The Northern District of California is considering an amendment to its rules that would make it the first district court in the United States to require that parties to a civil suit disclose the participation of third-party funding.

A federal district court in California may soon require litigants to disclose secret lending from third-party financiers. Third-party litigation funding is a growing phenomenon whereby capital investment firms provide non-recourse loans to plaintiffs to fund the costs of litigation. These loans are usually meant to pay for expert fees and discovery costs and are only enforceable if the plaintiff recovers. Interest rates on these loans regularly exceed 15 percent annually,¹ and we have heard of funding agreements with interest rates as high as 30 percent. The increase in third-party financing has ignited controversy about the practice itself as well as its disclosure.

The Superior Court of Pennsylvania recently concluded that a litigation funding arrangement was unenforceable because it violated Pennsylvania’s prohibition on champerty, a common-law doctrine that aims to prevent frivolous lawsuits by disallowing certain outsider participation in cases.² Other challenges to litigation financing will likely follow. Meanwhile, the Northern District of California is considering an amendment to its rules that would make it the first district court in the United States to require that parties to a civil suit disclose the participation of third-party funding.

There has been a recent influx of major litigation funders to California. Bentham IMF, the American arm of an Australian capital investment firm, opened its California office in November 2015, and there are reports that Longford Capital Management, a Chicago-based firm, is taking steps towards opening an office in California.³ The increase in outside funding and its potential effect on class actions and multidistrict litigations has not been well-received by some district courts in California. In the Northern District of California, Chevron is defending a class action against 12,500 Nigerian fishermen who allege injury from an offshore explosion of a drilling rig. Concerned that the litigation was being driven by the interests of unidentified third parties who were not known to the court, Chevron moved for and obtained an order for the production of all third-party funding agreements.⁴

Northern District of California Civil Local Rule 3-15 now requires all parties in a civil matter to disclose “entities other than the parties themselves” who have any interest in the outcome of the litigation. In June 2016, District Judge Richard Seeborg, chairman of the court’s rules committee, proposed a revision to insert three words into the rule: “including litigation funders.” These three words could possibly change the landscape of mass litigation by making California less attractive and by creating pressure to amend the Federal Rules of Civil Procedure to include a disclosure requirement for third-party funding.

Because Civil Local Rule 3-15 imposes a duty to supplement, the proposed change could have an immediate effect on existing multidistrict litigation in California. The rules committee made public four comments submitted in response to the proposed amendment. Two litigation funders submitted comments opposing the amendment, arguing that the amendment would be unfair and discriminatory. In its letter to the rules committee, Burford Capital stated that the company was “publicly listed on the London Stock Exchange with a market capitalization of more than $1 billion” and estimated that single-case funding amounted to approximately “15 [percent] of its investment activity last year.”⁵ In Bentham IMF’s response to the rule change, the litigation investment firm argued that “[c]ommercial litigation funding assists claimants with strong cases to achieve fair outcomes by removing the financial imbalance between parties.”⁶ Bentham IMF argued that requiring the automatic disclosure of third-party financing “will give defendants in all cases the unprecedented and unintended advantage of knowing which claimants lack the resources to weather a lengthy litigation campaign.”⁷

While Bentham might be correct that disclosure will provide information of potential benefit, defendants have long been required to disclose the presence of insurers and insurance policies during the discovery process — information that provides plaintiffs with the “advantage” of knowing which defendants lack insurance resources to “weather a lengthy litigation campaign.” The disclosure of third-party litigation funding merely evens the playing field with regard to information about the parties who have financial interests and who may affect the course of the litigation.

Regardless of whether third-party financing is here to stay, disclosures are warranted. Courts should have visibility into these otherwise hidden entities who have an interest in cases pending before them.

Endnotes

¹ Binyamin Appelbaum, “Investors Put Money on Lawsuits to Get Payouts,” The New York Times (Nov. 14, 2010), https://www.nytimes.com/2010/11/15/business/15lawsuit.html?pagewanted=all&_r=0.

² WFIC, LLC v. Labarre, 2016 WL 4769436 (Pa. Super. Sept. 13, 2016).

³ Ben Hancock, “Litigation Funder Plans Bay Area Expansion,” The Recorder (Oct. 27, 2016), https://www.therecorder.com/id=1202770946023/Litigation-Funder-Plans-Bay-Area-Expansion.

⁴ Gbarabe v. Chevron Corp., No. 14-cv-00173-SI, 2016 U.S. Dist. LEXIS 103594 (N.D. Cal. Aug. 5, 2016).

⁵ Letter from Christopher P. Bogart, Chief Executive Officer of Burford Capital, to Susan Y. Soong, Clerk of Court, U.S. District Court for the Northern District of California (July 22, 2016), available at https://www.cand.uscourts.gov/news/23.

⁶ Letter from Matthew D. Harrison, Investment Manager/Legal Counsel, Bentham IMF, to Susan Y. Soong, Clerk of Court, U.S. District Court for the Northern District of California (July 22, 2016), available at https://www.cand.uscourts.gov/news/23.

⁷ Id.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

Content contributed by attorneys of Troutman Sanders LLP and Pepper Hamilton LLP prior to April 1, 2020, is included here, together with content contributed by attorneys of Troutman Pepper (the combined entity) after the merger date.

This article was published in the Lexis Practice Advisor: Private Equity by Lexis Securities Mosaic on November 24, 2016. It is reprinted here with permission.

Introduction

A leveraged dividend recapitalization is a partial exit strategy of private equity sponsors, whereby proceeds of a new indebtedness incurred by a portfolio company are used to fund a dividend distribution to the portfolio company’s stockholders. Interest among private equity sponsors and the growing appetite of lenders to provide debt financing to fund leveraged dividend recapitalizations reached a pinnacle in 2007, before the onset of the financial crisis in 2008, with dividend driven loan volume of $49.3 billion. After being virtually nonexistent during the two years following the financial crisis, there was a resurgence in dividend-driven loans beginning in 2010. According to Standard & Poor’s Leveraged Commentary & Data, the years following 2010 saw dividend recap activity at astonishing rates and surpassing 2007 levels, with dividend driven loan and high yield bonds volume of $56.9 billion in 2012, $73.9 billion in 2013 and $53 billion in 2014.

The easing of credit markets coupled with the ability of financial institutions to finance dividend recaps at attractive interest rates have played a significant role in the comeback of leveraged dividend recapitalizations following the financial crisis. The excitement surrounding leveraged dividend recapitalizations has been tempered, however, with concerns about bankruptcy and related claims of fraudulent conveyance, breach by portfolio company directors of their fiduciary duties and payment of distributions in violation of statutory requirements under state corporate law.

The first bankruptcy of KB Toys, Inc. in 2004 may serve as a cautionary tale for leveraged dividend recapitalizations gone awry. In 2000, Bain Capital LLC and other investors (collectively, Bain) acquired KB Toys from Big Lots Stores Inc. In 2002, KB Toys was recapitalized by issuing significant secured and unsecured debt, and the proceeds were used to pay executive bonuses and dividends exceeding $120 million that ultimately flowed through the corporate structure and back to Bain. When KB Toys filed for bankruptcy almost two years later, creditors alleged that the dividend contributed in large part to the company’s insolvency, was a result of self-dealing and outright fraud, and constituted a breach by the directors of KB Toys of their fiduciary duties. Though the case eventually settled, it still stands as an example of what can go wrong in a leveraged dividend recapitalization transaction.

Under appropriate circumstances, a leveraged dividend recapitalization is not illegal and may constitute an appropriate course of action to enable stockholders to receive a return of capital through a dividend. Indeed, if done correctly, a leveraged dividend recapitalization can maximize the present value of future earnings of a corporation. If a company’s profitability, future earnings and capital structure are sound, a leveraged dividend recapitalization can be a useful tool to presently extract the expected future earnings of the company and enable the private equity sponsor stockholder to employ that cash to bolster another profiting enterprise. As this practice note will explore however, these are big “ifs.” If a leveraged dividend recapitalization threatens a company’s solvency, or appears to be a result of self-dealing, its creditors will find ample recourse in the law to protect their own interests. A prudent course of action requires a mindful approach to the minefield of potential issues surrounding the decision to effect a leveraged dividend recapitalization. The balance of this note examines the metrics used for identifying opportunities for executing a successful leveraged dividend recapitalization, the potential risks surrounding leveraged dividend recapitalizations, and risk mitigation strategies.

Identifying Appropriate Opportunities for Engaging in a Leveraged Dividend Recapitalization

A company with investors seeking a current return on their capital and having (1) conservative debt levels or debt at less market-friendly terms than its peers, (2) a history of consistent revenue growth, and (3) predictable cash flows presents a viable candidate for a leveraged dividend recapitalization. Once it is determined that the company is a suitable candidate for engaging in a leveraged dividend recapitalization, a variety of metrics can be evaluated by the management and the board to determine whether a leveraged dividend recapitalization is appropriate. A few of these metrics are discussed below and in essence speak to the capacity of the company to incur additional indebtedness at competitive levels.

The existence of one or more of the following conditions may favor an opportunity for a company to engage in a leveraged dividend recapitalization:

• Comparative debt to EBITDA. The total debt to EBITDA ratio of the company is below the average debt to EBITDA ratio of its peers.
• Comparative cost of debt. The existing indebtedness of the company is priced higher than the average pricing disclosed for similar indebtedness issued in recent leveraged dividend recapitalizations. This may provide an opportunity to refinance existing debt at lower rates, incur additional debt at competitive levels and distribute a substantial portion of the proceeds as a dividend.
• Debt covenants. The company’s existing indebtedness is subject to more onerous financial covenants and ratios than currently available to the company for similar indebtedness. This may present an opportunity for the company to both refinance its existing indebtedness and incur additional indebtedness that forms the basis for a leveraged dividend recapitalization.

Potential Risks

If a company’s solvency is threatened following an leveraged dividend recapitalization, then creditors may initiate actions to attempt to recover dividends that may have been improperly distributed on one or more of the following grounds, (1) that the dividend constituted a fraudulent conveyance, (2) the company was insolvent at the time the dividend was paid, and (3) the board of directors breached their fiduciary duty by declaring and paying the leveraged dividend recapitalization financed dividend.

Fraudulent Conveyance

A dividend paid in connection with a leveraged dividend recapitalization may be subject to claims of creditors under the U.S. Bankruptcy Code and the laws of most states (including Delaware) if it is deemed to be a fraudulent conveyance. While the issue of fraudulent conveyance most commonly arises in bankruptcy proceedings, under state law, the filing of a bankruptcy petition is not a prerequisite to a claim based on a fraudulent conveyance.

There are two types of fraud for purposes of fraudulent conveyance law: actual fraud and constructive fraud. Actual fraud exists where a transfer was made with actual intent to hinder, delay or defraud creditors. Constructive fraud is intended to deal with transfers that were not in the best interests of the transferor. The principal elements of constructive fraud are that the debtor:

• Received less than reasonably equivalent value in exchange for the transfer or obligation; and
• Such debtor (1) was insolvent at the time or became insolvent as a result of such transfer or obligation; (2) was left with unreasonably small capital; (3) intended to incur, or believed it would incur, debts beyond the debtor’s ability to pay; or ( 4) made such transfer or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.

Transfers that are deemed to be fraudulent conveyances that are made within two years prior to a bankruptcy filing are subject to a number of remedies, including (1) recapture of the dividend by the bankruptcy trustee into the bankruptcy estate, (2) attachment of the dividend or other property of the transferee, (3) an injunction against further disposition by the debtor or the transferee of any property, or (4) appointment of a receiver to take charge of any property of the transferee.

Insolvency at the Time of the Leveraged Dividend Recapitalization

While fraudulent conveyance statutes may scrutinize transfers that threaten the transferor’s solvency, many states, including Delaware, separately require directors to declare and pay dividends either out of the corporation’s surplus or, if there shall be no surplus, out of net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Delaware law defines surplus as the excess of the company’s net assets (being the amount by which total assets exceed total liabilities) over the amount determined to be capital by the board.

The responsibility for determining appropriate values for net assets and capital and whether there is a surplus ultimately falls to the board of directors. It is imperative that the board takes proactive steps to ensure that its determination complies with all applicable laws, because each director could be subject to personal liability under a claim for breach of fiduciary duty as discussed below.

Insolvency Tests

For purposes of the foregoing analysis, courts typically apply one of three solvency tests: the balance sheet test, the cash flow test, or the unreasonably small capital test.

• The balance sheet test deems a company insolvent when the sum total of its debts exceeds its assets at a fair market valuation.
• The cash flow test deems a company insolvent if, after effecting the transaction it is left in a cash flow position that will make it unable to satisfy its debts as they come due.
• The unreasonably small capital test sets the threshold at something short of what would qualify a company for insolvency under the cash flow test. Under this test, a company is insolvent if it lacks an adequate capital cushion that would enable it to weather reasonably foreseeable business risks – the key difference in the two being that in the former, the company need only prove that it can provide sufficient cash flow to pay its existing creditors while in the latter the company must maintain a capital reserve in order to survive reasonably foreseeable (though currently unknown) risks.

In order to manage the risks associated with creditor claims, a company considering a leveraged dividend recapitalization should ensure that it can pass each of these tests both before and after the transfer.

Statutes of Limitations

Owing to the variations in statutes of limitations for various creditor actions, special attention should be paid to the timing of leveraged dividend recapitalizations. The US Bankruptcy Code looks back to any transfers that occurred within two years before the filing of a bankruptcy petition. The Delaware statute allows a creditor to make a claim for fraudulent transfer as long as four years after the date of the transfer. Under Delaware law, the statute of limitations for breach of director duty is broad, making directors jointly and severally liable for up to six years after the dividend has been disbursed. However, such a statute of limitations may also be tolled for periods when the defendant either actively concealed such knowledge from the plaintiff, or the plaintiff relied on the defendant’s fiduciary role such that the plaintiff had no reason to suspect any wrongdoing. Thus, it is impossible to say with any confidence that a company is in the clear until at least six years after a leveraged dividend recapitalization, and even then the threat of litigation may persist.

Director Liability

Under Delaware law, a third-party creditor typically has no claim against the directors of a debtor corporation for breach of fiduciary duty. However, insolvency of a debtor corporation can give rise to a derivative claim of breach of fiduciary duty on the theory that satisfying the claims of a corporation’s creditors is essential to maintaining the business as an ongoing concern and thus consistent with the fiduciary duty owed to its shareholders. The standing that such creditors gain is a result of insolvency and does not exist merely because the corporation is “navigating the zone of insolvency.” See N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007). Therefore, a leveraged dividend recapitalization that leaves a corporation insolvent can also expose the directors to a breach of fiduciary duty claim from its creditors.

Under Delaware law, while directors are afforded a certain level of deference through the business judgment rule, the law nonetheless penalizes directors who act imprudently, thereby making them liable not only for the full amount of the dividend, but also for the accrued interest.

Risk Mitigation Strategies

Claims of breach of fiduciary duty and fraudulent conveyance are certainly not insurmountable, but are ones that should be carefully avoided. To avoid such liabilities, directors and corporations as a whole should seek and rely on truly independent solvency opinions and, if appropriate, create special committees charged to evaluate whether a leveraged dividend recapitalization is a justifiable transaction. While there is no safe harbor for leveraged dividend recapitalizations, best practices should involve a three-pronged approach focusing on (1) the solvency of the company both before and after the transaction, (2) complete independence by the board (or any special committee of the board that has been delegated the appropriate authority to consider a leveraged dividend recapitalization) and any financial advisors, and (3) business decisions made with the best information available. Each of these is discussed below.

Corporate Solvency

Ensuring that the company is solvent both before and after the leveraged dividend recapitalization is effected is essential to any risk mitigation strategy. This is true not only to mitigate the risk of liability arising under the bankruptcy law or fraudulent conveyance statute, but also to reduce the risk of director liability under a theory of breach of fiduciary duty, as insolvency is the prerequisite that gives rise to creditors’ standing to bring such a claim. Best practices include obtaining a solvency opinion from an independent financial advisor. This solvency opinion should address the company’s ongoing viability under each of the three insolvency tests discussed above. That is, the opinion should be sufficient to assure the board of directors that (1) the company’s assets will exceed its liabilities immediately after the leveraged dividend recapitalization, (2) the company’s projected cash flow will be sufficient to cover its ongoing debt payments, and (3) the company’s will retain a capital cushion sufficient to weather any foreseeable problems in the future. In addition, the opinion should demonstrate that the leveraged dividend recapitalization is paid from the corporation’s surplus.

The financial advisor providing the solvency opinion should work closely with the company’s legal counsel to tailor its analysis to the specific legal requirements of the jurisdiction in which the company is incorporated. Moreover, the financial advisor should also have sufficient knowledge and experience in the particular industry of the company to make accurate cash flow and capital needs projections.

Independent Decision Making

Independence of the decision makers is essential to ensure that the transaction is consistent with the best interests of the corporation and its shareholders and is not influenced by self-dealing. Therefore, in the event there is any actual or perceived conflict of interest with respect to any member of the corporation’s board of directors, an independent committee of directors should be formed to evaluate and consider the leveraged dividend recapitalization. Such committee should have full and complete access to its own financial and legal advisors counseling the proposed transaction. Moreover, any situations or circumstances where undue influence can be exerted upon the board or, if applicable, the independent committee, in connection with the decision making process should be minimized or removed. Thus it is imperative that the directors and the advisors be given sufficient autonomy, and that the transaction be properly documented (including through an appropriate record of all board or committee proceedings) so as not to eliminate the appearance of any undue influence.

Director independence may also help to ensure that the company obtains the benefit of the business judgment rule. If the decision to distribute a leveraged dividend recapitalization is made by directors who have acted on an informed basis, in good faith and with the honest belief that their actions are in the best interest of the corporation, then the decision is more likely to be evaluated under the business judgment rule. A court viewing the transaction in hindsight would thus afford the decision a favorable presumption and would be more likely to defer to the decision of an independent board or committee to engage in the leveraged dividend recapitalization.

Companies should consult with legal counsel to ensure compliance with all of the relevant laws surrounding dividend distribution. If directors, after reviewing all of these sources, do not agree with the decision to effect a leveraged dividend recapitalization, then they should make their dissent clear and such dissent should be reflected in the records of the board proceedings. Through these vigilant actions, directors will be more likely to demonstrate a good faith reliance on dependable sources, as well as a reasonable and prudent decision-making processes.

Best Information

Finally, it is crucial that all parties act with the best information available to them. Thus, a financial advisor rendering a solvency opinion should have as much access as possible to the company’s information, and the independent directors who are evaluating the decision to engage in a leveraged dividend recapitalization should base their decision upon all available information. In its complaint against Bain Capital dated January 13, 2006, in the Massachusetts Superior Court, the residual trust of KB Toys asserted that the solvency opinion delivered by the independent financial advisor was based on misleading projections derived from “overly optimistic and unreasonable” assumptions compared to historic trends and “incomplete financial information” and as such the solvency opinion was “inherently inadequate.”

Conclusion

The popularity of leveraged dividend recapitalizations waxes and wanes from year to year based on market fluctuations and the terms and availability of credit to finance the related dividend; however, the liability created by such transactions remains constant. Before initiating a leveraged dividend recapitalization, it is crucial that corporations and their respective boards consider the various risks, benefits, and other factors described above, and be vigilant in implementing appropriate processes and procedures to limit claims and liabilities associated with a leveraged dividend recapitalization. Despite the clear risks, leveraged dividend recapitalizations continue to be an attractive solution for private equity investors to address liquidity needs and desires, particularly in the face of constraining market conditions that may limit alternatives for providing such liquidity, and may very well continue to grow in popularity in the future, particularly in a low interest rate environment.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

Content contributed by attorneys of Troutman Sanders LLP and Pepper Hamilton LLP prior to April 1, 2020, is included here, together with content contributed by attorneys of Troutman Pepper (the combined entity) after the merger date.

Issuers and their advisors need to be aware of the potential pitfalls and uncertainties of the applicable high-yield discount obligation rules, which can have the effect of permanently disallowing a portion of interest deductions.

Though the issuance of PIK toggle high-yield debt bottomed out following the credit crisis, its issuance has resumed and increased over the last several years, beginning in 2012 and increasing in 2013 and 2014. With more of this debt entering the market, issuers and their advisors need to be aware of the potential pitfalls and uncertainties of the applicable high-yield discount obligation (AHYDO) rules, which can have the effect of permanently disallowing a portion of interest deductions.

A “PIK toggle” debt instrument is one that permits the issuer to decide annually whether to pay interest in cash or accrue it for payment later, commonly known as “paying in kind” or “PIK.” Because interest is not mandatorily payable on at least an annual basis, the debt instrument has original issue discount (OID),¹ and if the AHYDO rules are met, the deductibility of the OID may be deferred or denied. As described below, there is a mechanism to preclude the denial of the deduction, but its application is subject to considerable interpretative uncertainties.

When Is Debt Subject to AHYDO?

Debt with OID may be subject to the negative effects of the AHYDO rules if it (1) is issued by a corporation,² (2) has a term of more than five years, (3) has a yield to maturity (YTM) greater than 5 percent plus the applicable federal rate (AFR) for the month of the debt’s issuance,³ and (4) the instrument’s OID is “significant.” OID is “significant” if, under the terms of the debt, the amount of accrued but unpaid OID at the end of an accrual period that occurs more than five years after the issuance of the debt could be greater than one year’s worth of yield, calculated based on the YTM of the debt (referred to herein as the one-year yield or OYY).

The most significant downside for an issuer subject to the AHYDO rules is the possibility of the suspension of, or permanent disallowance of, interest deductions. For all OID on AHYDO debt, the issuer will not receive an interest deduction until the OID is actually paid (which, in many cases, will be at maturity).⁴ The “disqualified portion” of the OID interest, which is never deductible, is generally the OID attributable to the amount by which the total YTM of the debt exceeds 6 percent (not the 5 percent as above) plus the AFR.

Self-Help to Avoid AHYDO

Typically, issuers attempt to prevent debt from being treated as AHYDO debt by adding what is referred to as an “AHYDO savings clause” or “AHYDO catch-up clause” to the terms of the debt. These provisions alter the terms of the debt such that, notwithstanding any other term of the debt,⁵ when the accrued but unpaid OID could exceed the OYY at the end of any accrual period occurring more than five years after the date of the debt’s issuance, the issuer will make a cash payment to the holder (before the end of that post-five-year accrual period) in an amount sufficient to decrease the accrued but unpaid OID to less than the OYY. It is often in the interest of both issuers and holders to include an AHYDO catch-up clause because it allows issuers to avoid AHYDO treatment while not paying any more than they would otherwise pay and it accelerates cash payments to holders.⁶

For example, in the case of straight PIK debt issued in January 2012 with a $100 issue price, 10-year term, semi-annual accrual period, and 10 percent YTM (all of which is attributable to OID), prior to the end of the accrual period five years and six months from the issuance of the debt (July 2017, and for each accrual period thereafter) a cash payment would be made to the holder such that the accrued but unpaid OID did not exceed $10.

Special Problems with PIK Toggle Debt

The amount of an AHYDO catch-up payment likely can be calculated with relative certainty in the case of PIK debt that does not have a “toggle” feature (whereby the issuer can elect to pay in cash or in kind). However, in the case of PIK toggle debt, the elective nature of the PIK payment raises significant questions because the calculation of the amount of the catch-up payment is not addressed in the applicable sections of the Internal Revenue Code of 1986, as amended (Code), or Treasury Regulations.

PIK toggle debt generally only provides for the option to pay in kind during the earlier years of the debt, and typically an election to pay in kind results in a higher interest rate for the issuer. Under the OID regulations, because the cash payment option produces a lower yield, the issuer generally is assumed to pay in cash for purposes of calculating the YTM at the time of issuance. This assumption is, however, in conflict with certain of the AHYDO rules.⁷ Further, under the general OID rules, when, contrary to the “low yield payment assumption” in the OID regulations, an issuer elects to pay interest in kind, the debt is deemed (solely for tax purposes) to be retired and reissued at an amount equal to the issue price at that time. This reissuance generally has the effect of changing the YTM of the debt and creating a new issue price for the remainder of the term of the debt.

Determining the OYY is a critical component of determining the amount of an AHYDO catch-up payment. There is, however, no clear guidance on how to make that determination. When the YTM and the issue price of debt change during its term, it is not clear under the AHYDO rules whether it is (1) the issue price of the debt on day one or (2) the issue price at a later date (closer to the time of the catch-up payment) as a result of an election to PIK that should be used in calculating the OYY. Similarly, the YTM of PIK toggle debt also may change during the term of the instrument. In this case, it is unclear whether the YTM would be (1) the initial YTM calculated under the general OID rules, (2) the YTM determined under the AHYDO assumption that interest eligible to be paid in kind is paid in kind, or (3) the actual YTM based on the facts that occur prior to the end of the first accrual period after the debt’s fifth year outstanding.

The uncertainty as to the appropriate determination of the YTM and issue price affects other aspects of determining the amount of a catch-up payment as well. For example, to determine amount of the catch-up payment, the accrued but unpaid OID at the end of the relevant post-five-year accrual period must be calculated. This requires a determination of the applicable YTM and issue price.

Pepper Perspective

In each of the cases above, issuers are left with the difficult decision of choosing to interpret the provisions of the Code and Treasury Regulations in a reasonable way such that they produce (1) a conservative (larger) catch-up payment (e.g., by choosing interpretations that reduce the OYY amount) or (2) a smaller catch-up payment.

As a result of the significant negative consequences of an instrument becoming subject to the AHYDO rules, it may be appealing for an issuer to simply select a larger payment (as, assuming sufficient cash, this may allow them to pay off a portion of high-yield debt earlier). However, a larger payment may run afoul of certain provisions of the debt (perhaps a redemption premium on any amount exceeding the appropriate amount). Aside from living with the tax uncertainty, holders may prefer to be paid earlier and, thus, would object to what they believe to be an inadequate catch-up payment. Accordingly, issuers and their advisors must balance these considerations and model the impact of these rules based on their specific situation because many of the issues associated with these rules are not addressed by the Code and Treasury Regulations.

Endnotes

1 Generally, OID is the difference between the total amount of payments received under a debt instrument (whether in the form of principal or characterized as a payment of interest) that are not interest payments made on at least an annual basis. OID is typically accrued into the income of the holder on a yield-to-maturity basis, regardless of whether payments are actually received by the holder (a corresponding interest deduction for the issuer is typically available at the same time). “Yield to maturity” (YTM) is not defined in the AHYDO rules, but, under the general OID rules, it is the discount rate at which the present value of all payments under a debt instrument equals its issue price. OID accounts for the fact that, for example, a two-year debt instrument that is issued in exchange for $100 and pays $121 at maturity (without annual interest payments) is the economic equivalent of debt that makes annual interest payments at a 10 percent annual percentage yield.

2 Although, in some cases, debt issued by a partnership with corporate shareholders can be subject to the AHYDO rules with respect to such corporate shareholders.

3 AHYDO debt would use either the mid-term (if its term was less than nine years) or long-term AFR (if it has a greater than nine-year term). For October 2016, the mid-and long-term AFRs were 1.29 percent and 1.94 percent, respectively. As discussed below, if the YTM is greater than 6 percent plus the AFR, the most draconian effect of the AHYDO rules (permanent disallowance of interest deductions) may apply.

4 Compare this to the general OID rules, where issuers are typically permitted to claim an interest deduction in the year that the holder takes the OID into income.

5 Including potential restrictions imposed by intercreditor agreements in the case of debt that is not first lien. Documents other than the debt instrument may need to be updated to account for this.

6 Holders may be less enthused when they would prefer compounding at the high rate of interest on the capitalized PIK interest, but this consideration is typically outweighed by the negative effects of the AHYDO rules on the issuer.

7 When determining if debt is subject to the AHYDO rules, if the terms of the debt permit an optional payment of interest in kind, such payment is assumed to be made in kind, even if that would have the effect of increasing the yield.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

Content contributed by attorneys of Troutman Sanders LLP and Pepper Hamilton LLP prior to April 1, 2020, is included here, together with content contributed by attorneys of Troutman Pepper (the combined entity) after the merger date.

This article was published in the Intellectual Property and Life Sciences sections of Law360 on September 7, 2016. © Copyright 2016, Portfolio Media, Inc., publisher of Law360. It is republished here with permission.

When can an old compound be considered new again? Apparently, when the U.S. Food and Drug Administration says so, of course. On May 31, 2016, the FDA awarded Amarin Pharma Inc. five years of new chemical entity (NCE) exclusivity for Vascepa,¹ overturning their previous rejection of NCE exclusivity due to a District of Columbia decision, which vacated and remanded the FDA’s administrative decision.² The Amarin case highlights the complexity of determining whether certain drugs that contain a previously FDA-approved active ingredient will be considered a new chemical entity.

There are now three relatively recent examples of the FDA having been asked to modify its policy as it relates to NCE status: (1) where the previously approved active moiety is combined with a new chemical entity in a fixed dose combination; (2) where the subject active moiety is part of a previously approved multicomponent drug mixture; and (3) when the same components (i.e. active moieties) have been previously approved, but in a different ratio. On the flip side, FDA appears to be taking a stricter view of the core pharmacophore of an active ingredient by stating that esters (whether stable or labile) of a previously approved active moiety are not eligible for NCE status. Below, we explore how the FDA has been evolving its determination of what qualifies for NCE exclusivity.

What Does It Mean to Have NCE Exclusivity?

FDA marketing exclusivity is a statutory right provided by the Federal Food, Drug and Cosmetic Act under Sections 505(c)(3)(E), granting certain exclusive marketing rights upon approval of a drug. Such exclusivity is independent of and may run concurrently with any patent exclusivity. NCE exclusivity of five years is awarded to drugs that contain “no active moiety that has been approved by FDA in any other application submitted under section 505(b) of the act.”³ If not entitled to NCE exclusivity, the drug may be granted “clinical investigation” exclusivity if new clinical investigations are conducted or sponsored by applicant and are essential for approval.⁴

Obtaining NCE status can be critical to commercialization because it controls the timing of a challenge by generic companies and ensures commercial exclusivity from generic competition. If a drug is granted NCE exclusivity, an abbreviated new drug application or 505(b)(2) application cannot be approved by the FDA during the five-year exclusivity period. In addition, absent a paragraph IV certification, the FDA cannot accept a generic drug manufacturer’s ANDA/505(b)(2) application until the five-year NCE exclusivity period has expired. Furthermore, if a drug has Orange Book-listed patents, though an ANDA may be filed as early as the fourth year, if a paragraph IV certification suit is filed within 45 days, a 30-month stay will be awarded whereby no ANDA or 505(b)(2) application may be approved until the end of the seven and a half year period from the date of approval of the NCE drug.

What Is All the Fuss About Active Moiety?

According to the FDA’s regulations, NCE exclusivity is awarded to drugs that contain “no active moiety that has been approved by FDA.”⁵ However, under the FDCA, drugs with active ingredients⁶ that have not been previously approved would be entitled to five-year NCE exclusivity.⁷ The statute thus requires a one-to-one correlation of one active ingredient to one active moiety. This is the crux of the Amarin issue.

The Vascepa Story

Vascepa contains icosapent ethyl, which is the ethyl ester of eicosapentaenoic acid (EPA). The FDA approved Vascepa on July 26, 2012 under NDA 202057.⁸ On Feb. 21, 2014, the FDA determined that Vascepa was not eligible for five-year NCE exclusivity based on the previous approval of Lovaza. Lovaza is a mixture of about seven ethyl esters of omega-3-fatty acids, principally EPA and docosahexaenoic acid (DHA). Notably, in its approval of Lovaza, the FDA stated that the entire mixture is the active ingredient because the mixture was not sufficiently characterized.⁹

In denying NCE exclusivity for Vascepa, the FDA rejected the “one-to-one” framework used in single molecule drugs and, instead, for the first time, without notice, applied a “one-to-many” approach for well-characterized mixtures, stating that “[i]n cases where at least part of the mixture is well characterized and some components of the mixture that are consistently present and active are identifiable or have been identified, … the entire mixture is the single active ingredient, but that active ingredient may contain more than one component active moiety.” In essence, though the FDA had previously conceded that the active ingredient in Lovaza was the entire fish oil mixture, the FDA argued that the active moieties of the Lovaza mixture included both EPA and DHA.

Amarin appealed the FDA’s rejection of NCE exclusivity to the U.S. District Court of the District of Columbia. The court vacated and remanded the FDA’s decision denying NCE exclusivity and rejected the FDA’s “one-to-many” approach as inconsistent with the statute.¹⁰ On May 31, 2016, the FDA finally issued an exclusivity determination concluding that Vascepa has been granted the five-year NCE exclusivity, stating that due to the “multiple factors unique to the matter” and in light of the opinion, the FDA has decided to adopt the “one-to-one” framework in this case.¹¹

Extension of Amarin to Other Mixtures

In Amarin, the FDA conceded that for poorly characterized mixtures, the entire mixture should be characterized as the active moiety and that NCE exclusivity would be available for new, poorly characterized mixtures.¹² Under the Amarin decision, even if the mixture is “well-characterized,” the “FDA is free to determine whether any particular naturally derived mixture is better understood as containing one or multiple active ingredients.”¹³

Omthera Pharmaceuticals Inc., a wholly owned subsidiary of AstraZeneca PLC, is attempting to extend the logic of Amarin to its product, Epanova, a naturally derived mixture including EPA and DHA. The FDA approved Epanova on May 5, 2014, and lists omega-3-carboxylic acids as the active ingredient.¹⁴ The FDA has denied Epanova NCE exclusivity. After the Amarin decision, Omthera submitted a supplement to their Oct. 31, 2014, citizen petition challenging the FDA’s denial, arguing that, under Amarin, “when FDA approves a naturally derived mixture as a single active ingredient product, the agency cannot later treat its components as individual active moieties for exclusivity purposes. Rather, the mixture itself is the active ingredient and, to the extent applicable, the active moiety. If FDA has not previously approved a product that consists of the same mixture, then the new mixture must be awarded 5- year exclusivity.”¹⁵ The FDA has yet to act on this citizen petition.

What Other ‘Old’ Compounds May Be Eligible for NCE Exclusivity?

We explore below the FDA’s treatment of other “old” compounds, which may be able to secure NCE exclusivity, including fixed-dose combinations, prodrugs and enantiomers.

Fixed-Dose Combinations

The FDA had traditionally interpreted the statute and regulations as providing for NCE exclusivity only if all drug substances in the fixed-combination product are “new.” However, under a new guidance promulgated on Oct. 10, 2014, the FDA re-evaluated its interpretation and stated that fixed-dose combination products could qualify for a five-year NCE exclusivity period as long as any drug substance in the fixed-dose combination product is new.¹⁶ Examples of FDCs that have been awarded NCE status under this new interpretation include Gilead’s Harvoni (ledipasvir and sofosbuvir), and Eisai’s Akynzeo (netupitant and palonosetron).¹⁷

Enantiomers

The FDA had initially taken the position that the agency would not grant NCE exclusivity for an enantiomer when the racemate had previously been approved.¹⁸ However, in the 2007 Food and Drug Administration Amendments Act, Congress passed a change in the law that allows award of NCE exclusivity under new §505(u) for enantiomers not previously approved, where the enantiomer is approved for new indications in a different therapeutic class. This NCE exclusivity comes with certain requirements, including label restrictions. On July 25, 2013, Fetzima (levomilnacipran), a stereoisomer of the previously approved racemate, milnacipran HCl (Savella), became the first enantiomer drug to be granted NCE exclusivity under FDA §505(u).

Non-Ester Prodrugs

Vyvanse (lisdexamfetamine dimesylate) is a prodrug of dextroamphetamine (aka Adderall, a previously approved drug). The FDA approved Vyvanse on December 10, 2007 and granted NCE status along with five years of market exclusivity. Generic drugmaker Actavis sued the FDA over this decision, arguing that the active moiety inquiry should identify the specific molecule, or portion of the molecule, responsible for the physiological or pharmacological action, and then treat that molecule as the active moiety.¹⁹ Actavis thus asserted that dextroamphetamine, as the molecule responsible for the pharmacological action of lisdexamfetamine, is the active moiety in Vyvanse and should not be accorded NCE status.

In reaffirming its decision to grant NCE exclusivity, the FDA articulated a structure-centric interpretation of “active moiety” (rather than an activity-based interpretation) under which a drug is classified as an NCE regardless of which portions of the active ingredient contribute to the overall therapeutic effect of the drug.²⁰ The D.C. Circuit upheld the FDA’s determination.²¹

Thus, the FDA’s bright-line structure-centric interpretation of the “active moiety” turns a blind eye to any activity-based arguments for prodrugs exhibiting covalent derivatives. Esters, another type of covalent derivative, are, however, treated differently as seen below.

Esters

The FDA’s default position is that NCE exclusivity will not be awarded to a new ester of a previously approved active moiety/ingredient because most ester linkages are rapidly cleaved in vivo to provide the de-esterified molecule.²² Nevertheless, previously, the FDA had stated that, in exceptional cases, it could award NCE exclusivity to “[a]n ester that is stable, both in vitro and in vivo, is considered to be the active moiety, because the deesterified molecule is devoid of activity.”²³

However, when Veramyst (fluticasone furoate), an ester of Flonase (fluticasone propionate), was approved,²⁴ GlaxoSmithKline LLC, the sponsor, argued that “the furoate group remains an integral part of this new chemical entity while exerting therapeutic activity at the site of action, and reviewers should appreciate that neither fluticasone furoate nor fluticasone pripionate is ever metabolized to fluticasone.” The FDA rejected this activity-based argument and set forth the structure-centric approach articulated in the Vyvanse decision to determine that fluticasone furoate is not entitled to NCE exclusivity.²⁵ Thus, under the FDA’s bright-line structure-based analysis, even if a novel ester appendage can fundamentally change the pharmacokinetics or pharmacodynamics of a previously approved drug, the entire linked molecule will not be eligible for NCE exclusivity.

Conclusion

As discussed above, the prior approval of a drug containing an active ingredient of the innovator drug is not necessarily a death knell for NCE exclusivity. Where, as for Vascepa, the sole active ingredient was previously approved as a mixture and the active ingredient of the mixture is not well characterized, the FDA may confer NCE status to the sole ingredient. Furthermore, NCE status may be conferred on enantiomers, prodrugs, and fixed dose combinations. Given the recent evolution, it is prudent to review the court and FDA decisions to devise a strategy to try to obtain NCE exclusivity.

Endnotes

1 See https://investor.amarincorp.com/releasedetail.cfm?ReleaseID=973501.

2 Amarin Pharms Ireland Ltd. v. FDA, 14-cv-00324 (Dist. Court, Dist. of Columbia, 2015).

3 Id.

4 21 CFR 314.108(b)(4). This article does not address other available exclusivities such as e.g., orphan drug exclusivity, pediatric exclusivity, or GAIN Act exclusivity, because these exclusivities are not directly relevant to procuring NCE exclusivity.

5 See 21 CFR 314.108(a).

6 See 21 CFR § 210.3(b)(7).

7 21 U.S.C. 355(c)(3)(E)(ii).

8 FDA, NDA Approval Letter dated July 26, 2012, available here: https://www.accessdata.fda.gov/drugsatfda_docs/nda/2012/202057Orig1s000Approv.pdf.

9 See FDA, NDA Approval Letter dated November 10, 2004 available at https://www.accessdata.fda.gov/drugsatfda_docs/nda/2004/21-654_Omacor_Approv.pdf; See also FDA letter of November 1, 2004 available at https://www.accessdata.fda.gov/drugsatfda_docs/nda/2004/21-654_Omacor_AdminCorres_P1.pdf.

10 Amarin Pharms Ireland Ltd. v. FDA, 106 F.Supp.3d 196 (Dist. Court, Dist. of Columbia, 2015).

11 FDA, NCE status Approval Letter dated May 31, 2016 available here: https://www.accessdata.fda.gov/drugsatfda_docs/nda/
2012/202057Orig1s000AdminCorresedt3.pdf.

12 See Amarin at page 206.

13 See id.

14 FDA, NDA Approval Letter dated May 5, 2014.

15 AstraZeneca’s Supplement to its citizen petition dated November 3, 2015 accessible here: https://www.regulations.gov/document?D=FDA-2014-P-1796-0007.

16 Guidance for Industry – New Chemical Entity Exclusivity Determinations for Certain Fixed-Combination Drug Products accessible at https://www.fda.gov/downloads/Drugs/GuidanceComplianceRegulatoryInformation/
Guidances/UCM386685.pdf (published October 10, 2014; last accessed July 19, 2016).

17 Gilead’s Harvoni includes sofosbuvir, a drug approved in 2014 and marketed as Sovaldi. Eisai’s Akynzeo includes oral palonosetron, approved in 2008 under the brand name Aloxi.

18 See 59 Fed. Reg. 50,338-50,359 (Oct. 3, 1994).

19 Actavis Elizabeth LLC v. FDA, 625 F.3d 760, 765 (D.C. Cir. 2010).

20 FDA letter to Shire Development, Inc dated October 23, 2009, Docket No. FDA-2009-N-0184; see also 54 Fed. Reg. at 28898 and Exclusivity Determination for Emend available here: https://www.accessdata.fda.gov/drugsatfda_docs/NDA/2008/
022023s000_AdminCorres_P2.pdf.

21 See Actavis Elizabeth LLC, 625 F.3d at 765.

22 See 21 CFR 314.108(a).

23 Draft Manual of Policies and Procedures (MAPP) 7500.3 “Drug and Application Classification.”

24 Approved on April 27, 2007 under NDA 022051.

25 FDA letter regarding exclusivity dated 5/29/2012.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

Content contributed by attorneys of Troutman Sanders LLP and Pepper Hamilton LLP prior to April 1, 2020, is included here, together with content contributed by attorneys of Troutman Pepper (the combined entity) after the merger date.

This article was published in Pratt’s Energy Law Report (September 2016, Volume 16, No. 8).

On April 7, 2016, Tesla announced that it had received more than 325,000 reservations for its new Model 3 electric vehicle (EV) in a blog post titled “The Week That Electric Vehicles Went Mainstream.” Tesla expects to earn more than $14 billion in sales from the Model 3, which represents its most affordable vehicle to date. The rise of more affordable EV options, along with federal and state incentive programs, have led to a steady increase in the number of EVs in the United States. Despite this continued growth, the number of EV charging stations has remained low across the country, which may be partly attributed to the hazy regulatory environment surrounding EV charging stations.

Most local, state and federal regulations and codes do not specifically address the business of selling electricity to EVs in a clear or consistent way. While regulatory requirements are well-established for owners of privately owned gasoline service stations, those seeking to own or operate a commercial EV charging station often face significant regulatory hurdles or delays. In deciding how EV charging stations will be regulated, states have generally followed one of three approaches: (1) refraining from taking any action and potentially defaulting to regulation by the state’s public utility commission; (2) affirmatively deciding that utilities may own and operate EV charging stations; or (3) exempting EV service providers from existing public utility regulations either through legislation or interpretation of statutes and regulations.

States That Have Refrained from Taking Any Action Yet

Electricity is delivered to consumers mainly by investor-owned utilities, municipal utilities and cooperatives (collectively, the utilities).¹ In states that have restructured or partially deregulated, competitive generation suppliers also provide generation service to some consumers; these suppliers are typically licensed by the state or by the public utility commission, and they sell electric power to consumers, which is then physically delivered by the utilities. In states that have not restructured or partially deregulated, sales of electricity by unregulated firms may be unlawful, and such sales may intrude on the exclusive service territories granted to utilities. There are, of course, significant differences in the ways in which states regulate their utilities and other entities that supply electric power to end users² Many states have not yet decided whether to regulate EV charging stations or how best to regulate these stations, and, without regulatory changes, EV service providers may potentially be subject to a form of public utility regulation. Another complicating factor is that, in some states, the existing utilities may have established tariffs that prohibit the resale of electric power delivered over the utilities’ distribution systems. Likewise, in some states, there may be statutes or regulations that limit the ability of utility customers to resell or to mark up the price on electric power delivered by existing utilities.

States that have not yet made a distinction between the sale of electricity to consumers and the provision of electricity through EV charging stations include Arizona, Indiana, New Jersey, North Carolina and Pennsylvania.

In some of these states, like Pennsylvania, the regulation of the sale of electricity at EV charging stations has been developing at the local level, rather than the state level, through zoning codes and other initiatives. For example, the city of Philadelphia has added EV-related provisions to the city’s Traffic Code, despite a lack of regulatory change by Pennsylvania itself.³ These provisions grant the Philadelphia Parking Authority the ability to designate EV-reserved on-street parking spaces and describe the necessary procedures for installing curbside EV-charging units.⁴ Multiple Pennsylvania state agencies, such as the Pennsylvania Department of Transportation and the Department of Environmental Protection, have also provided grants and created tasks forces to encourage the development of EV infrastructure; however, it is unclear when the state will begin the process of deciding how to uniformly regulate EV charging stations, if at all. While the slow development of many states’ policies on EV charging stations may hinder the growth of the EV market, it also allows these states to observe the effectiveness of regulations that have already been adopted in other states.

States That Have Decided That Utilities May Own and Operate EV Charging Stations

A handful of states have affirmatively permitted utilities to own and operate EV charging stations. For example, the Public Utility Commission of Oregon decided that “[e]lectric utilities should be allowed to invest in [EV service equipment (EVSE)] and operate EV charging stations as a non-regulated, non-rate based venture.”⁵ The Public Utility Commission of Oregon also observed that it “[did] not find that allowing utilities to potentially participate in the EVSE market will necessarily impede the vibrancy of the whole market.”⁶

Other states have implicitly permitted only utilities to own and operate EV charging stations. For example, section 39.105 of the Texas Public Utility Regulatory Act requires sellers of electricity to demonstrate that they have “the financial and technical resources to provide continuous and reliable service to customers in the area for which the certification is sought.” This high burden has resulted in the exclusion of competitive private entities from owning or operating EV charging stations.⁷ Some companies have partnered with municipally owned electric companies to provide EV charging services as a workaround to the law.⁸ Interestingly, the utilities’ domination of the EV charging station market has not appeared to impede electric vehicle ownership in Texas, as the utilities have actively installed charging stations, especially in urban areas.⁹

As the example of Texas demonstrates, allowing utilities to own and operate EV charging stations provides both advantages and disadvantages. On one hand, the utilities are familiar with the local electrical grid and have the expertise and engineering background to operate charging stations safely and in a way that does not damage existing power lines or facilities. Potentially, the knowledge held by utilities may allow them to operate more efficient and, therefore, cheaper EV charging stations.¹⁰ On the other hand, allowing the utilities or utility affiliates to own and operate EV charging stations may lead to a lack of retail competition in these states, which could negatively impact EV consumers in the long run.¹¹ However, this potential negative impact may be mitigated by the fact that, unlike homeowners, apartment dwellers or business owners, vehicle owners are not completely captive to a local utility; they often have the ability to travel outside the service territory of their local utility. Vehicle owners also have the ability to choose a gasoline-powered vehicle or a vehicle that runs fully or partly on electric power. Consequently, vehicle owners may not need the full array of regulatory protections that normally exists vis-à-vis investor-owned utilities.

States That Have Exempted EV Service Providers from Existing Public Utility Regulations

The recent trend has been for states and state regulatory agencies to affirmatively exempt EV service providers from public utility regulation. California is perhaps the most well-known example of a state that has exempted EV service providers from the statutes governing public utilities. In 2010, the California Public Utility Commission decided that charging station owners should not be considered “electric corporations or public utilities” pursuant to California’s Public Utility Code. Eventually, the California legislature passed an amendment excluding EV charging stations from the “public utility” definition.

Similarly, New York’s Public Commission (the Commission) recently exempted EV charging station service providers from public utility regulation by finding that it did not have jurisdiction over EV charging stations. In 2013, the Commission decided that EV charging stations do not fall under New York’s Public Service Law (NY PSL) because charging stations only provide a service. Under the NY PSL, the Commission has jurisdiction over “the manufacture, conveying, transportation, sale or distribution of . . . electricity for light, heat or power, to gas plants and to electric plants and to the persons or corporations owning, leasing or operating the same.”¹² The Commission explained that, in order to determine whether its jurisdiction extended to the owners and operators of charging stations, it had to determine whether an EV charging station is considered an “electric plant.”¹³ The Commission concluded that a charging station is not an electric plant because “charging stations are not used for or in connection with or to facilitate the generation, transmission, distribution, sale or furnishing of electricity for light, heat or power.” Instead, these stations simply provide a service.¹⁴ The Commission further explained that “[w]hile the customer is using electricity, this is incidental to the transaction.”¹⁵

Approximately 15 other states, including Colorado, Florida, Illinois, Maryland, Massachusetts, Virginia and Washington, have followed an approach similar to California or New York and have exempted EV charging stations or their owners and operators from regulations applicable to public utilities.

Regulations Similar to Those Governing the Sale of Motor Fuel Should Not Be Applied in the EV Charging Station Context

When states exempt EV charging stations from the statutes or regulations governing the retail sale of electricity, the question arises as to which regulatory agencies, if any, will then be responsible for regulating the EV charging stations and what types of laws, if any, should govern the sale of electricity at EV charging stations. For many years, states have enacted numerous laws to protect gasoline service station dealers and consumers from predatory and deceptive practices relating to the sale of motor fuel at the wholesale and retail levels of the market. These laws govern the method of sale of motor fuel and range from below-cost sales statutes to labeling and price-posting requirements to weights-and-measures regulations. However, in stark contrast to the highly developed regulatory environment that currently exists for retail sales of motor fuel, very few states have taken meaningful steps to regulate the sale of electricity at EV charging stations.¹⁶

In our view, states should resist imposing regulations similar to those that exist for motor fuel to the sale of electricity at EV charging stations for three principal reasons. First, many of the regulations governing the sale of motor fuel are archaic and unnecessary in the electricity context. Motor fuel sales regulations were largely enacted years ago to protect consumers and retail dealers from the perceived dangers of oligarchy market power held by a handful of integrated oil companies. As described above, that situation simply does not exist today in the retail electricity marketplace.

Second, the market for the retail sale of electricity at EV charging stations has not developed enough yet to justify the kinds of consumer- and dealer-friendly regulations that exist for motor fuel sales. In some areas of the country, the retail market does not even exist. There is no indication that consumers need special protection from unscrupulous sellers of electricity to justify regulations requiring, for example, that retail prices be prominently displayed on the EV charging station premises or that prices should not be changed more than once in a 24-hour period to prevent price gouging.

Third, many of the regulations governing the sale of motor fuel are inapplicable to EV charging stations because the EV charging station sales model has developed so differently from conventional motor fuel sales. Many employers provide EV charging to employees for free; some parking garages also provide this service free of charge. Further, where states have exempted EV charging stations from existing public utility regulations, EV infrastructure companies, such as ChargePoint and NRG’s EVgo, allow consumers to sign up and pre-pay for monthly plans and locate charging stations online. Thus, state laws requiring gas stations to accurately display their motor fuel prices may not be practical or even necessary in the EV charging station realm.

The owners of EV charging stations likely will — and should — be subject to the rules on marketing and advertising that apply to most retail businesses. State and federal regulatory authorities can — and should — challenge any deceptive practices under existing consumer protection statutes and regulations. However, in our view, regulations specific to sales of electricity at EV charging stations should not be imposed in the absence of evidence that free market forces and existing laws are not protecting competition or consumers.

Despite this, some states have appeared to contemplate the imposition of regulations governing the sale of motor fuel in the EV charging station context. For example, in 2012, Florida passed a statute stating, “[t]he provision of electric vehicle charging to the public by a nonutility is not the retail sale of electricity for the purposes of this chapter. The rates, terms, and conditions of electric vehicle charging services by a nonutility are not subject to regulation under this chapter.”¹⁷ The statute also provided that “[t]he Department of Agriculture and Consumer Services shall adopt rules to provide definitions, methods of sale, labeling requirements, and price-posting requirements for electric vehicle charging stations to allow for consistency for consumers and the industry.”¹⁸ Although the Florida Department of Agriculture and Consumer Services held an open workshop in 2013 to solicit public comments on the definitions, methods of sale, labeling requirements and price-posting requirements for electric vehicle charging stations, no rule has been adopted yet.

Other states have appeared to contemplate the protection of consumers in the EV charging station context without directly applying regulations governing the sale of motor fuel to the retail electricity industry. Connecticut, for example, has sought to protect consumer access to EV charging stations by recently proposing a bill that includes requirements for public access to EV charging stations.¹⁹ Under the bill, EV charging station owners and operators that charge a fee cannot condition the use of the station on subscription fees or membership in any organization.²⁰ Instead, owners and operators that charge a fee can utilize different price schedules based on a subscription or membership.²¹

Over time, states could explore whether additional light-handed regulation of EV stations is necessary. If necessary, the owners and operators of EV stations could be subjected to licensing and bonding requirements that are similar to requirements imposed on competitive power suppliers. Again, however, careful study should be undertaken before imposing regulation on this new sector.

Conclusion

For EVs to become a successful alternative to gasoline-powered vehicles, EV charging infrastructure must become more widespread. This will require more states to eliminate unnecessary rules and remnants of public utility regulation, while adopting licensing and financial responsibility requirements where appropriate. Because local, state and federal regulations and codes are changing every day, EV charging station owners and operators and potential owners and operators should stay well informed. Additionally, in the long run, EV suppliers and consumers would benefit from a higher level of regulatory certainty. Regulatory uncertainty will only serve to impair the development of this nascent industry.

Endnotes

For most of the past decade, contributions to partnerships (including LLCs taxed as partnerships) have been non-recognition events under section 721(a).[1] Thus, partners did not have to recognize gain on the contribution of property to a partnership, even if the property had built-in gain. However, in August 2015, the Internal Revenue Service (IRS) changed the status quo with Notice 2015-54 (the Notice). The Notice announced that the IRS intends to issue regulations that will require gain recognition on the transfer of property to a partnership in certain situations. Even though the regulations have not been issued, the intended rules will apply to contributions to a partnership beginning on the date the Notice was published — August 6, 2015.

Background

Prior to repeal in 1997, the Code generally imposed a 35 percent tax on the gain inherent in appreciated property transferred by a U.S. person to a foreign partnership. Due to enhanced information reporting obligations enacted in 1997, Congress repealed this tax.[2] However, Congress also provided section 721(c), which allowed the Department of the Treasury (Treasury) to provide regulations requiring gain recognition if it determined that they were necessary to prevent inappropriate results.

Treasury issued no regulations requiring gain recognition on the contribution of property to a partnership for the next eight years. In August 2015, Treasury and the IRS decided to use the authority provided in section 721(c) to take action.

According to the Notice, Treasury and the IRS are aware of situations in which U.S. taxpayers contribute property with built-in gain to a partnership, and the partnership then allocates income or gain from the contributed property to a foreign partner that is not subject to U.S. tax. Moreover, these partnerships do not apply allocation methods, one of which is referred to as the “remedial method,”[3] to prevent shifting tax consequences among partners with respect to any built-in gain or loss on property contributed to the partnership. This effectively shifts the gain from a U.S. partner to a foreign partner, who may not be subject to U.S. tax. In order to ensure gain does not escape the United States untaxed, Treasury and the IRS will use their authority under section 721(c) to issue regulations that prevent the use of a partnership to shift gain to a foreign person in certain situations.

Future Regulations (Applicable Now) Will Override General Non-Recognition Treatment for Certain Contributions

The IRS intends to issue regulations requiring the recognition of gain on transfers of property to a partnership. Unless a partnership adopts the “Gain Deferral Method” (described below), the regulations will apply if the following three requirements are met:

1. The transferor partner must be a U.S. person who is not a domestic partnership (the Transferor).
2. The Transferor must contribute property with more than $20,000 built-in gain that is not a cash equivalent or a security (Section 721(c) Property).
3. The contribution must be made to a partnership, whether domestic or foreign, in which (a) the Transferor is directly or indirectly related to foreign partners and (b) the Transferor owns, in conjunction with any related parties, more than 50 percent of the interests in partnership capital, profits, deductions or losses.

In general, if these three requirements are met, then the Transferor must recognize gain on his or her contribution to the partnership.

Notwithstanding the general rule, the IRS plans to adopt a de minimis rule that continues tax-free treatment if the amount of built-in gain contributed by such U.S. persons and allocated to foreign partners is less than or equal to $1 million and the partnership is not applying the Gain Deferral Method to any prior contributions.

Example

USCo is a domestic corporation that developed a widget patent. USCo wholly owns FCo, a foreign corporation, that produces gadgets. With their combined expertise, USCo and FCo think they will be successful at widget production. USCo and FCo form a new partnership, XYZ, for the widget production business. FCo contributes cash of $1.5 million to XYZ, and USCo contributes a widget patent with a fair market value of $1.5 million and an adjusted basis of $0. Prior to August 6, 2015, neither USCo and nor FCo would recognize gain on their contributions to XYZ. However, now, unless XYZ adopts the Gain Deferral Method, USCo will have to recognize the gain inherent in the patent because USCo (i) is a U.S. person who is (ii) contributing Section 721(c) Property, (iii) to a partnership in which USCo is related to a foreign partner, and together they own all of XYZ.

Gain Deferral Method

If adopted by a partnership, the Gain Deferral Method will prevent the immediate recognition of gain on the contribution to the partnership, but will require the U.S. transferor to recognize built-in gain over time (generally, over the period of the useful life of the contributed property).

To use the Gain Deferral Method, the partnership must comply with the following five requirements:

1. The remedial allocation method is adopted for built-in gain for all Section 721(c) Property.
2. During any tax year in which there is remaining built-in gain in the Section 721(c) Property, the partnership allocates all items of income, gain, loss and deduction with respect to that Section 721(c) Property in the same proportion (i.e., items of income from the property must be allocated in the same proportion as items of deduction).
3. Certain reporting requirements are satisfied.
4. The U.S. transferor recognizes any remaining built-in gain with respect to Section 721(c) Property if there is an acceleration event.
5. The Gain Deferral Method is adopted for all subsequently contributed Section 721(c) Property until five years after the initial contribution or there is no built-in gain remaining.

Additionally, the U.S. transferor (and, in certain cases, the partnership) must extend the statute of limitations with respect to all items related to the Section 721(c) Property for eight years following the contribution.

Requirement #1: The requirement to use the remedial method means that U.S. transferors of Section 721(c) Property will be allocated income in each year of the partnership until it has recognized the entire amount of the built-in gain existing as of the time of the contribution. Thus, although the use of the Gain Deferral Method prevents recognition of all built-in gain at the time of the contribution, the Gain Deferral Method will require that built-in gain be recognized over time.

Requirement #4: An “acceleration event” is any transaction that would defer or reduce the amount of remaining built-in gain the U.S. transferor would recognize under the Gain Deferral Method. For example, a transfer by the U.S. transferor of its interest in the partnership generally is an acceleration event. However, an acceleration event will not occur if the U.S. transferor transfers an interest in the partnership to a lower-tier partnership or a domestic corporation in a transaction where the transferor’s basis is determined on a carryover basis.

Example (cont’d): If XYZ, the partnership from the above example, adopts the Gain Deferral Method, USCo will not have to recognize the $1.5 million built-in gain on the contribution of the patent to XYZ. Assuming the patent has a 10-year useful life, XYZ will have a $150,000 amortization deduction annually. Applying the remedial method, USCo will recognize $150,000 notional income, and FCo will have a $150,000 deduction for the 10-year life of the patent. Thus, USCo will recognize the entire built-in gain on the Section 721(c) Property contributed to XYZ but will not have to recognize that gain immediately on contribution.

Pepper Perspective

These new regulations will have a direct impact on the formation of partnerships in the international context. U.S. partners contributing property with built-in gain to a partnership with a related foreign partner should closely analyze these regulations to determine if gain is required to be recognized or whether the Gain Deferral Method may be applied to defer such recognition. This is particularly pertinent to contributions to a partnership of intangible assets (such as intellectual property, goodwill and going concern value), which often have little or no basis.

Endnotes

The Doctrine of Nullum Tempus, and Its Impact on Statutes of Limitation and Statutes of Repose

This article was published in the January 2016 issue of AGC Law in Brief (Vol. 2, No. 1). It is reprinted here with permission.

The common law doctrine of nullum tempus occurrit regi — generally translated to mean “time does not run against the king” — when applicable, may preclude the running of statute of limitations periods against government entities as plaintiffs. In practical effect, this can mean that contractors doing business with the government may not be able to assert defenses based on otherwise applicable statutes of limitations or statutes of repose and may, in effect, be exposed to indefinite potential liability.

The doctrine of nullum tempus has long been recognized in American jurisprudence. See United States v. Thompson, 98 U.S. 486, 489–90 (1878):

The rule of nullum tempus occurrit regi has existed as an element of the English law from a very early period. It is discussed in Bracton, and has come down to the present time. It is not necessary to advert to the qualifications which successive parliaments have applied to it.

The common law fixed no time as to the bringing of actions. Limitations derive their authority from statutes. The king was held never to be included, unless expressly named. No laches was imputable to him. These exemptions were founded upon considerations of public policy. It was deemed important that, while the sovereign was engrossed by the cares and duties of his office, the public should not suffer by the negligence of his servants. “In a representative government, where the people do not and cannot act in a body, where their power is delegated to others, and must of necessity be exercised by them, if exercised at all, the reason for applying these principles is equally cogent.”

When the colonies achieved their independence, each one took these prerogatives, which had belonged to the crown; and when the national Constitution was adopted, they were imparted to the new government as incidents of the sovereignty thus created. It is an exception equally applicable to all governments.

For a 50-state survey of the doctrine of nullum tempus, see US Law Network, Inc., Nullum Tempus Compendium of Law, available at https://newsmanager.commpartners.com/linktrack.php?url=http%3A%2F%2Fweb.uslaw.org%2Fwp-content%2Fuploads%2F2013%2F08%2FNullum_Tempus_Compendium_of_Law.pdf.

The application of the doctrine of nullum tempus to “ordinary” statutes of limitation is generally well established. The law has, however, been in flux in recent years, and some state legislatures have limited or eliminated nullum tempus by statute.

There is not as much case law dealing with the application of nullum tempus to statutes of repose. It is sometimes argued that, while a statute of limitations is a procedural device that limits the time within which an accrued claim must be asserted, a statute of repose, by contrast, operates to extinguish the underlying cause of action as of a certain time, regardless of whether any claim had then accrued or not. Because, as it is argued, the statute of repose extinguishes the underlying substantive right, nullum tempus should have no bearing.

Statutes of repose with respect to claims related to design and construction have been enacted in many jurisdictions. For a 50-state survey of statutes of repose, see American Institute of Architects, Statute of Repose State Law Compendium (Revised Jan. 2011), available at https://newsmanager.commpartners.com/linktrack.php?url=http%3A%2F%2Fwww.aia.org%2Faiaucmp%2Fgroups%2Faia%2Fdocuments%2Fpdf%2Faias078872.pdf.

In the remainder of this article, we review how some courts have addressed questions involving the application of nullum tempus to statutes of limitations and statutes of repose as they apply to construction-related claims asserted by government entities.

Washington

In Bellevue School District No. 405 v. Brazier Construction Co., 691 P.2d 178 (Wash. 1984), the Washington Supreme Court held that nullum tempus barred the application of both the statute of limitations and the “builder limitation statute” — the then-current statute of repose (codified at Wash. Rev. Code § 4.16.310). The court held that statutes of limitations do not apply to the state, by virtue of Washington Revised Code section 4.16.160, which expressly provides in part that “there shall be no limitation to actions brought in the name or for the benefit of the state, and no claim of right predicated upon the lapse of time shall ever be asserted against the state. . . .” Bellevue, 691 P.2d at 181.

As to the statute of repose, the contractor in Bellevue argued that the statute was a “non-claim” statute — e.g., a statute that both created a right and also limited the time during which that right could be exercised. The court held that the statute of repose was not a “non-claim” statute because it created no new right, but was simply a statute defining the period within which a claim must be asserted — in essence, a period of limitations. The only difference between the statute of limitations and the builder limitation statute (the statute of repose) was, the court noted, the point at which the limitation period begins to run.

The legislature responded to Bellevue in 1986 with amendments to sections 4.16.160 and 4.16.310. These amendments expressly provide that the state is subject to the construction statute of repose. See Washington State Major League Baseball Stadium Public Facilities Dist. v. Huber, Hunt & Nichols-Kiewit Constr. Co., 296 P.3d 821 (Wash. 2013). As amended, section 4.16.310 (the statute of repose) provides as follows:

Any cause of action which has not accrued within six years after such substantial completion of construction . . . shall be barred. * * * The limitations prescribed in this section apply to all claims or causes of action . . . brought in the name of the state which are made after June 11, 1986. (Emphasis added.)

The principal issue in the Washington State Major League Baseball case was when the cause of action accrued. Section 13.7 of the contract provided that, with respect to claims arising from acts or omissions occurring prior to substantial completion of the project, “any alleged cause of action shall be deemed to have accrued in any and all events not later than such date of Substantial Completion.” In light of this provision, the court concluded that the cause of action accrued within the six-year period of repose, which was, in the court’s words, “the end of the statute of repose inquiry.” Id. at 826. Because by agreement of the parties in section 13.7 of the contract, the claim accrued during the six-year period of repose, the court held that the statute of repose was satisfied, and under section 4.16.160, there was no other period of limitations applicable to the state.

Oklahoma

Nullum tempus was expressly recognized by the Oklahoma Supreme Court in 1913 in the case of Foot v. Town of Watonga, 130 P. 597 (Okla. 1913). In Oklahoma City Municipal Improvement Authority v. HTB, Inc., 769 P.2d 131 (Okla. 1988) the court addressed the interplay between nullum tempus and the statute of repose. There, the claim by the municipal authority against the contractor (for alleged defective construction of a water pipeline) was asserted more than 10 years after substantial completion of the improvement. The contractor argued that the claim was barred by the 10-year statute of repose (Okla. Stat. title 12, § 109) and also argued that the construction and operation of a water system was a proprietary function and not a governmental function. Taking the issues in reverse order, the court held that, while the operation of a waterworks is a proprietary function, that is not the test for the application of the doctrine of nullum tempus in Oklahoma. Rather, the test in Oklahoma turns on whether the rights to be enforced are public rights — and held that the rights at issue were public rights, and therefore nullum tempus applied. On the second issue, the court applied reasoning similar to that in Washington State Major League Baseball. The court held that the cause of action had accrued and vested within the time prescribed by the statute of repose, and the plaintiff’s failure to comply with the separate statute of limitations was excused under the doctrine of nullum tempus.

Virginia

In Virginia, the Supreme Court has held that the doctrine of nullum tempus does not apply to claims that have been extinguished by the running of the statute of repose. Commonwealth of Virginia v. Owens-Corning Fiberglas Corp., 385 S.E.2d 865 (Va. 1989). Nullum tempus has been codified in Virginia in Code of Virginia section 8.01-231, which provides that “[n]o statute of limitation which shall not in express terms apply to the Commonwealth shall be deemed to bar any proceeding by or on behalf of the same.” The Commonwealth argued that nullum tempus should apply to the statute of repose as well as the statute of limitations. The court held that, unlike a statute of limitations, when the statute of repose has run, a substantive right of repose is created, which the legislature may not abridge. Owens-Corning, 385 S.E.2d   at 868.

New Jersey

In New Jersey, the statute of repose now applies to claims asserted by government entities (with four exceptions), as discussed below. The path to this result has had some twists and turns. Nullum tempus was the established law of New Jersey until 1991. In New Jersey Educational Facilities Authority v. Gruzen Partnership, 592 A.2d 559 (N.J. 1991), the New Jersey Supreme Court abrogated the doctrine as a “legal relic,” stating that “[a]s a matter of logic, it would seem that an entity which would not be protected by sovereign immunity would also not be entitled to benefit from nullum tempus.”

Two years later, in Rutgers University v. The Grad Partnership, 634 A.2d 1053 (N.J. Super. App. Div. 1993), the Appellate Division held that, notwithstanding the abrogation of nullum tempus in Gruzen, the doctrine should continue to apply to Rutgers as the doctrine existed at the time that Rutgers commenced the litigation. The court held that “statutes of limitation are statutes of repose” and concluded that “we can find no rational basis for precluding the application of nullum tempus to [the statute of repose] as of the time the State commenced its action.” Id. at 1056.

The next development came in State of New Jersey v. Cruz Construction Co., 652 A.2d 741 (N.J. Super, App. Div. 1995). Even though nullum tempus had been abrogated in Gruzen, the court in Cruz held that, since the statute of repose (N.J.S.A. § 2A:14-1.1) did not by its express terms apply to the state, “it logically follows that nullum tempus cannot be deemed to have been altered by the enactment of the statute.” The court held that the claims of the state were not barred by the statute of limitations.

The question was finally resolved in 1997, when the legislature amended section 2A:14-1.1 to make it clear that the statute of repose applies to both private citizens and government agencies (with four enumerated exceptions):

§ 2A:14-1.1. Damages for injury from unsafe condition of improvement to real property; statute of limitations; exceptions; terms defined

a. No action, whether in contract, in tort, or otherwise, to recover damages for any deficiency in the design, planning, surveying, supervision or construction of an improvement to real property, or for any injury to property, real or personal, or for an injury to the person, or for bodily injury or wrongful death, arising out of the defective and unsafe condition of an improvement to real property, nor any action for contribution or indemnity for damages sustained on account of such injury, shall be brought against any person performing or furnishing the design, planning, surveying, supervision of construction or construction of such improvement to real property, more than 10 years after the performance or furnishing of such services and construction. This limitation shall serve as a bar to all such actions, both governmental and private, but shall not apply to actions against any person in actual possession and control as owner, tenant, or otherwise, of the improvement at the time the defective and unsafe condition of such improvement constitutes the proximate cause of the injury or damage for which the action is brought (emphasis added).

b. This section shall not bar an action by a governmental unit:

 (1) on a written warranty, guaranty or other contract that expressly provides for a longer effective period;

 (2) based on willful misconduct, gross negligence or fraudulent concealment in connection with performing or furnishing the design, planning, supervision or construction of an improvement to real property;

 (3) under any environmental remediation law or pursuant to any contract entered into by a governmental unit in carrying out its responsibilities under any environmental remediation law; or

 (4) Pursuant to any contract for application, enclosure, removal or encapsulation of asbestos (emphasis added).

North Carolina

The North Carolina Supreme Court has held that “nullum tempus survives in North Carolina and applies to exempt the State and its political subdivisions from the running of time limitations unless the pertinent statute expressly includes the State.”Rowan County Board of Education v. U.S. Gypsum Co., 418 S.E.2d 648 (N.C. 1992). It was also argued that the construction and maintenance of local public schools is a proprietary function and not a government function. Although the court acknowledged the viability of the proprietary/governmental distinction with respect to the application of nullum tempus in North Carolina, the court held that the operation of public schools (and libraries) are government functions and, therefore nullum tempus applied.

Conclusion

The doctrine of nullum tempus and its application to statutes of limitations and statutes of repose vary state by state. Contractors are cautioned to review the specific law of any state in which they are doing business.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

Content contributed by attorneys of Troutman Sanders LLP and Pepper Hamilton LLP prior to April 1, 2020, is included here, together with content contributed by attorneys of Troutman Pepper (the combined entity) after the merger date.

A nonconforming use may continue, and a nonconforming structure may stand, despite their current status of being in violation of a zoning ordinance.

What is a nonconforming use?

 

A nonconforming use is a land use or structure that was legal prior to the adoption of a zoning ordinance that renders the use or structure illegal. Examples include:

 

• A gas station established prior to a municipality’s adoption of any zoning ordinance, but, as a result of the enactment of a zoning ordinance, the gas station property is located in a zoning district (such as a residential district) that does not permit gas stations.
• An office building legally established under the then-applicable zoning ordinance, but, as a result of a comprehensive rezoning and adoption of an amended zoning ordinance, the office building use is no longer permitted at its location.
• A junk yard legally established in a commercial district prior to a text amendment to a zoning ordinance removing junk yards as a permitted use in a commercial district.
• A building erected within 10 feet of its front boundary line before the enactment of a zoning ordinance in the municipality requiring a 50-foot front yard setback.

 

May I continue a nonconforming use legally?

 

Yes. A nonconforming use may continue, and a nonconforming structure may stand, despite their current status of being in violation of a zoning ordinance. This is justified by constitutional principles. Zoning regulations are, in effect, takings of private property, and, although governments have broad powers to take private property for a public purpose, individual property owners must be compensated for the property taken. Additionally, to be enforceable without the payment of compensation, a municipality’s zoning power must be exercised in a reasonable and proper manner. Accordingly, a zoning restriction that requires a landowner to discontinue a previously legal use of his or her land or remove from the property a nonconforming building or other structure without compensation would be of dubious constitutionality. Based on these principles, a survey of Pennsylvania case law over the last half-century demonstrates that courts have exhibited a sympathetic attitude toward nonconforming uses and structures.

 

May I expand a nonconforming use on my property?

 

Generally, yes. Pennsylvania appellate courts have adopted a “doctrine of natural expansion” with respect to a landowner’s right to expand a nonconforming use on his or her own property. As stated by the Pennsylvania Supreme Court:

 

a nonconforming use cannot be limited by a zoning ordinance to the precise magnitude thereof which existed at the date of the ordinance; it may be increased in extent by natural expansion and growth of trade, neither is it essential that its exercise at the time the ordinance was enacted should have utilized the entire tract upon which the business was being conducted.

 

Peirce Appeal, 119 A.2d 506, 509 (Pa. 1956).

 

A classic example of the doctrine of natural expansion of a nonconforming use is a manufacturing facility, the establishment of which predates zoning and which is currently located in a district where such a use is not permitted. As the manufacturing industry and related technologies evolve since the establishment of the facility, additional space and buildings must be erected on the property to house new equipment for the owner or lessee of the facility to remain competitive. Under Pennsylvania law, the property owner will be allowed to expand the use on the property to install the necessary equipment to stay economically viable.

 

Many zoning ordinances permit by right, special exception or conditional use the expansion of a nonconforming use up to a percentage limit (usually 25 percent or 50 percent). Although these ordinance provisions have generally been upheld, courts have at times allowed greater expansion than otherwise permitted under the ordinance by virtue of the doctrine of natural expansion.

 

Note, however, that any expansion must be in compliance with the current zoning ordinance’s dimensional regulations applicable to the property (e.g., setbacks, building coverage, parking, signage), and there is no similar right to expand a nonconforming structure that would exacerbate the structure’s dimensional nonconformity.

 

May I change the use of my property from a nonconforming use to another nonconforming use or add a nonconforming use to the property?

 

Generally, no. Although Pennsylvania law protects a property owner’s right to continue using a property for a use established prior to the use’s prohibition by ordinance and to naturally expand that use, no protection is provided to the property owner who desires to use the property for an additional or different nonconforming use. An additional use or change of use that is not otherwise permitted in the property’s respective zoning district would require a use variance granted by the zoning hearing board before its establishment.

 

That said, in determining whether a desired use is a change in use or an additional use, or merely just a continuation of the existing nonconforming use, Pennsylvania appellate courts have ruled that a new activity may be a permitted continuation of a nonconforming use if it is similar to the existing use. The proposed use need not be identical to the existing nonconforming use; rather, similarity is all that is required. For example, a pizza restaurant with seating was found to be similar to an existing use as a sandwich shop that had limited seating and sold primarily take-out food. Likewise, a proposed day camp and swim club were found to be similar to an existing use as an amusement park. However, a use centered on entertainment by dancers was not sufficiently similar to a restaurant to be deemed a continuation of the restaurant’s legal nonconforming use.

 

Further, many municipalities permit by special exception or conditional use a use change on a property from one nonconforming use to another nonconforming use. Such permission is specific to the municipality and subject to the specific criteria for the grant of such special exception or conditional use set forth in the zoning ordinance.

 

If the building housing my nonconforming use burns down, may I reconstruct and continue the use?

 

This depends on the applicable zoning ordinance. Although normal repairs and maintenance to buildings and equipment are intrinsic in the continuation of a nonconforming use, many municipalities’ zoning ordinances prohibit the restoration of a nonconforming use or building that has been entirely or nearly entirely damaged or destroyed by fire or casualty. For example, if a nonconforming factory located in a residential district is entirely or mostly destroyed by fire, the zoning ordinance may prohibit the reconstruction of the factory building, in effect terminating the nonconforming use. However, ordinance provisions that do not allow for the reconstruction of nonconforming uses where less than a majority of the building has been destroyed have been ruled constitutionally invalid by Pennsylvania courts.

 

In addition, where the zoning ordinance is silent on the topic of reconstruction of nonconforming uses, courts have generally sided with property owners who desire to continue the nonconforming use so long as such use has not been abandoned.

 

When is a nonconforming use abandoned by the property owner?

 

A use entitled to the legal recognition and protection as a nonconforming use does not lose such status unless the use is “abandoned.” The concept of abandonment is best illustrated through the facts of the seminal Pennsylvania Supreme Court case on the topic, Latrobe Speedway, Inc. v. Zoning Hearing Board of Unity Township, 686 A.2d 888 (Pa. 1996).

 

From 1977 to 1982, the subject property was used as an automobile race track. In 1982, the race track operations ended, but the structures were not dismantled; however, they did fall into disrepair, and the property was overgrown with weeds. In 1991, the zoning map was amended to place the property in an agricultural district, which did not permit the race track operations. In 1994, the property was leased for use as a race track, but the use was challenged by the township. Following proceedings before the township’s zoning hearing board, the Court of Common Pleas and the Pennsylvania Commonwealth Court, the Pennsylvania Supreme Court ultimately ruled that the race track use could continue as a nonconforming use, despite its dormant state at the time of the ordinance adoption. Instead, the nonconforming use continues until abandonment, which requires proof of (1) an intent to abandon and (2) actual abandonment. The property owner in Latrobe did not intend to abandon the use because he allowed for and paid taxes based on the property being assessed as a race track and continuously negotiated for the sale or lease of the property as a race track.

 

Many municipalities have adopted zoning ordinances with provisions that deem a discontinued use to be abandoned after a set period of time (typically one year). Courts have ruled, however, that those ordinance sections do not independently determine abandonment. Instead, they are to be interpreted as creating a presumption that the use has been abandoned, which may be rebutted by a property owner with evidence that he or she did not intend to abandon the use.

 

How can I be sure that a use is a nonconforming use permitted to continue?

 

Potential buyers and lenders, during their due diligence, often desire comfort that the current use of a property is recognized by the municipality as a nonconforming use permitted to continue. To facilitate such requests, many, but not all, municipalities keep registries of legal nonconforming uses. A property owner — upon recognizing that his or her use is not permitted under the current zoning ordinance, but is allowed to continue as a nonconforming use — may register such a use. The registration, once confirmed by the zoning officer, is then used as evidence of the use’s legal nonconforming status.

 

Although many such ordinances require property owners to register their nonconformities, Pennsylvania courts have recently ruled that the failure of a property owner to register a nonconforming use does not affect the nonconforming use’s protection to continue.

 

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

Content contributed by attorneys of Troutman Sanders LLP and Pepper Hamilton LLP prior to April 1, 2020, is included here, together with content contributed by attorneys of Troutman Pepper (the combined entity) after the merger date.

IF A SETTLEMENT AGREEMENT IS SILENT, A DEFENDANT IS NOT REQUIRED TO ‘GROSS UP’ THE SETTLEMENT, AND THE PLAINTIFF WILL SUFFER THE WITHHOLDING TAX BURDEN.

This article was published in the Tax section of Law360 under the title “When a Settlement Agreement Is Silent About Tax” on September 3, 2015.

What happens when settling parties agree that the defendant will pay a specific sum to the plaintiff, and the defendant discovers later that withholding of taxes is required? Does the defendant withhold and pay the net amount to the plaintiff, or is the defendant required to gross up the payment, such that the plaintiff receives the agreed-upon amount net of taxes?

The U.S. District Court for the Eastern District of Michigan ruled on this question in I.E.E. International Electronics & Engineering, S.A. v. TK Holdings Inc. (E.D. Mich. July 27, 2015). In I.E.E., the parties reached a settlement at a conference conducted by the district court. However, the parties later reached an impasse on account of a withholding tax issue when they sought to memorialize their settlement in a written agreement. The oral settlement that they reached called for the defendant, Takata A.G., to pay I.E.E. $1.1 million, but there was no discussion with respect to withholding taxes. After the conference, Takata was informed by its tax advisors that the contemplated payment from a German corporation to a Luxembourg entity was subject to tax withholding under German law. The plaintiffs took issue with the defendant’s stated intention to withhold the German taxes.

The court first observed that the parties failed to anticipate the possibility that withholding taxes might be payable. It then determined that the parties’ silence on this issue could not be construed as evidencing their tacit agreement that the defendants would pay the full $1.1 million and also would shoulder the burden of the withholding tax. Because there was mutual unawareness of the withholding tax issue, the court was required to determine how the unanticipated tax obligation should be handled in the settlement agreement. There were two bases for the court’s conclusion that the tax obligation rested solely on the plaintiff.

First, it cited the settled principle of contract interpretation that the terms of an agreement should be presumed to comply with applicable law. German law required withholding tax, and, therefore, the defendants were required to withhold the tax.

Second, the court cited and relied on three cases in which the parties had reached a settlement that obligated the defendant to pay the plaintiff a specific sum, but where the parties had not considered the tax consequences, specifically tax withholding. The courts in all three cases were called on to determine whether the defendant was required to gross up the settlement payment or whether the burden of the tax would be borne by the plaintiff. The courts reached the same result, namely that a settlement agreement’s silence with regard to tax consequences leaves the paying party free to withhold taxes from its settlement.

The court in I.E.E. also rejected the plaintiffs’ suggestion that the defendants should ignore the tax withholding and let the plaintiffs be solely responsible for their tax liability, taking cognizance of the defendants’ assertion that this course of action would not comport with German law. The three cases relied on by the I.E.E. court were:

• International Union, United Automobile Aerospace & Agricultural Workers v. Hydro Automotive Structures North America, Inc., 2015 WL 630457 (W.D. Mich. 2015), in which the court rejected the plaintiffs’ contention in a class action settlement that the silence in the settlement agreement required the defendants to gross up the payment
   
• Powertech Tech. Inc. v. Tessera, Inc., 2014 WL 2538973 (N.D. Cal. 2015), in which the case law was viewed as establishing that, when there is a withholding requirement imposed on one party, that party must comply with the requirement as it applies to settlement payments and that silence as to tax withholding leads to a presumption that taxes are levied on the total settlement amount agreed upon
   
• Josifivich v. Secure Computing Corp., 2009-2 U.S. T.C. (CCH) P50, 543 (D. N.J. 2009), where a settlement agreement regarding unpaid commissions and employment discrimination was silent concerning the withholding of employment taxes, and the court held that it would not alter the terms of the voluntary settlement agreement and require the defendant to pay more because the plaintiff was dissatisfied with the anticipated tax consequences of the agreement.

In applying the cases to the instant situation, the I.E.E. court held as follows:

Defendants may comply with the withholding requirements of German tax law without “grossing up” their payment to Plaintiffs to account to and offset this tax withholding. As the courts have recognized, the withholding of taxes is a natural and wholly foreseeable consequence of a payment made by one party to another pursuant to a settlement agreement, and the parties here were free to allocate this withholding burden among themselves as they negotiated their settlement. Having failed to address this issue, the parties are subject to the presumption that “each side has to bear the tax consequences” attendant to the performance of their obligations under the settlement agreement. Although Plaintiffs suggest that Defendants should simply pay the entire $1.1 million settlement amount and leave it to Plaintiffs to fulfill any obligations imposed by the pertinent tax authorities, Defendants state without contradiction that this proposed course of action would not comport with German law, and that they have no choice but to withhold taxes from their settlement payment. Thus, if Defendants were required to pay the full $1.1 million settlement amount to Plaintiffs and also make the payment demanded by the German taxing authorities, this would result in payments by Defendants in excess of the $1.1 million figure they agreed to in the parties’ settlement. Moreover, Plaintiffs would obtain both the full value of Defendants’ $1.1 million settlement payment and the economic benefit derived from Defendants’ satisfaction of the tax obligation owed by the parties to the German taxing authorities as a result of their agreed-upon settlement transaction.

As observed in above-cited cases, silence in a settlement agreement as to the tax consequences of payments surely does not warrant such a reapportionment of the parties’ benefits and burdens under their agreement. Rather, if Plaintiffs wished to ensure that they would receive a full $1.1 million settlement payment without regard to any tax consequences of the parties’ agreed-upon transaction, they should have negotiated for such a term in the parties’ settlement agreement. Because they did not, the Court declines to alter the terms of a settlement reached in hard-fought, arms-length negotiations among sophisticated parties, each of which was represented by highly skilled counsel and had ample opportunity to consider the tax consequences of the opposing party’s settlement proposals. By resort to the principles articulated in the pertinent case law, the Court construes the parties’ settlement here as calling for Defendants to withhold taxes from their $1.1 million payment to Plaintiffs in accordance with German tax law, without any obligation for Defendants to “gross up” its payment to ensure that Plaintiffs receive the full $1.1 million settlement amount. [Citations omitted.]

Pepper Takeaway

The tax consequences of a settlement should be addressed in the settlement agreement, particularly where withholding tax is involved. If the agreement is silent, I.E.E., and the cases it cited, show that the plaintiff will suffer the withholding tax burden. The court in I.E.E. stated conclusively that the defendant is not required to gross up the settlement for the plaintiff because that would increase the amount of the agreed-upon settlement.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Content contributed by attorneys of Troutman Sanders LLP and Pepper Hamilton LLP prior to April 1, 2020, is included here, together with content contributed by attorneys of Troutman Pepper (the combined entity) after the merger date.

Disputes between policyholders and insurance carriers often arise in the context of an insured’s payments made before providing notice of a claim to its carrier.  However, California courts routinely hold that, absent special circumstances discussed in more detail below, when the policy at issue includes a standard “no-voluntary-payment” clause, such “pre-tender fees and costs” are not covered by the policy.  

 

California courts have long held that no-voluntary-payment provisions are enforceable and preclude coverage in the context of pre-tender defense fees and costs incurred in connection with a duty to defend policy.  See, e.g. Insua v. Scottsdale Ins. Co., 104 Cal. App. 4th 737, 745 (2002) (holding that no-voluntary-payment provision precluded recovery of pre-tender defense costs); Jamestown Builders, Inc. v. General Star Indemnity Co., 77 Cal. App. 4th 341, 345-50 (1999) (holding that no-voluntary-payment provision precluded recovery of pre-tender expenses).   Moreover, no-voluntary-payment provisions are enforced without regard to whether or not the insurer is prejudiced by the insured’s delayed notice of the underlying matter.  See, e.g. Jamestown Builders, Inc., 77 Cal. App. 4th at 349-50; Low v. Golden Eagle Ins. Co., 110 Cal. App. 4th 1532, 1544 (2003) (explaining that, unlike a notice provision or cooperation clause, no-voluntary-payment provisions are enforceable without a showing of prejudice). 

 

The application of no-voluntary-payment provisions in reimbursement policies without a duty to defend was somewhat of an open issue under California law before 2013, and insureds would often argue that the existing precedent only applied to situations where the carrier had a duty to defend.  This issue, however, was addressed by the Central District of California in National Bank of California v. Progressive Casualty Insurance Company, where the court explicitly rejected the insured’s argument that “[t]he logic underlying the exclusion of pre-tender fees is inapplicable where . . . [the insurer] owes no duty to defend and . . . never undertakes [the insured’s] defense.”  938 F. Supp. 2d 919, 939 (C.D. Cal. 2013).  According to the National Bank of California court, the proper inquiry was not whether the policy at issue created a duty to defend on the part of the insurer, but rather whether the insured agreed through the acceptance of the policy not to voluntarily make payments in connection with a claim without the insurer’s consent.  Id.  Accordingly, the National Bank of California court held that the rule regarding pre-tender defense fees and costs should be the same in the context of reimbursement policies without a duty to defend as it is in the context of duty to defend policies.

 

Although no-voluntary-payment provisions are enforceable and routinely enforced under California law, there are limited circumstances in which California courts will refuse to enforce those provisions.  The Jamestown Builders court summarized these situations when it explained that no-voluntary-payments provisions will be enforced “in the absence of economic necessity, insurer breach, or other extraordinary circumstances.”  77 Cal. App. 4th at 346 (citing Gribaldo, Jacobs, Jones & Assocs. v. Agrippina Versicherunges A. G., 3 Cal. 3d 434, 449 (1970)).  California courts have interpreted these exceptions very narrowly and generally disallowed insureds’ attempts to undermine the effect of no-voluntary-payment provisions.

 

With regard to the “economic necessity” and “extraordinary circumstances” exceptions, the Jamestown Builders court itself interpreted them to mean that “an insured may be able to avoid the application of a no-voluntary-payments provision where the previous payments were made involuntarily because of circumstances beyond its control.”  77 Cal. App. 4th at 348.  This may occur where “the insured is unaware of the identity of the insurer or the contents of the policy” or where “the insured may be faced with a situation requiring immediate response to protect its legal interests.”  Id.  However, insureds’ attempts to avail themselves of this exception are met with criticism by California courts and are often rejected.  See Dietz Int’l Pub. Adjusters of Cal., Inc. v. Evanston Ins. Co., 796 F. Supp. 2d 1197, 1216-1271 (C.D. Cal. 2011) (rejecting insured’s argument that payments were made involuntarily because he was busy paying off claims in order to preserve his business, which was “a complete mess” after an embezzlement; the court explained that the “[f]ailure to investigate and assess potential coverage does not support a finding that payments made prior to tender [are] involuntary”); see also Jamestown Builders, Inc., 77 Cal. App. 4th at 349 (rejecting insured’s arguments that payments were involuntary because it was “inordinately preoccupied with the magnitude of remedial work” and its erroneous belief that the policy would not provide coverage; the court explained that the insured had ample opportunity to review the policy, investigate the claims and tender its defense and noted that the insured’s “ignorance of its policy rights does not extend the time in which it was required to take action”).

 

With regard to an “insurer breach,” the Jamestown Builders court noted that application of the no-voluntary-payment provision in a policy is “superseded by an insurer’s antecedent breach of its coverage obligation.”  Jamestown Builders, 77 Cal. App. 4th at 348.  “[I]nsurers that decline a tendered defense are out of luck.”  Id. at 347.  However, while the Jamestown Builders court appears to have recognized an exception to the applicability of a no-voluntary-payment provision in the context of insurer breach, it appears that the court was doing nothing more than stating the general rule of law in California that an insurer which denies coverage to its insured is not permitted to rely on an insured’s breach of policy conditions in a subsequent coverage dispute.  The Eastern District of California, in Burgett, Inc. v. American Zurich Insurance Co., specifically addressed whether pre-tender fees and costs were recoverable by an insured in the event of an insurer’s breach of the duty to defend and held that such payments were not recoverable because an insurer’s duty to defend arises upon tender.  875 F. Supp. 2d 1125, 1126-1128 (E.D. Cal. 2012).  The court rejected the insured’s reliance on Jamestown Builders and explained that, “[w]hile an insurer is undoubtedly liable for the consequences flowing directly from its breach, it is not liable for costs incurred before it did anything wrong, and was unaware that there was even a claim to defend.”  Id. at 1128.  The Burgett court found that it did not have to reach the “pre-tender payments” issue because, “under California law, the duty to [defend] does not arise until tender, and thus, [the insurer] [was] not required to pay pre-tender expenses.”  Id. at 1128 n.4.  In other words, under Burgett, even in the event of a breach, an insurer has no obligation t o pay “pre-tender fees and costs.”

 

In summary, as the enforceability of no-voluntary-payment provisions is established under California law in the context of duty to defend policies, and has been held to apply with equal force in the context of reimbursement policies, the question of whether defense fees and costs incurred prior to tender are recoverable by an insured will often turn on whether there is “economic necessity, insurer breach, or other extraordinary circumstances.”  Although a plain reading of these exceptions may suggest broad application, as explained above, California courts have narrowly construed these exceptions and have generally rejected arguments to circumvent no-voluntary-payments provisions in favor of enforcement.

 

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