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June 2018

CSG Corporate & Securities Insights Q2 | 2018

Judicial Decisions, Legislative Actions and Regulatory Announcements

New Jersey Bureau of Securities Conducts "Cryptosweep" and Orders Companies to Stop Offering Unregistered Securities

On May 21, 2018, New Jersey officials issued cease-and-desist orders against the Bullcoin Foundation, Trident, and Springcryptoinvest – three online cryptocurrency-related investment companies – to stop offering unregistered securities in New Jersey. The enforcement action by the New Jersey Bureau of Securities is among a wave of similar measures being taken throughout the United States and Canada.

In the summary cease-and-desist order against Bullcoin, Christopher W. Gerold, Chief of the New Jersey Bureau of Securities (and a CSG alum), stated that Bullcoin has been offering its Bullcoin Gold cryptocurrency, known as Bullcoin Tokens, through its website and other social media outlets. Bullcoin describes itself as “the newest cryptocurrency hedge fund.” Its physical address is in Singapore and it is not registered with the Bureau of Securities as a broker-dealer. Bullcoin’s January 20, 2018, initial coin offering was a self-proclaimed “amazing opportunity,” and included projections showing a 5,000% increase in the value of a Bullcoin Token by 2022.

The Bureau concluded that Bullcoin’s initial coin offering was an offering of unrestricted securities. It further alleged that Bullcoin fraudulently made materially false and misleading statements to potential investors. As a result, the Bureau ordered Bullcoin to cease and desist from acting as a broker-dealer and from offering for sale any security in New Jersey until the company, its agents, and its securities are registered with the Bureau.

The Bureau alleged that Springcryptoinvest, which claims to be registered in the United Kingdom, and Trident, which has no physical address or principal place of business on its website, committed similar violations.

In evaluating potential cryptocurrency offerings, investors are warned to carefully diligence the issuing companies and be particularly wary of foreign issuers with no domestic, or an entirely online, presence – promising unsubstantiated claims of high investment returns. Potential investors should also investigate whether the issuer and the securities are properly registered with the applicable state authorities or whether any applicable registration exemptions apply. Investors should also have the issuing company make appropriate representations and warranties to that effect in the investment documentation.

Delaware Court Rules CEO Elon Musk Controlled Board of Directors In Tesla Motors Inc. Stockholder Litigation

Following the $2.6 billion acquisition of SolarCity Corporation (“SolarCity”) by Tesla, Inc. (“Tesla”), Tesla’s shareholders brought a suit alleging breach-of-duty, claiming that the acquisition was an attempt to rescue CEO Elon Musk’s failing investment in SolarCity. The acquisition was approved by the Board of Directors and also ratified by the Shareholders. In Corwin v. KKK Fin. Holdings, 125 A. 3d 304 (Del. 2015), the Delaware Supreme Court held that a contested transaction which was approved by shareholder ratification would excuse evidence of self-dealing or conflict of interest, unless a controlling shareholder could have influenced the Board. In the latest development under the case at hand, In Re Tesla Motors, Inc. Stockholder Litigation, No. CV 12711-VCS, 2018 WL 1560293 (Del. Ch. Mar. 28, 2018), the court refused a motion to dismiss brought by the Defendants under Corwin, finding that Musk may have controlled the Board despite owning only 22 percent of its stock.

The Court highlighted the fact that six of Tesla’s seven Directors had an interest in SolarCity, either financially or through a family connection. Furthermore, the Court noted that Musk showed control over the Board as he continued to pitch the transaction despite SolarCity’s continuous financial decline. The Court pointed out that Musk had substantial influence over the Board due to his status as Tesla’s visionary, as a key player in the fundraising of Tesla, and the fact that he had strong connections with many of Tesla’s Directors.

Significantly, the Court noted that “it is reasonably conceivable that a majority of the five board members who voted to approve the offer and acquisition… were interested in the acquisition or not independent”. This case highlights the importance of special committees for an interested director transaction and confirms that Corwin does not require that a controlling stockholder own a majority stake to influence a Board.

Delaware Superior Court Finds Delaware Law Does Not Prohibit Insurance for Fraud Claims

In a recent decision, the Delaware Superior Court examined whether Delaware law prohibits a corporation from obtaining directors’ and officers’ liability insurance that covers breach of loyalty based on fraud. In the instant case, directors and officers of a corporation were found to have breached their duty of loyalty as part of a take private transaction. The Court stated that “[a] court may not enforce an insurance provision that is contrary to Delaware public policy.” However, the Court further noted “[a] court will not void an otherwise valid contract provision based on public policy ‘in the absence of clear indicia that such a policy actually exists.’” The Court went on to determine that “[a]lthough it may strain public policy to allow a director to collect insurance on a fraud, it does not appear to [be] explicitly prohibited by Delaware statutory law.” Also, the Court did not find that “indemnification would violate Delaware public policy.” This case highlights the breadth of indemnification that a Delaware corporation may be able to provide to its directors and officers through insurance.

Arch Insurance Co. et al. v. David H. Murdock et al., C.A. No. N16C-01-104 EMD CCLD (Del. Sup. Ct. March 1, 2018)

IRS Issues Initial Guidance on Limitations to Business Interest Expense Under Amended IRC §163(j)

The Internal Revenue Code of 1986, as amended on December 22, 2017 (the “Code”), by P.L. 115-97 (the “Tax Cuts and Jobs Act of 2017” or the “Act”) put a cap on a company’s deductions of “business interest” as defined in Section 163(j) of the Code. Section 163(j) was amended by the Act to provide new rules limiting the deduction of business interest expense for taxable years beginning after December 31, 2017. Prior to the Act, Section 163(j) disallowed a deduction for disqualified interest paid or accrued by a corporation in a taxable year if it satisfied two threshold tests: (1) the payor’s debt-to-equity ratio exceeded 1.5 to 1.0 (safe harbor test) and (2) the payor’s net interest expense exceeded 50% of its adjusted taxable income. Disqualified interest included interest paid or accrued to: (1) related parties when no Federal income tax was imposed to such interest; (2) unrelated parties in certain instances in which a related party guaranteed the debt; or (3) a real estate investment trust (“REIT”) by a taxable REIT subsidiary of that REIT.

Section 163(j)(1) now limits the taxpayer’s annual deduction for business interest expense to the sum of: (A) the business interest income of such taxpayer for such taxable year, (B) 30% of the adjusted taxable income of such taxpayer for such taxable year, plus (C) the floor plan financing interest of such taxpayer for such taxable year. The amount determined under subparagraph (B) shall not be less than zero. The Act now defines “business interest” as “any interest paid or accrued on indebtedness properly allocable to a trade or business. Such term shall not include investment interest.” The Act further defines “business interest income” as “the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business. Such term shall not include investment income.”

The Department of the Treasury and the IRS intend to issue proposed regulations to guide taxpayers in complying with the amended Section 163(j).

In its Notice 2018-28, the IRS confirms that under Section 163(j)(2), “taxpayers that cannot deduct all of their business interest because of the limitation of Section 163(j)(1) may carry their disallowed business interest forward to the succeeding taxable year, and such interest is treated as business interest paid or accrued in the succeeding taxable year.” The Notice also provides that “in the case of a taxpayer that is a C corporation, all interest paid or accrued by the C corporation on indebtedness of such C corporation will be business interest within the meaning of Section 163(j)(5), and all interest on indebtedness held by the C corporation that is includible in gross income of such C corporation will be business interest income within the meaning of Section 163(j)(6).” The pending regulations will not apply to S corporations.

The Treasury Department and IRS intend to issue regulations clarifying that the limitation in Section 163(j)(1) on the amount allowed as a deduction for business interest applies at the level of the consolidated group (as defined in Treasury Regulation 1.1502-1(h). The Treasury Department and the IRS also intend to issue regulations clarifying that the disallowance and carryforward of a deduction for a C corporation’s business interest expense under Section 163(j), as amended by the Act, will not affect whether or when such business interest expense reduces the earnings and profits of the payor C corporation.
Finally, Section 163(j)(4) “requires that the annual limitation on the deduction for business interest expense be applied at the partnership level and that any deduction for business interest be taken into account in determining the non-separately stated taxable income or loss of the partnership. Although Section 163(j)(4) is applied at the partnership level with respect to the partnership’s indebtedness, Section 163(j) may also be applied at the partner level in certain circumstances.

Choice of Law Provision Upheld

The Delaware Superior Court recently upheld a choice of law provision in an agreement designating Delaware law as the law governing any dispute arising under the agreement.

In Change Capital Partners Fund I, LLC v. Volt Electrical Systems, LLC, C.A. No. N17C-05-290 RRC (Del. Super. April 3, 2018), pursuant to a Merchants Receivable Purchase and Security Agreement, the defendant agreed to transfer a certain amount of purchased receivables to the plaintiff. The agreement provided that Delaware law would govern any disputes arising thereunder and that a defaulting party would be entitled to attorney fees and interest. The defendant ultimately defaulted on its obligations under the agreement and the plaintiff brought suit in Delaware.

The defendant argued that the court should not enforce the choice of law provision and instead should apply New York or Texas law under Section 187(2)(b) of the Restatement (Second) of Conflicts, which provides an exception to the enforcement of choice of law provisions. The exception provides that courts may disregard a choice of law provision if it is determined that application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state and which state would be the applicable law in the absence of an effective choice of law provision. The defendant argued that the transactions were usurious and against New York and Texas public policy.

The court found that despite New York and Texas laws having strong public policies against usurious loan transactions, as opposed to Delaware law which places no cap on interest, the existence of the choice of law clause establishes a significant, material and reasonable relationship with Delaware. Additionally, the defendant failed to identify a state which, absent the choice of law provision, would be the default law to apply to the controversy.

This decision emphasizes the importance of carefully selected and negotiated choice of law provisions and understanding the chosen state's policy of the subject matter of the underlying agreement.

Delaware Amendments Would Apply "Market-Out" Exception to Eliminate Appraisal Rights in Stock-for-Stock Public Mergers Under Section 251(h)

Last month, the Corporate Council of the Corporation Law Section of the Delaware State Bar Association approved proposed legislation to amend certain provisions of the Delaware General Corporation Law (“DGCL”). The proposed amendments would, among other things, amend DGCL Section 262(b) to provide that the “market out” exception to the availability of statutory appraisal rights will apply in exchange offers followed by a back-end merger consummated without a vote of shareholders pursuant to Section 251(h). This proposed amendment would eliminate an inconsistency regarding the availability of appraisal rights in stock-for-stock public mergers structured as two-step transactions under Section 251(h) and those structured as long form mergers.

Shareholders of Delaware corporations generally have appraisal rights in corporate mergers and consolidations. There is, however, a “market-out” exception which eliminates appraisal rights for certain transactions affected pursuant to a long form merger in which the target company calls a special meeting in order to obtain shareholder approval. Subsections (b)(1) and (b)(2) of Section 262, as currently drafted, provide a “market out” exception where the shareholders of any class or series of stock of a target corporation that is listed on a national securities exchange or held of record by more than 2,000 holders are not entitled to appraisal rights in connection with a merger or consolidation (with some exceptions) if the merger consideration for such shares consists solely of (i) stock of the surviving corporation or any other corporation (or depository receipts in respect thereof) that is listed on a national securities exchange or held of record by more than 2,000 holders, (ii) cash in lieu of fractional shares or depository receipts, or (iii) any combination of (i) and (ii). The “market out” exception presumes that shareholders do not need appraisal rights when they are not being cashed out in the merger and there is a public and liquid market for the consideration that they are receiving.

This “market out” exception, however, does not currently apply to mergers effected pursuant to DGCL Section 251(h). Subsection (b)(3) of Section 262, as currently drafted, provides that appraisal rights will be available for any “intermediate-form” merger effected pursuant to Section 251(h) unless the offeror owns all of the stock of the target corporation immediately prior to the merger. This means, under Section 262(b)(3), shareholders of any class or series of stock of a target corporation that is listed on a national securities exchange or held of record by more than 2,000 holders would be entitled to appraisal rights in an “intermediate-form” stock-for-stock merger in which they receive only stock of a corporation listed on a national securities exchange, despite the fact that such shareholders would not be entitled to appraisal rights in a comparable “long-form” merger as a result of the “market out” exception in subsections (b)(1) and (b)(2) of Section 262.

The proposed amendments to Section 262(b) attempt to reconcile and align these subsections by extending the “market out” exception provided for by subsections (b)(1) and (b)(2) of Section 262 to mergers effected pursuant to Section 251(h) by eliminating the carve-out of such “intermediate-form” mergers from Section 262(b)(3). Thus, if the amendments are adopted by the Delaware legislature, exchange offers followed by a merger under Section 251(h) will receive the same treatment as “long-form” mergers requiring a vote of shareholders with respect to the availability of appraisal rights.

This change could make such two-step mergers more attractive to dealmakers. Only time will tell whether the elimination of appraisal rights in Section 251(h) for stock-for-stock public mergers will increase the utility of two-step mergers.

Delaware Courts Rule on Application of Implied Covenant of Good Faith and Fiduciary Duties in LLC Operating Agreements for Blocking Company Sales

Two recent Delaware Chancery Court rulings demonstrate different approaches to when and how to apply fiduciary duties through an implied covenant of good faith in LLC operating agreements to block a company sale. Delaware law affords LLC members freedom of contract to dictate their relationship and limit or expand fiduciary duties, but does not eliminate the implied covenant of good faith and fair dealing applicable to all contracts under Delaware law. Depending on how used, this flexibility can help LLCs attract private investment by encouraging minority member participation or have a chilling effect by imposing fiduciary obligations favoring minority investors.

In Miller v HCP & Company, et al. No. 0291-5G, 2018 WL 656378 (Del. Ch. February 1, 2018), the Court rejected using the implied covenant to impose fiduciary duties on the LLC’s board to minority investors attempting to block a company sale. Miller founded Trumpet Search, LLC, and later sold a controlling stake to a private equity firm (HCP) and retained a minority membership interest. The parties amended the company’s operating agreement adding a distribution “waterfall” giving majority holder TPC priority returns on its capital investment over Miller when distributing company sale proceeds, and also that if the Board approved a sale of all company membership units to an independent third party (an “Approved Sale”), it had power to determine in its sole discretion the manner in which the sale would occur and a “drag-along” right to require non-consenting members to sell their units to the third party. The agreement also stated that, except as otherwise provided by law, no member or Board manager had any fiduciary duties to the others or the company “provided, however, that the Board ... shall have the duty to act in accordance with the implied contractual obligations of good faith and fair dealing.” When HCP negotiated and the Board approved, over Miller’s objection, a relatively quick company equity sale for $43 million without running an open sale process (leaving Miller little under the waterfall), Miller sued claiming that notwithstanding the waiver of fiduciary duty in the operating agreement the Board had an implied covenant of good faith and fair dealing to take further steps to maximize value for all members, including an open market sale and trying for a higher purchase price.

The Court rejected Miller’s arguments, holding the covenant applies only if the contract is silent on the subject at issue creating a “gap” to be filled in, and the test for finding that “gap” was whether or not it was clear, from what was expressly agreed upon, that the parties would have agreed to proscribe an act as breaching the implied covenant had they thought to negotiate the matter or, in other words, what the parties would have agreed to on an issue had they considered it in their original bargaining positions at the time of contract. The Court did not find a “gap” because (i) the operating agreement expressly waived fiduciary duties and expressly addressed the issue of how the company could be sold, by giving the MCP controlled Board power determine in its sole discretion the manner of the sale to an independent third party, and (ii) HCP using its controlling position to act in its own self-interests to pursue a quick and profitable exit (without regard to Miller) was a benefit HCP bargained for, and the parties chose to address this concern by requiring an unaffiliated third party purchaser to avoid self-dealing. The Court also noted the fiduciary duty of good faith and fair dealing doesn’t always require equitable behavior and is a duty to take actions faithful and consistent with the terms of the parties’ contract (which explicitly gave the Board broad discretion in a company sale), and not used to rectify one party’s negotiating a bad deal in hindsight.

The Court then took a different approach under In Re Oxbow Carbon LLC Unitholder Litigation, No. 12447-VCL 2018 Westlaw 818760 (Del. Ch. February 12, 2018), finding an implied covenant of good faith and fair dealing allowing minority members to force the sale of a company over the majority members’ objection. William Koch formed and controlled Oxbow Carbon LLC in 2005, and in 2007 Crestview Partners, L.P. (a private equity firm) and Load Line Capital LLC (the “Minority Members”), invested a total $265 million for a total 32.8% equity interest in Oxbow, while Koch and his family (the “Majority Members”) held the remaining 67.2%. They amended Oxbow’s operating agreement adding provisions granting the Minority Members certain rights to require all members to engage in an “Exit Sale” (a sale of all, but not less than all, the Company’s outstanding equity to a non-affiliated third party in a bona fide arms-length transaction), provided that the Minority Member may not require any other member to engage in the Exit Sale unless such other member receives sale proceeds of at least 1.5 times its aggregate capital contributions (the “1.5x Clause”), and that all members’ interests be transferred on the same terms and conditions and result in a pro rata distribution of sale proceeds to all members. In 2011, Oxbow issued an additional 1.4% membership interests to Koch family members (the “Small Holders”) for $20 million without any formal purchase agreement or amending the operating agreement.

The relationship with Koch deteriorated and in 2016 the Minority Members sought to exercise their Exit Sale right to force a full equity sale of Oxbow per the operating agreement. Oxbow received an offer satisfactory to the Minority Members at a price meeting the 1.5x Clause for all members except the Small Holders. Koch disapproved and tried to hinder the sale, and the Minority Members sued to compel the offered Exit Sale. The Majority Members contended the express terms of the operating agreement blocked the proposed Exit Sale because it did not satisfy the 1.5x Clause for all members including the Small Holders. The Minority Members claimed the 1.5x Clause did not apply to the Small Holders since were never properly admitted as members because Oxbow failed to comply with the operating agreement’s approval and procedural requirements of at the time of admission, but the Court held the Small Holders were in fact members and barred this claim in equity because they never objected to Small Holders’ admission and treatment as members until the litigation.

The Minority Members also claimed the 1.5x Clause did not block a company sale if not satisfied for a particular member, but gave that member an option not to participate while allowing the remaining members to proceed, and that permitting an Exit Sale only if a third party offered all members a uniform price high enough for every member, including the Small Holders, to get a 1.5x return would be prohibitively expensive here and nullify the liquidity right the Minority Members negotiated for when they invested in Oxbow. The Court allowed the Exit Sale using the implied covenant of good faith and fair dealing to impose a “topping off” option for Minority Members to pay additional consideration directly to the Small Holders to get their 1.5x return. The Court held that because the operating agreement contemplated admitting additional members (e.g., the Small Holders) on terms to be determined by the Board, the Board’s failure to specify rights of the Small Holders upon admission created confusion over application of the 1.5x Clause - a “gap” allowing application of the implied covenant. The Court concluded that the other members would have negotiated and agreed to the “top off” right when the Small Holders were admitted since it was the most commercially reasonable option at that time, and imposed it to fill the “gap” created when the Small Holders were admitted.

The important takeaway from these cases is that using the implied covenant of good faith and fair dealing to help minority investors cash out of a Delaware LLC through a company sale often has uncertain results, and operating agreements need clear and careful drafting, and consider specifically addressing particular concerns, to minimize these uncertainties.

Delaware Court of Chancery Applies Broader Approach to Traditional Contract Interpretation Principles

The Delaware Court of Chancery decision in Plaze, Inc. and Apollo Aerosole Industries LLC v. Chris K. Callas et al., C.A. No. 2017-0432-TMR (Del. Ch. Mar. 29, 2018), refers to recent Supreme Court decisions that provided arguments for considering a broader approach to the more traditional “four corners of the document” view of contract interpretation. In this case, the court addresses contract interpretation in the context of post-closing issues arising from Plaze, Inc.’s (“Plaze”) purchase of Apollo Aerosole Industries LLC (“Apollo”) pursuant to a stock purchase agreement which included provisions for non-competition, non-solicitation, indemnification and post-closing adjustments.

Plaze is the sole member of Apollo. In 2015, Plaze acquired Apollo from Defendants (or the “Sellers”) for $100,000,000 pursuant to a stock purchase agreement (the “SPA”). The SPA sets out a mechanism for post-closing adjustments to the purchase price, as well as a limitation on the Sellers’ post-closing indemnification liability. The SPA also contains representations and warranties by Defendants on behalf of Apollo that are at issue in this litigation. Indemnification is the sole remedy for a breach of a representation or warranty under the SPA. The SPA also contains several restrictive covenants, including non-compete, non-solicit, and confidentiality provisions.

Subsequent to the closing of the transaction, Defendants Chris Callas and Maria Callas continued to work at Apollo. After the relationship soured, Apollo and Chris Callas entered into a mutual separation and settlement agreement (the “Separation Agreement”), which included a severance amount, a repurchase of LLC units, and a settlement of the purchase price under the SPA, as well as additional representations, warranties, and restrictive covenants applicable to Chris Callas.

Plaintiffs contend that the Callases started a competing business and attempted to solicit employees from Apollo and several breaches of representations and warranties, for which Defendants owe them indemnification, arose during the survival period. Plaintiffs filed the complaint seeking to enjoin the competitive behavior of Defendants and compel payment of the indemnification and tax adjustment amounts. Defendants argued that the Separation Agreement superseded the indemnification provisions in the SPA and moved to partially dismiss the complaint.

The court began its analysis with the still applicable principle that Delaware applies to the objective theory of contracts, i.e.: “A contract’s construction should be that which would be understood by an objective, reasonable third party.” The court provided that it will give priority to the “parties’ intentions as reflected in the four corners of the agreement, construing the agreement as a whole and giving effect to all its provisions.” But, the court cited to a recent Delaware Supreme Court decision, the most recent statement of Delaware law regarding contract interpretation which provides for a more holistic approach expressed in the following quote: “In giving sensible life to a real-world contract, courts must read the specific provisions of the contract in light of the entire contract.” (Chicago Bridge & Iron Co. N.V. v. Westinghouse Elec. Co., 166 A.3d 912, 913-14 (Del. 2017)).

The court found that the extensive indemnification provisions for breach of representations and warranties in the SPA was not impacted by the Separation Agreement with one of the executives who allegedly violated the restrictive covenants and other provisions in the SPA, and denied the motion to dismiss.

Plaze, Inc. and Apollo Aerosole Industries LLC v. Callas, C.A. No. 2017-0432-TMR (Del. Ch. Mar. 29, 2018)