Category: Corporate law

FTC and DOJ Propose Significant Changes to US Merger Review Process

On 27 June 2023, the Federal Trade Commission (FTC) and the Department of Justice–Antitrust Division (DOJ) (collectively, the Agencies) announced sweeping proposed changes to the US-premerger notification filing process. The proposed changes mark the first significant overhaul of the federal premerger notification form since its original release in 1978 and would require parties to report

On 27 June 2023, the Federal Trade Commission (FTC) and the Department of Justice–Antitrust Division (DOJ) (collectively, the Agencies) announced sweeping proposed changes to the US-premerger notification filing process. The proposed changes mark the first significant overhaul of the federal premerger notification form since its original release in 1978 and would require parties to reportable transactions to collect and submit significantly more information and documentation as part of the premerger review process. If finalized, the proposed rule changes would likely delay deal timelines by months, requiring significantly more time and effort by the parties and their counsel in advance of submitting the required notification form.

In this alert, we:

  • Provide an overview of the current merger review process in the United States;
  • Describe the proposed new rules announced by the Agencies;
  • Explain the Agencies’ rationale for the new proposed rules;
  • Predict how the proposed new rules could impact parties’ premerger filing obligations, including deal timelines; and
  • Explain what companies should expect over the next several months.

BACKGROUND ON THE HSR MERGER REVIEW PROCESS

The Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the HSR Act or “HSR”) requires certain persons making acquisitions of assets, voting securities, and non-corporate interests (i.e., interests in partnerships and limited liability companies) to:

(a)    File premerger notifications with the FTC and DOJ; and

(b)    Wait until the expiration or termination of a waiting period (usually 30 days) before consummating the acquisition.

Most mergers and acquisitions valued in excess of USD$111.4 million fall under the HSR Act subject to size-of-party thresholds in certain cases. Additionally, there are several exemptions that may apply to an otherwise reportable transaction.

The FTC or the DOJ reviews the parties’ HSR filings during the waiting period to determine whether the transaction may substantially lessen competition in violation of the antitrust laws. If, at the end of the waiting period any concerns have not been placated, the reviewing agency may issue a Request for Additional Documents and Information (commonly referred to as a Second Request), a very broad subpoena-like document seeking documents, data, and interrogatory responses from the filers. This tolls the waiting period until both parties substantially comply with the Second Request. The reviewing agency then has an additional 30-day period to decide whether to challenge the transaction in court.

WHAT ARE THE PROPOSED CHANGES?

On 27 June 2023, the FTC and DOJ announced a number of significant changes to the HSR notification form and filing process, the first such overhaul in almost 45 years. The Agencies released the proposed changes and rationale for the same in a 133-page Notice of Proposed Rulemaking (Notice) that will be published in the Federal Register later this week. While antitrust practitioners are still digesting the full extent of all of the proposed changes, it is clear that they would require parties to submit significantly more information and documentation to the Agencies as part of their HSR notification form. The most notable additional information and documentation includes:

  • Submission of additional deal documents, including draft agreements or term sheets (as opposed to just the preliminary agreement), where a definitive transaction agreement has not yet been executed; draft versions of all deal documents (as opposed to just the final versions); documents created by or for the deal team lead(s) (as opposed to just officers and directors); and verbatim translations of all foreign language documents.
  • Details about acquisitions during the previous 10 years.
  • Identification of and information about all officers, directors, and board observers of all entities within the acquiring person, including the identification of other entities these individuals currently serve, or within the two years prior to filing had served, as an officer, director, or board observer.
  • Identification of and information about all creditors and entities that hold non-voting securities, options, or warrants totaling 10% or more.
  • Disclosure of subsidies (e.g., grants and loans), by certain foreign governments, including North Korea, China, Russia, and Iran.
  • Narrative description of the strategic rationale for the transaction (including projected revenue streams), a diagram of the deal structure, and a timeline and narrative of the conditions for closing.
  • Identification and narrative describing horizontal overlaps, both current and planned.
  • Identification and narrative describing supply agreements/relationships.
  • Identification and narrative describing labor markets, as well as submission of certain data on the firms’ workforce, including workforce categories, geographic information on employees, and details on labor and workplace safety violations.
  • Identification of certain defense or intelligence contracts.
  • Identification of foreign jurisdictions reviewing the deal.

WHY ARE THESE CHANGES BEING PROPOSED?

In its press release announcing the proposed new rules, the FTC stated that “[t]he proposed changes to the HSR Form and instructions would enable the Agencies to more effectively and efficiently screen transactions for potential competition issues within the initial waiting period, which is typically 30 days.”1 The FTC further explained:

Over the past several decades, transactions (subject to HSR filing requirements) have become increasingly complex, with the rise of new investment vehicles and changes in corporate acquisition strategies, along with increasing concerns that antitrust review has not sufficiently addressed concerns about transactions between firms that compete in non-horizontal ways, the impact of corporate consolidation on American workers, and growth in the technology and digital platform economies. When the Agencies experienced a surge in HSR filings that more than doubled filings from 2020 to 2021, it became impossible to ignore the changes to the transaction landscape and how much more complicated it has become for agency staff to conduct an initial review of a transaction’s competitive impact. The volume of filings at that time also highlighted the significant limitations of the current HSR Form in understanding a transaction’s competitive impact.2

Finally, the FTC also cited certain Congressional concerns and the Merger Fee Filing Modernization Act of 2022, stating that the “proposed changes also address Congressional concerns that subsidies from foreign entities of concern can distort the competitive process or otherwise change the business strategies of a subsidized firm in ways that undermine competition following an acquisition. Under the Merger Filing Fee Modernization Act of 2022, the agencies are required to collect information on subsidies received from certain foreign governments or entities that are strategic or economic threats to the United States.”

HOW WILL THESE CHANGES POTENTIALLY IMPACT PARTIES’ HSR FILINGS?

The proposed changes, as currently drafted, would require significantly more time and effort by the parties and their counsel to prepare the parties’ respective HSR notification forms. For example, the proposed new rules require the identification, collection, and submission of more deal documents and strategic documents; significantly more information about the parties, their officers, directors and board observers, minority investments, and financial interests; and narrative analyses and descriptions of horizontal and non-horizontal relationships, markets, and competition. Gathering, analyzing, and synthesizing this information into narrative form will require significantly more time and resources from both the parties and their counsel to comply.

Under the current filing rules, it typically takes the merging parties about seven to ten days to collect the information needed for and to complete the HSR notification form. Under the proposed new rules, the time to gather such information and complete an HSR notification form could be expanded by multiple months.

WHAT IS NEXT?

The Notice will be published in the Federal Register later this week. The public will then have 60 days from the date of publication to submit comments. Following the comment period, the Agencies will review and consider the comments and then publish a final version of the new rules. The new rules will not go into effect until after the Agencies publish the final version of the new rules. This process will likely take several months to complete, and the new rules–or some variation of them–will not come into effect until that time.

While the final form of the proposed rules are not likely to take effect for several months, the Agencies’ sweeping proposed changes to the notification form and filing process are in line with the type of information that the Agencies have been increasingly requesting from parties during the merger review process. Accordingly, parties required to submit HSR filings over the next several months should be prepared to receive similar requests from the Agencies, either on a voluntary basis (e.g., during the initial 30-day waiting period) or through issuance of a Second Request, and they should build into their deal timeline (either pre- or post-signing) sufficient time to comply with these requests.

 

1 “FTC and DOJ Propose Changes to HSR Form for More Effective, Efficient Merger Review,” FTC Press Release, June 27, 2023, available at FTC and DOJ Propose Changes to HSR Form for More Effective, Efficient Merger Review | Federal Trade Commission.  

2 “Q and A on the Notice of Proposed Rulemaking for the HSR Filing Process,” FTC Proposed Text of Federal Register Publication, available at 16 CFR Parts 801 and 803: Premerger Notification; Reporting and Waiting Period Requirements | Federal Trade Commission (ftc.gov).

Copyright 2023 K & L Gates

Diving Into SECURE 2.0: Changes for Small Employer Retirement Plans

International arbitration provides a binding, neutral, and consensual process for resolving contractual disputes between parties, often resulting in resolutions that are quicker, cheaper, more private, and more controllable than litigation in a court of law. Accordingly, arbitration for the resolution of international disputes between contracting parties from different legal jurisdictions has emerged as a fundamental method for resolving complex disputes in an ever-increasingly interconnected world. Multinational companies should make sure they stay up to date on the fundamentals of international arbitration, and it all starts with ensuring any arbitration clause included in an international agreement is drafted in a way that is enforceable and provides contracting parties a clear path toward the resolution of their dispute.

Why Should You Care about What Your Arbitration Clause Says?

An arbitration clause is the starting point for determining the parties’ intent in resolving their dispute outside a court of law. It is an independent agreement within the broader contract, likely enforceable even if the remainder of the contract is procured by fraud, and sits at the apex of what a court or arbitrator will look for to determine the parties’ intent with respect to how a dispute between contracting parties should be resolved.

A clear arbitration clause results in a meaningful, enforceable outcome, minimizes the intervention of U.S. or foreign judiciaries in what should be a private dispute resolution process, grants the third-party administrator and/or the arbitrator the powers necessary to resolve the dispute, and is conducted in accordance with procedures that help guarantee a fair, efficient proceeding.

In contrast, if an arbitration clause is ambiguous, there may be a finding that there is no dispute resolution agreement to enforce. This can result in challenges to the arbitration clause’s enforceability and potential litigation in unfavorable and less-than-ideal judicial systems. Of course, such ambiguity and challenges will create higher costs, longer windows of time to resolve disputes, greater risks that your claims in the dispute will be vulnerable to collateral attacks, and other unintended and unexpected consequences.

What Are the Hallmarks of a Clear Arbitration Clause?

For purposes of clarity, you should ensure your contract’s arbitration clause identifies:

  • Applicable Law. Which country’s (or state’s) law applies?
  • Forum and Rules. There are any number of arbitral forums, each with its own nuances in terms of procedure. Knowing the business and potential disputes that could arise will assist in selecting a good fit in terms of applicable rules.
  • Seat of Arbitration. The seat of the arbitration is more than just the place where the final hearing will take place. It provides a significant backbone to the proceeding and is as important as the selection of the forum and applicable rules.
  • Number of Arbitrators. The more arbitrators, the larger the cost, but a three-member tribunal has its place in certain disputes.
  • Language. Selecting the language (or languages) of the arbitration can greatly affect the cost of the proceeding.

Why Does Selecting the Seat of Arbitration Matter?

More than just the physical place where the arbitration will take place, the seat of arbitration is a legal construct that determines the lex arbitri — the procedural law of the arbitration.

Where the contract between the parties or the rules selected by the parties do not provide for certain procedures, the procedural laws of the seat of arbitration will be applied. Among the important aspects of a proceeding that the seat of the arbitration determines is:

  • Which courts will have supervisory jurisdiction over the arbitration;
  • Definitions and form of an agreement to arbitrate;
  • The arbitrability of the dispute;
  • The constitution of the arbitral tribunal and any grounds for challenge;
  • The equality of treatment of the parties;
  • The freedom to agree on detailed rules of procedure;
  • Interim measures of protection and court assistance;
  • Default proceedings;
  • The validity of the arbitration award; and
  • The finality of the arbitration award, including which courts will hear challenges to the award.

If not clearly identified by the parties, the seat of arbitration — and the procedural laws of that seat — will be selected by the arbitral tribunal.

What Do the Rules You Picked Say About Interim Measures?

A major consideration in selecting the applicable arbitral rules is the availability of interim measures. These are measures of relief, which can include injunctive relief, obtained prior to the commencement of, or during, an arbitral proceeding.

One of the most interesting forms of interim measures is an award of security. An interim award of security in arbitration is a payment of an amount of monies (usually tied to damages) pre-hearing for the conservation of, and enforcement of, a judgment so as to not render a judgment in the future a Pyrrhic victory. These securities prevent the dissipation of assets before it is too late to reach those assets. As such, it is an extremely powerful tool, and determining whether the rules you select, and/or the seat of the arbitration, allows for such an interim award should be a key consideration in drafting your arbitration clause.

What Are the Abilities and Liabilities of Third Parties?

Depending on the circumstances, jurisdiction chosen, governing law, and seat of the arbitration, a third party (a non-signatory to the agreement) can compel arbitration and be compelled to arbitration, the latter being the rarer occurrence. Knowing if there is potential exposure to such parties, which can include directors, officers, employees, beneficiaries, and others, should be assessed prior to entering into an arbitration agreement.

On What Basis Are Arbitral Awards Enforceable?

Arbitral awards, because of the adherence by more than 160 countries to the 1958 New York Convention on the Recognition and Enforcement of Arbitral Awards (“New York Convention”), are the most enforceable award anywhere in the world. Under the New York Convention:

  • A written agreement to arbitrate, including as contained in a contractual arbitration clause, is generally enforceable.
  • Subject to very narrow exceptions, an arbitral award may be recognized and enforced as a final judgment in each contracting country.

In contrast, no treaty requires that the judgments of a country’s court system be recognized; these enforcement decisions are made on an ad hoc basis according to principles of comity and public policy. The Hague Judgments Convention on the Recognition and Enforcement of Foreign Judgments, a treaty similar to the New York Convention, may become the relevant applicable framework in the future but is still in its infancy.

How Can Legal Counsel Help My Multinational Company Address International Arbitration Issues?

The best way to ensure a reliable and enforceable arbitration agreement is a careful examination of the structure and purpose of the contract as well as the company’s unique business profile based on how and where it does business.

Adequate legal counsel should provide clients with practical guidance in drafting and enforcing international arbitration agreements. Services provided should include:

  • Counseling: Counseling companies to understand how international arbitration clauses apply to their multinational operations, how they may benefit from such clauses, and/or how such clauses may not be in their best interest.
  • Drafting: Working with clients to ensure enforceable and clearly understood arbitration clauses are prepared for the specific contractual relationship, considering the myriad factors that go into preparing such a clause.
  • Risk Assessments: Working with companies to conduct risk assessments in the event of contract disputes with arbitration clauses.
  • Arbitration: Arbitrating before tribunals to secure interim securities and/or enforceable arbitral awards in the event of a contract dispute anywhere in the world.

© 2023 Foley & Lardner LLP

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European Commission Aims to Tackle Greenwashing in Latest Proposal

On March 22, the European Commission unveiled a proposal, the Green Claims Directive (Proposal), aimed at combating greenwashing and misleading environmental claims. By virtue of the Proposal, the EC is attempting to implement measures designed to provide “reliable, comparable and verifiable information” to consumers, with the overall high-level goal to create a level playing field in the EU, wherein companies that make a genuine effort to improve their environmental sustainability can be easily recognized and rewarded by consumers. The Proposal follows a 2020 sweep that found nearly half of environmental claims examined in the EU may be false or deceptive. Following the ordinary legislative procedure, the Proposal will now be subject to the approval of the European Parliament and the Council. There is no set date for entry into force at this time.

The Proposal complements a March 2022 proposal to amend the Consumer Rights Directive to provide consumers with information on products’ durability and repairability, as well as to amend the Unfair Commercial Practices Directive by, among other things, banning “generic, vague environmental claims” and “displaying a voluntary sustainability label which was not based on a third-party verification scheme or established by public authorities.” The Proposal builds on these measures to provide “more specific requirements on unregulated claims, be it for specific product groups, specific sectors or for specific environmental impacts or aspects.” It would require companies that make “green claims to respect minimum standards on how they substantiate and communicate those claims.” Businesses based outside the EU that make environmental claims directed at EU consumers will also have to respect the requirements set out in the Proposal. The criteria target explicit claims, such as “T-shirt made of recycled plastic bottles” and “packaging made of 30% recycled plastic.”

Pursuant to Article 3 of the Proposal, “environmental claims shall be based on an assessment that meets the selected minimum criteria to prevent claims from being misleading,” including, among other things, that the claim “relies on recognised scientific evidence and state of the art technical knowledge,” considers “all significant aspects and impacts to assess the performance,” demonstrates whether the claim is accurate for the whole product or only parts of it, provides information on whether the product performs better than “common practice,” identifies any negative impacts resulting from positive product achievements, and reports greenhouse gas offsets.

Article 4 of the Proposal outlines requirements for comparative claims related to environmental impacts, including disclosure of equivalent data for assessments, use of consistent assumptions for comparisons and use of data sourced in an equivalent manner. The level of substantiation needed will vary based on the type of claim, but all assessments should consider the product’s life-cycle to identify relevant impacts.

Pursuant to Article 10, all environmental claims and labels must be verified and certified by a third-party verifier before being used in commercial communications. An officially accredited body will carry out the verification process and issue a certificate of conformity, which will be recognized across the EU and shared among Member States via the Internal Market Information System. The verifier is required to be an officially accredited, independent body with the necessary expertise, equipment, and infrastructure to carry out the verifications and maintain professional secrecy.

The Proposal is part of a broader trend of governmental regulators, self-regulatory organizations, and standard setters across industries adopting a more formalized approach toward greenwashing. For example, as we recently reported, the UK’s Advertising Standards Authority (ASA) published rules on making carbon neutral and net-zero claims. Instances of enforcement actions over greenwashing allegations have also been on the rise. The Securities and Exchange Board of India recently launched a consultation paper seeking public comment on rules to prevent greenwashing by ESG investment funds, and the European Council and the European Parliament reached an agreement regarding European Green Bonds Standards aimed at, among other things, avoiding greenwashing.

Article By Sukhvir Basran and Rachel Rodman of Cadwalader, Wickersham & Taft LLP

Click here to visit the National Law Review for more environmental law news.

© Copyright 2023 Cadwalader, Wickersham & Taft LLP

Sexual Harassment Prevention Training Deadline Approaches for Chicago Employers

As a reminder to employers in Chicago, anti-sexual harassment training is required by Chicago’s Human Rights Ordinance and must be completed by July 1, 2023.  This requirement applies to all Chicago employers, regardless of size or industry.

The training consists of one (1) hour of anti-sexual harassment training for all non-supervisory employees and two (2) hours of anti-sexual harassment training for supervisory employees.  Regardless of supervisory status, all employees must also undergo one (1) hour of bystander training.  Employers must provide training on an annual basis.  Additional information about training requirements can be found here. Employers who fail to comply may be subject to penalties.

Article By Audrey H. Shinn of Vedder Price

© 2023 Vedder Price

The NLRB Curtails the Scope of Nondisparagement and Confidentiality Provisions in Severance Agreements

On Tuesday, February 21, 2023, the National Labor Relations Board (“NLRB” or “Board”) issued McLaren Macomb, a decision that curtails the permissible scope of confidentiality agreements and non-disclosure provisions in severance agreements. See McLaren Macomb, 372 NLRB No. 58 (2023). Analyzing the broad provisions in the agreements at issue in this case, the Board held that simply offering employees severance agreements that require employees to broadly waive their rights under Section 7 of the National Labor Relations Act (“NLRA” or “the Act”) was unlawful. The Board held:

Where an agreement unlawfully conditions receipt of severance benefits on the forfeiture of statutory rights, the mere proffer of the agreement itself violates the Act, because it has a reasonable tendency to interfere with or restrain the prospective exercise of Section 7 rights, both by the separating employee and those who remain. Whether the employee accepts the agreement is immaterial.

The Board’s decision is part of a broader trend by courts and administrative agencies applying heightened scrutiny to contractual provisions that limit employees’ rights. The decision also provides a crucial reminder to union and nonunion workers alike of the relevance of federal labor law in providing legal protections for most private-sector workers.

Case Background

The case arose when Michigan hospital operator McLaren Macomb permanently furloughed eleven employees, all bargaining unit members of Local 40 RN Staff Council, Office of Professional Employees International Union (OPEIU), AFL-CIO, because it had terminated outpatient services during the COVID-19 pandemic in June 2020. After McLaren Macomb furloughed these employees, it presented them with a “Severance Agreement, Waiver and Release” that offered severance amounts to the employees if they signed the agreement. All eleven employees signed.

The agreements provided broad language regarding confidentiality and nondisparagement. The confidentiality provision stated, “The Employee acknowledges that the terms of this Agreement are confidential and agrees not to disclose them to any third person, other than spouse, or as necessary to professional advisors for the purposes of obtaining legal counsel or tax advice, or unless legally compelled to do so by a court or administrative agency of competent jurisdiction.” (emphasis added). The non-disclosure provision provided, in relevant part, “At all times hereafter, the Employee agrees not to make statements to Employer’s employees or to the general public which could disparage or harm the image of Employer…” The employees faced substantial financial penalties if they violated the provisions. The Employer conditioned the payment of severance on Employees’ entering into this agreement.

The NLRB’s Decision

In McLaren Macomb, the Board held that simply offering employees severance agreements that contain these broad confidentiality and nondisparagement provisions violates the NLRA.

The NLRA provides broad protections of employees’ rights to engage in collective action. Section 7 of the NLRA vests employees with a number of rights, including the right “to engage in other concerted activities for the purpose of collective bargaining or other mutual aid or protection.” Section 8(a)(1) of the Act makes it an unfair labor practice (ULP) for an employer to “interfere with, restrain, or coerce employees in the exercise of the rights guaranteed in section 7.” As the Supreme Court, federal courts, and the NLRB have repeatedly held and reaffirmed, Section 7 provides broad rights for employees and former employees—union and nonunion alike—to engage in collective action, including discussing terms and conditions of employment and workplace issues with coworkers, a union, and the Board. As the Supreme Court has stated in elaborating on the broad construction of Section 7, “labor’s cause often is advanced on fronts other than collective bargaining and grievance settlement within the immediate employment context.” Eastex, Inc. v. N.L.R.B., 437 U.S. 556, 565 (1978).

Applying these foundational principles to the severance agreements at hand, the Board reversed Trump-era NLRB precedent and concluded that the employer’s proffer of these broad nondisparagement and confidentiality provisions contravened the employees’ exercise of Section 7 rights, which is an unfair labor practice under Section 8(a)(1). Notably, the Board held that an employer’s merely offering such broad provisions violates the Act—it does not matter whether the employee signs the agreement or not.

The Board determined that the nondisparagement provision substantially interfered with employees’ Section 7 rights on its face. That provision prohibits the furloughed employee from making any “statements to [the] Employer’s employees or the general public which could disparage or harm the image of [the] Employer.” Analyzing this language, the Board reasoned that the provision would encompass employee conduct or critiques of the employer regarding any labor issue, dispute, or term and condition of employment. Accordingly, this proscription sweeps far too broadly—it prohibits employees from exercising their right to publicize labor disputes, a right which is protected by the Act. Moreover, the nondisparagement provision chills employees from exercising Section 7 rights, including efforts to assist fellow employees, cooperate with the Board’s investigation and litigation of unfair labor practices, and raise or assist in making workplace complaints to coworkers, their union, the Board, the media, or “almost anyone else.” As the Board underscored, “Public statements by employees about the workplace are central to the exercise of employee rights under the Act.”

The Board then concluded that the confidentiality provision also interfered with employees’ Section 7 rights in at least two ways. First, the Board explained that because the confidentiality provision prohibits the employee from disclosing the terms of the agreement “to any third person,” the agreement would reasonably tend to coerce the employee not to file a ULP charge with the Board or assist in a Board investigation. (emphasis added). Second, the same language would also prohibit the furloughed employee from discussing the terms of the agreement with former coworkers in similar situations, which would frustrate the mutual support between employees at the heart of the Act. As the Board summarized, “A severance agreement is unlawful if it precludes an employee from assisting coworkers with workplace issues concerning their employer, and from communicating with others, including a union, and the Board, about his employment.”

Takeaways for Employment Lawyers and Plaintiffs

First, while one might assume that labor law is exclusively the province of unions, their members, and their lawyers, McLaren Macomb demonstrates the relevance of the NLRA for employees regardless of union status. Although the workers in this case were unionized, the Section 7 rights at the heart of the NLRA apply to most private-sector employees, including nonunion employees. Indeed, because nonunion workers often have fewer workplace protections than their unionized counterparts, Section 7’s protections are critically important for nonunion employees. Employees who are asked to sign confidentiality and nondisparagement provisions and their attorneys should be aware that broad restrictions on employees’ concerted activity may be illegal.

Second, this decision is part of a broader effort to protect workers from being muzzled by their employers. For instance, the recent federal Speak Out Act establishes that predispute nondisclosure clauses and nondisparagement clauses—often included in employment contracts—are unenforceable in disputes involving sexual assault or sexual harassment. These recent developments in the law should be on the radar of workers and their attorneys who are navigating employer’s contracts, policies, handbooks, and proposed severance agreements.

Article By Kyle Bigley of Katz Banks Kumin LLP

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Non-Negotiable Arbitration Agreements May Be Required as a Condition of Employment

On February 15, 2023, the Ninth Circuit struck down AB 51, a California statute that imposed criminal and civil penalties against employers who required employees to enter into an arbitration agreement as a condition of employment, finding the statute to be an “unacceptable obstacle to the accomplishment and execution of the full purposes and objectives” of the Federal Arbitration Act (“FAA”).  Chamber of Commerce of the United States of America, et al. v. Bonta, et al., No. 20-15291 (9th Cir. 2023).

As discussed in our prior post and articles (link here), in August 2022 the Ninth Circuit withdrew its prior decision, which had upheld portions of AB 51, following the United States Supreme Court’s June 2022 decision in Viking River Cruises v. Moriana.

AB 51, embodied in California Labor Code §432.6 effective January 1, 2020, prohibited an employer from entering into a non-negotiable agreement that required the employee to waive “any right, forum, or procedure” for a violation of the Fair Employment and Housing Act or the California Labor Code, including “the right to file and pursue a civil action.”  Further, AB 51 imposed harsh penalties for employers who violated the statute, including a fine of up to $1,000 and up to six months’ imprisonment, as well as the potential for civil litigation by the State of California or by private individuals.  In an effort to avoid Supreme Court decisions striking down state laws that improperly targeted arbitration agreements, the California legislature also created the confusing outcome that potentially criminalized the formation of non-negotiable arbitration agreements, but permitted their enforcement once executed.

Noting that arbitration agreements by their very nature require parties to waive their rights to bring disputes in court, and crediting the plaintiffs’ evidence that the possible imposition of civil and criminal penalties deterred employers from attempting to enter into non-negotiable agreements with employees, the court affirmed the district court’s preliminary injunction in favor of several trade associations and business groups who sought to block the implementation of the statute.  Relying on principles of preemption and judicial precedent striking down similar state laws or judge-made rules that singled out executed arbitration agreements, the Court found AB 51 improperly “burden[s]” the formation of arbitration agreements in violation of the FAA.

Having written the previous 2-1 decision upholding AB 51, Judge Lucero now found himself dissenting.  Arguing that the majority “misconstrue[d] the jurisprudence” of the Supreme Court, the dissent claimed that arbitration was permissible only if consensual and that AB 51 only applied to conduct occurring prior to the formation of the contract and thus was not an obstacle to the objectives of the FAA.

Employers may require their California employees to sign non-negotiable arbitration agreements to obtain or maintain their employment.  Arbitration agreements may still be unenforceable however if they are procedurally and substantively unconscionable, if the agreement lacks mutual consent because a party was forced to sign by threats or physical coercion or “upon such grounds as exist at law or in equity for the revocation of any contract.”  Thus, employers should review their agreements to ensure they are in compliance with other California requirements, that the terms are not unfair or one-sided, and, the agreement presented is not unfair, surprising or oppressive.

Article By Sheryl L. Skibbe of Vedder Price

For more arbitration legal news, click here to visit the National Law Review.

© 2023 Vedder Price

Biden Administration Sets New Course on ESG Investing in Retirement Plans

In late 2022, the Department of Labor finalized a new rule titled “Prudence in Selecting Plan Investments and Exercising Shareholder Rights,” largely reversing Trump-era guidance that had strictly limited the ability of plan fiduciaries to consider “environmental, social, and governance” (ESG) factors in selecting retirement plan investments and generally discouraged the exercise of proxy voting. In short, the new rule allows a fiduciary to consider ESG factors in selecting investment options, provided that the selection serves the financial interests of the plan and its participants over an appropriate time horizon, and encourages fiduciaries to engage in proxy voting.

The final rule moves away from 2020 Trump-era rulemaking by allowing more leeway for fiduciaries to consider ESG factors in selecting investment options. Specifically, the rule states that a “fiduciary’s duty of prudence must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis and that such factors may include the economic effects of climate change and other ESG considerations on the particular investment or investment course of action.” The rule makes clear, however, that there is no requirement to affirmatively consider ESG factors, effectively limiting its scope and effect and putting the onus on fiduciaries to determine whether they want to incorporate ESG factors into their assessments of competing investments.

Overview

  • Similar to the Trump-era guidance, there is no definition of “ESG” or an “ESG”-style fund. Debate continues over what kinds of funds can be considered ESG investments, especially in light of the fact that some companies in industries traditionally thought to be inconsistent with ESG conscious investing are now trying to attract ESG investors (e.g. industrials, energy).
  • Fiduciaries are not required to consider ESG factors in selecting investment options. However, the consideration of such factors is not a presumed violation of a fiduciary’s duty of loyalty or prudence. Unlike the prior rule, which suggested that consideration of ESG factors could only be considered if all other pecuniary factors between competing investments were equal (the “tiebreaker” approach), the new rule allows a fiduciary to consider potential financial benefits of ESG investing in all circumstances.
  • Plan fiduciaries may take into account participant preferences in constructing a fund lineup. Therefore, if participants express a desire for ESG investment options, then it may be reasonable for plan fiduciaries to add ESG funds or to consider ESG factors in crafting the fund lineup.
  • ESG-centric funds may be used as qualified default investments (QDIAs) within retirement plans, reversing the prior outright prohibition on use of such funds as QDIAs.
  • In some situations, fiduciaries may be required to exercise shareholder rights when required to protect participant interests. It is unclear whether the exercise of such rights is only limited to situations that have an economic impact on the plan, or applies to additional situations. The clarification suggests that the exercise of proxy voting is not disfavored as an inefficient use of fiduciaries’ time and resources, as the prior iteration of the rule suggested.

Effective Date and Challenges to the Regulation

The new rule became effective in January 2023, except for delayed applicability of proxy voting provisions. However, twenty five state attorneys general have joined a lawsuit in federal court in Texas that seeks to overturn the regulation. The court is in the Fifth Circuit, which historically has been hostile to past Department of Labor regulations (including Obama-era fiduciary rules overturned in 2018, though the ESG rule is less far-reaching than the fiduciary rule and may survive a challenge even in the Fifth Circuit). Congressional Republicans have also introduced a Congressional Review Act (CRA) review proposal to repeal the regulation that has gained the support of Joe Manchin (D-WV). Although CRA actions are not subject to Senate filibuster rules, they are subject to presidential veto, which President Biden is sure to do if the repeal reaches his desk.

Action Steps

Employers should assume that the ESG rules will remain in effect and engage with plan fiduciaries, advisors, and employees and determine the extent to which ESG considerations should (or should not) enter into fiduciary deliberations when considering plan investment alternatives. Some investment advisors have already begun to include separate ESG scorecards for mutual funds and other investments in their regular plan investment reviews. Fiduciaries should also consider whether and how the approach that is ultimately taken should be reflected in the plan’s investment policy statement. Plans that delegate full control over investments to an independent fiduciary (an ERISA 3(38) advisor) should engage with their advisor to determine whether and the extent to which ESG considerations will be part of that fiduciary’s process, and whether that is consistent with the desires of the plan fiduciaries and participants.

Article By Alex H. Glaser and Timothy Brechtel of Jones Walker LLP

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© 2023 Jones Walker LLP

Was This The Least Transparent Report In SEC History?

Professor Alexander I. Platt at the University of Kansas School of Law has just released a draft of a forthcoming paper that takes the Securities and Exchange Commission to task for the lack of transparency in its whistleblower program, Going Dark(er): The SEC Whistleblower Program’s FY 2022 Report Is The Least Transparent In Agency History.  As Professor Platt notes in a footnote, I have been complaining about the whistleblower’s lack of transparency since at least 2016.  See Five Propositions Concerning The SEC Whistleblower Program.  Last summer, I observed that “There is certainly no dearth of irony in a federal agency dedicated to full disclosure cloaking in secrecy a billion dollar awards program”.

Professor Platt offers four possible reasons for the SEC’s lack of transparency: (1) resource constraints; (2) lack of respect for public participation and accountability; (3) data problems; and/or (4) an intent to bury something controversial or embarrassing.  My concern is, and has been, that whatever the reason(s), the SEC’s lack of transparency creates an ideal substrate for fraud.  Unless the SEC drops its cloak of secrecy and exposes its whistleblower program to public scrutiny, it is highly likely that the next article will be about how the whistleblower program was used and abused.

Article By Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP

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© 2010-2023 Allen Matkins Leck Gamble Mallory & Natsis LLP

New York Adult Survivors Act

New York’s Adult Survivors Act[1] (“ASA” or “the Act”) (S.66A/A.648A) became effective on November 24, 2022. The Act provides a one-year lookback window for people to seek civil remedies for sexual abuse they experienced after they turned 18, regardless of what year the abuse occurred. This law adds critical energy to the ongoing momentum of the #MeToo movement, allowing survivors to file suit against both their abusers and the institutions that enabled them.

The one-year lookback window lasts until November 23, 2023, so as of today, survivors have just over ten months to take advantage of the law. The following guide provides context and recommendations for understanding and using New York’s Adult Survivors Act.

What does the ASA do?

The ASA creates a one-year lookback window for sexual assault survivors to pursue civil claims in court for abuse that may have occurred years earlier, as long as they were over 18 at the time. Previously, a person who experienced sexual abuse only had a few years to file a lawsuit in New York before their claim would be time-barred. This meant that survivors had little time in which to come to terms with the abuse they experienced, find an attorney, prepare a case, and file an action. For those who missed that small window, the ASA reopens the courthouse doors. So until November 23, 2023, whether you experienced abuse in 2015, 2000, or 1985, you can file a claim in court and seek recovery for what happened to you.

What does the law cover?

Sexual offenses covered by the ASA span a wide range of behaviors, including but not limited to forcible touching, rape, sexual assault, sexual misconduct, and other forms of sexual abuse. Not every sexual offense is covered under the ASA,[2] and an attorney can help assess whether your claim falls within its provisions.

Who can you sue?

Another powerful provision of the law is who it allows to be named as a defendant. Survivors are not limited to suing their abusers—they can also hold accountable the institutions that insulated those abusers from justice. These institutions can include entities that had responsibility to keep the survivor safe and to control the actions of the abuser. Claims against the institutions can involve both intentional and negligent acts. If your abuser was part of a larger organization that contributed to or failed to prevent, notice, or stop the abuse, the ASA empowers you to go after that organization.

This provision comes directly from New York’s 2019 Child Victims Act (“CVA”).[3] Over 10,000 people have used the CVA to sue institutions that had a role to play in their abuse, including churches, hospitals, overnight and day camps, and schools. For example, a large number of CVA cases name the Roman Catholic Church and the Boy Scouts of America as institutional defendants. The ASA provides a similar recourse to justice: oftentimes, survivors are subject to abuse by people who hold power over them. For minors, these people could be coaches, religious leaders, teachers, mentors, or other caregivers. For people over 18, those in power may be employers, professors, or community leaders. The ASA enables adult survivors to sue the institutions that gave their abusers power and protected those abusers from answering for their actions.

The institutional defendant provision of the ASA opens significantly larger opportunities for recovery, as institutions oftentimes have deeper pockets than individual abusers. Examples of institutions that could face liability under the ASA include employers, colleges and universities, social organizations such as fraternities and sororities, medical practices, and facilities that house people with disabilities. Any entity that knew about or should have known about and stopped the abuse could be on the hook.

Who is it for?

The ASA opens the courts to people who were over the age of 18 when they experienced sexual abuse but are otherwise unable to file due to missing the statute of limitations. You can use the ASA even if you have previously tried to file but had your suit dismissed as untimely.[4]

It is important to note that if you have resolved or released your claims through a settlement process, you may not file under the ASA. For example, the nearly 150 women who received payment from a settlement with Columbia University Irving Medical Center and New York Presbyterian Hospital based on sexual abuse by Dr. Robert Hadden cannot use the ASA to file new suits as their claims have been fully resolved.

Why do we need this?

The Adult Survivors Act is a game-changer for people who were previously unable to file claims for sexual abuse due to a short statute of limitations. In 2019, New York extended the statute of limitations for certain civil lawsuits related to sex crimes from five to 20 years. But that law did not apply retroactively, so survivors who experienced abuse just a few years prior were still barred from seeking justice.

The ASA honors the lived reality of sexual abuse. Like the CVA before it, the ASA recognizes sexual abuse can take years to process, and those years often extend far beyond the short filing windows New York historically placed on these types of claims.

Survivors have many reasons for waiting to come forward with claims of sexual abuse. Some face retaliation by their abusers, some fear the risk of community backlash, and others lack the resources to seek legal representation. Finally, “[t]rauma takes time,” as New York State Senator and ASA champion Brad Hoylman said when promoting the then-bill. Many sexual assault and sexual abuse survivors need years to process what they endured. This can be particularly true when an abuser uses power, manipulation, or threats to coerce submission to sexual contact, a common tactic of notorious abusers Harvey Weinstein, Kevin Spacey, and Dr. Robert Hadden. Understanding the event as sexual abuse, reconciling yourself with your experience, and deciding how to move forward can take decades. The ASA is an effort to respect this process and empower survivors to hold their abusers accountable.

Why would I file a lawsuit about what happened to me?

For many people, surviving sexual abuse is not something that can be “fixed” by any kind of legal action. But the remedies available through civil suits can serve as a proxy for some measure of justice, and that proxy can enable survivors to move forward.

Successful ASA plaintiffs can recover economic, compensatory, and punitive damages from both the individual abuser and the institution. Many survivors suffer financial loss in addition to the mental, emotional, and physical harm of the abuse itself. If your boss sexually harasses you and then terminates you when you protest, you may find yourself without an income. If a classmate assaults you, you may forfeit tuition money after deciding to leave campus for your safety. Civil courts can make you financially whole and further compensate you for the pain of the experience and the efforts you must make to heal. Courts can also provide other remedies, requiring the people who perpetrated or allowed abuse to do or stop certain behaviors, thereby protecting other potential future targets of abuse and assault.

How do I use the ASA?

The first thing you should do is consult an attorney. These cases can be complicated, and plaintiffs still maintain the burden of proof, so you want the expertise of an experienced lawyer. There are several firms that regularly bring these kinds of actions, and many will provide you with a free consultation. If you decide to move forward with your case after a consultation, your attorney will work with you to determine the best strategy. This strategy may include going to court, or it may involve seeking a resolution that works for you outside of court.

As you go through the process of finding an attorney, please know that you deserve counsel that is compassionate, knowledgeable, and focused on your needs and interests as a client. This is about what happened to you, and your attorney is there to guide you. You should feel heard, understood, and respected.

When do I need to file?

You must file your claim by November 23, 2023.

While the ASA is a powerful effort by New York to support the rights of sexual abuse survivors, it is time-limited. November 23, 2023 is the cutoff date for filing a claim, but if you are interested in seeking recovery under the Act, you should take action now. It may take time to find the right attorney for you, and your lawyer will need additional time to put together your case. If you and your lawyer decide to pursue a resolution without going to court, that process could take even longer.

Ten months sounds like a long time, but in the legal world, it can move very quickly. Start considering whether you want to take advantage of the ASA and reach out to an attorney as soon as possible.

What happens after I file?

This will come down to conversations you have with your attorney. Filing is the first major step in the process. Following that process through might include discovery, more court filings, and hearings before a judge or a jury.

What else should I consider?

Take care of yourself as you think about your next steps. Reach out to trusted loved ones and mental health professionals. It is critical that you ground yourself in what is best for you.

FOOTNOTES

[1] New York Governor Kathy Hochul signed the ASA into law on May 24, 2022. The ASA passed the New York Assembly by a majority vote of 140 in favor to 3 against after receiving unanimous support in the state Senate one month prior.

[2] Article 130 of the New York Penal Law lists offenses covered under the ASA.

[3] The CVA came into effect in 2019, providing a two-year lookback window for people who experienced abuse as minors. The CVA amends N.Y. C.P.L.R. § 208 (2019) and allows victims to initiate civil action against their abusers and enabling institutions. As to victims where civil actions were barred before the CVA took effect, N.Y. C.P.L.R. 214-g (2020) creates a lookback period to file a claim. Since 2019, over 10,000 people have filed lawsuits in New York against abusers and the institutions that protected them.

[4] The ASA can revive your claim only if it was dismissed for failure to file by the statutory deadline. If your claim was dismissed for other reasons, this law cannot fix that.

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Structuring the Acquisition of an S Corporation

Introduction

S corporations, or S-corps, are one of the most popular entity choices for businesses. In contemplating the sale of an S-corp, it is important to plan how the transaction is structured from a tax perspective (ideally before an LOI is signed), both to maximize the gain on the sale and avoid pitfalls that can result in liabilities for the selling shareholders.

For corporate purposes, businesses are generally formed as limited liability companies, partnerships, or corporations. For tax purposes, however, entities are taxed as corporations, partnerships, or disregarded entities.[1] Corporations[2] are taxed as either a C corporation or an S corporation. C corporations are taxed at the corporate level and again at the shareholder level.[3] S corporations are corporations that, for federal tax purposes, elect to pass corporate income, losses, deductions, and credits through to their shareholders and are only taxed at the shareholder level.[4]

To qualify as an S corporation, the corporation must meet the requirements of Section 1361,[5] which provides that the corporation not have more than 100 shareholders, not have non-individual shareholders (with the exception of certain types of trusts, estates, and tax-exempt organizations), not have a nonresident alien as a shareholder, not have more than one class of stock, and not be an ineligible corporation (as defined in the Code).[6]

When sellers begin to explore the sale of their business, tax considerations are important to discuss at the outset so that the seller and buyer are on the same page – no one wants to attempt to renegotiate the terms of a deal in the middle of a transaction. For tax purposes, acquisitions of companies are categorized as either an asset purchase or stock purchase. In general, owners prefer to sell their stock (as opposed to the company’s assets) for a few reasons. First, a stock sale results in capital gain to the shareholders because their stock is a capital asset.[7] In an asset sale, however, noncorporate sellers (including S-corp shareholders) recognize ordinary income or capital gain, depending on the type of asset sold. Second, unlike in an asset sale, a stock sale may not require the seller to transfer company assets and licenses or obtain third party consents.

On the other hand, buyers usually want to engage in an asset sale to obtain a step-up in basis of the purchased assets. In a stock acquisition, the buyer gets a carryover basis in the acquired corporation’s assets, without any basis step-up. In an asset purchase, however, the buyer takes a cost basis in the assets, including in the target corporation’s goodwill (which otherwise will generally have a zero basis), and allows the buyer to take higher depreciation deductions to reduce the buyer’s annual tax liability.[8] Unless otherwise agreed, the buyer also does not assume corporate liabilities in an asset sale.

Sellers who agree to engage in an asset sale should negotiate with the buyer to be compensated for the additional tax that the seller may incur for engaging in an asset sale.

There are two additional ways for a buyer to obtain a basis step-up in the seller’s assets. The first is a 338(h)(10) election under Section 338 and the second is an F reorganization pursuant to Section 368(a)(1)(F) and consistent with Revenue Ruling 2008-18.[9]

Making the 338(h)(10) Election

A buyer and seller will sometimes make a 338(h)(10) election, which treats an acquisition of a corporation’s stock as a sale of assets for federal income tax purposes, but a sale of stock for legal purposes.[10] The sale is treated as if buyer and seller engaged in a regular asset sale for income tax purposes (so the buyer obtains a step-up in the tax basis of the assets), yet the seller does not need to re-title each asset.[11] Seller does not have capital gain on the sale of stock. Instead the parties must allocate the sales price among the assets based on each asset’s fair market value.[12] The price paid in excess of the fair market value of the tangible assets of the business is allocated to business intangibles and then to goodwill.[13]

The 338(h)(10) election is only available if a “qualified stock purchase” is made.[14] A “qualified stock purchase” is defined as any transaction (or series of transactions) in which a corporation purchases at least 80% of the stock (both voting and value) from a member of a consolidated group(as defined in 1.1502-1) or from shareholders of a S corporation during a 12 month period.[15] If during diligence it is revealed that the target corporation in fact failed to qualify as an S corporation, the 338 election will be invalid.[16] If the Section 338(h)(10) election is invalid, the transaction will be treated as a straight stock sale and buyer will not receive a basis step-up in the target’s assets.

A section 338(h)(10) election is made jointly by the purchaser and seller on Form 8023.[17] S corporation shareholders who do not sell their stock must also consent to the election. The election must be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.[18]

If the target failed to qualify as an S corporation (thereby becoming a C corporation), an election can be made to treat the sale of the corporation’s stock as an asset sale under Section 336(e). The election can be made if target is owned by a parent corporation that sells at least 80% of target’s stock.[19] A 336(e) election closely resembles a 338(h)(10) election, but the purchaser does not have to be a corporation.[20] Note that a transaction that qualifies under both 336(e) and 338(h)(10) will be treated as 338(h)(10) transaction.[21]

Consequences of a 338(h)(10) Election

Under the Regulations, the target corporation is treated as making a deemed sale of its assets and liquidating following the deemed asset sale.[22] The transaction is treated as a taxable acquisition of 100% of the target’s assets for income tax purposes.[23] This means that the stock cannot be acquired in a tax free transaction or reorganization (such as a transfer to a controlled corporation, merger or spinoff) or a transaction where the seller does not recognize the entire amount of gain or loss realized on the transaction.[24]

Issues with a 338(h)(10) Election

While the 338 election can be a useful way for a buyer to achieve a basis step-up without burdening the seller to retitle and transfer assets, the following disadvantages of the election should be considered:

  1. The rules under Section 338 require all S corporation shareholders (whether or not they sell their stock) to pay tax on all of the target’s assets, even if selling less than 100% of the target.[25] This effectively eliminates any structuring of a deal on a tax-deferred basis (i.e. where seller only pays tax on the consideration attributable to non-rollover equity). Sellers need to be aware that they will pay tax on all of the target company’s assets regardless of the percentage of assets sold.
  2. The election presents an issue for rollover transactions where the seller rolls over more than 20% of its equity on a pre-tax basis in a Section 721 or Section 351 transaction (in which seller receives equity in buyer, buyer’s parent, a holding company that holds target, or another form of equity). Rolling over more than 20% of equity will invalidate the 338(h)(10) election because it will not meet the “purchase” requirement under Section 338.[26]
  3. If the target company’s S corporation election turns out to be invalid (which happens frequently due to the ease with which S corporation status can be voided), the 338(h)(10) election will be invalid, thereby eliminating any advantage provided by the election.[27] Note that the seller will also be in breach of its representations and warranties under the purchase agreement.

F-Reorganization

An alternative to a 338(h)(10) election is an F reorganization, or F reorg., which allows sellers to avoid the potential issues that come with a 338 election. In an F reorg., the seller recognizes gain only with respect to the assets that it is deemed to have sold, allows the seller to roll over equity on a pre-tax basis, and avoids some of the risk that the target may have not properly qualified as an S-corp (thereby invalidating a Section 338(h)(10) election).

Engaging in an F-Reorganization

The first step in an F reorg. is to engage in a tax free reorganization of the S-corp.[28] Shareholders of the target S-corp (“T”) form a new corporation (“Holdco”) and transfer their shares in T to Holdco in exchange for Holdco shares. As a result of the transaction, T shareholders own all shares of Holdco, which in turn owns all shares of T, making T a fully owned subsidiary of Holdco. Holdco then elects to treat T as a Qualified Subchapter S Subsidiary (“QSub”) by making the election on form 8869. For federal tax purposes, T, as a QSub, becomes a disregarded entity and all assets and liabilities of T are treated as part of Holdco.[29] Note that the QSub election made by T also suffices as the S-corp election for Holdco.[30] After T becomes a QSub of Holdco, T converts into a limited liability company (“LLC”) under state law in a nontaxable transaction by converting from one disregarded entity to another.[31] Holdco will need to obtain its own EIN, but T retains its old EIN after the conversion.[32] Once the conversion to an LLC is complete, the shareholders of Holdco can sell some or all of the LLC interests of T; the sale is treated as an asset sale for tax purposes, thereby resulting in a step up in basis for the purchaser.[33] The seller recognizes gain from the deemed sale of each asset of T. If less than 100% of the LLC interests are sold to the buyer, the transaction is treated as the purchase of a proportionate interest in each of the LLC assets, followed by a contribution of the respective interests to a partnership in exchange for ownership interests in the partnership, resulting in a stepped up basis in the assets for buyer.[34] In this scenario, T is no longer a QSub and is converted to a partnership for tax purposes.[35]

Note that a straight conversion of the existing S corporation target from an S-corp to an LLC should not be done because it is treated as a taxable liquidation of the S corporation (i.e. a deemed sale of its assets) resulting in a fully taxable event to the shareholders.[36]

Alternatively, the S-corp could form a new LLC, contribute all its business assets and liabilities to the new LLC in exchange for the LLC interests, and sell the LLC interests to the buyer. However, the transfer of assets might require third party consents; the F reorg. achieves the same result without any potential assignment issues, and even preserves the historical EIN of the S-corp.

Advantages of an F-Reorganization

The F-reorganization is an effective way to avoid the issues that arise with a 338(h)(10) election:

  1. If the acquisition is for less than 100% of the target, the S-corp shareholders will only recognize gain on the portion of the LLC sold by the S-corp parent. Any portion of the LLC interests rolled over will be tax-deferred. Rollover transactions are perfectly suitable in a F reorg. and do not present the issues that come with a 338(h)(10) election.
  2. The converted LLC retains its old EIN number and is essentially the same entity for legal purposes. This can be useful for a target in a regulated industry (such as healthcare, food services, manufacturing, etc.) by possibly avoiding the need to reapply for new permits and licenses.
  3. An F reorg. can be useful for planning purposes under Section 1202 (Qualified Small Business Stock, or QSBS), which allows shareholders of a C corporation to exclude from their taxable income the greater of ten million dollars or ten times the adjusted basis of their stock upon a sale.[37] One requirement is that the stock must be stock of a C corporation, not an S corporation.[38] S corporation shareholders who want to qualify under 1202 can perform an F reorg. and contribute the LLC interests of their operating company to a newly formed C corporation in a tax free exchange under 351. The S corporation (which owns the C corporation which owns the LLC) is now an eligible shareholder of QSBS and will qualify for favorable treatment under Section 1202.[39]

Footnotes

[1] Reg. §301.7701-2. Entities may also be taxed as cooperatives or as tax-exempt organizations if the statutory requirements are met.

[2] For purposes of this article, a corporation includes a limited liability company (LLC) that has elected to be taxed as a corporation.

[3] IRC §11(a).

[4] IRC §1363. For state tax purposes, treatment of S corporation status varies – certain states either conform with the federal treatment or conform with certain limitations and adjustments, while others do not recognize the S election at all and tax S corporations as regular corporations. In particular, California imposes an entity level tax of the greater of $800 or 1.5% of net income.

[5] Section references are to the Internal Revenue Code of 1986, as amended.

[6] See IRC §1361 (for example, an insurance company or certain financial institutions). In addition, Form 2553 must be filed to make the S corporation election.

[7] See IRC §1221(a).

[8] See IRC §1012(a) and §167.

[9] A 338(g) election also obtains a basis step-up, but results in two layers of tax and is not generally used for domestic transactions.

[10] IRC 338(a).

[11] Reg. 1.338(h)(10)-1(d)(9).

[12] In accordance with the allocation provisions set forth in IRC 1060 and Reg. 1.338-6 and 1.338-7.

[13] Reg. 1.338-6(b)(vi) and (vii).

[14] IRC 338(a).

[15] IRC 338(d)(3) and Reg. 1.338(h)(10)-1(c). For the purposes of this article, we assume that target is a standalone S-corp.

[16] Reg. 1.338(h)(10)-1(c)(5). However, the transaction may still qualify under Section 336(e). See below.

[17] Reg. 1.338(h)(10)-1(c)(3). Form 8883 also needs to be filed. If an F reorg is done, form 8594 will need to be filed.

[18] Reg. 1.338(h)(10)-1(c)(3).

[19] Reg. 1.336-2(a). The election is made unilaterally by seller and target. See Reg. 1.336-2(h).

[20] Reg. 1.336-1(b)(2). See Reg. 1.336-1 – Reg. 1.336-5 for the mechanics of making the 336(e) election and what qualifies as a “qualified disposition” under 336.

[21] Reg. 1.336-1(b)(6)(ii)(A).

[22] See Reg. 1.338(h)(10)-1 for the tax aspects of the deemed asset sale and liquidation.

[23] A deemed asset sale under Section 338 does not give rise to California sales tax. Cal. Code of Regs. 1595(a)(6).

[24] IRC 338(h)(3). See below for rollover transactions.

[25] Reg. 1.338(h)(10)-1(d)(5).

[26] IRC 338(h)(3)(A)(ii). Beware of situations where the acquiror appears to “purchase” at least 80% of target’s stock (and target rolls over 20% or less of its stock in a 351 transaction), but the acquiror in fact does (or might be deemed to) “purchase” less than 80% of target’s stock, thereby invalidating a 338, 338(h)(10), or 336(e) election. This most commonly occurs where purchaser is a newly formed corporation and target rolls over 20% (or less) of its shares. See Ginsburg, Levin & Rocap, Mergers, Acquisitions, and Buyouts, § 4.06.1.2.2 (relating to redemption of stock held by target’s shareholders and recharacterizing a 351 transaction and cash sale as a single 351 exchange with boot).

[27] See footnote 16.

[28] In accordance with Rev. Rul. 2008-18.

[29] IRC 1361(b)(3).

[30] Rev. Rul. 2008-18. Obviously, Holdco must meet all the requirements of an S-corp. In many cases, the parties will file Form 2553 to treat Holdco as an S corporation as a “belt and suspenders” step.

[31] Upon conversion, T is no longer treated as a QSub per 1361(b)(3). The conversion has no tax consequences; see Reg. 1.1361-5(b)(3), example 2, where the merger of two disregarded entities owned by the same entity is a disregarded transaction for tax purposes because the assets continue to be held by the same entity. The same should apply when one disregarded entity converts to another. The QSub can also merge with a newly formed LLC subsidiary of Holdco to achieve the same result.

[32] Rev. Rul. 2008-18.

[33] Rev. Rul. 99-5; Reg. 1.1361-5(b)(3), example 2.

[34] Rev. Rul. 99-5; see also Rev. Rul. 99-6.

[35] Id. Although not required, a Section 754 election is often required by the Buyer.

[36] IRC 336(a).

[37] IRC 1202(b). See Section 1202 for the requirements to qualify for QSBS.

[38] IRC 1202(c).

[39] The S corporation shares do not qualify as QSBS. The new shares of the C corporation issued after the reorganization qualify as QSBS to begin the 5 year holding period.

Article By Ben Gruen of Stubbs Alderton & Markiles, LLP

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