On May 15, 2017, the United States Supreme Court ruled that the Eleventh Circuit erred when it found a debt buyer liable under the Fair Debt Collection Practices Act for filing proofs of claim in bankruptcy on debts that had become time-barred. A copy of the Court’s opinion can be found here.

Background

In Johnson v. Midland, the Eleventh Circuit revisited the issue of whether debt collectors violate the FDCPA when filing proofs of claims in bankruptcy cases when those claims are based on unenforceable, time-barred consumer debts. The Eleventh Circuit affirmed its prior decision in Crawford v. LVNV Funding, LLC, 758 F.3d 1254 (11th Cir. 2014), concluding that when a “creditor is also a ‘debt collector’ as defined by the FDCPA, the creditor may be liable under the FDCPA for ‘misleading’ or ‘unfair’ practices when it files a proof of claim on a debt that it knows to be time-barred, and in doing so ‘creates the misleading impression to the debtor that the debt collector can legally enforce the debt.’”

Many courts have rejected Crawford. The Eighth Circuit, in Nelson v. Midland Credit Management, Inc., 828 F.3d 739 (8th Cir. 2016), was especially critical of the Crawford rationale, noting that the bankruptcy process protects debtors against harassment and deception. The Eighth Circuit noted, “[u]nlike defendants facing a collection suit, bankruptcy debtors are aided by ‘trustees who owe fiduciary duties to all parties and have a statutory obligation to object to unenforceable claims.’” The Eighth Circuit reasoned that “[d]efending a lawsuit to recover a time-barred debt is more burdensome than objecting to a time-barred proof of claim.” The Court found, “there is no need to protect debtors who are already under the protection of the bankruptcy court, and there is no need to supplement the remedies afforded by bankruptcy itself.”

Beyond the substantive arguments about whether the filing of a proof of claim on a debt outside the statute of limitations violates the FDCPA, courts began wrestling with whether the Bankruptcy Code preempts the FDCPA, an issue specifically left unanswered in Crawford. As with the substantive analysis, Circuit Courts have been split on the preemption issue. The Ninth Circuit in Walls v. Wells Fargo Bank N.A., 276 F.3d 502 (9th Cir. 2002), held that the FDCPA is not needed to protect debtors protected by the automatic stay and other provisions of the Bankruptcy Code.

Since the preemption argument was not addressed in Crawford, the District Court in Johnson was the first to confront the preclusion question that the Eleventh Circuit left open. In Johnson, the debtor filed for Chapter 13 bankruptcy relief. A debt collector filed a proof of claim that disclosed on its face that the claim was barred by the statute of limitations. The debtor sued the debt collector, alleging that the filing of the proof of claim was deceptive and misleading under § 1692e and unfair and unconscionable under § 1692f. The District Court found that there was an irreconcilable conflict between the Bankruptcy Code and the FDCPA, because a creditor can properly file a proof of claim on a time-barred debt under the Bankruptcy Code but the same creditor cannot file the proof of claim without violating the FDCPA, as construed by Crawford. In other words, the District Court said, “the Code authorizes filing a proof of claim on a debt known to be stale, while the [FDCPA] (as construed by Crawford) prohibits that precise practice,” and “those contradictory provisions cannot possibly be given effect simultaneously.” And in the face of that conflict, the District Court ruled that the FDCPA “must give way” to the Bankruptcy Code.

The Eleventh Circuit reversed stating that it saw no irreconcilable conflict between the Bankruptcy Code and the FDCPA. The Court pointedly ruled: “[A]lthough the (Bankruptcy) Code certainly allows all creditors to file proofs of claim in bankruptcy cases, the Code does not at the same time protect those creditors from all liability. A particular subset of creditors – debt collectors – may be liable under the FDCPA for bankruptcy filings they know to be time-barred.” In finding no conflict between the federal statutes, the Eleventh Circuit noted “when a particular type of creditor” – a “debt collector” as defined under the FDCPA – files a proof of claim for a debt it knows is out-of-statute, the creditor must “still face the consequences” imposed by the FDCPA for a ‘misleading’ or ’unfair’ claim.”

Midland petitioned the Supreme Court to grant certiorari and the reply by Johnson agreed with the need for review. As Midland pointed out in its reply brief, the case presented an unusual situation where both petitioner and respondent agreed that the questions presented implicate clear circuit conflicts on important issues of federal law.

The Opinion

The majority’s opinion analyzed the FDCPA application in two parts. Justice Breyer, writing for the Court, first analyzed whether the filing of a proof of claim on its face that is time-barred is not “false, deceptive or misleading.” The Court noted first that under the Bankruptcy Code, a “claim” is defined as a “right to payment” and relevant state law usually determines whether a person has such a right. In this case, Alabama law, “like the law of many states, provides that a creditor has a right to payment of a debt even after the limitations period has expired.” The opinion specifically rejects the consumer’s attempt to redefine “claim” to require a claim be enforceable. The Court noted “the word ‘enforceable’ does not appear in the Code’s definition of ‘claim.” Moreover, Section 502(b)(1) “says that, if a ‘claim’ is unenforceable,’ it will be disallowed. It does not say that an ‘unenforceable’ claim is not a claim.” The Court relied on the presence of the Chapter 13 trustee and his or her understating that “a proof of claim is a statement by the creditor that he or she has a right to payment subject to disallowance (including disallowance based upon, and following, the trustee’s objection for untimeliness)” to conclude that filing a claim on a time-barred debt is neither misleading or deceptive.

The Court then turned to whether assertion of a time-barred claim is “unfair” or “unconscionable” under the FDCPA. In concluding that such activity is neither the Court distinguished claims administration in bankruptcy proceedings from ordinary state court collection litigation. The Court found that unlike a collection case, in bankruptcy the consumer initiates the judicial proceeding, aided by the benefit of a bankruptcy trustee who “bears the burden of investigating claims and pointing out that a claim is stale.”

The Court was clearly troubled about the potential slippery slope of adopting Johnson’s argument that would change untimeliness as an affirmative defense that must be raised by the debtor or trustee. Creating an exception to the simple affirmative defense approach, the Court noted, “would required defining the boundaries of” such an exception, including whether such an exception was limited to facially time-barred claims or whether other affirmative defenses would be affected. “The law has long treated unenforceability of a claim (due to the expiration of the limitations period) as an affirmative defense. And we see nothing misleading or deceptive in the filing of a proof of claim that, in effect, follows the code’s similar system.”

Although the Court ruled that the Code does not preempt the FDCPA, finding the statutes “have different purposes and structural features,” the Court held that substantively, the conduct of filing time-barred claims does not violate the FDCPA. The Court rejected the United States’ amicus argument that the Advisory Committee on the Rules of Bankruptcy Procedure settled the issue when in adopted Bankruptcy Rule 9011, authorizing sanctions against a party submitting any paper that to the best of their knowing was not warranted by existing law. Instead, the Court noted that the Committed rejected a proposal that would have required a creditor to make a prefiling investigation based on a time-bar defense.”

In a dissent joined by Justices Ginsburg and Kagan, Justice Sotomayor disagreed with many of the justifications of the majority. In response to the majority’s view that the Chapter 13 trustees can serve as gatekeepers in the proof of claim administration, the dissent noted that time-barred claims have “deluged” the courts and “overworked trustees.” The dissent noted the application of the opinion was limited to Chapter 13 cases and left open the possibility of legislative action if Congress wanted to amend the FDCPA to prohibit filing of time-barred debt.

Conclusion

The opinion settles an issue that has led to tremendous litigation (and divergence) throughout the country – a creditor can no longer face FDCPA liability for filing a proof of claim in a Chapter 13 case on account of a debt beyond the statute of limitations. Johnson, however, makes clear that filing of lawsuit to collect a time-barred debt outside of bankruptcy could have a different result.

© TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result.

This is the second article in our five-part series on PTE.

Everywhere you look, patent term extension (PTE) is described using the “Rule of Ones:” one patent, one product, one PTE. However, the Rule of Ones does not account for the fact that multiple PTEs can be awarded for multiple patents for a single product. Innovators should keep in mind the following when seeking PTEs for their products:

• Multiple PTEs may be awarded based on distinct regulatory review periods for the same product when the approvals occurred on the same day. The PTEs would run concurrently, but may be different lengths depending on the applicable regulatory review period.

• Patent prosecution efforts should be aligned with the multiple PTE strategy.

• Innovators should consider pursuing multiple indications or combination products in parallel, rather than in series, to ensure that eligibility for multiple PTEs is preserved.

PTE allows a patent owner to obtain up to five years of additional term on a patent that covers a drug, biologic or class III medical device.¹ Generally, for a patent to be eligible for PTE, the product must have been subject to a regulatory review period before its commercial marketing, and the product’s approval must be the first approval of such a product by the FDA.² The PTE statute provides that “in no event shall more than one patent be extended . . . for the same regulatory review period for any product.”³

Relying on this language, if a product obtains multiple, distinct first approvals on the same day, the U.S. Patent and Trademark Office allows PTE to be awarded for each regulatory review period that was incurred. For instance, if two or more new drug applications (NDAs) were approved on the first same day for the same drug, then that drug could be eligible for multiple PTEs.

Examples of multiple PTEs being awarded include Omnicef® (cefdinir), Lyrica® (pregabalin), Mycamine® (micafungin sodium) and Vimpat® (lacosamide). In these cases, each product was the subject of two separate NDAs with different dosage forms or indications. In each instance, both NDAs were approved on the same day, and the active ingredient had not previously been approved by the FDA. The innovators sought PTE for two different patents covering their drugs — each one relying on the regulatory review period for one of the two NDAs.

In fall 2016, the USPTO awarded three PTEs to three different patents based on the same-day approval of three different NDAs for Nesina® (alogliptin benzoate) and two combination products, Kazano® (alogliptin benzoate and metformin hydrochloride) and Oseni® (alogliptin benzoate and pioglitazone hydrochloride). Alogliptin had never been approved by the FDA before, but metformin and pioglitazone had been.

U.S. Patent No. 8,173,663 was awarded 262 days of PTE for Nesina®; U.S. Patent No. 8,288,539 was awarded 101 days of PTE for Kazano®; and U.S. Patent No. 6,329,404 was awarded five years of PTE for Oseni®. In this case, each product had a different regulatory review period, and each patent was issued on a different day. For each product, the investigational new drug filing dates were different, and the NDA submission dates were different, but each NDA was filed and approved on the same day.

The value of obtaining multiple PTEs on different patents could incentivize innovators to revise their clinical development programs to pursue multiple indications or combination products in parallel, rather than in series. Companies developing a new product should consider reviewing their clinical development plans and exploring approaches with both patent and regulatory counsel to increase the likelihood of obtaining multiple PTEs for their product.

Endnotes

Nicole Stakleff 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. Kyle Dolinsky is an associate in the Health Sciences Department.

Patent term extension is a valuable tool that drug manufacturers should consider, even when their products are not new entities. Recent decisions from the U.S. Patent and Trademark Office, coupled with various court decisions, have granted patent term extensions (PTEs) for certain pharmaceuticals that do not qualify as new chemical entities (NCEs). The USPTO, however, has been inconsistent in determining eligibility. Among other requirements, to be eligible for PTE, a drug product must be the first permitted commercial marketing for which there was a regulatory review period. The “first permitted commercial marketing of the product” is not equivalent to the FDA’s classifying the drug as an NCE. Although NCEs are eligible for PTE, manufacturers should note that there are other circumstances under which a non-NCE may still obtain PTE:

• New esters or salts of previously approved acids or bases are eligible for PTE.

• Combination drug products may be eligible for PTE.

• Combination drug-device products may be eligible for PTE.

Overview of PTE

PTE affords a patent owner up to five additional years on a patent that covers a drug, biologic or class III medical device.¹ Generally, to be eligible, the drug product must have been subject to regulatory review before its commercial marketing, and the drug product’s approval must be the first approval of the drug by the FDA. The statute defines a “product,” in part, as a human drug product, which is “the active ingredient of a new drug . . . including any salt or ester of the active ingredient, as a single entry or in combination with another active ingredient.”²

In evaluating a drug’s PTE eligibility, the “product” may be the “active ingredient,” and not the entire composition of the drug product, based on the statute’s plain language.³ The Federal Circuit has remarked that PTEs were intended to be limited to NCEs — and not new uses and new doses of drugs already approved for commercial marketing⁴ — but the definition of NCE has been expanding.⁵ Even so, not all companies are seeking approval of an NCE. If they are not seeking NCE approval, are their products still eligible for PTE?

NCEs and New Esters or Salts

An NCE is a drug that contains “no active moiety that has been approved by FDA in any other” new drug application.⁶ An active moiety is defined as “the molecule or ion, excluding those appended portions of the molecule that cause the drug to be an ester, salt (including a salt with hydrogen or coordination bonds), or other noncovalent derivative (such as a complex, chelate, or clathrate) of the molecule, responsible for the physiological or pharmacological action of the drug substance.”⁷

In contrast, the PTE statute defines a drug product as “the active ingredient,” including any salt or ester. The active ingredient of a drug product is the compound that is actually present in the drug (that gets administered) for which FDA approval was obtained.⁸ If a product contains a new salt or ester of a previously approved acid, it may be eligible for PTE.⁹ Similarly, if a product contains a new salt or ester of a previously approved salt or ester, it may be eligible for PTE.

The USPTO takes a different position. It says that if a product contains the acid of a previously approved salt or ester, it is not eligible for PTE, despite the fact that the compound present in the drug that gets administered is different.¹⁰ In March 2017, the USPTO issued a decision denying PTE for buprenorphine because the FDA had previously approved a salt of buprenorphine (buprenorphine hydrochloride).¹¹ The USPTO denied PTE for buprenorphine, reasoning that the active ingredient buprenorphine was not the first commercial marketing of buprenorphine or a salt or ester of buprenorphine (since buprenorphine hydrochloride was previously approved) and relied on the decisions in Glaxo v. Quigg, 706 F. Supp. 1224 (E.D. Va. 1989), and Hoescht.

Combination Drug Products

For combination drug products, including fixed-dose combination products, PTE eligibility depends on whether at least one ingredient in the combination product would otherwise be eligible for PTE had it been developed as a monotherapy. In a combination product, if at least one ingredient is an NCE or is a new ester or salt of a previously approved acid, then the combination product will be eligible for PTE.¹² If none of the ingredients of the combination product falls into that category, then the combination product will not be eligible, despite the fact that the particular combination of drugs has never been approved before in that combination.

Combination Drug-Device Products

The FDA will review drug-device combination products as either a drug or a medical device for approval purposes. However, for purposes of classifying a product under the Hatch-Waxman Act, “it makes no difference whether the FDA reviews a product as a device, as a drug, as a biological product, or as a unicorn.” This is because 35 U.S.C. § 156 enables a drug-device combination product to be classified as either a drug or a medical device for determining PTE eligibility.¹³ Similar to combination drug products, if either the drug or the device would otherwise be eligible for PTE, the drug-device combination will be eligible for PTE.

Companies developing a new drug product, even if it is not an NCE, should consult with both patent and regulatory counsel to consider whether their product may be eligible for PTE and explore ways to increase the likelihood of obtaining and maximizing PTE.

This article is the first of a five-part series on PTE. Keep an eye on pepperlaw.com for more guidance on how to obtain and maximize PTE for your products.

Endnotes

This article was published in the Third Quarter 2017 Commercial Real Estate Review.

Commercial office building landlords frequently find themselves leasing to health care provider tenants. A landlord may not consider doctor’s offices or diagnostic labs as specialty uses, but there are several lease provisions that may warrant special attention when a tenant is a medical service provider. Additionally, while a commercial landlord who is not a physician or other health care service provider is not subject to the Stark Law¹ or the Anti-Kickback Statute,² larger health care tenants may nevertheless require that their landlords agree to comply with these regulatory laws. Accordingly, landlords will need to consider these regulatory requirements in their leases.

Stark and Anti-Kickback Laws

The Stark Law and the Centers for Medicare & Medicaid Services’ (CMS’s) companion regulations prohibit a physician from referring Medicare and Medicaid patients for “designated health services”³ to an entity if the physician or a member of the physician’s immediate family has a financial (including ownership/investment or compensation) relationship with the entity, unless a specified exception or safe harbor applies. The Stark Law also prohibits entities from presenting or causing to be presented a claim to any individual, payor or other entity for designated health services furnished under a prohibited referral.

The federal Anti-Kickback Statute prohibits any knowing and willful offer, payment, solicitation or receipt of any form of remuneration, either directly or indirectly, in return for, or to induce, (i) the referral of an individual for a service for which payment may be made by Medicare, Medicaid or another government-sponsored health care program or (ii) the purchasing, leasing, ordering or arranging for, or recommending the purchase, lease, order or arrangement of, any service or item for which payment may be made by Medicare, Medicaid or another government-sponsored health care program.

While commercial landlords who are not physicians (or the immediate family member of a physician) and who do not make or receive referrals to or from their medical service provider tenants are not subject to Stark and Anti-Kickback laws, some larger health care provider tenants may insist on strict compliance with these regulatory laws due to the heightened scrutiny health care entities receive from authorities. The good news for commercial landlords is that the safe harbor requirements under the Stark and Anti-Kickback laws are typically satisfied in the normal course of most arm’s length commercial leases:

• The lease must be in writing and signed by the parties.

• The lease must specify the premises to be leased by the tenant and cover all of the space leased between the parties. Any storage space or other space that the tenant leases in addition to the premises should also be covered by the terms of the lease.

• The lease term and any renewal terms must be for at least a one-year period. Neither the initial lease term, nor any extension periods may be for less than one year.

• Rental charges for the premises (including tenant concessions, such as allowances and free rent periods) must be at fair market value, consistent with arm’s length lease transactions. The rent must be set in advance and cannot take into account the value or volume of any referrals. This requirement is unlikely to be a concern when a landlord is not a medical service provider. For regulatory purposes, fair market value means the value of the rental property for general commercial purposes, not taking into account the intended use of the premises. To satisfy these safe harbor requirements, the parties should confirm that the health care provider tenant’s lease terms are no more favorable than those of other tenants of the building. The “set in advance” requirement does not forbid future rental increases so long as there is either a definitive formula (such as adjustments tied to the consumer price index) for calculating how rent will be increased during the term or specified increases.

• The space leased must not exceed that which is reasonably necessary to accomplish the commercially reasonable business purpose of the rental. The leased premises must be used exclusively by the tenant and may not be shared with or used by the landlord or any entity related to the landlord.

Utilities and Medical Waste

Medical office and lab users often have more intensive water and electricity usage than typical office users. Additionally, health care service provider tenants may need an uninterrupted power supply, requiring the installation of back-up generators. The parties should determine how the cost of these utilities and services, which may exceed the usage by other tenants, will be paid for by the tenant under the lease.

Additionally, health care tenants typically generate medical waste. The parties should allocate the responsibility for the separation, storage, removal and disposal of this waste in the lease, all of which must be done in compliance with applicable laws. Additionally, the party responsible for the medical waste (typically the tenant) should indemnify the other party for any failures to comply with law or other claims related to the medical waste.

Security and Landlord Access

The Health Insurance Portability and Accountability Act (HIPAA) requires health care provider tenants to take steps to prevent the disclosure of protected health information (PHI). In the typical landlord-tenant context, any PHI exposure would likely be incidental only, but tenants should still ensure that their leases prevent landlords from accessing or disclosing PHI. A tenant may require that their landlord follow the tenant’s adopted security protocol before entering the premises, and the tenant should require that PHI and any equipment containing PHI be excluded from any landlord liens, so that the landlord has no legal right to acquire this property to satisfy any claims that the landlord may have. If a tenant stores pharmaceuticals or other regulated substances within the premises, the parties should determine who is responsible for providing security to the space. Often due to regulatory concerns, the tenant is most likely responsible for, and may be best equipped to contract for, any required security.

Tenant Improvements

Medical user tenants may require more expensive tenant improvements than typical office tenants. Floors may need to be reinforced to handle heavy equipment or lead-lined partitions may be needed for x-ray rooms. Exam rooms may each require sinks and special cabinetry. The parties should consider the scope of any potential build-out or tenant improvement allowance early on in the negotiation of lease terms.

ADA

The offices of health care service providers are typically considered places of public accommodation under the Americans with Disabilities Act of 1990 (ADA). Both the landlord and tenant are subject to accessibility requirements under the ADA. If upgrades to the building or property will be required under the ADA (such as increases in handicapped parking or ramps), the parties should negotiate who is responsible for the cost and performance of these improvements in the lease.

While every lease is unique, leasing space to health care service providers requires the parties to consider regulatory and statutory requirements that may not be familiar to landlords traditionally leasing office space. The parties should also negotiate the allocation of the responsibility for and costs of any specialty services or utilities provided to the tenant.

Endnotes

This article was published in The Professional Lawyer, Volume 24, Number 2, ©2017 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

Introduction

Landing a corporate client usually is cause for celebration. But what terms and conditions apply to the arrangement? In the early 2000s, when the demand for legal services was high, law firms generally set the terms of the engagement with their corporate clients. Attorneys had freedom to make strategy decisions, identify and research legal issues as they arose, and schedule both internal team meetings and external meetings as appropriate. Billing may have been in 15 minute increments, with clients agreeing to pay for working dinners, cab rides home when working after 7 p.m. and domestic travel in business class.

In the late 2000s, the economy struggled, and competition among law firms for corporate clients intensified. Many corporate clients wanted to take control over reimbursement of expenses. Corporate clients also looked for ways to control the billing for services rendered, even as attorneys continued to work the same demanding hours. The answer was the corporate “outside counsel policy.” Anecdotally, where large law firms may have seen a handful of these policies in any given year in the early 2000s, today most large corporate clients have their own set of outside counsel policies.

Over time, these policies have become increasingly comprehensive and restrictive. They address a wide range of subjects from: 1) the ownership of the client file—the client owns everything; to 2) the level of skill of attorneys providing services—no attorney with less than two years of experience, for example; to 3) the number of attorneys who can attend a single meeting—just one. In some cases, they even require advance approval from in-house counsel before the lead partner at the outside law firm can make substantive decisions—even on issues as routine as whether legal research is appropriate. Sample provisions include:

• With respect to any work product or other material prepared by your Firm for [Company] (Works), [Company] shall have a non-exclusive, worldwide, royalty-free license to reproduce and distribute copies of such Works, to prepare derivative works based on such Works, and to otherwise use such Works.
• Please note that we generally will only approve use of first—and second-year associates for tasks they can perform more competently and cost-effectively than alternative personnel. Use of such associates will not be approved for tasks they cannot handle efficiently due to inexperience, nor will their use be approved for tasks that are simple enough to be performed by lower-cost timekeepers such as paralegals or contract attorneys.
• The Company will not pay for duplicative services performed by different members of the Outside Counsel. Accordingly, without prior approval, the Company should not be billed for time spent by more than one attorney attending the same meeting, conference, conference call, hearing or proceeding, or for time spent training junior lawyers or educating replacements when staffing changes occur. . . .
• . . . Moreover, no legal research—regardless of its nature—that requires more than five (5) hours of work should be undertaken without first discussing with us the specific issue to be researched and the purpose of the project. . . .

And which entity benefits by these rules? Is it just the corporation for which the lawyer is providing services? That is the question this article examines in detail.

Which Corporate Entity Do You Represent?

Model Rule 1.7 and Corporate Affiliates

One of the most complicated areas of professional responsibility in corporate representation is analyzing conflicts of interest. Determining which entity is the “client” is always important, particularly so when a firm is asked to represent a large, international corporation with wholly—and partially-owned subsidiaries or affiliates. If the law firm is asked to represent the interests of one wholly-owned, but third-tier subsidiary, is that company the firm’s only client? Or, if the client is a closely-held corporation, does the lawyer servicing the parent company represent its one subsidiary as well?

Comment [34] to Model Rule 1.7 provides a general rule that representation of a corporation does not result in representation of affiliates and subsidiaries. It states in pertinent part:

A lawyer who represents a corporation or other organization does not, by virtue of that representation, necessarily represent any constituent or affiliated organization, such as a parent or subsidiary. See Rule 1.13(a). Thus, the lawyer for an organization is not barred from accepting representation adverse to an affiliate in an unrelated matter . . . .

Courts consistently have reinforced the proposition that the existence of an attorney-client relationship with one corporate affiliate does not create, by default, an attorney-client relationship with all corporate affiliates. See GSI Commerce Solutions, Inc. v. BabyCenter, LLC, 618 F.3d 204, 210 (2d Cir. 2010) (restating the general proposition that a lawyer who represents a corporation does not, by virtue of that representation, represent any constituent or affiliated organization); HLP Props., LLC v. Consolidated Edison Co. of N.Y., Inc., No. 14 Civ. 01383, 2014 U.S. Dist. LEXIS 147416 (S.D.N.Y. Oct. 16, 2014) (same); ABA Comm. on Ethics & Prof’l Responsibility, Formal Op. 95-390 (1995) (noting that “whether a lawyer represents a corporate affiliate of his client . . . depends not upon any clear-cut per se rule but rather upon the particular circumstances.”); Apex Oil Co., Inc. v. Wickland Oil Co., et al., CIV-S-94-1499-DFL-GGH, 1995 U.S. Dist. LEXIS 6398, *5 (E.D. Cal. March 2, 1995) (holding that even though the entities at issue are co-subsidiaries managed by the same legal department, the co-subsidiaries are not the same client for the purpose of the current client conflicts rule).

Outside Counsel Policies and Corporate Affiliates

The general rule is clear: a lawyer who represents a corporation is not deemed to represent any constituent or affiliated organization. Some corporate outside counsel policies are consistent with this general rule. For example, the outside counsel policy for Company A provides that the law firm’s client is only the company and its divisions, which are not independent legal entities. See, e.g., In re Federal-Mogul Global Inc., 411 B.R. 148, 164 (D. Del. 2008) (citing AK Steel Corp. v. Viacom, Inc., 835 A.2d 820, 824 (Pa. Super. Ct. 2003) “[A] division of a corporation is not a separate legal entity capable of being sued . . . [A]n unincorporated association is not a legal entity and has no legal existence.”):

As part of this [engagement], each law firm is required to disclose to Company any actual or potential conflicts of interest that would affect its representation of Company. For purposes of the rules of professional conduct barring or limiting an attorney’s representation adverse to the interests of existing or former clients, Company and all of its unincorporated divisions should be deemed the “client” of the firm.

However, Comment [34] to Rule 1.7 contains three exceptions to this general rule:

. . . [1] unless the circumstances are such that the affiliate should also be considered a client of the lawyer, [2] there is an understanding between the lawyer and the organizational client that the lawyer will avoid representation adverse to the client’s affiliates, or [3] the lawyer’s obligations to either the organizational client or the new client are likely to limit materially the lawyer’s representation of the other client.¹

Many corporate outside counsel policies fall within exception [2]. Most conflicts of interest provisions in corporate outside counsel policies require that law firms treat all corporate affiliates of the client as the client itself for conflicts purposes. For example, the outside counsel policy for Company B contains a “Conflicts of Interest” provision that states:

Company greatly values loyalty and good judgment in its law firms, particularly in the area of conflicts of interest. We therefore expect outside counsel to promptly bring any potential conflicts to Company’s attention . . . Outside counsel must also perform a conflicts check prior to accepting each matter. All of Company’s subsidiaries and affiliates, wherever located, should be considered as clients for conflicts purposes. Outside counsel must advise Company immediately in writing, of any actual or potential representation that may be or become adverse to the interests of Company.

Some outside counsel policies are even broader, requiring any entity “controlled” by the client to be treated as the client itself. For example, Company C’s outside counsel policy provides:

For conflicts purposes, all of the Company’s controlled or managed affiliates and subsidiaries are to be considered your client even though they may be separate legal entities. Upon request, the supervising attorney can supply you with a current list of the names of the Company’s affiliates and subsidiaries . . . .

Thus, by agreeing to such outside counsel policies, law firms are contractually obligated to follow the requirements of Model Rule 1.7 on conflicts with current clients in situations where that rule otherwise would not apply.²

Affiliates as De Facto Clients

The first exception in Comment [34] addresses the situation where entering into an attorney-client relationship with one member of a corporate family will be deemed to create an attorney-client relationship with other members of the corporate family. When faced with this issue, courts have focused on two key factors: the degree of operational commonality between affiliated entities, and the extent to which one depends financially on the other. See GSI Commerce Solutions, Inc. v. BabyCenter, LLC, 618 F.3d 204, 201-11 (2d Cir. 2010). In examining the first factor—operational commonality—courts have considered the extent to which entities: 1) rely on a common infrastructure; 2) share common personnel such as managers, officers and directors; and 3) handle responsibility for the provision and management of legal services. See id., 618 F.3d at 211. In considering the second key factor—financial interdependence—courts consider the extent to which an adverse outcome in the matter at issue would result in substantial and measurable loss to the client or its affiliate and the entities’ ownership structure.³ See id.

The leading case on this issue is GSI Commerce Solutions, Inc. v. BabyCenter, LLC, 618 F.3d 204 (2d Cir. 2010). There, Johnson & Johnson (J&J) engaged a law firm (Firm) to serve as counsel to both J&J and certain J&J affiliates in connection with foreign compliance matters. The engagement letter contained multiple conflicting statements regarding the identity of the client. On one hand, the letter stated that the Firm represented only J&J and none of its “affiliates, subsidiaries, partners, joint venturers, employees, directors, officers, shareholders, members, owners, agencies, departments or divisions.” On the other hand, the engagement letter included an advance waiver from J&J allowing the Firm to represent other clients in patent-related proceedings adverse to unspecified J&J affiliates—a waiver only necessary if the Firm considered all J&J affiliates to be clients as well. Id. at 206-07. Five years later, the Firm agreed to represent GSI Commerce Solutions, Inc. in a breach of contract claim adverse to BabyCenter, LLC, a wholly-owned subsidiary of J&J. BabyCenter, which was represented by other counsel, moved to disqualify the Firm as counsel for GSI because of its ongoing attorney-client relationship with J&J and, necessarily, also with BabyCenter.

The Second Circuit analyzed the corporate relationship between J&J and BabyCenter and concluded that the “substantial operational commonality” between BabyCenter and J&J required that they be considered the same entity for conflicts purposes:

• BabyCenter substantially relied on J&J for accounting, audit, cash management, employee benefits, finance, human resources, information technology, insurance, payroll, and travel services and systems.
• Both entities relied on the same in-house legal department.
• A member of J&J’s in-house legal department served as “board lawyer” for BabyCenter.
• J&J’s legal department was involved in the BabyCenter dispute since it first arose, participating in mediation efforts and securing outside counsel for BabyCenter.
• BabyCenter was a wholly-owned subsidiary of J&J, with some overlap in management control.

The Circuit Court summarized its analysis as follows:

When considered together, these factors show that the relationship between the two entities is exceedingly close. That showing in turn substantiates the view that [the Firm], by representing GSI in this matter, “reasonably diminishes the level of confidence and trust in counsel held by J&J.”

Id. at 211-12 (citing Certain Underwriters at Lloyd’s, London v. Argonaut Ins. Co., 264 F. Supp. 2d 914, 922 (N.D. Cal. 2003)). The Circuit Court also concluded that the language of the advance waiver diluted the Firm’s position that J&J was its only client. Id. at 213.

By agreeing to outside counsel policies which require that all affiliates should be treated as clients for conflicts purposes, law firms are forfeiting the freedom the Model Rules provide and eliminating the need to engage in the exacting corporate/affiliates legal analysis. Instead, they are contractually obligating themselves to clear conflicts for any matter adverse to any affiliate or subsidiary of those corporate clients.

Implications

There are numerous practical implications for law firms. First, a “conflict” is created through a contractual obligation and not by a conflict otherwise recognized by Model Rule 1.7, the governing rule on conflicts of interest with current clients. So, for example, honoring the policy, a law firm must request a waiver to handle a transaction for another client with a third-tier subsidiary of the corporate parent which is a firm client for benefits work, only. And the firm has no recourse for a client’s unreasonable refusal to grant the waiver. A firm may be turning away business, in the aggregate, which is more valuable than the work being performed for the parent company.

In addition, these provisions create a conflict-checking nightmare for law firms. Many corporate clients have an extensive and constantly-changing lists of affiliates. Corporate structure can change by the day, when a parent acquires new subsidiaries or sells affiliates to other owners. Unless the corporate client agrees to inform the firm of changes in its corporate structure, the law firm must shoulder the substantial burden of updating the affiliate list—and inputting any changes into the conflicts-checking system. Many clients are not proactive about notifying their outside counsel about corporate structure changes, despite the requirements in the outside counsel policies. Overlooking this function may be understandable, as general counsel and other attorneys tasked with coordinating with outside counsel often are involved in many other aspects of the day-to-day management of the relationship or of the company. But, that would not excuse a breach by counsel of the conflict of interest section of the outside counsel policy. And such a breach exposes the firm to liability under traditional contract principles.

An Example Highlighting the Risks

Consider this series of events: Law Firm handles patent prosecution work for Large Pharmaceutical Company, LPharma. LPharma’s outside counsel policy requires Law Firm to treat all LPharma affiliates as clients of Law Firm for conflicts purposes. At the inception of the engagement, Law Firm enters all of the affiliates into its conflict system. Three months later, LPharma buys a thirty percent (30%) interest in Smaller Pharmaceutical Company, SPharma. Law Firm is not notified and has no knowledge of the investment. Six months later, Law Firm is engaged by Other Client to defend litigation against it by SPharma. When Law Firm lawyers appear on the first day of trial, the General Counsel for LPharma is sitting at counsel’s table for SPharma. She wants to know why Law Firm is representing Other Client adverse to SPharma’s interests. Relying on the outside counsel policy, SPharma immediately moves to disqualify Law Firm.

Where does the fault lie? And does it matter? Law Firm accepted an engagement governed by an outside counsel policy that required it to treat all corporate affiliates as clients of Law Firm for conflicts purposes, no matter how attenuated the affiliation. Law Firm could argue that the client failed in its obligation to notify Law Firm of changes in its affiliate list which excused Law Firm’s performance under the policy. Courts, however, generally reject the “blame the client” strategy. Law Firm likely would have to defend a disqualification motion, solely because of the provision in the outside counsel policy,⁴ and also could be exposed to contract damages.

Rule 1.7 and Conflicts Associated with a Client’s Business Interests

Model Rule 1.7 and Representation of Competitors

The Model Rules provide guidance with respect to a lawyer’s representation of business competitors. Comment [6] to Rule 1.7 states, in pertinent part, that “simultaneous representation in unrelated matters of clients whose interests are only economically adverse, such as representation of competing economic enterprises in unrelated litigation, does not ordinarily constitute a conflict of interest and thus may not require consent of the respective clients.” In addition, comment [24] notes that a lawyer “may take inconsistent legal positions in different tribunals at different times on behalf of different clients. The mere fact that advocating a legal position on behalf of one client might create precedent adverse to the interests of a client represented by the lawyer in an unrelated matter does not create a conflict of interest.”

Like the rule with respect to corporate affiliates, courts have consistently upheld the general principle that business interests or economic adversity do not create ethical conflicts of interest under the Model Rules. See, e.g., Curtis v. Radio Representatives, Inc., 696 F. Supp. 729, 736-37 (D.C. 1998) (simultaneous representation of business competitors in separate matters does not create a conflict of interest); ABA Comm. on Ethics & Prof’l Responsibility, Formal Op. 05-434 (2004), at 140 (direct adversity under Rule 1.7 requires a conflict as to the legal rights and duties of the clients, not merely conflicting economic interests). Even in the area of intellectual property law, where conflicts of interests analysis often requires an examination of the technology at issue, courts have held that the potential legal, ethical and practical problems that may result when a firm represents clients seeking patents in the same subject matter area do not, standing alone, constitute a conflict of interest under Rule 1.7. See Maling v. Finnegan, Henderson, Farabow, Garrett & Dunner, LLP, 473 Mass. 336 (Mass. S.J.C. 2015) (no conflict where a law firm represented two competitors applying for patent protection for products in the same market because the clients were not competing for the same patent, but rather different patents for similar devices).

Outside Counsel Policies and Representation of Competitors⁵

Outside counsel policies impose far greater conflict waiver obligations when representing business competitors. Perhaps in light of this case law, corporations are restricting counsel by contract provisions which either forbid them—based on the concept of “loyalty”—from representing competitors, or requiring that they seek advance approval before doing so. For example, Company W’s outside counsel policy is extremely broad and states:

Furthermore, please advise the supervising attorney: (i) if your firm generally represents a party whose business interests are adverse to the Company, even if that party is not currently in proceedings against the Company; and/or (ii) if your firm represents or proposes to represent another party in a proceeding that is adverse to the Company’s business interests, whether or not the Company is a named party in the proceeding.

Company X’s outside counsel policy is similar, but at least attempts to identify some of those entities the client deems to be competitors:

Any actual or potential conflict must be waived by the supervising attorney before outside counsel undertakes or continues representation. Company is likely to consider that a conflict of interest exists if outside counsel were to be retained or engaged by a competitor of Company in the Industry, including, by way of example but not limitation, . . . Company 1, Company 2 or Company 3. Accordingly, outside counsel should obtain the consent of the supervising attorney before accepting such a retainer or engagement.

The outside counsel policy for Company Y exemplifies one of the broadest “business conflict” provisions. It states:

Conflicts of interest must be disclosed to Company and waived in writing prior to beginning a matter. Company has a broad array of business interests. It is important that you be sensitive both to direct conflicts of interest posed by your representation of Company and other clients and more indirect, issue or policy, conflicts that may arise from your firm’s advocacy on behalf of other clients of positions conflicting with Company business interests. We expect to be informed of and consulted with respect to all potential direct and indirect conflicts promptly.

It is also expected that you will advise Company of any positions the firm has taken in the recent past or is presently taking on issues which to your knowledge may be adverse, harmful or otherwise prejudicial to the interests of Company in this or another Company matter. This includes, without limitation, decisions taken by your firm before administrative and regulatory agencies and bodies as well as administrative and regulatory issues before other tribunals.

As a final example, Company Z’s policy is more succinct, but of equal concern:

Outside counsel shall seek Company’s prior consent in advance of undertaking any work for another company in the rubber, tire or fleet management sectors.

Implications

These provisions create countless issues for law firms. First, whose burden is it to identify the competitors in the same industry? Like the issue with corporate affiliates, corporate clients rarely identify the entities they deem to be competitors, and therefore, are subject to the contractual obligations cited above. If an initial list is provided, it is not regularly updated even though the client, and not the law firm, is in the best position to identify its competitors. Similarly, the task of maintaining an up-to-date list of competitors, to the extent it changes, should fall squarely on the corporate client.

Second, how broad is the list of competitors? Is it limited to those entities who are the same size, in the same market, in the same geographic region as the client? Or is it much broader, including entities across geographic regions and ranging in size without regard to the corporate structure of the actual client? What happens when there is a disagreement between the law firm and the corporate client about whether a particular entity is, in fact, a competitor? How is that dispute resolved?

Third, do these provisions, like the one outlined above in Company Z’s outside counsel policy, implicitly require that a law firm violate its duty of confidentiality under Model Rule 1.6 to its other existing or prospective clients? Model Rule 1.6 protects as confidential all “information relating to the representation of a client.” While the identity of a client—or the fact of the representation—is not protected by the attorney-client privilege, “the client’s name, the fact that the client consulted a lawyer and the general nature of the consultation may nevertheless constitute ‘secrets’ of the client which the lawyer may not disclose” absent the client’s express consent. See, e.g., N.Y. State Bar Ass’n Op. 720 (1999) (analyzing the similar Rule 1.6 in New York); N.Y. State Bar Ass’n Op. 1088 (2016) (same); Model Rules of Prof’l Conduct R. 1.6 (2016). A limited exception to the confidentiality obligation to current clients appears in Model Rule 1.6(b) (7) where disclosure is required to resolve conflicts in certain situations.⁶ But the obligations in the outside counsel policies apply in situations far broader than conflicts recognized under the Rules of Professional Conduct. By requiring a law firm to obtain the consent of a corporate client before representing a client deemed a “competitor,” the law firm is required to disclose the identity of another client even where the services are wholly unrelated and no actual conflict exists. For example, under these policies, a firm that represents a widget manufacturer in employment matters would have to disclose that engagement if asked to represent its other widget maker client in connection with a federal investigation—work wholly unrelated to the employment work and not triggering any conflict under Model Rule 1.7. Yet, the second client may well want to keep confidential the fact that it has retained a law firm for advice in connection with such an investigation, as the information may be harmful to the company.

The problem is the same with respect to prospective clients, where a lawyer must maintain as confidential information received from the prospective client which may be significantly harmful to the prospect if disclosed. See Model Rules of Prof’l Conduct R. 1.18(b) (2016).

Fourth, do these provisions also unduly restrict a law firm’s ability to practice law? The idea that a law firm—particularly a law firm with a diverse client base and multiple areas of expertise—could not represent Credit Card Company A in its litigation while simultaneously representing Credit Card Company B in unrelated corporate work, where no adversity exists, is not tethered to any legitimate risk that a law firm’s loyalties would be divided. Indeed, many law firms focus on certain subject matter areas—entertainment law or health law, as examples—in order to develop special expertise to attract clients within that subject matter or industry. Yet, read literally, the outside counsel policies would allow Credit Card Company A to refuse to consent to the law firm’s engagement for Credit Card Company B, thus limiting the engagements the law firm can undertake even where no actual conflict exists.

Conclusion

In light of the increasing prevalence of both outside counsel policies generally, and specifically those containing these types of conflicts provisions, law firms must have the appropriate tools to manage these requirements. First, these policies should be reviewed consistently by a centralized staff. Problem areas should be addressed with the clients. These provisions are not always set in stone. Often corporate clients will agree to modified clauses which are less restrictive. For example, a client may realize that treating all of its affiliates and subsidiaries as clients for conflicts purposes is too onerous, and may substitute a short list of the “key” entities. Similarly, after some discussion, a corporate client may well understand that tracking and revealing the engagements of competitors, particularly where there is no relationship to the work the law firm is performing for the corporate client, violates an attorney’s confidentiality obligations—obligations the client itself would want the law firm to honor in all circumstances.

In addition, the law firm and client should agree as to which party will be responsible for maintaining lists of affiliates or competitors and how they will be treated in the conflict system. They also should agree upon the schedule for updating—whether monthly, quarterly, bi-annually or annually.

Outside counsel policies should be maintained either with the other engagement documentation for the particular client or centrally in an electronic file to allow for easy access and reference in the event questions arise. This ease of access will facilitate the regular review of the outside counsel policies by the team working for the client to insure compliance with the detailed requirements which cover a wide range of issues.

Maintaining an open dialogue with the client is instrumental to a smooth engagement. Initiating this dialogue upon presentation of the outside counsel policy can and should be done in a responsible and professional manner. Most of these issues can be resolved in a way that satisfies the client as well as the firm. Many in-house corporate counsel frequently engage law firms, are familiar with the issues they face, and often are willing to accommodate a law firm’s considered requests to modify certain policy provisions. The result of this process is a policy with which the law firm can comply and which also upholds the core provisions addressing attorney loyalty and other important interests of the corporate client in its relationship with its outside counsel.

Endnotes

This article sponsored by Pepper Hamilton originally appeared in The Legal Special 2017 by PEI in April 2017.

For many years, permanent capital was an aspirational concept in private equity. It is gaining momentum, however, and is becoming a reality in today’s investment platforms. By leveraging the optionality and understanding the limitations of permanent capital, managers may seamlessly use it to enhance their business.

Permanent capital is an investment for an indefinite period of time in an underlying vehicle. The vehicle can be any form – a corporation, trust or partnership. The investment entity could be publicly traded or privately held which we focus on here.

The most recognised, and perhaps most successful, example of permanent capital may be Berkshire Hathaway. In simple terms, Warren Buffett created a pool of investments where new capital could be added, capital could be withdrawn, management incentivised and the investments within the pool could change. Family offices have been doing this for years, so why don’t more private equity managers adopt permanent capital techniques?

How Permanent Capital Works

Permanent capital vehicles, or PCVs, utilise principles of traditional fund structures. They are often limited partnerships with a governing general partner, a carry-owning special limited partner and a separate management company as manager. They also integrate valuation and redemption concepts of hedge funds and incentive concepts more familiar in a single perpetual holding company.

For ease of understanding and communication and to track all the special investor calculations, a PCV will often have a capital structure stated in units rather than percentages. The units can be designated in classes. For example, class A units may evidence investor (or manager) capital, and class B units could reflect the manager carry. Units represent commitments to contribute capital when called. Because units can be issued over the life of the company, special attention is needed to distributions based on units where some may be fully funded and others not yet so.

One key to a fund manager’s success is maintaining the rhythm of fund formation without being out of the market, on either a brand recognition or deal consummation basis. This is much less of an issue if the fund manager is managing PCVs. The PCV will have a designated long term, often as much as 25 years, or a perpetual term that ends only when the last investor has redeemed its interest or the manager decides to liquidate after the entity has disposed of each of its investments. While it may be the vehicle’s most differentiating factor when compared to private equity funds, the term receives little negotiation.

Adding Capital

Investors in perpetual vehicles do not want to hinder the diversification of the portfolio by always having the same investments in them. They also often want to add more capital to the funds under management either to broaden portfolio diversity, increase deal size or continue making new investments. To add more capital requires that the manager determine a unit value derived from the vehicle’s net asset value. It is the price paid to acquire more units in the company.

An example is illuminating here. Let’s say investor #1 joins PCV Partners, LLC at its initial closing. Capital is represented by class A units, issued in $1,000 increments. Investor #1 makes a $10 million commitment and receives 10,000 class A units. PCV Partner’s founders contribute two warehoused investments at the initial closing in exchange for class A units equal to the agreed value of the warehoused investments. The NAV of each unit is thus $1,000 immediately after the initial closing. Investor #1 is required to contribute 20 percent, or $2 million, in cash at the initial closing. This can either be retained or distributed to the contributors of the warehoused investments – just like a private equity fund. (Caution is warranted here as to the tax consequences that distribution may cause to the in-kind contributors.)

Investor #11 comes along in the second closing 12 months later and also commits $10 million. As with a private equity vehicle, one of the design points of the PCV is to decide (1) how long the initial fundraising period should be at which additional capital is guaranteed the same NAV upon admission; (2) whether an interest factor should be charged to the latecomer for the period of time that it did not contribute capital – in this case 12 months (the “interest amount”); and (3) whether the pre-existing investments should be revalued. For convenience, unless there has been a spectacular appreciation, it is rare to revalue investments in the initial fundraising period (which may be as long as 24 months in a private equity fund or in a permanent capital entity).

Assuming PCV Partners had a 12-month initial fundraising period, investor #11 would also receive 10,000 class A units. At this point, PCV Partners has the capital it wanted to build its initial portfolio.

Roll forward three years, and PCV Partners has deployed all of the initial capital (or reserved). It issues class A units to investor #12 at $1,000 divided by the NAV in effect at the time of the issuance. If the NAV is $2,000 at the time, investor #12 receives 5,000 class A units for a $10 million commitment.

Investor #12’s commitment is new and the prior investors’ commitments are fully drawn. PCV Partners may choose to draw #12’s cash disproportionately or to return cash to pre-existing partners and restore their commitments. Notably, if it is not returned, investors #1-11 and #12 could be at different tiers in the distribution waterfall when there is cash available for distribution. 

Striking a net asset value in privately held investments is not easy. As NAV is the basis on which transactions in units occur, NAV provisions in the governing documents are often highly negotiated and detailed. Determining an NAV frequently involves third-party appraisers, which can get expensive. Hence, the PCV is likely to require limits on when unit-based transactions can occur.

---

THE KEY ADVANTAGES

• A permanent capital vehicle affords an investment manager enhanced stability, the ability to invest in longer-term growth strategies and a tool for sophisticated co-investment structures, all without diminishing fees and carry.
• Managers can avoid dedicating time and money to fundraising every four or so years.
• Investors, especially family offices, welcome the reduced investment costs and the increased investment options, primarily because permanent capital avoids the artificial holding terms imposed by private equity fund models.

---

Skin in the Game

The same alignment of interest considerations apply to private funds and PCVs. Investors expect the management team to invest their own “skin in the game” in the same amounts as in a private equity fund (between 1 percent and 5 percent). The questions arising about manager investment in a PCV relate more to when the manager can withdraw their investment. Investors look to keep the original alignment by limiting manager redemptions. For example, manager redemptions may be limited either in size or by a percentage of the capital account, or they may be subordinated to investor redemptions if gates are triggered.

To solve the liquidity conundrum, PCVs offer controlled redemptions after some period of years, where the investor has a put right for a portion of their interest in the vehicle. The redemption rights and the right to add more capital to the vehicle receive the most attention. Usually, though it does not have to be, this is a “horizontal slice” of the whole portfolio, not a vertical slice, ie, where their interest in one or more companies is sold. The right may be exercised after some period of years, which is set based on the design of the investments held in the vehicle required to pay the redemption price. Similar to hedge funds, there are often “gates” on the amount that can be put in any one year.

Manager Compensation

The basic tenets of private equity activity are investors making capital available and paying a management fee and carried interest in exchange for the fund manager locating, vetting, acquiring and disposing of portfolio companies.

Permanent capital is no different. Its investors (other than the managers) bear a management fee that is comparable to that borne by investors in a private equity fund. With permanent capital, however, the management fee may be designed just to cover the operating budget of the investment manager. There may be investor approval  rights over the budget or caps on aggregate fee amounts. In a budget-based system, the budget must be “allocated” among the PCV and any other investment vehicles or separate accounts which the manager manages.

Since investors can come in at any time (based on NAV), the management fee is calculated on an investor-by-investor basis. The management fee may be a percentage of contributed capital or of NAV, or a combination of both. It is usually payable for between five and nine years. As new capital comes in, it bears a management fee, even while a pre-existing investor’s obligation may be winding down. The management fee’s budgetary underpinning and its finite life mean that it needs to be carefully designed to align with the ability to add additional investors, or to realise carry, which will depend in large part on the investment strategy of the company and the success of its implementation.

---

WHAT ARE THE TOUGHEST ISSUES?

While the time horizon for a PCV may differ from that of a typical private equity fund, many of the PCVs toughest issues are largely the same as for PE funds:

• Conflicts of interest, valuations, fees and costs remain integral to the due diligence process for the investor and the disclosure process for the manager.
• Investment advisor registration, broker-dealer, securities law and investment company issues are largely the same. 
• Valuations are complicated by the long-term nature of the PCV. To implement a compensation structure for the manager that compares favourably with the private equity world, PCVs may set a fixed date or dates at the outset at which to set NAV in order to address perceived cherry-picking or other valuation issues. Alternatively, the PCV may utilise outside valuation services on a biannual or annual basis to assist the manager in the valuation process and insulate them from liability concerns.
• The manager must always be mindful of the perpetual, or long-term, nature of the PCV when creating its mechanics in order to ensure that the vehicle addresses perceived or potential issues addressed by shorter-term private equity funds.

---

Calculating Carry

There are three basic ways to calculate carry: (1) at the investor level on an investor-by-investor basis (akin to a hedge fund); (2) at the entity level on a deal-by-deal basis; or (3) at the entity level on a pooled basis (eg, by treating all investments made in a certain period, say five years, in the same pool for carry calculation purposes).

What happens to carry, regardless of how it is calculated, is one of the things that makes PCVs unique. Since NAV is determined periodically, the carry value can, relatively easily, be converted at designated times into “permanent capital” and continue in the company in the same way as investor’s capital. This can go on until the investment is sold, or the carry can be withdrawn through the same redemption rights as the other investors. Alternatively, the redemption rights may be different for converted carry (ie, allow for slower withdrawal) than for the redemption rights applicable to invested capital. For example, a conversion may be voluntary or required at year eight, but withdrawal is limited until year 10 or 12.

The ability to add more investors and more capital to the company complicates the calculation of the manager’s carried interest. If the carry is represented by class B units, the PCV’s designers need to consider whether the class B units receive a share of all profits on all investments, realised investments or a pooled group of investments and when that value is able to be “realised” through the conversion mechanism above. 

The whole purpose of permanent capital is to avoid the need to distribute proceeds earned from investments, but to instead recycle them and grow by reinvestment. Accordingly, distributions are not mandatory. Rather investors reap the benefits of their investment through the redemption mechanism. Alternatively, the same effect, with even more optionality for investors, can be achieved with distribution of cash and voluntary “re-ups” on the commitment amount. This is essentially a first right to provide any new capital. If it comes with a break on carry it may be tracked in a new unit class.

Investor Appeal

While it may be readily apparent why managers would like to implement a long-term vehicle with predictable management fees, what does it offer to the investor? Many investors, both individuals and family offices, are often looking to invest a percentage of their assets in a cost-controlled and longer-term vehicle. The longer-term vehicle, with a perpetual reinvestment cycle in a particular sector, permits the investor to make a one-time allocation and build its portfolio around the allocation.

The cost-controlled structure, in the absence of extraordinary events, permits the investor to plan year on year for an extended period of time with some degree of consistency. Similar to any other allocation, the percentage of an investor’s assets that are suitable for a PCV is specific to the investor. The sector of the vehicle combined with factors including geography, management team and risk profile will all be factors in the allocation process.

PCVs are frequently discussed within family offices. On the one hand, family offices do not want capital to be taken out of deployment at a time horizon suitable to a fund manager as opposed to when it is the best time to harvest the investment. On the other hand, they do not want capital locked up indefinitely. The manager therefore offers liquidity through redemption opportunities during designated windows (after a lock-up period), or sale of the interest. The manager may even be required to assist in that sale. The manager gains greater certainty with respect to income and affording the investor opportunities to invest in long-term strategies.

The percentage of a family office’s assets that are allocated is particular to the demographic and investing profile of that family office. For many family offices, the allocation process can be both time-consuming and onerous, especially if there are a large number of constituents that must be consulted.

The longer term of the PCV allows the board or manager of the family office to revisit the allocations of the family office on a less frequent basis, without foregoing the ability to revisit it whenever it wants to. This is both efficient from a cost and time perspective. For example, a family office may determine that it would like to allocate a portion of its assets to a particular strategy. The family office would, depending on its governance terms, either consult with each constituent or implement a broad allocation across the family.

If the sector vehicle was a typical 10- to 12-year fund with a four- to six-year investment period, the family office would, potentially, be revisiting the allocation to that sector in three to four years, when it may be faced with evaluating new managers if it wants to continue that strategy. Whereas, with a PCV, it could leave the strategy allocation as is until it affirmatively decides to change it. 

Permanent capital, individually or as part of a large multi-faceted investment platform, may offer a solution to managers and investors alike that are seeking a long-term and fee-stable vehicle. With longer investment holding periods being available, and with the comparable fee and carry results, albeit differently structured, the permanent capital model avoids the need to harvest investments at artificially created time horizons and to dedicate immense resources to fund formation every several years. The PCV provides a source of “ready” capital for the manager while, if successful, protecting original capital. It permits the manager and the investor to invest in a long-term relationship, which, if structured correctly, can be fruitful for the both the investor and the manager in the short term and the long term.

On December 28, the U.S. Small Business Administration (SBA) released a Final Rule modifying its regulations on the ability of a small business investment company (SBIC) to finance passive businesses. A business is considered to be “passive” if (1) it is not engaged in a regular and continuous business operation; (2) its employees do not carry on the majority of day-to-day operations, and the company does not exercise day-to-day control and supervision over contract workers; or (3) the business passes through substantially all financing proceeds to another entity. The mere receipt of payments such as dividends, rents, lease payments or royalties is not considered a regular and continuous business operation. SBICs are generally prohibited from financing passive businesses. However, the SBIC program regulations provide for two exceptions to this prohibition. The Final Rule expands and makes certain clarifications to these exceptions.

This Client Alert provides a summary of these two exceptions and describes how they have been modified by the Final Rule. The Final Rule is effective January 27, 2017.

Passive Business Investment Exceptions

The “Holding Company” Exception

The holding company exception currently permits an SBIC to structure a financing through up to two tiers of passive businesses (holding companies) so long as the holding company financed by the SBIC passes substantially all of the financing proceeds through to one or more “subsidiary companies” that are eligible small businesses and not themselves holding companies (operating companies). A “subsidiary company” is an operating company in which the financed holding company either:

• directly owns at least 50 percent of the outstanding voting securities, or
• indirectly owns at least 50 percent of the outstanding voting securities (by directly owning the outstanding voting securities of another holding company that is the direct owner of the outstanding voting securities of the operating company).

Thus, under the existing holding company exception, an SBIC can finance a holding company (Holdco 1) if Holdco 1 directly owns at least 50 percent of the outstanding voting securities of the operating company or if Holdco 1 directly owns a sufficient percentage of the outstanding voting securities of an intermediate holding company (Holdco 2) that would enable Holdco 1 to own indirectly through its ownership of Holdco 2 at least 50 percent of the outstanding voting securities of the operating company.

The Final Rule includes technical modifications to codify SBA’s existing interpretation of the holding company exception to (1) permit an SBIC not only to finance a holding company in accordance with the exception, but also to form the holding company being financed and (2) enable a holding company not only to pass substantially all of the financing proceeds through to the operating company, but also to use substantially all of the financing proceeds to acquire the operating company either directly or indirectly through an intermediate holding company in which the holding company owns a sufficient percentage of the outstanding voting securities that would enable the holding company to own indirectly (through its ownership of the intermediate holding company) at least 50 percent of the outstanding voting securities of the operating company.

Figure 1 illustrates how an SBIC could structure the financing of an operating company under the holding company exception:

Figure 1

The “Blocker Corporation” Exception

The blocker corporation exception currently permits an SBIC, with SBA’s prior written approval, to finance an eligible unincorporated small business through a passive business that is organized as a corporation and wholly owned by the SBIC, but only if a direct financing of the small business by the SBIC would cause one or more of the SBIC’s investors to incur “unrelated business taxable income” (UBTI) under section 511 of the Internal Revenue Code. The passive business formed under this exception is typically referred to as a “blocker corporation.”

The Final Rule modifies the blocker corporation exception by:

• Permitting the blocker corporation (referred to as a “blocker entity” in the Final Rule) to be organized as a corporation or limited liability company that elects to be taxed as a corporation for federal income tax purposes
• Replacing the requirement for an SBIC to obtain SBA prior written approval before forming a blocker entity with a requirement that the SBIC prepare and maintain in its files for review by SBA a certification that the blocker entity was formed in accordance with the exception
• Expanding the circumstances under which an SBIC may form a blocker entity.

Under the Final Rule, an SBIC will be permitted to finance, without prior SBA approval, one or more eligible unincorporated small businesses through one or more blocker entities wholly owned by the SBIC if a direct financing of the small business by the SBIC would cause (1) any of the SBIC’s investors to incur UBTI, (2) any of the SBIC’s foreign investors to incur “effectively connected income” under sections 871 and 882 of the Internal Revenue Code or (3) any of the SBIC’s investors that have elected to be taxed as a regulated investment company (e.g., business development companies) to receive (or be deemed to receive) gross income that does not qualify under section 851(b)(2) of the Internal Revenue Code.

A wholly owned blocker entity financed by an SBIC under the Final Rule is permitted to provide a financing directly to:

• One or more operating companies
• A holding company that passes substantially all of the financing proceeds directly to (or uses substantially all of the financing proceeds to acquire) one or more operating companies in which the holding company directly owns (or will own as a result of the financing) at least 50 percent of the outstanding voting securities.

Figure 2 illustrates how an SBIC could structure the financing of an operating company under the blocker corporation exception:

Figure 2

SBA specifically did not adopt industry comments that would have permitted an SBIC to finance a wholly owned blocker entity under the blocker corporation exception and then have that blocker entity finance an operating company through a two-tier holding company structure in accordance with the holding company exception. Thus, an SBIC that forms a wholly owned blocker entity in accordance with the blocker corporation exception will not be permitted to provide financing to a holding company that is more than one tier removed from the operating company.

New Conditions to Availability of These Exceptions

The Final Rule incorporates the following additional conditions to an SBIC’s ability to structure financings under the holding company and the blocker corporation exceptions.

Meaning of “Substantially All”

The Final Rule defines “substantially all” of the financing proceeds to mean at least 99 percent of the financing proceeds after deduction of actual application fees, closing fees and expense reimbursements to the extent the fees and reimbursements are permitted to be charged under SBIC program regulations.

Maximum Amount of Financing and Management Fees

The Final Rule clarifies that if an SBIC or any of the SBIC’s “associates” charge financing or management fees, then the total amount of all fees so charged to all holding companies and operating companies that are part of the same financing cannot exceed the fees that would have been permitted if the financing had been provided directly to the operating company.

Requirement for an SBIC’s “Associates” to Pay Over Fees Received by Them to the SBIC

If an “associate” of an SBIC receives any financing or management fees, then the associate is required to pay over these fees to the SBIC in cash within 30 days of the associate’s receipt of the fees.

The Final Rule’s new pay-over condition treats fees received by an SBIC’s associate in a financing completed by the SBIC utilizing the holding company or the blocker corporation exceptions differently than the manner in which those fees would be treated if the SBIC had completed the financing directly to the operating company without using either exception. This difference lies in the requirement under SBA’s TechNote 7A (which provides SBA’s policy guidelines concerning allowable management fees for leveraged SBICs) that any such fees received by an SBIC’s associates either be paid over to the SBIC in cash or treated as a dollar-for-dollar offset to the management fee paid by the SBIC. Moreover, TechNote 7A includes an exception to this requirement for investment banking fees received by an SBIC’s associate who is an SEC-registered broker-dealer regularly engaged in the business of providing investment banking services. This investment banking exception is not specifically recognized in the Final Rule’s new pay-over condition. Thus, financings made by SBICs through holding companies are on a different footing than financings made directly because fees received by an SBIC’s associate in financings made directly can be offset against the management fee paid by the SBIC, while fees received in financings made through holding companies must be paid over in cash by the associate to the SBIC.

In implementing the Final Rule, SBA did not accept the industry’s comment that the pay-over condition was unnecessary in light of TechNote 7A and because most SBICs addressed the issue through a dollar-for-dollar offset to the management fee paid by the SBIC for tax reasons. SBA did not adopt the industry’s comment because of SBA’s views concerning the difficulty in monitoring investments utilizing holding company structures and identifying fees associated with each holding company in addition to those paid by the operating company.

Extension of the Term ‘Portfolio Concern’ to Passive Businesses

The Final Rule modifies the term “Portfolio Concern” to clarify that all holding companies and operating companies included in a financing are Portfolio Concerns and, therefore, subject to SBIC program regulations concerning:

• Certain recordkeeping, information and reporting requirements of, and with respect to, Portfolio Concerns
• An SBIC’s designation of its associates to serve as officers, directors or other participants in the management of a Portfolio Concern
• The manner in which a change in a Portfolio Concern’s size or activity affects the SBIC’s ability to continue to hold and make investments in the Portfolio Concern
• Restrictions on the terms under which an SBIC is permitted to redeem equity securities of a Portfolio Concern.

Changes to SBA Form 1031

The Final Rule implements changes to SBA’s Form 1031 (Portfolio Financing Report) that must be submitted by SBICs to SBA within 30 days after the completion of each financing. These changes do the following:

• Clarify that SBICs should report data on the operating company when reporting information on financings using holding companies in Part A, Part B and, with the exception of the amount of financing dollars in Question 29, Part C of Form 1031 (for Question 29 of Part C, the amount of the financing dollars provided by the SBIC should be included regardless of whether the financing dollars were provided directly or indirectly to the operating company)
• Incorporate an additional question regarding whether the financing utilizes one or more holding companies as part of the financing
• Require SBICs to upload an information file in PDF format that:
  • Identifies whether the SBIC is utilizing the holding company or the blocker corporation exceptions and, if so, the name and employer ID number for each holding company used in the financing
  • Describes the financing structure, including the flow of money between the SBIC and the holding companies that receive the proceeds (including amounts and the types of securities between each entity) and the ownership from the SBIC through each entity to the operating company
  • Identifies whether the financing is an SBIC-identified impact investment or an SBA-identified impact investment (for Impact SBICs).

Technical Changes

The Final Rule also incorporates several technical changes that are unrelated to the passive business SBIC program regulations. These technical changes:

• Implement SBA’s current oversight practices that allow the minimum $5 million regulatory capital and $2.5 million leveragable capital requirements for SBICs to be less if the reductions are performed in accordance with an SBA-approved wind-up plan
• Reflect the increase in the maximum amount of SBA leverage available to SBICs under common control from $225 million to $350 million that was implemented by congressional legislation passed in December 2015.

A more detailed description of the SBIC Program is available in Pepper Hamilton LLP’s “Description of the Small Business Investment Company Debenture Program.”

For additional information contact:

Christopher A. Rossi | 610.640.7846 | rossic@pepperlaw.com
Michael A. Temple

The Second Circuit Court of Appeals sent a clear message to secured creditors with its recent decision, Ring v. First Niagara Bank, N.A. (In re Sterling United, Inc.),¹ that in the case of a collateral description in a financing statement for blanket liens covering all of a debtor’s assets — less is more. In the case, the secured party, First Niagara Bank, supplemented its “all assets” UCC-1 description with the phrase “including but not limited to, [all assets located at]”, followed by a specific address where the collateral was located.² When the debtor later moved to a new location, this unnecessary additional phrase almost backfired on the secured party when a bankruptcy trustee moved to avoid the financing statement as a preference.³ The Court ultimately found after protracted litigation that the collateral description was sufficient, but First Niagara’s experience serves as a reminder to creditors (and their attorneys) that a simple “all assets” UCC-1 description limits the risk of future litigation.

By way of factual background, between 2005 and 2007, Sterling Graphics, Inc. entered into three separate loan agreements with First Niagara Bank, to support its printing business.⁴ In connection with the loan facility, Sterling granted First Niagara a security interest over all of its assets.⁵ To perfect this security interest, First Niagara filed three UCC-1 financing statements, which described the collateral as follows:

All assets of the Debtor including, but not limited to, any and all equipment, fixtures, inventory, accounts, chattel paper, documents, instruments, investment property, general intangibles, letter-of-credit rights and deposit accounts now owned and hereafter acquired by Debtor and located at or relating to the operation of the premises at 100 River Rock Drive, Suite 304, Buffalo, New York, together with any products and proceeds thereof including but not limited to, a certain Komori 628 P & L Ten Color Press and Heidelberg B20 Folder and Prism Print Management System.⁶

Prior to October 2012, the Debtor changed its name to Sterling United, Inc. and moved its headquarters to 6030 North Bailey Avenue, Amherst, NY.7 First Niagara amended its UCC filings to change the debtor’s name and address, but failed to update the collateral descriptions.8 Four months later, First Niagara amended its filings a second time in order to correct the location provided in the original collateral descriptions.9 Unfortunately for First Niagara, however, the debtor filed for bankruptcy 88 days after this second amendment was filed.10 Since Chapter 11 of the Bankruptcy Code allows a bankruptcy trustee to avoid any transfer made within a 90-day period prior to the Petition Date, First Niagara could not perfect its security interests with these latter amendments.11

As a result, the issue presented was whether the original collateral description met the requirements of New York’s UCC § 9-504, namely that “a financing statement sufficiently indicate[] the collateral that it covers.”¹² Section 9-504 of the UCC typically provides a safe harbor for secured parties, stating that a financing statement sufficiently indicates the collateral that it covers if the financing statement provides, among other things, “an indication that the financing statement covers all assets or all personal property.”¹³ The trustee offered two primary arguments to rebut this: (1) that the address limited the coverage of the collateral description and (2) that the incorrect address created a seriously misleading description under NY UCC § 9-506. The Second Circuit, affirming both the district and bankruptcy courts, found neither argument to be persuasive.¹⁴

First, the Court held that the superfluous detail First Niagara provided illustrated, rather than limited, the “all assets” blanket that it sought. The Court relied heavily on the “including, but not limited to” language to arrive at this conclusion.¹⁵ Although the trustee argued that “a non-exhaustive list of assets can still be, and was, limited to a particular location,” the trustee could only make this argument plausible by erasing the conjunction “and” (before the words “located at”) from the collateral description.¹⁶

Second, the Court dismissed the argument that the collateral description caused the financing statement to be “seriously misleading”, holding that the trustee failed to find a comparable case on point.¹⁷ In none of the presented cases was a misleading description offered for illustrative purposes paired with an otherwise unambiguous description.¹⁸

Interestingly, in reaching this conclusion, the Second Circuit sidestepped the debate over a relevant Eighth Circuit case, ProGrowth Bank, Inc. v. Wells Fargo Bank, N.A., that was discussed at length by both parties in their briefs and by the lower courts.¹⁹ In ProGrowth Bank, the creditor’s financing statements purported to cover all of the debtor’s assets and annuity contracts, but incorrectly identified the annuity company and the annuity contract numbers.²⁰ Despite these errors, the Eighth Circuit held that the financing statements met the liberal requirements of UCC § 9-504.²¹ The Court reasoned that the primary role of a UCC-1 collateral description is to put “subsequent searchers on notice,” and“[w]here a description can reasonably be interpreted in one of two ways–one of which may cover the collateral at issue and one of which does not–notice filing has served [this] purpose.”²² The conjunction “and” separated the “all assets” blanket lien from the inaccurate annuity contract description, creating two plausible interpretations, and because one of these interpretations put subsequent creditors on notice, the description in its entirety passed muster.

In Ring, the Second Circuit implicitly distinguished the ProGrowth Bank case by emphasizing the illustrative nature of the address. First Niagara prefaced the address with the “including, but not limited to” language, which was absent from the description in ProGrowth Bank. Therefore, the court did not view the collateral description in the Ring case as presenting two plausible interpretations.

It is possible that the Second Circuit’s decision not to rely on ProGrowth Bank–especially when it was cited by both the district court²³ and the bankruptcy court²⁴ –signals the Second Circuit’s hesitancy to adopt such a liberal sufficiency standard for UCC § 9-504. It is unclear whether the Second Circuit would have reached the same conclusion if First Niagara failed to include an illustrative non-exhaustive list in its description. Moreover, the Second Circuit issued a Summary Order in this case, declining to give precedential effect to its holding.²⁵

Clients and practitioners should exercise restraint in providing superfluous detail to “all assets” UCC-1 collateral descriptions. Even if future courts do not decide that bankruptcy trustees may avoid such security interest, such superfluous detail provides no benefit to creditors and exposes them to the risk of future litigation. This risk should be avoided, especially given the Second Circuit’s narrow holding in this case. Secured parties wishing to perfect a security interest with an all asset filing should use in their financing statements the simple collateral description “All present and future assets of the Debtor.” Finally, the practitioner should bear in mind that while “all asset” collateral descriptions are sufficient for perfecting a lien under Article 9, such collateral descriptions are insufficient under Article 9 to create a security interest in a security agreement.

---

¹ Ring v. First Niagara Bank, N.A. (In re Sterling United, Inc.), No. 15–4131–bk (2d Cir. Dec. 22, 2016) (Summary Order).

² Id., at * 4

³ See id.

⁴ Ring v. First Niagara Bank, N.A. (In re Sterling, Inc.), 519 B.R. 586, 588 (Bankr. W.D.N.Y. 2014) , aff’d, 2015 U.S. Dist. LEXIS 159414 (W.D.N.Y. Nov. 24, 2015).

⁵ Id.

⁶ Summary Order, at * 3. (emphasis added).

⁷ Brief for Appellant at 13, Ring v. First Niagara Bank, N.A. (In re Sterling United, Inc.), No. 15–4131–bk (2d Cir. Dec. 22, 2016) (Summary Order).

⁸ Id.

⁹ Id.

¹⁰ Id. at 14.

¹¹ 11 U.S.C. § 547(b)(4)(A) (2016); Summary Order, at *4.

¹² NY UCC § 9-504 (2016).

¹³ NY UCC § 9-504(2) (2016).

¹⁴ Summary Order, at *2.

¹⁵ Id., at *4-5.

¹⁶ Brief for appellant, at 31; Summary Order, at *3.

¹⁷ Summary Order, at *6.

¹⁸ Id.

¹⁹ ProGrowth Bank, Inc. v. Wells Fargo Bank, N.A., 558 F.3d 809 (8th Cir. 2009).

²⁰ Id. at 813.

²¹ Id.

²² Id. at 813-14.

²³ Ring v. First Niagara Bank, N.A. (In re Sterling, Inc.), 2015 U.S. Dist. LEXIS 159414, at * 4 (W.D.N.Y. Nov. 24, 2015

²⁴ Ring v. First Niagara Bank, N.A. (In re Sterling, Inc.), 519 B.R. 586, 590-91 (Bankr. W.D.N.Y. 2014).

²⁵ Summary Order, at *1.

© TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result.

In order for a corporation to qualify as a regulated investment company (RIC), it must derive 90 percent of its gross income for each taxable year from certain categories of qualifying income, including dividends, interest, gain from the sale of stock or securities and certain other income (Qualifying Income). The “other income” category is limited to “other income . . . derived with respect to [the RIC’s] business of investing in such stock, securities, or currencies.”¹ Generally, commodity income received directly by a RIC is not considered Qualifying Income for RIC qualification purposes. Due to the limitations on investments that produce non-Qualifying Income, fund managers deploy specific strategies to gain exposure to those investments. New proposed regulations seek to limit the strategies employed to gain exposure to commodity investments.

Direct Investments by a RIC in the Commodities Market

Commodity income received directly by a RIC generally is not Qualifying Income (i.e., it is a “bad” investment for RIC qualification purposes). In December 2005, the IRS specifically ruled that a derivative contract with respect to a commodity index was not a security and, thus, did not produce “other income.”² However, the IRS backtracked six months later, when it clarified the earlier ruling, limiting it to a total return swap on a commodity index.³ This left open the possibility that certain structured notes that were treated as securities could produce Qualifying Income, while providing limited exposure to commodity returns. The IRS confirmed in a series of private letter rulings between 2006 and 2011 that income and gain from certain structured notes where the interest income was tied to a commodity index was “other income” from a security and, thus, Qualifying Income.

In order to gain additional exposure to the commodity markets beyond notes paying interest based, in part, on a commodities index, RICs began investing in foreign corporations classified as controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs) that invested in commodities. To understand the changes in the proposed regulations that affect these investments, a brief overview of the taxation of CFCs and PFICs is required.

Foreign Taxation of CFCs and PFICs – A Primer

Investments in certain foreign corporations require a U.S. investor to recognize income as it is earned by the foreign corporation, regardless of whether it is distributed to the U.S. investor (deemed income). Deemed income arises in the context of a CFC and a PFIC.

A CFC is a foreign corporation in which U.S. investors, each holding 10 percent of the vote of the corporation, collectively hold more than 50 percent of the vote. These U.S. investors in the CFC must include certain types of income (referred to as Subpart F income) from the CFC, regardless of whether it is distributed. Subpart F income includes income from dividends, notional principal contracts and commodities. Thus, a RIC investing in a CFC that earned income relating to commodities investments would be required to include deemed income relating to these investments in income, even if there were no distributions from the CFC.

A PFIC is a foreign corporation where 75 percent or more of its gross income is passive and 50 percent or more of the average value of its gross assets consists of assets that would produce passive income. A PFIC’s retained income is not taxed to a U.S. investor unless the investor makes a qualified electing fund (QEF) election. A U.S. investor who makes a QEF election with respect to a PFIC must take into account his pro rata share of the PFIC’s ordinary earnings and net capital gain for each year the corporation is a PFIC, whether or not they are distributed.

Analysis of Indirect Investments by a RIC in the Commodities Market Through a CFC or PFIC Prior to Proposed Regulations

Before the proposed regulations were issued, there were two arguments that could apply to treating income from a CFC or a PFIC as Qualifying Income.

First, under the explicit “Matching Distribution Rule,”⁴ taxpayers argued that dividends that are actually distributed from CFCs and PFICs are viewed as Qualifying Income because they constitute dividends. Thus, a RIC can gain exposure to the commodities market without the risk of non-Qualifying Income by forming a foreign subsidiary that invests directly in commodities investments and makes actual distributions equal to the deemed income of the CFC to the RIC.

Second, many taxpayers argued that the RIC’s investment in the CFC or the PFIC is viewed as a security and, thus, any income from that security is “other income” derived with respect to securities, whether or not it was actually distributed. Accordingly, the deemed income from CFCs and PFICs, regardless of whether it is distributed to the RIC, should be Qualifying Income. Thus, a RIC could gain exposure to the commodities market through a foreign corporation without having to actually distribute cash to the RIC, allowing the RIC to have a greater deployment of funds and a greater return on investment. Because the position on whether deemed distributions constituted Qualifying Income was uncertain, many taxpayers sought and received IRS-issued private letter rulings between 2006 and 2011 that agreed with this analysis. These rulings held that the deemed income inclusion from a CFC was Qualifying Income, regardless of whether the CFC made distributions.⁵

Current Analysis of Exposure to the Commodities Market

By 2010, the IRS was “devoting substantial resources” to these private letter ruling requests.⁶ Accordingly, in 2011, the IRS announced it would no longer issue private letter rulings as to whether certain commodity-related investments, either directly by a RIC or indirectly through foreign corporations, produced Qualifying Income.

In 2016, the IRS decided to address the strategies RICs were using to invest in commodities investments that created Qualifying Income — (1) investing directly in certain derivatives on the commodities index and (2) investing indirectly in commodities investments through certain foreign corporations.

In the proposed regulations, the IRS punted to the Securities and Exchange Commission (SEC) on whether direct investments in certain derivatives linked to a commodities index were securities (and, thus, produce “other income,” which is Qualifying Income). As “security” is defined under section 2(a)(36) of the Investment Company Act of 1940, which is enforced by the SEC, the IRS concluded the SEC is in a better position to determine what qualifies as a security.⁷ The IRS also asked for comments regarding whether its previous rulings on whether a RIC’s direct investment in certain commodity derivatives qualify as a security should stand as good law.

For indirect investments in the commodities market through foreign corporations, the proposed regulations now explicitly require a distribution from a CFC or a PFIC in order for deemed income to be Qualifying Income. This is contrary to the IRS’s prior private letter rulings position. Thus, the proposed regulations now provide that CFC or PFIC income is Qualifying Income only to the extent there is an actual distribution from the PFIC or the CFC to the RIC that qualifies under the Matching Distribution Rule. Deemed income without a corresponding distribution is no longer considered Qualifying Income under the “other income” category.

Pepper Perspective

While these proposed regulations are not effective until 90 days after they are finalized, RICs should carefully consider whether their portfolios or policies run afoul of the proposed regulations (i.e., ensure all investments are classified as “securities” under the SEC’s interpretation of the 1940 Act and ensure any CFCs or PFICs make actual distributions).

RICs may be surprised to learn that the SEC’s definition of securities is not the same as the IRS’s definition. RICs should seek counsel to ensure their investments qualify under the SEC’s definition.

For RICs that invest in CFCs or PFICs and have deemed income inclusions, managers need to ensure there is a distribution from those CFCs or PFICs on or before the last day of the RIC’s taxable year. There is no grace period, and RICs will have to rely on an estimate of their deemed income from such an investment. To the extent a RIC’s estimate is too low, the “unmatched” inclusion will be non-Qualifying Income. Requiring a distribution may be difficult for certain RICs that are not in control of the CFC or the PFIC. These investments should be reconsidered prior to finalization of the proposed regulations.

In addition, RICs need to ensure that a distribution from a CFC or a PFIC will be respected. While no guidance from the IRS has been issued regarding mechanics for distributions, we do not believe that the IRS is likely to look kindly on netting a distribution from a CFC or a PFIC and recontributing to the CFC or the PFIC. Thus, if the RIC intends to re-invest the distribution in the CFC or the PFIC at a later date, the RIC should not use a netting concept by declaring a dividend and simultaneously recontributing that amount on the same day. We think the prudent course of action is to make an actual cash distribution of the funds from the foreign corporation and re-invest at a later point in time.

Endnotes

Many taxpayers choose partnership structures (including LLCs taxed as partnerships) to operate their businesses. The tax consequences of setting up and contributing property to a partnership can be beneficial because contributing property in exchange for interest in the partnership generally does not result in recognition of gain or loss for the contributing partner or the partnership.¹ However, when property is contributed to an “investment partnership,” that same contribution may be treated as a taxable exchange to the contributing partner. Under section 721(b), an “investment partnership”² is a partnership in which more than 80 percent of the value of the assets of the partnership is from “stock and securities” that are “held for investment” (the 80 Percent Test).³ Under the 80 Percent Test, “stocks and securities” include a variety of liquid assets, such as cash, stock in corporations and interests in other entities that hold such liquid assets. The determination of whether a partnership is an investment partnership with respect to a contribution is made immediately after the contribution. However, if subsequent events occur pursuant to a plan in existence at the time of the contribution, the determination takes into account those subsequent events.⁴

‘Stock or Securities’ Defined

While cash is generally included in the 80 Percent Test, it is not clear if cash that is working capital is included. Although cash is included in the list of liquid assets treated as stocks or securities, all of the liquid assets considered in the 80 Percent Test must be “held for investment.” Accordingly, since working capital presumably is not “held for investment,” it would not be considered cash that is within the definition of stock or securities for purposes of the 80 Percent Test.

Certain practitioners appear to agree that cash held for working capital should not be included in the 80 Percent Test, but, in the absence of formal authority, the most conservative approach would be to treat operating cash as stock or securities for purposes of the 80 Percent Test. If faced with a situation in which the treatment of working capital is critical to the status of the partnership under the 80 Percent Test, it may be difficult to determine the appropriate amount of cash to treat as working capital. A reasonable methodology might be to determine the typical cash balances carried by companies in a similar industry, with a similar capital structure and cash-flow needs, though this data may be less available than metrics based on all current assets (rather than just cash). No formal guidance has been issued, however, to support a particular methodology for partnerships hoping to validate that their cash is not within the scope of “stock and securities” under section 721(b).

Additionally, if there is a defined plan in place to use cash to acquire property that would not be treated as stock or securities under the 80 Percent Test, it likely should not be treated as stock or securities.⁵

The Look-Through Rules

When applying the 80 Percent Test to a partnership, two look-through rules apply:

A partnership is treated as owning directly its ratable share of the assets held by any corporation in which it owns a 50 percent (by vote or value) or greater interest.⁶

The value of an interest in a lower-tier partnership is treated as being apportioned between “stocks and securities” and other assets based on the assets held by the partnership when the partnership’s holdings of assets that are treated as “stock and securities” constitute 20 percent or more of its total assets and 90 percent or less of its total assets by value.⁷

Corporate Subsidiary Look-Through Rule
While there appear to be few ambiguities associated with the corporate look-through rule, two common issues can arise.

First, how does the look-through rule apply in the context of tiered corporate subsidiaries? For example, if a partnership (P) owns 75 percent of the stock of a first-tier corporate subsidiary (S1), and S1 owns 65 percent of the stock of a second-tier corporate subsidiary (S2), it is unclear whether P may apply the look-through rule to S2. The applicable regulatory language states:

[S]tock and securities in subsidiary corporations shall be disregarded and the parent [partnership] shall be deemed to own its ratable share of its subsidiaries’ assets. A corporation shall be considered a subsidiary if the parent owns 50 percent or more of (i) the combined voting power of all classes of stock entitled to vote or (ii) the total value of shares of all classes of stock outstanding.⁸

Although P owns less than 50 percent of the stock of S2 indirectly (49 percent), you could take the view that, because it owns more than 50 percent of S1, the assets of S2 are pushed up to P. Because S1 owns more than 50 percent of S2, P would be able to look through to the assets of S2 under this approach. However, the literal language of the regulation, which focuses on the ownership of the “parent” (the tested partnership) with respect to the subsidiary, suggests that the assets of S2 are not taken into account by P.

Second, what ratable percentage of the underlying assets is treated as being owned when the partnership owns a different percentage of voting interest in the corporation than it does in the value of the corporation (e.g., when the tested partnership holds both voting and nonvoting stock with equal economic rights)? From a practical standpoint, when testing a particular partnership, it may be sufficient to use the lesser ownership percentage if this does not have a material effect on the assets being treated as held by the tested partnership. However, at least one commentator has suggested that value (rather than vote) is the appropriate measure.

Partnership Look-Through Rules
The partnership look-through rules are based primarily on a reference in legislative history to rules similar to the regulations promulgated under section 731(c)(2). These rules look to the value of assets that constitute stocks or securities owned by the partnership. A critical question in determining which assets are treated as owned by a lower-tier partnership is whether the lower-tier partnership is treated as owning assets of a corporation in which it owns more than 50 percent of the vote or value. Within the context of section 731(c)(2) and the associated corporate regulations, there is no corporate look-through rule. However, based on a private letter ruling, it appears that a lower-tier partnership may look through 50-percent-owned subsidiaries in determining the composition of its assets when applying the partnership look-through rules.

In the matter addressed by Private Letter Ruling 200211017, persons contributed property to a corporation (C1 — the tested entity) that included a percentage interest (the actual percentage ownership interest was redacted in the ruling) in a partnership (P1). P1 owned a percentage (also redacted in the ruling) of the stock of a corporation (C2), which owned 100 percent of a subsidiary corporation (S). The assets of S constituted more than 80 percent of C1’s assets immediately after the contribution. The ruling concluded that the transfer of the P1 interest was not a transfer to an investment company under section 721(b). Thus, the redacted percentage interest in C2 was apparently greater than 50 percent, and P1 was treated as holding the assets of C2 and S, and, therefore, C1’s interest in P1 was not treated as a stock or security.

Pepper Perspective

Because partnership structures are very commonly used for business operations, including for funds and other investment businesses, taxpayers need to carefully review the mix of assets to ensure tax-free treatment when the partnership is formed and assets are contributed to the partnership in exchange for interest in the partnership. The definition of “stocks or securities” under section 721(b) can be very inclusive, and there is very little guidance to provide a safe-harbor-type methodology for determining whether or not cash or assets fall outside the definition of under the rules. Thus, careful evaluation and planning should be undertaken when the partnership is formed and when assets are contributed to evaluate the potential impact of section 721(b).

Endnotes