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Setting up a closely held Opportunity Fund

The 2017 Tax Act provides a special tax incentive to encourage investing in low-income communities.  The new rule encourages taxpayers to sell their appreciated capital assets and invest an amount equal to the resulting capital gain in “Qualified Opportunity Funds” (“O-Funds”) that, in turn, invest in designated low-income communities, called “Opportunity Zones” (“O-Zones”).   Despite the use of the word “fund,” this is not something that can only be set up by a large corporate investor or needs an elaborate securities law disclosure.  It isn’t hard for a home office, closely held business, or a few family members or friends to set up a fund and make investments.

To encourage these investments, the law provides three basic tax incentives:

  • By timely investing an amount equal to the capital gain in an O-Fund, an investor can delay recognizing the gain (and paying the resulting tax) until December 31, 2026.
  • When recognized, the taxable gain will generally be reduced by 15 percent, or possibly more, if the investment has been held for seven years.
  • There will be no further tax on a sale of the O-Fund investment if it is held for ten years or more.  

Until recently, the rules were sparse on detail, and only a few taxpayers with large capital gains and an expiring opportunity to make an O-Zone investment were willing to take a chance on making investments.  However, with the recent publication of proposed regulations, the IRS has provided a sufficient, even if less than complete, framework for investors to make investments.  Still, even with this guidance, tax advisors are sometimes left to making their best judgments about what will and won’t work. 

Moreover, summarizing the O-Zone tax rules isn’t easy.  Almost every rule has one or more exceptions, and the rules are so technical that it can make for the kind of reading that exhausts even an experienced tax lawyer or accountant.  For example, many of the tax benefits are derived from adjustments to a taxpayer’s “basis” in its investment, a pretty complicated tax concept, even before we get to the more specific O-Zone rules.  Rather than give a graduate course in tax law, I’ll be describing the typical tax benefits associated with O-Zone investing.  So, as you read this summary, remember that it is just a summary.  Discussing the tax rules with your tax advisor is crucial to make sure that you get the tax breaks that you are expecting.

 A Brief Overview of the Rules.

  • No Direct Investing.  All investing must be done through an O-Fund.  Simply making an investment in your own name will not qualify for the benefits.  An O-Fund must be a partnership or a corporation, or a limited liability company (“LLC”) taxed as a partnership (because it has two or more members) or corporation (because it makes an election).  So, one of the basic requirements is that you will have to form an entity that files tax returns in order to make O-Fund investments.
  • Invest in O-Fund Within 180 Days.  Investments must be made within 180 days of the transaction that generated the capital gain.  There is a special exception for gains recognized by partnerships; either the partnership or its partners can be the investor in an O-Fund, and if it’s the partners, their 180-day period can begin far later, on the final day of the partnership’s tax year, which will often be December 31 of the year that resulted in the gain.
  • Character of the Gain.  Even after the deferral, short term capital gains (generally taxed at higher rates for individuals) will still be short term capital gains in the year that the gain is recognized, and the gain will be taxed at the then applicable tax rates.
  • Reducing the Amount of Gain.  The gain recognized in 2026 is the difference between the amount invested and the taxpayer’s basis, with a couple of exceptions.  An investor’s basis in its investment in the O-Fund starts at 0.  It is increased to 10 percent for investments held for 5 years, and another 5 percent for investments held for 7 years.  If the 5 or 7-year requirement would run beyond 2026, then that benefit is lost.  For example, investments made in O-Funds after December 31, 2019 will not qualify for the 10 percent step-up.
  • Smaller Amount Recognized.  If the investment in the O-Fund is sold before December 31, 2026, then the gain is recognized at that time, and if an investment declines in value, then the smaller value is used instead of the original amount deferred.
  • Tax Treatment of Selling Assets.  The no-tax-after-10-years rule applies to sales or transfers of the investment in the O-Fund.  Under current law, it does not apply to a sale of assets owned by the Fund.  It should be noted that many (including the original proponents of the new rules) have argued that it should apply to sales of assets, but it will take a change in law to make that happen.
  • Taxation of O-Funds.  The O-Fund itself will be a partnership or corporation, or an LLC taxed as one or the other. So, if it is a partnership, it will prepare a partnership tax return, and allocate its income, losses, credits, and other tax items among its partners in accordance with its partnership agreement and applicable tax law.  If it is a corporation, then it will prepare a corporate tax return and pay its own taxes.  The O-Zone rules do not eliminate the normal tax rules that apply to partnerships, LLCs, and corporations.


Where are O-Zones?

For many years, the government has announced “low income communities” (or LICs), which are census tracts with specified high poverty rates or low median family income.  The O-Zone rules allowed each state to designate not more than 25% of its LICs, plus a few census tracts that are adjacent to LICs, as O-Zones.  In total, there are now 8,700 O-Zones, which is about 11% of all census tracts.  IRS Notice 2018-48 ( provides a complete list, and maps of the census tracts can be found in many locations, including this one maintained by the federal government: 

What do I have to do to set up an O-Fund?   

As I noted earlier, O-Funds are simply partnerships, corporations, or LLCs that are taxed as partnerships or corporations, and which elect to be treated as an O-Fund.  The IRS has posted a short, draft form for making the election.  So, the first steps, forming an entity and making an election, are easy.   

A bit harder is meeting the percentage and timing tests.  First, an investor must make an equity investment in the O-Fund with an amount that is equal to (or less than) a recent capital gain, and receive back a partnership or LLC interest or stock.  As noted above, the investor generally has 180 days, including the date of the sale or exchange, to invest in an O-Fund, and the rules allow an investor to invest in multiple O-Funds, provided the total invested does not exceed the amount of the gain.  Second, your O-Fund must invest, either directly or indirectly, in opportunity zone business property in accordance with specified, highly technical, timetables.  I discuss some of those rules below.  Note that you don’t have to “trace” the funds used to make your investment; you could use the gain from a sale of stock to buy a boat, and then, a few months later, use other money to make your O-Zone investment.

Here’s Just a Bit of the Technical Rules. 

Ongoing compliance with the O-Zone rules is where the “heavy lifting” begins.  The rules are deep in computations, and the tax rules impose requirements that may seem arbitrary.  Much of this is due to the significantly different rules that apply when an O-Fund acquires O-Zone business assets directly as compared to investing indirectly by acquiring Qualified O-Zone Stock or Qualified O-Zone Partnership Interests, with these “subsidiary entities” running the O-Zone business.  In general, it can really matter whether an investment is made directly or through another entity, and this makes it extremely difficult to have rules of thumb or best practices. 

A few observations –

  • The Ninety Percent Test.  First, no matter which structure is chosen, 90 percent of an O-Fund’s assets must be in certain “good” assets, and this is tested at the 6-month point and year-end of each taxable year.
  • Good Direct Investments.  The following are good assets --  
    • Tangible assets used in a trade or business that are either new or substantially improved (more on that below) and acquired from an at least 80 percent unrelated person, after 2017.
    • O-Zone Stock and O-Zone Partnership Interests, also discussed in greater detail, below.
  • Ten Percent Other Investments.  The following are “other” investments, and must be limited to no more than ten percent of the O-Fund’s assets –
    • Everything Else.

    The other investments can be just about anything, provided they are kept below ten percent of total assets.

  • Subsidiary Entities.  With indirect ownership, each subsidiary entity is tested to assure that it passes additional tests, some of which are easier than the tests that apply to direct ownership by the O-Fund, and some of which are harder. 
  • First, an easier rule -- only 70 percent of a subsidiary’s tangible assets have to be either new or substantially improved, and acquired from an at least 80 percent unrelated person after 2017.

    But here are tougher rules -- no more than 5 percent of the subsidiary entity’s assets can consist of something called “nonqualified financial property, essentially cash and similar liquid assets, as well as partnership interests and stock.  And, certain so-called “sin businesses” like liquor stores and tanning parlors, are prohibited altogether.  Finally, at least 50 percent of the subsidiary entity’s income must come from the conduct of an active trade or business in the O-Zone. 

    Here’s the important distinction from direct investing – so long as a subsidiary entity passes the relevant tests, the entire interest in the entity counts as a good asset.  In other words, even though a O-Fund can directly own just ten percent non-qualifying assets, it can own a subsidiary entity that has thirty percent non-qualifying tangible assets, and an indefinite amount of certain kinds of intangibles.  For example, using a subsidiary partnership or corporation, an O-Fund can indirectly own a business with significant intangibles, e.g., a franchise or goodwill, that it could not own directly under the 90 percent test that applies to direct ownership.  It can also indirectly own a business that fails other tests – for example, it could have up to 30 percent unimproved, used tangible assets, or tangibles located outside the O-Zone.  On the other hand, a subsidiary entity can only have five percent of its assets in the form of cash, which is less than the ten percent other assets permitted for an O-Fund, if held directly.  But don’t miss one last distinction between the two possible structures, perhaps the most arbitrary of all – an O-Fund’s directly owned assets must be used in a “trade or business,” while a subsidiary entity must be engaged in an “active trade or business.”  At this time, it’s not clear whether certain traditionally passive businesses, e.g., triple-net leasing, can be conducted by a subsidiary entity and still be eligible for favorable O-Zone benefits.

  • Substantial Improvement.  I noted earlier that used property must be substantially improved.  This requires the owner to make “additions to basis” within any 30-month period after acquisition greater than the basis in the property at the start of the 30-month period.  Basis in land does not count for this purpose.  The IRS has gone one step farther on this rule, and provides a “safe harbor” -- if a property is newly constructed or rehabilitated by a subsidiary entity within a 31-month period in substantial compliance with a written plan, then any cash that the entity holds awaiting use in the new construction or rehabilitation is not nonqualified financial property, and the entity will generally be considered engaged in an active trade or business during the construction or rehabilitation.  The safe harbor can be particularly important to project development, for example, allowing a 31-month window to construct or rehabilitate a building.

Penalties and Reasonable Cause.

The Code provides a relatively low cost solution when an O-Fund fails to meet the 90 percent requirement.  The Fund is subject to a penalty at the IRS’s “underpayment rate,” currently 5 percent, on the shortfall.  An O-Fund can avoid this penalty if the failure is due to reasonable cause.  At this time, we don’t know whether investors can simply “do their best” to comply with the rules and thereby avoid the penalty, even if the O-Fund never had sufficient good assets to meet the 90 percent requirement, but the Code provision certainly appears to call for this favorable treatment. 

A Few Final Observations.

As I noted earlier, the O-Zone rules are so technical that it isn’t possible to describe them in anything that is both short and understandable.  So, in lieu of many more pages of discussion, here are a few more highlights –

  • Developers.  The O-Zone rules can also be used by developers.  Remember that like a third-party investor, a developer has to invest an amount equal to a recent capital gain.  Having done that, it should be possible to structure an O-Fund that gives the investor a preferred interest in the O-Fund and the developer a larger share of the back-end.
  • The Ten Year Rule.  As I noted earlier, there has been a significant outcry about the no-tax-after-ten-years rule only applying to sales of interests in O-Funds (and not the underlying assets).  Don’t be amazed if this rule gets amended sometime in the next ten years.  Unless and until that happens, it may be desirable for O-Funds to have a limited number of similar assets so as to facilitate a sale of interests in the entity down the road.  An O-Fund with many different assets will benefit from diversification, but it may have trouble finding a buyer at the entity level.
  • Be Sure to have a Plan.  With the two primary benefits of O-Zone investing being a delay in the payment of current tax and the elimination of tax on gains associated with very long term investing, it is important to make smart investments.   For some investors, this means just getting a delay in payment of tax and preserving capital; for others, it means taking a risk and trying for a non-taxable “home run” from the future sale of a significantly appreciated investment of the next brilliant start-up.  Be sure to have a plan and a team for implementing your strategy.  Depending on an investor’s current assets, it will generally make sense to find an O-Zone investment, and then sell assets to generate a capital gain.
The SEC’s Guidance on When Digital Assets May Be Deemed Securities, and How This Affects Investment Funds

In June, the Director of the SEC’s Division of Corporation Finance provided important but nonbinding guidance on the factors that are likely to be reviewed when determining whether a digital asset, such as a utility token, may be deemed a security.  Ever since the DAO report issued in July 2017, the SEC has showed a slow evolution on its views on the approaches taken by some crypto and digital asset industry participants that have attempted to structure digital assets so that they are not securities in sales.  In the DAO report, the SEC first officially applied the “Howey Test,” a test from a 1946 Supreme Court case regarding the sale of orange grove plots that to this day continues to be the primary guidance for when an instrument is an “investment contract” and thus a security.  The Howey Test, generally, requires (i) an investment of money (which need not be in the form of cash), (ii) a reasonable expectation of profits, that are (iii) derived from the managerial efforts of others.

Guidance Takeaways

As noted by Director Hinman in his remarks, these are still the “early days” of crypto, but with this latest guidance, the SEC has provided more clarity around securities law compliant digital asset sales.  That said, his guidance leaves a lot of questions unanswered.  Hopefully, over time ambiguities will become clear as more no-action letters and other informal guidance are released.  Until then, Director Hinman’s remarks can help us understand how the SEC will fit digital assets into its current framework, particularly since there have been public statements that the SEC has no intention of making new regulations tailored to these instruments.  Certain key takeaways from this speech are as follows:

  • Digital assets that represent a set of rights giving the holder a financial interest in an enterprise likely are subject to US securities laws. 
    Referring to the digital asset as a “coin” or “token” will not impact the analysis regarding whether the digital asset is a security.  Just because you patent a method as a currency, it doesn’t mean it’s a currency for securities law purposes—instead the economic substance governs.  Although a digital asset may begin its life as a security, it may change character over time.  For instance, a cryptocurrency that starts its life as a currency could subsequently become a commodity, particularly if the purchasers are not making an investment in the development of an enterprise.  A digital asset that is (i) initially offered in a securities offering and is no longer connected to an investment in a central enterprise or (ii) is later sold only to be used to purchase goods or services available through the digital asset’s network might possibly lose its character as a security. 
  • A number of factual circumstances surrounding the sale or offering of a digital asset will be important to the analysis under the Howey Test regarding whether the digital asset is a security:
    • Passivity of purchasers.  It is more likely to be a security if purchasers are passive in nature and rely on the efforts of others to increase the value of the purchased digital asset.
    • Marketing efforts.  It is more likely to be a security when the issuer solicits many types of investors, regardless of whether they intend to use the digital asset for its intended purposes or to resell it for a profit.
    • Network maturity.  It is more likely to be a security if the digital asset is being sold at a time when the platform on which it will be used is largely undeveloped, as it looks more like a bet on the success of the enterprise through efforts of others than the purchase of something used to exchange for goods or services.
    • Network decentralization.  It is less likely to be a security if the network is sufficiently decentralized, for instance where a person or group is no longer carrying out essential managerial or entrepreneurial efforts.
  • Central to determining whether a digital asset is a security is how the digital asset is being sold and what the purchaser expects when making the decision to purchase the digital asset.
    While an asset may not be a security under certain circumstances—like if it is mined.  Under different circumstances the same asset may be a security—like if it is sold to non-users for the purpose of developing an enterprise, by a person or coordinated group (including unincorporated organizations) where the value of the asset may be dependent on the success of the enterprise.
  • Bitcoin and Ether are sufficiently decentralized such that no central third party exists whose efforts are key determining factors in the enterprise, and therefore, the sale and resale of Bitcoin and Ether are not securities transactions.
    That said, a cryptocurrency that isn’t a security could be packaged in a way that makes it a security.  For example, if Bitcoin were placed in a fund or trust and interests in the fund or trust were sold, the interests would be a security even though the asset in the fund or trust is not.  Further, a factor in determining whether a cryptocurrency might be a security is whether applying the disclosure regime of federal securities laws would add value to investors.  It also appears based on this factor that a mined cryptocurrency would be less likely to be a digital asset.
  • Certain other factors will be considered, on a non-exclusive basis, in determining whether a digital asset is a security:
    • Did someone sponsor or propose the creation or sale of the digital asset where the efforts of others play a significant role in the development and maintenance of the asset and its potential increase in value?
    • Has the sponsor retained a stake in the digital asset so it can benefit from an increase in value?
    • Has the promoter raised more than it needs to establish a functional network, and, if so, has it disclosed the use of proceeds? Will the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
    • Are purchasers seeking a return?
    • Would the application of the Securities Act provide additional protection to investors, and does that make sense?
    • Do persons or entities other than the promoter exercise governance rights or meaningful influence, or is governance based solely on consensus?


So how does this affect private equity and venture capital?  The lack of specificity, and lack of knowledge on how much weight the SEC would provide to each of these factors, create a lot of uncertainty.  Questions abound when looking at this guidance from an investment fund’s perspective:

  • If I manage or invest in a fund that invests in crypto assets, how can I be sure that the assets in which I invest are securities, commodities, currencies, or something else?
     Securities, commodities, and currencies are subject to completely different regulatory regimes.  Securities are governed by federal securities laws, SEC rules, and state Blue Sky laws.  Commodities are governed by the Commodity Exchange Act and the rules of the CFTC, and additional local laws in some states.  Currencies that are not federally issued currencies are still subject to state money transmitter laws.  Navigating through this morass can be a daunting task.  Furthermore, it’s still not clear whether a virtual asset could be both a security and a commodity at the same time, like certain types of swaps.
  •  If you’re a venture capital firm, do you need to revisit agreements from prior rounds to ensure the portfolio company can’t have an initial coin offering without your consent or complying with pre-emptive rights? 
    While the latest round of NVCA forms contemplates digital assets, many older forms do not, and oftentimes there are only protective provisions with respect to the issuance of equity securities.  Even if these rights are limited to securities, the SEC has left the door open for the issuance of certain types of utility tokens that might not be securities.  While virtual assets generally don’t have an immediately dilutive effect, there may be significant effects on revenue streams down the line, and it might make it more difficult to exit the investment.
  • Are digital assets equity securities?
    While most securities practitioners have long agreed that the Howey Test would determine whether a digital asset is a security, there’s no consensus on how to determine whether a security is an equity security or some other kind of security.  This may add uncertainty to investors that do want a portfolio company to ICO, and if the securities are equity securities, registration under the Securities Exchange Act would be required, and thus the issuer would need to file burdensome periodic reports such as 10-Ks and proxy statements if there are more than 2,000 holders or more than 500 holders who aren’t themselves accredited investors.
  • Are you subject to limitations on compensation for developers, and can an instrument be both a security in the hands of some people and not a security in the hands of others? 
    A key component of the Howey Test is that the profits would come solely through the efforts of others.  If you’re actually developing and inventing the security yourself and working on the development of the platform on which the token will be used, is it still a security in the hands of that developer?  If it is, then issuers would still likely be confined by Rule 701 under the Securities Act, which may be very difficult to monitor since the coins can’t be granted, and the price can’t be determined, until after they exist.
  •  Will a coin be a security when used in substitution for cash for an already-existing product and there’s already enough cash to incorporate the additional technology? 
    Some existing products and services are incorporating blockchain into their products and services, and having a blockchain nexus can make an ICO attractive as a bridge or pre-IPO round, or can help give the investor additional upside if it can exercise a right of first offer. Can the coin no longer be a security if it has a specific purpose and the point of the capital raise is to expand an existing offering rather than to create one?
  • What if a physical or software product is pre-loaded with a token and the token is required to use the product?
    In this instance, a token may look a lot more like a license for use, but if there’s an ability to trade that token it might be an investment contract under the Howey Test, even if the end user has no intent to transfer the token because they want to continue using the product.
  • Does it make sense to move a capital raise offshore rather than to keep it in the U.S.? 
    If an ICO is solely outside of the United States (or some type of restricted instrument is sold in a Regulation D offering in the U.S. and the non-U.S. sale is compliant with Regulation S pertaining to offshore offerings) and the issuer is a non-U.S. subsidiary of the portfolio company, there still is the potential to ICO without significant U.S. regulation.  That said, issuing instruments in foreign jurisdictions might create a number of regulatory issues for the portfolio company.
  • How will this guidance be applied at the state level?
    Not every state has adopted the Howey Test.  Thus, even if a virtual asset is not a security at the federal level, it still might be one at the state level, which could complicate the ability of issuers to sell in certain states.

Generally, Director Hinman’s remarks suggest a fairly major step forward in the SEC’s thinking regarding the regulation of virtual assets.  The SEC has recently made a point of being more transparent than under prior administrations, but there are still significant questions left to be answered.  While it is a very positive step that there is guidance that might help limit the securities laws’ recent chilling effect on token offerings and blockchain innovation in the U.S. markets, there is still a lot of uncertainty, which is something most fund managers are looking to mitigate.

Cybersecurity standards for private companies: Taking notes from the SEC’s public company guidance

The Securities and Exchange Commission (“SEC”) recently updated and expanded its guidance to public companies on cybersecurity risks and incidents in its "Commission Statement and Guidance on Public Company Cybersecurity Disclosures" (the “2018 Guidance”). The 2018 Guidance represents a broad recognition of the critical role that cybersecurity plays in the health of companies and the stability of markets.

“There is no doubt that the cybersecurity landscape and the risks associated with it continue to evolve,” said a statement released by SEC Chairman Jay Clayton. “Public companies must stay focused on these issues and take all required action to inform investors about material cybersecurity risks and incidents in a timely fashion.”

To support this effort, the SEC has created a cybersecurity website with helpful alerts and bulletins, compliance toolkits, and educational resources. In addition, the SEC has constituted a Cyber Unit charged with targeting a wide range of cyber-related misconduct, such as market manipulation through the spread of false information, hacking, and intrusions and attacks on trading platforms and market infrastructure.

While a private company can be reassured that a member of the Cyber Unit will not show up at its door, the 2018 Guidance offers useful insights about the evolving risks in the digital marketplace, as well as effective controls and procedures to manage these risks—all of which can inform a private company that must navigate similar pitfalls in the modern e-commerce environment. Cybersecurity is, as the SEC’s website states, “a responsibility of every market participant.”

To that end, the following are some key takeaways for private companies from the 2018 Guidance:

  • Disclosure is key. It is critical for companies to take appropriate action to inform investors about material cybersecurity risks and incidents in a timely fashion. Indeed, the SEC goes so far as to advise that a company may be obligated to make a disclosure even if it has not been the target of a cyberattack, but is merely subject to material cybersecurity risks.

    Throughout the 2018 Guidance, the SEC stresses the importance of disclosure of all of the material facts of material cybersecurity risks and incidents. But, a company may ask, what is “material”?

    • With regard to the materiality of facts, public companies follow the guideline disclosing facts that are required or necessary to make the disclosure and the statements therein not misleading. A company should disclose information if there is “a substantial likelihood that a reasonable investor would consider the information important in making an investment decision or that disclosure of the omitted information would have been viewed by the reasonable investor as having significantly altered the total mix of information available.” Measuring information to be disclosed against these standards will help a company avoid making a selective or partial disclosure.
    • With regard to the materiality of cybersecurity risks and incidents, a company should generally weigh the nature, extent and potential magnitude of the risk or incident—particularly as they relate to the compromised information or the business and scope of company operations. The range of harm—including harm to the company’s reputation, financial performance, and customer and vendor relationships—as well as the possibility of litigation or regulatory investigations or actions—is also an important indicator of materiality.
    • Bearing this in mind, a company might feel obligated to issue a tell-all statement to be sure to give a full disclosure. However, the 2018 Guidance clarifies that companies are not required to issue a “road-map” disclosure that might compromise cybersecurity efforts. Even so, while a company is not required to disclose so much information that it makes itself more vulnerable to a cyberattack, a company must be sure to disclose the risks and incidents that are material to investors, including the concomitant financial, legal or reputational consequences.
  • Policies and procedures are must-haves. Disclosure controls and procedures are crucial to a company’s ability to discern the impact of cybersecurity risks and incidents, and to take appropriate action in a timely fashion.

    • Effective controls and procedures should enable a company to identify cybersecurity risk and incidents, assess and analyze their impact and significance, provide for open communication with technical experts, and allow for timely disclosures. These procedures should include a protocol to determine the potential materiality of such risks and incidents.
    • Companies should assess their compliance with these policies regularly, as well as assess whether they have sufficient disclosure controls and procedures to ensure that relevant information makes its way to appropriate personnel, including senior management.
  • Management must be involved. A company’s directors, officers, and others responsible for developing and overseeing the controls and procedures must be informed about actual and potential cybersecurity risks and incidents in order to effectively develop and institute disclosure controls and procedures. Management has to remain informed of and engaged in cybersecurity efforts.

    Ultimate responsibility, however, does not fall solely on management. The 2018 Guidance states that a company’s governing body (such as a board of directors) is also responsible for overseeing management of cybersecurity risk and engaging with management on cybersecurity issues.

  • Companies must protect against cybersecurity-based insider trading. Knowledge regarding a significant cybersecurity incident may constitute material nonpublic information. Companies need to have policies and procedures in place to guard against insiders taking advantage of the period between discovery of a cybersecurity incident and disclosure to other investors.

    Companies should consider how their code of ethics or conflict of interest policies take into account and prevent transfers of company securities on the basis of material nonpublic information related to cybersecurity risks and incidents. Furthermore, companies should specifically consider whether it would be appropriate to restrict transfers during an ongoing investigation of a cybersecurity incident.

Effective cyber governance is becoming an essential component of a well-managed business. While the 2018 Guidance from the SEC is aimed at public companies, it is also a useful tool for private companies to assess their cybersecurity protections and protocols to ensure that they are taking every reasonable step possible to adequately guard against, yet be prepared for, cybersecurity risks and incidents. After all, public and private companies face many of the same challenges when it comes to adapting to the evolving risks of an increasingly digital world. Private companies would do well to take note of the standards set for their public peers as they forge their own paths forward, grow the size and complexity of their businesses, and look for useful resources on how to deal with information security issues in the digital age.

Minority investors beware, Delaware courts will not rewrite your operating agreement
A recent decision from Delaware’s Court of Chancery (the “Court”) makes clear that parties entering into an operating agreement for a noncorporate entity have wide discretion when structuring the rights of controlling and minority investors. It is possible for parties to waive fiduciary duties they might otherwise be owed, or to empower boards to engage in conflicted or self-interested transactions, and rarely will the implied covenant of good faith and fair dealing be available to a party seeking relief from onerous or unfair terms to which it expressly agreed. This freedom when contracting underpins the attractiveness of limited liability companies and limited partnerships; however, investors need to be mindful of potential outcomes permitted by a target entity’s governing documents in order to avoid a bad deal. The Court will not save them.
In Miller v. HCP, decided by the Court on February 1, 2018, a minority investor in a limited liability company challenged its board’s decision to sell the company without an auction process. The majority of the board was allied with a controlling shareholder entitled to the bulk of the modest sale proceeds due to the particulars of the entity’s operating agreement, whereas the minority investor who filed suit would receive very little compensation unless the company was sold at a much higher price. The board had little incentive to seek bids beyond what would satisfy the controlling shareholder and in fact did not pursue a fulsome auction process despite indications that other bidders might have been willing to pay significantly more for the company. The minority investor raised objections during the sale process and later claimed that the board breached its implied covenant of good faith and fair dealing by failing to try to maximize the sale price.
Significantly, under the terms of the operating agreement, the parties waived all fiduciary duties and granted the board sole discretion in pursuing a sale with an unaffiliated third party. The Court reasoned that the implied covenant of good faith and fair dealing—which is available to address contractual gaps the parties did not anticipate when negotiating the operating agreement —could not be invoked by the minority investor given there was not in fact a contractual gap implicated by the sale. Rather, since the operating agreement included an express waiver of fiduciary duty and a grant of authority to the board with respect to a sale process, and the slanted waterfall provision in black and white, the minority investor was stuck with the deal.
This unbending contractual overlay on the noncorporate form is in contrast to the world of corporations, where different standards of judicial review apply and boards have fiduciary duties to other investors that may not be waived. While the case remains subject to appeal, minority investors in LLCs or limited partnerships should be cautious since they choose to forego the statutory and common law protections tied to the corporate form and therefore must live with the operating agreement bearing their signature.
Contract 1 v. Fraud 0

Fraud. It’s something that we hope to never come across in a transaction, but the unfortunate reality is that it occurs from time to time and those involved in corporate transactions would be well-served to have at least a basic understanding of how it will be treated by courts.

A recent case – Teva Pharmaceuticals v. Fernando Espinosa Abdala, et. al. (Index No. 655112/2016, (July 31, 2017 N.Y. Sup. Ct.)) – provides some valuable insights in this area. In this case, Teva Pharmaceuticals (“Teva”) acquired a pharmaceutical company (the “Target”) and related intellectual property from two brothers for $2.3 billion, and after the transaction closed, Teva brought a fraud claim against the brothers alleging that: (i) the Target was selling pharmaceutical drugs that had not been approved by the Mexican government and (ii) the brothers had concealed this from Teva.

One of the key issues in this case was whether Teva could use evidence from the due diligence phase of the transaction to support their fraud claim.  The sellers argued that this evidence was barred because the purchase agreement contained a non-reliance provision, wherein Teva agreed that it was relying solely on the representations and warranties in the purchase agreement and not on “any materials made available to [Teva], during the course of its Due Diligence Investigation.”

Ultimately, the court sided with the sellers and enforced the non-reliance provision.  For some, this may be a surprising result because the alleged fraud goes directly to the very heart of the transaction.  A seemingly fundamental expectation of acquiring a pharmaceutical company would be that it is selling its pharmaceutical drugs legally. Moreover, Teva paid a substantial amount for the Target – $2.3 billion.  However, the court reasoned that the non-reliance provision in the contract was “specific” and thus, reflected the intent of the parties to be bound by it. It also pointed to the fact that Teva “is a sophisticated entity and performed extensive diligence.”

This case contains a number of valuable lessons and reminders for those involved in corporate transactions – namely:

·      To not gloss over non-reliance provisions, which are often viewed as part of the “boilerplate;”

·      For sellers, to incorporate references to the diligence process in their non-reliance provisions; and

·     For buyers, to undertake a thorough diligence process because as seen in the Teva case, the remedies for any issues that are not discovered in the diligence process may be limited.

Trends in public pension investments in private equity

Over time, public pension funds have become significantly underfunded. There are a lot of factors that explain this. Some are poor planning by the pensions, such as decreasing investments after periods of strong returns; overly optimistic promises to pensioners; changes in demographics; and stock market fluctuations. As a result, pension funds are now $2 trillion underfunded.

Additionally, typical pension investments, such as safer, low-interest bearing investments, are not providing the returns for pension funds to address their unfunded liabilities. So pension funds are under pressure to provide stronger returns from other asset classes, including private equity.

But investing in PE comes with some downsides. For one, management fees are higher than with other asset classes, which digs into the profitability of the funds. Over the past decade, fees have increased by 30%.  There are also ongoing monitoring and strategic costs related to PE investments that are greater than other asset allocations.

These high investment costs have not led to great returns. For example, one study showed that New York City’s biggest pensions would have done better had they invested in a stock index fund rather than PE.

So what are pension funds doing about this?

For starters, many are questioning their PE investments, and asking for justification for the high fees. Pension funds are pressing funds to provide more transparency of their fees and are looking most closely at their most expensive funds.

Some pension funds are also making private equity investments directly, rather than through a separate PE fund. Pensions are looking at co-investment opportunities, which allows for direct investment and often without management fees or with lower overall fees.

Pension funds are decreasing their allocations in private equity as compared with other asset classes.  One article notes that pensions have reduced by one-half their allocations in PE in 2017. Pensions are also decreasing the number of funds that they invest in. The New York City pension fund invests in over 200 funds, which is a huge amount. They intend to decrease that to 60 funds.

Pensions like the Illinois State Board of Investment are
looking to index funds rather than PE and hedge fund managers. They feel that investment returns are the same over the long term, at a fraction of the cost. And they don’t need to monitor the performance of individual investment managers.

Most notable for PE funds, in some cases, pensions are trying to bring as much work in-house as possible. This may be impractical for most funds, given the cost and difficulty to obtain the talent needed to carry out complex investment strategies. Pensions are trying to reduce their reliance on pension consultant firms, which larger pensions pay tens of millions of dollars per year, and are hiring their own consultants at lower rates than what they pay outside firms.  Particularly large funds have also considered buying a PE firm or creating a separate entity that would make its own investments.

As a result of recent challenges and competition among PE fund managers, commentators have opined that pension funds will likely continue to seek more favorable fees and reevaluate their PE investments. This may mean that PE funds will face more difficulty raising capital, and will have less cash to carry out investments. However, despite these changes, commentators think it is unlikely that public pension plans will exit private funds as an asset class in the near future, given the ability of PE to historically outpace returns of other investment classes and the need to cure unfunded liabilities.

Changes to cybersecurity laws in the European Union and their potential impact on M&A deals

There have been two recent changes to cybersecurity laws in the European Union, specifically relating to the use of personal data of E.U. residents, which are further summarized below.  M&A professionals will need to keep these two laws in mind when (a) a target company uses the personal data of E.U. residents in its ordinary course of business or (b) a U.S. acquirer needs to access the personal data of E.U. residents during the due diligence process.

First, the Privacy Shield Data Transfer Pact (the “Privacy Shield”) was approved by the E.U. member states on July 12, 2016 and sets forth how companies established or using equipment in the E.U. can share the personal data of E.U. residents with U.S. companies.  The Privacy Shield replaces the invalidated Safe Harbor program that was previously relied on by both U.S. and E.U. based companies to legally transfer the personal data of E.U. residents from the E.U. to the U.S.  In addition to imposing stronger obligation on U.S. companies to protect the personal data of Europeans and mandating tougher monitoring and enforcement by the U.S. Department of Commerce and the Federal Trade Commission, the Privacy Shield also includes written assurances from the U.S. that any access to the data by law enforcement will be subject to clear limitations to prevent surveillance of European citizens’ data.  For more detail on the specific requirements of the Privacy Shield, please see this NP Privacy Partner Blog Post

One of the ways a U.S. company can be in compliance with the Privacy Shield is to complete a self-certification, which includes name and contact details of the recipient of the personal data, a description of the activities that will be completed with respect to the personal data received from the E.U., and a description of how the U.S. company is in compliance with the Privacy Shield.  The U.S. Department of Commerce and the Federal Trade Commission have expressed their commitment to enforce the Privacy Shield and violations of the Privacy Shield can result in penalties of up to $40,000 per violation or $40,000 per day for continuing violations. More information on the enforcement of the Privacy Shield can be found at this website.

Second, the General Data Protection Regulation (the “GDPR”) is the next iteration of E.U. data protection laws and will be effective on May 25, 2018.  The GDPR applies to all companies based in the E.U. as well as any foreign companies processing the personal data of E.U. residents.  The GDPR is intended to strengthen and unify data protection for all individuals within the E.U. and requires companies to completely transform the way that they collect, process, securely store, share and securely wipe personal data.  The changes that GDPR will implement include requirements for companies to appoint a data protection officer responsible for implementing and monitoring compliance with GDPR. In addition, companies will be required to implement privacy by design meaning that they must take a proactive approach to ensure that an appropriate standard of data protection is the default position taken when personal data is being processed.  GDPR also includes a clear focus on data subjects’ consent to processing and accessing data, as well as requiring a data breach notification obligation to notify the E.U. protection authority of a breach without undue delay and, where feasible, within 72 hours.  Companies must also notify the individuals where there is a high risk to the individuals concerned.

In the event GDPR is violated, then the penalties can be significant: for breaches, including security and data breach notification obligations, the penalties can be up to €10,000,000 or 2% of worldwide revenue, whichever is higher; and for more significant breaches, including consent violations and transfer restriction violations, the penalties can be up to €20,000,000 or 4% of worldwide revenue, whichever is higher.

Given the potential penalties for violations of both the Privacy Shield and the GDPR, M&A professionals will want to include in their due diligence of a target company an analysis as to whether the target company is in compliance with both laws.  If the due diligence results conclude that the target company is not currently in compliance with the Privacy Shield, or that the target is not in compliance with the GDPR when it takes effect in May 2018, then these issues may require some changes to the purchase agreement, including the exclusion of certain non-compliance liabilities from the transaction, the addition of certain specific indemnities relating to such non-compliance issues, the inclusion of a covenant enabling for ongoing safeguards of sensitive information by the target company in between signing and closing, or the addition of a new closing condition requiring the target company to take steps to address non-compliance issues or the implementation of missing IT safeguards.

Will President Trump’s tax plan eliminate the carried interest “loophole”?

Carried interest is the contractual right received by a private equity or hedge fund manager representing their share of profits or gains from the fund’s investments, which amount is unrelated to any capital invested by the manager. When properly structured, carried interest is taxed at the lower long term capital gains tax rate of 20% (plus 3.8% investment income tax or “NIIT”) instead of the higher ordinary income tax rate of 39.6% (assuming such manager is taxed in the highest federal income tax bracket, plus 3.8% investment income tax or “NIIT”). President Donald Trump vowed on the campaign trail to eliminate what he characterized as the “carried interest loophole” by changing tax laws so that carried interest would be taxed at the ordinary income tax rate; however, the Trump administration has not given any indication as to how they want to deal with this change through legislation and private equity groups and lobbyists have not been shy about continuing to lobby against any such tax change making it into a final law.

On March 27, 2017, the Wall Street Journal reported that Treasury Secretary Steven Mnuchin signaled that the Trump administration wanted hedge funds taxed more heavily, but was still deciding whether or not higher taxes on carried interest could hurt private equity’s ability to drive jobs and economic growth because higher taxes could disincentive investments by pensions, state funds and other investors into infrastructure, real estate and energy. This was an early signal that the Trump administration may have been considering handling the taxation of carried interest differently between hedge fund managers and private equity managers.

In addition on April 26, 2017, the Trump administration released its outline of a tax plan, which was silent on the treatment of any changes to the taxation of carried interest. According to a New York Times article, several tax experts and lawyers have stated that by not mentioning the matter at all, the Trump administration could be signaling that the tax proposal would effectively eliminate the unique taxation of carried interest. However, this does not mean that carried interest necessarily would be taxed at a higher rate because the outline of the tax plan stated that certain “small” pass-through entities, which could include the management entities used by private equity firms and hedge funds, would be subject to a 15% tax rate, which tax rate is lower than the long-term capital gains tax rate of 20%.

However on April 30, 2017, White House Chief of Staff, Reince Priebus, reiterated in an interview that carried interest could be on the chopping block and warned against analysts taking the view that fund managers would continue to benefit from the loophole. Mr. Priebus reiterated President Trump’s campaign message that he wants to get rid of the loophole.  It remains to be seen how the Trump administration’s final tax plan will look as well as how lawmakers will change such proposed tax plan prior to some, all or none of it being enacted into law.

In the event that the taxation relating to carried interest is increased to the ordinary income tax rate, fund managers could find their carried interest taxed as high as 43.4% (current rates) or as low as 25% if Trump follows through and slashes ordinary income tax rates and repeals the so-called Obama Care tax (3.8% NIIT).


Enforceability of non-reliance provisions against extra contractual claims including fraud claims

As a matter of course, a seller of a business includes a provision in a sale agreement to limit its liability to breaches of specific representations and warranties included in the sale agreement and not for representations made outside of the contract such as management presentations, data room disclosures and projections. The seller’s goal is to eliminate all such extra contractual claims including fraud claims. The buyer, on the other hand, will generally push back that if a seller commits fraud (i.e. intentionally misleads or omits to disclose a material fact) in extra contractual communications, most likely found in projections, the seller should not be able to avoid liability. But how does each accomplish its goals?

Of recent date, the Delaware courts have given guidance on this matter. See IAC Search, LLC v. Conversant LLC; C.A. No. 11774–CB Submitted: September 20, 2016. Decided: November 30, 2016; Anvil Holding Corporation v. Iron Acquisition Company, Inc., C.A. Nos. 7975–VCP, N12C–11–053–DFP [CCLD]. Submitted: April 22, 2013. Decided: May 17, 2013; and TransDigm Inc. v. Alcoa Global Fasteners, Inc., C.A. No. 7135–VCP. Submitted: Feb. 1, 2013. Decided: May 29, 2013.

A seller looking to bar claims based on extra-contractual statements, including fraud claims, should include an affirmative, comprehensive buyer acknowledgement clause with a clear statement that the buyer did not rely on any extra-contractual information, and that no other representations or warranties were made, including with respect to virtual data rooms, due diligence materials, management presentations, etc., unless such information is expressly included in a representation and warranty in the sale agreement. A seller should also include a standard integration clause to compliment the buyer acknowledgement clause to properly limit the documents that constitute the parties’ agreement. A buyer must be diligent when negotiating a buyer acknowledgement clause and should confirm the scope of the acknowledgement to prevent the seller from overreaching. Moreover, a buyer should ask for a specific fraud carve out to preserve its right to claims for fraud based on extra-contractual statements and representations.

A buyer and seller each have compelling arguments for their respective positions and the outcome is found in the art of persuasion and negotiation of the sale agreement terms.

Reactions to President Trump's "Buy American and Hire American" Executive Order

President Trump recently issued an Executive Order called “Buy American and Hire American,” requiring certain federal agency heads to suggest reforms to the H-1B visa program including how - and to whom - these visas are awarded.  (Additional coverage of this development is available here).

H-1B visas are offered to foreign workers who are coming to the United States temporarily to perform services in a “specialty occupation,” and typically require the applicants to have highly specific knowledge and a specialized degree. The White House has asserted that the H-1B program is harmful to Americans because companies routinely pay H-1B workers below-market rates, which makes it more likely that these visa holders will replace similarly qualified American workers.

Reaction to this Executive Order from the business community – and particularly the tech industry – has been cautious. The tech industry, which is the most reliant on the H-1B program, has contended that this order will impede their ability to attract and retain top talent. The industry has asserted that a visa program that favors higher-paid workers will give larger, more established companies an advantage.  Silicon Valley leaders have pointed to the large number of employees that are foreign born, arguing that immigration is an economic benefit, not a burden. The industry has also asserted that the H-1B program is essential to their ability to keep foreign high-tech students with unique qualifications in the US after getting their degrees, and that there is a shortage of qualified Americans for these jobs.  

Specific implications from this Executive Order remain to be seen, but it is fair to say that those companies that have traditionally benefited from the H-1B program will be paying close attention to the reforms recommended by federal agencies.

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