intervened in the litigation.[52] Like the SEC, the accounting firm opposed the defendants’ motion to compel.[53] But unlike the SEC,[54] the firm disputed the very first step in the defendants’ argument: The firm contended that SOX prohibited the SEC from disclosing the PCAOB documents whether or not the SEC had relied on them to draft the complaint.[55] In support, the firm cited Subparagraph (B)’s mandate that the SEC “shall maintain” SOX-privileged “information as confidential and privileged.”[56] It also pointed out that this mandate contains no exceptions.[57]

The court disagreed with the accounting firm and concluded that, despite this mandate, the SEC had the authority to disclose the material.[58] The court ultimately did not order the SEC to produce the documents, though only because it found that, as a factual matter, the SEC had not actually relied on them in the litigation.[59] But the damage to the SOX privilege was done, because the court had already concluded that the SEC has the authority to terminate the privilege.[60]

To reach this conclusion, the court first turned to the SOX clause stating that covered information remains privileged “unless and until presented in connection with a public proceeding or released in accordance with subsection (c).”[61] This clause is contained in Subparagraph (A), not Subparagraph (B), and is the only clause in the statute that addresses termination of the privilege. The court construed the word “proceeding” to refer, not only to PCAOB disciplinary proceedings, but also to SEC litigation. In other words, the court reasoned, this clause indicated that the SEC has the authority to terminate the SOX privilege by “presenting” privileged material in its own litigation.[62]

The court’s reading of this Subparagraph (A) clause to include SEC litigation was clear error, as explained below. But even in light of its reading of Subparagraph (A), the court still was confronted with Subparagraph (B)’s explicit mandate that the SEC “shall maintain” the privilege.[63] This mandate contains no written exceptions.[64]

The court proceeded to infer an exception that is unwritten. The court reasoned that it makes no sense to permit the SEC to receive privileged information from the PCAOB—as the first part of Subparagraph (B) permits—while also requiring the SEC to keep that information confidential—as the latter part of Subparagraph (B) requires.[65] The court explained its reasoning: “If the Attorney General or the SEC could never bring an action and present the information, there would be no useful reason to share the information.”[66]

Although the court also reasoned that “the ‘until presented’ language [in Subparagraph (A)] would not mean anything” if the SEC were not permitted to “present” PCAOB information in SEC litigation, the court reiterated that the decisive factor was the Subparagraph (B) provision permitting the PCAOB to share information with the SEC.[67] The court thus summed up: “The Court is not sure what benefit it would be for the PCAOB to share documents and information from its investigations or inspections,” as Subparagraph (B) permits, “if the SEC or other government agencies may not then use the information.”[68]

2.          Flaws in the Court’s Reasoning

The court’s discussion makes a hash of the statute. To begin, Subparagraph (A)’s “unless and until presented” clause does not apply to material that the PCAOB discloses to the SEC. That material is covered by Subparagraph (B), and Subparagraph (A) begins with the simple carve-out clause, “Except as provided in Subparagraph[] (B).” The court thus erred by even considering the “unless and until presented” clause.[69]

In any event, although the court cited this clause, the decisive factor for the court was Subparagraph (B)’s provision permitting the PCAOB to share privileged information with the SEC.[70] Based on the court’s view of the purpose of this sharing provision, the court overrode the plain text of the privilege requirement contained later in the same subparagraph—in fact, later in the same sentence. It did so based on its belief that a more sensible statute would permit the SEC to use PCAOB information in its own litigation. The court apparently concluded that, if Congress had thought about it, Congress would have created an exception permitting the SEC to use this information in enforcement matters.

This reasoning has no basis in the statute’s words or structure; it overrides both in pursuit of a better policy. And that pursuit rests on another error: the assumption that, unless the SEC can use PCAOB material in enforcement actions, it cannot use the material at all. But SOX does permit the SEC to use PCAOB materials for other purposes—purposes that are quite important. In particular, the SEC can use this information to inform its oversight of the PCAOB as well as to support its responsibility for rulemaking relating to financial-statement audits.[71] These uses do not require the Commission to break the SOX privilege. On the other hand, SOX itself shows that Congress was aware of the possible use for which the Goldstone court created an exception: litigation relating to the audits at issue.[72] Yet, Congress did not create an exception permitting use of PCAOB material in litigation outside the PCAOB.

Congress also knew that the SOX privilege does what every legal privilege does: It forbids the discovery and use of evidence that may be relevant in litigation.[73] Yet Congress chose to require regulators, specifically including the SEC, to preserve the SOX privilege.

The court’s reasoning suffers from one more flaw. Not only did the court override clear text based on a policy goal, it chose a policy goal that conflicts with the one that motivated the statute at issue. The court’s policy goal was to increase the SEC’s authority in enforcement cases, but the statute’s policy goal was to improve the oversight regime for financial-statement audits—and to do so by ensuring that PCAOB oversight activities remain confidential.[74] The Goldstone court’s conclusion works against that goal by opening a hole in the shield of confidentiality—thus working against Congress’s purpose in creating the SOX privilege in the first place.

B.          The Goldstone Holding Upsets the Information-Sharing Scheme Established by SOX and Works Against SOX’s Statutory Purpose

Applied to other cases, the Goldstone holding can lead to the disclosure of reams of PCAOB-related documents that, to date, have been shielded by the SOX privilege. When Subparagraphs (A) and (B) are read correctly—with no inferred exceptions—SOX-privileged information can be disclosed only by the PCAOB, and only in a specific, narrow context. This context is limited to final orders in PCAOB disciplinary actions that result in sanctions against an auditor or firm.[75] These orders disclose a limited amount of privileged information, because an order describes only the facts that are relevant to the final decision.[76] The PCAOB does not disclose any privileged documents at all.[77]

By contrast, the Goldstone reading of SOX permits the SEC to produce extensive amounts of privileged information. By producing PCAOB material in discovery, the SEC can disclose extensive documentary records otherwise covered by the SOX privilege: for example, entire histories of firm inspections, files of correspondence with auditors, and volumes of the extensive testimony that the PCAOB takes during its investigations. Once these documents are disclosed, they are available to any third party with access to a subpoena—indeed, once the documents have been disclosed, third parties could subpoena them directly from the SEC. Goldstone thus creates a glaring anomaly: It gives the SEC, and through it these unknown third parties, far broader authority to disclose PCAOB oversight materials than the statute gives the PCAOB itself.[78]

In sum, Goldstone re-creates the same problems that led SOX’s drafters to create the privilege in the first place, because it weakens the protection the privilege provides to accounting firms. This result works against Congress’ purpose in adopting the SOX privilege.[79]

C.         The Court’s Opinion Conflicts with the Stated Position of the PCAOB

Goldstone also presents the PCAOB itself with significant compliance and ethical issues, as well as complications in its relationship with the SEC. The PCAOB has stated that it reads SOX to prohibit agencies from disclosing privileged information that the PCAOB shares with them.[80] For this reason, the PCAOB already has warned that, if an agency did disclose privileged information, the PCAOB could exercise its discretion to decline to provide requested information or could “require appropriate assurances of confidentiality.”[81] Against this background, Goldstone puts the PCAOB in an uncomfortable bind.

V.         The SEC Should Adopt a Policy Stating That It Will Comply with Its Statutory Duty to Preserve the SOX Privilege

A.         The SEC Staff Has Taken Inconsistent Positions in Litigation

These problems are further complicated by the SEC’s own inconsistent positions on the SOX privilege. In Goldstone the SEC did not dispute that it has the authority to disclose material covered by the SOX privilege.[82] In another enforcement action, the Enforcement Division actually produced privileged information it had received from the PCAOB.[83] In yet another case, however, the SEC properly asserted that SOX Section 105(b)(5)(A) and (B) “expressly prohibit the Commission from turning [materials received from the PCAOB] over in discovery to anyone.”[84] This inconsistency creates various risks for the SEC. Among other problems, it could invite arguments that the Commission’s positions are arbitrary and capricious—arguments that conceivably could lead to reversal of a judgment in the SEC’s favor.[85]

B.         An Express SEC Policy Could Ensure Compliance with SOX and Restore Certainty to the Privilege Protection that Is Critical to the PCAOB’s Oversight Regime

Without waiting for the courts to correct Goldstone, the SEC can and should restore certainty to the SOX privilege by adopting a written policy that governs information it receives from the PCAOB. The policy should acknowledge the SEC’s statutory obligation to “maintain” covered information as “confidential and privileged.”[86] It should include a process through which senior staff evaluates the risks in each case before the SEC even requests privileged material from the PCAOB.

The policy also should include procedures to ensure that, once the SEC does take possession of privileged material, it can show that it did not waive the privilege. (Although the proper reading of SOX indicates that the SEC cannot waive the privilege, even inadvertently, litigating that point in multiple enforcement proceedings would be costly and wasteful.)[87] A policy should establish that SEC Staff will oppose any discovery demands for privileged material. The policy also should require the Staff to notify the PCAOB and the relevant accounting firm about any such demands.

Such a policy would not hinder the SEC’s enforcement efforts. Preserving the SOX privilege does not reduce access to the types of evidence the Enforcement Division routinely obtains in accounting cases, such as audit workpapers and auditor testimony.[88] And PCAOB-inspection materials have no real evidentiary value anyway; inspection reports are non-adjudicated statements that, as the PCAOB has warned, “are not intended to result in conclusive findings.”[89]

Nor would a policy preserving the SOX privilege cause any prejudice to the defense in SEC enforcement actions. Like the SEC, respondents would still have the rights to use the usual discovery tools.[90] And Section 105’s statement that privileged information is inadmissible as evidence protects respondents in administrative proceedings and defendants in civil litigation from use of this information against them.[91]

While such an SEC policy would not hinder either side in enforcement actions, its benefits would be substantial. It would ensure that SEC Staff take an informed, uniform position on the SOX privilege. It would give the Staff guidance about appropriate practices for working with PCAOB materials. And it could help avoid the substantial collateral litigation, as seen in Goldstone, that can flare up when the SEC possesses privileged information.

A written policy also would guide the proper development of the law. Most judges have no experience with the PCAOB, and they would give considerable weight to the view of the agency that exercise oversight over it.

An SEC policy also would guide other regulators to which the PCAOB may provide SOX-privileged information, including the Department of Justice, state attorneys general, and other regulatory bodies.[92] SOX Section 105(b)(5)(B) requires these regulators to preserve the privilege.[93] When these regulators analyze their privilege obligations under SOX, they are likely to give considerable weight to the views of the SEC, which is the agency with the most expertise on the issue.

Most importantly, by removing much of the uncertainty created by Goldstone and the SEC’s litigation positions, a policy would strengthen the PCAOB inspection system. It would assure the PCAOB that information it provides to the SEC will remain confidential. This assurance would, in turn, preserve the ability of auditing firms to cooperate fully and freely with the PCAOB without fear that their cooperation could be used against them. All of these developments would contribute to improved audit quality, which is the goal established by Congress and shared by the PCAOB and the SEC.[94]

 

Preferred citation: Andrew J. Morris, The Sarbanes Oxley Privilege For Public Company Accounting Oversight Board Materials: Its Implications For SEC Enforcement Proceedings, 5 Harv. Bus. L. Rev. Online 87 (2015), https://journals.law.harvard.edu/hblr//?p=3999.

* Andrew J. Morris is a partner in Morvillo LLP.

[1] Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002) (codified as amended in sections of 11, 15, 18, and 29 U.S.C.).

[2] See 15 U.S.C. § 7211(a) (2012) (“There is established the Public Company Accounting Oversight Board, to oversee the audit of companies that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.”)

[3] In 2014, PCAOB Member Lewis Ferguson stated that, “I think those of us in this business do have a sense that audit quality is improving.” Ken Tysiac, Regulators Suggest Firms Take Deep Dive Into Audit Quality, Journal of Accountancy (Apr. 10, 2014), http://www.journalofaccountancy.com/News/20149944.htm. In 2012, PCAOB Member Jeanette M. Franzel stated that, “[w]e’ve had many stakeholders and members of the profession tell us that they believe that auditor independence and audit quality have been strengthened since the passage of the Sarbanes-Oxley Act, and we also believe that audit quality has improved.” Jeanette M. Franzel, Member, PCAOB, Keynote Address at the American Law Institute Continuing Legal Education Conference: PCAOB: Protecting Investors and the Public Interest (Sep. 13, 2012) (transcript available at http://pcaobus.org/News/Speech/Pages/09132012_FranzelALICLEConference.aspx). In the same vein, a recent SEC Commissioner put it, “[t]hanks to the PCAOB’s work we have seen huge improvements in audit quality, investor confidence, and overall corporate governance.” Roel C. Campos, Comm’r, SEC, Remarks Before the SEC Open Meeting on the 2007 PCAOB Budget (Dec. 4, 2006) (transcript available at http://www.sec.gov/news/speech/2006/spch120406rcc.htm).

[4] 15 U.S.C. § 7215(b)(5)(A) (2012).

[5] 15 U.S.C. § 7215(b)(5)(B) (2012).

[6] Id.

[7] See SEC v. Goldstone, 301 F.R.D. 593, 666–71 (D.N.M. 2014).

[8] S. Rep. No. 107-205, at 5 (2002).

[9] See Accounting Reform and Investor Protection: Hearings Before the S. Comm. on Banking, Hous., and Urban Affairs, 107th Cong. 987 (2002) [hereinafter Hearings] (prepared statement of the Public Oversight Board) (reproducing white paper by the predecessor to the PCAOB, entitled The Road to Reform: A White Paper from the Public Oversight Board on Legislation to Create a New Private Sector Regulatory Structure for the Accounting Profession). Witnesses testifying before Congress agreed that privilege would make the investigatory and disciplinary functions of the new audit regulator more effective. See, e.g., Hearings, supra note 9, at 579 (statement of Joel Seligman, Dean, Washington University School of Law in St. Louis) (recommending that Congress create a new auditing regulator whose activities are protected by a “privilege from discovery of investigative files to facilitate auditing discipline during the pendency of other Government or private litigation”); S. Rep. No. 107-205, at 10 (2002) (“Committee witnesses also emphasized that information gathered by Board investigators should be ‘privileged from outsiders’ during the investigative process.”).

[10] Framework for Enhancing the Quality of Financial Information Through Improvement of Oversight of the Auditing Process, 67 Fed. Reg. 44,964, 44,987 (July 5, 2002) [hereinafter Proposed SEC Framework].

[11] See id. at 44,987 n.122.

[12] PCAOB, Statement Concerning The Issuance Of Inspection Reports, PCAOB Release No. 104-2004-001, at 2 (2004).

[13] Steven B. Harris, Member, PCAOB, Background on the PCAOB, Address at Kennesaw State Meeting of Graduate Students of Accounting (2013) (transcript available at http://www.pcaob.org/News/Speech/Pages/05162013_Kennesaw.aspx).

[14] See generally PCAOB, Report on the PCAOB’s 2004, 2005, 2006, and 2007 Inspections of Domestic Annually Inspected Firms, PCAOB Release No. 2008-008 (2008).

[15] See id. at 7–8.

[16] Id.

[17] Id.

[18] Id.

[19] See id. at 9–10 (outlining the “regular and comprehensive review” process, which entails inspectors preparing and providing draft reports to audit firms for review and comment before the report is finalized, and gives each firm twelve months within which to remedy quality control defects before the PCAOB issues a public report on those defects).

[20] PCAOB, The Process for Board Determinations Regarding Firms’ Efforts to Address Quality Control Criticisms in Inspection Reports, PCAOB Release No. 104-2006-077, 2 (2006).

[21] Id. at 8; see also PCAOB, 2006 Annual Report 10 (2007) (stating that SOX “reflects a legislative policy choice encouraging self-correction and is a cornerstone of the PCAOB’s supervisory oversight model”).

[22] See, e.g., Hearings, supra note 9, at 22 (testimony of David S. Ruder, former chairman of the SEC) (referring to the need for a privilege), 371 (testimony of John Biggs, member of the Public Oversight Board and Chairman, President, and CEO of TIAA–CREF) (same).

[23] See infra text accompanying notes 28–40.

[24] See, e.g., PCAOB, Observations on the Initial Implementation of the Process for Addressing Quality Control Criticisms Within 12 Months After an Inspection Report, PCAOB Release No. 104-2006-078, 2 (2006) (“The Board’s initial experience with the 12-month remediation process generally validates the premise of the approach set out by Congress . . . that firms could be genuinely motivated by the prospect of keeping the Board’s quality control criticisms confidential. . . . [T]he firms were responsive to the Board’s supervisory model, taking the initiative to engage constructively with the staff in an ongoing dialogue toward a result satisfactory to the Board, rather than emphasizing points of disagreement and taking an adversarial approach.”).

[25] PCAOB, 2007 Annual Report 3 (2008).

[26] PCAOB, 2008 Annual Report 9 (2009); see also Sarbanes-Oxley at Four: Protecting Investors and Strengthening Markets: Hearing Before the H. Comm. on Fin. Serv., 109th Cong. 72 (2006) (statement of then-PCAOB Chairman Mark Olson) (“When firms approach inspections with a cooperative attitude, the PCAOB has been able to achieve significant real-time improvements, often even before an inspection is concluded.”).

[27] See PCAOB Release No. 104-2006-077, supra note 20, at 8.

[28] See 15 U.S.C. §7215(b)(5) (2012).

[29] 15 U.S.C. §7215(b)(5)(A) (2012).

[30] Id.

[31] See infra text accompanying notes 38–40.

[32] 15 U.S.C. § 7215(b)(5)(A) (2012).

[33] Id.

[34] Id.

[35] SOX prohibits the PCAOB from disclosing SOX-privileged information in inspection reports that it makes public. See Sarbanes-Oxley Act of 2002 § 104(g)(2), 15 U.S.C. § 7214(g)(2) (2012). The PCAOB typically acknowledges this limitation on the first page of the public version of inspection reports, which state that “[p]ortions of the complete report are omitted from this document in order to comply with Sections 104(g)(2) and 105(b)(5)(A) of” SOX. See, e.g., Inspection of Aaron Stein, PCAOB Release No. 104-2008-126A, at 1 (July 31, 2008).

[36] 15 U.S.C. § 7215(b)(5)(A) (2014) (emphasis added).

[37] See Sarbanes-Oxley Act of 2002 § 105(c), 15 U.S.C. § 7215(c) (2012) (“Disciplinary procedures”). This provision refers to PCAOB disciplinary proceedings, which are confidential unless and until there is a settled order or, after hearing and exhaustion of appeals to the Board and the full Commission, there is a final finding of unprofessional conduct against an auditor. See id.

[38] See 15 U.S.C. §§ 7215(b)(5)(B), (C) (2012).

[39] SOX provides that the PCAOB is permitted to make covered information available to regulators other than the SEC only when the Board determines that making the information available is “necessary to accomplish the purposes of this Act or to protect investors.” Sarbanes-Oxley Act of 2002 § 105(b)(5)(B), 15 U.S.C. § 7215(b)(5)(B) (2012).

[40] Id. (emphasis added). Subparagraph (C) imposes a similar duty on the PCAOB; it requires PCAOB to obtain sufficient “assurances of confidentiality” from foreign regulators before disclosing privileged information. See 15 U.S.C. § 7215(b)(5)(C).

[41] Sarbanes-Oxley Act of 2002 § 105(b)(5)(B), 15 U.S.C. § 7215(b)(5)(B).

[42] SEC v. Goldstone, 301 F.R.D. 593, 593 (D.N.M. 2014).

[43] Id. at 607.

[44] Id.

[45] Id. at 608.

[46] Id.

[47] Id. at 607–08, 612.

[48] Id. at 608.

[49] Id. at 607–­08, 612.

[50] Id. at 608.

[51] Id. at 672–73.

[52] Id. at 616, 670–71  The court acknowledged that the auditor was a holder of the privilege. Id. at 670–71. But the court went on to conclude—incorrectly—that the SEC also was a holder of the privilege and therefore had the power to waive it. See id. at 671–72.

[53] Id. at 616, 670-71.

[54] The SEC did not dispute that it had the authority to disclose privileged material. See id. at 608, 613–15, 638, 640, 671; see also Plaintiff SEC’s Opposition To Defendants’ Motion To Compel Production of PCAOB Deposition Transcripts & Plaintiff’s Notes & Memoranda Of Interviews With Non-Party Witnesses at 6–9, SEC v. Goldstone, 301 F.R.D. 593, 593 (D.N.M. 2014) (No. 12-257), 2012 WL 6709556 (arguing that the SEC had not presented the transcripts in a public proceeding).

[55] See Goldstone, 301 F.R.D. at 616, 670–72; see also United States v. Cuthbertson, 630 F.2d 139, 147 (3d Cir. 1980) (finding that, as a general matter, only the holder of a privilege can waive it).

[56] Goldstone, 301 F.R.D. at 671.

[57] Id. at 620. The firm also argued that the words “unless and until” limit the clause’s application to PCAOB proceedings. Id. The firm explained that this clause limits “public proceedings” to those covered by “subsection (c)” and that “subsection (c)” addresses only PCAOB disciplinary matters. Id. at 616.

[58] Id. at 672.

[59] Id. at 673–74.

[60] Id. at 672.

[61] Id. at 671–72 (quoting 15 U.S.C. § 7215(b)(5)(A)).

[62] Goldstone, 301 F.R.D. at 672.

[63] See 15 U.S.C. § 7215(b)(5)(A).

[64] Goldstone, 301 F.R.D. at 672.

[65] Id.

[66] Id.

[67] Id.

[68] Id.

[69] Even if Subparagraph (A) did not contain the carve-out for documents shared under Subparagraph (B), the “unless and until presented” clause still would not apply to SEC proceedings. The clause limits its application to matters brought under SOX Section 105(c), which addresses PCAOB disciplinary procedures. See Sarbanes-Oxley Act of 2002 § 105(c), 15 U.S.C. § 7215(c).

[70] See Goldstone, 301 F.R.D. at 672.

[71] See 15 U.S.C. § 7217 (“The Commission shall have oversight and enforcement authority over the Board”).

[72] SOX acknowledges that PCAOB inspections may include the “subject of ongoing litigation or other controversy between the firm and 1 or more third parties.” 15 U.S.C. § 7214(d)(1).

[73] See 2-V Moore’s Federal Rules Pamphlet § 500.1 (2014) (“A privilege works to keep relevant and otherwise admissible evidence from the trier of facts.”). Congress is presumed to know common law. See Lorillard v. Pons, 434 U.S. 575, 583 (1978) (“[W]here words are employed in a statute which had at the time a well-known meaning at common law or in the law of this country they are presumed to have been used in that sense unless the context compels to the contrary.”) (citation and internal quotation marks omitted).

[74] See supra text accompanying notes 6–24.

[75] See 15 U.S.C. § 7215(b)(5)(C) (requiring the PCAOB to provide a supporting statement for each determination to impose a sanction). The PCAOB also can disclose privileged information in a disciplinary hearing, but only if the respondent so consents. See 15 U.S.C. § 7215(b)(5)(A) (permitting disclosure in a “public proceeding”); 15 U.S.C. § 7215(c)(2) (permitting a public hearing only “with the consent of the parties to such hearing”).

[76] 15 U.S.C. §§ 7215(c)(3), 7215(b)(5); see also Enforcement, Public Company Accounting Oversight Board, http://pcaobus.org/Enforcement/Pages/default.aspx (last visited May 25, 2015).

[77] Enforcement, Public Company Accounting Oversight Board, http://pcaobus.org/Enforcement/Pages/default.aspx (last visited May 25, 2015).

[78] The PCAOB can disclose SOX-privileged information without the auditing firm’s consent only after the completion of a disciplinary proceeding in which it imposes sanctions on an auditor. See 15 U.S.C. § 7215(b)(5)(A)  (authorizing disclosure in accordance with 15 U.S.C. § 7215(c)); 15 U.S.C. § 7215(c)(3) (requiring the PCAOB to provide a supporting statement when it imposes a sanction).

[79] On interpreting statues to effect statutory purpose as evidenced by the text, see W. Va. Univ. Hosps., Inc. v. Casey, 499 U.S. 83, 98–99 (1991).

[80] See 15 U.S.C. §§ 7215(b)(5)(A), (c)(2); see also PCAOB Release No. 104-2004-001, supra note 12, at 9 (acknowledging that SOX requires the PCAOB to keep information covered by SOX Section 105 and other information about investigations and disciplinary proceedings confidential unless and until the Board finds a violation and the respondent has had the opportunity to seek SEC review of that finding). According to a 2003 PCAOB Release adopting initial rules on investigations and disciplinary proceedings, Subparagraph (B) “forbids [agencies] to disclose” privileged material they have received from the PCAOB. PCAOB, Rules On Investigations And Adjudications, PCAOB Release No. 2003-015, at A2-42 (2003).

[81] See PCAOB Release No. 2003-015, supra note 80, at A2-42.

[82] See supra notes 51 and 54.

[83] See Goldstone, 301 F.R.D 593 at 613, 619, 637–38, 641; see also Objections of Plaintiff SEC to Special Master Order Granting Defendant Tekulve’s Motion to Compel Responses to Second Set of Interrogatories, SEC v. Jensen, No. CV 11–5316–R, 2013 WL 6499699 (C.D. Cal. Dec. 10, 2013) (No. 11-5316). Because the Staff did not assert the privilege before it produced this material, that case did not generate an analysis of the relevant SOX provisions. See Jensen, No. CV 11–5316–R, 2013 WL 6499699 (C.D. Cal. Dec. 10, 2013).

[84] Plaintiff’s Memorandum of Law in Support of Its Motion for a Protective Order at 11, SEC v. Aragon Capital Mgmt., LLC, No. 07 Civ. 919(FM), 2011 WL 3278642 (S.D.N.Y. July 26, 2011), (No. 114), 2008 WL 2779505. That case did not lead to a relevant opinion, however, because the court granted the SEC’s motion for a protective order without reaching the privilege issue. See Discovery Order, SEC v. Aragon Capital Mgmt., LLC, No. 07 Civ. 919(FM), 2011 WL 3278642 (S.D.N.Y. July 26, 2011), (No. 123).

[85] See 5 U.S.C. § 706 (2012) (identifying as “unlawful” any “agency action . . . found to be . . . arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law”).

[86] Sarbanes-Oxley Act of 2002 § 105(b)(5)(B), 15 U.S.C. § 7215(b)(5)(B) (2012).

[87] As a general matter, only the holder of a privilege can waive it. See Moore’s, supra note 73.

[88] See PCAOB Release No. 104-2004-001, supra note 12, at 8–9.

[89] See id.

[90] The SEC pointed this out more than ten years ago, in its 2002 discussion of audit regulation. See Proposed SEC Framework, supra note 10, at 44,987.

[91] See 15 U.S.C. § 7215(b)(5)(A) (stating that covered material “shall be confidential and privileged as an evidentiary matter”).

[92] See 15 U.S.C. § 7215(b)(5)(B).

[93] Id.

[94] See S. Rep. No. 107-205, supra note 8, at 58.

By

Losing Momentive: A Roadmap to Higher Cramdown Interest Rates

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Evan D. Flaschen, David L. Lawton & Mark E. Dendinger*

I.         Introduction

There has been a lot of press regarding the lengthy Momentive[1], bench ruling delivered in late 2014.[2] In Momentive, the Bankruptcy Court for the Southern District of New York held that debtors could satisfy the “cramdown” requirements of section 1129(b) of the Bankruptcy Code by distributing to secured creditors replacement notes paying below-market interest rates based on small margins.[3] Several months later, the Ninth Circuit Bankruptcy Appellate Panel (“BAP”) issued an unpublished decision in which it took a more nuanced approach to cramdown interest rate calculation.[4] Instead of identifying a defined range for acceptable margins, as was the case in Momentive, the Ninth Circuit BAP concluded that creditors should shoulder the evidentiary burden to prove the risk factors used to determine the appropriate cramdown rate.[5] In the wake of Momentive, the Ninth Circuit BAP has offered undersecured creditors a roadmap to higher cramdown interest rates under the right circumstances.[6]

II.        Till Sets the Cramdown Interest Stage

A chapter 11 plan of reorganization may be confirmed without the consent of an impaired class of secured creditors if the plan satisfies the conditions set out in section 1129(b) of the Bankruptcy Code.[7] Such conditions include a requirement that the plan be fair and equitable with respect to the objecting class, which, in the case of secured creditors, is satisfied when creditors in the class retain the lien securing their claims and receive deferred cash payments with a present value at least equal to the value of their secured claims.[8] The present value is determined as of the effective date of the plan, and the deferred cash payments must consist of an appropriate cramdown interest rate and amortization of principal.[9]

The Bankruptcy Code is silent as to how bankruptcy courts should calculate the appropriate cramdown interest rate.[10] In the absence of a clear statutory directive, “[c]ourts have used a wide variety of different rates as benchmarks in computing the appropriate interest rate (or discount rate as it is frequently termed) for the specific risk level in their cases.”[11] Among these methods are the formula rate, the coerced loan rate, the presumptive contract rate, and the cost of funds rate.[12]

Till v. SCS Credit Corp. is the leading case on cramdown interest rates. Under Till, the United States Supreme Court eschewed a market interest rate and held instead that the cramdown rate should be determined by a “formula” approach: taking the national prime rate and adjusting it by a margin that takes into consideration “the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan.”[13] However, the Supreme Court noted specifically that, in a chapter 13 case, “there is no free market of willing cramdown lenders,” and that “the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession.”[14] Nevertheless, since Till, many courts have been persuaded by Till‘s reasoning and have adopted its formula approach in cases under chapters 13 and 11.[15]

III.       Along Comes Momentive

In 2012, Momentive Performance Materials Inc. and its affiliates (collectively, “Momentive”) issued $1.1 billion of first-lien notes and $250 million of “1.5-lien” notes due 2020 under indentures with substantially similar terms governed by New York law. In April 2014, Momentive filed a chapter 11 petition and subsequently proposed a death-trap plan to pay noteholders either (i) in full in cash, without a make-whole premium, if the noteholders voted in favor of the plan, or (ii) seven-year replacement notes in the amount of their allowed claims at a below-market rate and the right to litigate their make-whole claims, if they did not vote in favor of the plan.[16] The noteholders did not vote in favor of the plan, and they objected to confirmation of the plan on grounds that the treatment of their claims was not fair and reasonable under applicable cramdown standards.[17]

Because secured noteholders rejected the debtors’ proposed plan, the debtors were required to satisfy the cramdown requirements of section 1129(b)(2) of the Bankruptcy Code, as described above.[18] At issue was whether the secured noteholders would receive deferred cash payments totaling at least the value of the secured portion of their claim as of the effective date of the plan under section 1129(b)(2) of the Bankruptcy Code and, more specifically, whether the cramdown rate on the replacement notes to be issued under the plan was sufficient.[19] The debtors argued that their plan provided sufficient present value to satisfy the cramdown requirements standard enumerated in Till and by the Second Circuit in In re Valenti, 105 F.3d 55 (2d Cir. 1997), in which the respective courts applied a “formula” approach under an analogous chapter 13 provision to determine a proper interest rate by taking a risk-free base rate, such as the prime rate or the Treasury rate, and adding a margin to account for debtor-specific risk of non-payment.[20] The secured noteholders argued that (i) the formula approach was only relevant in the absence of a clear market rate, and (ii) the higher rate in the debtors’ exit financing commitment clearly evidenced a market rate.[21]

In August 2014, the Bankruptcy Court for the Southern District of New York issued a lengthy bench ruling, which was later corrected and re-issued in September 2014.[22] The Bankruptcy Court rejected market-based approaches (such as the “coerced loan” approach) used by other courts, whereby the cramdown interest rate is determined based on the rates for similar loans in similar circumstances, the cost of funds, and other conditions, assuming a market exists.[23] Instead, the Bankruptcy Court held, inter alia, that the debtors could cram down their plan of reorganization on the secured lenders under section 1129(b)(2)(A)(i) of the Bankruptcy Code by providing them with replacement notes paying below-market interest rates, limiting the interest rate determined by the formula approach to the prime rate plus a margin of 1 to 3 percent depending on the risk of nonpayment.[24] The Bankruptcy Court reasoned that the formula approach meets the objective of section 1129(b)(2)(A)(i)(II) by putting the creditor in the same economic position as it would have been in if it immediately received the value of its allowed claim[25]—and that such value should not include any degree of profit.[26] The Bankruptcy Court ultimately found that (i) the elements of profit and transaction cost considered in the market approach are not to be considered in calculating present value with respect to cramdown rates, and, moreover, such market approach requires costly evidentiary hearings that involve issues unfamiliar to bankruptcy judges; and (ii) the formula approach should start with a riskless rate and be adjusted upward (1 to 3 percent) for debtor-specific risks (i.e., “based on the circumstances of the debtor’s estate, the nature of the collateral security and the terms of the cramdown note itself, and the duration and feasibility of the plan”).[27] The Bankruptcy Court reiterated that application of an appropriate risk premium is not a means to achieve a market rate, finding that up to 1 to 3 percent per annum is appropriate in the absence of “extreme risk.”[28]

In determining the appropriate risk premium for the Momentive noteholders, the Bankruptcy Court looked to the market testimony of the debtors and the parties’ investment bankers.[29] The Bankruptcy Court relied almost exclusively on the debtors’ financials, projections, and budgets to conclude that the noteholders’ investment bankers engaged in no independent analysis and failed to engage in a rigorous testing of the debtors’ projections.[30]  The Bankruptcy Court found that repayment was very likely given a healthy asset coverage ratio under the plan (closer to 50 percent than 75 percent), a much-reduced total debt leverage (with debt reduced from $4.4 billion to $1.3 billion), and a committed $600 million equity investment.[31] Accordingly, the Bankruptcy Court concluded that the risk of non-payment (as opposed to the risk of default) was relatively low and that the 1.5 and 2 percent risk premiums, for the first and 1.5-lien replacement notes established by the debtors under the plan, were appropriate.[32] The Bankruptcy Court disagreed only with the debtors’ selection of the Treasury rate as the base rate because the Treasury rate assumes virtually no risk of payment by the United States—whereas a rate closer to the prime rate more accurately accounts for the risk of the debtors’ performance.[33]

The decision in Momentive provides both debtors and secured creditors clear guidance as to how Judge Drain views the calculation of the appropriate interest rate in a secured creditor cramdown situation. While the result was disappointing to secured creditors, the decision bolsters the body of law applying the Till formula approach.

IV.        Dunlap Oil to the Rescue?

Creditors winced after reading the Momentive decision’s interpretation of the Till cramdown rate formula, but they may take a little comfort in the fact that other courts are not strictly limiting the maximum risk margin applied in the formula approach to only 3 percent. In a recent decision, the Ninth Circuit BAP held that the bankruptcy court below did not err in applying a 1.75 percent margin to the 3.25 percent prime rate.[34] Although the secured creditor appellant argued that the rate was still unreasonably low, the Ninth Circuit BAP did not identify a percentage to serve as a cap in all cases, as Judge Drain did in dicta in Momentive.[35] Instead, the Ninth Circuit BAP emphasized Till‘s language in placing the burden on secured creditors to submit evidence to prove that the risks under a particular plan warrant a higher cramdown interest rate: “[S]tarting from a concededly low estimate and adjusting upward places the evidentiary burden squarely on creditors, who are likely to have readier access to any information absent from the debtor’s filing . . . .”[36]

In In re Dunlap Oil Co., Inc., the secured creditors argued that the only evidence on the record that the risk factors required a 4 percent adjustment to the prime rate was testimony from the debtor’s financial consultant.[37] While not eliminating the possibility of such a higher margin, the Ninth Circuit BAP held that the burden of proof rests squarely on the creditors to provide such evidence and that the bankruptcy court had not abused its discretion in selecting a lower rate, noting that the bankruptcy court had properly considered the feasibility of the plan, the market conditions, and the absence of evidence that the collateral would decline in value over the term of the plan.[38]

Whereas Momentive’s approach to the Till rate limited the applicable cramdown rate, Dunlap Oil illustrates adherence to precedent in allowing the facts and circumstances in each case to dictate the rate. The flexibility of Till and Dunlap Oil grants secured creditors their day in court instead of foreclosing higher rates where they might be warranted. Nonetheless, that day in court—and the evidence it requires—can have a significant cost. Without clear evidence of an established market for the secured claim in question, evidence of comparable rates under similar circumstances and the likelihood of nonpayment in each case may not be readily available, apart from evidence created by advisors of the debtor or its creditors; accordingly, the dispute as to the appropriate rate may be costly. To avoid indecision in the absence of probative evidence, a court may consider eschewing the flexibility of Till’s formula approach, as followed by Dunlap Oil, in favor of a more rigid standard. However, such rigidity should result in judicial economies, e.g., where costly, time-consuming analyses consistently reach the same conclusion. Although it is unlikely that the market rate and risk of non-payment would consistently be the same in wholly different circumstances, the United States Bankruptcy Courts for the Northern and Southern Districts of Mississippi issued a standing order setting the current presumptive Till rate at 5.0 percent.[39] A presumptive rate is particularly useful where evidence is lacking and a rate must still be set, as long as the presumptive rate remains only a presumption, rebuttable by contrary evidence. But a fixed interest cap used in Momentive offers neither presumption nor efficiency. Enforcing a cap still requires the court to consider evidence in setting the cramdown rate—it merely limits the effect of such evidence, regardless of its probative value. Therefore, it is encouraging that Momentive’s establishment of a maximum cramdown rate threshold remains an isolated, case-specific approach that, to date, has failed to gather momentum.

V.         Conclusion

While the Momentive decision sent ripples throughout the lending market,[40] its application is limited by the facts of the case. Moreover, while other courts may yet find its reasoning persuasive, the establishment of a judicial cramdown interest rate cap is not gaining widespread traction. As explained above, the Ninth Circuit BAP, in a post-Momentive decision, eschewed a clearly defined range for acceptable margins and focused instead on the evidentiary burden creditors have to overcome to prove that higher risks warrant a higher interest rate. Such a “proof-of-risk” approach requires a probative inquiry without foreclosing appropriately higher rates where greater risk exists.

 

Preferred citation: Evan D. Flaschen, Mark E. Dendinger & David L. Lawton, Losing Momentive: A Roadmap to Higher Cramdown Interest Rates, 5 Harv. Bus. L. Rev. Online 100 (2015), https://journals.law.harvard.edu/hblr//?p=4003.

* Evan D. Flaschen is the chair of the Financial Restructuring Group at Bracewell & Giuliani LLP. Mark E. Dendinger and David L. Lawton are associates in that group.

[1] In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335 at *34 (Bankr. S.D.N.Y. Sept. 9, 2014). MPM stands for “Momentive Performance Materials”, and we refer to the case as “Momentive” throughout.

[2] See e.g., Matt Wirz, Momentive Ruling Shakes Up Debt Markets, MoneyBeat (Aug. 28, 2014), http://blogs.wsj.com/moneybeat/2014/08/28/momentive-ruling-shakes-up-debt-markets/; Adam C. Harris & Karen S. Park, Bankruptcy Court Approves Non-Market Cramdown Rate on Momentive Secured Creditors, Harvard Law School Bankruptcy Roundtable (Mar. 17, 2015), http://blogs.law.harvard.edu/bankruptcyroundtable/2015/03/17/bankruptcy-court-approves-non-market-cramdown-rate-on-momentive-secured-creditors/; Mark I. Bane, Bankruptcy Court Holds Secured Creditors Can Be “Crammed Down” With Below-Market Replacement Notes, Harvard Law School Forum on Corporate Governance and Financial Regulation (Sept. 6, 2014), http://corpgov.law.harvard.edu/2014/09/06/bankruptcy-court-holds-secured-creditors-can-be-crammed-down-with-below-market-replacement-notes/; Alan Zimmerman, Bankruptcy: In Cram-Down Fight, Momentive Loses the Battle, but Wins the War, HighYieldBond.com (Aug. 27, 2014, 10:24 AM), http://www.highyieldbond.com/in-cram-down-fight-momentive-loses-the-battle-but-wins-the-war/.

[3] In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014).

[4] In re Dunlap Oil Co., Inc., No. AZ-14-1172-JuKiD, 2014 WL 6883069 (B.A.P. 9th Cir. Dec. 5, 2014).

[5] Id. at *20.

[6] See Dunlap Oil, 2014 WL 6883069.

[7] See 11 U.S.C. § 1129(b) (2010).

[8] See 11 U.S.C. § 1129(b)(1); In re Dynamic Brokers, Inc., 293 B.R. 489, 499 (B.A.P. 9th Cir. 2003); In re Arnold & Baker Farms, 85 F.3d 1415, 1420 (9th Cir. 1996).

[9]See Matter of Briscoe Enterprises, Ltd., II, 994 F.2d 1160, 1169 (5th Cir. 1993).

[10] See In re Am. HomePatient, Inc., 420 F.3d 559, 565 (6th Cir. 2005).

[11] Briscoe, 994 F.2d at 1169.

[12] See Till v. SCS Credit Corp., 541 U.S. 465, 473 (2004) (discussing methods of calculating cramdown interest rates in analogous chapter 13 cases).

[13] Id. at 479.

[14] Id. at 476 n.14.

[15] See In re Texas Grand Prairie Hotel Realty, L.L.C., 710 F.3d 324, 331 (5th Cir. 2013) (discussing the persuasive, yet non-binding, nature of the “splintered” Till decision); In re Blanton, No. 10-60160, 2010 WL 4503188 at *2 (Bankr. N.D. Ohio Oct. 29, 2010) (critiquing the precedential value of Till and its formula approach); see also, e.g., In re Toso, No. BAP EC-05-1290, 2007 WL 7540985 at *8–9 (B.A.P. 9th Cir. Jan. 10, 2007); Mercury Capital Corp. v. Milford Conn. Assocs., L.P., 354 B.R. 1, 12 (D. Conn. 2006). But see, e.g., Am. HomePatient, 420 F.3d at 566–68 (refusing to fully adopt the Till formula approach in a chapter 11 case).

[16] Voluntary Petition, In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014); Joint Chapter 11 Plan of Reorganization for Momentive Performance Materials Inc. and Its Affiliated Debtors, In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014).

[17] Cramdown Objection of Wilmington Trust, National Association, as Indenture Trustee, to Confirmation of Debtors’ Proposed Joint Chapter 11 Plan of Reorganization, In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014); Objection of Wilmington Trust, National Association, as Indenture Trustee, to Confirmation of Debtors’ Proposed Joint Chapter 11 Plan of Reorganization, In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014).

[18] See 11 U.S.C. § 1129(b) (2010).

[19] In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335, at *23 (Bankr. S.D.N.Y. Sept. 9, 2014).

[20] Id. at *24-*25.

[21] Id. at *24, *25.

[22] In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014).

[23] See id. at *25.

[24] Id. at *29.

[25] The Bankruptcy Court found no reason to distinguish between the statutory objectives of analogous provisions regarding plan confirmation under chapters 13 and 11 and therefore found Valenti’s conclusion that the formula approach satisfies section 1325(a)(5)(B)(ii) wholly supportive of the argument that it likewise satisfies the requirement for plan confirmation under section 1129(b)(2)(A)(i)(II). Id. at *25.

[26] Id..

[27] Id. at *26.

[28] See id. at *31.

[29] See id. at *30.

[30] Id.

[31] Id. at *30–31.

[32] Id. at *31.

[33] Id.

[34] In re Dunlap Oil Co., Inc., No. AZ-14-1172-JuKiD, 2014 WL 6883069, at *20 (B.A.P. 9th Cir. Dec. 5, 2014).

[35] Id.

[36] Id. (quoting Till v. SCS Credit Corp., 541 U.S. 465, 479 (2004)); see also In re Tapang, No. 11-59479-ASW, 2014 WL 7212959, at *2 (Bankr. N.D. Ca. Dec. 17, 2014) (likewise concluding that the creditors—not the debtor—bear the burden of proof on the issue of the appropriate cramdown interest rate under chapter 11).

[37] Dunlap Oil, at *20; see also In re Chardon, LLC, 519 B.R. 211, 221 (Bankr. N.D. Ill. 2014) (The court there was forced to rely on the debtor’s financial advisor, who was not “a particularly compelling witness,” in the absence of any evidence of a market rate for debtor-in-possession financing, the current prime rate, or an appropriate risk adjustment).

[38] Dunlap Oil, at *20.

[39] See In re Fortenberry, No. 14-50768, 2014 WL 7407515, at *5 (Bankr. S.D. Miss. Dec. 30, 2014) (examining cramdown interest rates in the chapter 13 context).

[40]See, e.g., Matt Wirz, Momentive Ruling Shakes Up Debt Markets, MoneyBeat (Aug. 28, 2014), http://blogs.wsj.com/moneybeat/2014/08/28/momentive-ruling-shakes-up-debt-markets/.

By

When is Renewable not Renewable? The Constitutionality of State Laws Denying New Large Canadian Hydroelectric Projects Treatment as Renewable Resources

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Harvey L. Reiter*

I.         Introduction

Over the past fifteen years, many states—twenty-nine at last count—have adopted renewable portfolio standards (RPS) as a means both to reduce their dependence on imported fossil fuels and to combat climate change.[1] To comply with these standards, electric utilities must demonstrate that a significant minimum percentage of their supply portfolios will consist of renewable resources by the various target dates specified in state law.[2] Most states affirmatively describe what counts as renewable resources—wind, geothermal, and solar energy are commonly referenced in RPS legislation.[3] But some state RPS laws also contain negative provisions, excluding from eligibility what otherwise would surely be considered renewable resources.[4] Hydroelectric projects are quintessential examples of renewable energy sources.[5] The fuel source—water—replenishes itself. It rains; the rain evaporates and condenses; and the cycle starts all over again. Under these laws, however, only new small-scale hydroelectric projects count as renewable resources. Large-scale hydroelectric projects, both existing and new, do not.[6]

Laws of this type amount to hidden barriers to power imports from Canada, the only source of electricity from new large-scale hydroelectric facilities. This article explains why the restrictions are unconstitutional under the Commerce Clause and bad for consumers and the environment, and why other states should follow the lead of Vermont and Wisconsin and modify their statutes to permit power from large hydroelectric projects to be treated as a renewable resource under their RPS laws.

II.         The “Dormant” Commerce Clause and State Regulation of Foreign Commerce

The Commerce Clause gives the federal government authority to regulate interstate and foreign commerce.[7] The courts have found this power to be exclusive and, by negative implication, to bar states from unduly burdening or discriminating against interstate and foreign commerce.[8] Perhaps because the temptation of legislators to protect local businesses is so strong, cases under which the federal courts have struck down state legislation invoking this implicit, or “dormant,” Commerce Clause restriction are “legion.”[9]

Although most of these cases have involved legislation that disadvantages out-of-state interests, the Clause also serves to prevent states from erecting barriers to foreign commerce. “Power to regulate foreign commerce,” after all, “is given in the same words, and in the same breath, as it were, with that over the commerce of the States and with the Indian tribes.”[10] And, just as the power to regulate interstate commerce resides exclusively with the federal government, the power to regulate commerce with other nations is also solely federal.[11]

The impact of the Commerce Clause on state laws affecting foreign commerce, in fact, is somewhat broader than in the case of state laws affecting interstate commerce. “Like the Import-Export Clause, the Foreign Commerce Clause recognizes that discriminatory treatment of foreign commerce may create problems, such as the potential for international retaliation, that concern the Nation as a whole.”[12] This means, of course, that a state cannot protect in-state interests by granting them preferential treatment over foreign competitors.[13] But it also means that “a State’s preference for domestic commerce over foreign commerce is inconsistent with the Commerce Clause even if the State’s own economy is not a direct beneficiary of the discrimination.”[14]

III.         Large-Scale Hydro Restrictions as De Facto Barriers to Foreign Competition

Numerous articles in recent years have discussed how various state RPS laws discriminate against interstate commerce in violation of the Commerce Clause.[15] Many of these same state laws include provisions declaring that large-scale hydroelectric facilities, both new and existing, are not to be considered renewable resources.[16] None of the articles discussing in-state preferences, however, address whether the large hydro exclusions also operate as in-state preferences. But, as discussed below, the large-scale hydro exclusions are de facto restrictions on the import of Canadian hydropower since the only new sources of large-scale hydroelectric power are located in Canada. The constitutional and economic significance of that fact is the subject of this Article.

Had states that have chosen to exclude large scale hydroelectric projects from treatment as renewable resources confined the exclusion to existing facilities, no constitutional issue would have been presented. Where states are already hydro-rich, restrictions on counting existing large-scale hydroelectric facilities as renewable resources would serve the obvious purpose of promoting the development of new renewable resources.[17] This may or may not be good policy,[18] but it is not fashioned to exclude out-of-state or foreign competitors. Consider Washington, for example. It accounts for more than a quarter of all the hydroelectric power production in the United States, and, not surprisingly, well over half of the electricity its residents and businesses use comes from hydroelectric facilities.[19] If existing hydroelectric facilities counted toward a renewable portfolio goal of, say, thirty percent, there would be no impetus to develop any new renewable energy sources. And, since the states that have chosen to adopt these restrictions already have their own existing hydroelectric facilities,[20] the purpose of the exclusion would be neutral from a Commerce Clause perspective. This is so, even though the statutory distinction is fictitious; existing hydroelectric facilities produce energy from water, an indisputably renewable energy source.[21]

But the picture is completely different where the exclusion extends, as it does in several states, to new large-scale hydroelectric projects.[22] Although the statutes in question do not single out Canadian energy suppliers, a restriction can be discriminatory under the Commerce Clause even if it is not express.[23] The viable sites for new large-scale hydroelectric production are located in British Columbia, Manitoba and Québec,[24] the three Canadian provinces with the largest hydroelectric output.[25] It is of course true that a state law does not discriminate against out-of-state (or foreign) commerce simply because it adversely affects out-of-state or foreign entities.[26] But when a state excludes new large-scale hydroelectric facilities, even for ostensibly environmental reasons, its only targets are foreign producers. There are no sites left in the United States where large-scale hydro facilities can be developed.[27] The de facto effect of the restrictions, then, is to limit competition from Canadian entities to supply renewable energy. This should be enough of a reason to strike down the restrictions on Commerce Clause grounds as state interference with federal regulation of foreign trade.[28]

Were proof of a discriminatory or protectionist motive needed, however, there seems ample evidence to support that conclusion as well. Renewable energy advocates in New England, for example, have successfully argued that defining large hydroelectric facilities as renewable resources “would slow down the development of renewable energy projects in the region.”[29] This, in fact, was official government policy in Vermont for over a quarter century. “Vermont policy-makers reached a consensus that if large hydropower were deemed renewable, it would hinder the development of smaller renewable energy projects.”[30] And New Hampshire’s protectionist intent is quite explicit. The text of its RPS states as its “purpose” that “[r]enewable energy generation technologies can provide fuel diversity to the state and New England generation supply through use of local renewable fuels and resources that serve to displace and thereby lower regional dependence on fossil fuels.”[31]

To be sure, there are unquestionable environmental concerns associated with the construction and operation of large-scale hydroelectric facilities. “Damming rivers,” notes former Vermont Public Service Board Member David Coen (an advocate for treating large hydroelectric projects as renewable resources), “forever alters a region’s geologic landscape, and a hydroelectricity facility’s turbines often kill the fish that get caught in the plant.”[32] And, he adds “roughly 600 dams have been removed in the last 50 years” because of “safety concerns and concerns over their long-term impact on the environment and recreation.”[33]

It is highly doubtful, however, that environmental concerns about large-scale hydroelectric projects in Canada could justify denying their eligibility as renewable resources. For one thing, a good environmental motive will not save discriminatory legislation. “Even if environmental preservation were the central purpose” of a state law or regulation, it “would not be sufficient to uphold a discriminatory regulation.”[34]

In any event, restrictions like exclusions from RPS eligibility are economic, not environmental. Canadian hydropower producers are not banned from exporting; their products are simply not credited toward meeting the buyer’s renewable portfolio obligations.[35] Indeed Canadian suppliers continue to sell large amounts of hydroelectric power to U.S. buyers.[36] Several New England states have proposed legislation to ease restrictions on the eligibility of large hydro facilities to satisfy renewable energy targets.[37] But, the environmental groups that have opposed these initiatives have, no doubt unintentionally, articulated their concerns in economic, not environmental terms.

When, for example, New Hampshire was considering legislation to allow large hydro to qualify as a renewable resource, the Conservation Law Foundation described the legislation as simply a way to allow Hydro-Québec to take business away from homegrown renewables. As one reporter recounted the statement of the Foundation’s director:

Tom Irwin, VP and Director of the Conservation Law Foundation, New Hampshire, writes in his blog that HB 302 is “clearly intended to tilt the playing field in favor of the Northern Pass.” He said that “HB 302 will greatly undermine one of the core purposes of New Hampshire’s RPS law: the stimulation of investment in renewable energy technologies in New England and, in particular, in New Hampshire.”[38]

Mr. Irwin’s objections, in other words, were not that removing the limitations would damage the environment, but that they would force New Hampshire’s mom and pop renewable energy producers to compete with the Hydro-Québec behemoth. That may articulate a populist theme, but it is not an environmental one.

IV.         Conclusion

As the courts have construed it, the core purpose of the interstate commerce provisions of the Commerce Clause was to prevent states from erecting protectionist barriers to interstate trade.[39]  By contrast, as University of Chicago law professor Richard Epstein put it, “there was clear, if regrettable, evidence that protectionism against foreign competition was one reason why Congress was given (and given first) power over foreign commerce” in the very same provision of the Constitution.[40]  In other words, if anyone was going to discriminate against foreign competition, it would be the federal government, not the states.

Happily, the conflicting motives behind the inclusion of these two aspects of the Commerce Clause do not produce conflicting Constitutional outcomes. Even accepting an environmental impetus for restrictions on the treatment of new large hydro facilities under state RPS laws, under the Commerce Clause the judgment whether to limit foreign imports based on environmental (or any other) considerations would reside exclusively with the federal government, not the states. And while the federal government’s silence would not create space for state-imposed restrictions on foreign trade, here the federal government has spoken loudly against trade restrictions through ratification of both the North American Free Trade Agreement (NAFTA) and its companion treaty, the North American Agreement on Environmental Cooperation (NAAEC). The latter obligates each of the signatory states—Canada, Mexico, and the United States—to adhere to responsible environmental policies.[41] So, not only are states barred from erecting their own barriers to foreign competition, but the federal government has made a policy choice that it should embrace competition from Canada and Mexico as well.

This, in the author’s view, is a good outcome for consumers and for the environment. There are certainly environmental concerns associated with the development of large-scale hydroelectric projects. But, no renewable resource is without its warts.[42] Just as hydroelectric projects can alter an ecosystem and damage aquatic life, so too can wind farms and large solar arrays pose risks to birds and other wildlife.[43] And, somewhat counterintuitively, large solar installations, if not dry cooled, can also put stress on critical water resources.[44] Constitutional considerations aside, the solution is to mitigate environmental effects, not to erect economic barriers to the use of carbon-free technology.

The question from the consumers’ perspective is why, if the goal is to reduce carbon emissions, should they be forced to pay for less efficient and more costly solar or wind-based power when equally carbon-free hydroelectric power is available for less? Propping up local businesses or protecting local jobs by erecting trade barriers is simply bad economics. “[W]hile protectionism is sold as job saving, it probably really amounts to job swapping. It protects jobs in some industries only by destroying jobs in others.”[45]

Protectionist economic legislation targeting efficient sources of renewable energy may cause the environment to suffer as well. With scarce dollars to go around, subsidizing inefficient or comparatively less efficient home grown renewable resources leaves fewer consumer resources to pay for other climate-friendly options, like energy efficient devices or conservation technologies.[46]

Vermont, no environmental slouch among the states, made the choice a few years ago to remove its longstanding restriction on the treatment of new large hydroelectric facilities as renewable resources.[47] Wisconsin followed suit about a year later.[48] One can hope that, in the interests of consumer protection—or maybe simply to forestall legal challenges by disadvantaged foreign competitors and their would-be customers—other states will follow their lead.

 

Preferred citation: Harvey L. Reiter, When is Renewable not Renewable? The Constitutionality of State Laws Denying New Large Canadian Hydroelectric Projects Treatment as Renewable Resources, 5 Harv. Bus. L. Rev. Online 76 (2015), https://journals.law.harvard.edu/hblr//?p=3993.

* Partner, Stinson Leonard Street, LLP, Washington, D.C. J.D., Boston University School of Law, B.A., Michigan State University. Executive Articles Editor, Energy Law Journal (2007–present), Adjunct Professor, Vermont Law School (2010–11). The author extends special thanks to Delia Patterson, General Counsel of the American Public Power Association, for her valuable comments and insights.

[1] The latest Environmental Protection Agency figures say that, as of March 2013, twenty-nine states and the District of Columbia have adopted binding renewable portfolio standards; eight more states have adopted non-binding renewable portfolio goals. Renewable Portfolio Standards, Envtl. Protection Agency, http://www.epa.gov/agstar/tools/funding/renewable.html (last visited Mar. 6, 2015).

[2] Id.; see also Renewable Portfolio Standard Policies, U.S. Dep’t. of Energy, http://www.dsireusa.org/documents/summarymaps/RPS_map.pdf (last visited Mar. 6, 2015) (displaying map listing renewable portfolio target dates by state).

[3] See Renewable Portfolio Standards, Envtl. Protection Agency, http://www.epa.gov/agstar/tools/funding/renewable.html (last visited Mar. 6, 2015). The Department of Energy maintains a comprehensive list of renewable resource programs and the types of resources that qualify as renewable in the Database of State Incentives for Renewables & Efficiency (DSIRE). See Database of State Incentives for Renewables & Efficiency, U.S. Dep’t. of Energy, http://www.dsireusa.org/ (last visited Mar. 19, 2015).

[4] See, e.g., KSE Focus, States Debate Large-Scale Hydro Power and Renewable Portfolio Standards, Congress.org (Aug. 7, 2013), http://congress.org/2013/08/07/state-debate-large-scale-hydro–power-and-renewable-portfolio-standards/.

[5] The American Heritage New Dictionary of Cultural Literacy defines a renewable resource as “any resource, such as wood or solar energy, that can or will be replenished over time.” The New Dictionary of Cultural Literacy: What Every American Needs to Know 519 (James Trefil et al. eds., 3d ed. 2005). Energy Information Administration’s “Energy Kids” website similarly defines renewable energy sources as those that “can be replenished,” and identifies biomass, hydropower, geothermal, wind and solar as the five most common forms of renewable energy. Energy Sources—Renewable, Energy Kids, U.S. Energy Info. Admin., http://www.eia.gov/kids/energy.cfm?page=renewable_home-basics (last visited Mar. 6, 2015).

[6] See Val Stori, Environmental Rules for Hydropower in State Renewable Portfolio Standards 4, CleanEnergy States Alliance (April 2013), http://www.cesa.org/assets/2013-Files/RPS/Environmental-Rules-for-Hydropower-in-State-RPS-April-2013-final-v2.pdf (“the majority of states allowing existing hydropower facilities to qualify for the RPS restrict eligibility to ‘small’ hydro facilities”); David C. Coen & Robert J. Thormeyer, Should Large Hydroelectric Plants be Treated as Renewable Resources?, 32 Energy L.J. 541, 543–44 (2011).

[7] U.S. Const. art. I, § 8, cl. 3. The Commerce Clause grants Congress the “power . . . [t]o regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.” Id.

[8] Or. Waste Sys., Inc. v. Dep’t of Envtl. Quality of State of Or., 511 U.S. 93, 98 (1994) (citing Wyoming v. Oklahoma, 502 U.S. 437, 454 (1992)).

[9] See West Lynn Creamery, Inc. v. Healy, 512 U.S. 186, 194 (1994).

[10] Gibbons v. Ogden, 22 U.S. 1, 228 (1824) (Johnson, J., concurring) (emphasis in original).

[11] Id. at 228–29; see also Japan Line, Ltd. v. Cnty. of L.A., 441 U.S. 434, 453–54 (1979).

[12] Kraft Gen. Foods, Inc. v. Iowa Dept. of Revenue and Fin., 505 U.S. 71, 79 (1992).

[13] Japan Line, 441 U.S. at 448–49.

[14] Kraft Gen. Foods, 505 U.S. at 80 (emphasis added).

[15] See Daniel K. Lee & Timothy P. Duane, Putting the Dormant Commerce Clause Back to Sleep: Adapting the Doctrine to Support State Renewable Portfolio Standards, 43 Envtl. L. 295 (2013); Steven Ferrey, Threading the Constitutional Needle With Care: The Commerce Clause Threat to the New Infrastructure of Renewable Power, 7 Tex. J. Oil, Gas & Energy L. 59 (2012); Carolyn Elefant & Edward A. Holt, The Commerce Clause and Implications for State Renewable Portfolio Standard Programs, Clean Energy States Alliance State RPS Policy Report (2011); Stephen C. Braverman, State Renewable Portfolio Standards and the Commerce Clause, 25 SPG Nat. Resources & Env’t 15 (2011); Trevor D. Stiles, Renewable Resources and the Dormant Commerce Clause, 4 Envtl. & Energy L. & Pol’y J. 33 (2009); Nathan E. Endrud, State Renewable Portfolio Standards: Their Continued Validity and Relevance in Light of the Dormant Commerce Clause, the Supremacy Clause, and Possible Federal Legislation, 45 Harvard J. on Legis. 259 (2008); Patrick R. Jacobi, Renewable Portfolio Standard Generator Applicability Requirements: How States Can Stop Worrying and Learn to Love the Dormant Commerce Clause, 30 Vt. L. Rev. 1079 (2006); Nancy Rader & Scott Hempling, Nat’l Ass’n of Regulatory Util. Comm’rs, The Renewables Portfolio Standard: A Practical Guide, A-2–4 (2001), available at http://www.scotthemplinglaw.com/files/naruc.org/Publications/rps.pdf; Kirsten H. Engel, The Dormant Commerce Clause Threat to Market-Based Environmental Regulation: The Case of Electricity Deregulation, 26 Ecology L.Q. 243, 268–81 (1999).

[16] See Coen & Thormeyer, supra note 6, at 543 (“Oregon, Washington, and Missouri do not include hydropower at all in their RPS, and other states, such as New Hampshire, California, and North Carolina, only make new hydropower projects eligible for inclusion in their renewable programs,” but exclude large-scale hydro projects).

[17] See Mary G. Powell, Treatment of Large Hydropower as a Renewable Resource, 32 Energy L.J. 553, 556 (2011).

[18] State policies excluding existing large-scale hydroelectric facilities from their definition of eligible renewable resources may also result in exclusion of additional hydroelectric output resulting from expansion of existing facilities. This impact, falling on in-state and out-of-state suppliers alike, may well be neutral in Commerce Clause terms, but the policy benefits are questionable. Expansion of existing hydroelectric projects is likely to be more economic than development of other sources of renewable energy. See Coen & Thormeyer, supra note 6, at 543. If the goal is to reduce carbon emissions, the exclusion becomes a costly choice for consumers.

[19] State Profile and Energy Estimates—Washington, 2014, U.S. Energy Info. Admin.,  http://www.eia.gov/state/?sid=WA (last updated July 17, 2014). Oregon similarly relies on hydroelectric energy for seventy percent of its energy needs. State Profile and Energy Estimates—Oregon, 2014, U.S. Energy Info. Admin., http://www.eia.gov/state/?sid=OR (last updated July 17, 2014).

[20] There are existing hydroelectric projects in all of these states. The Federal Energy Regulatory Commission posts a “Complete list of Issued Licenses” on its website. Licensing, Fed. Energy Regulatory Comm’n, http://www.ferc.gov/industries/hydropower/gen-info/licensing.asp (last updated Dec. 4, 2014).

[21] See Mary G. Powell, Treatment of Large Hydropower as a Renewable Resource, 32 Energy L.J. 553 (2011). See generally Coen & Thormeyer, supra note 6.

[22] See Coen & Thormeyer, supra note 6. Large-scale hydroelectric projects are considered to be those with a capacity of thirty or more megawatts. See Electric Power Research Inst., Assessment of Waterpower Potential and Development Needs 2-1 (2007), http://www.epri.com/abstracts/Pages/ProductAbstract.aspx?ProductId=000000000001014762&Mode=download.

[23] See Best & Co. v. Maxwell, 311 U.S. 454, 455–56 (1940) (“The commerce clause forbids discrimination, whether forthright or ingenious. In each case it is our duty to determine whether the statute under attack, whatever its name may be, will in its practical operation work discrimination against interstate commerce.”).

[24] Canada is a major exporter of electricity to the United States, most of which comes from hydroelectric facilities. See Charlotte Helston, Large Hydro, Energy bc (2012), http://www.energybc.ca/profiles/largehydro.html (last visited Mar. 6, 2015) (“60% of electricity produced in Canada is drawn from hydro. Only a portion of that hydroelectricity is used in Canada; the rest is exported for profit.”). And, while many of the most suitable sites for large-scale hydroelectric projects in Canada have already been developed, there still remains the potential for additional large-scale project development, particularly in Québec and British Columbia. Hydro-Québec, for example, broke ground in 2009 on the Romaine project, a 1550-megawatt hydroelectric project on the Romaine River. See Strategic Plan 2009-2013, Hydro–Québec 20 (2009), http://www.hydroquebec.com/publications/en/docs/strategic-plan/plan-strategique-2009-2013.pdf. The project is part of a larger plan to develop up to 4,500 megawatts of new large-scale hydroelectric facilities. Id. at 22. Further, in British Columbia, plans have been underway for several years to develop the Site C Clean Energy Project, a 1,100-megawatt hydroelectric facility on the Peace River in the northeastern portion of the province. See Site C Clean Energy Project, https://www.sitecproject.com (last visited Mar. 6, 2015). Manitoba also has some potential, although more limited, to develop new large-scale hydro projects. Manitoba Hydro’s current development plan contemplates the construction of  a 695 MW project and a 1,485 MW project that would support the province’s demand growth and exports to the U.S. See Development Plan and NFAT, Manitoba Hydro, http://www.hydro.mb.ca/projects/development_plan/index.shtml (last visited February 26, 2015).

[25] See Helston, supra note 24.

[26] See City of Philadelphia v. New Jersey, 437 U.S. 617, 627 (1978); Rocky Mtn. Farmers Union v. Corey, 730 F.3d 1070, 1089 (9th Cir. 2013).

[27] See Pew Center on Global Climate Change, Climate TechBook—Hydropower 5 (2011), http://www.c2es.org/docUploads/Hydropower_0.pdf (stating “[t]he best sites for large hydropower generation in the United States have already been developed,” and “the construction of new large hydropower dams is not considered a practical option for increasing hydropower generation due to the environmental impacts and unavailability of proper sites to develop for large-scale hydropower generation”); Lea Kosnik, The Potential of Water Power in the Fight Against Global Warming in the U.S., Energy Policy 1, 2 n.1 (2008), http://www.umsl.edu/~kosnikl/Saved%20Emissions.pdf (“We do not consider any potential coming from the construction of new large (i.e. traditional) hydropower dams.”); Water Use FAQ: What is hydroelectric power and how is it used?, U.S. Geological Survey, http://www.usgs.gov/faq/node/3248 (last modified Nov. 19, 2004) (“New large-scale hydroelectric facilities will be few and far between in the future as most of the prime locations to place large dams suitable for hydroelectric-power production have already been used.”).

[28] See Japan Line, 441 U.S. at 448–49.

[29] See Powell, supra note 17, at 556.

[30] Id. Vermont has since amended its laws to allow the inclusion of large-scale hydroelectric facilities as a renewable resource for RPS purposes, becoming the first state in the nation to do so. Id. at 553.

[31] See N.H. Rev. Stat. Ann. § 362-F:1 (2015) (emphasis added). There is both some protectionist consistency and some irony in New Hampshire’s position. Years earlier, the Supreme Court struck down the State’s legislation seeking to limit the export of energy from its own valuable large hydroelectric facilities for violating the Commerce Clause. New England Power Co. v. New Hampshire, 455 U.S. 331, 339 (1982).

[32] Coen & Thormeyer, supra note 6, at 544.

[33] Id.

[34] West Lynn Creamery, Inc. v. Healy, 512 U.S. 186, 204 (1994). States excluding new large hydroelectric projects from the definition of renewable resources may argue that their statutes do not single out Canadian energy sources in purpose or effect. The reason to advance such an argument is obvious: statutes that are discriminatory are subject to strict scrutiny under the dormant Commerce Clause, Or. Waste Sys., 511 U.S. at 101, while statutes alleged to burden interstate commerce come under the more lenient Pike balancing test, Pike v. Bruce Church, Inc., 397 U.S. 137, 142 (1970). In the author’s view, however, convincing a court that the restrictions on new large hydro facilities do not single out Canadian sellers is a pretty tough sell; they are the only entities selling power from facilities of this type.

[35] To be sure, while the exclusions are economic in nature, some legislators may have seen the exclusions as a deterrent, albeit an unconstitutional one, aimed at limiting the environmental harm from large hydro projects.

[36] It bears emphasis that when we are talking about Canadian hydroelectric facilities, we are not talking about ecological disasters like the Three Gorges Dam in China, which are subject to only limited environmental review. See Mara Hvistendahl, China’s Three Gorges Dam: An Environmental Catastrophe?, Scientific American (March 25, 2008), http://www.scientificamerican.com/article/chinas-three-gorges-dam-disaster/. As Hydro-Québec points out in its recent Strategic Plan, the Romaine Project now under way is subject to strict environmental review and was preceded by a required 2,500-page environmental impact statement. See Strategic Plan 2009–2013, Hydro–Québec, supra note 24 at 21.

[37] See Jennifer Runyon, Small States Grapple with Big Canadian Hydropower, Renewable Energy World, (March 7, 2011), http://www.renewableenergyworld.com/rea/blog/post/print/2011/03/small-states-grapple-with-big-canadian-hydropower; Erin Ailworth, Legislation raises question: What is clean energy?, Boston Globe, (February 26, 2014), http://www.bostonglobe.com/business/2014/02/26/legislation-would-increase-clean-energy-requirements-for-utilities/xrcj54IRKPudoYjmPZAFCK/story.html.

[38] Runyon, supra note 37. The reaction of Jake Brown, spokesman for the Vermont Natural Resources Council, to similar legislation in Vermont was not much different from Mr. Irwin’s:

So Vermont would be in many ways a domino falling and in our view a standards being dropped which is very unlike Vermont, Vermont is a place that has high standards and is proud of its high standards and what we’re doing here is really just slicing off a little piece of our reputation and giving it to Hydro Quebec.

Bob Kinzel, Lawmakers Pass Bill Making Hydro-Québec ‘Renewable’, Vermont Public Radio (May 7, 2010 5:49 PM), http://www.vpr.net/news_detail/87979/. Environmental groups opposing legislation that would relax the restrictions on large hydro in Connecticut and Wisconsin likewise articulated protectionist objections. The Sierra Club similarly criticized a 2011 Wisconsin bill allowing large hydro to qualify as a renewable resource, referring to it as the “Outsourcing Clean Energy Jobs to Canada Bill.” See Sierra Club – John Muir Chapter 2012 Legislative Scorecard, Sierra Club, http://www.sierraclub.org/sites/www.sierraclub.org/files/sce/wisconsin-john-muir-chapter/newsletters/SCJMC_2012_LegScorecard.pdf. In Connecticut, the Conservation Law Foundation warned that “RPS recognition of large-scale hydropower will merely serve to funnel ratepayer funds to foreign Canadian utilities for a resource that is already economically viable.” Letter from N. Jonathan Peress, Dir., Clean Energy and Climate Program, Conservation Law Found., to Debra Morrell, Connecticut Dep’t. of Energy and Envt. Protection, Bureau of Energy and Tech. Policy, regarding 2012 Comprehensive Energy Strategy for Connecticut at 8 (December 21, 2012) (on file with author).

[39] See West Lynn Creamery, 512 U.S. at 205 (“Preservation of local industry by protecting it from the rigors of interstate competition is the hallmark of economic protectionism that the Commerce Clause prohibits.”).

[40] Richard A Epstein, How Progressives Rewrote the Constitution 23 (Cato Institute, 2006).

[41] North American Agreement on Environmental Cooperation, U.S.-Can.-Mex., Sept. 14, 1993, 32 I.L.M. 1480, available at http://www.cec.org/Page.asp?PageID=1226&SiteNodeID=567 (last visited Mar. 19, 2015).

[42] Harvey L. Reiter, America’s Energy Future: So Who Are the Good Guys?, 151 Public Utilities Fortnightly,. no. 10 52, 56 (2013) (and sources cited therein).

[43] See, e.g., John Upton and Climate Central, Solar Farms Threaten Birds, Scientific American (August 27, 2014), http://www.scientificamerican.com/article/solar-farms-threaten-birds/ (describing how thousands of birds have crashed into or been incinerated by large solar arrays in Arizona and Nevada); Rose Eveleth, How Many Birds Do Wind Turbines Really Kill, Smithsonian.com (December 16, 2013), http://www.smithsonianmag.com/smart-news/how-many-birds-do-wind-turbines-really-kill-180948154/?no-ist (citing estimates that “somewhere between 140,000 and 328,000 birds die each year from collisions with wind turbines”).

[44] See Todd Woody, Water Use by Solar Projects Intensifies, N.Y. Times (Oct. 27, 2009), http://green.blogs.nytimes.com/2009/10/27/water-use-by-solar-projects-intensifies/?_r=0.

[45] Alan S. Blinder, Free Trade, in The Concise Encyclopedia of Economics (David R. Henderson ed., 2d ed. 2007), available at http://www.econlib.org/library/Enc/FreeTrade.html.

[46] Reiter, supra note 42, at 59, 69.

[47] See Vt. Stat. Ann. tit. 30, § 8002(2)(C) (West 2014).

[48] See Wis. Stat. Ann. § 196.378 (West 2014) (under Wisconsin’s law, removal of the limitation on treating large-scale hydroelectric facilities as renewable will take effect on December 31, 2015).

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Changing Management in the Face of Shareholder Activism: Issues to Consider

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Melissa Sawyer and Matt Friestedt*

Recently it has become relatively common for shareholder activists to advocate for changes in senior management, not just changes in board composition.[1] In the face of this pressure, some companies have announced changes to their leadership teams.[2] These changes can create strife in the boardroom and tension among employees.[3] Leadership transitions also raise a number of disclosure and other legal issues that companies should take into account if a board decides to respond to activism in this manner. This article provides a checklist of issues that regularly arise in these situations, although it is certainly not an exhaustive list since the facts and circumstances of every situation vary. For simplicity, this checklist focuses on the scenario where the leadership change is occurring at the CEO level, since that is the position most frequently called out for change by activists.

I.         Selecting the Successor

Once a board decides to change the CEO, the first issue the board will face is who should be the successor. Many boards perform succession planning in the ordinary course of business.[4] However, if the designated successor for a departing CEO is that same CEO’s next in command, an activist may not view this as a satisfactory solution, since the perception may be that the “number two guy” will just offer “more of the same” as the departing CEO. That being said, if the decision to terminate a CEO is made quickly and confidentially, it may not be practical to line up an alternative successor who can assume the reins immediately upon the announced departure. Meanwhile, it is typically considered undesirable to leave a lame duck CEO at the helm for a transition period while the board looks for his or her replacement. Accordingly, many companies opt to appoint an interim CEO while they conduct a broader search for a permanent CEO.[5]

The interim CEO could be one of the company’s existing executives, but he or she could also be a director who has prior industry experience and knowledge of the company.[6] Another option is to bring back a former CEO or founder who had previously retired from the company.[7] The decision of whom to select as interim CEO will depend in part on what the board perceives to be the primary responsibility of the interim CEO. Some examples include, a “seat warmer” who is charged with managing the day-to-day operations until the board selects a permanent CEO, a “marketer” who sets the company up for an IPO or sale, and a “fixer” who tries to make significant strategic or operational changes to the company’s existing businesses or sells off or shuts down underperforming parts of the business.[8] This can also be an opportunity for the board to “test drive” the interim CEO to see how he or she performs in the role, with the possibility of permanent appointment afterwards.[9]

If the interim CEO is an existing member of the management team or even a board member, it is possible that he or she will want to be considered as a candidate for the permanent CEO position. There is no general reason why this should not be permitted, although no promises should be made in that regard, especially given that the leadership transition may need to occur very quickly under the spotlight of a proxy contest and the board may not have an opportunity to vet the relative merits of the interim CEO relative to other potential candidates.  In this regard, it is important that the new employment agreements and equity awards (if any) that are granted to the interim CEO be consistent with the interim/temporary nature of the appointment (e.g., term of employment period, severance and vesting period of equity awards).[10]

To identify a permanent CEO, it is typical for the board to form a search committee, comprised of board members with expertise and interest in the issue.[11] Typically, the search committee includes the chairman of the board, and often the chair of the compensation committee and/or the chair of the nominating and corporate governance committee. The search committee usually retains an executive search firm to help identify a short list of prospective candidates.[12] Industries undergoing consolidation tend to have many qualified candidates available, whereas in other industries the search committee may have to look further afield. At the outset, the search committee should articulate the key characteristics it is seeking in a permanent CEO. These characteristics may be informed in part by the activist’s criticisms of the outgoing CEO, but should also account for the directors’ own views regarding the company’s strategic direction and culture and the candidate’s ability to work well with the remaining management team.

II.        Compensation and Benefits

There are at least five critical issues regarding compensation and benefits associated with leadership transition: (1) what separation arrangements to implement with the departing CEO; (2) what arrangements to implement with the interim CEO; (3) what retention arrangements, if any, to implement for the rest of the management team that remains; (4) what arrangements to implement for the permanent CEO; and (5) whether to make any changes to current director compensation in consideration for the additional time the board must spend in executing the transition.

A.     Departing CEO Arrangements

Many boards consider whether it makes sense to keep a departing CEO in place during a transition period.[13] This question especially arises in cases where the board is having difficulty in identifying an interim or permanent CEO candidate, but still wants to announce the management change to investors. However, boards often determine that keeping a lame duck CEO in place, even for a short transition period, is not in the company’s best interests. It can be disruptive to the management team, can lead to investor confusion regarding the potential changes in the company’s strategic direction, and a lame duck CEO may not be able or willing to aggressively implement the board’s new mandates.[14] In such situations, one potential compromise is to enter into a short-term consulting arrangement with the departing CEO.[15] Even such consulting arrangements can raise difficult social issues, however, including whether the departing CEO can keep his or her current office and secretary.[16] Despite these difficulties, such consulting arrangements can help provide a basis to enforce a non-compete arrangement or effectively place the departing CEO on “garden leave.” In any case, such a consulting arrangement would not obviate the need to find a replacement, whether interim or permanent.

The departing CEO’s existing employment agreement may already adequately address the possibility of his or her departure so that no additional severance or other arrangements need to be implemented. Even where the activist has criticized the departing CEO for specific performance issues, the departing CEO is typically deemed to be terminated “without cause.”[17] Unless there has been a change of control of the company, a termination “without cause” usually entitles the departing CEO to severance equal to one or two-times salary and bonus (not the two or three-times salary and bonus that would apply following a change of control).[18] The departing CEO may also be entitled to accelerated vesting of his or her equity awards and to a prorated bonus for the year of termination.[19] In some cases, even if the departing CEO’s employment agreement does not expressly provide for accelerated vesting of outstanding equity awards, the company may agree to provide some vesting in order to ensure a smooth and amicable separation. When considering severance benefits or equity vesting beyond those required by the employment agreement, the company should consider whether those benefits will trigger additional accounting charges.[20] Such additional benefits may also form the basis for negotiation to extend the departing CEO’s non-compete or non-solicit periods (to the extent legally permissible in the applicable jurisdiction) or to obtain a release of claims from the departing CEO, all of which can be beneficial to the company. Typically, the Code Section 162(m) deduction limits will not apply to severance provided to a departing CEO, as long as he or she is not the CEO on the last day of the calendar year.[21] Despite this concern, the company needs to be cognizant that the rest of the management team may take a keen interest in how the departing CEO is treated, both out of continuing loyalty to the departing CEO as well as a perception that the departing CEO’s treatment is a potential prelude to how other executives might be treated.[22]

Certain long-serving CEOs have employment agreements that include perks that by today’s corporate governance standards may appear to be atypical, such as life-time health insurance, life insurance policies, car leases, country club memberships or company plane usage rights.[23] To the extent that the departing CEO is entitled to receive any of these benefits post-separation, the company may want to consider “buying-out” these benefits so as to fully cut ties with the prior CEO.

B.     Interim CEO Arrangements

When an interim CEO is brought in on short notice to address activist demands, he or she will typically receive some sort of offer letter, which is often short of a full employment agreement.[24] The compensation committee should review this offer letter with input from an executive compensation consultant.

The interim CEO’s compensation and benefits package should contemplate that the position could very well be a short term one, even if the interim CEO is viewed as a potential candidate for the permanent position.[25] For example, if the interim CEO is a board member who does not live in the city where the company’s headquarters are located, he or she will likely require a housing and travel allowance to facilitate travel to the headquarters on a regular basis while maintaining a permanent residence elsewhere.[26] An interim CEO who is not a member of the current management team (and therefore may be giving up possible job opportunities elsewhere in order to accept the interim CEO position) might request a more robust salary and/or bonus than what would be provided to the permanent CEO, in order to compensate him or her for the opportunity cost of potentially foregoing more permanent positions with other companies during the interim period. It may not be advisable to give an interim CEO equity compensation awards, which are typically contingent on long-term performance and service. Rather, such amounts can instead be rolled into salary or into a special performance-based discretionary bonus.

The board should also consider how to introduce the interim CEO to the management team, and discuss with the interim CEO his or her “day one” plan for hitting the ground running and the board’s expectations about the amount of information or reporting that the interim CEO will provide to them. The board cannot and should not expect to be able to monitor all of the cultural, strategic and other changes that the interim CEO will implement, but the board should try to ensure that the board and the interim CEO share a unified sense of direction. If an earnings call or investor conference is imminent, the chairman should also review talking points with the interim CEO to make sure the interim CEO’s messages regarding the recent management changes and future of the company are consistent with the board’s views.[27] The company’s investor relations firm should also prepare a draft Q&A for the interim CEO to help him or her answer potentially difficult questions regarding the management changes and the interim CEO’s future plans.

C.     Retention Arrangements

If leadership changes are borne out of a proxy fight with an activist, the compensation committee should consider whether to implement additional retention arrangements for the key remaining executives. Depending on the design of the company’s existing equity compensation plans, such arrangements may not be necessary or appropriate. It is possible that getting key employees to sign on to retention arrangements that bridge the time until a permanent CEO is found might be beneficial from an optics perspective, signaling stability to investors and other employees.[28] When discussing these issues with the interim CEO, the compensation committee should consider if there are any other key executives who should not receive retention arrangements, because they may be terminated in the near future.

D.     Permanent CEO Arrangements

Once the search committee identifies a permanent CEO, the CEO’s executive compensation and benefits arrangements should be “business as usual.” Normally, the compensation committee would take advice from an executive compensation consultant about the arrangements, as well as refer to other sources such as ISS pay-for-performance data.[29] Importantly, to the extent that the departing CEO’s compensation arrangements were a source of activist complaints in the past, the company should try to avoid similar complaints when implementing its new arrangements.

E.     Director Arrangements

A significant management transition such as replacing a CEO will probably require a board to have many more meetings than typical. Accordingly, directors (especially members of the compensation committee) should prepare themselves for a significant time commitment to the process. Whether directors should receive extra compensation for these services, however, is very much a fact dependent analysis. In some cases, directors will already benefit from “per meeting” compensation, in which case no additional compensation should be needed.[30] In other cases, where directors receive annual compensation, the optics of increasing director compensation in the face of a proxy contest or other activist activity may be too negative to justify making a change. The issue is a fair topic for discussion at the board level, and should be considered in light of other strategic planning under consideration by the board (such as, for example, whether the board intends to initiate a strategic alternatives process for the company).

III.      Related Changes to Board Composition

Typically, the departing CEO has also served as a director. In such a scenario, his or her separation agreement should also provide for his or her resignation as director of the company and any subsidiaries.[31] If the interim CEO is not already a director, the board should consider whether he or she should be added to the board for the duration of his or her service as interim CEO. If the interim CEO is already a director, then consideration should be given to whether he or she can or should continue to serve on certain board committees. Both the NYSE and Nasdaq have rules that address the independence of an interim CEO and by extension his or her ability to serve on the compensation and audit committees.[32] These rules may continue to apply even after the company has hired a permanent CEO and the interim CEO has returned to his or her prior role. For example, an interim CEO can be expected to participate in the preparation of the company’s financial statements during the interim period, which under Nasdaq rules would bar him or her from serving on the audit committee for three years.[33] Moreover, the interim CEO would be permanently prohibited from serving as an “outside director” under the Code Section 162(m) rules, which will prevent him or her from being on the compensation committee.[34]

In addition, if the interim CEO is already a director and the departing CEO is resigning as a director, the board may find itself short by one member. If the company is in the midst of a proxy fight, it may wish to either appoint a replacement director immediately, or to reduce the size of the board by one seat so as not to leave a vacancy prior to the upcoming shareholder meeting (assuming the company’s bylaws do not impose a higher minimum number of directors).

To the extent that the CEO changes occur in the midst of defending against an activist, the departing CEO’s resignation from the board may present an opportunity for the board to consider other board-level changes. For example, if the departing CEO was also acting as the chair of the board – a situation that is less common now due to ISS and activist attention to this structure[35] but still remains at many companies[36] – his or her departure may create an opportunity for the board to split the chair and CEO positions more permanently by adopting a board policy to that effect. A CEO’s departure can also offer companies a reason to reassess the chairs of various board committees, and in some cases, to revisit who the board’s director nominees will be at the upcoming meeting. For example, if any existing directors are close to the departing CEO, they may not wish to continue serving on the board following the departure.

To the extent a CEO’s departure and related events result in cascading changes at the board level, the company should keep in mind that its debt instruments or equity compensation and severance plans may contain “change of control” provisions that are triggered by proxy contest related turnover at the board level. The company should assess in advance if any of these provisions may be implicated, and to what extent the company can avoid or mitigate the adverse economic or accounting consequences associated with triggering a “change of control”.

IV.      Investor Relations and Disclosure

Many of the changes connected with replacing a CEO will trigger line-item disclosure requirements under Form 8-K, including requirements related to departures of directors and officers and the associated employment and retention arrangements.[37] If the company will be filing a Form 10-Q or Form 10-K within four business days of making the CEO change, it is permitted to announce the changes in that periodic report filing.[38] However, many companies do not want to delay the announcement even by a matter of days, and will file the press release announcing the changes on a Form 8-K as soon as practicable so that they have made sufficient information public to schedule one-on-one discussions with key investors without fear of triggering any Regulation FD issues. Investors will likely be keen for details concerning strategic plans for the company, but the company may not be able to provide them until some time after the interim CEO has been “in office” and has had an opportunity to consider the relevant options.

V.        Trading by the Departing Executive

In addition to Form 8-K disclosures, the departing CEO and interim CEO will likely need to file Section 16 filings.[39] This is a relatively standard disclosure that in and of itself should not raise any eyebrows. However, Section 16 filings raise the question of to what extent the company can and should open its trading window once the CEO change has been disclosed. This issue calls for a very “facts and circumstances” based analysis. While the CEO change itself may be public knowledge, there could be other attendant circumstances – e.g., an upcoming earnings announcement or pending strategic developments – that are not yet public knowledge. A further question sometimes arises as to whether the company can help the departing CEO divest his or her stake in the company, such as authorizing a share buy-back. If the trading window is open and the company is authorized to execute buy-backs, such an action is theoretically possible. However, the optics of such a strategy may be negative in the face of a proxy contest. In any event, the company should consider imposing a discounted repurchase price relative to the then-current market price of the company’s common stock. The rationale for the discount is that it dispels the potential optics of the departing executive deriving any undue profit at the expense of the Company’s shareholders by trading at an especially fortuitous time not in the Company’s interests, achieving liquidity not otherwise available to other market participants and/or avoiding the potential impact of pressure on the market price that could result from a large trade.

VI.      Other Issues

Many other legal questions will arise in connection with a CEO transition. For example, ISS and other proxy advisory firms have adopted policies regarding the extent to which interim executives can be considered independent once they revert to merely being directors (and the proxy advisory firm’s requirements are not necessarily consistent with applicable stock exchange or Exchange Act requirements).[40]

Because these questions are so complex and fact specific, companies are recommended to retain outside advisors with expertise in these matters sooner rather than later. Indeed, in order to preserve confidentiality, the board may wish to engage outside advisors before even alerting the general counsel or director of human resources about the impending changes.

 

Preferred citation: Melissa Sawyer & Matt Friestedt, Changing Management in the Face of Shareholder Activism: Issues to Consider, 5 Harv. Bus. L. Rev. Online 61 (2015), https://journals.law.harvard.edu/hblr//?p=3978.

* Melissa Sawyer is a partner in the Mergers and Acquisitions Group of Sullivan & Cromwell LLP, and Matt Friestedt is a partner in that firm’s Executive Compensation and Benefits Group.

[1] See, e.g.,Bill George & Jay W. Lorsch, How to Outsmart Activist Investors, Harvard Bus. Rev. (May 2014), http://hbr.org/2014/05/how-to-outsmart-activist-investors/ar/1; Moody’s Investors Service, Shareholder Activism: Impact on North American Corporate Sectors 10, 12, (Mar. 2014); Doug Steiner, Wes Hall: From Mail Room Clerk to Bay Street Power Broker, The Globe and Mail (Jan. 30, 2014), http://www.theglobeandmail.com/report-on-business/rob-magazine/make-friends-now-or-enemies-later/article16579456/?page=1 (“Wall Street agitators…want underperforming executives to raise shareholder returns fast, or get out of the way”). For example, Hertz Global Holdings Inc.’s Chairman and CEO Mark Frissora stepped down from his position less than three weeks after activist investors Carl Icahn and Fir Tree Partners called on him to resign, and was replaced by an interim CEO as the board searched for a long-term replacement. Alexandra Higgins, Hertz CEO Frissora Resigns Amid Investor Pressure, CQ Roll Call Washington Corporate Governance Briefing, 2014 WL 4401300 (Sept. 8, 2014). Jeff Ubben’s Value Act applied pressure in private “to ease out Steve Ballmer as chief executive at Microsoft.” Stephen Foley, Shareholder Activism: Battle for the Boardroom, Financial Times (Apr. 23, 2014), http://www.ft.com/intl/cms/s/2/a555abec-be32-11e3-961f-00144feabdc0.html#axzz3Dm2Rlint. Corvex Management and Related Fund Management pursued new management at CommonWealth REIT, which resulted in a special meeting of CommonWealth REIT’s shareholders, which in turn resulted in the departure of its President, Treasurer/CFO, Senior Vice President/COO and certain other officers and the appointment of seven new trustees, all of whom were activist nominees. CommonWealth REIT, Current Report (Form 8-K), (May 27, 2014 ), http://biz.yahoo.com/e/140527/eqc8-k.html; David Gelles, Activists Solicit Shareholders to Replace Board at CommonWealth REIT, N.Y. Times (Jan. 30, 2014), http://dealbook.nytimes.com/2014/01/30/activists-solicit-shareholders-to-replace-board-at-commonwealth-reit/?_php=true&_type=blogs&_php=true&_type=blogs&_r=1.

[2] See, e.g., Alexandra Higgins, New ALCO Board Replaces CEO After Proxy Win, CQ Roll Call Washington Corporate Governance Briefing, 2014  WL 4401308 (Sept. 8, 2014) (describing ALCO Stores Inc. board’s decision to appoint an interim CEO after dissident shareholders replaced all seven board members at the company’s annual meeting); Pamela Park, Wausau Shakes Up Leadership Amid Shareholder Activism, Westlaw Corporate Governance Daily Briefing, 2014 WL 1316116 (Apr. 3, 2014) (Wausau Paper announced that its CEO and chairman of the board were both resigning amid activist shareholder calls for leadership changes at the board and management levels); Pamela Park, Corporate Governance 2013: Shareholder Activists Demand Voices in the Boardroom and Changes to Corporate Strategy, Westlaw Corporate Governance Daily Briefing, 2014 WL 241758 (Dec. 26, 2013) (BlackBerry received a $1 billion injection of new capital from Fairfax Financial after agreeing to implement a number of governance changes, including having the CEO step down in favor of a Fairfax nominee and appointing Fairfax’s founder to the Blackberry board as lead director and as chair of the Compensation, Nomination and Governance Committee).

[3] For example, consider the story of activist investor and director of J.C. Penney’s board, Bill Ackman, who replaced the previous CEO with Ron Johnson. After the board replaced Johnson with Myron Ullman as interim CEO, Ackman subsequently entered a standoff with Ullman, and encouraged the board to replace Ullman, before himself resigning. Suzanne Kapner & Emily Glazer, Investor William Ackman Targets J.C. Penney’s CEO, The Wall Street Journal (Aug. 8, 2013), http://online.wsj.com/news/articles/SB10001424127887323477604579000691399643208?mg=reno64-wsj; Susanna Kim, J.C. Penney’s Public Boardroom Battle Ends with Ackman Exit, ABC News (Aug. 13, 2013), http://abcnews.go.com/Business/billionaire-investor-bill-ackman-resigns-jc-penneys-board/print?id=19945920. See also Photo-Me Says CEO and Chairman to Leave Soon, Reuters News (Aug. 24, 2007), http://64.150.182.63/details.php?id=72860&cid=1 (chairman commenting on activist investors’ pressure: “To brutally remove the CEO is madness….He has the loyalty of many people within the business, and the damage caused within the business would be enormous”).

[4] See, e.g., The Board’s Role in Succession Planning, Intel 2011 Proxy Statement (Apr. 4, 2011), http://www.intc.com/intelProxy2011/governance/succession_planning/ (“the Board’s primary responsibilities include planning for succession with respect to the position of CEO and monitoring and advising on management’s succession planning for other executive officers”); Corporate Governance Principles, J.P. Morgan Chase & Co., http://www.jpmorganchase.com/corporate/About-JPMC/corporate-governance-principles#successionplanning (last visited Feb. 26 2015) (succession planning is considered at least annually by the non-management directors and CEO).

[5] See Matthew Semadeni, et al., Interim CEO: Reasonable Choice or Failed Selection?, The Conference Board, June 2014, http://www.conference-board.org/retrievefile.cfm?filename=TCB_DN-V6N12-141.pdf&type=subsite.

[6] See, e.g., CONMED Corp., Proxy Statement (Form DEFA14A) (Aug. 11, 2014) (CONMED appointed an independent director with more than 22 years of experience in the industry as interim CEO); Alexandra Higgins, Platinum calls for special meeting at Echo, CQ Roll Call Washington Corporate Governance Briefing, 2014 WL 3397708, July 14, 2014, (activist investor Platinum Management LLC called for the board of Echo Therapeutics, Inc. to hire a new CEO to replace the interim CEO, who is also Echo’s general counsel and senior vice president).

[7] See, e.g., Jeremy Bogaisky, Congrats, Bill Ackman: Bob McDonald Out at P&G, A.G. Lafley Returning as CEO, Forbes.com (May 23, 2013), http://www.forbes.com/sites/jeremybogaisky/2013/05/23/bob-mcdonald-out-at-procter-a-g-lafley-returning-as-ceo/ (noting the return of ex-CEO Alan George Lafley as President and CEO of Proctor & Gamble after activist investor Bill Ackman urged the board to replace CEO Bob McDonald); Eugene Kim, The Man Who Steve Jobs Considered for Apple’s CEO is Back with a Startup that Lights Google’s Buildings, Business Insider (Sept. 14, 2014), http://www.businessinsider.com/joe-costello-enlighted-interview-2014-9 (Founder Steve Jobs returned as interim CEO for Apple in 1997, eventually dropping “interim” from his title).

[8] Christine H. Mooney et al., Six Ways Companies Use Interim CEOs, 41 ORGANIZATIONAL DYNAMICS 13 (2012); Semadeni et al., supra note 5.

[9] See, e.g., EveryWare Global, Inc., Current Report (Form 8-K) at ex. 10.1 (Feb. 25, 2014) (interim CEO Employment Agreement providing company “may consider” the interim CEO for the position of permanent CEO under terms and conditions to be negotiated after his “initial term” of six months).

[10] See, e.g., Aegion Corp, Current Report (Form 8-K) at ex. 10.2 (May 4, 2014); Tecumseh Products Co., Current Report (Form 8-K) at ex. 99.4 (June 27, 2014).

[11] See, e.g., Globe Newswire, SMTC Announces the Appointment of Larry Silber as Interim CEO and Clarke Bailey as Executive Chairman, Announces Departure of Co (May 14, 2013) (SMTC Corporation appointed executive chairman of the board with “extensive experience as a Chairman and Executive of public companies” to lead the CEO Search Committee’s efforts to identify and appoint a permanent CEO).

[12] See, e.g., Alexandra Higgins, Novatel Wireless shareholders oust CEO Leparulo, CQ Roll Call Washington Corporate Governance Briefing, 2014 WL 2724191 (June 17, 2014) (Novatel Wireless Inc. engaged executive search firm to evaluate candidates for permanent CEO).

[13] For a more in-depth discussion of the various factors to consider in deciding whether to retain a departing CEO on the board during a transition period, see Jason D. Schloetzer, Retaining Former CEOs on the Board, Director Notes (Sept. 2010) https://www.conference-board.org/retrievefile.cfm?filename=DN-015-10.pdf&type=subsite.

[14] “A large survey of U.S. corporate directors concluded that ‘it is very difficult to discuss steps that may reverse a course of action with a board that includes the person who made the original decision and which is comprised substantially of directors whom that individual has appointed.’” Id.

[15] See, e.g., CafePress Inc., Current Report (Form 8-K) (Aug. 4, 2014); CommunityOne Bancorp., Current Report (Form 8-K) (Sept. 12, 2014); CPI Aerostructures, Inc., Current Report (Form 8-K) (Mar. 6, 2014); Curis, Inc., Current Report (Form 8-K) (June 3, 2014); Infusystem Holdings, Inc. Annual Report (Form 10-K) (Mar. 28, 2013); Landauer, Inc., Current Report (Form 8-K) (Sept. 17, 2014); Overseas Shipholding Group, Inc., Current Report (Form 8-K) (Aug. 15, 2014); Pulse Electronics Corp., Current Report (Form 8-K, Ex. 99.2) (July 16, 2014); Reynolds American Inc., Current Report (Form 8-K) (Apr. 16, 2014).

[16] For examples of the “turmoil some directors faced after retaining the departing CEO on the board,” see Schloetzer, Supra note 13 at 1-2, 5-6 (Sept. 2010). In acknowledgement of such difficulties, some companies “take action to stem prevent future difficulties. For example, the governance guidelines outlined in Qwest Communications’ 2007 proxy statement includes, ‘Our CEO must resign as a director when he ceases to be CEO.’ Jeffrey Bewkes, who replaced Richard Parsons in 2007 as CEO of Time Warner Inc., reportedly had a clause in his employment agreement that allowed him to resign if the former CEO (Mr. Parsons) remains on the board for more than one year.’” Schloetzer, Supra note 13 at 7.

[17] See Joann S. Lublin & Scott Thurm, How to Fire a CEO, The Wall Street Journal (Oct. 30, 2006) http://online.wsj.com/articles/SB116217755560707504 (noting the significant litigation risks involved in firing a CEO “for cause” and explaining most boards prefer to minimize adverse publicity, cost and distraction in such situations); Garry G. Mathiason, How to Fire a CEO, Executive Counsel 13 (Fall 2004).

[18] See, e.g., Acxiom Corp., Current Report (Form 8-K, Ex. 10.1) (May 20, 2014); CMG Holdings Group, Inc., Quarterly Report (Form 10-Q, Ex. 10.1) (May 15, 2014); Global Brass and Copper Holdings, Inc., Current Report (Form 8-K, Ex. 10.1) (May 14, 2014); Kalobios Pharmaceuticals, Inc., Quarterly Report (Form 10-Q, Ex. 10.3) (May 8, 2014); KMG Chemicals, Inc., Current Report (Form 8-K) (July 2, 2013); MVB Financial Corp., Current Report (Form 8-K/A, Ex. 99.1) (Jan. 3, 2014); Pulse Electronics Corp., Current Report (Form 8-K, Ex. 99.3) (July 16, 2014); WPX Energy, Inc., Current Report (Form 8-K, Ex. 10.1) (May 2, 2014).

[19] See, e.g., CMG Holdings Group, Inc., Quarterly Report (Form 10-Q, Ex. 10.1) (May 15, 2014); Emcore Corp, Form 8-K, Ex. 10.1) (Sept. 18, 2014).

[20] The company should consider and comply with Section 409A restrictions and limitations, including the six-month delay from the date of employee’s separation from service for deferred compensation owed to the fifty key employees with the highest salaries. I.R.C. § 409A(a)(2)(B)(i).

[21] I.R.C. § 162(m) (2014) (“In the case of any publicly held corporation, no deduction shall be allowed under this chapter for applicable employee remuneration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year with respect to such employee exceeds $1,000,000 . . . . For purposes of this subsection, the term “covered employee” means any employee of the taxpayer if . . .as of the close of the taxable year, such employee is the chief executive officer of the taxpayer or is an individual acting in such a capacity”).

[22] Jessica Silver-Greenberg & Susanne Craig, Citi Chairman Is Said to Have Planned Chief’s Exit Over Months, N.Y. Times (Oct. 25, 2012) http://www.nytimes.com/2012/10/26/business/citi-chairman-is-said-to-have-planned-pandits-exit-for-months.html?pagewanted=1&_r=1& (After an “abrupt” and “dramatic boardroom coup” at Citi, “senior executives at the investment bank convened a group of employees to try to stem any exodus…Among the employees’ questions: why remain at a bank that treated its top executive so harshly?”).

[23] See, e.g., Monster Beverage Corporation, Current Report (Form 8-K) (Mar. 11, 2009) (granting CEO initial and annual fees and all other reasonable expenses relating to membership in up to two business or social clubs to be selected by the CEO at his sole discretion, all costs and expenses relating to the purchase or lease of a luxury automobile, as well as medical, dental, disability, group life, accidental death and travel accident insurance plans at the most favorable level of participation and providing highest levels of benefits available to him); Occidental Petroleum Corporation, Quarterly Report (Form 10-Q, Ex. 10.1) (Nov. 4, 2008) (during any period following Ray Irani’s retirement or termination from the company until his death, company will provide for life insurance at a minimum level equal to three times his rate of highest career annual salary, medical and dental benefits for him and his spouse to an extent no less favorable than the medical benefits provided prior to his retirement or termination, personal tax, accounting and financial planning services); Quintiles Transnational Holdings Inc., Registration Statement (Form S-1) (Feb. 15, 2013) (providing for city/country club dues, an automobile selected by the CEO that is “consistent with his position with the Company,” business use of an aircraft, irrevocable life insurance trusts for himself and his wife, and health insurance for himself and his wife for the duration of their lives).

[24] See, e.g., Aegion Corp, Current Report (Form 8-K, Ex. 10.2) (May 5, 2014); Ambassadors Group, Inc., Current Report (Form 8-K, Ex. 10.1) (May 19, 2014); Hansen Medical, Inc., Current Report (Form 8-K, Ex. 10.1) (Feb. 21, 2014); KMG Chemicals, Inc., Current Report (Form 8-K, Ex. 10.29) (July 2, 2013); Pulse Electronics Corp., Current Report (Form 8-K, Ex. 99.2) (July 16, 2014); Tecumseh Products Co., Current Report (Form 8-K, Ex. 99.4) (June 27, 2014); Verifone Systems, Inc., Current Report (Form 8-K, Ex. 10.2) (Mar. 15, 2013).

[25] See, e.g., Aegion Corp, Current Report (Form 8-K, Ex. 10.2) (May 5, 2014); EveryWare Global, Inc., Current Report (Form 8-K, Ex. 10.1) (Feb. 25, 2014); Hansen Medical, Inc., Current Report (Form 8-K, Ex. 10.1) (Feb. 21, 2014); Tecumseh Products Co., Current Report (Form 8-K, Ex. 99.4) (June 27, 2014).

[26] See, e.g., Aegion Corp, Current Report (Form 8-K, Ex. 10.2) (May 5, 2014); Ambassadors Group, Inc., Current Report (Form 8-K, Ex. 10.1) (May 19, 2014); EveryWare Global, Inc., Current Report (Form 8-K, Ex. 10.1) (Feb. 25, 2014); Hansen Medical, Inc., Current Report (Form 8-K, Ex. 10.1) (Feb. 21, 2014); KMG Chemicals, Inc., Current Report (Form 8-K) (July 2, 2013); Tecumseh Products Co., Current Report (Form 8-K, Ex. 99.4) (June 27, 2014); Verifone Systems, Inc., Current Report (Form 8-K, Ex. 10.2) (Mar. 15, 2013).

[27] See, e.g., Seracare Life Sciences, Inc., Current Report (Form 8-K, Ex. 99.6) (Feb. 13, 2012) (interim President and CEO’s talking points for acquisition announcement conference call). For an example where the Interim CEO and Chairman of the Board of Directors issued consistent messages to stockholders regarding recent resignation of prior CEO and appointment of Interim CEO and company’s financial performance, see Alere Inc., Current Report (Form 8-K, Ex. 99.1-99.2) (July 7, 2014).

[28] See, e.g., Alere Inc., Current Report (Form 8-K) (Sept. 4, 2014) (Alere’s compensation committee awarded retention-based restricted stock units to a number of executives and key employees); Infusystem Holdings, Inc. Annual Report (Form 10-K) (Mar. 28, 2013) ($0.6 million was recorded for retention payments to key employees during a period when “concerned stockholders” successfully lobbied for a series of changes to the board and senior leadership and the CEO resigned).

[29] ISS has a number of primary evaluation factors for its analysis of executive pay. Institutional Shareholder Services, 2014 U.S. Proxy Voting Summary Guidelines 39 (Mar. 12, 2014).

[30] Of the 100 largest US public non-controlled companies that have equity securities listed on the NYSE or NASDAQ, 30 paid board and/or committee meeting attendance fees in 2013. (Of the 30, 23 paid both board and committee meeting attendance fees, 4 paid only committee meeting attendance fees, and 3 paid only board meeting attendance fees.) Shearman & Sterling LLP,Compensation Governance 2013: 11th Annual Survey of the Largest US Public Companies  47 (2013), https://reaction.shearman.com/reaction/corpgov/2013/CorpGov2013_Compensation.pdf. Among the 100 companies, the number paying meeting attendance fees to board and/or committee members rose from 28 in 2012, but overall has declined from previous years, evidencing a growing consensus that director attendance at meetings is mandatory. Id. Many of the 100 companies pay committee retainers, which might serve to compensate directors for additional time spent on an executive search committee. Id.

In surveying 300 publicly traded companies in the financial services, industrial, retail, technology, and energy sectors, Frederic W. Cook & Co. found that compensation for committee member service is usually in the form of meeting fees, and that the median meeting fee was $1,500. Frederic W. Cook & Co., 2013 Director Compensation Report: Non-Employee Director Compensation Across Industries and Size 2 (December 2013), http://www.fwcook.com/alert_letters/The_2013_Directors_Compensation_Report.pdf. But see Melissa Means, NACD Directorship, Establishing, Paying An Ad Hoc CEO Search Committee (Oct. 24, 2012), http://www.directorship.com/establishing-paying-an-ad-hoc-ceo-search-committee/ (“Most companies provide additional pay for service on the three major standing board committees (audit, compensation and nominating and corporate governance) in the form of cash retainers and/or meeting fees. However, we find many boards overlook the need to consider compensation for a newly created ad hoc search committee. As a general rule, any decision regarding whether to compensate an ad hoc committee ideally should be made prior to the committee’s formation. Once the committee has begun its work, it may appear self-serving to go back and compensate members for services already provided. In our experience, companies that consider the issue upfront do end up providing some form of compensation. We recommend that the additional payment be delivered entirely as a cash retainer, rather than as meeting fees, because of the issues involved in having to define and track search committee meetings. Typically, companies set a cash retainer for an ad hoc committee’s chair and members that approximates the cash retainer provided to the audit and compensation committee members.”).

[31] See, e.g., Advanced Energy Industries, Inc., Current Report (Form 8-K, Ex. 10.1) (June 2, 2014); Aegion Corp, Current Report (Form 8-K, Ex. 10.1) (May 5, 2014); Coastal Caribbean Oils & Minerals, Ltd., Annual Report (Form 10-K, Ex. 10(o)) (June 3, 2014); Emcore Corp, Form 8-K, Ex 10.1) (Sept. 18, 2014); Hertz Corp, Current Report (Form 8-K, Ex. 10.1) (Sept. 19, 2014); Pulse Electronics Corp., Current Report (Form 8-K, Ex. 99.3) (July 16, 2014). For examples of the complications that may arise when retaining the departing CEO as a director, see Jason D. Schloetzer, Supra note 13, at 1-2, 5-6 (Sept. 2010).

[32] The NYSE requires listed companies to have a compensation committee composed entirely of independent directors and an audit committee that satisfies the requirements of Rule 10A-3 under the Exchange Act. NYSE Listed Company Manual, Regulation 303A.05, 303A.06 (2014).

Regulation 303A.02(a)(i) of the manual provides, “No director qualifies as ‘independent’ unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company),” with accompanying commentary noting, “the concern is independence from management.” Regulation 303A.02(b)(i) adds, “In addition, a director is not independent if…The director is, or has been within the last three years, an employee of the listed company, or an immediate family member is, or has been within the last three years, an executive officer, of the listed company.” However, the commentary for Regulation 303A.02(b)(i) notes, “Employment as an interim Chairman or CEO or other executive officer shall not disqualify a director from being considered independent following that employment.” Furthermore, although Regulation 303A.02(b)(ii) states a director is not independent if the director has received more than $120,000 in direct compensation from the company, the accompanying commentary notes, “Compensation received by a director for former service as an interim Chairman or CEO or other executive officer need not be considered in determining independence under this test.” NYSE Listed Company Manual, Regulation 303A.02 (2014).

Rule 10A-3 under the Exchange Act requires that members of the audit committee be independent, which excludes individuals who are affiliates of the company and individuals who accept, directly or indirectly, any consulting, advisory, or other compensatory fee from the company. 17 C.F.R. § 240.10A-3(b)(1) (2014).

NASDAQ Stock Market Rules, Regulation 5605(a)(2) (2014) provides a definition of “independent directors” with clarification in Regulation IM-5605 that,

For purposes of paragraph (A) of the Rule, employment by a director as an Executive Officer on an interim basis shall not disqualify that director from being considered independent following such employment, provided the interim employment did not last longer than one year. A director would not be considered independent while serving as an interim officer. Similarly, for purposes of paragraph (B) of the Rule, compensation received by a director for former service as an interim Executive Officer need not be considered as compensation in determining independence after such service, provided such interim employment did not last longer than one year. Nonetheless, the Company’s board of directors still must consider whether such former employment and any compensation received would interfere with the director’s exercise of independent judgment in carrying out the responsibilities of a director.

[33] NASDAQ Stock Market Rules, Regulation IM-5605 (2014) (“if the director participated in the preparation of the Company’s financial statements while serving as an interim Executive Officer, Rule 5605(c)(2)(A)(iii) would preclude service on the audit committee for three years”).

[34] 26 C.F.R. § 1.162-27(e)(3)(i)(C) (2014) (“The performance goal under which compensation is paid must be established by a compensation committee comprised solely of two or more outside directors. A director is an outside director if the director . . . [h]as not been an officer of the publicly held corporation”).

[35] ISS recommends that shareholders generally vote for shareholder proposals requiring that the chairman’s position be filled by an independent director (i.e. that the chair be separate from the CEO), unless the company satisfies an extensive list of criteria. Institutional Shareholder Services, Supra note 29, at14-16 (Mar. 12, 2014). ISS has shown little tolerance for seemingly modest variations from its policies regarding specific duties that the lead independent director must have in order for ISS to recommend against a proposal to split the CEO and chair positions. Sullivan & Cromwell LLP, 2014 Proxy Season Review 7 (June 25, 2014). Proposals requesting that companies separate the roles of CEO and chair were the most common type of governance-related shareholder proposal in the first half of 2014. Id. The number of companies in the S&P 500 that also elected their new CEO as chairman of the board of directors was down to 9.5% in 2013, from 18.8% in 2012, and 19.2% in 2011. Matteo Tonello, CEO Succession in the S&P 500: Statistics and Case Studies, The Harvard Law School Forum on Corporate Governance and Financial Regulation (Apr. 25, 2014), http://blogs.law.harvard.edu/corpgov/2014/04/25/ceo-succession-in-the-sp-500-statistics-and-case-studies/. See also Shelley K. Schwartz, Tipping Point for Combined Chairman and CEO?, CNBC News (Nov. 15, 2012), http://www.cnbc.com/id/49829626#., (“The combined role of chairman and chief executive officer, a corporate governance structure favored by many Fortune 500 firms, may soon go the way of the pension plan….A study of 860 public company directors earlier this year by PriceWaterhouseCoopers’ Center for Corporate Governance found that among the companies that still have a combined chairman and CEO, nearly half of their boards are discussing splitting the role at their next CEO succession”); Charles Tribbett, Splitting the CEO and Chairman Roles – Yes or No?, Russell Reynolds Associates, Dec. 2012, http://www.russellreynolds.com/content/splitting-ceo-and-chairman-roles-yes-or-no.

[36] For example, JPMorgan Chase & Co.’s CEO and Chairman Jamie Dimon emerged victorious in a shareholder vote over whether he would retain both positions in May 2013. Dawn Kopecki & Hugh Son, Victory for Dimon as JPMorgan Shareholders Reject CEO-Chairman Split, Bloomberg (May 22, 2013), http://www.bloomberg.com/news/2013-05-21/victory-for-dimon-as-jpmorgan-shareholders-reject-ceo-chairman-split.html. Other examples of joint CEO-Chairmen and Chairwomen include Wes Bush of Northrop Grumman, Marillyn Hewson of Lockheed Martin, Jeff Immelt of General Electric, Ellen Kullman of DuPont, and Randall L. Stephenson of AT&T. Wes Bush, Northrop Grumman, http://www.northropgrumman.com/AboutUs/CompanyLeadership/Pages/Detail.aspx?itemId=0001&loc=%2F&rel=%2F&name=CorporateLeadership; Marillyn A. Hewson, Lockheed Martin, http://www.lockheedmartin.com/us/who-we-are/leadership/hewson.html; Jeff Immelt, General Electric, http://www.ge.com/about-us/leadership/jeff-immelt; Ellen Kullman, DuPont (Jan. 2014), http://www.dupont.com/corporate-functions/our-company/leadership/board-of-directors/articles/kullman.html; Randall L. Stephenson, AT&T, http://www.att.com/gen/investor-relations?pid=7824. According to an analysis of proxy statement disclosures performed by Spencer Stuart and features in its U.S. Board Index (series 2003-2011), the number of S&P 500 companies with one person serving as both CEO and chairman dropped significantly between 2003 and 2011, from 77% to 59%. Deloitte, Board Leadership: The Split CEO/Chairman Structure Debate, The Wall Street Journal (June 29, 2012), http://deloitte.wsj.com/cfo/2012/06/29/board-leadership-the-split-ceochairman-structure-debate/. Interestingly, the percentage of companies with independent board chairs was far lower in the United States than in Canada, Germany, and the United Kingdom (as of 2011, when Deloitte conducted an analysis of the large publicly held companies in those countries). Id.; Deloitte Global Center for Corporate Governance, Board Leadership: A Global Perspective (May 2011).

[37] United States Securities and Exchange Commission, Current Report (Form 8-K), Item 5.02; Federal Securities Law Reporter, Regulation 229.401, Item 401(“Regulation S-K”)) (2014).

[38] Exchange Act Form 8-K Questions and Answers of General Applicability, United States Securities and Exchange Commission, Question 101.01 (May 16, 2013), available at http://www.sec.gov/divisions/corpfin/guidance/8-kinterp.htm (“a triggering event occurring within four business days before the registrant’s filing of a periodic report may be disclosed in that periodic report”).

[39] 15 U.S.C. 78p (2014). With regard to 16(a), “Upon becoming an officer or director of a company that has equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934 (an ‘issuer’), a person immediately incurs an obligation to file reports under Section 16(a) of the Securities Exchange Act of 1934 . . . . Section 16(a) reports must be filed by reporting persons for transactions by them, unless otherwise exempted, involving securities of the issuer . . . . An officer or director who terminates his or her position with an issuer will continue to be a reporting person and to have an obligation to file reports under Section 16(a) for a six-month period following the date of his or her last opposite way transaction, which was subject to Section 16(b), prior to the date he or she terminated his or her reporting position.” Stanton P. Eigenbrodt, A Practical Guide to Section 16: Reporting and Compliance § 3.01 (4th ed. 2013).

Exchange Act Section 16(b) allows issuers to recover short-swing profits from insiders, using the definition contained in Section 16(a), and applies to every person who is directly or indirectly the beneficial owner of more than 10 percent of any class of any equity security, other than an exempted security, which is registered pursuant to Exchange Act Section 12, or who is a director or an officer of the issuer of such security. “Short-swing profits are profits derived from any purchase and sale, or any sale and purchase, by defined insiders of their own company’s equity securities, or security-based swap agreements involving any such equity security, within a six-month period. The sales and purchases need not be connected to each other. In addition, with the reference to any purchase and sale, an insider will be liable even if the net result of a series of transactions during the short-swing period is a net loss if any single purchase can be matched with a sale at a higher price during a six-month period.” James Hamilton et al., Guide to Section 16: Insider Reporting and Short-Swing Trading Liability ¶801 (2004).

[40] ISS considers former CEOs (including CEOs prior to the company’s IPO, to be “Affiliated Outside Directors,” and recommends voting against them or withholding one’s vote when the Affiliated Outside Director will serve on the audit, compensation or nominating committee, when the company lacks an audit, compensation or nominating committee so that the full board functions as that committee, when the company lacks a formal nominating committee, even if the board attests that the independent directors fulfill the functions of such a committee, or when independent directors make up less than a majority of directors. Institutional Shareholder Services, Supra note 29, at14-16 (Mar. 12, 2014). Glass Lewis has stated that a director currently serving in an interim management position should be considered an insider, while a director who previously served in an interim management position for less than one year and is no longer serving in such capacity is considered independent. However, a director who previously served in an interim management position for more than one year and is no longer serving in such capacity should be considered an affiliate for five years following the date of his or her resignation or departure from the interim management position. Glass Lewis & Co., Proxy Paper Guidelines: 2014 Proxy Season 2 (2014). Egan-Jones defines “independent director” to be an individual who has no material relationship with the company other than his or her directorship, has not been employed by the company or an affiliate within the previous five years, has no personal services contracts regarding matters such as aircraft rental, real property leasing with the company, an affiliate, or a member of the company’s senior management, and has not provided legal or consulting services to the company within the previous three years. Egan-Jones Proxy Services, 2014 Proxy Season, Voting Principles and Guidelines 2 (2014).