U.S. Citizenship and Immigration Services (“USCIS”) has thrown a wrench into the works of the seemingly simple task of counting three days.  In connection with the requirement for enrolled employers to submit a new hire’s information into the E-Verify system within three days of hire, USCIS states that this must be completed by the third business day after the employee started work for pay. For an employee who starts work on a Monday, the employer would have to submit the information in E-Verify by that Thursday. For related E-Verify Advisories and information, click here.

However, this conflicts with the long-standing interpretation of the three-day rule as it applies to completion of Form I-9 for new hires.  In connection with Form I-9, Section 1 (employee data) must be completed on the first day of hire and Section 2 (employer’s verification) must be completed within three business days of hire.  U.S. Immigration and Customs Enforcement (“ICE”), the agency that conducts audits of I-9 records and has the authority to fine employers, has repeatedly stated that this means the third day of employment – counting the first day of employment as day one – and not three days after the first day of employment.  This means that, for an employee hired on a Monday, the employer would have to complete Section 2 of Form I-9 by that Wednesday.

After being informed of the new USCIS interpretation of the three-day rule, ICE indicated through informal liaison that it would follow this interpretation.  However, ICE has yet to put this change of policy in writing, leaving employers who wish to rely on the informal agreement in a tenuous position.

Mass Modification of Federal Supply Service (FSS) Contracts to Include E-Verify

The General Services Administration has announced that, effective June 24, 2010, a mandatory mass modification requires all FSS contracts to include the requirement for contracting companies to enroll in E-Verify pursuant to the FAR E-Verify Rule, unless the contract falls under an exception to the rule. Since the implementation of the FAR E-Verify Rule in September 2009, agencies have been incorporating the E-Verify requirement into contracts on an ad-hoc basis.  This mass modification will result in a large increase in the number of companies who are required to enroll in E-Verify, within a short period of time.  E-Verify implicates a number of compliance issues for employers. Enrollment in and implementation of E-Verify should be carefully planned in advance.

If you have any questions about these issues, please contact any attorney in the Immigration Group.

Beginning on August 22, 2010, most gift cards sold in the United States will have to comply with a new federal statute.  In the last few years, several states passed or expanded gift card laws, with over thirty states now having gift card statutes.  Adding to the patchwork of laws, Congress got into the act recently when it passed the Credit Card Accountability, Responsibility and Disclosure Act (the “Credit CARD Act”), which President Obama signed in May.  While chiefly aimed at reforming credit card practices, the Credit CARD Act contains several provisions that all issuers of gift cards must consider when structuring their gift card programs in addition to the various state laws already on the books as the new law does not preempt state laws that are more restrictive.

The Credit CARD Act will impose requirements on gift certificates, store gift cards, and general-use prepaid cards, each of which the legislation defines.  The new law places restrictions on “inactivity fees,” “dormancy fees,” and “service fees,” as several state laws already do. Such fees will only be permitted where: (1) there has been no activity with respect to the certificate or card in the 12-month period ending on the date on which the fee is imposed; (2) the certificate or card clearly and conspicuously states—(i) that such a fee may be imposed; (ii) the amount of such fee; (iii) how often such fee may be imposed; and (iv) that such fee may be imposed for inactivity.  Also, not more than one fee may be charged to the consumer during any one-month period.  Issuers or vendors of gift certificates or cards must inform consumers of any fees before the consumer purchases the card.  Gift certificates and cards that are distributed as part of award, loyalty or promotional programs for which no money or other value is exchanged are exempt from the new law.

The new law also places restrictions on expiration dates, another common feature of state gift card laws.  It will prohibit the sale of gift certificates or cards that have an expiration date which is less than five years after the date it was issued, or the date that funds were last loaded on a store gift card or general-use prepaid card.  A certificate or card carrying an expiration date must clearly and conspicuously disclose the expiration date. 

The law requires the Federal Reserve Board to issue final regulations, including any relating to the amount of any fees which may be imposed, by February 22, 2010, after consulting with the Federal Trade Commission. The gift card provisions of the Credit CARD Act were inserted into the already existing Electronic Funds Transfer Act, which is generally enforced by the FTC.

Investors in private placements of securities are subject to legal constraints on their ability to freely resell those securities, and responsible investors readily abide by those constraints.

These restrictions include a minimum holding period for the securities, which is intended to ensure that the investor is subject to meaningful market risk consistent with the nature of a private placement. Some securities professionals, including attorneys, have created entire lines of business designed to enable investors in private placements to evade the legal restrictions on reselling their restricted securities, and this article will describe some recent examples of this activity, including the efforts of the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) to combat this activity.

Background

The Securities Act of 1933 (the Securities Act) makes it illegal to offer or sell securities without filing a registration statement with the SEC unless an exemption from registration is available. The certificates representing restricted securities are typically stamped with a legend indicating that they cannot be resold unless they are registered pursuant to the Securities Act or exempt from registration. If a legitimate exemption is available, the restrictive legend is removed from the certificate by the transfer agent, enabling the securities to be resold. Transfer agents often require the issuer of securities to provide a legal opinion from its counsel to the effect that the proposed resale is exempt from registration before removing the restrictive legend from the certificate, making the issuer’s attorney the “gatekeeper” whose consent will enable securities to be freely traded. Once the restrictive legend is removed, the shares may be freely sold on the stock market through any stockbroker.

Abused Exemptions

Section 4(2) of the Securities Act exempts transactions by an issuer not involving any public offering. Because of the difficulty in interpreting Section 4(2), the SEC adopted Regulation D which provides a safe harbor from registration pursuant to Section 4(2). Regulation D provides three exemptions, including one in Rule 504 that, subject to a number of conditions, provides an exemption from registration for the sale by an issuer of securities not exceeding $1 million.

A purchaser who acquires restricted securities and wishes to resell the securities must then rely on a resale exemption (as opposed to the exemptions for issuer sales provided by Regulation D). Investors may acquire restricted securities through Regulation D offerings or other private placement offerings, under unregistered stock-based employee benefit plans for directors and executive officers, or through offshore placements under so-called Regulation S. Subject to a number of conditions, Rule 144 provides an exemption from registration for an investor’s resale of restricted securities.

To rely on the safe harbor provided by Rule 144 under the Securities Act, a number of conditions must be met. Among these is a requirement that the securities must be held for the requisite minimum holding period (if the issuer is subject to the Securities Exchange Act of 1934 (the Exchange Act) the holding period is six months, otherwise the holding period is one year), and the availability of adequate current information about the issuer (generally meaning that the issuer must be in compliance with the reporting requirements of the Exchange Act).

Recent Cases

The SEC and the DOJ have recently brought a number of charges alleging the fraudulent issuance of legal opinions by attorneys, which have enabled restricted securities to be freely traded in violation of the securities laws.

Stephen J. Czarnik

In February 2010, the SEC filed charges against securities lawyer Stephen J. Czarnik, asserting participation in a multi-million-dollar pump-and-dump stock scheme. As legal counsel to three companies, Czarnik issued legal opinion letters stating that offerings were in compliance with a private placement exemption under Rule 504 of the SEC’s Regulation D and authorized the transfer agent to issue stock certificates without a restrictive legend, facilitating their free transferability. Rule 504 generally allows issuers which are not SEC-reporting companies¹ to sell up to $1 million of securities in any one year. The stock of many smaller public companies is traded through the “Pink Sheets,” a largely unregulated electronic quotation and trading system in the over-the-counter securities market which does not require issuers to file periodic reports with the SEC, thereby enabling smaller, non-reporting issuers to take advantage of Rule 504. In this case, the SEC alleges that Czarnik knew or was severely reckless in not knowing that no securities law exemption was available in these offerings.

The complaint alleges that Czarnik falsely represented that stock promoters intended to hold the shares of the companies (a necessary element for the exemption to apply), when instead they distributed the shares into the public market after holding them for only a brief period during which they advertised and sent promotional mailers (“ACT NOW BEFORE THE WHOLE WORLD FINDS OUT ABOUT THIS STOCK!”). The SEC asserts that Czarnik knew that the three promoters intended to distribute the stock at the time he issued the opinion letters, pointing to e-mail traffic discussing the plans for advertising and immediate distribution (“[W]e are ready to sign and start trading.”) and an SEC suit against Ryan Reynolds, one of the promoters, in 2007 alleging participation in the unregistered resale of penny stock. The SEC is seeking, among other things, disgorgement of the gains related to the scheme and civil penalties.

144 Opinions, Inc.

In May 2009, the SEC filed a complaint against 144 Opinions, Inc., asserting that the company operated as a legal “opinion mill” which fraudulently facilitated the sale of securities in violation of the registration provisions of the federal securities laws. The complaint alleges that Sandra Masino (the owner of the company), and attorneys Albert J. Rasch, Jr. and Kathleen R. Novinger of Albert J. Rasch & Associates, prepared and issued at least 24 legal opinion letters that induced the removal of restrictive legends on unregistered shares of Mobile Ready Entertainment Corp., resulting in the sale of 22 million shares to the public in violation of Rule 144.

144 Opinions, Inc. operates its business primarily through a Web site, www.144opinions.com. As part of the scheme alleged by the SEC, Masino would input shareholders’ information into a database and prepare a template of an opinion. Rasch’s firm would then make an independent decision as to whether to issue the opinion. Masino charged customers $259 for the opinions she prepared and paid Rasch and Novinger $45 for each opinion executed. Typically, the attorneys would have no direct contact with the shareholder. The defendants claimed that before issuing their opinions, they obtained the necessary back-up information from the SEC’s EDGAR filings database. The SEC asserted, however, that Mobile Ready Entertainment Corp. had not filed any documents with the SEC at the time the opinions were issued. The SEC further asserted that the defendants knew, or were severely reckless in not knowing, that the legal opinions contained false and misleading statements.

William D. O’Neal

In August 2008, the SEC filed charges against Alliance Transcription Services and others, asserting that the defendants manipulated Alliance’s stock prices and trading volume through false and misleading public disclosures and issuing and selling the stock in an unregistered distribution. Charges were also brought against William D. O’Neal, the attorney who issued the opinion letters that enabled Alliance to issue the purportedly unrestricted stock. Simultaneous with filing the complaint, the SEC settled the charges against O’Neal. The settlement required him to disgorge more than $220,000 of gains and prohibited him from issuing similar legal opinions concluding that unregistered offerings are exempt from SEC registration under Rule 504 of Regulation D and that the securities issued in such offerings are unrestricted.

Phillip Windom Offill, Jr.

In March 2009, the DOJ filed charges against securities attorney Phillip Windom Offill, Jr., alleging that he participated in a stock registration evasion scheme that allowed millions of unregistered shares of 9 different companies to be freely traded that were not legally entitled to be freely tradable.² The charges further assert that as part of the conspiracy orchestrated by Offill, legal opinions were issued in connection with a “pump-and-dump” scheme that facilitated the creation of new companies with no assets and the issuance of unregistered securities to co-conspirators, after which the co-conspirators inflated the prices of the stock by publicly issuing materially false statements about the companies and then sold their stock to the investing public at artificially inflated prices.

According to the SEC, one or more co-conspirators issued legal opinion letters that gave the appearance that the companies were complying with an exemption provided by Rule 504 of Regulation D and its Texas securities law counterparts. Under Rule 504, if the offering is conducted under a state securities law exemption that permits general solicitation and general advertising in connection with sales made to accredited investors, the shares may be freely resalable and a Securities Act restrictive legend is not required to be placed on the stock certificates. Texas has a state securities law exemption that permits limited advertising in offers and sales to accredited investors who acquire the securities for investment and not with an intention to engage in a distribution of the security, and the issuer of the legal opinion in the Offill case attempted to rely on this Texas law to justify the issuance of stock without a restrictive legend. For purposes of the Texas law, any resale within 12 months, except to other accredited investors, is presumed not to comply with the Texas exemption, and Offill and his co-conspirators knew that there was no intention to hold the shares for the requisite period.

In this case, the conspirators facilitated the sale by the issuers to accredited investor entities resident in Texas and controlled by Offill, which would then immediately resell the securities to co-conspirators, using false representations to the transfer agent to acquire unlegended stock certificates in contravention of federal and state securities laws. The co-conspirators would then illegally sell the purportedly “free trading stock” of small public companies to the general investing public through listings on the Pink Sheets marketplace.

Offill’s involvement was primarily related to facilitating the unregistered issuance of the shares, then his co-conspirators would take over the “pump” phase. Offill hid his profits from the scheme by billing legal fees to co-conspirators, including a transaction in which an entity he controlled purported to purchase common stock from an issuer. Offill’s participation resulted in his conviction in January of 2010.

Additional Policing Activity

The SEC issued a statement as early as 1962 providing guidance for exemptions based on legal opinions stating that “[i]t is the practice of responsible counsel not to furnish an opinion concerning the availability of an exemption from registration under the Securities Act for a contemplated distribution unless such counsel have themselves carefully examined all of the relevant circumstances and satisfied themselves, to the extent possible, that the contemplated transaction is, in fact, not part of an unlawful distribution.”³ Further, “if an attorney furnished an opinion based solely upon hypothetical facts which he has made no effort to verify, and if he knows that his opinion will be relied upon as the basis for a substantial distribution of unregistered securities, a serious question arises as to the propriety of his professional conduct.”⁴

In addition to the SEC and the DOJ, the Pink Sheets marketplace is making an effort to police opinion letters. The Pink Sheets Web site includes a publicly available list of firms and attorneys from which it will not accept legal opinions.

Responsible securities lawyers will review all of the relevant paperwork and facts relating to a proposed removal of a Securities Act restrictive legend from a stock certificate. Among other things, the attorney will require the submission of signed factual certifications from the shareholder and the broker, confirming the accuracy of relevant information, including, among other things, how long the shareholder has held the securities. Any discrepancy between the certifications and any related paperwork requires further due diligence by the attorney to verify the underlying facts. Only after thoroughly vetting the relevant facts and confirming the legitimate availability of an exemption from registration will a responsible attorney issue the necessary legal opinion to permit the removal of the restrictive legend.

Conclusion

The highest level of diligence and care must be taken by attorneys issuing legal opinions with respect to registration as they are relied upon by financial intermediaries and the investing public. Similarly, shareholders and issuers should take great care when dealing in restricted securities to ensure that their securities law attorney is not leading them down a path that will attract the negative attention of the SEC and DOJ.

Endnotes

1 Generally, companies with fewer than 500 shareholders of record or less than $10 million of total assets as of the beginning of a fiscal year, and which have not filed a registration statement for the public offering of securities that has been declared effective by the SEC, are not required to file periodic reports with the SEC.

2 This was not the SEC’s first allegation of misconduct. Offill was a defendant along with Ryan Reynolds in the 2007 case referenced above under “Stephen J. Czarnik.”

3 Distribution by Broker-Dealers of Unregistered Securities, Securities Act Release No. 4445, Exchange Act Release No. 6721 (February 2, 1962).

4 Id.

Robert A. Friedel and Lara Thane

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.

Foreign persons and their tax advisors have long questioned and considered how extensive lending activities in the U.S. by a foreign person have to be in order to give rise to U.S. taxation of the U.S. sourced interest.  There has been little guidance from the IRS on the issue. 

On September 22, 2009, the IRS Office of Chief Counsel issued a memorandum (the “Memorandum”) to the IRS Director of Field Operations for Financial Services, in Manhattan, setting forth its position with respect to lending activities by a foreign corporation through a U.S. agent.  The Memorandum concludes that a foreign lender with no U.S. office may still have U.S. taxable income resulting from U.S. source interest if the foreign lender has a U.S. agent – even if the agent cannot enter into contracts on behalf of the foreign lender.  The Memorandum was issued to provide guidance to IRS agents auditing taxpayers, and is not binding precedent.  However, it is significant because it is the first indication from the IRS that lending activities by a foreign person’s U.S. agent, with no authority to bind, may give rise to net income taxation in the U.S. 

IRS Chief Counsel Memorandum

By way of background, if a foreign person (an alien who does not reside in the U.S. or a foreign corporation) carries on a trade or business in the U.S., the person is taxed at regular income tax rates on taxable income that is effectively connected with the U.S. business, which taxable income is determined on a net basis, with deductions for all otherwise deductible items that are directly connected with the effectively connected income.  If, on the other hand, a foreign person has U.S. source income that is not effectively connected with a U.S. business, the income is not taxed at regular income tax rates; rather, it is taxed at a flat 30% rate.  As a practical matter, where the foreign person has U.S. source interest income and does not have a U.S. trade or business, such interest income often is not subject to U.S. taxation.  This is because the 30% flat rate is often reduced or eliminated by an applicable tax treaty, or the interest is exempt from taxation under the “portfolio interest exemption” (which exempts from the 30% tax, interest from U.S. sources, excepting interest on some unregistered obligations and interest on bank loans and on obligations held by 10% or greater owners of the debtor).

The facts of the Memorandum are fairly narrow.  A non-U.S. corporation (“Foreign Corporation”) is 100% owned by shareholders that are not U.S. persons.  Foreign Corporation has no office or employees located in the U.S.  In order to originate loans to U.S. borrowers, Foreign Corporation outsources the origination activities to a U.S. corporation (“U.S. Origination Corporation”).  Under a service agreement between U.S. Origination Corporation and Foreign Corporation, Foreign Corporation pays U.S. Origination Corporation a fee, and in return U.S. Origination Corporation performs loan origination activities, including soliciting U.S. Borrowers, negotiating the terms of loans, and performing the credit analyses with respect to the U.S. borrowers.  U.S. Origination Corporation is not authorized to conclude contracts on behalf of Foreign Corporation, however.  Foreign Corporation’s employees, who work in an office located outside of the U.S. give final approval of the loans and physically sign the loan documents on behalf of Foreign Corporation.

Generally, while the office and activities of an independent agent are not attributed to its non-U.S. principal, the activities of a dependant agent that regularly exercises the authority to conclude contracts that bind the non-U.S. principal may in fact create a U.S. trade or business and thus result in effectively connected income.  Specifically, in the case of the conduct of a banking, financing, or similar business, when determining whether a foreign corporation has an office or other fixed place of business in the U.S., the Internal Revenue Code (the “Code”) provides that that the office or other fixed place of business of an agent will be disregarded unless the agent (i) has the authority to negotiate and conclude contracts in the name of the foreign corporation and regularly exercises such authority and (ii) is not a general commission agent, broker or other independent agent acting in the ordinary course of business.  Code Section 854(c)(5)(A). 

The Memorandum notes that the “Service is aware that some taxpayers may have taken the position that interest income is not effectively connected with banking, financing or similar business activity because the income is not attributable to a U.S. office of the Foreign Corporation and that the office of Foreign Corporation’s agent is not attributable to the Foreign Corporation . . . .”  However, the IRS Chief Counsel concluded that on the set of facts addressed in the Memorandum, despite the fact that the U.S. Origination Corporation did not have authority to conclude contracts on behalf of Foreign Corporation, the interest income received by Foreign Corporation was effectively connected with such foreign corporation’s U.S. banking, financing or similar business.

Why This Is A New Development

Until the issuance of this Memorandum, there was no guidance directly addressing whether lending activities such as those described would cause the non-U.S. lender to have U.S. taxable income.  As suggested in the Memorandum, some non-U.S. taxpayers have been taking the position that since their U.S. agents did not have the ability to conclude binding contracts for the non-U.S. principals, their U.S. office could not be attributed to them.  This Memorandum makes clear that the IRS Chief Counsel’s office does not accept this position.
           
In addition to providing guidance as to the IRS’s view of this particular set of facts, the Memorandum is noteworthy in that it states “[w]e understand that foreign corporations and non-resident aliens may have used other strategies to originate loans in the United States giving rise to effectively connected income . . . ” and goes on to advise and assure the Director of Field Operations that “[w]e encourage you to develop these cases, and we stand ready to assist you in the legal analysis.”  This statement was seen by some as an encouragement to IRS agents to audit foreign corporations that engage in lending activities and have arrangements similar to the ones in the Memorandum.

Since the issuance of the Memorandum, IRS officials have reportedly cautioned against reading too much into the Memorandum and asserted that the Memorandum dealt with the very narrow question of whether only the office of the non-U.S. person should be looked at or the office of an agent as well.  In response to a question as to the meaning of their statements that they encouraged IRS field agents to develop these cases, and that the IRS Chief Counsel’s office stood ready to assist them in the legal analysis – the IRS official stated:  “I think you can take from it that we’re actively looking at cases and considering various issues that come up, including this one . . . .  It’s a statement to the field that we’re there to help parse through some of these iterations.”  Kristen A. Parillo, Memo on Foreign Corporation’s U.S. Lending Activities Activity Is Not Major Guidance, IRS Official Says, 2009 TNT 185-4 (Sep. 28, 2009).

Implications for Future

Even if, as the IRS official stated, the Memorandum addressed only the very narrow question of whether the term “U.S. office” that could give rise to effectively connected taxable interest income from a banking, financing or similar activity meant only the taxpayer’s office or an agent’s office as well (even where such agent could not conclude contracts for the foreign person), given that the answer given was “yes,” this is quite a significant question.  Many have noted that the IRS’s interpretation of the relevant statute to reach its conclusion may have been a questionable interpretation.  While the Memorandum certainly provides useful guidance as to the IRS’s view on the question, it likely is not the final word, and we may expect to hear further on the topic in the near future.  In the meantime, offshore lenders — particularly those that took some level of comfort in taking the position that their interest income from U.S. borrowers was not subject to U.S. tax  because they did not have any agent that could enter contracts on their behalf — would we well advised to revisit their positions and exposure.

The North American Electric Reliability Corporation (“NERC”) has been around since the early 1960s as a voluntary industry organization. The Energy Policy Act of 2005 (“EPAct 2005”) required the Federal Energy Regulatory Commission (“FERC” or “the Commission”) to designate an Electric Reliability Organization (“ERO”). NERC, the only obvious candidate, was designated ERO by the Commission in Order No. 672 on July 20, 2006.

The development of reliability standards has long been NERC’s primary responsibility. For years before its designation as ERO, NERC developed reliability standards for industry’s voluntary adoption. Designation as ERO broadened NERC’s authority considerably, but development of standards remains a central pillar of NERC’s mission.

On April 19, 2007, the Commission approved NERC’s pro forma agreement with the eight regional entities receiving NERC’s delegation of authority to monitor and enforce compliance with the approved reliability standards. The eight regional entities cover the continental United States, most of Canada, and parts of Mexico. The entities are:

• Florida Reliability Coordinating Council,
• Midwest Reliability Organization,
• Northeast Power Coordinating Council,
• ReliabilityFirst Corporation,
• SERC Reliability Corporation,
• Southwest Power Pool,
• Texas Regional Entity, and
• Western Electricity Coordinating Council (“WECC”).

The Reliability Standards

On March 15, 2007, FERC issued Order No. 693, which approved the first 83 NERC reliability standards. These standards became effective and enforceable on June 18, 2007. On May 18, 2007, the Commission issued Order No. 696, which subjected previously exempt Qualifying Facilities to the reliability standards.

On the same day, FERC approved over 700 violation “risk factors” associated with requirements and subrequirements of the 83 reliability standards. The risk factor framework recognizes that not all of the requirements associated with reliability standards are equally important. Under the risk factor framework, reliability standard violations may draw different size penalties based on whether the requirement violated is deemed to be a high-risk requirement, a medium-risk requirement, or a low-risk requirement. The Commission made clear that risk factors are not part of the reliability standards. Rather, they are part of the NERC policy for evaluating the severity of violations.

Generally, the Commission will only approve regional-specific standards when they are either (1) “more stringent than the continent-wide Reliability Standard, including a regional difference that addresses matters that the continent-wide Reliability Standard does not,” or (2) “necessitated by a physical difference in the Bulk-Power System.” On June 8, 2007, the Commission approved eight additional reliability standards applicable only to the WECC region (Docket RR07-11). The eight additional standards are:

• WECC-IRO-STD-006-0 (Qualified Path Unscheduled Flow Relief);
• WECC-PRC-STD-001-1 (Certification of Protective Relay Applications and Settings);
• WECC-PRC-STD-003-1 (Protective Relay and Remedial Action Scheme Misoperation);
• WECC-PRC-STD-005-1 (Transmission Maintenance);
• WECC-BAL-STD-002-0 (Operating Reserves);
• WECC-TOP-STD-007-0 (Operating Transfer Capability);
• WECC-VAR-STD-002a-1 (Automatic Voltage Regulators);
• WECC-VAR-STD-002b-1 (Power System Stabilizers).

On December 27, 2007, in Order No. 705, FERC adopted three additional reliability standards relating to planning and operation that NERC developed. The three new standards were:

• FAC-010-1 (System Operating Limits Methodology for the Planning Horizon),
• FAC-011-1 (System Operating Limits Methodology for the Operations Horizon), and
• FAC-014-1 (Establish and Communicate System Operating Limits).

They require planning authorities to “determine system operating limits for the Bulk-Power System in the planning and operation horizons.” The Commission concurrently approved 63 of the 72 violation risk factors that NERC submitted with the standards, and regional differences for WECC regarding the FAC-010-1 and FAC-011-1.

On January, 18, 2008, FERC approved eight reliability standards that NERC developed related to critical infrastructure protection (“CIP”). The standards are intended to protect the bulk-power system from “cyber attacks.” The eight new standards are:

• CIP-002-1 (Critical Cyber Asset Identification),
• CIP-003-1 (Security Management Controls),
• CIP-004-1 (Personnel & Training),
• CIP-005-1 (Electronic Security Perimeters),
• CIP-006-1 (Physical Security of Critical Cyber Assets),
• CIP-007-1 (Systems Security Management),
• CIP-008-1 (Incident Reporting and Response Planning), and
• CIP-009-1 (Recovery Plans for Critical Cyber Assets).

On October 16, 2008, FERC issued Order No. 716, which added another standard: NUC-001-1 Nuclear Plant Interface Coordination. This standard specifically requires a nuclear plant generator operator and its suppliers of back-up power and transmission and/or distribution services to coordinate concerning nuclear licensing requirements for safe nuclear plant operation and shutdown and system operating limits.

On March 19, 2009, FERC issued a Notice of Proposed Rulemaking (“NOPR”) to approve six Modeling, Data and Analysis (“MOD”) Reliability Standards that would require certain users, owners and operators of the transmission system to develop consistent methodologies for the calculation of available transfer capability (“ATC”). NERC originally submitted such standards to the Commission on August 29, 2008 and November 21, 2008. The proposed standards are:

• MOD-001-1 – Available Transmission System Capability Reliability Standard would require transmission service providers and transmission operators to select and implement one of three methodologies for calculating ATC for each path for each time frame (hourly, daily or monthly) for the facilities in its area. The three proposed methodologies are as follows:
  • 1. 1. MOD-028-1 – Area Interchange Methodology – This methodology would require a determination of incremental transfer capability via simulation, from which total transfer capability can then be mathematically derived. Total transfer results are generally reported on an area to area basis.
       2. MOD-029-1 – Rated System Path Methodology – This methodology would include an initial total transfer capability, determined via simulation. As with the area interchange methodology, capacity benefit margin, transmission reliability margin, and existing transmission commitments are subtracted from the total transfer capability, and postbacks and counterflows are added, to derive ATC.
       3. MOD-030-1 – Flowgate Methodology – This third methodology for calculating ATC begins with an identification of key facilities as flowgates. Total flowgate capabilities are determined based on facility ratings and voltage and stability limits. The impacts of existing transmission commitments are then determined by simulation. To determine the available flowgate commitments, the transmission service provider or operator must subtract the impacts of existing transmission commitments, capacity benefit margin, and transmission reliability margin, and add the impacts of postbacks and counterflows. Available flowgate capability can then be used to determine ATC.

• MOD-008-1 – Transmission Reliability Margin Methodology would require entities to prepare and keep current implementation documents that provide for the calculation of Transmission Reliability Margin, which is the transmission transfer capability set aside to mitigate risks to operations, such as deviations in dispatch, load forecast, outages, and similar other conditions.

• MOD-004-1 – Capacity Benefit Margin Methodology would require entities to prepare and keep current implementation documents that provide for the calculation of Capacity Benefit Margin, which is transmission transfer capability set aside to allow for the import of generation upon the occurrence of a generation capacity deficiency.

Modifying and Interpreting the Standards

FERC is authorized only to approve or reject the reliability standards that NERC submits. EPAct 2005 does not empower FERC to modify standards directly. Even as the Commission approved the original 83 standards, it requested that NERC modify and resubmit 56 of them. On July 21, 2008, the Commission issued Order No. 713, which approved modifications of five previously-approved Reliability Standards, including two of the 56 modifications requested by the Commission. Modifications were approved for:

• INT-001-3 (Interchange Information).
• INT-004-2 (Dynamic Interchange Transaction Modifications).
• INT-005-2 (Interchange Authority Distributes Arranged Interchange).
• INT-006-2 (Response to Interchange Authority).
• INT-008-2 (Interchange Authority Distributes Status).

In response to NERC’s proposed modification of a sixth standard, IRO-006-4 (Reliability Coordination – Transmission Loading Relief), the Commission neither accepted nor rejected NERC’s interpretation, but asked the ERO for more information.

Order No. 713 also approved NERC interpretations of five other reliability standard requirements:

• BAL-001-0 (Real Power Balancing Control Performance), Requirement 1.
• BAL-003-0 (Frequency Response and Bias), Requirement 3.
• BAL-005-0 (Automatic Generation Control), Requirement 17.
• VAR-002-1 (Generator Operation for Maintaining Network Voltage Schedules), Requirements 1 and 2.

It is expected that the Commission will review and approve modifications and interpretations in the future on an ongoing basis.

The Risk Factors

Each reliability standard is broken down into requirements and subrequirements. Of course, not all requirements and sub-requirements are equal—some are administrative in nature, whereas others go directly to the integrity of the power grid. Recognizing this fact, FERC approved NERC proposals to rate each requirement and sub-requirement on a scale of low, medium and high.

The “Low” risk factor applies to those requirements and subrequirements that are “considered administrative in nature where a violation would not be expected to affect the reliability of the Bulk-Power System.” The medium risk level applies to those that “while unlikely to cause or contribute to Bulk-Power System instability or cascading failures, could, however, directly affect the electrical state, capability, monitoring and control of the Bulk-Power System.” High risk requirements are those that “could conceivably cause or contribute to Bulk-Power System instability or cascading failures.” The process of assigning risk factors is a continuing process parallel to the approval of reliability standards. In May 2007, the Commission approved over 700 risk factors, which correspond to the original 83 standards.

On June 26, 2007, FERC approved 22 more violation risk factors (Docket No. RR07-12) that also pertain to the original 83 approved standards. NERC proposed two additional risk factors relating to three additional proposed standards, but the Commission delayed action on these because the standards to which they related had not been approved yet. Approving violation risk factors before the standards they apply to, it seems, is putting the cart before the horse.

Violation Policy

Under a Penalty Review Policy for Reliability Standards Violations approved by FERC on April 17, 2008, NERC may impose penalties on companies that violate the standards it administers, either directly or through the eight regional entities to which it has delegated such authority, subject to FERC review.

Under the new policy, entities subject to a NERC notice of penalty (or FERC on its own motion) may file an application for review within 30 days of the notice being filed with the Commission. Interventions on the application for review are due within 20 days. FERC stated that, generally, it will take action on the application within 60 days of the application for review, although this time period may be extended. The policy was also modified to permit FERC to review penalty settlements, though the Commission reiterated its encouragement of the settlement process and stated that such settlements will generally be allowed to stand.

On June 19, 2008, FERC approved Reliability Standard Violation Severity Levels (Docket RR08-4). Severity levels attempt to reflect “how bad” the violation was. The severity level is the degree to which a requirement or subrequirement has been violated, the last piece of the NERC penalty-setting matrix for standard violations. There are four levels: Lower, Moderate, High, and Severe.

Once a violation is found, an assessment is made regarding badly the requirement or subrequirement has been violated, at which point FERC will determine an appropriate penalty. Incidentally, repeated violations do not increase the severity level. Once a violation of that subrequirement is found, it is categorized according to the above severity levels. The determination of the violation severity level will be considered in light of the requirement’s risk factor designation to come up with an appropriate penalty amount.

On June 4, 2008, just short of a year after the first reliability standards became mandatory, NERC filed 37 notices for 106 violations with the Commission. Most were for administrative “low-risk” violations issued without financial penalties. However, financial penalties in the amounts of $180,000 and $75,000 were levied against two companies for violations of standard FAC-003-1 (Vegetative Management). Both of these violations were self-reported, and one was the result of a settlement.

However, the most-violated standards were CIP-001-1 (Critical Infrastructure Protection: Sabotage Reporting), comprising 46% of the violations, PRC-005-1 (Protection and Control: Transmission and Generation Protection System Maintenance and Testing), comprising 22% of the violations, and FAC-008-1 (Facilities Design, Connections, and Maintenance: Facility Ratings Methodology), comprising 14% of the violations.

Going Forward: Who Pays the Penalties? Who Pays for Compliance?

One problem with penalties for violations of the mandatory reliability standards is what RTOs and ISOs should do when assessed penalties that are attributable to one of their members. The organizations themselves are non-profit organizations, and they are registered as the entity responsible for many reliability standards, even where ultimate responsibility for compliance of those standards has been delegated. This raises the possibility that an RTO/ISO may be penalized for a violation that was the responsibility of a member. In such a case, who should pay?

The Midwest Independent System Operator, Inc. (“MISO”) proposed tariff changes that would have allowed it to investigate who was at fault for the violation, and pass such penalties it received through to that member. In the case where MISO was unsuccessful in identifying the responsible party, the revised tariff would let it socialize the penalty among all its members. On May 31, 2007, the Commission declared the proposed practice improper (Docket No. AD07-12) without prejudice for refiling, and scheduled a staff technical conference on the subject. The technical conference was held on September 18, 2007. At the conference, NERC promised to do its best to identify the responsible party, although it “stops short of committing to determine the percentage of parties’ culpability for violating standards when multiple parties contribute to a violation, deferring instead to the registered entities as being accountable to NERC in the first instance for all penalty cost liability.”

On March 20, 2008, the Commission issued an Order Providing Guidance. The Commission found that although the penalties “raised legitimate concerns regarding their not-for-profit status,” it is not appropriate to automatically pass the penalties through because such tariff amendments could eliminate “the appropriate incentives to proactively comply with Reliability Standards if they have blanket authority to automatically pass through monetary penalties to their customers.” MISO’s proposal was also inappropriate because the Federal Power Act (“FPA”) assigns the responsibility for investigating reliability violations to the ERO alone—the RTO or ISO should not be permitted a “second, de novo hearing on the issue of determining responsibility for Reliability Standard violations.” The Commission stated that the proper process would be for the RTO or ISO to request recovery on a case-by-case basis through an FPA section 205 filing.

On September 18, 2008, FERC issued an order accepting PJM’s proposal to address this matter (Docket No. ER08-1144). The Commission found that PJM’s Schedule 11 will allow for a reasonable penalty recovery, without a universal pass-through.” Instead, “PJM or its Members may only pass through penalties when NERC or one of its Regional Entities concludes from its fact-finding that the targeted entity substantially contributed to the Reliability Standards violation.”

If NERC has traced the “root cause” of a violation to a single culprit, PJM’s revised tariff permits the RTO to pass associated penalties to that entity. When NERC has identified several contributing violators, PJM will establish a process to permit apportionment “on a basis reasonably proportional to the parties’ relative fault consistent with the NERC’s root cause analysis.” If PJM members disagree with the apportionment, they are directed to non-binding dispute resolution procedures.

Once an apportionment has been fixed, the penalties will be submitted to FERC in an FPA section 205 filing. Any portion of the penalty found to be the fault of PJM itself will be paid from “the sum of (i) projected current year stated rate revenues less projected current year operating expenses (excluding the penalties), and (ii) any earnings retained in the financial reserve portion of the deferred regulatory reliability fund,” and will not be simply passed through to members. If this is not sufficient, PJM will file a section 205 filing with FERC.

The registered direct offering (RDO) presents an intriguing alternative for companies contemplating a private investment in public equity (PIPE), because it combines the marketing appeal of a PIPE with the pricing of an underwritten public offering, and is quicker to close than either one. While not a panacea for all financing woes, companies large and small should unholster the RDO when a tight financing window demands its flexibility.

In a PIPE transaction, a public company negotiates the sale of its securities – frequently common stock and warrants – to private investors. Because a private placement provides investors with illiquid securities, the sale is conditioned on a resale registration statement subsequently being filed with, and declared effective by, the Securities and Exchange Commission. Investors then must hold the restricted securities until the resale registration statement becomes effective, typically 60 to 90 days later. Because the shares purchased in the PIPE are not immediately transferable, investors can demand a steep discount to compensate for the illiquidity. While the discount for established, stable companies generally ranges from around 8 to 12 percent below the market price prior to the announcement of the PIPE, actual discounts vary widely, from no discount to over 50 percent in some cases, depending on the volatility of the issuer’s stock and the relative negotiating leverage of the parties. Unfortunately for the issuer, the public markets tend to react negatively to a discounted sale price in a PIPE deal, and the public trading price typically falls to around, or below, the price offered in the PIPE.

The beauty of an RDO is that it combines the strengths of a PIPE with a price point similar to that achieved in a public offering. In a registered direct offering, the issuer files a shelf registration statement with the SEC in advance of the anticipated need for funding, which allows the registered shares to be taken “off the shelf” when market conditions are ideal. The company can then line up a group of investors. Investors are not required to negotiate or sign any purchase agreement; consequently, no documentation has to be completed with purchasers. This reduces legal and administrative expenses and shortens the marketing period. Because investors receive fully liquid securities, they are not in a position to demand a substantially discounted price, so the issuer avoids the dilutive effect of a PIPE transaction. The average discount offered in an RDO is only 4 to 6 percent, which helps prevent a substantial drop in the market price of the securities, in contrast to a PIPE. In short, an RDO enables an issuer to move quickly and quietly, just like a PIPE, but also delivers a reliable price.

RDOs have existed for years, but they have only recently become a preferred capital-raising technique. For smaller issuers, the increased use can be traced to SEC rule changes which became effective in 2008, aimed at making it easier to conduct a shelf registration. Under the revised rules, a company with less than $75 million in public float may file a shelf registration for a primary offering, provided they:

• meet other eligibility criteria for the use of Form S-3 (including having a class of securities registered under the Securities Exchange Act of 1934 and making timely periodic filings under the Exchange Act for the past 12 months)
• have a class of common equity securities that is listed and registered on a national securities exchange (including the NYSE, NASDAQ, AMEX or any of seven other smaller exchanges)
• sell no more than the equivalent of one-third of their public float in primary offerings in reliance upon the new relaxed eligibility criteria over the period of 12 calendar months before filing the registration statement
• are not shell companies and have not been shell companies for at least 12 calendar months before filing the registration statement.

The increased use of RDOs also can be traced, in part, to differences in regulation of RDOs as compared to PIPEs. Securities exchanges require prior shareholder approval if an issuer conducts an offering of securities other than a public offering, such as a PIPE, that results in the issuance of 20 percent or more of the issuer’s total outstanding capital stock. Issuers may be able to sidestep the 20 percent rule by conducting an RDO because a properly structured RDO will be deemed a “public offering” by the securities exchanges, eliminating the need to seek shareholder approval. To be considered a public offering, the RDO must either be, or be disclosed and distributed in the same general manner as, a firm commitment underwritten securities offering. Relevant factors the securities exchanges will consider in determining if an RDO is a public offering include the number of investors, the breadth of the marketing effort, and the extent to which the issuer (rather than the underwriter or placement agent) controls the offering and its distribution.

Meanwhile, larger issuers also have turned to the registered direct offering as a preferred financing vehicle as increased competition for scarce funds has driven demand for flexibility. In much of 2008 and so far in 2009, capital market volatility has made it difficult for companies to spot and take advantage of tight financing windows. In addition, companies have worried that short sellers would deflate the issuing price in advance of an announced public offering in anticipation of a drop in the price of the securities upon completion of the offering. Under normal market conditions, security holders of large, seasoned issuers might not be spooked by a sudden drop in stock price, but with the market slowdown, even large companies were wary of leaving their capital-raising to the whims of a skittish public. In short, companies large and small have found a need for a capital-raising process that is quick and quiet. The RDO structure largely satisfies these considerations.

However, the RDO is not a cure-all. Merely filing an S-3 could spook the market if the investor relations aspect is not handled correctly. The RDO also has not been immune from the economic downturn. Even as a growing number of companies have sought to make registered direct offerings, purchasers have practically disappeared, having retreated to the sidelines in anticipation of more stable capital markets. Consequently, investors have been putting growing pressure on issuers to include warrants alongside steeper discounts in registered direct deals. Since the middle of 2007, two-thirds of registered direct deals issued by companies with market capitalization of less than $250 million have included warrants. Even large issuers are compelled to include warrants almost one-fifth of the time. While the RDO has proven better than many alternatives, it is not without its drawbacks.

The key to effective use of the RDO, of course, is early registration on Form S-3, which necessitates a different way of thinking about raising capital. The issuer cannot simply wait until it needs funds to begin thinking about how it will raise them. Given the many advantages of an RDO, it makes sense for companies to place some securities on the shelf in anticipation of a future offering.

If you are considering a public offering of securities, please contact any of the attorneys of Pepper Hamilton’s Corporate and Securities Practice Group. We can assist you and your company with a wide variety of capital raising alternatives, including raising capital through a public offering registered on Form S-3.

Robert A. Friedel and Neil C. Cavanaugh

The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, 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.

This is the third in a series of e-Alerts that the Compensation and Employee Benefits Practice Group of Troutman Sanders LLP is issuing on Code Section 409A.  Please refer to our earlier e-Alerts which are posted on our website for a general overview of Code Section 409A and a more specific analysis of the rules regarding separation pay.

Stock options and stock appreciation rights with exercise prices less than the fair market value of the underlying stock at the date of grant (with certain exceptions), and restricted stock and other equity awards that are not paid shortly after vesting, need to be brought into compliance with Code Section 409A by December 31, 2007.  Exercises of such options and rights, and payments of such other rights, before January 1, 2008 could result in a violation of Code Section 409A.

Section 409A of the Internal Revenue Code, as amended (the “Code”), imposes significant requirements on “deferred compensation.”  As noted in our first e-Alert dated May 5, 2007, deferred compensation under Code Section 409A includes certain types of equity-based compensation arrangements that are not usually thought of as deferred compensation, if no exemption is applicable.

Companies should review their equity plans and outstanding awards to determine whether and the extent to which Code Section 409A applies.  Although the new tax regime generally became effective as of January 1, 2005, the written document that sets forth the award must comply in form with Code Section 409A by December 31, 2007.  To the extent any stock options or other equity awards have been modified, repurchased, exercised or terminated after October 3, 2004, they should be reviewed by the company for operational compliance with Code Section 409A.  If not compliant, the correction could not only be very complex but also costly for the affected service provider (e.g., employee, director or independent contractor).  Failure to comply with Code Section 409A may result in the service provider including the “deferred compensation” in income at the time it vests (and periodically thereafter) and being assessed a 20 percent tax in addition to normal income taxes. 

A.        Equity Awards Not Subject to Code Section 409A

Many typical equity arrangements are not subject to Code Section 409A because of a number of available exemptions.  Incentive stock options and purchase rights under qualified employee stock purchase plans are exempt from Code Section 409A (absent no impermissible modification).  Restricted stock awards generally are exempt from Code Section 409A provided the service provider does not elect to defer receipt and taxation of the stock later than the time it vests.  Stock options and SARs that were granted before October 4, 2004 and fully vested by December 31, 2004 (unless materially modified) are exempt from Code Section 409A under a special grandfather rule.

Non-qualified stock options and stock appreciation rights (“SARs”) are not subject to Code Section 409A provided (i) the exercise price is no less than the fair market value of the underlying stock on the date of grant, (ii) the number of shares subject to the option or SAR is fixed on the date of grant, (iii) the option or SAR covers “service recipient stock,” and (iv) the option or SAR does not include any deferral feature.  Exempt SARs cannot give the holder compensation that is greater than the excess of the fair market value of the underlying stock on the date of exercise over the exercise price. 

• To be exempt from Code Section 409A, non-qualified options or SARs must be granted with respect to “service recipient stock,” which generally means any common stock of an “eligible issuer of service recipient stock.”  An eligible issuer of service recipient stock means (i) the corporation (if the entity receiving the services is a corporation) for which the service provider provides direct services and with respect to whom the right to the compensation arises and (ii) any corporation in a chain of corporations or other entities in which each corporation or other entity has a controlling interest in another corporation or other entity in the chain, ending with the corporation or other entity that has a controlling interest in the corporation or other entity for whom the services are being provided on the date of grant of the option or SAR.  For this purpose, a controlling interest generally means 50 percent or more, although a controlling interest may be as low as 20 percent if a legitimate business reason exists for using the lower threshold.  An eligible issuer of service recipient stock is not the same as the service recipient.  The service recipient generally means the person for whom the services are performed and with respect to whom the legally binding right to the compensation arises (and all related entities within the same controlled group of corporations or under common control with the service recipient).
• The common stock for purposes of this exemption does not include any class of stock that has any preferences as to distributions other than distributions of service recipient stock and distributions in liquidation of the issuer of the stock.
• Common stock is not “service recipient stock” if it is subject to a mandatory repurchase obligation (other than a right of first refusal), or a permanent put or call right, at other than fair market value.
• Code Section 409A also imposes certain valuation requirements to determine the fair market value of the underlying stock for purposes of the exemption.  If the stock is publicly traded, the value may be the closing price or an average price on the trading date before or on the date of grant, so long as the method is consistently applied.  The value can also be based on an average selling price that covers a specified period within 30 days before or after the date of grant, provided the commitment to grant the award is irrevocable and the valuation method is consistently applied and fixed in advance.
• For stock that is not publicly traded, any reasonable valuation may be used as long as it is consistently applied.  A reasonable valuation should address (i) the value of tangible and intangible assets of the corporation, (ii) the present value of anticipated future cash flows, (iii) the market value of the stock, (iv) the value of other entities engaged in similar trades or business, (v) recent arms length transactions involving the stock, and (vi) other relevant factors such as control premiums and discounts for lack of marketability.  The valuation method is not reasonable if it does not take into account all available material information.  For purposes of the exemption, the valuation cannot be as of a date that is more than 12 months earlier than the date of grant of the award.  There also are “safe harbor” valuation methods for certain independent appraisals (including ESOP valuations), formula valuations and start-up companies.  These safe harbor methods are presumed to result in a reasonable valuation that can only be rebutted by a showing that the valuation method was grossly unreasonable.
• Any right that allows a recipient to elect to defer payment to a time later than the exercise of the right or the time the stock acquired would become vested likely would constitute a prohibited deferral feature.
• Special attention should be given to any right to receive dividends on the shares underlying the stock right.  To the extent the right to receive the dividends is, directly or indirectly, contingent upon the exercise of the right, the stock option or SAR will not be exempt.  If the right to dividends is not contingent upon, or otherwise payable on, exercise of the right, the dividend rights should not cause the option or SAR to fail to be exempt, although the dividend right is potentially a separate deferred compensation arrangement.
• The exemption should apply to tandem rights where all the terms except the mode of payment, i.e., cash or stock, are the same.
• Until further guidance is issued, taxpayers may apply these same principles to equivalent rights in partnership interests.

B.        Equity Awards Subject to Code Section 409A

The most significant exemption available for equity awards that do not qualify for the exemption described above for options and SARs is the “short term deferral rule.”  This rule exempts payments from Code Section 409A provided they are to be made by the 15th day of the third month following the end of the year in which the right to the payments vest (either the year of the service recipient or of the service provider, whichever is later).

Accordingly, discounted options or SARs or options or SARs covering stock that does not qualify as “service recipient stock” generally are subject to Code Section 409A where the option or SAR can be exercised later than the 15th day of the third month following the end of the year in which the right to exercise the option or SAR vests.  Restricted stock units, performance awards and other incentive awards also are subject to Code Section 409A, unless they qualify under one or more of the other exemptions under Code Section 409A, such as the short-term deferral rule described above.

Moreover, exempt options and SARs may become subject to Code Section 409A if they are impermissibly modified or the period for exercise of the option or SAR is extended.  Options and SARs that are vested as of December 31, 2004 and grandfathered also remain so only as long as they are not materially modified.  Options and SARs generally are deemed vested if there is no substantial risk of forfeiture or any requirement to perform future services.  As a general rule, a noncompete restriction is not considered a substantial risk of forfeiture for purposes of Code Section 409A.  However, options or SARs that are subject to a noncompete restriction will not be considered vested for purposes of the grandfather rule.

Before January 1, 2008, discounted options and SARs that are not grandfathered may be replaced with fair market value options or SARs provided cancellation and reissuance does not include the payment in 2007 of cash or other vested property to the holder of the replaced option or SAR.  This transitional rule does not apply to options or SARs granted by a public company to a director, officer or principal shareholder to the extent the compensation expense related to the discounted option or SAR was not timely reported according to generally accepted accounting principles.

An option that is exempt from Code Section 409A may become subject to Code Section 409A if it is modified, because the modification may be treated as the grant of a new award.  The term “modification” generally includes any change in the terms of the option or SAR that provides the holder with (i) a direct or indirect reduction in the exercise price, (ii) an additional deferral feature, or (iii) an extension or renewal of the right, regardless of whether the holder in fact benefits from the change in such terms.  An extension includes not only an extension of the option or SAR but also conversion of the right into a payment of compensation in the future.  When the term of an option or SAR is extended, it is treated as having an additional deferral feature and, thus, subject to Code Section 409A from the original date of the grant, unless the option is extended to no later than the earlier of the original maximum term of the award determined without regard to any early termination feature or 10 years from the date of grant.  Extensions that are not later than the earlier of the original maximum term of the award or such 10 years will not be treated as the grant of a new award.  Certain modifications will not disqualify the option’s or the SAR’s exempt status, such as (i) accelerating vesting of the award, (ii) allowing the stock right to be transferred, (iii) permitting payment of the exercise price through previously-owned shares, (iv) changing the way required withholdings are paid, (v) extending underwater options or SARs (which will be treated as a new right) or (vi) if the right is tolled while the holder cannot exercise it in certain circumstances.  For example, there is not a prohibited extension of an option or SAR if the expiration of the option or SAR is tolled while the holder cannot exercise the right because the exercise would violate federal, state, local or foreign law, or jeopardize the ability of the company to continue as a going concern, provided that the period during which the option or SAR could be exercised is not extended more than 30 days after the exercise of the option or SAR first would no longer violate an applicable federal, state, local or foreign law or jeopardize the ability of the company to continue as a going concern.

There also is an exemption for modifying options or SARs in connection with corporate reorganizations or transactions so long as certain ratio and spread tests are satisfied.  For Code Section 409A purposes, if the aggregate spread of the new stock right does not exceed the aggregate spread of the old stock right and the ratio of the exercise price to the fair market value of the shares subject to the right immediately after the substitution is not greater than the ratio of the exercise price to the fair market value of the shares subject to the right immediately before the substitution, then the substituted stock right will not be treated as a grant of a new option or SAR for Code Section 409 purposes. 

On August 15, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued Notice 2025-42, which provides guidance on the beginning of construction requirement as it relates to the new credit termination dates for wind and solar projects enacted by the One Big Beautiful Bill Act (OBBBA).

The OBBBA terminates the clean energy production tax credit under Section 45Y (CEPTC) and the clean energy investment tax credit under Section 48E (CEITC) for wind and solar facilities that begin construction after July 4, 2026, and are placed in service after 2027. On July 7, 2025, President Trump issued an executive order directing Treasury “to strictly enforce the termination” of the CEPTC and the CEITC for wind and solar facilities and to issue new and revised guidance “to ensure that policies concerning the ‘beginning of construction’ are not circumvented.”

Key takeaways from Notice 2025-42:

Applicability/Effective Dates. Notice 2025-42 is effective for wind and solar projects that begin construction on or after September 2, 2025.

• Troutman Pepper Locke Insight: This means that the pre-existing guidance (i.e., Notice 2022‑61) continues to apply to determine whether solar and wind facilities have begun construction on or before September 1, 2025, for purposes of the CEPTC and CEITC. Notice 2022-61 applies principles from prior beginning of construction notices (specifically Notice 2013-29 and Notice 2016-31) to the CEPTC and CEITC, including the Five Percent Safe Harbor, Physical Work Test, and Continuity Safe Harbor.  
• Troutman Pepper Locke Insight: The notice applies to wind and solar only (and not, e.g., to batteries).  

Five Percent Safe Harbor. Notice 2025-42 generally eliminates the Five Percent Safe Harbor, although there is an exception for facilities with a nameplate capacity of less than 1.5MW (AC), subject to an aggregation rule.

• Troutman Pepper Locke Insight: The aggregation rule is different from the “single project” rule from prior beginning of construction guidance, but it is generally consistent with the aggregation rule for the less than 1 MW exception to the prevailing wage and apprenticeship requirements in the CEPTC and CEITC regulations.  

Physical Work Test. Notice 2025-42 preserves the Physical Work Test.

• Troutman Pepper Locke Insight: The initial draft of the notice issued by the IRS included a parenthetical referencing transformers that “step up the voltage to less than 69 kV,” which was removed in an update later in the day.  

Continuity. Notice 2025-42 preserves the four-year Continuity Safe Harbor and the “continuous program of construction” facts-and-circumstances test, but removes the “continuous efforts” test.

• Troutman Pepper Locke Insight: Preservation of the four-year Continuity Safe Harbor is a welcome development. Elimination of the “continuous efforts” test, which had initially been applied only to the Five Percent Safe Harbor under early beginning of construction guidance and was later extended to the Physical Work Test in Notice 2021-41, will make satisfying the continuity requirement under the facts-and-circumstances test more difficult.  

Notice 2025-42 is better than many feared and worse than many hoped for. Preservation of the Physical Work Test, including for off-site work, and the four-year Continuity Safe Harbor is a relief. Elimination of the Five Percent Safe Harbor for most projects, rather than a mere increase in the percentage, is disappointing. The September 2, 2025, effective date provides taxpayers a very narrow window for adjusting their beginning of construction strategies.

Please contact any of the authors of this advisory if you have further questions or need help implementing beginning of construction strategies.

Introduction

It is well-settled law in Virginia that the plain terms of contracts must be enforced as written. However, contracting parties “may evince a mutual intent to modify the terms of their contract” through a “course of dealing.” That means that a party can argue that a court should not apply the written terms of an agreement when the parties have modified the contract terms through a course of conduct. To give effect to any alleged modification, however, the party asserting the change must satisfy several rigorous requirements. Additionally, once it is shown that a contract should be modified by a course of dealing, questions may remain as to the permissible scope of any modification. This article explores the effect of a “course of dealing” on contract modification practices in Virginia and how any such claims could be advanced and contested under Virginia law.

Click here to read the full article in Virginia Lawyer Magazine.

Chris Porter and Martha G. Dean, 2025 summer associates with Troutman Pepper Locke who are not admitted to practice law in any jurisdiction, also contributed to this article.