Suppliers are caught in the middle of a new enforcement trend in federal, state, and local investigations of disadvantaged business enterprise (DBE) fraud. Historically, DBE fraud investigations have focused on the relationships between DBE services or labor subcontractors and the prime or subcontractors with whom the DBEs contracted. The government enforcement agencies would allege that the DBE was a sham or “passthrough” because it was incapable of performing, or simply did not perform, the work for which it subcontracted to perform. Investigations of DBE subcontracting have led to a well-known list of fraudulent schemes including, for example, DBEs using the prime contractors’ employees and equipment to perform the work or DBEs subcontracting all of the work to non-DBE firms.
The latest enforcement trend focuses on DBE suppliers. Rather than having to explore the nuances of whether a DBE subcontractor did enough work on a project to satisfy the program requirements, investigators and prosecutors who focus on DBE suppliers have found instances of straight pass-through arrangements where the DBE supplier adds no value and performs no commercially useful function, but instead merely lends its name in exchange for a small percentage of the contract value.
Unfortunately, the situations in which DBE suppliers act as pass-throughs create potential liability not only for the prime or subcontractor who benefits from the DBE credits for using such a supplier, but these situations also create investigative interest in and potential liability for the legitimate non-DBE supplier from whom the DBE supplier that is inserted in the transaction purchases merchandise. The scenario for legitimate, non-DBE suppliers is familiar. The supplier provides a quotation and negotiates a subcontract to provide the materials necessary for a project with a prime or subcontractor. The project involves government money, and, after all of the terms of the supply agreement are negotiated and the prime contractor wins the job, the prime or subcontractor tells the supplier that it needs to use a DBE on the project. A “certified” DBE supplier is located. The DBE executes the supply subcontract with the prime or subcontractor and then agrees to purchase the supplies from the non-DBE supplier. The prime or subcontractor provides the DBE supplier with all of the purchase order information, which the DBE puts on its letterhead and submits to the non-DBE supplier. The non-DBE supplier fulfills the purchase order, delivering the supplies straight to the job site. The supplier invoices the DBE, who adds a small percentage fee (often two to three percent) and submits its invoice to the prime subcontractor. When the prime or subcontractor pays the DBE, the DBE takes its two to three percent off the top and remits the balance of the money to the non-DBE supplier.
This scenario is troubling because the non-DBE supplier is potentially committing a crime, despite the fact that (1) the supplier is a legitimate business, and it is the DBE, not the supplier, that is the sham, and, (2) the prime or subcontractor, not the supplier, is the party insisting on using the DBE as a pass-through and taking the DBE credit. Many suppliers believe that the fact that a DBE is certified by a government agency shields them from liability with respect to these transactions. Certification, however, is not a complete defense, because it only addresses the prerequisites that make a company a DBE, i.e., social and economic disadvantage. Although the exact terminology may vary among DBE regulations, it is a fundamental requirement of every DBE program that, in addition to being certified, a DBE must perform a “commercially useful function” on a project, meaning that the DBE does actual work and adds value to the project.
Suppliers are caught in the middle, but are garnering little sympathy from government enforcement agencies, who just see a scheme in which suppliers are helping to create the false appearance that a DBE is performing a commercially useful function. These schemes have become pervasive in the construction industry, such that it can be difficult for any party in the contracting chain to claim they did not know the DBE was a pass-through. Increasingly, federal and state prosecutors, inspector generals, and other law enforcement investigators are viewing suppliers who allow their customers to put them in these situations as aiding and abetting or conspiring to commit a fraud on DBE programs or to submit false claims for payment to the government.
Recent Prosecutions Illustrate the Risk to Suppliers
Two recent federal criminal cases – one where the defendant just finished her sentence and one where the defendant was just charged – illustrate the trend of DBE fraud cases focused on suppliers.
On October 25, 2014, the owner of a sham “certified” minority and woman-owned business that acted as a supplier on government-funded projects was released from federal custody after serving the 26-month sentence imposed in the case of United States v. Azteca Supply Company, Crim. No. 10-80 (N.D. Ill.). In February 2010, a federal grand jury in the Northern District of Illinois returned an indictment charging Aurora Venegas, her husband, and Azteca Supply Company (Azteca) with mail fraud and false statement charges relating to runway and restroom projects at O’Hare International Airport for the City of Chicago and a landscaping project at a Metra commuter rail station for the Village of Orland Park, a Chicago suburb.
According to the indictment, Venegas, as the owner of Azteca, falsely represented that Azteca performed a commercially useful function and made it appear that contractors were purchasing supplies from Azteca. In reality, Azteca acted as a “pass-through,” and contractors were actually purchasing supplies from a majority-owned supplier. Venegas allegedly would learn from contractors what supplies they needed, and then Azteca would act solely as a broker causing those items to be shipped from the actual suppliers to contractors, despite the fact that Chicago’s M/WBE policy makes clear that credits for using a M/WBE[1] cannot be claimed on a project if the M/WBE’s role is limited to “fill[ing] orders by purchasing or receiving supplies from a third party supplier rather than out of its own existing inventory” and the if firm does not provide “substantial service other than acting as a conduit between his or her supplier and his or customer.”
Venegas pled guilty to one count of mail fraud and was sentenced to 26 months in prison and ordered to disgorge $482,850 in profits. As part of her plea agreement, Venegas admitted that on the Metra commuter rail station project in the Village of Orland Park, despite having a subcontract to supply plants to the landscaping subcontractor, Azteca had no role in connection with the ordering, warehousing, storage, or delivery of the plants. Rather, Azteca agreed with the landscaping subcontractor and a majority-owned supplier that Azteca would generate invoices and other documents to create the appearance that Azteca had purchased the plants from the majority-owned supplier and supplied them to the landscaping subcontractor. In reality, the landscaping subcontractor directly communicated with and obtained the plants it required from the majority-owned supplier, bypassing Azteca. As a result of its participation in this particular project, Azteca received a net payment of only approximately $2,800, although there was evidence that between 2001 and July 2008, Azteca received in excess of $9 million by acting as a sham M/WBE pass-through on other government projects.
Importantly, although the Azteca criminal case focused on the M/WBE and the individual owners of that business, the indictment named seven unindicted co-conspirators, labeling them as companies “A” through “F.” From the indictment, it is clear that these unindicted co-conspirators include majority-owned suppliers, subcontractors, a general contractor, and a manufacturer. Because at the time of indictment these coconspirators were not charged criminally, the government did not disclose their identities. However, this does not mean that these companies or individuals were not investigated. Indeed, it is likely the unindicted co-conspirators were approached by the government and suffered the substantial costs and disruption caused by being the subject of a federal investigation.
On September 26, 2014, in another federal criminal case, United States v. Tubbs, Crim. No. 7:14-mj-02137 (S.D.N.Y.), federal prosecutors in the Southern District of New York charged the regional manager at a general contractor that performed a construction project on Bronx-Whitestone Bridge with fraud for allegedly setting up a pass-through arrangement with a DBE supplier. According to the criminal complaint, in October 2008, the Metropolitan Transportation Authority (MTA) awarded a general contractor identified only as “General Contractor-1” a $192 million contract to repair and replace the approaches to the suspension bridge over the East River that connects the Bronx and Queens. To satisfy the M/WBE goal on this project, General Contractor-1 allegedly claimed, in utilization forms and compliance reports, that structural steel would be supplied by a “certified” MBE supplier, identified only as “MBE-1.” According to the criminal complaint, the defendant, Aaron Tubbs, in his capacity as the Regional Manager at General Contractor-1, allegedly participated in setting up a fraudulent scheme whereby the structural steel was actually provided by other companies and MBE-1 was used as a pass-through.
According to the criminal complaint, after a supplier agreed to a contract with General Contractor-1, Mr. Tubbs informed the supplier that the purchases of structural steel had to be run through MBE-1 for purposes of meeting minority requirements. Thereafter, the complaint alleged that General Contractor-1 received purchase order information from the supplier, arranged for the information to be placed on letterhead of MBE-1, and arranged for the purchase order to be submitted to and fulfilled by the supplier. The complaint alleged that, for these reasons, MBE-1 did not meaningfully participate in the bridge project, and it received only a small fraction of the state funds that General-Contractor 1 represented it had received.
Mr. Tubbs was charged with one count of wire fraud. He has not yet been indicted and is presumed innocent. Recently filed court documents show that his counsel “has been engaging in preliminary discussions with the Government concerning possible disposition of this case without trial.” Regardless of what happens in Mr. Tubbs’ case, the criminal complaint suggests that there is an active and ongoing investigation of other MTA contractors, subcontractors, and suppliers. As in the Azteca case, there are a number of unindicted co-conspirators identified in the complaint, including a General Contractor-1, Supplier-1, and MBE-1. Indeed, the complaint alleges that MBE-1 has been “used by general contractors repeatedly on large construction projects in Westchester County, the Bronx, Manhattan, Staten Island, and elsewhere, to obtain credit toward MBE/WBE goals and/or their federal equivalent” as part of a pervasive “pass-through fraud” scheme.
While Azteca and Tubbs were defendants in federal criminal cases, not all DBE fraud cases result in federal criminal charges. Sometimes suppliers, DBEs, and prime and subcontractors have been named in federal civil cases brought under the False Claims Act. For example, in October 2012, the United States Attorney for the Western District of New York announced that Lafarge North America, Inc. (Lafarge), a national supplier of building a construction materials and manufacturer of concrete and concrete products, paid $950,000 to the United States to resolve False Claims Act Claims. According to the government’s press release, Rayford Enterprises, Inc. d/b/a Rayford Concrete Products (Rayford), a Buffalo company, was awarded subcontracts on highway construction projects in the Western District of New York which were partially funded by Federal Highway Administration and, therefore, had DBE requirements. The U.S. Attorney who handled the case described how Rayford obtained the subcontracts “based on its representations that it was a DBE manufacturer of concrete” when “Rayford was not, in fact, a manufacturer of concrete, nor did the company have a concrete batching facility or other equipment necessary to manufacture concrete.” According to the government, “[i]nstead, Rayford had an agreement with Lafarge North America to manufacture and deliver concrete for these projects” and “Lafarge North America is not a DBE.” A separate press release from the U.S. Department of Transportation, Office of Inspector General, which jointly investigated the matter, summarized that, “the settlement was based on claims that [Lafarge] fraudulently obtained subcontracts that were supposed to be performed by [DBEs], by virtue of an alleged fraudulent agreement with Rayford.” The owner of Rayford pled guilty to mail fraud and was sentenced to probation while LaFarge agreed to pay $950,000 in a civil settlement without admitting liability.
And, of course, not all DBE fraud cases are brought at the federal level. Many state and local agencies have active and ongoing DBE fraud investigations and, increasingly, those investigations are focused on suppliers. In January 2012, the City of Philadelphia announced that “in the wake of a Philadelphia Office of the Inspector General investigation into a sham minority contracting scheme,” the City had “begun debarment proceedings against one contractor, removed a second from its list of certified minority businesses and reached a no-fault settlement with a third contractor, which … agreed to pay the City $100,000.” The Philadelphia Inspector General alleged that William Betz, Jr., Inc. (Betz), JHS and Sons Supply Company (JHS), and UGI HVAC, Inc. (UGI) colluded to create the appearance that JHS, a certified minority vendor, provided equipment and supplies for a $1 million contract UGI signed with the Philadelphia Housing Development Corporation to weatherize houses for low-income residents of Philadelphia. According to the Inspector General, in reality, UGI actually purchased those products from Betz, which paid JHS three percent of the contract proceeds for the use of its name and minority certification. UGI and Betz allegedly generated false invoices to conceal their scheme. Similar investigations and enforcement actions are being brought by local and state Inspector Generals and local and state prosecutors’ offices across the country.
So What Are the Rules for DBE Suppliers?
These case examples beg the question of whether and how a DBE supplier can legitimately participate as a subcontractor on a publicly-funded project. A fundamental requirement of every DBE program[2] is that the DBE perform a “commercially useful function,” meaning, in plain terms, that a DBE must actually perform work before its services can be counted toward the DBE goal for a project. The phrase “commercially useful function” comes from the federal Department of Transportation (DOT) regulations, which define the requirement as follows:
A DBE performs a commercially useful function when it is responsible for execution of the work of the contract and is carrying out its responsibilities by actually performing, managing, and supervising the work involved.
49 C.F.R. § 26.55(c)(1). With respect to materials and supplies used to perform a contract, the DBE must be responsible “for negotiating price, determining quality and quantity, ordering the material, and installing (where applicable) and paying for the material itself.” 49 C.F.R. § 26.55(c)(1). The DOT regulations make clear that a DBE serving as a “pass-through” entity is not sufficient:
A DBE does not perform a commercially useful function if its role is limited to that of an extra participant in a transaction, contract, or project through which funds are passed in order to obtain the appearance of DBE participation.
49 C.F.R. § 26.55(c)(2). While other local and state and federal agencies use different phrases for commercially useful function and vary slightly in defining this requirement, the concept is the same: the DBE cannot just be inserted in the transaction and must participate in more than name only.
The DOT regulations recognize two different ways in which a contractor can receive credit for materials supplied by a DBE. First, a contractor can receive DBE credit for the fee or commission a DBE “broker” receives for arranging the procurement of the supplies, but not for any of the value of the supplies obtained through a DBE broker. A DBE broker is defined by the DOT regulations as a firm that arranges for or expedites transactions, e.g., a firm that purchases and resells to the contractor materials that become a permanent part of the project. A DBE broker may be a facilitator, packager, manufacturer’s representative or other person who arranges or expedites transactions, but does not supply on a regular basis and cannot be a regular dealer. (49 CFR § 26.55(e)(3)). Not many contractors look to engage DBE brokers because of the limitations on the amount of credit the contractor can receive in this situation.
On the other hand, under the DOT regulations, a contractor can receive DBE credit equal to 60% of the value of the supplies it procures from a DBE supplier that qualifies as a “regular dealer.” In order to qualify as a “regular dealer,” a DBE must be an established, regular business that engages, as its principal business and under its own name, in the purchase and sale or lease of products of the same general character as those involved in the contract and for which DBE credit is sought. (49 CFR § 26.55(e)(2)). A DBE “regular dealer” must maintain a store, warehouse, or other establishment where the products are bought, kept in stock, or sold or leased to the public in the usual course of business. It is not necessary for every item the DBE firm supplies be stored in the DBE’s warehouse, however, the place where the DBE firm keeps the supplies should be more than a token location or, as some cases have demonstrated, an empty warehouse. A DBE supplier may be a dealer in bulk items such as petroleum products, steel, cement, gravel and stone, or asphalt without owning or operating a place of business, if the firm owns and operates the distribution equipment for the products.
A DBE supplier performs a commercially useful function if it performs tasks such as sourcing materials/supplies, negotiating price, ensuring that the quality and quantity of materials meet contract requirements, purchasing and making payment for the materials from its own funds, making arrangements for and scheduling the delivery materials, and invoicing. A DBE supplier is not a “regular dealer” and does not perform a commercially useful function if it merely places an order with a manufacturer or other supplier who delivers the supplies directly to the job site, and then merely invoices the customer and collects payment on a “pay when paid” basis.
A DBE supplier’s status is a factual, contract-by-contract determination. Most importantly, as noted above, the fact that the DBE has been “certified” by a local, state, or federal entity does not mean that it will be performing a commercially useful function on any particular project. As prosecutors often point out, certification focuses on the ownership status and control structure, not on the actual performance of the entity.
When analyzing whether it is proper to take credits for a DBE supplier’s performance, it is important to know which DBE regulations govern the project. Unlike the DOT regulations, some state and local regulations do not recognize the distinction between brokers and regular dealers and provide no credit for commissions earned by DBE brokers. Other state and local regulations allow the contractor to take dollar-for-dollar credit for supplies obtained from a DBE “regular dealer.” Even the DOT regulations allow dollar-for-dollar credit for supplies obtained for a project by a DBE if the DBE then installs those materials or if the DBE is the manufacturer.
Regardless of the exact details of the applicable regulations, many of the questions investigators will ask about DBE suppliers are the same. Investigators who are looking for fraudulent, pass-through relationships will ask questions such as:
- Is the DBE supplier engaged in, as its principal business and in its own name, the purchase and sale or lease of the products being supplied?
- Is the DBE an established business that regularly engages in the purchase and sale of the products being supplied?
- Does the DBE supply materials to non-DBE goal projects?
- Does the DBE supply materials to more than one contractor?
- Does the DBE maintain a store, warehouse, or other establishment where products are bought, kept in stock, and sold to the public?
- Whose equipment will be used to deliver the DBE’s supplies to the project site?
Investigators also believe that indicators of sham DBEs include when the DBE firm works for only one contractor, the work is outside of the DBE’s known experience or capability, and the volume of work is beyond the DBE firm’s capacity. For example, in the Azteca case described earlier, federal investigators may have questioned how a single DBE could be in the business of regularly supplying widely disparate projects such as runway projects, restroom projects, and landscaping projects.
What Should Suppliers Do?
To avoid becoming a subject or target of a DBE fraud investigation, suppliers must avoid participating in arrangements where DBE suppliers are serving merely as pass-throughs, doing nothing more than placing an order with the supplier and invoicing the prime or subcontractor when the supplier delivers the materials to the job site. Unfortunately, investigators and prosecutors are often skeptical of the supplier’s claim that it did not know the DBE supplier with whom it was directed to do business by a prime or subcontractor was a sham.
If all of the facts and circumstances suggest that the DBE is doing nothing more than “renting” its name to a project, the investigators and prosecutors can pursue the supplier under a “willful blindness” theory. Willful blindness can be a substitute for proving knowledge when the evidence shows that a defendant intentionally avoided confirming facts or learning the truth. In other words, a defendant is willfully blind when the defendant is deliberately ignorant about matters that would make the person criminally liable. For example, when the supplier bid on a project but was then told by the prime or subcontractor that the supplier would have to lower its price by 3%, or honor prices originally quoted to the contractor, and “sell” its products to a DBE supplier so that the prime or subcontractor could get DBE credits, investigators and prosecutors likely will conclude that the supplier did know or was willfully blind to the fact that the DBE supplier was nothing more than a pass-through.
Similarly, investigators and prosecutors generally reject the supplier’s defense that it believed the DBE was legitimate because it was “certified” as a DBE by the relevant government agency. The law is clear that just because a DBE is “certified,” meaning that it is owned and controlled by a socially and economically disadvantaged individual, does not mean that it is performing a commercially useful function on any given contract. It also may not be a defense for a supplier to claim that they did not know the DBE pass-through arrangement was illegal, because conspiracy, aiding and abetting, and false claim statutes do not necessarily require that a defendant act with the purpose to disobey or disregard a specific law. Rather, it may be sufficient that a defendant knew of or was willfully blind to the objectives of the conspiracy and assisted a prime or subcontractor to claim DBE credits for a transaction in which the DBE was a mere pass-through.
Practically speaking, a supplier cannot function as a quasigovernment agency and conduct an exhaustive investigation of every DBE supplier that wants to become a customer. And, suppliers must consider the business risks associated with refusing to do business with any DBEs, legitimate or not. But what suppliers can do when their regular contractor customers ask them to work with a DBE supplier is to conduct some basic due diligence: ask the prime or subcontractor and/or the DBE what commercially useful function the DBE will be performing. If a supplier does not receive a satisfactory answer to that question, then the supplier should raise its concerns with the prime or subcontractor to ensure that the use of the DBE is in compliance with all of the applicable laws and regulations. If the supplier does not receive such assurances, then the supplier should not participate in the transaction.
If there is no legitimate DBE capable of performing a commercially useful function on a given project, suppliers should consider talking to the regular contractor customers about obtaining a waiver. The DOT’s DBE regulations, and most local and state DBE programs, make clear that DBE participation goals are not to be treated as quotas. A contractor cannot be penalized, or treated as having failed to comply with the DBE regulations, if its DBE participation falls short of the goal, unless the contractor has failed to make a good faith effort to meet the DBE participation goal. The various regulations often provide extensive guidance on what constitutes adequate good faith efforts including, for example, “conducing market research to identify small business contractors and suppliers and soliciting through all reasonable and available means the interest of all certified DBEs that have the capability to perform the work of the contract.” Making and documenting good faith efforts requires a proactive approach early in the contracting process, and suppliers may be able to assist in educating their contractor customers on this issue.
In addition, traditional suppliers should either develop or strengthen their internal DBE compliance programs and work to educate their employees and industry business partners on the perils of participating in pass-through arrangements. This protects not only the supplier, but their valued customers and the DBE, who may not fully appreciate the risks of such relationships, especially in this heightened enforcement environment.
- Some state and local jurisdictions set separate utilization goals for minority-owned business enterprises (MBEs), women-owned business enterprises (WBEs) and other designations, such as local business enterprises (LBEs).
- While we use the federal term DBE to refer to Disadvantaged Business Enterprises, local, state, and federal programs designed to encourage the use of, among others, minority owned, women owned, disabled owned, local business enterprises, and service disabled veteran owned businesses have been the subject of increased scrutiny.
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In spite of FDA’s best efforts, medication errors continue to burden our health care system. These errors can occur for a variety of reasons, ranging from pharmacists incorrectly interpreting the letters or words on a hand-written prescription, to nurses incorrectly interpreting physician instructions for hospitalized patients, and are estimated to cause approximately 7,000 deaths each year in the United States alone. The United States Food and Drug Administration (“FDA”) recently unveiled a new initiative to reduce medication errors by evaluating product names using a Phonetic and Orthographic Computer Analysis (“POCA”). In a May 2014 Draft Guidance, entitled Best Practices in Developing Proprietary Names for Drugs, FDA notes that its intentions are “to develop proprietary names that do not cause or contribute to medication errors or otherwise contribute to the misbranding of the drug.” The Draft Guidance offers certain rules and factors for increasing the safety profile of a proposed name. For example, FDA states that the name should not include product attributes (such as dosage form) because future modifications may create a greater likelihood of errors. The Draft Guidance contains other straightforward rules for avoiding confusion and promoting safe use of pharmaceutical products. For purposes of comparing drug names, FDA’s Draft Guidance attempts to give objective and quantifiable guidance in a field that inherently lends itself to at least some subjectivity. Specifically, the Draft Guidance emphasizes the role of the POCA score in early screening processes and determining what level of scrutiny a proposed name must bear. The POCA system comprises lists of pre-existing pharmaceutical product names (along with other relevant information, e.g., dosage). The database user enters the proposed name in the POCA system and queries the name against drug reference databases through an algorithm that weighs orthographic and phonetic similarities. This query results in a list of the most similar pre-existing names along with the combined POCA score for each result. The higher the POCA score for an entry, the more similar the proposed name is to that pre-existing name, and the less likely that FDA will accept the proposed name. The POCA score attempts to account for all aspects of a written prescription. Thus, in addition to the resemblance of syllables and letters, the score will account for the dose that must be written on the prescription, as well as any suffix such as “ER” or product concentration that is necessarily part of the prescription or physician instructions. In the Draft Guidance, FDA proposes weighing the combined score (generally, an average of the orthographic and phonetic scores) and classifying the results into one of three tiers—each with a different framework for analyzing the potential safety of the proposed name. Then, within each framework, FDA assigns more subjective criteria along with a sense of “burden” or “weight” that the proposed name must overcome. These frameworks are summarized in the chart below: |
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Critics and commentators of the Draft Guidance generally applaud the document as a first step in achieving more predictable results for FDA approval. To be sure, there are still many open questions about the weight and meaning of the POCA score in the ultimate approval process. What is clear, however, is that any proprietary name development process should incorporate a POCA score analysis and consider the potential risks identified in FDA’s Draft Guidance. © TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result.
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A common dispute between carriers and insureds involves the scope of information that may be considered when determining whether a duty to defend exists. Under California law, an insurer’s duty to defend is determined by facts – both facts alleged in the underlying complaint and facts known or available to the insurer from any source. It is no surprise that the insured and its counsel may supply facts outside of the complaint when seeking coverage. This leaves the insurer to determine whether the information it receives, be it facts, argument or speculation, should bear on the duty to defend analysis. As explained below, California case law demonstrates that the duty to defend cannot be based on unfounded attempts to manufacture coverage by “connecting the dots” between allegations and coverage. Rather, the duty to defend should be determined based only on supported facts.
The Duty to Defend May Be Triggered by Facts Outside of the Tendered Complaint
In the most basic analysis, an insurer’s duty to defend is triggered when the facts alleged in the complaint create a potential for coverage. See Scottsdale Ins. Co. v. MV Transp., 36 Cal. 4th 643, 654 (2005). Although an insurer must consider extrinsic facts in evaluating the duty to defend, this does not open the floodgates for coverage – an insurer does not need to accept speculation regarding the allegations in the underlying action as facts. As the court in Gunderson v. Fire Insurance Exchange, 37 Cal. App. 4th 1106, 1116 (1995) explained, “[a]n insured may not trigger the duty to defend by speculating about extraneous ‘facts’ regarding potential liability or ways in which the third party claimant might amend its complaint at some future date.” Likewise, in the case of Hurley Construction Co. v. State Farm Fire and Casualty Co., 10 Cal. App. 4th 533, 538 (1992), the court found that speculation from an insured’s counsel regarding how a claimant might amend its complaint could not trigger coverage. See also Friedman Prof. Mgmt. Co., Inc. v. Norcal Mut. Ins. Co., 120 Cal. App. 4th 17, 34–35 (2004) (“[T]he universe of facts bearing on whether a claim is potentially covered . . . does not include made up facts, just because those facts might naturally be supposed to exist along with the known facts.”) (emphasis original).
Against this backdrop – where the duty to defend may be triggered by facts not stated in the complaint, but where speculation regarding “facts” is not enough – the insurer must weigh what information may bear on coverage. This can be an important question, as “[a]n insurance company can [] get into trouble by refusing to consider facts it knows, but which are extrinsic to the complaint and which show . . . a potential for coverage.” Griffin Dewatering Corp. v. Northern Ins. Co. of New York, 176 Cal. App. 4th 172, 197-199 (2009).
The Perils of Disputing Facts that Trigger Coverage
Amato v. Mercury Casualty Co., 18 Cal. App. 4th 1784 (1993) demonstrates the challenges that come into play when considering extrinsic facts. In Amato, the insured was involved in a car accident while driving with his mother-in-law, and the mother-in-law sued the insured. The policy precluded coverage for claims by people who resided with the insured. The insured, however, claimed that he did not live with his mother-in-law. As part of the insurer’s investigation, the insurer called the mother-in-law’s house and was informed the insured did not live at the residence. The insurer did not believe the insured and denied coverage.
In finding that the insurer was incorrect in its denial, the court noted that the insurance company “possessed information which, if true, indicated that [he] was residing at locations other than the home of” his mother-in-law at the time of the accident. Id. at 1789. In addition to the phone call in which the insurer was advised the insured did not live at the mother-in-law’s residence, the Amato court also noted that, within a week of the accident, the insured had filed a change of address notice with the DMV, indicating the insured had moved from the mother-in-law’s home, and found that this information was available to the insurer at the time of the declination of coverage.
Even though at trial, the jury had found that the insured lived with his mother-in-law at the time of the accident – i.e., that the insurer’s assessment of the true facts was correct – the Amato court nonetheless found the insurer liable for failing to acknowledge the duty to defend because, at the time of the coverage decision, the insurer had facts available to it that created a potential that the exclusion did not apply. While one might question if Amato was correctly decided, the lesson for insurers that can be taken from Amato is that the duty to defend will be determined by the “facts” – and they must be “facts” – available to the insurer at the time.
The Importance of Supported Facts over Speculation of the Insured or Counsel
But what if the insurer in Amato did not have facts available showing that the insured did not live with his mother-in-law, but instead had only statements from the insured’s counsel that the insured had moved? Could this alone trigger the duty to defend? California courts addressing this situation say “no” – an attempt by counsel or the insured to “connect the dots” between facts at issue in the underlying case and coverage cannot, by itself, trigger the duty to defend. As discussed below, however, it can sometimes be a challenge to discern between uncorroborated argument and supported facts.
In Staff Pro, Inc. v. National Union Fire Insurance Co., 2006 Cal. App. Unpub. LEXIS 5919, at *7 (July 5, 2006), the insurer denied coverage on the grounds that the underlying complaint did not allege any sort of covered advertising injury. In response to the denial, counsel for the insureds argued that the claimant planned to use arguments regarding the insureds’ website advertising to prove its case against the insureds, so that the action involved covered advertising injury. The insurer asked for additional information supporting this argument, including deposition testimony. Counsel for the insureds failed to provide the testimony for months and, when he did, the insurer determined that the neither the insureds’ website nor the deposition testimony supported the argument that the claimant intended to assert any theories based on the insureds’ advertising. Id. at *9-11.
In its analysis, the Staff Pro court agreed that the underlying complaint, the insureds’ website and the deposition testimony did not reveal a potential for coverage. The court then explained that, according to the insureds, their counsel’s representations “‘connected the dots’ between [the claimant’s] predatory pricing claim and [the insured company’s] advertising.” Id. at *21. Relying on Gunderson and Hurley, the court rejected the argument that counsel’s statements regarding the allegations in the underlying action were “facts” that could trigger the duty to defend. Rather, “[counsel’s] ‘explanation’ was merely his characterization or analysis of [the claimant’s] arguments and theories and his speculation as to how [the claimant] might try to prove its claims at trial. But there was no evidence or facts to support [counsel’s] explanation.” Id. at *23-24 (emphasis original). Addressing Amato, the court explained that “[h]ere, [the insureds] did not provide [the insurer] with ‘facts’ which, if true, would establish a potential for coverage; rather, they provided respondent with their counsel’s uncorroborated analysis of the third party’s claims. An insured’s counsel’s ‘self-serving legal opinion’ about potentially covered claims ‘hardly constitutes a ‘fact’ known to [the insurer] which, under Gray, gives rise to a . . . duty to defend.’” Id. at*25-26 (quoting Nat’l Union Fire Ins. Co. v. Siliconix Inc., 726 F. Supp. 264, 272 (N.D. Cal. 1989)).
Tower Insurance Co. v. Capurro Enterprises, Inc., 2011 U.S. Dist. LEXIS 144436, at *16-18 (N.D. Cal. Dec. 15, 2011) arguably came to a contrary conclusion in dicta. In Tower, the insured was sued by a former franchisor for, among other things, improperly using the franchisor’s protected trademarks. Id. at *4-5. In tendering the action to the insurer, counsel for the insured explained that the insured was accused of using the franchisor’s advertising ideas, copyright, trade dress and slogans in advertising, so that the CGL policy at issue provided coverage. Id. at *8. Counsel also explained that it was possible that certain advertisements may have continued to be broadcasted by the insured using allegedly infringing material. Id. The insurer denied coverage, arguing that the complaint alleged no facts suggesting that the insured infringed any trade dress or slogans in any advertisement. Id. at *9. In response, counsel for the insured explained that the insured was unable to remove “wrapping” from its company van, which included protected slogans and advertising, so the insured arguably continued to advertise using infringing material. Id. at *17. The insurer maintained its denial and, apparently, did not ask for images of the van until discovery in the coverage action. Id. at *18.
In analyzing the duty to defend, the court first found that, contrary to the insurer’s analysis, the underlying complaint included allegations that may trigger coverage, although it was a close issue. Id. at *16. Since it found the allegations in the complaint itself triggered a duty to defend, the Tower court did not need to address whether the statements of counsel regarding the “wrapping” on the insured’s company van potentially gave rise to coverage. Nevertheless, the Tower court went on to suggest that the statements of the insured’s counsel could potentially give rise to coverage. Id. at *17-18. In making these comments, the court expressly noted that the insurer failed to seek corroborating evidence regarding the “wrapping” until discovery in the coverage action and found that, at the outset of the underlying action, the insurer was on notice of facts that could trigger coverage. Id. at *18. Thus, it appears that the Tower court’s concern was that the insurer did not attempt to corroborate counsel’s statement regarding the “wrapping” of the vehicle at the time it was making its coverage determination.
Connecting the Dots vs. Corroborated Facts
There is a line between facts extrinsic to a tendered complaint that may trigger coverage and mere speculation from an insured or its counsel. That line may not always be clear, but, as demonstrated in Staff Pro, California courts have found that statements or conjecture from counsel or the insured, uncorroborated by evidence, will not trigger the duty to defend. Rather, the insurer has the right to demand evidence supporting the statements from the insured or its counsel and, in the absence of evidence corroborating such arguments, efforts by the insured or its counsel to “connect the dots” are just speculation which cannot create a duty to defend.
An insurer, of course, cannot dismiss or ignore information that might impact the coverage evaluation. As demonstrated by Tower and Amato, the insurer must consider “facts” provided by the insured or its counsel and request corroborating evidence. If supporting evidence is not forthcoming or does not actually support the arguments advanced by the insured or its counsel, as in Staff Pro, the insurer may properly decline coverage. If, however, the insurer is provided evidence suggesting the arguments of counsel or the insured are actually rooted in fact, then a duty to defend may be triggered.
© TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result.
On its face, Form 10-Q does not require the inclusion of risk factors unless there have been “material changes” from the risk factors contained in the previous Form 10-K. Yet a lot of respected companies, including Apple, Procter & Gamble and United Technologies, choose to include risk factors in every Form 10-Q. Is it a good practice?
The basic structure of the SEC’s integrated disclosure system contemplates that a company’s ongoing disclosure package includes its most recent Form 10-K and all subsequently “filed” Form 10-Qs, Form 8-Ks and proxy statements. If the disclosure is contained in one of those filings, the market is on notice, and the disclosure should be effective for subsequent statements. From a traditional Rule 10b-5 litigation perspective, repeating risk factors in a Form 10-Q adds no substantive value, although it may call less attention to minor changes made from filing to filing and may be more comforting to a judge.
But not all aspects of securities law are that buttoned-down. In particular, the so called “safe harbor for forward-looking statements” has its own set of requirements. One of the requirements is that written forward-looking statements be “accompanied” by a “meaningful cautionary statement.” There are a few cases that have held that the requirement to be “accompanied” is satisfied by a cross-reference to some other document, but this concept has not been widely accepted, and we are concerned that it is inconsistent with the plain meaning of the word “accompany” as well as the overall structure of the safe harbor. As a result, we believe that the conservative course is to read the “accompanied” requirement as requiring inclusion of the meaningful cautionary statement in the same document as the forward-looking statements.
Form 10-Qs are required to contain forward-looking statements. For example, the liquidity disclosure required by Regulation S-K, Item 303 should discuss how a company expects to meet its future liquidity needs, an inherently forward-looking disclosure. Other required disclosures, including disclosure of “known trends and uncertainties,” also are likely to be forward-looking. And, the definition of what constitutes a forward-looking statement is quite broad, so statements that typically would not be perceived as “forward-looking” are eligible for the protection of the safe harbor, including, for example, statements regarding goals and objectives.
Risk factors and the meaningful cautionary statement needed to perfect the safe harbor serve different purposes and must fulfill different requirements. But they are similar. Risk factors are described in Regulation S-K, Item 503(c) as the “most significant factors that make the offering speculative or risky.” The language required for the safe harbor is described as a “meaningful cautionary statement identifying important factors that could cause actual results to differ materially from those in the forward looking statement.” The leading cases make it clear that the cautionary language is not required to align perfectly with the ultimate cause of the problem, but certainly greater specificity and broader coverage make it easier for a judge to conclude that language is “meaningful.” In theory, the required cautionary language is in most instances a subset of well-crafted risk factors.
As a result, risk factors contained in a Form 10-Q, with either a proper introduction or an appropriate cross-reference, can substitute for, or at least supplement, the required meaningful cautionary statement. And, given that they almost always are more robust, risk factors may be more protective. Moreover, their presence in a document could favorably factor into the availability of the bespeaks caution doctrine and other traditional defenses that remain viable today.
There also may be some benefit for oral forward-looking statements, such as those in earnings calls. For oral forward-looking statements, in order to get the benefit of the safe harbor, a company must refer the listener to a “readily available written document” that includes a meaningful cautionary statement. The gold standard for readily available documents is an SEC-filed document, so virtually all companies refer listeners to an SEC filing. Note that the referral should be to a specific SEC-filed document, not to “risk factors contained in our SEC filings.” A referral to a recent Form 10-Q containing an updated set of risk factors is much easier than a referral to, say, “our 2012 Form 10-K, as updated by our 2013 first quarter Form 10-Q and . . . all as filed with the SEC and available on our website.” (Please remember that the materials on a company’s website, including in all likelihood audio and video files, are written statements for purposes of the safe harbor, and the company must meet the “accompanied” requirement in order to perfect the safe harbor.)
As a result, while a robust meaningful cautionary statement may accomplish what a company needs, we believe there are solid benefits available from including risk factors in each Form 10-Q, even if not required, and believe that companies would be well-advised to consider that approach.
© TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result. Follow Troutman Sanders on Twitter.
In prior advisories, we have discussed the new withholding tax law commonly known as “FATCA” (standing for “Foreign Account Tax Compliance Act”). (See “FATCA’s July 1 Effective Date Has Arrived; Last-Minute Guidance Has Been Issued” and “Last Substantial Package of FATCA Regulations Released; Deadlines Approaching”.) To help implement FATCA, the Internal Revenue Service (IRS) issued new, updated withholding certificates (i.e., W-9s and W-8s) so that payees of U.S. source income can provide applicable FATCA information to payors/withholding agents. This advisory walks through one of these forms, the Form W-8BEN-E (Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities)), and its instructions.
Background. U.S. federal withholding taxes may apply to U.S. source payments made to foreign payees that consist of items such as interest, dividends, rents, royalties, premiums, annuities, compensation for services, substitute payments in a securities lending transaction, or other fixed or determinable annual or periodical gains, profits, or income.
The Form W-8BEN-E is used by foreign entities to document their status for purposes of the withholding tax laws under chapters 3 and 4 of the Internal Revenue Code (Code). FATCA is under chapter 4 of the Code. Foreign entities and individuals used to be able to use the same Form W-8BEN, but the new W-8BEN (revised as of February 2014) is just for individuals and entities are now supposed to use the W-8BEN-E.
A withholding agent that receives a properly executed Form W-8BEN-E from a payee may rely on the form to avoid having to withhold the 30% FATCA withholding tax.
Knowing Your FATCA Status. Part I, Line 5 of the Form W-8BEN-E asks the payee to check one of 31 boxes to identify its status. The box checked also determines which parts of the rest of the form the foreign entity needs to fill out. The 15-page instructions to the form explain what some of these choices are, but not all of them. While the actual definitions for these terms, provided in the FATCA regulations (including temporary regulations), are lengthy and complicated, we have provided the 31 choices below with a short description.
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Nonparticipating FFI (including a limited FFI or an FFI related to a Reporting IGA FFI other than a registered deemed-compliant FFI or participating FFI). This is an FFI (i.e., a foreign financial institution, which includes certain types of depository institutions, custodial institutions, investment entities, and insurance companies) that is not exempt from FATCA and has not taken the necessary steps to comply with FATCA.
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Participating FFI. This is an FFI that has agreed to comply with the terms of an FFI agreement, pursuant to which it agrees to diligence its accounts and disclose certain information about U.S. accountholders and its accounts to the IRS.
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Reporting Model 1 FFI. In order to assist FATCA implementation, many jurisdictions have entered into intergovernmental agreements (IGAs) with the U.S. to assist in the exchange of information and applicable reporting. These IGAs have their own diligence and reporting requirements that may differ from those in the U.S. regulations, so foreign entities must check to see if their jurisdiction has an IGA with the U.S. and read their applicable IGA. There are two “models” of an IGA that are used—Model 1 and Model 2. An FFI in a Model 1 IGA jurisdiction that performs account reporting to the jurisdiction’s government is a reporting Model 1 FFI. Click here to see the jurisdictions that have entered into a Model 1 IGA.
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Reporting Model 2 FFI. An FFI in a Model 2 IGA jurisdiction that has entered into an FFI agreement is a participating FFI, but may be referred to as a reporting Model 2 FFI. Click here to see the jurisdictions that have entered into a Model 2 IGA.
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Registered deemed-compliant FFI (other than a reporting Model 1 FFI or sponsored FFI that has not obtained a GIIN). Certain FFIs are deemed to comply with the FATCA regulations without the need to enter into an FFI agreement with the IRS. However, certain deemed-compliant FFIs are required to register with the IRS and obtain a Global Intermediary Identification Number (GIIN). These FFIs are registered deemed-compliant FFIs. FFIs eligible for this category include certain (a) “local” FFIs that are regulated in their jurisdiction and generally do not do business outside their jurisdiction, (b) FFIs that are members of a participating FFI group that move their accounts to the participating members of the group, (c) regulated investment vehicles whose interests are held by FATCA-compliant or FATCA-exempt investors, (d) regulated investment entities where interests issued by the fund are redeemed/transferred by the fund rather than on a secondary market and other interests are sold only through distributors that are FATCA-compliant or FATCA-exempt, (e) credit card issuers, and (f) investment entities or controlled foreign corporations with a sponsoring entity (i.e., an entity that agrees to act on and perform the applicable FATCA diligence, withholding, and reporting on behalf of the FFI, and has registered with the IRS).
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Sponsored FFI that has not obtained a GIIN. This is an investment entity, controlled foreign corporation, or closely held investment vehicle with a sponsoring entity (i.e., an entity that agrees to act on and perform the applicable FATCA diligence, withholding, and reporting on behalf of the FFI, and has registered with the IRS) that has not obtained its GIIN from the IRS.
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Certified deemed-compliant nonregistering local bank. A certified deemed-compliant FFI is not required to register with the IRS (this applies to the other certified deemed-compliant entities below as well). An eligible nonregistering local bank is a bank, or a credit union operated without profit, that does not have a place of business outside its jurisdiction, does not solicit customers outside its jurisdiction, and does not have more than $175 million in assets (and its expanded affiliated group does not have more than $500 million in total assets). Each member of the expanded affiliated group must be in the same country.
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Certified deemed-compliant FFI with only low-value accounts. This cannot be an investment entity. This FFI cannot have accounts with a balance or value in excess of $50,000, and cannot have more than $50 million in assets on its balance sheet as of the end of its most recent accounting year.
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Certified deemed-compliant sponsored, closely held investment vehicle. This type of FFI cannot be a qualified intermediary, withholding foreign partnership or withholding foreign trust, and it must be an FFI solely because it is an investment entity. It must have a contractual arrangement with a sponsoring entity that is a participating FFI, reporting Model 1 FFI, or U.S. financial institution, twenty or fewer individuals must own all of the FFI’s debt and equity interests, and the sponsoring entity needs to have registered with the IRS and agreed to perform the applicable diligence, withholding, verification, and reporting for the FFI.
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Certified deemed-compliant limited life debt investment entity. This is an FFI in existence as of Jan. 17, 2013, that has issued one or more classes of debt or equity interests to investors pursuant to a trust indenture or similar agreement on or before Jan. 17, 2013. The trust indenture or similar agreement must require the FFI to pay to substantial investors, on set dates, the amounts such investors are entitled to receive from the FFI, and the payments must be through a clearing organization/custodial institution/transfer agent that is a participating FFI, reporting Model 1 FFI, or U.S. financial institution. This type of FFI is formed for the purpose of acquiring specific types of debt and holding those assets subject to reinvestment only under prescribed circumstances to maturity.
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Certified deemed-compliant investment advisors and investment managers. This FFI is a financial institution solely because it is an investment entity but it does not maintain financial accounts.
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Owner-documented FFI. This entity is an FFI solely because it is an investment entity, it cannot be in an expanded affiliated group with any non-investment entity FFI, and it cannot maintain accounts for nonparticipating FFIs. It may only receive payments from and hold accounts with a designated withholding agent, which is a U.S. financial institution, participating FFI, or reporting Model 1 FFI that agrees to undertake certain additional due diligence and reporting obligations.
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Restricted distributor. This type of distributor holds debt or equity interests in a restricted fund as a nominee. The distributor must provide investment services to at least 30 unrelated customers, less than half of its customers can be related to each other, it must perform AML (i.e., anti-money laundering or similar requirements) due diligence procedures under its country’s laws, it must operate solely in its country, its affiliates must be in the same country, it cannot solicit customers or account holders outside its country, and it cannot have more than $175 million in assets under management and cannot have more than $7 million in revenue for its most recent accounting year (and its group cannot have more than $500 million in assets or more than $20 million in revenue). The distributor cannot distribute securities to specified U.S. persons, passive NFFEs that have one or more substantial U.S. owners, and nonparticipating FFIs.
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Nonreporting IGA FFI (including an FFI treated as a registered deemed-compliant FFI under an applicable Model 2 IGA). An FFI that is identified as a nonreporting financial institution pursuant to a Model 1 IGA or Model 2 IGA that is not a registered deemed-compliant FFI, and an FFI that is in a Model 1 or Model 2 IGA jurisdiction that meets the requirements for certified deemed-compliant FFI status.
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Foreign government, government of a U.S. possession, or foreign central bank of issue. A foreign central bank of issue is an institution that is by law or government sanction the principal authority, other than the government, issuing currency. It may be an instrumentality that is separate from a foreign government, whether or not owned in whole or in part by a foreign government.
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International organization. This is a public international organization entitled to enjoy privileges, exemptions, and immunities as an international organization under the International Organizations Immunities Act. The term also includes any intergovernmental or supranational organization that is comprised primarily of foreign governments, that is recognized as an intergovernmental or supranational organization under a similar foreign law or that has in effect a headquarters agreement with a foreign government, and whose income does not inure to the benefit of private persons.
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Exempt retirement plans. These are retirement plans that fall into one of 6 categories: (1) funds established in a country with which the U.S. has an income tax treaty where the fund is entitled to benefits under such treaty, and are operated to administer/provide pension or retirement benefits, (2) funds to provide retirement, disability, or death benefits to employees, provided that the fund does not have a beneficiary with a right to more than 5% of the fund’s assets, is subject to government regulation and provides annual information reporting, receives at least 50% of its contributions from retirement and pension accounts described in an applicable Model 1 or Model 2 IGA, distributions or withdrawals from the fund are allowed only upon the occurrence of specified events, and contributions by employees to the fund are capped, (3) funds to provide retirement, disability, or death benefits to employees, provided that the fund has fewer than 50 participants, the fund is sponsored by an employer that is not an investment entity or passive NFFE, contributions to the fund are limited, participants that are not residents of the fund’s country are not entitled to more than 20% of the fund’s assets, and the fund is subject to government regulation and provides annual information reporting, (4) pension plan funds that would meet the requirements of Code section 401(a), other than the requirement that the plan be funded by a U.S. trust, (5) funds established exclusively to earn income for retirement funds described in (1) through (5) or in an applicable Model 1 or Model 2 IGA, and (6) pension funds of an exempt beneficial owner (i.e., foreign governments, international organizations, foreign central banks of issue, and governments of U.S. territories).
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Entity wholly owned by exempt beneficial owners. This entity is an FFI solely because it is an investment entity, where each equity interest holder is an exempt beneficial owner (i.e., foreign government, international organization, foreign central bank of issue, government of U.S. territory, exempt retirement fund, and entity owned by exempt beneficial owners, or an exempt beneficial owner described in an applicable Model 1 or Model 2 IGA), and each debt interest holder is either a depository institution or an exempt beneficial owner.
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Territory financial institution. This is a financial institution that is incorporated or organized under the laws of any U.S. territory, not including a territory entity that is an investment entity but that is not a depository institution, custodial institution, or specified insurance company.
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Nonfinancial group entity. This is a foreign entity that is a member of a nonfinancial group if it is also a holding company, treasury center, or captive finance company with certain enumerated functions, and does not hold itself out as a private equity fund, venture capital fund, leveraged buyout fund, or any similar investment vehicle. Its expanded affiliated group is a nonfinancial group if for the last three years no more than 25% of its gross income is passive, no more than 5% of the group’s gross income is derived by FFIs, and no more than 25% of the value of the group’s assets are passive assets. Any FFIs in the group must be a participating FFI or deemed-compliant FFI.
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Excepted nonfinancial start-up company. A foreign entity that is investing capital in assets with the intent to operate a new business or line of business other than that of a financial institution or passive NFFE for 2 years from its initial organization or from the date the new line of business is approved, provided that the entity qualified as an active NFFE for the 2 years preceding the date of approval. This category does not include investment funds.
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Excepted nonfinancial entity in liquidation or bankruptcy. A foreign entity that was not a financial institution or passive NFFE at any time during the past 5 years and that is in the process of liquidating its assets or reorganizing with the intent to continue or recommence operations as a nonfinancial entity.
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501(c) organization. Various tax-exempt organizations under the Code.
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Nonprofit organization. A foreign entity that is established and maintained in its country of residence exclusively for religious, charitable, scientific, artistic, cultural or educational purposes if it is tax-exempt in its country, it has no shareholders or members who have a proprietary or beneficial interest in its income or assets, the distribution of its income and assets are limited to maintain the entity’s charitable activities, and upon its liquidation its assets are distributed to a foreign government or another nonprofit organization.
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Publicly traded NFFE or NFFE affiliate of a publicly traded corporation. An NFFE is a non-financial foreign entity. An NFFE is publicly traded if its stock is regularly traded on one or more established securities markets for the calendar year.
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Excepted territory NFFE. This is a territory NFFE that is directly or indirectly wholly owned by one or more bona fide residents of the U.S. territory under the laws of which the entity is organized.
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Active NFFE. This is an NFFE where less than 50% of its gross income for the preceding taxable year is passive and less than 50% of the weighted average percentage of its assets (tested quarterly) produce or are held for the production of passive income. Passive income, with certain exceptions, consists of, e.g., dividends, interest, rents and royalties, annuities, certain gains from sales of passive assets and hedging transactions, certain foreign currency gains, net income from notional principal contracts, amounts received under cash value insurance contracts, and amounts earned by an insurance company in connection with its reserves for insurance and annuity contracts.
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Passive NFFE. This is an NFFE that is not an excepted NFFE. An excepted NFFE means a payee that is a qualified intermediary, withholding foreign partnership or withholding foreign trust. The term excepted NFFE also means a publicly traded NFFE or affiliate (see 25 above), excepted territory NFFE (see 26 above), or active NFFE (see 27 above). A passive NFFE must identify and provide the name, address, and taxpayer identification number of each of its substantial U.S. owners in Part XXX of the Form W-8BEN-E.
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Excepted inter-affiliate FFI. This is an FFI that is a member of a participating FFI group if the FFI does not maintain financial accounts (other than for the members in its group), does not hold an account with or receive payments from any withholding agent other than a member of its expanded affiliated group, does not make withholdable payments to any person other than to members of its expanded affiliated group that are not limited FFIs or limited branches, and has not agreed to report or otherwise act as an agent for FATCA purposes on behalf of any financial institution, including a member of its expanded affiliated group.
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Direct reporting NFFE. This is an NFFE that elects to report information about its direct or indirect substantial U.S. owners to the IRS. It must register with the IRS to obtain a GIIN, get certifications from its substantial U.S. owners, and report to the IRS each year about each of its substantial U.S. owners, payments made to each substantial U.S. owner, and the value of each substantial U.S. owner’s equity interest in the NFFE.
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Sponsored direct reporting NFFE. This is a direct reporting NFFE where another entity, other than a nonparticipating FFI, has agreed to act as its sponsoring entity (i.e., it will register with the IRS and agrees to perform, on behalf of the NFFE, all due diligence, reporting, and other requirements that the NFFE would have been required to perform as a direct reporting NFFE).
The IRS continues to update and modify the various forms and their instructions, including a recent update for users of the W-8BEN-E. The above constitutes a brief and general summary of the listed terms to assist readers in determining which part of Part I, Line 5 of the Form W-8BEN-E may be most applicable to them. You are encouraged to read the full definitions to determine how to fill out the form in accordance with your particular circumstances.
Click here for more information on FATCA.
© TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result. Follow Troutman Sanders on Twitter.
Although employees are subject to income and employment taxes on amounts paid to them as compensation, employees are not taxed on amounts paid to them as reimbursement of substantiated business expenses, including for meals and other incidental expenses while working away from home. 1 Employers can reimburse employees based upon documents substantiating the travel and related expenses. Alternatively, to simplify record-keeping for employers and employees, employers can provide, in certain circumstances, employees with a per diem allowance for lodging, meals, and incidental expenses incurred when traveling in an amount that does not exceed guidance approved annually by the Internal Revenue Service. Such a per diem allowance, commonly referred to as a qualified per diem plan, is deemed to satisfy the expenditure substantiation requirement without the need to maintain detailed records and receipts for expenditures. Nevertheless, the employee must still maintain a log recording the days worked away from home, the location where the services are performed, and the business purposes of the travel, and provide the log to the employer.
Many entities that utilize the services of contingent workers for specific or limited duration projects utilize the services of staffing firms and we will refer to them herein as customers of staffing firms. If a per diem plan is not a qualified per diem plan, the employee will be subject to various taxes and reporting obligations on the per diem payments, and could also lose his or her deduction for the expenses at issue. However, it is not just the employee who is at risk for participating in a non-qualifying per diem plan. The employer and potentially a customer using a staffing firm may be penalized for not properly withholding and paying employment related taxes on the disqualified per diem amounts, and for not properly reporting wages on a W-2. Such an employer and potentially a customer using a staffing firm may not be able to take a business expense deduction for the amounts at issue, and may not be able to avail itself of a compensation deduction on the re-characterized amounts. 2
Merely interposing a per diem plan does not in and of itself make such payments tax-free to workers. Since a disqualified per diem plan affects the employee, the employer and potentially the customer, abuses and missteps should be avoided and the following requirements must be met:
► Per Diem Allowances Are Not Salary Alternatives. 3 Per diem policies may not be constructed to provide an alternative label for what is salary. Employees may not be offered the choice to accept a higher salary with no per diem or a lower salary with per diem so that the total compensation paid under either approach is substantially the same. Thus, the split of wages versus per diem allowances should not be at anyone’s subjective discretion, similar jobs should be provided similar allowances, and the salary component should be comparable to the salary offered to local employees or other employees who are not eligible for per diem.
► Business Connection Requirement. Per diem allowances may only be used for qualifying traveling expenses. Qualifying traveling expenses are “ordinary and necessary” business expenses incurred, or that are reasonably expected to be incurred, by an employee for lodging, meal, and incidental expenses (or for meal and incidental expenses) for travel away from home in connection with the performance of services as an employee. Also, the per diem allowance must be reasonably calculated not to be greater than the amount of the expenses (or the expected expenses) that would otherwise be allowable deductions if incurred by the employee. 4
► Substantiate that the Employee is Away from His/Her “Tax Home”. Per diem allowances are only nontaxable as long as the employee is traveling sufficiently far away from his/her “tax home.” The employee should establish that he/she in fact has a tax home and the location of the tax home in order to be eligible for business expense reimbursement. Such substantiation may include certification of the address used on the employee’s most recent tax return, the address on the employee’s driver’s license, the address used by the employee on the job application, or a copy of the employee’s lease of his “tax home” residence.Employers should be wary where the address on the employment application is inconsistent with the tax home or where the employee’s prior work history does not indicate employment at the tax home.
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- A customer using a staffing firm should make certain that the staffing firm is not arbitrarily allocating worker compensation between salary and per diem where the customer is paying the staffing firm a fixed daily or hourly amount based upon the applicable job classification irrespective of the distance between the work location and the employee’s principal residence.
► Does the Employee have a Tax Home? It is possible for an employee not to have a tax home. If an employee habitually obtains temporary work assignments in different locations, such employee may not have a tax home. The result of not having a tax home is that an employee will not be considered to be working away from home and will not be eligible for the favorable tax treatment given to per diem arrangements. Employers should review the employee’s prior work history to determine that the employee had sufficient work in the locale of his/her tax home to establish it as a regular or principal place of business. If the employee has no regular or principal place of business, that employee’s “tax home” will usually be his/her residence, assuming a regular place of residence is maintained in a real and substantial sense. An employer should review the employee’s economic and social ties to the area, including the degree of historical business activity at the claimed tax home, the extent of the employee’s duplicated living costs (e.g., rent, utilities, etc.) and other evidence of ties to the community (e.g., family members, and the extent the employee’s possessions are stored at the alleged “tax home”).
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- A customer using a staffing firm should make certain that the staffing firm has adequate policies and procedures in place to determine the tax home of any worker receiving per diem payments or accountable expense reimbursements.
► Assignments Need to be Temporary. 5 Expenses relating to job assignments that are treated (for purposes of these rules) as lasting more than one year are not eligible for tax exemption under the per diem tax rules. If employment at a work location is realistically expected to last (and does in fact last) for one year or less, the employment is generally treated as temporary. Otherwise, it is generally treated as not temporary. To prevent unanticipated tax consequences, the employer should determine the temporary or long-term nature of the assignment before assigning an employee to a project that involves long-term travel. If, at the start of an assignment, the assignment is realistically expected to last one year or less, but later the employment is realistically expected to exceed one year, the employment is treated as temporary until the date that the expectation changes, and as not temporary after that date. Also, if at the start of an assignment at one location the assignment is realistically expected to last less than one year (e.g., ten months) and, at the end of the tenth month, the employee is assigned to a subsequent assignment at the same location that is expected to last six months, the assignments may be viewed together and neither may be considered to be temporary. This is because the one-year rule requires the employer to look at the total time spent at the temporary location. The employment must also not be indefinite and the term of the assignment should be documented.
Staffing firms and customers using staffing firms should also take note of prior or subsequent assignments the employee might have had, or may later have, in evaluating whether per diem is appropriate.
-
- A customer using a staffing firm should advise the firm at retention for a particular position of the expected time duration or whether the duration is indeterminate. The customer should also promptly advise the staffing firm of any change in the project duration expectations.
► Breaks in Assignments do not Always Restart the Clock. Employers need to make sure that any breaks in time between jobs at the same work location are respected and are not viewed as a “work-around” for the one-year rule discussed above. The Internal Revenue Service has issued guidance providing that breaks of three weeks or less may not be sufficient, but that breaks of seven months or more may be sufficient. 6 The employee’s prior work history should be scrutinized to determine the location of the employee’s last employment.
-
- A customer using a staffing firm should monitor that contingent workers are not switching from one staffing firm to another on an annual basis merely to disguise the fact that the project duration will exceed one year or the possibility that the worker’s tax home will have changed to the employer’s work location.
► Certain Record Keeping Required for Per Diem Plans. Although the need to substantiate expenditures and retain receipts is alleviated if the per diem reimbursement is paid pursuant to a qualified per diem plan, the employee must still maintain a written record of the time, place, and business purpose of the expense. For all other expense reimbursement plans, employees must substantiate their expenses within a reasonable time (ideally within 60 days after the expense is paid or incurred). Since the employee must provide the employer with copies of such records, staffing firms should institute a procedure to require that such information be provided on a regular basis.
► Limited Repayment Requirement for Certain Per Diem Plans. The general rule for business expense reimbursement plans is that employees need to repay (within a reasonable time, ideally within 120 days after the expenses are paid or incurred) any reimbursement in excess of the substantiated amount. If the plan is a qualified per diem plan, i.e., it meets all of the above requirements, the employee does not have to substantiate the amount expended and therefore would not have to repay the employer if the per diem reimbursement exceeds the employee’s actual expenses. If the plan meets all of the above requirements except that the per diem rate exceeds the applicable federal per diem rate, the employee will also not be obligated to return the excess of the reimbursement over the actual expenditure; however, such excess will be taxable income to the employee. If, on the other hand, a per diem payment relates to days of travel with respect to which the employee cannot verify the time, place, and business purpose of the expense, the employee must be obligated to repay to the employer within a reasonable time the per diem paid for such unverified days.
► Anti-Abuse Rules Apply: Even if the technical requirements for per diem policies appear satisfied, if an expense reimbursement arrangement evidences a pattern of abuse, all payments under the arrangement will be disqualified (and therefore treated as normal wages, subject to all applicable compensation tax rules). Employers should therefore be careful and should continually monitor how their per diem policies are implemented, the types of jobs they apply to, and the types of employees receiving per diem.
1 To see the rules briefly summarized in this document, see §§ 62, 162, and 274 of the U.S. Internal Revenue Code of 1986, as amended, U.S. Treasury Regulations §§ 1.62-2(c), 1.274-5, and 1.274-5T, Revenue Procedure 2011-47, 2011-42 I.R.B. 520 (for allowances paid after September 2011), Revenue Ruling 99-7, 1999-1 C.B. 361, and IRS Publication 463 (Travel, Entertainment, Gift, and Car Expenses).
2 See, e.g., UAL Corp. & Subsidiaries v. Comm’r, 117 T.C. 7 (2001) (where court analyzed amounts that could not be treated as deductible travel expense reimbursements to determine whether such amounts could be deducted as compensation payments; court analyzed facts such as relationship between “employer” and “employee” and obligation to pay such amounts to secure services).
3 Various authorities establish this requirement. See, for example:
- U.S. Treasury Regulations §1.62-2(j) Example 1 (“Employer S pays its engineers $200 a day. On those days that an engineer travels away from home on business for Employer S, Employer S designates $50 of the $200 as paid to reimburse the engineer’s travel expenses. Because Employer S would pay an engineer $200 a day regardless of whether the engineer was traveling away from home, … no part of the $50 Employer S designated as a reimbursement is treated as paid under [a qualifying] plan. Rather, all payments under the arrangement are treated as paid under a nonaccountable plan. Employer S must report the entire $200 as wages or other compensation on the employees’ Forms W-2 and must withhold and pay employment taxes on the entire $200 when paid.”).
- Revenue Ruling 2012-25, 2012-37 I.R.B. 337 (“Section 1.62-2(d)(3)(i) provides that the business connection requirement will not be satisfied if a payor pays an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur deductible business expenses. Failure to meet this reimbursement requirement of business connection is referred to as wage recharacterization because the amount being paid is…a substitute for an amount that would otherwise be paid as wages….The presence of wage recharacterization is based on the totality of facts and circumstances. Generally, wage recharacterization is present when the employer structures compensation so that the employee receives the same or a substantially similar amount whether or not the employee has incurred deductible business expenses related to the employer’s business…. For example, an employer recharacterizes wages if it temporarily reduces taxable wages, substituting the reduction in wages with a payment that is treated as a nontaxable reimbursement and then, after total expenses have been reimbursed, increases taxable wages to the prior wage level. Similarly, an employer recharacterizes wages if it pays a higher amount as wages to an employee only when the employee does not receive an amount treated as nontaxable reimbursement and pays a lower amount as wages to an employee only when the employee also receives an amount treated as nontaxable reimbursement.”).
4 The per diem allowance cannot be more than the applicable federal per diem rate, a specified flat rate, or an amount determined under a stated schedule. Rules relating to the applicable rates are not discussed in this summary.
5 See, e.g., Revenue Ruling 99-7, 1999-1 C.B. 361.
6 However, such guidance was issued for the benefit of the requesting taxpayer only and cannot generally be relied on by other taxpayers.
© TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result.
On July 1, 2013, the first major revisions since 2001 to the Uniform Commercial Code (UCC) Article 9 went into effect in Georgia and 42 other states. These amendments are the product of a 2010 recommendation from the Uniform Law Commission aimed at fixing some of the inconsistencies, ambiguities, filing issues, and other matters that have arisen over the past decade of practicing under the previous round of amendments. With the goal of providing greater guidance and clarity, the Commission’s recommendations were signed into law for Georgia by Governor Deal on May 6, 2013.
Article 9 of the UCC governs security interests in personal property, including the creation of a security interest in property through attachment, perfection of a security interest, and remedies available upon default of payment or performance. Importantly, Article 9 does not govern security interests in real property – with the exception of fixtures. State laws continue to govern deeds to secure debt, mortgages, deeds of trust, and other forms of real property security interests.
While it is assumed that all 50 states will soon enact the UCC amendments – as all 50 did for the 2001 amendments – currently, 43 states plus the District of Columbia have enacted such a law. The remaining 7 states, listed below, have all introduced similar legislation this year, but have yet to enact laws amending Article 9: Alabama, Arizona, California, Massachusetts, New York, Oklahoma, and Vermont.
The Major Change: Fixture Filings
Among other minor changes to the wording of the UCC, the most recent modifications alter the way that Georgia deals with fixture filings, amending sections 9-502 and 9-515, and reverting back to a practice followed in Georgia in the past.
- OLD RULE. Until last week, Georgia law did not allow a recorded deed to secure debt or mortgage (collectively “security instrument”) to be effective as a financing statement filed as a fixture filing. This meant that a separate filing, in addition to the recorded security instrument, was required to perfect a security interest in fixtures.
- NEW RULE. The revisions effective July 1, 2013 serve to eliminate the repetitive nature of filing an additional financing statement as a fixture filing. The amendments provide that a recorded security instrument can be effective as a fixture filing.
- REQUIRED INFORMATION. For the record of a security instrument to serve as a fixture filing, the following information must be included in the body of the security instrument:
- The record must indicate the goods or accounts that it covers
- The goods must be fixtures or to become fixtures related to the real property described in the record
-OR-
The collateral must be related to the real property described in the record and be (i) as-extracted collateral or (ii) timber to be cut[NOTE: In some cases it may be difficult to determine whether goods are or will become fixtures. Nothing prohibits the filing of a “precautionary” fixture filing, which would provide protection in the event that goods are determined to be fixtures.]
- The record does not have to indicate that it is to be filed in the real property records
- The record must sufficiently provide the name of the debtor, with surname and first personal name being sufficient (see below: no driver’s license rule applies)
- The security instrument must be duly filed for record in the real estate records of each county where any part of the land (including fixtures) is situated
[NOTE: The usual five-year maximum life for financing statements does not apply to security instruments that operate as fixture filings. Such a security instrument is effective for the duration of the real-property recording (until the security instrument is released, satisfied of record, or its effectiveness otherwise terminates as to the real property).]
Other Changes of Note
- Name of Individual Debtor. Previously, the ambiguous name requirement led to significant problems in practice, when names on financing statements would be changed, shortened, abbreviated, or misspelled. For individuals, the current revisions specify that the debtor’s name must match exactly the unexpired driver’s license or other state issued identification of the debtor. (Note: this will be interpreted quite literally, even if the driver’s license or identification card contains a typo, uses a nickname, or contains a suffix such as “Jr.”, “M.D.”, etc.)
- IMPORTANT EXCEPTION : A security instrument intended also to serve as a fixture filing does NOT have to follow the driver’s license rule (see above); however, a financing statement filed which specifically includes fixtures must meet the driver’s license test.
- Information required on financing statement. The old law required that statements include debtor’s type of organization, jurisdiction, and organizational ID number. Because of the burdens of cost and delay of filing created by this requirement, its limited benefit to only a small subset of registered organizations, and the fact that state laws already preclude the use of duplicate or deceptively similar names, the revisions to the UCC effective July 1, 2013 eliminate the requirement of these three pieces of information.
- Electronic Chattel Paper (ECP). Previously, “control” of ECP required meeting a six factor test. The new law, while retaining the six factor test as a safe harbor, expands the ability of secured parties to perfect a security interest in ECP by providing that “control” is also accomplished through any system for evidencing the transfer of interest in the ECP which reliably establishes the secured party as the person to which the ECP was assigned.
- Debtor moving states. Previously, when a debtor moved to another state or a debtor in another state was added by sale or merger, perfected security interests that attached prior to the move remained perfected for four months after the move. The four month rule did not apply to security interests in collateral acquired after the move, however, meaning that the secured party was unperfected in such new collateral until it perfected under the laws of the new state. The new law makes it more likely that a secured party will remain perfected after the move or after a new debtor from another state becomes bound by a sale, merger or like agreement to the original debtor, by providing perfection of security interests that attach within four months after the move or addition of debtor, as long as the secured party has taken steps that would have perfected the security interest in the debtor’s original state.
- Form UCC-5. The Article 9 revisions to the UCC change the name of the UCC-5 from “Correction Statement” to “Information Statement.” The form may be filed by secured parties or debtors, whenever they feel that clarification of the public record regarding the financing statements is needed. The form continues to have no legal effect.
© TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result.
In an opinion issued Wednesday, an Illinois Appellate Court held that a conflict of law can arise even if the courts of one state have never addressed the issue in dispute. Bridgeview Health Care Ctr., Ltd. v. State Farm Fire & Cas. Co., 2013 IL App (1st) 121920 (June 19, 2013) (“Bridgeview”). Under Illinois law, courts do not conduct a choice-of-law analysis unless it is shown that a conflict exists between the laws of the potentially applicable jurisdictions. If a competing jurisdiction has never addressed the determinative issue, Illinois courts have previously held that no conflict exists and, thus, would apply Illinois law to the dispute. In Bridgeview, however, the First District Appellate Court rejected that approach.
Bridgeview involved the issue of whether an insurer, State Farm, had a duty to defend its insured for claims alleging violations of the Telephone Consumer Protection Act (TCPA). State Farm had a duty to defend if Illinois law applied, but it was unclear whether State Farm had a duty to defend if Indiana law applied because no Indiana state court had addressed the issue. Following a prior Illinois Appellate Court decision, the trial court held that there could be no conflict between the laws of Illinois and Indiana because of the lack of authority from Indiana state courts. In reaching that holding, the trial court disregarded the federal decisions predicting that Indiana courts would not provide coverage for TCPA violations. The court found no conflict of law and applied Illinois law without engaging in Illinois’ “significant contacts” choice-of-law inquiry. As a result, the trial court concluded that State Farm had a duty to defend.
On appeal, the First District Appellate Court reversed and remanded, instructing the trial court to conduct the “significant contacts” analysis because of the potential conflict of law between Illinois and Indiana. The Appellate Court further instructed the trial court to “use decisions from the federal courts and the courts of other states, as well as law reviews, treatises, and other sources, in an attempt to predict how the Indiana courts would decide the determinative issues here.” The Appellate Court explained that “the potential for conflict between Indiana law and Illinois law requires the trial court to engage in a choice-of-law analysis.”
Bridgeview represents a potentially significant shift in Illinois choice-of-law analysis, which may have a widespread impact in all types of civil litigation disputes. Previously, if there was only Illinois law on a particular issue and no clear law in another jurisdiction, a litigant could have comfort that an Illinois court would apply Illinois law without making a choice-of-law determination. Now, however, courts following Bridgeview are required to analyze the contacts and make a choice-of-law determination if there is any argument that the law of the competing jurisdiction is different – an argument that now can be made even if the competing jurisdiction has no law on an issue.
© TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyer-client relationship. Information on previous case results does not guarantee a similar future result.
Public and private entities can access the U.S. capital markets without registering the offering with the U.S. Securities and Exchange Commission (SEC) by issuing securities under Rule 144A and/or Regulation S of the U.S. Securities Act of 1933, as amended (the Securities Act). Rule 144A offerings are typically used to offer non-convertible or convertible debt and preferred stock. Rule 144A and Regulation S offerings are frequently conducted simultaneously and give an issuer the flexibility to offer its securities inside the United States in reliance on Rule 144A at the same time as it offers its securities outside the United States in reliance on Regulation S. These offerings are particularly attractive to issuers of debt in low-interest-rate environments. Private entities, including foreign issuers, view Rule 144A and Regulation S offerings favorably because such offerings provide an opportunity to raise capital without subjecting themselves to the burdensome periodic filing requirements of the SEC1 or the internal controls requirements imposed by the Sarbanes-Oxley Act of 2002 (SOX). Because of the absence of SEC registration and review, Rule 144A and Regulation S offerings are also typically accomplished at a lower cost than a registered U.S. underwritten offering.
The process for Rule 144A and Regulation S offerings is similar to underwritten U.S. registered offerings. The issuer would prepare an offering memorandum with the assistance of its legal counsel and the initial purchasers (the analog to the underwriters in a registered offering) and their legal counsel. An offering memorandum would be similar to an initial public offering prospectus and would include operational and financial information about the issuer, risk factors, use of proceeds, capitalization, management’s discussion and analysis of the issuer’s financial condition and results of operations, plan of distribution and other customary disclosures. The operative documents that will require negotiation include an indenture (for debt offerings), a purchase or placement agreement and customary pricing and closing deliverables such as officers’ certificates. An offering memorandum for a debt offering would also include a section with a description of the notes being issued, which includes the material terms of the notes. The issuer’s independent auditor would be required to deliver a comfort letter addressed to the initial purchasers with respect to the financial information included in the offering memorandum. Legal counsel for the issuer and the initial purchasers would also be required to deliver legal opinions and a 10b-5 negative assurance relating to the offering documents.
In addition, an issuer would be subject to certain standard incurrence-based covenants relating to indebtedness, affiliated party transactions, restricted payments, restricted transactions, liens and periodic financial reports, among others. There could also be additional covenants relating to certain ratios and maintenance obligations depending on the issuer’s business and financial position and the structure of the notes. These additional covenants are considered on a case-by-case basis and are subject to negotiation.
Once the offering memorandum is complete and the operative documents have been agreed to in principle, the issuer’s management and the deal team from the initial purchasers will go on a “road show.” The securities will be priced at the conclusion of the road show and the parties will sign the purchase or placement agreement2 and other signing deliverables. The ultimate terms of the securities will depend on the success of the road show and the market and interest rate environment (with respect to debt offerings) at the time of pricing. The maturity of notes issued in connection with a Rule 144A or Regulation S debt offering customarily range from seven to 10 years.
The issuer’s management should begin the process of obtaining ratings of its notes weeks in advance of any debt issuance. The rating process includes due diligence by the rating agencies, management presentations and meetings. It is also important to obtain eligibility from The Depository Trust & Clearing Corporation (DTC) prior to closing a Rule 144A or Regulation S offering if the securities will be listed for trading on a foreign stock exchange. In addition, the listing application must be approved by the applicable foreign stock exchange in advance. The foreign stock exchange approval process includes a review of the offering memorandum and compliance with the foreign stock exchange’s disclosure rules, which must be summarized in the offering memorandum. It is advisable that issuer’s legal counsel coordinate with the foreign stock exchange examiner as soon as possible in the process.
Rule 144A Background
Rule 144A is a non-exclusive safe harbor from the registration requirements of Section 5 of the Securities Act for certain private reoffers and resales of securities to qualified institutional buyers (QIBs).3 QIBs include institutions that in the aggregate own and invest on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the institution. An individual can never be deemed a QIB. In addition, there is a net worth requirement of $25 million for banks, savings and loan associations. A registered broker-dealer participating in a Rule 144A transaction can also be deemed a QIB so long as the broker-dealer in the aggregate owns and invests on a discretionary basis at least $10 million of securities of issuers that are not affiliated with the broker-dealer or in connection with a riskless principal transaction. A riskless principal transaction is when a QIB commits to purchase the securities from the broker-dealer simultaneously at the closing.
Securities of U.S. and foreign issuers are eligible for resale under Rule 144A so long as such securities are not listed on a U.S. national securities exchange or quoted in a U.S. automated inter-dealer quotation system. This rules out the offering of listed common stock under Rule 144A. As a technical matter, the Rule 144A safe harbor is only available to sellers of securities other than the issuer. As a result, an issuer must rely on another exemption from the registration requirements of Section 5 of the Securities Act, which is typically Section 4(a)(2), Regulation D or Regulation S of the Securities Act, when selling the securities to one or more initial purchasers. The initial purchasers then immediately resell the securities to a number of QIBs.
Issuers in Rule 144A offerings also have certain ongoing disclosure obligations to the security holders and their prospective purchasers. If the issuer is not (i) a reporting company subject to Section 13 or 15(d) of the Exchange Act, (ii) exempt from reporting pursuant to Rule 12g3-2(b) under the Exchange Act, or (iii) a foreign government (as defined in Rule 405 of the Securities Act), the holder and a prospective purchaser designated by the holder have the right to obtain from the issuer the following information (which must be “reasonably current” in relation to the date of resale): (a) a brief statement of the nature of the business of the issuer and the products and services it offers, and (b) the issuer’s most recent balance sheet and profit and loss and retained earnings statements, and similar financial statements for two preceding fiscal years (which should be audited to the extent reasonably available). The term “reasonably current” means that (i) the most recent balance sheet date must be as of a date less than 16 months before the date of resale, (ii) the most recent profit and loss and retained earnings statements must be for the 12 months preceding the date of the balance sheet, and (iii) the statement of the nature of the business of the issuer and the products and services it offers must be as of a date within 12 months before the date of resale. With respect to foreign issuers, however, the information required would be deemed “reasonably current” if such information meets the timing requirements of the foreign issuer’s home country or principal trading markets.
Regulation S Background
Regulation S is a non-exclusive safe harbor from the registration requirements of Section 5 of the Securities Act for offers and sales made outside the United States and resales outside the United States.4 The main conditions of the safe harbor are that: (i) the offer or sale are made in an “offshore transaction”5 (outside the United States), and (ii) there be no “directed selling efforts” in the United States.6
In addition, Regulation S offerings by issuers and their affiliates are subject to additional conditions depending upon the risk of flow back into the United States. The additional conditions vary and are grouped by categories, referred to as “Category 1,” “Category 2” and “Category 3.”
There are no additional restrictions for Category 1 transactions since there is little risk of flow back into the United States. In order for securities to be eligible for Category 1, the securities must be:
(i) issued by a foreign issuer under circumstances where there is no substantial U.S. market interest in the securities
(ii) an overseas directed offering of any securities by a foreign issuer or of non-convertible debt securities by a U.S. issuer7
(iii) backed by the full faith and credit of a foreign government,8 or
(iv) offered to non-U.S. persons under a compensatory employee benefit plan established and administered pursuant to foreign law.9
Securities may be eligible for Category 2 if they are not eligible for Category 1 and are equity securities of a foreign issuer, or debt securities of a SEC-reporting issuer or of a non-reporting foreign issuer. Category 2 transactions are subject to:
(i) “offering restrictions” (described more fully below)
(ii) a 40-day distribution compliance period whereby such securities cannot be offered or sold to a U.S. person or for the account or benefit of a U.S. person (other than a distributor) for at least 40 days after the later of the date such securities were first offered or the closing date, and
(iii) for securities sold before the expiration of the 40-day distribution compliance period, each distributor must send a confirmation or other notice to the purchaser stating that the purchaser is subject to the same restrictions on offers and sales that apply to a distributor.
Category 3 would be applicable to securities that are not eligible for Category 1 or Category 2, including, among other types of securities, debt securities of a non-reporting U.S. issuer or common stock of a reporting or non-reporting U.S. issuer. Category 3 transactions are subject to:
(i) “offering restrictions”
(ii) for debt securities,
(a) a 40-day distribution compliance period, and
(b) the global note must not be exchangeable for definitive securities until after a 40-day distribution compliance period, and for any person other than a distributor, until receipt of a certification of beneficial ownership from a non-U.S. person or a U.S. person who purchased securities in a transaction that did not require registration under the Securities Act
(iii) for equity securities,
(a) a one-year distribution compliance period (or 6 months if the issuer is a reporting issuer), and
(b) if an offer or sale is made before the expiration of the one-year distribution compliance period,
(1) the purchaser (other than a distributor) must certify that it is not a U.S. person and is not acquiring the securities for the account or benefit of any U.S. person or is a U.S. person who purchased securities in a transaction that did not require registration under the Securities Act
(2) the purchaser agrees to resell the securities only in compliance with Regulation S, pursuant to registration under the Securities Act, or pursuant to an applicable exemption from such registration requirements, and the purchaser agrees not to engage in hedging transactions with respect to such securities unless in compliance with the Securities Act
(3) the securities of a U.S. issuer must contain a legend describing the restrictions to resell the securities only in compliance with Regulation S, pursuant to registration under the Securities Act, or pursuant to an applicable exemption from such registration requirements, and that the purchaser agrees not to engage in hedging transactions with respect to such securities unless in compliance with the Securities Act, and
(4) the issuer is contractually required to refuse to register any transfer of the securities not made in accordance with Regulation S, pursuant to registration under the Securities Act, or pursuant to an exemption from such registration requirements,10 and
(iv) for securities sold before the expiration of the 40-day, six-month or one-year distribution compliance period, as applicable, each distributor must send a confirmation or other notice to the purchaser stating that the purchaser is subject to the same restrictions on offers and sales that apply to a distributor.11
The “offering restrictions” applicable to Category 2 and Category 3 transactions provide that each distributor must agree in writing to (i) abide by the applicable distribution compliance period or the registration requirements or exemption therefrom under the Securities Act, and (ii) for offers and sales of equity securities of U.S. issuers, not to engage in hedging transactions with respect to such securities unless in compliance with the Securities Act. All offering materials and documents must also include an appropriate legend setting forth the applicable offer and sale restrictions imposed by Regulation S.
It is important to note that any offering pursuant to Regulation S must also be compliant with the laws and requirements of any applicable foreign jurisdiction and the rules and regulations of any applicable foreign securities exchange or listing authority. As a result, an issuer offering securities under Regulation S will need the assistance of both U.S. and local counsel.
Endnotes
1 Issuers should note that any issuer with more than $10 million in assets and 2,000 or more holders of record, or 500 or more holders of record who are not “accredited investors” (subject to certain exceptions) would be required to register the applicable class of securities under Section 12(g) of the U.S. Securities and Exchange Act of 1934, as amended (the Exchange Act). For bank holding companies, the threshold number of shareholders is 2,000 or more holders of record (subject to certain exceptions).
2 A placement agreement could be appropriate for Regulation S securities offerings whereby the investment banks do not purchase securities for resale but rather serve as “placement agents” that assist the issuer with finding interested buyers. Investment banks take on very little transaction risk in a private placement. In contrast, an issuer would bear the risk of a failed private placement transaction.
3 It should be noted that Title II (Access to Capital for Job Creators) of the Jumpstart Our Business Startups Act (the JOBS Act) directed the SEC to revise Rule 144A to permit securities to be offered to persons other than QIBs, including through general solicitation or advertising, provided that such securities wind up being sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a QIB. Title II of the JOBS Act is still awaiting rulemaking by the SEC although the SEC has issued a proposed rule to eliminate the prohibition against general solicitation and general advertising in Rule 506 and Rule 144A offerings. The proposed rule can be found at: https://www.sec.gov/rules/proposed/2012/33-9354.pdf. For additional information relating to the JOBS Act, see our prior Client Alert, “If Three’s a Crowd, Thousands Are … an Investment Round? JOBS Act Presents Significant Changes to the Federal Securities Laws,” published March 29, 2012.
4 Open-end investment companies or unit investment trusts registered or required to be registered or closed-end investment companies required to be registered, but are not registered, under the Investment Company Act of 1940 may not rely upon Regulation S.
5 See Rule 902(h) of Regulation S.
6 See id. at Rule 902(c).
7 See id. at Rule 903(b)(1)(ii).
8 See id. at Rule 903(b)(1)(iii).
9 See id. at Rule 903(b)(1)(iv).
10 If, however, foreign law prevents the issuer of the securities from refusing to register such transfers, other reasonable procedures must be implemented to prevent any transfer of securities not made in compliance with Regulation S.
11 There are additional conditions for guaranteed securities and warrants set forth in Rule 903(b)(4) and (5) of Regulation S.
Robert A. Friedel and Alexander D. Gonzalez
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.
On May 17, 2013, the Consumer Financial Protection Bureau (CFPB) barred a Texas homebuilding company and its affiliate (Respondents) from engaging in real estate settlement business, including mortgage origination, for five years. Respondents were also ordered to disgorge all kickbacks that Respondents received from a bank and a mortgage company to whom Respondents referred the loan origination business. The CFPB’s order, to which Respondents consented (Consent Order), resolves allegations that Respondents violated Section 8 of the Real Estate Settlement Procedures Act (RESPA), which prohibits kickbacks for services involving federally related mortgages. The CFPB became aware of the Respondents’ conduct through a referral from the Federal Deposit Insurance Corporation (FDIC). The FDIC separately fined a bank for its role in the RESPA violations.
Respondents referred home buyers to a joint venture they formed with a mortgage company wholly owned by the lending bank. The joint venture was a sham entity through which the kickbacks were passed back to Respondents in the form of profit distributions and payments through a “service agreement.” In determining whether the Affiliated Business Arrangement (ABA) at issue was bona fide, the CFPB applied the factors listed in the HUD 1996 Statement of Policy (Statement of Policy) that was issued as guidance on RESPA’s application to ABAs. Specifically, the CFPB considered the fact that the joint venture had a shared management with Respondents and the lending bank, conducted no origination business outside of the referrals from Respondents, did not advertise itself to public, did not have its own office space, and conducted all its operations through an employee of the lending bank. Based on these facts, the CFPB concluded that the joint venture was a sham. Instead of imposing a statutory penalty pursuant to the RESPA, the CFPB elected to seek disgorgement of the kickbacks—remedy available to the CFPB under the Dodd-Frank Act. In addition, the Respondents were barred from participating in the mortgage settlement business.
The CFPB’s probing inquiry into the inner workings of the ABA in this case serves as a reminder that compliance with the RESPA and the Statement of Policy on paper is not sufficient to create a bona fide ABA that can survive regulatory scrutiny.
Please do not hesitate to contact David Anthony, John Lynch, or Maryia Jones if you have questions or would like additional information on compliance with the RESPA or the Statement of Policy.