If goodwill is personal to a shareholder of a C corporation (or an S corporation with built-in gain), in the context of a sale of the corporation’s assets to a buyer, the shareholder may be able to sell the goodwill separately from the assets at capital gains rates and without corporate-level tax. The buyer will be able to amortize the personal goodwill for tax purposes in the same manner as if the goodwill belonged to the corporation. This approach is subject to significant factual development and legal analysis, as described below.

The Personal Goodwill Advantage

The buyer of a corporate target often will prefer acquiring the corporation’s assets instead of its stock. From an income tax perspective, an asset acquisition generally is favorable for a buyer compared to a stock acquisition because it can provide an increase, or step-up, in the tax basis of the assets acquired based on the purchase price. For certain assets, this increased tax basis may be depreciated or amortized, providing tax benefits to the buyer. Acquired goodwill is one such asset: Its tax basis may be amortized over 15 years. In contrast, a step-up in the corporate stock tax basis resulting from a stock acquisition (that is not treated as a deemed asset acquisition under the tax laws) does not result in increased depreciation or amortization, because stock is not an amortizable asset.

A selling shareholder, on the other hand, often will prefer a stock sale over an asset sale. Provided that the shareholder has held its stock for more than a year, gain on the stock disposition generally will be taxed only once (at the shareholder level) at the long-term capital gains rate. If the target corporation is a C corporation or an S corporation subject to entity-level tax on built-in gain (because, for example, it had converted from a C corporation to an S corporation within the last five years), an asset sale, in contrast, generally would result in two levels of tax — once at the corporate level on gain in the asset sale and a second time on the distribution of the net proceeds to the selling shareholder.¹

In instances in which goodwill is a significant asset, the parties’ ability to structure the sale in part as a sale by the shareholder of personal goodwill and in part as a sale by the corporation of its assets may provide desired results to both parties. The buyer will obtain a stepped-up tax basis in all the assets acquired, including the amortizable personal goodwill. The shareholder will incur two levels of tax only on assets sold by the corporation; the personal goodwill sold directly by the shareholder will be subject to only individual taxation at the long-term capital gains rate, provided it has been held for more than one year.

The following examples demonstrate the potential effectiveness of this planning:

Example 1: Corporate Asset Sale

In this case, the target C corporation, Target Corp, sells its assets to Buyer Corp for $1 million cash. Target Corp’s basis in its assets is $0, and thus the corporate-level taxable gain is $1 million. At a 21 percent federal rate, the corporate tax is $210,000.²

Target Corp, after paying $210,000 to the federal government, distributes the remaining $790,000 in liquidation to Shareholder, who is assumed to have a basis of $100,000 in its Target Corp stock. Shareholder’s gain, therefore, is $690,000 and attracts tax at a 23.8 percent rate (combined capital gains rate, Medicare surcharge, and net investment income tax rate), resulting in a tax of $164,220. The total tax paid on the transaction, therefore, is $374,220, leaving Shareholder with $625,780 from the transaction.

Example 2: Corporate Asset Sale With Sale of Personal Goodwill

In this example, Target Corp sells its assets while Shareholder simultaneously sells personal goodwill to which a value of $250,000 has been ascribed. As before, Target Corp pays corporate tax on its sale of assets, but since they are worth less than in the prior case — only $750,000 — there is less corporate tax to pay ($157,500). After Target Corp pays $157,500 of tax, it distributes $592,500 of proceeds to Shareholder. Its gain on this distribution is $492,500 (after reduction for the $100,000 stock basis). Shareholder also pays tax on the sale of the personal goodwill; the goodwill produces $250,000 of gain (personal goodwill, being self-generated, has $0 basis). The gain on the distribution ($492,500) plus the gain on the sale of personal goodwill ($250,000) together are taxed at a 23.8 percent rate, resulting in a total tax to Shareholder of $176,715 and a total tax on the transaction of $334,215. This is $40,005 (approximately 11 percent) less total tax than in Example 1 and provides $40,005 more in after-tax proceeds to Shareholder.

Substance Must Support Form

The significant advantages, described above, to be gained from the proper allocation of consideration to personal goodwill of the shareholders of a corporation should not lure taxpayers to overly aggressive tax planning. A number of factors must be taken into account in determining whether consideration can be allocated properly to personal goodwill and the amount of such allocation. We describe many of these factors below. Certain fact patterns may raise “red flags” that require extra analysis before allocating consideration to goodwill. Examples include:

a proposed allocation of purchase price to the “goodwill” of shareholders proportionately according to shareholdings, regardless of the shareholders’ involvement in the business or the extent of the shareholders’ knowledge and relationships and their benefit to the business, does not support a claim that goodwill is being sold

the lack of any (or any significant) allocation of consideration to the assets of the target corporation (which value may include corporate goodwill, going concern value and workforce in place)

late-in-the-negotiations reallocations of consideration to personal goodwill without a significant nontax business reason for the change

payments of monies to nonowner employees that the employees seek to have treated as payments for personal goodwill rather than transaction bonuses generally will not work.

In what cases, then, does personal goodwill exist, and how does one substantiate and document the sale of such an asset?

Personal Goodwill Must Be Personal

The goodwill must be personal to the selling shareholder and must exist separately from corporate goodwill. Determining whether certain skills, experience, knowledge or personal relationships possessed by shareholders constitute personal goodwill is a fact-intensive inquiry.

In the seminal Martin Ice Cream decision, a father and son operated an ice cream distribution business through Martin Ice Cream Company.³ Mr. Arnold, the controlling shareholder, exchanged his stock for ownership of a subsidiary called Strassberg Ice Cream Company. Martin Ice Cream then transferred its distribution business to Strassberg, which then sold Mr. Arnold’s personal goodwill related to his relationships with customers to another company. The Tax Court held that the goodwill related to Mr. Arnold’s relationships with customers belonged to Mr. Arnold, not the corporation, because Strassberg’s distribution business depended on Mr. Arnold’s relationships. The court further reasoned that Mr. Arnold did not transfer personal goodwill to Strassberg because he never entered into a noncompetition or employment agreement.

More recently, in Bross Trucking, the IRS argued that Bross Trucking Inc. distributed intangible assets to its sole shareholder, Chester Bross, who then transferred those assets to a trucking corporation his sons owned.⁴ The Tax Court held that there was no distribution of intangible assets from Bross Trucking to Mr. Bross because the personal goodwill already belonged to Mr. Bross. The court explained that, after a government-imposed suspension of Bross Trucking’s operations due to regulatory infractions, any remaining goodwill was a result of Mr. Bross’s personal relationships with Bross Trucking customers. The court then ruled that Mr. Bross never transferred any of his personal goodwill to Bross Trucking because neither Mr. Bross nor his sons signed employment or noncompete agreements.

Subsequently, in Estate of Adell, the Tax Court addressed the impact of personal goodwill in an estate tax valuation concerning the value of the decedent’s stock in a corporation.⁵ The Tax Court found that the corporation’s success was due to the personal goodwill of the decedent’s son, reasoning that the decedent’s son’s personal relationships with customers as well as technical expertise were critical to the success of the corporation. The court also recognized that the decedent’s son did not transfer his goodwill to the company through a noncompetition agreement, but instead was free to use his relationships to directly compete against the corporation.

A Noncompete Kills Personal Goodwill

Courts consistently have held that personal goodwill exists when an individual possesses the right to sell his or her personal goodwill. Conversely, personal goodwill is transferred to a corporation and, thus, does not exist when noncompetition or employment contracts are in force. These agreements demonstrate an intent to transfer personal goodwill and grant exclusive rights to the corporation, ensuring that the individual cannot benefit from personal goodwill without working for the corporation.

For instance, a dentist was unable to allocate any consideration to personal goodwill upon the sale of his wholly owned corporation in a case where he entered into a covenant not to compete when he incorporated his sole proprietorship.⁶ The court held that the goodwill the dentist generated in his sole proprietorship was corporate goodwill
because “the economic value of” the dentist’s relationships with customers “did not
belong to him” because “he had conveyed control of them” through the
noncompetition agreement.

On the other hand, personal goodwill existed when shareholders’ noncompetition agreements expired before they sought to liquidate a corporation and distribute its intangible assets among themselves.⁷ The Tax Court reasoned that, although the shareholders previously signed noncompetition agreements transferring any goodwill they possessed to the corporation, no such contracts existed at the time of the corporation’s dissolution and any personal goodwill of the shareholders did not belong to the corporation.

Transferring Personal Goodwill

To reap the benefits of personal goodwill in an asset sale of a corporation, a seller should document its intention to allocate a value to personal goodwill early in negotiations.⁸ Ideally, the portion of the purchase price of an asset sale related to personal goodwill should be supported by an independent valuation.

To ensure the proper transfer of personal goodwill, a seller typically will enter into a separate agreement to transfer the goodwill as well as a noncompetition agreement (and/or an employment agreement) supporting the goodwill transfer. Generally, in connection with a corporate asset transaction, an amount separately paid in consideration of a noncompetition agreement is taxed to the seller at ordinary income rates. On the other hand, if the noncompetition agreement is made primarily to ensure the buyer has the exclusive right to use the acquired personal goodwill, allocation of consideration may be able to be made away from the noncompetition agreement and to the personal goodwill transfer, resulting in taxation to the seller at capital gain rates.

Notably, a noncompetition agreement may be insufficient to meaningfully support a transfer of personal goodwill from seller to buyer. If personal goodwill represents a seller’s relationships with customers, the buyer should ensure that the seller is contractually obligated to provide introductions and facilitate a smooth transition of these relationships. On the other hand, if personal goodwill represents the seller’s knowledge, skills or experience, the buyer should ensure that the seller is contractually obligated to teach the buyer these skills or knowledge.

Pepper Perspective

As noted above, tax planning with respect to transactions involving the potential sale of personal goodwill depends on all the facts and circumstances of the relevant business and various agreements between the seller (personal goodwill owner) and the corporation. Specifically, the seller may be precluded from selling its goodwill separate from the sale of the corporation’s assets if, for example, a noncompete between the seller and the corporation is in place at the time of the sale. Given the potential significance of the tax consequences to a seller who does have valuable personal goodwill, a review of the relevant agreements, facts and documentation of this type of asset is advisable well in advance of preparing for a sale transaction.

Endnotes

This article was published in Law360 on September 7, 2018. © Copyright 2018, Portfolio Media, Inc., publisher of Law360. It is republished here with permission.

Merger agreements typically include post-closing purchase price adjustment provisions. A net working capital, or NWC, adjustment, for example, increases or decreases the purchase price post-closing based on a comparison of the final NWC amount delivered at closing to either a target or estimated NWC amount. If parties cannot agree on the proper purchase price adjustment, merger agreements often provide for a dispute resolution process before a third-party accountant or other financial professional. Often, a threshold question in these disputes is whether the agreement’s dispute resolution process is an expert determination or an arbitration — and the answer can have a meaningful impact.

Unlike arbitrators, experts typically do not have the authority to interpret an agreement’s language or address legal arguments. Instead, experts are limited to deciding a specific factual question (e.g., what is the proper value of a particular asset?). In addition, the Federal Arbitration Act only applies to arbitrations — not expert determinations — and, therefore, parties cannot compel an expert determination or enforce an expert’s decision under the FAA. Finally, the standard of review is more onerous for an arbitration award than an expert determination, and that distinction can affect the parties’ ability to overturn the decision maker’s ruling.

Expert Determination or Arbitration?

Many states recognize a meaningful difference between expert determinations and arbitrations. In July 2018, in Penton Business Media Holdings v. Informa PLC,¹ the Delaware Court of Chancery reaffirmed this distinction under Delaware law, noting accord with 24 other states and a split among federal appellate courts.²

In Penton, the court considered a merger agreement that required the parties to submit disputes about the proper allocation of post-closing tax benefits to an independent accounting firm. The seller wanted to provide the accounting firm with term sheets and other extrinsic evidence to support its position on the tax benefit allocation and argued that the accounting firm could determine for itself what evidence it could consider in reaching a decision. Conversely, the buyer claimed that the accounting firm could not decide what information it could consider. The buyer argued that the accounting firm was an expert — not an arbitrator — and therefore had no authority to interpret the agreement.

The parties’ agreement explicitly stated that the accountant shall act as an “expert, not an arbitrator.”³ The Penton court recognized, however, that nomenclature is not necessarily dispositive. Even when an agreement includes the “expert not arbitrator” language, the court envisaged a situation where the dispute resolution process could still be an arbitration.⁴ The court cited with approval New York’s “well-developed body of expert-determination jurisprudence,” which “places heavy weight upon the scope of the [dispute resolution] provision and the procedure that the parties agree to follow” when deciding the question of expert determination versus arbitration.⁵

When an agreement provides for a complete resolution of the parties’ dispute, the process is typically considered an arbitration. Conversely, in an expert determination (often referred to as an “appraisal” in New York), the decision maker’s authority is limited to deciding a specific factual dispute within the decision maker’s area of expertise.⁶ Similarly, an arbitration often follows certain procedural formalities, such as hearings, discovery and witness testimony. On the other hand, an expert determination is more informal and allows the decision maker to investigate beyond the parties’ submissions and to draw on his or her own subject matter expertise.⁷

In Penton, the court held that the parties’ dispute resolution process was, in fact, an expert determination — not an arbitration. The court found that the agreement’s “expert not arbitrator” language was evidence of the parties’ intent and that there was no conflict with the agreement’s provisions defining the dispute resolution process. The agreement limited the accounting firm to resolving disputes about the information contained on the tax form and further limited the information that the accountant could consider in reaching a decision.⁸

Federal common law arguably requires less to find an agreement to arbitrate. In McDonnell Douglas Finance Corp. v. Pennsylvania Power & Light Co., the Second Circuit held that an agreement’s dispute resolution mechanism constituted an arbitration clause because its “language clearly manifests an intention by the parties to submit certain disputes to a specified third party for binding resolution.”⁹ Other federal courts similarly have held that “an adversary proceeding, submission of evidence, witnesses and cross-examination are not essential elements of arbitration …. [I]f the parties have agreed to submit a dispute for a decision by a third party, they have agreed to arbitration.”¹⁰ Accordingly, it is important to understand what law will govern any dispute. Indeed, the Penton court noted that 22 states have eliminated the distinction between expert determinations and arbitrations.¹¹

Does the Decision Maker Have the Authority to Interpret the Contract?

In Penton, the parties’ agreement was silent regarding the accounting firm’s authority to interpret the agreement or decide legal issues. But in finding that the dispute resolution process was an expert determination, the court held that the accounting firm did not have this authority. The court instead found that because the agreement “structures a tailored procedure that assigns only narrow questions to the expert … [a]ll other issues go to this court, which is the plenary adjudicator under the forum selection clause.”¹² Conversely, if the court had determined that the dispute resolution process was an arbitration, it likely would have ruled that the accounting firm had authority because an arbitrator has authority to interpret the contract absent specific agreement language to the contrary.

The Penton court proceeded to interpret the parties’ agreement and held, based on the agreement’s “plain language,” that the accounting firm could not consider term sheets or any other extrinsic evidence in reaching its decision. Specifically, the agreement stated that the accounting firm “shall not import or take into account usage, custom or other extrinsic factors” and prohibited “ex parte conferences, oral examinations, testimony, deposition, discovery or other forms of evidence gathering or hearings.”¹³ The court found that this language limited the accounting firm to considering the contract’s language and the relevant tax and accounting principles.¹⁴

Can You Compel a Party to Submit the Dispute for Resolution?

Congress enacted the FAA in 1925, establishing a strong public policy that favors arbitration as a method for resolving disputes. The FAA provides a right of action to compel arbitration and to enforce an arbitration award;¹⁵ however, it only governs arbitrations — not expert determinations. Accordingly, in jurisdictions that recognize a distinction between expert determinations and arbitrations, a party cannot compel an expert determination or enforce an expert’s decision under the FAA.

The FAA’s inapplicability makes it more difficult to compel expert determinations and to enforce the expert’s decision. Generally, a party must file a breach of contract action seeking a declaratory order that instructs the parties to complete the dispute resolution process. These actions invariably include issues beyond whether the parties intended to submit their dispute for expert determination. Parties resisting the expert determination process often claim breach of contract as well as other legal defenses and seek discovery to support those defenses. This can result in a more protracted and costly litigation before the parties ever reach the agreement’s contemplated dispute resolution process.

New York has passed legislation, CPLR § 7601, that specifically allows parties to file petitions to compel expert determination proceedings and to enforce expert decisions. Importantly, however, CPLR § 7601 explicitly reserves the courts’ right to determine legal defenses and arguments regarding contract interpretation, providing that “[w]here there is a defense which would require dismissal of an action for breach of the agreement, the proceeding shall be dismissed.”

What Is the Standard of Review?

Arbitration awards are subject to a more onerous review standard than expert determinations. The FAA provides four bases for vacating an arbitration award:

1. Where the award was procured by corruption, fraud or undue means
    
2. Where there was evident partiality or corruption in the arbitrators, or either of them
    
3. Where the arbitrators were guilty of misconduct in refusing to postpone the hearing, upon sufficient cause shown, or in refusing to hear evidence pertinent and material to the controversy; or of any other misbehavior by which the rights of any party were prejudiced
    
4. Where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final and definite award on the subject matter submitted was not made.¹⁶

Many jurisdictions will also vacate an arbitration award upon a finding of “manifest disregard of the law.”¹⁷ The Second Circuit has “cautioned that manifest disregard clearly means more than error or misunderstanding with respect to the law.”¹⁸ Simple mistakes are insufficient to vacate an arbitration award. “[A] court must find both that (1) the arbitrators knew of a governing legal principle yet refused to apply it or ignored it altogether, and (2) the law ignored by the arbitrators was well defined, explicit, and clearly applicable to the case.”¹⁹

To the contrary, courts have reviewed expert determinations for “fraud, bad faith, or palpable mistake.”²⁰ While this is still a deferential standard, it is significantly less onerous than the review standard for arbitration awards. Courts may overturn an expert determination if the expert lacked a reasonable basis for the decision, failed to follow the dispute resolution agreement’s specific instructions, or incorrectly decided legal issues.²¹ Accordingly, there is a more meaningful opportunity to overturn an expert determination, whereas arbitration awards are vacated “only in those exceedingly rare instances where some egregious impropriety on the part of the arbitrator is apparent.”²²

Conclusion

So what does this all mean? Parties structuring dispute resolution clauses should be both deliberate and explicit. The drafting process is an opportunity to tailor a dispute resolution process that best accomplishes the parties’ objectives. The more specific the agreement’s provisions are, the less opportunity there will be for dispute. Too often, parties use boilerplate language without understanding the potential impact it will have if there is a dispute. Understand your goals, what type of dispute resolution process best achieves those goals, and how different jurisdictions will interpret various agreement provisions. Doing so may help you avoid litigation about the nature of your dispute resolution process.

Endnotes

Daniel Boland is a partner in the firm’s Trial and Dispute Resolution Practice Group, a seasoned and trial-ready team of advocates who help clients analyze and solve their most emergent and complex problems through negotiation, arbitration and litigation.

Published for the 8th International Society of Construction Law Conference-Chicago (September 26-28, 2018). Reprinted here with permission.

ABSTRACT— Far too many mega-projects have failed because of recurring root causes. These causes include: (1) First of a kind (FOAK) projects, either in terms of new technologies or scale; (2) Insufficient information to develop effective project controls and schedules; (3) Design schedules, scope and schedule creep; and (4) cultural differences, whether inside the organization or outside. When one or more of these conditions exist, careful planning at the earliest stages; contract drafting at the risk allocation stage; implementation of certain project management techniques; and early intervention with a variety of dispute resolution techniques can avoid or mitigate costly litigation or arbitration – even before the dust finally settles.

A panel of arbitrators with professional lifetimes of experience dealing with global mega-projects will: (a) explore common root causes of project failures; (b) suggest what changes could have been made at the project planning stage to avoid failure; (b) explain various contracting options to avoid or mitigate risks; (c) discuss practical options during the project to correct or mitigate impending failure; (d) identify various options short of litigation and arbitration to resolve project disputes.

Common Causes and Cures – Planning Stage

Distinctive Aspects of Mega-projects

Mega-projects are generally defined within the industry as very large-capital investment projects that attract a high level of public attention or political interest because of substantial direct and indirect impacts on the community, environment, and companies that undertake such projects.¹ The projects are typically so large that not one company can provide sufficient resources and personnel for all aspects of the project. Nor can a single company afford to finance or absorb all the risks associated with a project of such large magnitude over an extended period of time – a period in which most of the original project team may not even be around to see the ribbon cut at final completion. Typical attributes of a megaproject include:

• Cost above $1 billion USD
• An extended project schedule (greater than four years measured from initial concept development to final completion)
• Multiple and multi-national involvement of designers, engineers, contractors, equipment suppliers and specialty material vendors
• Multiple specialty trade contractors and specialty trade workforces numbering in the thousands of individuals
• Execution of an engineered facility, structure or asset which is technically complex or unusual
• Consortium financing and/or ownership, with multiple, multi-national project stakeholders and investors
• Government involvement with enhanced political dimensions and risks, and
• Cultural and social differences and risks.

As each mega-project features its own complexities and the environment in which it is executed there is often a lack of suitable benchmark projects. It is well known that no two megaprojects are alike, and therefore, such projects cannot be compared. Nevertheless, there are common denominators with respect to cost development and typical underestimation of costs during project appraisal.

Cost overruns occur on almost every mega-project. Without doubt, it can be said that the main cause of cost overruns is the lack of realism in initial cost estimates. Generally, initial cost estimates do not account for changes in project specifications, changes in design, delays and cost of delays, as well as changes in exchange rates among currencies, financing arrangements and safety and environmental demands. Cost underestimation and overruns cannot just be explained by clerical errors and seem to be best explained by strategic over-optimism and misinterpretation of the need, scope and cost of the projects. The usual focus is to get the project underway, then deal with problems as they progress.

At one point in time it was believed that projects executed in the public sector were more prone to cost overruns; but with privately owned, privately financed, and privately-operated projects, the phenomenon of cost underestimation and overruns would disappear — for example, by inducing more discipline and accountability in the planning and execution stages. However, the data indicate, whether the project is managed and executed within the public or private sector or as a public-private partnership, the dual phenomena of cost underestimation and resulting overruns still occur.

While there is some commonality, the challenges faced on a typical construction project are several orders of magnitude less challenging that those faced on a megaproject. The technological complexities, in and of themselves, mean that each mega-project presents unique challenges, any one of which may have a direct bearing on the context within which the management of a project should be examined and judged.

Management of Mega-projects

The management of a mega-project is more challenging than the management of a typical construction project. For example, in a megaproject there is simply not a “one-size-fits-all” or “best” methodology for sub-contracting for the numerous different sub-scopes of work required in a mega-project. The sheer size and complexity of most mega-projects generally results in an execution methodology that involves multiple delivery methodologies and contracting approaches. For example, the specialty trade elements of a process or power generation mega-project may cost more and take longer than the average construction project, requiring the use of multiple specialty trade contractors, each working on an element of the whole and each under a different tailored contractual agreement. A typical construction project may hire one specialty trade contractor to execute the entire scope of that specialty work. But, on a mega-project, management will have to work with multiple contractors to gain sufficient resources to execute that trade specialty scope of work.

Mega-projects are primarily delivered using methods known as Design Build (DB), Engineer-Procure-Construct (EPC), construction manager at risk (CMAR) or construction manager/general contractor (CMGC). Often these approaches are referred to as alternative delivery methods as opposed to the more traditional approach of Design-Bid-Build (DBB). In each case the designer and builder have a relationship that allows for substantial collaboration and interaction, as opposed to the relationships that are formed under DBB where the owner develops the design without substantial input from the contractor who will build the facility.

And, there is the time factor. It is a given in life that the further one attempts to see into the future the less reliable one’s predictions of future conditions will be. The same given applies to mega-projects. The only thing anyone really knows for certain about the future, insofar as a mega-project is concerned, is that there will be changes which will impact the planned execution of that mega-project, and these changes must be managed.

The two primary factors in successfully planning and executing a mega-project are (1) how well the megaproject is managed; and (2) establishing and maintaining control during planning and execution. Management and control are two different, yet interrelated, factors on which the ultimate success of the megaproject rests:²

Management is best defined within the Project Management Institute’s (PMI) Body of Knowledge: Project Management is application of knowledge, skills, tools and techniques to project activities to meet project requirements. PMI then identifies 42 “logically grouped project management processes”³ that form the application platform from which project management activities and actions are taken. (PMI 2008) Essentially, project management is a process (or set of processes) employed to guide and focus work towards achievement of goals which have been set for the project.

Control however is not so easily defined. According to to exercise restraining or directing influence over; Black’s Law Dictionary control would be “To direct or indirect power to govern …” the planning and execution of a megaproject.⁴ In more common usage, control means to “to exercise restraining or directing influence over;⁵ Within megaprojects, and all construction projects, control means primarily to hold in check, to prevent such things as cost overruns and schedule delays or to maintain minimum required quality.

Why is this distinction important? Simply because one can manage a mega-project well, using all of the best available tools and processes, and yet still fail to exercise control over the mega-project during planning and execution. Such failure almost always results in the mega-project failing to meet its scope, cost, schedule and quality goals. Inattention to either management or control at any point in the project execution can have devastating impacts on the success of the megaproject as a whole.

First of a Kind (FOAK) Mega-projects

One often recurring cause of project failures are first-of-a-kind (FOAK) elements via technology, equipment and/or various components. Mega-projects that are one-of-a-kind, by definition, do not have typical historical cost records and data from which to develop a basis for estimates or projections so as to understand whether the technology, the design, the equipment or the components will actually perform to the “theoretical” calculations that formed the basis of the prototypical engineering concepts.

There are good examples and good reasons for wanting to proceed with FOAK projects. For example, in the early 2000s’, the United States Government believed that with its rich and extensive reserves of coal deposits, proceeding with technologies that allowed integrated gasification, combined with combined cycle power plant technology (IGCC), would allow utilities to utilize coal deposits while producing power with significantly less harmful air emissions. But, even though small pilot projects, such as the TECO-IGCC project in Florida, produced economic power at 250 MW, when scaled up to over 600 MW, the impact of that scale up had an unforeseeable and negative impact on the estimated price and schedule. The result was an operating plant, but late on the schedule and with cost overruns of over $1 billion.

Another example was a different IGCC technology, which again based its technology on successful small-scale pilot plants. Yet, the scale up when combined with the unknowns of interconnecting pieces of equipment finally resulted in billions of dollars of cost overruns, coupled with shareholders having to absorb those cost overruns. The end result was a decision to abandon the integrated gasification portion of the plant using only the combined cycle portion of the project to generate electricity.

The question who bears the liability and cost of FOAK impacts becomes even more complicated when there are several parties involved in the engineering planning, typically involving the Employer, the manufacturer of equipment, the designer of the technology and the constructor, all or some of whom may typically be in consortium with the designer who is constructing the FOAK project.

The most effective way to achieve a successful FOAK or complex design that meets the Employer’s requirements and is constructible is to involve both the Employer and the constructor in the design process from the beginning, so as to better understand expected scope, responsibilities and allocations of risk. Attempting to reduce the cost of a mega-project by reducing engineering staff too quickly, or to a level that cannot efficiently and effectively support construction, can cost more than it can save the mega-project.

Project Change and Evolution

The typical construction project is developed in several discrete stages, the most common of which are Initial Project Planning, Engineering/Design, Procurement, Construction, and Commissioning. There may be additional stages, such as testing and start-up of process systems, but almost every construction project includes these basic stages. Within the construction industry there are two methods by which one can stage the execution of a project:

(1) One can move sequentially through those stages generally in the order in which we have listed them, or

(2) One can overlap those stages, initiating each subsequent stage as the preceding stage reaches a point at which it can maintain a lead over the subsequent stage — which is generally referred to in the construction industry as a “fast-track” project schedule.

In a typical construction project, the Employer and constructor have some flexibility as to which sequencing method they will follow over the execution of the project. Mega-projects, from a practical perspective, do not have the same choice for project sequencing. Virtually, all mega-projects are executed on a fast-track schedule, simply due to the fact that sequential staging adds a tremendous amount of time to the already lengthy duration to complete a mega-project. As noted above, the more time it takes to execute a mega-project the less reliable the future project condition predictions. And, the less reliable the future project condition predications, the higher the probability that those conditions will change.

Managing Scope Creep⁶

When design is not well managed and design changes ensue, scope creep is introduced. Not surprisingly, the impacts that can occur on a mega-project is significant. Everyone involved with construction projects generally understands the phenomenon of “ripple effect”. For example: the delay to the delivery of a needed commodity will “ripple” through a particular string of schedule activities necessary to complete a specific element of the full scope of work. Ripple effects are likewise common within mega-projects, but which exhibit another effect which we call the “ricochet effect.” In fact, it is almost impossible to introduce a significant change into one element of work in a mega-project which does not have some unexpected and unintended impact on some other element(s) of work in the mega-project. While ripple effects are generally isolated to a particular string of logically related activities within a scope of work, a ricochet effect can bounce through non-logically linked activity strings in unexpected and unpredictable ways all of which can result in unintended impact consequences for those other activities and often the entire project.

Change management cannot remain a more or less ad hoc activity during which only involve those directly responsible for planning and managing the activity. When a change in any work activity string is contemplated, then it is wise to designate “change representatives” from each of the primary participatory stakeholders who can be actively involved in examining the change. Their particular responsibility will be to determine if there are any ricochet effects which would impact other activity strings thought to be outside of the impact zone of the change.⁷ If any such ricochet effects are identified then the cost and schedule estimates for that change, and the planning to execute the change, need to reflect the ricochet effects.

Controlling cost on mega-projects requires that project management transition from a reactive based cost management to a predictive based cost management. There are three “givens” when it comes to controlling cost on mega-projects.

• First: cost on a megaproject cannot be definitively estimated – for the very simple fact that no one can foresee economic conditions 4 to 7 years (or further) into the future. In the last ten years it has become abundantly clear that the typical historical factors (i.e., average escalation over the previous five years in the construction industry) are not reliable indicators of future economic conditions.
• Second: “the economy” is no longer confined or defined by local, national or even regional location; what happens in one region of the globe can (and does) impact the economy in every region of the globe.
• Third: there is nothing that anyone can do to control the first and second “givens”, including mega-project estimators and project managers. However, participatory stakeholders can stop making the situation worse by overoptimistically “assuming the best possible outcome” at the start of every mega-project.

The hard reality is that there is no basis in fact for a “promised cost” to the participatory stakeholders. No matter how often the term “estimate” is used on a mega-project, the only two realistic data points that can be relied on by non-participatory stakeholders are the original total cost, handed out in the promotional materials, and the actual final cost at the end of the project. Hence, the very first action to take in controlling “cost” is to do a better job of setting non-participatory stakeholders cost expectations. Never give “a number” from which a single promised cost is assumed. Risk models should provide the participatory stakeholder with a probabilistic range of cost results depending upon certain assumptions. Planners should simply provide the range, together with the primary factors which explain the range from best case to at least the most probable case. Then describe how project management intends to exercise control over that which it has control.

Cost control is not the same thing as cost accounting. Cost accounting tells project management where it’s been by reporting where money was expended and compares the costs to date against the control budget. However, once an expenditure has been made and is accounted for, it is history, and even the best project management team cannot control what has already happened. Unlike cost accounting, cost control is focused on where the megaproject cost is at a specific point in time and forecasts where it will be at given points in time in the future based on current conditions, evolving expectations, and cost performance on the megaproject to date. Project computerized cost control tools are amazingly powerful and sophisticated and if properly populated and used can provide project management with cost data in almost real time. Such tools can also perform any number of “what if” forecast scenarios from which project management can chart a cost course through the megaproject.

Managing Schedule Creep

Unlike cost management and control – two distinct elements, schedule management and control are encompassed in one master document which reports where the mega-project has been, where it is headed, and the plan for completion of the Project. From that perspective schedule data is more easily captured, recorded and distributed than cost data. However, the fact that the data is encompassed in a single schedule may also be one of the significant weaknesses when attempting to exercise control over “the schedule.” This is because of the nature of scheduling and preconceptions relative to CPM scheduling which have been set over years of experience with CPM scheduling on “typical” construction projects. For example, unlike a typical construction schedule:

• the megaproject schedule will encompass a much longer total duration than the typical project
• the mega-project schedule will cover a broader, more complex scope of work
• the megaproject schedule will most likely involve initial input and updating from a higher number of participatory stakeholders
• the megaproject master schedule is not easily converted into a document which can be used by separate participatory stakeholders to actually plan, manage, and control their own individual scopes of work.

The first schedule control point is to recognize that developing a schedule for a mega-project is an iterative process which necessarily involves input and by-in by participatory stakeholders, all or some of whom may not be known until planning is underway or complete. Consequently, mega-project management is often forced into the position of prematurely trying to forecast a completion date, without having the details which would confirm the reasonableness of the completion date, which, of course sets the stage for stakeholder frustration.

The second schedule control fact is that optimistic bias is actually built into the schedule in the form of the critical path, which assumes no float in that critical path schedule. However, as much as cost is impacted by events and issues completely outside of management’s control, schedule is even more vulnerable to such impacts as they can flow from something as catastrophic as an earthquake or as seemingly benign as having to move a heavy haul crane more times than expected.

The third schedule control fact is that schedule is much more sensitive to both ripple effects and ricochet effects than cost, which makes both identification, trending and forecasting more complicated as those effects may pass through hundreds of different and even seemingly unrelated activities on a given megaproject.

Fortunately, some of the most powerful planning and control tools available to project management are specifically designed to address planning, managing and controlling schedule on what is essentially a real time basis. Those sophisticated schedule and control tools, operated by enough properly trained and experienced schedule control staff, provide project management with both a sound trend and forecasting capability. Most often, however, the problematic issues are not in the tools, but failing to use the tools effectively.

Managing Cultural Differences

Although effective schedule and cost control are crucial to the success of the mega-project, effective management also requires knowledge about dealing with people, organizational options, and communications. Cultural factors may differ significantly in the diverse cultures which exist around the world. For example, an examination of cultural perspectives of engineers and constructors from Japan reveals that the Japanese consulting engineers have traditionally designed and constructed projects in a different manner than that of their counterparts in the United States and Europe (collectively the “Western Nations”). These differences are typically reflected in management and operation methods and have primarily been based upon Asian values, which from a cultural perspective are quite in contrast with the values perceived to be important in the Western Nations.

One of the most significant cultural differences, for example, resides in the difference in perspective between the Japanese contract management basis of “mutual trust” versus the Western Nations contract management basis of “mutual mistrust”. This dichotomy is a major contributor in Japanese consulting engineers having difficulties managing multi-national mega-projects with a high level of Western Nation stakeholder participation. Simplistically, “mutual trust” assumes that regardless of what a contract document might state, the parties will ultimately resolve issues “fairly” once the mega-project has been completed. “Mutual trust” leads the Japanese consulting engineer to resist preparing formal written notices of impacts, regardless of what the contract document may require. The assumption by the Japanese consulting engineer is that everyone is fully aware of the impact issue, and that the Employer will, in fairness, adjust the cost and/or schedule requirements contained in the contract in recognition of those known impacts. To submit a formal notice is seen as an insult, implying, for example, that the Employer will not act “fairly” or honorably.

While our example was based on one country, Japan, and one region, the Western Nations, such differences in cultural perspectives exist around the world, and among all countries. Mega-projects by their very nature are seldom owned, financed, planned, executed, and operated by stakeholders residing in a single country. Mega-project management structures by their very size, breadth and complexity involve stakeholders from different countries, each with a different cultural perspective which influences how that stakeholder executes their role within that particular management structure. Success of multi-national mega-projects demands that those stakeholders recognize, and proactively work through, those cultural differences. In particular, project management should ensure that it has sensitized the control staff to the possibility of cultural differences and established processes and systems which address the areas where such differences are most likely to arise:

• Miscommunication across cultural lines is usually a primary cause of cross-cultural problems. Miscommunication can have several sources, including differences in body language or gestures, different meanings for the same word and different assumptions made in the same situation.⁸ Different languages also contribute to the problem, and frequently, the language barriers seem to be ignored, creating confusion and a sense of mistrust among the parties.
• Differing approaches to problem solving is another source of cross-cultural problems. The approaches used by engineers and project managers of different cultural backgrounds to tackle the same technical problem are likely to differ widely. The type of approach used to solve engineering problems is often a reflection of what is emphasized in educational curricula leading to engineering degrees in various countries.
• Differences within organizational cultures can also be problematic. Large companies operate quite differently from small companies, and the same occurs as between government entities and private ones. Some of the most noticeable differences include: the way information is shared and distributed, the hierarchy of departments, approval and decision-making processes. Large firms, as well as government agencies have the tendency to be more bureaucratic.

In order to overcome cross-cultural differences, all stakeholders need to be aware of these differences from the onset of the mega-project. Successful communication is essential, including clarification to ensure that the team players understand everything that needs to be done, as well as getting into the details to avoid the temptation of agreements based on general principles that can create major problems in the long run. At a minimum, training is required with respect to doing business in a given country, as well as doing business with people with different cultural backgrounds. Selection of the right people and with the right attitude towards international and multinational assignments should be a top priority of the executive team. Executives, senior management and management teams should include at least one person originally from the location where the project is to be executed and staff which have experience working with the other cultures represented within the participatory stakeholders on the megaproject.

Common Causes and Cures – Contracting Stage

It is not prudent to discuss legal considerations regarding mega-projects in a vacuum. Strategic objectives and risk tolerance must shape the legal considerations at each stage of the life cycle of the project. Construction lawyers work with all disciplines, including operations, engineering, procurement, finance, project controls and risk assessment. Construction lawyers also work in several roles: to assist with the planning and development of the project, to refine the scope of Work, to select the appropriate project delivery system, to negotiate the relevant contracts, to document the transactions, to provide advice and claims avoidance strategies during the execution of the contract, and, finally, to assist with project closeout and resolution of disputes, if any.

While axiomatic, contract negotiations are, at their core, the negotiation of the risk matrix for the project. Assumption of additional risk in exchange for the payment of additional money or risk premium does occur, and, most efficiently, each risk should be borne by the party best able to manage that particular risk. It is very difficult to allocate risk and establish a risk matrix for the project unless the foreseeable risks are identified pre-contract and expressly allocated to one party or the other during the contract negotiation process.

Project Delivery System

The importance of selecting the appropriate mega-project delivery system cannot be overstated. There are a variety of project delivery methods on mega-projects,⁹ including the one-stop EPC or “turn-key” model, the multiple Contractor model, the Employer’s performance of all or some of the engineering or procurement functions, or the Employer’s responsibility for the engineering, procurement, and construction functions through a cost-reimbursable model. Each approach presents certain advantages and disadvantages, particularly with respect to financial risk, project management responsibilities, and cost control. It is fair to say that the contracting relationships, and the resulting allocation of risks, are defined by the project delivery system.¹⁰ Consequently, the project delivery model must be carefully considered and evaluated to ensure that a proper project delivery method is selected for this particular project, this owner, these financing parties and stakeholders. The failure to select an appropriate project delivery system can be the death knell to a mega-project and can have disastrous financial consequences to all involved.

EPC Consortiums

Given the size, complexity, and duration of mega-projects, EPC consortiums have become the preferred and most common method used for projects of that scale.¹¹ Using the EPC consortium arrangement, the Employer contracts with a consortium on an EPC basis, while the consortium participants internally allocate responsibility for development and execution of the project among themselves. The consortium participants are generally jointly and severally liable to the Employer or Owner, with allocation of responsibility for schedule, costs, and performance for consortium partners addressed in the consortium agreements. A typical collection of participants forming an EPC consortium could include one or more major equipment suppliers, an international engineering firm, and multi-national contractors, and local market contractors.¹²

The EPC consortium allows each of the consortium partners to pool their resources and knowledge in an effort to effectively complete the project, but requires a heightened level of communication and coordination among the consortium members. This method contemplates a single line of communication between a designated representative of the consortium and the Owner, and a separate and distinct internal line of communication between the designated representative of the consortium and the designated representative of each participating members of the consortium and potentially their subcontractors and suppliers.

There are a number of risks and challenges associated with an EPC consortium, each of which must be identified and addressed in order to achieve a successful project. Two of the primary challenges facing consortiums are differences in culture among its members and differences in approach to a project.

EPC Consortiums – Cultural Differences

EPC consortiums are typically composed of members that are based in different countries and which come from different legal traditions.¹³ The presence of these fundamental legal and cultural differences can present increased difficulty with communication and in achieving consensus and agreement regarding the development and execution of the project. Aside from the potential communication-language barrier, varying business practices and approaches stemming from each members’ culture can present significant obstacles if not dealt with directly and affirmatively. For example, on a large fossil fuel power plant, the design and major equipment for the boiler works may come from Japan, while pipe and structural steel for the boiler works are supplied to the boiler OEM from China and eastern Europe. The design and major equipment for the air quality control system may come from France, the design and major equipment for the turbines and related scope of supply may come from Germany, and the balance of plant design and civil design is subcontracted to a local engineer, while structural steel, miscellaneous metals, and other supplies come from China, Asia, or other regions of the world. The Contractor, and its project execution, project management, contract management, and project scheduling and controls teams may come from the United States. Under this scenario, the consortium must clearly define the responsibilities and potential liabilities of each participant, and must ensure that each participant understands the unique nature of constructing a megaproject in the local region. Each country or region has many unique features that must be clearly understood, anticipated, and managed if a project is to be successful. Labor unions rules and the price of labor, for example, may be a significantly larger cost in the United States and Canada than it may be in Japan, China, Latin America, or other areas of the world. Consortium participants that typically work in parts of the world with low labor costs may not commonly face the same demand for labor efficiency and competition for skilled resources that is present in the U.S. Many of the mega-projects, in particular, power projects, that have been built in the U.S. and Canada in the recent past have experienced enormous overruns in labor hours and labor costs. Typically, these cost overruns resulted from schedule delays as a result of late or incomplete engineering or late, incomplete, or out of sequence equipment supply, all of which resulted in a shorter duration for construction. Constructors added crews and worked overtime, often on an extended basis, and also added second or third shifts, leading to significantly higher labor costs than originally anticipated. Because the number of the craft labors significantly increased (doubling or more in some cases), extended travel and lodging were required on most of these projects, further adding to the cost of labor and stressing the capacity and quality of labor pool.

Similar issues have existed with large multi-national contractors performing work in regions remote to their base of operations. A number of contractors have encountered significant issues with the quality of foreign labor contracted to the project. To offset issues with foreign labor, contractors may significantly increase the number of expatriates dedicated to the project, causing an increase in overall labor and staffing costs. Other issues, such as fundamental differences in project scheduling and project controls, can create significant difficulties among consortium members from different cultures and backgrounds.

EPC Consortiums – Differences in Experience and Approach

EPC consortiums often include a collection of participants that have had significant successes on EPC projects and have developed certain approaches and methods that have proved to be “the right way to do it” through their respective experiences. This blending of knowledge and experience is one of the benefits of the consortium, but it also presents practical difficulties in executing the project because there is normally not necessarily a singular entity guiding the project. The consortium partners must identify and discuss their respective experiences and approaches prior to consortium formation, and they must establish communication and chain of command processes so that the consortium can decide which approaches are best suited for the successful completion of the particular project. The consortium must designate a Project Representative who shall have the singular responsibility of interfacing with the Employer on behalf of the consortium. Selecting a qualified and experienced Project Representative to interface with the Employer, while at the same time effectively communicating within the consortium, is critical to the success of the mega-project.

Another example of differing experiences has to do with the approach to project controls, project scheduling, and cost management. Different organizations may have different approaches to project controls, scheduling, and cost reporting. In addition to the tracking that is performed at the member level, the consortium must have a unified approach to project controls, scheduling, and cost management. This requires a team that is employed by the consortium to monitor and report on behalf of the consortium. Independence from the individual participants is highly desirable, and transparency with the Employer and the EPC participants yield the highest likelihood for a successful project.

It is particularly important to fully consider all aspects of project controls prior to negotiation of the Contract. The Employer must fully develop its own internal controls and reporting requirements, as well as the reporting requirements of the financing parties and the “independent engineer.” The Contract must consider and integrate these project controls and project reporting requirements with the information being provided to the Employer by the Contractor. This integration is typically handled through detailed appendices to the Contract which provide specific requirements for schedule, cost, quantities, progress, and other performance metrics. The appendices also typically address the requirements for demonstrating entitlement to any extension of contract time and/or contract price, including the requirements of any schedule analysis or time impact analysis. In many cases, the appendices will incorporate recommended standards, protocols, and practices, such as those of the AACE International (AACEI) or the Society of Construction Law (SCL).¹⁴

Proactively identifying cost and schedule issues and trends allows the parties to evaluate mitigation options and other strategies to minimizes schedule and cost risk on large capital projects. It is worthy of note that some of the information that the Employer requires to proactively manage the project execution is exclusively developed by the Contractor.¹⁵ The process of integrating the information and submittal requirements of the Contract with the Employer’s project controls process and project reporting obligations are critical functions that are sometimes overlooked during the contract drafting process. The requirements of the Contract should be designed to require the Contractor to provide to the Employer any information needed so as to meet the Employer’s internal and external reporting requirements, and to fully assess mitigation strategies when adverse schedule or costs trends arise on the project.

Project controls should allow the early identification of performance, budget, and schedule risks, and allow prudent decisions to be made in light of the issues identified. While the level of detail and definition of the project controls system and staff will vary, based on the size, location, complexity, contract type and risk profile of the project, the Employer typically should perform the following functions during the Execution Phase of the project:

• Report costs to date and forecast costs to complete
• Monitor, verify, and document project status against various metrics, including budget, schedule, and payments
• Verify schedule status, including schedule status of major engineering, procurement, and construction activities
• Monitor status of major scopes of supply
• Change management, including design maturation, and
• Internal and external reporting of project data.

Contractors are typically required to submit to the Employer the following types of information on a monthly basis as a precondition to invoice approval and payment:

• contract and payment status
• schedule status
• schedule progress
• quantities installed and stored
• work-in-process
• total project costs
• project progress and other project metrics
• submittal logs
• drawing logs
• status of pending change requests
• status of requests for information
• safety and quality data
• manpower and equipment utilization, and
• a myriad of other project information.

This information is typically provided through a detailed monthly progress report. The key from the Employer’s perspective is to ensure that the Contract requires the Contractor to submit the quantity and quality of information needed in the form most useful. At a minimum, the information must meet the tracking and reporting needs of the Employer and must be sufficient to allow verification of the validity of the construction and schedule progress and all other relevant aspects of the Work.

Addressing Risk Allocation in the EPC Contract

Perhaps the most important task faced by the project participants is the clear allocation of responsibility and risk in the Contract. Identification and acceptance of defined risks by each participant at the outset of the project is crucial, as is trying to ensure that all potential risks are allocated to at least one of the parties and, to the extent possible and financially prudent, mitigated by insurance or other financial instruments. The parties must work diligently at the outset of the project to identity and address all foreseeable risk contingencies. In the context of the EPC Contract, it is generally the Employer’s goal to shift as much risk as possible to the Contractor. Nevertheless, in a general sense, the Employer provides the performance criteria for the project, the site for the project, and access to the work areas as needed to complete the Contract. The Contractor in a general sense agrees to construct the project to meet the agreed criteria within the agreed schedule and in compliance with all applicable laws.

Risks Typically Retained by the Owner/Employer

Although one of the primary benefits to an Employer in utilizing an EPC project delivery system is reduction of risk (and presumably the payment of a risk premium to the Contractor), there are still certain elements of risk that an Owner or Employer typically retains. Examples of the general responsibilities and risks often retained by the Employer include:

• Payment – Securing project financing and being able to pay pursuant to the terms of the Contract
• Environmental Permits and Permissions – Because the Employer assumes the risk of hazardous substances on the site, typically the Employer will obtain the necessary environmental and other permits required to allow for the performance of the work on the project site
• Site Availability and Access – Providing the site for the project, along with the logistics related to accessing the site and often retaining responsibility for materially differing subsurface conditions at the site;
• Site Power – Providing permanent power interconnection to the facility
• Owner’s Representative – Providing an Owner’s Representative with authority to make decisions for the Owner in a timely basis
• Owner Non-performance – The Owner must fully and timely perform its obligations under the Contract
• The right to direct variations and changes in the scope of the Work, with a concurrent obligation to assume the impacts on cost and schedule
• Owner’s Suspension of the Work – While retaining the right to suspend all or part of the work, the Owner will typically bear responsibility for any suspension of the work that it initiates
• Force Majeure and Changes in Law – Force majeure events and changes in law during the execution of the work are typically Owner risks, but are sometimes allocated to and assumed by the Contractor in an EPC Contract
• Performance Guarantees and Performance Testing – Providing achievable performance criteria and evaluation prior to the execution of the Contract.¹⁶

In addition to these responsibilities and risks expressly retained by the Employer under the Contract, there may be certain implied obligations that may be imposed upon an Employer under the federal, state, or local laws of the United States.¹⁷ These implied obligations may include the following:

• The duty to disclose material information to prospective bidders
• Implied warranty of the adequacy of any plans and specifications provided
• The duty to provide accurate performance specifications, and to provide performance criteria that are achievable
• The duty to provide accurate site information, including information concerning known subsurface conditions
• The duty to obtain necessary regulatory approvals, permits, and easements to allow, at a minimum, access to the project site of the purpose of completing the contractual works
• The duty to provide access to the work site, and
• Duties relating to owner-furnished products, materials or equipment.

Risks Typically Allocated to the Contractor in an EPC Contract

The following are items for which the Contractor typically assumes responsibility and risk under an EPC project delivery method:¹⁸

• Site Safety – Ensuring that the labor force is utilizing construction practices and procedures that minimize the potential for incidents and injuries and comply with all applicable health and safety regulations, norms, and standards
• Price – Committing to complete the project at an agreed price
• Labor Risk – Labor risks, including risks relating to labor productivity and labor quality, and labor availability
• Schedule – Managing and implementing an overall project schedule in order to achieve the contractual completion dates, including coordination with all designers, suppliers and subcontractors to ensure compliance with overall schedule and deliverable obligations
• Management of Subsurface Conditions – Constructing the project without disruption or delay due to subsurface conditions that were identified and disclosed by the Owner
• Performance Guarantees – Committing to provide a facility that functions within the specifications and performance criteria agreed in the Contract
• Environmental Compliance – Committing to provide a facility that operates in compliance with environmental rules and regulations required by the government or the underlying environmental permits and environmental laws
• Compliance with Applicable Laws – Committing to comply with all applicable laws, permits, and regulations governing the performance of the works
• Quality Assurance/Quality Control – Developing an appropriate Quality Assurance/Quality Control Plan to ensure that the project complies with the specifications and satisfies the warranty obligations of the Contractor, and
• Craft Support of Commissioning – Providing and managing the craft labor necessary in order to support the start-up and commissioning of the facility.

Ideally, the EPC delivery system should attempt to assign the risks to the party that can best manage and minimize the that particular risk. The failure to properly identify, allocate and manage project risk can be devastating to the overall project, causing severe to catastrophic financial implications to each of the project participants.

Common Causes and Cures – Execution Stage

We have addressed disputes in our last section, below, but it is extremely important to try to resolve individual disputes on the project during execution and as they arise. For example, notice letters are often written during the execution or performance stage of projects, identifying disputes, putting a party on notice, or otherwise “preserving” a position on an issue. Often, these letters become change requests, including a request for additional costs and a request for an extension of time supported by a time impact analysis. Rather than attempt to resolve the issue at that point, project participants often wait until the project is nearing completion, or until consideration is given to assessing liquidated damages for failing to achieve an interim milestone, or, in a worst case scenario, until notice is sent and a default termination is threatened. By that point, the losses have grown, the claims have morphed, positions have polarized, and amicable resolution of the underlying dispute(s) becomes a difficult possibility. Proactive leadership between the project participants is imperative if the project is to be successful. If left unresolved, small, manageable disputes tend to tend destroy cooperative working relationships among project participants, give rise to major claims with significant cost and schedule impacts.

It is often the case that communication issues are at the root of these problems. The personality, background, culture, or perspective of the designated representatives clash, impeding the ability of their respective organizations to communicate with one another to resolve a discrete and manageable issue. If this pattern develops, it can become difficult to control unless addressed promptly by strong management action.¹⁹ Similarly, due to the duration and physical location of mega-projects, there tends to be turnover of the senior site management personnel, and often of the executive management personnel. This can present a number of issues, including the loss of institutional knowledge of both sides. Unless the situation is managed properly, issues that were resolved at an earlier time are questioned, and relationships among project personnel that once existed are lost. Project Examples and Solutions

In dealing with performance problems on mega-projects, identification of “root causes” is critical. We have identified the most common recurring problem scenarios. Now, we shall take several project examples and illustrate how first of a kind” (FOAK) projects can present challenges if not anticipated in contracting and project controls , including schedule preparation. Also, the absence of good communication and accountability for change management and early identification of risks can result in “scope creep.” This increase in work which normally results in major claims occurs particularly when project personnel approach a project from the perspective of a “cost reimbursable” culture as opposed to the contract is “lump sum” or GMP. These cultural differences can also manifest on budget-controlled cost reimbursable projects in substantial overruns and schedule delay. After we examine several projects and illuminate the “root causes of failure or challenge,” we shall suggest a remedy that can minimize risk, identify and resolve issues early, and help record cost and time for later resolution.

Offshore Wind Farm, Europe

An EPC company undertook a windfarm project in conditions that were FOAK – at the time the largest — at least in terms of number of actual wind turbine generators (WTGs) sitting in nacelles supported by masts set into transition pieces which were on top of monopiles driven deep into the seabed. Installation of the WTGs required specialized vessels and were only allowed to work (and in certain cases, only available) in certain months of the year. Further, the conditions at the wind farm were windy — good for electric generation — and stormy. The surrounding seabed was 1,000 feet plus deep, with the sandbar where the WTGs were installed only 35 feet deep in places. The depth differential, plus the wind, resulted in occasional 60-foot high waves, all of which necessitated a careful design, timing, and installation of each unit. The approach taken by the project controls team was challenging – to try to measure wave height, wind speed (and hence a force majeure event for cost, time, or both); it was also extensive, complicated, and required constant record keeping, regardless of season, to record non-work days and adjust schedule activities.

These unique conditions for work under unique circumstances, with a defined force majeure, resulted in substantial additional cost and over a year’s delay of the project to completion. Further, the unique conditions made the inter array cables — which linked with ocean substations for collection and transmittal by massive cables to onshore transmission facilities — were particularly challenging, especially in an area of shipwrecks and unexploded WWII ordinance. The failure by the owner and EPC contractor to contemplate risks of such a FOAK project manifested in prodigious cost and schedule growth.

Processing Facility, Western Hemisphere

A reimbursable EPCM services contract for a FOAK processing facility was designed and built for an owner based on the owner’s proprietary process technology. The owner had previously designed a pilot plant (1:200 scale). After trial runs on the pilot plant, the owner then procured front-end engineering design (FEED) work for a full-scale facility. The owner then procured on a fast-track basis an EPCM services contract from a different firm to perform detailed design, procurement and construction management where all trade contractors reported to the owner (i.e., a multi-prime arrangement).

The FEED work-product, which was given to the EPCM contractor upon award, turned out to be poor and incomplete. Not only was the “scale up” of the owner’s proprietary process inaccurate, but the FEED missed or under-designed usual and customary utilities support (boilers, chilled water systems, building HVAC, etc.). The EPC was challenged to exercise project controls in terms of cost and schedule in an environment where the engineering was being determined as field work progressed. The resulting difficulties included a plethora of design and long-lead procurement problems that ultimately cascaded through all execution aspects, given the fast-tract nature of the project. The problems in construction were exacerbated by the multi-prime approach and the owner’s communications to the multiple prime contractors on how to complete the project.

Lump Sum Turnkey Contract (LSTK) Gas Turbine Power Plant

As a result of a truncated bid exercise, an EPC contractor familiar with the client-Employer was short-listed on a lump sum turnkey gas turbine power plant with a compressed schedule. The Employer maintained responsibility for procurement and delivery of key equipment, including a gas turbine and heat recovery steam generator (HRSG), but elected to use the EPC Contractor as “agent” for final erection and completion. The project controls team could not develop a detailed schedule or cost itemization without delivery information that was slow to materialize; in fact, delivery was incomplete to project controls even after site construction commenced. The culture that evolved over time between the Employer and EPC Contractor was akin to a “cost-reimbursable” relationship, meaning that the EPC’s activities as “agent” included, at the request of the owner, certain installation and erection duties normally undertaken by the suppliers. In addition, the “lay down” area should have been smaller to accommodate parking on the congested site. This fact necessitated “double handling” of materials from a rented yard to the (now) smaller laydown area at the site. The materials handling (and productivity and safety issues) were not improved by placing the laydown yard between the parking area and the actual construction site.

While this particular project had no aspect of new or novel design or construction, insufficient information on deliveries and problems with material and equipment handling exacerbated productivity problems because trades were required to walk some distance, even in bad weather to get to their work stations. The scope of work on scheduled activities was extended as additional tasks were undertaken by the EPC at the owner’s request or default in failing to assign matters to suppliers. Thus, project controls were challenged to keep budgets even close to plan, and the change management was not consistent with a lump sum turnkey project. As a result of the tight time lines and mixed relationships of the parties, the culture of the project evolved into a “get ‘er done” mentality, without careful contemplation or recording of impacts to schedule or cost. The inevitable result was substantial delay, increase in cost of many activities without relief from supplier’s costs, plus redesign costs because of moved valves and instrumentation. Ultimately, liquidated damages were assessed and project overruns became a significant percentage above the contract value.

Hydrocarbon Facility, Europe

In this example of an EPC/LSTK hydrocarbon facility for an international oil company on a brownfield, congested site, the Employer’s contract documents included both site specific and company-wide requirements. The Employer’s team consisted of two disparate stakeholders with two different internal philosophies and cultures – the projects group (with a company-wide purview) and the local site team (whose interests stopped at the site boundary). The requirements from each Employer group were often in conflict; and, to solve its own internal culture conflict, the Employer adopted a “most stringent” approach to interpreting Contract documents.

Added to this unhappy scene, the execution plan called for diverse design resources by the EPC contractor in India and in the Far East. This, in turn, compounded the issues by not alerting project management to potential conflicting directions and led to increased scope growth from each Employer faction. The divided design resources were not sensitive to the need for close coordination, because they were accustomed to pleasing their own clients on cost-reimbursable jobs, coupled with the cultural circumstance that it could be viewed as offensive to correct the Employer on conflicting directions.

These challenging conditions ultimately manifested into cost growth and substantial schedule slippage. Compounding the problems were that the site was highly congested and required significant off-site modularization. Modular-intense projects are particularly impacted by late design and logistical/procurement decisions.

Suggested Execution Stage Solutions

The common causes of mega-project failures we have outlined above, including FOAK technologies, ineffective management and control teams, and cultural differences during execution of major projects can be dealt with to the benefit the Employer and design and contracting disciplines. We now suggest a possible solution by augmenting the project team with an individual filling a key position whose task it will be to early identify and resolve developing problems on mega-projects – before the problem threatens the success of the project. We believe that this measure will be cost-effective, minimize risk, while not displacing or threatening the normal project management team with a “police informant.”)

The “Early Action” Coordinator

The key objective in avoiding or minimizing threats to the success of a mega-project is to first identify and then timely respond to developing issues. Many large EPC and EPCM organizations, including joint ventures, have tried a project counsel;¹ The case has important takeaways for private equity companies, including:

• Private equity companies should perform thorough due diligence on a seller’s ability to assign its assets.
• Private equity companies should review anti-assignment clauses carefully to determine whether they restrict the “right” or the “power” to assign.
• Private equity companies should obtain protections from a seller, including representations and warranties regarding the transferability of assets.

Background

In 2016 and 2017, before it declared bankruptcy, debtor Woodbridge Mortgage Investment Fund 3A, LLC, entered into a prepetition loan agreement and issued three promissory notes to Elissa and Joseph Berlinger in the principal amount of $25,000 each. The promissory notes contained the following anti-assignment clause:

14. No Assignment. Neither this Note, the Loan Agreement of even date herewith between Borrower and Lender, nor all other instruments executed or to be executed in connection therewith (collectively, the “Collateral Assignment Documents”) are assignable by Lender without the Borrower’s written consent and any such attempted assignment without such consent shall be null and void.

The anti-assignment clause not only restricted the assignability of the notes without the borrower’s written consent; it provided that any assignment without consent would be deemed null and void. The underlying loan agreement was similarly drafted.

At the end of 2017, Woodbridge filed for bankruptcy under chapter 11. During the bankruptcy case, the Berlingers assigned their promissory notes to a claims purchaser, Contrarian Funds, LLC. The Berlingers and Contrarian entered into an agreement, in which the Berlingers would “sell, convey, transfer and assign” the promissory notes and rights thereunder to Contrarian. Contrarian then filed a proof of claim in the amount of $75,000 in Woodbridge’s bankruptcy case. Woodbridge objected to Contrarian’s claims on the grounds that the transfers were void and, therefore, Contrarian did not hold a valid interest to submit a claim.

Analysis

Contrarian challenged Woodbridge’s objection on three grounds:

1. Delaware law does not permit anti-assignment clauses that restrict the power to transfer.
2. Woodbridge’s breach of the promissory notes rendered the anti-assignment clause unenforceable.
3. The UCC overrides anti-assignment clauses.

Contrarian’s first argument was that the anti-assignment clause was a restriction on the power to transfer, which is prohibited under Delaware law. Delaware law distinguishes between whether an anti-assignment clause prohibits the “right” or the “power” to assign without consent. A right to assign makes a prohibited transfer a breach of contract, in contrast to a power to assign, which makes a prohibited transfer void. In this case, the court noted that the anti-assignment clause and the loan agreement were clear and unambiguous. The express language of the anti-assignment clause provided a clear intent to restrict the power to assign, as opposed to restricting only the right to assign. Accordingly, the note transfer was void.

Contrarian’s second argument was that because Woodbridge defaulted in its payment, the anti-assignment clause was void. The court held that Woodbridge’s breach did not make the other provisions of the promissory notes, including the anti-assignment clause, unenforceable and that “a non-breaching party may not emerge post-breach with more rights than it had pre-breach.” The court noted that, under basic contract principles, when one party to a contract feels that the other contracting party has breached its agreement, the non-breaching party may either stop performance and assume the contract is voided or continue its performance and sue for damages. Under no circumstances may the non-breaching party stop performance and continue to take advantage of the contract’s benefits.

Contrarian’s last argument to escape the anti-assignment clause was that UCC § 9-408 overrides any anti-assignment clauses. The UCC only prohibits restrictions on the assignment of a security interest in a promissory note and does not prohibit restrictions on assignment of rights under the promissory note itself. Contrarian did not hold, or even assert that it held, a security interest in the promissory notes. It only held an interest on the rights under the notes. Accordingly, the court found that UCC § 9-408 was inapplicable.

The Takeaway

The court rejected Contrarian’s assertions and held that the anti-assignment clause was legally valid under Delaware law, contract law and the UCC. Therefore, the assignment of the promissory notes to Contrarian was null and void, and Contrarian did not have a valid claim in the bankruptcy case.

Private equity companies can take important lessons from this decision, including that they should not underestimate the importance of performing thorough due diligence on any contracts being assumed in an acquisition. In particular, private equity companies should review anti-assignment clauses carefully to determine whether they contain any restrictions on the “right” or the “power” to assign. If the latter, then the assumed contract may be null and void. Finally, private equity companies should obtain protections from a seller, including representations and warranties regarding the transferability of assets. If the seller represents that an assumed contract is transferable and it is actually not transferable, then the private equity company may have a breach of warranty claim.

Pepper Hamilton attorneys have deep experience in drafting commercial contracts and representing private equity companies. If you have any questions about what this case may mean for you or your business, please contact the attorneys at Pepper Hamilton.

Endnote

This article was published in the August 9, 2018 issue of Middle Market Growth, a weekly newsletter published by Association of Corporate Growth (ACG). It is reprinted here with permission.

At this point, private equity firms are very conscious that debt of their U.S. acquisition vehicles or portfolio companies cannot be guaranteed by controlled foreign corporations (CFCs), nor can more than 65 percent¹ of the stock of such CFCs be pledged to support the debt of U.S. shareholders of the CFCs without triggering tax consequences under Section 956 of the Code. While tax reform did not eliminate these rules, certain provisions affect the application of the rules and may, in certain circumstances, raise the question of whether it still is necessary to plan around them.

Background on CFCs and CFC Guarantees/Pledges

A CFC is a foreign corporation where more than 50 percent of the corporation’s stock (determined by vote or value) is owned by one or more U.S. persons (including U.S. partnerships), each of which owns 10 percent or more of the stock (determined by vote or value). Certain indirect stock ownership and stock attribution rules apply in determining whether a U.S. person owns 10 percent or more of the stock and whether U.S. persons collectively own more than 50 percent of the stock of the foreign corporation.

If a corporation is considered a CFC, each U.S. shareholder (i.e., each U.S. person owning 10 percent or more of the CFC’s stock) must include in income, similar to a deemed dividend, certain income of the CFC, known as Subpart F income. Subpart F income generally includes specific types of income that Congress considered easy to shift outside the United States, including passive income, insurance income and certain sales and services income earned outside the United States, but involving related parties.

In addition, the investment of earnings by a CFC in U.S. property also gives rise to an income inclusion for U.S. shareholders. This rule provides a backstop to the Subpart F rules (i.e., if earnings escape inclusion in income as Subpart F income, U.S. shareholders are taxed on the earnings if earnings of the CFC effectively come back to the United States through investment in U.S. property). U.S. property includes the investment by a CFC in debt of a U.S. shareholder of the CFC. If the CFC guarantees the debt of a U.S. shareholder, or the U.S. shareholder pledges more than 66 2/3 percent of the stock of the CFC, the CFC will be deemed to have invested in the debt of the U.S. shareholder, resulting in the requirement to include the income of the CFC up to the amount of earnings and profits of the CFC (or if less, the amount of the debt).

The Rules Are Still in Effect

The House of Representatives tax reform proposal would have eliminated the income inclusion under Section 956 for domestic corporations. Unfortunately, this was not enacted into law, and the rules continue to apply to corporations as well as individuals.

More Corporations Will Be CFCs After Tax Reform
Tax reform revised various rules in a way that will result in a dramatic increase in the number of CFCs. These changes include:

• The 10 percent threshold for determining if a person is a U.S. shareholder now is determined by vote or value (previously, the determination was based solely on vote).
   
• Stock now may be attributed from foreign persons to U.S. persons in determining if the 10 percent and 50 percent thresholds are satisfied.

  For example: If a foreign parent owns all of the stock of each of a foreign subsidiary and a U.S. subsidiary, the U.S. subsidiary is deemed to own all of the stock of the foreign subsidiary, and the foreign subsidiary is a CFC of which the U.S. subsidiary is its U.S. shareholder.
   

• The rule requiring a CFC to be a CFC for 30 days during a year was eliminated.

Global Intangible Low Taxed Income (GILTI) Does Not Eliminate the Issue

Tax reform dramatically expanded the reach of the rules for U.S. shareholders of CFCs. In addition to significantly expanding the class of foreign corporations that will be treated as CFCs, the new provisions require U.S. shareholders to include in income not only Subpart F income, but also their share of a CFC’s GILTI. Essentially, all income of a CFC in excess of a 10 percent return on the CFC’s basis in tangible personal property is GILTI, with certain exceptions. These exceptions include income that avoids treatment as Subpart F income because it is subject to tax in the foreign country at a rate at least 90 percent of the U.S. tax rate (High-Taxed Income). However, for a CFC involved in a service business without a significant investment in equipment, almost all income that does not fall into one of the exceptions will be GILTI.

In light of GILTI, the natural question is whether we should worry about the rules regarding investment in U.S. property. The authors suggest that we should. Ignoring these rules will subject income of a CFC that is not considered GILTI — such as income equal to the return on tangible personal property, High-Taxed Income and certain other types of income — to current taxation at regular tax rates.

Moreover, Treasury has not yet issued regulations clarifying that the GILTI provisions trump Section 956 inclusions. Although the statutory language suggests that this is the case, there is no detailed rule clarifying this, and some commentators have indicated that the opposite is at least a plausible reading. If (while not expected) Treasury were to determine that 956 inclusions take priority over GILTI inclusions, then this would subject the income to significantly higher tax rates in the hands of corporations.

Notably, the determination of a U.S. shareholder’s share of Subpart F income or GILTI is not determined in the same manner as a U.S. shareholder’s 956 inclusion. Moreover, after tax reform, especially the change in the constructive stock ownership rules that now allow stock of a foreign person to be attributed to U.S. persons, many more entities will be treated as CFCs. These two factors may result in U.S. shareholders having income inclusions under Section 956 in cases where they otherwise would avoid GILTI.

Non-Tax Rationale for the Status Quo

It is also worth bearing in mind that providing guarantees and grants of collateral by foreign subsidiaries can be expensive and time consuming. Creditors in U.S.-led credit facilities or debt issuances have generally accepted that they do not need this additional credit support (and are unlikely to take advantage of it in a default scenario), and can be adequately protected through limitations on the incurrence of indebtedness by the foreign subsidiaries. Accordingly, even in circumstances where the new tax law may reduce the impact of having CFC income included under Section 956, consideration should be given to the overall costs relative to the expected benefits to creditors.

Pepper Perspective

Tax reform did not change the rule that requires U.S. shareholders to take into income their share of the earnings of a CFC invested in U.S. property — including by reason of a CFC’s guarantee of debt, or the pledge of the CFC’s stock to secure the debt — of a U.S. shareholder. Changes in the definition of a U.S. shareholder and CFC, and the expansion of the constructive ownership rules, will create significantly more CFCs than under pre-tax reform rules. Although the GILTI rules will subject the income of many CFCs to taxation in the hands of their U.S. shareholders, certain exceptions, including the exception for High-Taxed Income and the return on tangible property, may present limited opportunities for deferral of a CFC’s income, unless 956 were to apply. Additionally, differences in the calculations of a GILTI and Section 956 inclusion could result in larger inclusions under Section 956 than under GILTI. In light of the tax reform changes, U.S. borrowers should reconsider existing financing structures to ensure that they continue to avoid Section 956 concerns. Non-tax reasons, including the fact that lenders have been living with restrictions on CFC guarantees and stock pledges for many years, reinforce the conclusion that U.S. borrowers should continue to restrict the use of CFC guarantees and stock pledges to secure their debt.

Endnote

On May 24, 2018, President Trump signed into law the “Economic Growth, Regulatory Relief, and Consumer Protection Act” (S. 2155), which reformed the widely unpopular rules relating to High Volatility Commercial Real Estate (“HVCRE”) loans. Below is a brief summary of some of the key changes to the HVCRE rules that will impact lending practices with respect to acquisition, development and construction loans.

1. Equity is no longer unreasonably trapped in the project.

Previously: All contributed capital, including all internally generated capital, had to remain in the project. The previous rules trapped any capital a borrower contributed to the project, even if in excess of its requirement to contribute capital of at least 15 percent of the real property’s appraised, as completed value (the “Borrower’s Minimum Capital Contribution Requirement”), which penalized over-capitalized projects. It also trapped all internally generated capital from the project, including all net operating income and any other distributable funds generated by the project, which penalized better-performing projects. So, while the purported goal of the previous rules was to ensure borrowers had skin in the game when dealing with risky highly volatile commercial real estate, the previous rules actually resulted in better capitalized and performing projects being forced to have more skin in the game, which was at best unfair and at worst antithetical to the purported goal.

Now: Only capital equal to 15 percent of the real property’s appraised, as completed value (tested at closing) is required to remain in the project, and this is only until the loan has been reclassified as a Non-HVCRE ADC Loan (see # 2 below for information on such reclassification). This change alone relieves much of the consternation associated with HVCRE, as it means that now, even prior to re-classification, borrower may make distributions so long as the 15 percent minimum equity rule continues to be satisfied. This is of great help for loans that may be classified as an HVCRE ADC Loan even though the financed project already may generate sufficient net operating income prior to completion of the contemplated improvements (e.g., a multi-phased project, a value-add project, etc.).

2. It is now much easier to reclassify a loan as a Non-HVCRE ADC Loan.

Previously: No distributions were permitted until the loan was either converted to permanent financing, sold or paid in full. The ambiguity around how a loan could be converted to a permanent loan created undue burdens on borrowers and lenders alike, with borrowers either being forced to refinance loans upon completion and stabilization or being subject to stringent conversion requirements built into the loan (effectively requiring a re-underwriting of the loan using the same criteria for a permanent loan). Even with this, lenders faced uncertainty as to how the regulators would treat a loan so converted.

Now: A loan can be reclassified by a lender as a Non-HVCRE ADC Loan once the project has been substantially completed and has stabilized such that the cash flow generated by the project satisfies the minimum debt service requirements, in each case using the lender’s underwriting criteria for permanent financing. This means that it is now much easier for a lender to determine when it can re-classify a loan by simply inserting a substantial completion and a debt service threshold condition into the loan agreement at closing which is consistent with the lender’s substantial completion and debt service thresholds for permanent loans. Once those conditions are satisfied, the loan is then considered a permanent loan (without having to amend or restate the loan documents) and there are no further HVCRE related conditions or restrictions against distribution (i.e., the above described 15 percent equity rule no longer applies).

3. Borrowers can count the appraised value of property to satisfy Minimum Capital Contribution Requirement.

Previously: In order to satisfy Borrower’s Minimum Capital Contribution Requirement, lenders could only count capital in the form of cash, unencumbered readily marketable assets, paid for, out-of-pocket development expenses and/or cash paid for the real property. This meant that only the actual cost of the project (acquisition, improvement costs etc. previously incurred by the borrower) could count toward satisfaction of the 15 percent contributed equity requirement. Lenders could not use the current, appraised value of that project. This appeared to be an artificial and unrealistic restriction and was also a source of frustration and challenge for borrowers and lenders alike.

Now: The reformed rule is identical to the previous rule; however, instead of only counting cash paid for the real property, lenders can count the appraised value of the real property toward borrower’s satisfaction of the Borrower’s Minimum Capital Contribution Requirement. This is a significant improvement in the rule and a better reflection of reality with respect to the amount of equity actually being contributed.

4. Loans made prior to January 1, 2015, are now excepted from the HVCRE rules.

Previously: HVCRE rules applied to loans that were made prior to January 1, 2015 (the effective date of the Final Rule). This was fundamentally unfair as it required lenders to suddenly categorize certain pre-existing loans as having HVCRE exposure and to assign such loans a heightened risk weight unless such loans met one of a handful of exemptions (which was unlikely given that such loans were negotiated and closed without any knowledge of the future HVCRE rules).

Now: Any loan made prior to January 1, 2015, is excluded from the definition of an HVCRE ADC Loan and lenders do not have to assign a heightened risk weight to the same.

5. Loans with tenant improvement holdbacks are no longer HVCRE ADC Loans.

Previously: A loan for minor capital or tenant improvements, where the project was cash flowing on day one, could still be required to be classified as having HVCRE exposure. Again, this required lenders and borrower to negotiate a myriad of terms and conditions in an effort to address HVCRE, many times for a loan that should never have been classified as having HVCRE exposure but for the poorly drafted regulation.

Now: Loans for the acquisition, refinancing of existing income-producing real property “where the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution’s applicable loan underwriting criteria for permanent financings” are expressly excepted from the definition of HVCRE ADC Loan. (This rule is similar to the reclassification rule set forth in paragraph 2 above, removing only the substantial completion requirement).

This article was published in the July 2018 issue of AGC Law in Brief (Volume 4, Issue 4), Practical Construction Law & Risk Issues. It is reprinted here with permission.

On May 1, 2017, the American Arbitration Association (AAA) announced a new procedure under the AAA’s Arbitration Rules¹ aimed at lowering the administrative cost of arbitrations involving three-arbitrator panels.²

The new procedure, referred to as the “Streamlined Three-Arbitrator Panel Option,” allows parties to reduce arbitrators’ fees by allowing a single arbitrator to manage the arbitration through the preliminary procedural and discovery stages, while calling on the complete three-arbitrator panel for the evidentiary hearing and final award. According to the AAA, “a three-arbitrator panel can actually cost five times as much as a single arbitrator” and “[b]y maximizing the use of single arbitrator, parties can capitalize on the cost savings, while still preserving their right to have the case ultimately decided by a panel of three arbitrators.”³

This article sheds light on the new procedure and explains how parties can better assess whether the Three-Arbitrator Panel Option is a good fit for their dispute. Indeed, the Three-Arbitrator Panel Option is not explicitly incorporated into the AAA’s Arbitration Rules, and, therefore, parties may not necessarily consider the Three-Arbitrator Panel Option when initially proceeding to arbitration.

The Three-Arbitrator Panel Option is a novel attempt by the AAA to limit the costs of arbitration and make arbitration a more attractive method of dispute resolution. However, before parties opt into the Three-Arbitrator Panel Option, there are a few points worth considering. As explained below, while there is no reason to necessarily doubt that the Three-Arbitrator Panel Option would improve efficiencies in an arbitration, in some cases, those efficiencies may only be seen at the margins and could raise certain risks that, if not addressed at the outset of a case, may create problems down the road.

Streamlined Three-Arbitrator Panel Option

The Three-Arbitrator Panel Option is not explicitly included in the AAA’s Arbitration Rules and, therefore, is not triggered by a specific filing or form. Instead, the parties are typically given an opportunity to opt into the Three-Arbitrator Panel Option during the initial administrative conference. Specifically, during the initial administrative conference, the AAA’s representative overseeing the administrative conference may raise the Three-Arbitrator Panel Option for the parties’ consideration if the AAA’s representative believes that the dispute could benefit from the procedure.

If the parties opt into the Three-Arbitrator Panel Option, the AAA will seek to determine what form of the procedure the parties will utilize. Specifically, the Three-Arbitrator Panel Option comes in two flavors, which the AAA refers to as “Option 1” and “Option 2.”

Under “Option 1,” the parties will, during the arbitrator selection phase, appoint the entire three-arbitrator panel pursuant to the applicable rules or the parties’ agreement. In most cases, this involves the appointment of the panel through a roster of potential arbitrators (see, e.g., Commercial Rule R-12; Construction Rule R-14) or through direct party appointment (see, e.g., Commercial Rules R-13, R-14; Construction Rule R-15). Once the panel is formally appointed, the two party-appointed or “wing” arbitrators (i.e., the arbitrators who are not chair) are placed on inactive status, with the expectation that they will only become active and participate in the arbitration during the evidentiary hearing and while preparing the final award. As a result, the chair will manage all preliminary stages of the case and may decide any dispositive motions before the hearing. However, if either party believes that a dispositive motion requires the full panel, the full panel can be made available to hear and decide the motion.

Under “Option 2,” at the outset of the case, the parties skip the initial panel selection process and only appoint a single arbitrator to manage the pre-hearing stages of the case. Like Option 1, the sole arbitrator is permitted to hear and decide any dispositive motions filed before the hearing. After the arbitration has proceeded for some time, but no less than 60 days before the scheduled evidentiary hearings, the parties will work with the AAA to appoint the two remaining arbitrators, with the initial arbitrator serving as chair.⁴

Lastly, the AAA provides that if the parties elect to use the Three-Arbitrator Panel Option, under either Option 1 or Option 2, but one party decides to withdraw from the procedure later on, that party is entitled to do so. If a party elects to withdraw from Option 1, the wing arbitrators are made active and will participate in all future proceedings. In an Option 2 scenario, the AAA will immediately work with the parties to select the two party-appointed arbitrators. However, if a party elects to withdraw from Option 2 before the formal appointment of the panel, the sole arbitrator will continue to manage the case; if a dispositive motion was argued or briefed before the sole arbitrator, the sole arbitrator will decide the issue before the full panel is appointed.

Considerations

As the AAA is likely to admit, the Three-Arbitrator Panel Option may not be well-suited for all disputes. Critically, parties must consider and actively manage the effects of the Three-Arbitrator Panel Option to ensure it produces the best results. Below are some issues that parties may wish to consider when deciding whether to opt into the procedure.

Dramatic Cost Savings or Benefits at the Margins?

First, parties should consider whether this procedure is fundamentally different from the practices they would otherwise experience during the course of any other arbitration. Specifically, it is commonly the case that, following the appointment of the panel, the chair takes the lead and makes determinations/decisions on procedural issues and other disputes leading up to the hearing without much, if any, input from the party-appointed arbitrators. Often, the parties will expressly agree to this delegation of authority, and their agreement will be recorded in an initial procedural order following the first procedural conference.⁵ However, arbitration management practices vary between chairs and wings and, without the Three-Arbitrator Panel Option in place (or some other clear directive), the wing arbitrators could be more engaged in the proceedings than the parties would otherwise prefer. The point is this: Although the Three-Arbitrator Panel Option may offer parties some comfort that arbitrator fees will be kept down during the pre-hearing phases of the arbitration, whether the procedure will produce a dramatically different result in the overall efficiencies, as compared to customary arbitration management practices, may be debatable.

Is the Cost of Keeping Party-Appointed Arbitrators Engaged Worth the Expense?

Second, to the extent the parties decide that they will utilize the Three-Arbitrator Panel Option, the parties must carefully consider how much benefit they perceive will be lost by keeping the wing arbitrators on the sidelines. This is a cost-benefit analysis between ensuring that the panel members understand the intricacies of the dispute and minimizing unnecessary costs (especially considering the amount in dispute).

Wing arbitrators who remain engaged in the proceedings will no doubt better appreciate the nuances of a dispute and thus, will be better able to appreciate the points at issue during an evidentiary hearing. By contrast, declining to keep the wings apprised of the proceedings until the weeks before the hearing may cause those arbitrators to be less familiar with the issues in dispute, potentially leading to a sub-optimal result. This is particularly significant for complex arbitrations involving a large number of contested issues, highly technical facts, and bifurcated evidentiary hearings.

On the other hand, the more the wing arbitrators are involved in the proceedings, the more expensive the arbitration becomes. If the issues in dispute are relatively straightforward or the amount in controversy is relatively small, little may ultimately be gained by asking the wings to remain intricately involved in the arbitration.

The Added Importance of Controlling the Chair Selection Process

Third, under either Option 1 or Option 2, the Three-Arbitrator Panel Option makes the chair selection process all the more significant. Specifically, the Three-Arbitrator Panel Option amplifies the effect of an ill-qualified chair by leaving an individual who might lack the requisite background, personality or arbitration experience with the sole authority to decide substantive issues in the arbitration. By contrast, if the wings are more involved in the procedural elements of the case, the impact of an ill-qualified chair could be better contained. This is a problem that parties’ counsel should seek to manage during the initial phases of the arbitration. For the construction industry, this issue is critical, as arbitrators serving in construction-related arbitrations are frequently appointed because of their expertise in the field. If the parties intend to utilize the Three-Arbitrator Panel Option, they would be well-advised to ensure they can exert significant control over the selection of the chair to avoid the compounding the problems generated by an unqualified chair.

Option 1 or Option 2: Which Do I Choose?

Fourth, and lastly, if the parties opt into the Three-Arbitrator Panel Option, the choice between Option 1 or Option 2 will require another cost-benefit analysis. While Option 2 will likely generate more cost savings than Option 1, Option 2 may present unique challenges during the arbitration. Specifically, under Option 2, the parties will begin to work with the AAA to appoint the remaining two arbitrators at least 60 days before the evidentiary hearing. If, during the course of the arbitration, one party concludes that its likelihood of success in the case has diminished, that party could engage in tactics aimed at stalling the proceedings and disadvantaging the other party in the lead up to the hearing. Indeed, even if each of the two remaining arbitrators were to be independently appointed by the parties, a dissatisfied party could stall its appointment process to create leverage over its opponent. Relatedly, if a party concludes that the sole arbitrator has a favorable view of its case, it could take advantage of Option 2 by briefing/arguing a dispositive motion and having the motion decided by the sole arbitrator, without allowing of the opposing party to first engage the full panel. As a result, if the parties are interested in the cost savings generated by Option 2, they must ensure that there are adequate procedures in place to limit gamesmanship by a dissatisfied party later in the proceedings.

Conclusion

Without a doubt, the Three-Arbitrator Panel Option reflects the AAA’s ongoing efforts to develop and adapt arbitration rules to suit the needs of its users. For that, the AAA deserves to be commended. When the disputes are relatively simple and the amounts in controversy are low, the Three-Arbitrator Panel may be an option worth considering. However, as would be true for any procedural decision in an arbitration, if the parties elect to structure the arbitration using the Three-Arbitrator Panel Option, they must carefully consider and manage the effects of the procedure to ensure it generates the best results.

Endnotes

On June 22, 2018, the Internal Revenue Service (the “IRS”) issued Notice 2018-59, which provides long-awaited guidance on when construction of energy property will have begun for purposes of the Investment Tax Credit (“ITC”) under section 48 of the Internal Revenue Code (the “Code”).

The guidance is similar in many respects to the beginning of construction guidance issued for wind facilities and other facilities that are eligible for the PTC under section 45 of the Code or the ITC in lieu of the PTC (the “Prior Guidance”). Although the rules in Notice 2018-59 should be familiar to those who have worked with the Prior Guidance, this client alert covers the applicable rules in detail. Furthermore, this client alert will focus on solar PV projects, though Notice 2018-59 also applies to solar hot water, fiber-optic solar, geothermal, fuel cell, qualified microturbine, CHP, small wind, and geothermal heat pump property.

At the end of this client alert, we provide a brief overview of the strategies for beginning construction on solar projects that we expect to be widely used.

Background

The applicable percentage for the ITC for a solar project depends on when construction on the property begins and when the project is placed in service. The percentage is 30% if construction begins before 2020, 26% if construction begins in 2020, and 22% if construction begins in 2021, in each case, as long as the property is placed in service before 2024. If construction begins after 2021, or if the property is placed in service after 2023, the percentage is 10%. Notice 2018-59 includes a useful chart covering the applicable dates for solar and other relevant projects.

Two Methods for Beginning Construction

Notice 2018-59 provides two methods by which a taxpayer can satisfy the beginning of construction requirement: (i) starting physical work of a significant nature (the “Physical Work Test”) or (ii) incurring 5% or more of the costs of the facility (the “5% Safe Harbor”). Both methods require that a taxpayer make continuous progress toward completion once construction has begun (the “Continuity Requirement”).

Although a taxpayer may satisfy both methods of establishing the beginning of construction, construction will be deemed to have begun on the date the taxpayer first satisfies one of the two methods. Notice 2018-59 provides that this rule applies “to energy property the construction of which begins, as determined under the earlier of either the Physical Work Test or the 5% Safe Harbor, after December 31, 2018.” Unfortunately, the effective date rule is inconsistent with an example in Notice 2018-59, which applies the alternate method rule to a taxpayer that satisfies the Physical Work Test in 2018 and the 5% Safe Harbor in 2019. Accordingly, it appears that either the effective date rule or the example is incorrect.

Physical Work Test

The Physical Work Test requires that a taxpayer begin physical work of a significant nature.

• No Fixed Minimum. Note that the test requires that the taxpayer “begin” (as opposed to complete or make substantial progress toward the completion of) physical work of a significant nature. As Notice 2018-59 states, (i) the Physical Work Test focuses on the nature of the work performed, not the amount or the cost and (ii) assuming that physical work performed is of a significant nature, there is no fixed minimum amount of work or monetary or percentage threshold required to satisfy the Physical Work Test. This is consistent with the Prior Guidance and with public statements from IRS and Treasury officials with respect to the wind guidance.

• Work Under Binding Written Contract. Work performed by the taxpayer and work performed for the taxpayer by other persons under a binding written contract that is entered into before the manufacture, construction, or production of the property is taken into account to determine whether construction has begun.

• On-Site and Off-Site Work. Both off-site and on-site work may be taken into account. Generally, off-site physical work of a significant nature may include the manufacture of components, mounting equipment, support structures such as racks and rails, inverters, and transformers and other power conditioning equipment. If a manufacturer produces components of property for multiple energy properties, a reasonable method must be used to associate individual components of property with a particular purchaser. On-site physical work of a significant nature for solar energy property may include the installation of racks or other structures to affix solar panels, collectors, or solar cells to a site. Notice 2018-59 also provides examples of on-site work for other types of projects.

• Inventory. Physical work of a significant nature does not include work (whether performed by the taxpayer or another person) to produce components of energy property that are either in existing inventory or are normally held in inventory by a vendor.

• Preliminary Activities. Physical work of a significant nature does not include certain preliminary activities, even if the cost of the activities is included in the depreciable basis of the energy property. Preliminary activities include, among other things, planning, designing, obtaining permits, engineering, conducting environmental studies, excavating to change the contour of the land (as distinguished from excavation for a foundation), and removal of old energy property.

5% Safe Harbor

The 5% Safe Harbor requires that a taxpayer pay (if using the cash method) or incur (if using the accrual method) 5% or more of the total cost of the energy property.

• The Numerator of the 5% Safe Harbor. The applicable requirements for “paying or incurring” a cost are highly technical and filled with traps for the unwary. It is very important to have tax counsel review supply agreements and other contracts the costs of which are intended to satisfy the 5% Safe Harbor .

• The Denominator of the 5% Safe Harbor. All costs properly included in the depreciable basis of the energy property are taken into account to determine whether the 5% Safe Harbor has been met. The total cost of the energy property does not include the cost of land or any property not integral to the energy property. See below for a discussion of what property is integral to the production of electricity.

• Cost Overruns – Single Energy Property. If the total cost of a single energy property exceeds its anticipated total cost, so that the amount a taxpayer actually paid or incurred with respect to the single energy property as of an earlier year is less than 5% of the total cost of the single energy property at the time it is placed in service, then the taxpayer will not satisfy the 5% Safe Harbor with respect to any portion of the single energy property in such earlier year. See below for a discussion of what is treated as a single energy property for this purpose.

• Cost Overruns – Single Project with Multiple Energy Properties. If the total cost of an energy property that is a single project comprised of multiple energy properties exceeds its anticipated total cost, so that the amount a taxpayer actually paid or incurred with respect to the single project turns out to be less than 5% of the total cost of the single project when it is placed in service, the 5% Safe Harbor is not fully satisfied. However, the 5% Safe Harbor will be satisfied with respect to some, but not all, of the energy properties comprising the single project, as long as the total aggregate cost of those energy properties is not more than 20 times greater than the amount the taxpayer paid or incurred. Although not entirely clear, there does not appear to be any requirement that the property, the costs of which were paid or incurred by the taxpayer to satisfy the 5% Safe Harbor, be incorporated into the energy properties for which the ITC is claimed. To mitigate the risk of cost overruns, most taxpayers will incur an amount equal to 6-8% of projected costs.

• Look-Through Rule. Under the so-called “Look-Through Rule,” a taxpayer may take into account amounts paid or incurred by a contractor. For property that is manufactured, constructed, or produced for the taxpayer by another person under a binding written contract with the taxpayer, amounts paid or incurred with respect to the property by the other person before the energy property is provided to the taxpayer are deemed paid or incurred by the taxpayer when the amounts are paid or incurred by the other person for federal income tax purposes.

Continuity Requirement

Where a taxpayer has satisfied the Physical Work Test, the Continuity Requirement requires that the taxpayer maintain a continuous program of construction, which involves continuing physical work of a significant nature. Where a taxpayer has satisfied the 5% Safe Harbor, the Continuity Requirement requires that the taxpayer make continuous efforts to advance toward completion of the energy property. In each case, whether the Continuity Requirement is satisfied depends on the relevant facts and circumstances.

Certain disruptions in a taxpayer’s continuous construction or continuous efforts to advance toward completion of an energy property that are beyond the taxpayer’s control will not be considered as indicating that a taxpayer has failed to satisfy the Continuity Requirement. Notice 2018-59 provides a non-exclusive list of these “excusable disruptions.”

Notice 2018-59 provides a safe harbor (the “Continuity Safe Harbor”) pursuant to which the Continuity Requirement is deemed to be satisfied if a taxpayer places an energy property in service by the end of a calendar year that is no more than four calendar years after the calendar year during which construction of the energy property began (the “Continuity Safe Harbor Deadline”). The excusable disruption rules do not apply for purposes of applying the Continuity Safe Harbor. For example, if construction begins on an energy property on January 15, 2018, and the energy property is placed in service by December 31, 2022, the energy property will satisfy the Continuity Safe Harbor.

Under the so-called “disaggregation rule”, multiple energy properties that are treated as a single project may be disaggregated and treated as multiple separate energy properties for purposes of the Continuity Safe Harbor. The disaggregated energy properties that are placed in service before the Continuity Safe Harbor Deadline will be eligible for the Continuity Safe Harbor. The remaining disaggregated energy properties may satisfy the Continuity Requirement under the facts and circumstances determination.

Because the facts and circumstances tests for the Continuity Requirement are difficult to apply in practice, we expect that most taxpayers will ensure that they satisfy the Continuity Safe Harbor.

Unfortunately, Notice 2018-59 did not include an additional safe harbor provision pursuant to which the Continuity Requirement would be deemed to be satisfied with respect to projects placed in service before 2020, notwithstanding that there was such a rule in the Prior Guidance. As a matter of statutory interpretation, it seems clear that if a solar project is placed in service before 2020, construction on that project must also have begun before 2020, and therefore the Continuity Requirement should be satisfied.

Transfers

A taxpayer that owns energy property on the date it is originally placed in service may elect to claim the ITC even if the taxpayer did not own the energy property when construction began, though any ITC is limited to the taxpayer’s basis in the energy property. Accordingly, the general rule is that a fully or partially developed energy property may be transferred without losing its qualification under the Physical Work Test or the 5% Safe Harbor. However, an exception provides that if a transferor transfers solely tangible personal property (or contractual rights to such property under a binding written contract) to an unrelated transferee, the transferee cannot take into account work performed or amounts paid or incurred by the transferor for purposes of the Physical Work Test or the 5% Safe Harbor. For this purpose, whether a transferor and transferee are related is determined under section 197(f)(9)(C) of the Code, which at a high level requires 20% overlapping ownership. Accordingly, for a transferee to take into account the physical work performed by or the costs incurred by a transferor, either the transferee and transferor must be related or the transferred property must include project assets other than tangible personal property or the rights to acquire tangible personal property (e.g., land rights, a PPA, an interconnection agreement, etc.).

A special rule provides that if a taxpayer begins construction of an energy property with the intent to develop the energy property at a certain site, and thereafter transfers the energy property to a different site, the taxpayer may take into account the work performed or the amounts paid or incurred before the site transfer for purposes of the Physical Work Test or the 5% Safe Harbor.

Retrofits

Notice 2018-59 applies the so-called “80/20 Rule” for purposes of determining whether retrofitted energy property qualifies for the ITC. Under the 80/20 Rule, energy property may qualify as originally placed in service even though it contains some used components if the fair market value of the used components of property is not more than 20 percent of the energy property’s total value. For this purpose, the total value is the cost of the new components of property plus the value of the used components of property, and the cost of new property includes all properly capitalized costs. In the case of a single project comprised of multiple energy properties, the 80/20 Rule is applied to each energy property comprising the single project.

For purposes of the beginning of construction requirement, the Physical Work Test and the 5% Safe Harbor are applied only with respect to the work performed on, and amounts paid or incurred for, new property that is integral to the energy property. For the 5% Safe Harbor, all costs properly capitalized in the basis of the energy property are taken into account.

Other Rules

• Single Energy Property. Applying Notice 2018-59 requires identifying separate “energy properties”. Notice 2018-59 treats all components of property that are functionally interdependent (unless such equipment is an addition or modification to an energy property) as a single energy property. (The parenthetical, which appears in the Notice, appears to acknowledge that after-installed equipment of a type that would otherwise be functionally interdependent—e.g., a replacement inverter—can be placed in service independently.) Components of property are functionally interdependent if the placing in service of each component is dependent upon the placing in service of each of the other components in order to generate electricity. Citing Rev. Rul. 94-31, which treats each wind turbine, together with its tower and foundation, as a single unit of property, Notice 2018-59 concludes that all components of property necessary to generate electricity up to and including the inverter generally are treated as a single energy property. For rooftop solar energy property, all property integral to the generation of electrical energy that is installed on a single rooftop is considered a single unit of property.

• Single Energy Project. For purposes of the begin construction test, multiple energy properties that are operated as part of a single project (along with any components of property, such as a computer control system, that serves some or all such energy properties) will be treated as a single energy property. Whether multiple energy properties are operated as part of a single project depends on the relevant facts and circumstances applicable to the energy properties, including whether they are (i) owned by a single entity; (ii) constructed on contiguous pieces of land; (iii) described in a common PPA; (iv) have a common intertie; (v) share a common substation; (vi) described in the same environmental or other regulatory permits; (vii) constructed pursuant to a single master construction contract; or (viii) financed pursuant to the same loan agreement. Whether multiple energy properties are operated as part of a single project is determined in the calendar year during which the last of the multiple energy properties is placed in service.

• Property Integral to Energy Property. Notice 2018-59 provides that only physical work on, and costs paid or incurred with respect to, property integral to the production of electricity will be taken into account for purposes of the Physical Work Test and 5% Safe Harbor, respectively. PV panels, mounting equipment, support structures, tracking equipment, monitoring equipment, other power conditioning equipment, and inverters are all integral to the production of electricity. Transmission property (including a transmission tower) is not integral to the production of electricity, but a transformer that steps up the voltage of electricity produced at an energy property to the voltage needed for transmission is integral because it is power conditioning equipment. Although not clearly stated, Notice 2018-59 appears to adopt a rule pursuant to which transmission means transmission at 69kv or greater. Following the Prior Guidance, Notice 2018-59 also provides that (i) onsite roads that are used for equipment to operate and maintain the energy property are generally integral to the production of electricity and (ii) roads primarily for access to the site, or roads used primarily for employee or visitor vehicles, fencing, and buildings are generally not integral to the production of electricity.

• Binding Written Contracts. Notice 2018-59 follows the definition of “binding written contract” from the Prior Guidance. For this purpose, a written contract is binding only if it is enforceable under local law against the taxpayer or a predecessor and does not limit damages to a specified amount (for example, by use of a liquidated damages provision). A contractual provision that limits damages to an amount equal to at least 5% of the total contract price will not be treated as limiting damages to a specified amount.

• Master Contracts. Notice 2018-59 follows the master contract rule from the Prior Guidance. Under that rule, if a taxpayer enters into a binding written contract for a specific number of components of property to be manufactured, constructed, or produced for the taxpayer by another person under a binding written contract (the master contract), and then through a new binding written contract (the project contract) assigns its rights to certain components of property to an affiliated special purpose vehicle that will own the energy property for which such components of property are to be used, work performed or amounts paid or incurred with respect to the master contract may be taken into account in determining when construction begins with respect to the energy property.

Strategies for Beginning Construction

Notice 2018-59 suggests there are several strategies for beginning construction on a solar facility.

• Purchase of Solar Modules. Taxpayers can satisfy the 5% Safe Harbor by purchasing solar modules or other equipment for their projects. This could be a key part of the “begin construction” strategy for residential solar developers.

• Installation of Posts and Racking. Taxpayers looking to satisfy the Physical Work Test could install posts and/or racking, which is clearly discussed in Section 4.02(2)(a) of Notice 2018-59. Taxpayers could do so directly, through a standalone construction agreement, or as part of an EPC contract.

• Custom-Made Transformer. Taxpayers can enter into a supply agreement for the construction of a custom-made transformer. This strategy was contemplated in the Prior Guidance and widely used for wind projects. The strategy is clearly contemplated in Section 7.02(1) of Notice 2018-59.

• Construction on Roads. Section 7.02(2) of Notice 2018-59 states that “onsite roads that are used for equipment to operate and maintain the energy property” are integral to the production of electricity. Although a similar rule applied in the Prior Guidance, the statutory language applicable to PTC-eligible facilities is different from that applicable to solar facilities (which, among other things, suggests solar energy property is limited to equipment). In Notice 2018-59, the IRS has taken the position that roads should qualify as solar energy property, notwithstanding the differences in the applicable statutory language. For utility-scale solar projects, construction on O&M roads may be a viable strategy for beginning construction.

For more information, contact any of the attorneys listed in this advisory.

A version of this article was originally published in the June 2018 issue of The HR Specialist. It is reprinted here with permission.

Most employers value a diverse workforce, and many employers are required by clients or customers to have diversity initiatives and meet diversity requirements. While these initiatives and requirements are meant to increase diversity, and provide diverse applicants and employees with increased opportunities, they can present a challenging dynamic for employers. Is hiring a candidate because of his or her protected category considered to be discrimination itself? Is staffing a project with diverse employees per client request discriminatory?

In most cases, Title VII, a federal law, prohibits employers from making decisions based on an applicant’s or employee’s protected status. The only legally recognized exception is when employers establish “affirmative action” plans based on a historical imbalance or disparity in the workforce. See Johnson v. Transp. Agency, Santa Clara Cnty., Cal., 480 U.S. 616 (1987). These plans are permissible when (1) preferences are intended to “eliminate conspicuous racial imbalances in traditionally segregated job categories”; (2) the rights of nonminority employees are “not unnecessarily trammeled”; and (3) the preferences are temporary in duration. United Steelworkers of Am. v. Weber, 443 U.S. 193 (1979).

Although it may seem common sense that courts generally support affirmative action plans, in practice, courts scrutinize these plans very closely. For example, in Schurr v. Resorts International Hotel, a Caucasian plaintiff alleged that he was denied a technician position based on race when the job was offered to an equally well-qualified minority candidate. 196 F.3d 486 (3d Cir. 1999). Under the Casino Control Act, the employer was required to take affirmative steps to employ minorities. At the time of the hiring decision, the technician category was 22.5 percent minorities, compared to the regulation’s goal of 25 percent, so the employer believed it was obligated to hire the minority applicant. The Third Circuit held that the employer’s affirmative action plan violated Title VII because it was not based on a finding of discrimination in the casino industry or the technician job category and so was not put in place based on a historical imbalance or disparity in the workforce.

Schurr illustrates the challenge facing employers. Even when an affirmative action plan is required by state regulation, it can be found to be in violation of Title VII. Thus, employers that are considering affirmative action plans must ensure that they meet all the required factors. While there is no bright-line rule on what constitutes a “conspicuous racial imbalance,” case law provides some guidance. See, e.g., Shea v. Kerry, 796 F.3d 42 (D.C. Cir. 2015) (sufficient degree of imbalance when 631 of 655 officers were white); Higgins v. City of Vallejo, 823 F.2d 351 (9th Cir. 1987) (sufficient degree of imbalance when 11.4 percent of the workforce was minority, versus 30 percent of the city’s population, and when 7.3 percent of the workforce was black, versus 17 percent of the population).

Another potential exception to Title VII’s prohibition on making employment decisions based on protected status is Executive Order 11246, which requires certain federal contractors and subcontractors to take affirmative action to ensure equal employment opportunity. Affirmative action plans under the Executive Order are typically mandated by government contract, whereas affirmative action plans that address a historical imbalance or disparity are typically either voluntary or mandated by court or agency order. The courts have not yet decided whether hiring decisions based on an affirmative action plan can still violate Title VII.

What should employers do when they do not meet the requirements of an affirmative action plan, but still want to promote diversity? Courts have made it clear that any non-remedial affirmative action plan, if aimed at promoting diversity, rather than remedying discrimination, could be in violation of Title VII. See, e.g., Taxman v. Bd. Of Educ., 91 F.3d 1547, 1550 (3d. Cir. 1996) (“Given the clear antidiscrimination mandate of Title VII, a non-remedial affirmative action plan, even one with a laudable purpose, cannot pass muster.”).

While there is no clear legal guidance for employers, it is helpful to analogize to the educational context, which suggests the solution may lie in treating diversity as a factor in employment decisions, rather than as a preference or a deciding factor. Similarly, it behooves employers to have diversity goals, rather than specific quotas or numbers.

In 2003, the Supreme Court upheld a college admissions system that considered the race or ethnicity of applicants a “plus” factor, Grutter v. Bollinger, 539 U.S. 306 (2003), and struck down a system that allocated points to underrepresented minorities, Gratz v. Bollinger, 539 U.S. 244 (2003).

In Fisher v. University of Texas, the most recent Supreme Court decision on the issue, the Court upheld an admissions system in which “consideration of race is contextual and does not operate as a mechanical plus factor for underrepresented minorities.” 136 S. Ct. 2198, 2207 (2016). In the system at issue, the university made decisions based on an applicant’s Academic Index and Personal Achievement Index (PAI) scores. A PAI score is based on information such as essay scores, letters of recommendation and community service, with race given weight as a subfactor. Thus, “although admissions officers can consider race as a positive feature of a minority student’s application, there is no dispute that race is but a ‘factor of a factor of a factor’ in the holistic-review calculus.” Id. at 2207.

Applying Fisher to the employment context, employers should consider diversity as one factor in their overall assessment of a candidate. Employers should never hire a diverse candidate based solely, or primarily, on the candidate’s diversity. Rather, employers should consider diversity as one of the many individualized considerations about a candidate. In the context of individualized assessments and diversity goals (rather than quotas or other hard numbers), it is likely that a court would uphold an employer’s decision to hire a diverse, qualified candidate. However, such an outcome is never guaranteed, and the decision to promote workplace diversity is ultimately a business decision that comes with potential risks.

Forty-five years ago, a scandalous medical experiment in Alabama caused the United States to reexamine the concept of informed consent. While that scrutiny continues today, a recent case from Alabama, Looney v. Moore, rejected an invitation to provide clinical trial patients recovery for failure of informed consent in the absence of provable injury.

In 1972, the Associated Press broke the story of the Tuskegee Syphilis Study, a federally funded experiment on unsuspecting African-Americans with syphilis in rural Alabama. In the study, medical researchers and health providers withheld treatment from hundreds of men from 1932 to 1972 in order to study the course of the untreated disease. Researchers did not obtain informed consent from the men, who “were persuaded to participate by promises of free transportation to and from hospitals, free hot lunches, free medical treatment for ailments other than syphilis and free burial.” Even after penicillin became the standard for treating syphilis in 1945, researchers did not offer it to the study participants.¹

In the wake of the disclosure of the Tuskegee Syphilis Study, Congress created the National Commission for the Protection of Human Subjects of Biomedical and Behavioral Research. The Commission’s report, the Belmont Report, set forth ethical principles to govern future human research, including the requirement of adequate standards for informed consent that recognize prospective research subjects must “be given the opportunity to choose what shall or shall not happen to them.”²

In addition to a class action lawsuit, a settlement and a presidential apology, the Tuskegee Study gave rise to the current model for informed consent in the United States.³ The informed consent process involves three key features: (1) disclosure of the information needed to make an informed decision; (2) understanding by the research subject of what has been disclosed; and (3) a voluntary decision about whether or not to participate in the research.⁴ Informed consent must be legally effective and prospectively obtained.

History of Clinical Trial Informed Consent Cases

Based on these core concepts of modern informed consent, there have been lawsuits challenging the adequacy of informed consent in clinical studies. In addition to allegations of failure to disclose potential risks from the research (or the likelihood of such risks occurring), some of these cases also allege that researchers failed to inform subjects of the researchers’ financial interest in the new therapy. Other cases have included unique allegations, including falsification of Institutional Review Board approval or the failure to inform the patient that the delay in active treatment due to being randomized into the placebo arm might risk permanent harm.⁵

Many clinical trial informed consent cases settled quickly. One of the only cases to go to trial was a case brought against the bone marrow transplant center at Fred Hutchinson following the deaths of five research participants. In that case, a jury returned a defense verdict after finding that the plaintiffs did not prove that any missing information would have changed the patients’ decisions to participate in the research.⁶

The plaintiffs in all these cases shared one thing: They were all injured. A recent case arising in Alabama proposed to hold researchers liable for failure of informed consent in a clinical trial in the absence of physical injury.

Looney Case

The clinical trial at issue was performed at the University of Alabama. Premature infants were treated with varying levels of oxygen — all within the standard of care — in order to determine the ideal oxygen percentage. Following an investigation, the U.S. Office of Human Research Protection found the informed consent to be inadequate due to a failure to describe how the risks of blindness, neurological damage and death were affected by the varying levels of oxygen exposure, and how those risks differed from the risks incurred by premature infants not participating in the study. The infants’ parents sued, alleging that their children’s participation was based on a lack of informed consent and that the participation caused their injuries. The plaintiffs brought claims for negligence, negligence per se, breach of duty and products liability, in addition to lack of informed consent. The U.S. District Court for the Northern District of Alabama dismissed all of the plaintiffs’ claims because their own experts were unable to conclude that participation in the study, rather than premature birth and low birthweight, caused the injuries.

The Eleventh Circuit affirmed the district court’s dismissal of all claims, except lack of informed consent. The court found that it was not clear under Alabama law whether a plaintiff must “prove that an injury actually resulted from the medical treatment in order to succeed on a claim that his consent to the procedure was not informed.”⁷ The Eleventh Circuit certified the question to the Alabama Supreme Court, which declined to resolve the issue, without comment.

Had the Alabama Supreme Court recognized a cause of action for failure to provide informed consent in the absence of injury, it would have created a strict liability cause of action on the basis of dignity harm alone. Such an expansion of liability would be contrary to the overwhelming case law that requires actual injury for relief.⁸ The few courts that have addressed the issue of informed consent in the context of clinical trial injuries have treated the claim as one sounding in negligence, which requires causation and actual injury.⁹

In fact, only one state — Pennsylvania — may treat claims for lack of informed consent otherwise; Pennsylvania courts have suggested that they would treat them as battery claims, which do not require injury.¹⁰ All other states distinguish between claims of “lack of consent” and “lack of informed consent,” with the former falling into the category of battery, and the latter falling into the category of negligence.

Recognizing that state laws almost universally view lack of informed consent claims as negligence-based claims that require actual injury, on March 30, the Eleventh Circuit held that Alabama law requires the same. In reaching this decision, the court pointed first to indications from Alabama case law that the “injury” requirement of the Alabama Medical Liability Act (AMLA) applies to informed consent claims, just as it does to traditional medical malpractice claims based on negligent treatment.¹¹ As the Eleventh Circuit stated, “it seems a bit incongruous that a patient subjected to negligent medical treatment is required to show that the treatment caused his injury, while a person whose only beef is that he was not fully informed of the risks of a procedure could prevail even if he suffered no injury at all.”¹²

Even if the AMLA did not apply to the plaintiffs’ claims, the Eleventh Circuit held, Alabama common law governing negligence actions also requires an injury.¹³ The plaintiffs’ attempts to take their claims out of the negligence realm by analogizing informed consent claims to intentional battery were unavailing. The Eleventh Circuit found that Alabama, like most other states, distinguishes between a “lack of consent” claim sounding in battery and a “lack of informed consent” claim sounding in negligence.¹⁴ Because the plaintiffs acknowledged that they consented to the specific conduct at issue, and alleged only that their consent was not fully informed, the Eleventh Circuit found that a battery framework was not appropriate.¹⁵

While plaintiffs in clinical trial informed consent cases may continue to propose novel strict liability causes of action on the basis of dignity harm alone, Looney holds that informed consent claims under Alabama law — like those under the law of almost every state in which the issue has been addressed — sound in negligence and thus require an actual injury.

Endnotes

Ronni Fuchs is a partner in Pepper Hamilton’s Health Sciences Department, a team of 110 attorneys who collaborate across disciplines to solve complex legal challenges confronting clients throughout the health sciences spectrum. Scott Robinson is an associate in the Health Sciences Department.