Category: Perspectives

Why Tax Reform Will Not Happen Soon

Posted on by Liam Mennitt

Corporations have been stockpiling cash awaiting promised tax reform. Enterprises have delayed capital investment, hiring, and cash allocation in anticipation of promised tax features such as lower rates. In February of 2017, the Secretary of the Treasury promised comprehensive tax reform before the August recess.

Because tax reform along the lines or scale articulated by some in government to date seems unlikely, I encourage businesses to consider deploying their capital more profitably than holding it in reserve.

I reviewed the circumstances generally present in the environments of each of the last eight significant tax reform acts. I found three factors present in the majority of them and offer here my view of why their presence then, and their absence now, bodes poorly for sweeping tax reform.

  1. Lobbyists need to be kept at a distance or soundly aligned with the reform goals. Thus far, Congress has led with its chin by pushing such things as the Border Adjustment Tax and lower corporate tax rates. Now, K Street is already fully immersed in the process, either for or against. Neither required element of “Fair” or “Simple” is any longer possible.
  2. A government more or less evenly divided, as it was in 1986, is essential so that no one party has to suffer the fallout from substantial tax reform. Division is considered not just by party within the legislative branch, but also as between the Houses of Congress and the president. See the chart below for an illustration of how this has shaped up in years when tax reform has passed. Also, recall that within 20 years after TRA 1986, over 15,000 changes to the tax law, most incrementally rolling back the changes, had already been made.
  3. Revenue neutrality is a necessarily stated goal of tax reform. In 1986, Representatives took turns at the podium declaring their support for a bill that neither raised nor lowered government revenues. With a current budget deficit of about $440 billion, a tax gap of about $410 billion, and the largest income polarization in history, it’s going to be a tough sell to offer revenue neutrality. Without it, there can be no meaningful tax reform.

Given that none of the factors that have been historically required to accomplish sweeping tax reform are now present, I suspect we will not see it this year or in 2018.

This memo is intended only as an illustration of general principles. It is not intended as legal or tax advice. The reader is cautioned to discuss his or her specific circumstances with a qualified practitioner before taking any action.

SEC Issues Report on the Application of Federal Securities Laws to Crowdfunding Through Cryptocurrency

Posted on by Liam Mennitt

On July 25, 2017, the Securities and Exchange Commission issued a Report following their investigation of The DAO.  The DAO is an unincorporated organization that is just one example of a “Decentralized Autonomous Organization” –  a virtual organization embodied in computer code and executed on a distributed ledger or blockchain.

The DAO was formed in 2015 as unique form of crowdfunding whereby participants would vote on proposals and be entitled to rewards.  Between April and May of 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for approximately 12 million Ether.  Ether is a form of virtual currency.  These DAO Tokens gave the holder certain voting and ownership rights.

Token holders could vote on predetermined proposals deciding where The DAO invested its money, with each token holder’s vote weighted according to how many DAO Tokens he or she held.  On June 17th, 2016, an unknown individual or group attacked The DAO and appropriated approximately 1/3 of the total funds.  Although the funds were eventually recovered by The DAO, the SEC began investigating the attack and The DAO.  Ultimately, the SEC determined that an Enforcement Action was not necessary, however it issued a report laying out how the Securities Act and the Securities Exchange Act applies to The DAO and similar entities.

Section 5 of the Securities Act prohibits entities not registered with the SEC from engaging in the offer or sale of securities in interstate commerce.  Upon investigation of the circumstances surrounding The DAO, the SEC stated that The DAO qualifies as an “issuer” and thus must register as such with the SEC in order to sell DAO Tokens – which the SEC considers to be securities – in compliance with federal securities laws.  Given the SEC’s flexible interpretation and application of the Act, this Report is a caution to virtual entities that the federal securities laws are applicable and that the SEC intends to pursue enforcement of these laws in the field of virtual currencies and securities.

SEC Issues Report on the Application of Federal Securities Laws to Crowdfunding through Cryptocurrency

Posted on by Liam Mennitt

On July 25, 2017, the Securities and Exchange Commission issued a Report following their investigation of The DAO.  The DAO is an unincorporated organization that is just one example of a “Decentralized Autonomous Organization” –  a virtual organization embodied in computer code and executed on a distributed ledger or blockchain.

The DAO was formed in 2015 as unique form of crowdfunding whereby participants would vote on proposals and be entitled to rewards.  Between April and May of 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for approximately 12 million Ether.  Ether is a form of virtual currency.  These DAO Tokens gave the holder certain voting and ownership rights.

Token holders could vote on predetermined proposals deciding where The DAO invested its money, with each token holder’s vote weighted according to how many DAO Tokens he or she held.  On June 17th, 2016, an unknown individual or group attacked The DAO and appropriated approximately 1/3 of the total funds.  Although the funds were eventually recovered by The DAO, the SEC began investigating the attack and The DAO.  Ultimately, the SEC determined that an Enforcement Action was not necessary, however it issued a report laying out how the Securities Act and the Securities Exchange Act applies to The DAO and similar entities.

Section 5 of the Securities Act prohibits entities not registered with the SEC from engaging in the offer or sale of securities in interstate commerce.  Upon investigation of the circumstances surrounding The DAO, the SEC stated that The DAO qualifies as an “issuer” and thus must register as such with the SEC in order to sell DAO Tokens – which the SEC considers to be securities – in compliance with federal securities laws.  Given the SEC’s flexible interpretation and application of the Act, this Report is a caution to virtual entities that the federal securities laws are applicable and that the SEC intends to pursue enforcement of these laws in the field of virtual currencies and securities.

Connecticut Unfair Trade Practices Act: Wesleyan University Case

Posted on by Liam Mennitt

On February 19, 2015 the Gamma Phi Chapter of Delta Kappa Epsilon (the “Fraternity” or “DKE”) filed suit against Wesleyan University, its President Michael S. Roth, and its Vice President for Student Affairs, Michael J. Whaley (collectively “Wesleyan University” or the “University”).  The lawsuit was filed as a result of the University denying DKE Program Housing status for the 2015-2016 academic year.  This denial meant that the Fraternity brothers who were, at the time, living in the house had to move out, and that those who planned to live in the house for the upcoming year had to make other living arrangements.

The twelve count complaint included one count which stood out among the rest.  DKE asserted that Wesleyan University had violated the Connecticut Unfair Trade Practices Act.

In 2014, Wesleyan University began implementing co-educational policies throughout their housing programs.  As such, it required DKE, along with all other organizations seeking Program Housing status, to submit plans to comply with the newly imposed co-educational requirements.  The center of the dispute surrounds DKE’s efforts to comply and Wesleyan University’s rejection of DKE’s plan.

DKE is an all-male international fraternity.  When informed of the new co-educational requirement, DKE sought clarification of what Wesleyan University meant by “substantial co-education” and “full and meaningful co-education.”  Despite the lack of clarity, DKE submitted a plan to make the house co-educational, but explained that it could not commit to “fully co-educate” the house given Wesleyan University’s refusal to define the term.  That plan was rejected, and the DKE house was eliminated as Program Housing for the 2015-2016 year.  In 2015, DKE made a second attempt to obtain Program Housing status, but that too was rejected, and again the DKE house was denied Program Housing status for the 2016-2017 year.

DKE argued that this was all part of Wesleyan University’s plan, that began in April 2014, to eliminate all all-male, Greek organizations from Program Housing.  Thus, any and all representations made concerning DKE as eligible for Program Housing were deceptive because Wesleyan University knew before the plan was submitted that any plan would be rejected.  On June 15, 2017 a jury found in favor of DKE, awarding $368,000 in damages.

The Connecticut Unfair Trade Practices Act (“CUTPA”) states, generally, that “[n]o person shall engage in unfair methods of competition and unfair or deceptive acts or practices in the conduct of any trade or commerce.”  Conn. Gen. Stat. § 42-110b(a).  It has been long established that CUTPA “provides a private cause of action to [a]ny person who suffers any ascertainable loss of money or property, real or personal, as a result of the use or employment of a [prohibited] method, act or practice . . . .”  Ulbrich v. Groth, 78 A.3d 76 (2013);  Harris v. Bradley Memorial Hospital & Health Center, Inc., 994 A.2d 153 (2010);  Landmark Inv. Grp., LLC v. CALCO Constr. & Dev. Co., 124 A.3d 847 (2015) (internal quotation marks omitted.)

Connecticut has adopted the Federal Trade Commission’s “cigarette rule” definition of unfairness:

  1. whether the practice, without necessarily having been previously considered unlawful, offends public policy as it has been established by statutes, the common law, or otherwise — whether, in other words, it is within at least the penumbra of some common-law, statutory, or other established concept of unfairness;
  2. whether it is immoral, unethical, oppressive, or unscrupulous;
  3. whether it causes substantial injury to consumers (or competitors or other businessmen).

Statement of Basis and Purpose of Trade Regulation Rule 408, Unfair or Deceptive Advertising and Labeling of Cigarettes in Relation to the Health Hazards of Smoking. 29 Fed. Reg. 8355 (1964);  FTC v. Sperry & Hutchinson Co., 405 U.S. 233, 244 n.5 (1972).

In support of their CUTPA claim, DKE first asserted that Wesleyan University is engaged in trade or commerce within the meaning of CUTPA.  DKE argued that Wesleyan University advertises and offers for rent or lease various properties to students as residential housing, and markets such housing as an integral part of their educational experience.  Further, DKE argued that the Fraternity, as well as the named Plaintiffs, are consumers within the meaning of the statute.  The crux of their argument was the Wesleyan University’s representations that it was to offer upperclassman housing in the DKE House were false, and that these representations were deceptive.

CUTPA on its face is broad, and thus it is no surprise to see that broad application and liberal interpretation has followed suit.  See Marinos v. Poirot, 66 A.3d 860 (2013);  Associated Investment Co. Ltd. Partnership v. Williams Associates IV, 645 A.2d 505 (1994).  The Connecticut General Assembly “deliberately chose not to define the scope of unfair or deceptive acts proscribed by CUTPA so that courts might develop a body of law responsive to the marketplace practices that actually generate such complaints.”  Associated Inv. Co., 645 A.2d at 510 (quoting Sportsmen’s Boating Corp. v. Hensley, 474 A.2d 780 (1984) (emphasis added)).  Therefore, “CUTPA has come to embrace a much broader range of business conduct than does the common law tort action” and  because it is “a self-avowed ‘remedial’ . . .  measure, it is construed liberally in an effort to effectuate its public policy goals.”  Id.  “Indeed, there is ‘no . . . unfair method of competition, or unfair [or] deceptive act or practice that cannot be reached [under CUTPA].” Id. (quoting the Conn. Joint Standing Committee Hearings, General Law, Pt. 2, 1973 Sess., p. 705, remarks of Attorney Robert Sils, Dept. of Consumer Protection).

This liberal interpretation and broad application is important because CUTPA “provides for more robust remedies than those available under analogous common-law causes of action.”  Marinos, 66 A.3d at 867.  Punitive damages and attorney’s fees and costs are available in addition to actual damages and injunctive or other equitable relief.  See Conn. Gen. Stat. § 42-110g (a).

Given the liberal interpretation, broad application and extensive penalties available thereunder, the case of DKE’s successful CUTPA claim against Wesleyan University ­­­should serve as a cautionary warning for Connecticut litigators and persons sued for violating Connecticut General Statutes § 42-110 et seq., alike.

CT’s New Limited Liability Act: New & Existing Operating Agreements Should be Reviewed for Compliance

Posted on by Liam Mennitt

Connecticut’s new Liability Company Act takes effect on July 1, 2017. It introduces numerous changes to Connecticut law and imposes several new requirements on LLCs and their members and managers. Of immediate importance to many LLCs are the several changes that the new law requires to existing operating agreements. This note will review some of those required changes.

While the new law was written to limit the impact it has on existing LLCs, it does require attention to every new and existing operating agreement so members and managers can be sure their agreements comply with the law and avail them of the opportunities within it.

At the outset, the new law changes the name of the initial LLC filing document from “Articles of Organization” to “Certificate of Organization.” The Act retroactively deems “Articles” filed under the old law to be a “Certificate” under the new law.

The new law also creates at least four statutory impositions which, if not suitably addressed by the operating agreement, control the LLC by new statutory requirements. Existing LLCs should immediately review their operating agreements (or the lack thereof) with an eye toward the effect of the new law.

One example of such impositions addresses admission of new members. Under the prior law, if the operating agreement was silent on the issue, the vote of a majority in interest was required to admit a new member. Under the new law, the default vote required is unanimity. If members want to retain the majority-in-interest vote for admission of new members, they must be sure the operating agreement affirmatively reflects this intent.

In a similar way, the old law required a two-thirds majority of votes in interest to amend the operating agreement. The new law now requires unanimous approval if the operating agreement is silent.

The new act describes in some detail the duty of care and level of loyalty required of members and managers. It also provides four areas in which the operating agreement may depart from these prescribed standards, so long as the departures are not “manifestly unreasonable.” The operating agreement may:

  • Alter or eliminate certain portions of the duty of loyalty
  • Identify specific behaviors that do not violate the duty of loyalty
  • Alter, but not eliminate, the duty of care
  • Alter, or eliminate, any other fiduciary duty

C.G.S. §34-243d(d)(3).

The notion of “manifestly unreasonable” will be refined by the courts over time. Pending that, it is imperative that LLCs preferring a less strict standard of loyalty or care for their members or managers, review and revise their operating agreements to so reflect.

It is also important to observe that the new law does not automatically recognize “sweat equity” as a valid metric for distributions. Rather, unless the operating agreement provides otherwise, the law now requires that distributions be based on their respective capital contributions rather than their percentage ownership. C.G.S. §34-255c(a). It is worth noting that federal partnership tax law has also changed to attribute losses differently under the new regulations under Section 707 of the Code.

C.G.S. §34-243d(d)(1)(B) allows for the operating agreement to provide for a more liberal definition of illiquidity than is provided by the default provision of §34-255d(a), which prohibits a LLC from making a distribution if any of the following tests for illiquidity are met: (1) The company would not be able to pay its debts as they become due in the ordinary course of the company’s activities and affairs; or (2) the company’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the company were to be dissolved and wound up at the time of the distribution, to satisfy the preferential rights upon dissolution and winding-up of members and transferees whose preferential rights are superior to those of persons receiving the distribution.

If the members want to use the more liberal provision of § 34-243d(d)(1)(B), they may include in the operating agreement a provision that a lawful distribution requires only that the company’s total assets not be less than the sum of its total liabilities.

While the new law provides LLCs considerable discretion in formulating their operating agreements, it provides fourteen circumstances in which LLCs either may not override the statutes or limits their ability to do so.

C.G.S. §34-243d(c) now provides:

(c) An operating agreement may not:

(1) Vary the law applicable under section 34-243c;

(2) vary a limited liability company’s capacity under subsection (a) of section 34-243h, to sue and be sued in its own name;

(3) vary any requirement, procedure or other provision of sections 34-243 to 34-283d, inclusive, pertaining to: (A) Registered agents; or (B) the Secretary of the State, including provisions pertaining to records authorized or required to be delivered to the Secretary of the State for filing under sections 34-243 to 34-283d, inclusive;

(4) vary the provisions of section 34-247c [giving the Superior Court jurisdiction to compel signing, filing, or filing of unsigned records with the Secretary of the State]

(5) alter or eliminate the duty of loyalty or the duty of care, except as provided in subsection (d) of this section;

(6) eliminate the implied contractual obligation of good faith and fair dealing under subsection (d) of section 34-255h, except that the operating agreement may prescribe the standards, if not manifestly unreasonable, by which the performance of the obligation is to be measured;

(7) relieve or exonerate a person from liability for conduct involving bad faith, willful or intentional misconduct, or knowing violation of law;

(8) unreasonably restrict the duties and rights under section 34-255i [generally governing rights of members and managers, and rights for former members to information], except that the operating agreement may impose reasonable restrictions on the availability and use of information obtained under said section and may define appropriate remedies, including liquidated damages, for a breach of any reasonable restriction on use;

(9) vary the causes of dissolution specified in subdivisions (4) and (5) of subsection (a) of section 34-267 [which address the jurisdiction of the Superior Court to dissolve the LLC on application by a member for any of four reasons: i) The conduct of all or substantially all of the company’s activities and affairs is unlawful; ii) it is not reasonably practicable to carry on the company’s activities and affairs; iii) the managers have acted, are acting or will act in a manner that is illegal or fraudulent; or iv) the managers have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant]

(10) vary the requirement to wind up the company’s activities and affairs as specified in subsections (a) and (e) of section 34-267a  [articulating general and specific circumstances of the wind up of  certain LLCs] and subdivision (1) of subsection (b) of section 34-267a [describing duties of filing and debt payment for wound-up LLCs]

(11) unreasonably restrict the right of a member to maintain an action under sections 34-271 to 34-271e, inclusive;

(12) vary the provisions of section 34-271d [generally describing the duties and powers of a special litigation committee], except that the operating agreement may provide that the company may not have a special litigation committee;

(13) vary the required contents of a plan of merger under subsection (b) of section 34-279h or, a plan of interest exchange under section 34-279m; or

(14) except as provided in section 34-243e [assent to Operating Agreement] and subsection (b) of section 34-243f, [obligations of LLC and members to transferees] restrict the rights under sections 34-243 to 34-283d [addressing a broad range of rights and duties of LLCs, members, and managers], inclusive, of a person other than a member or manager.

Under the new act, an LLC operating agreement may not relieve a person from liability for conduct involving bad faith, intentional or willful misconduct, or a knowing violation of the law. C.G.S. §34-243d(c)(7). I note especially this change in law here because many existing operating agreements exempt members or managers from liability exempting from such exoneration only in cases of “fraud, gross negligence, or willful misconduct.” LLC members should review their operating agreements and reconcile their intended relief with the new statutory requirements, insofar as possible.

The new statute also addresses the rights of members to access and inspect LLC records.  In practice, we have seen access to records as a point of friction, often within LLCs experiencing dissent among members. The law now provides that an operating agreement may not impose unreasonable restrictions on access to information. It may, however, impose reasonable restrictions on the availability of use of the information. For example, the LLC may require the accessing member to execute and deliver a non-disclosure agreement. The operating agreement may also define particular remedies for breaches of reasonable restriction on the use of the information. C.G.S. §34-243d(c)(8).

While the new act explicitly articulates that “[i]t is the policy of the act to give maximum effect to the principles of freedom of contract and to enforceability of LLC agreements,” the limitations and restrictions it establishes demand careful attention to both existing and new operating agreements.

LLCs that have never had an operating agreement are not required by the new law to adopt one, but LLCs without a compliant agreement will now be subject to the default provisions of the law, whose effect may not be intended or desired by the members or managers.

This note is intended only to illustrate general principles and is not legal or tax advice. The reader should discuss his or her specific circumstances with a qualified practitioner before taking any action.

IRS Seeks Leave from Court to Serve Sweeping Summons on Bitcoin Exchange

Posted on by Liam Mennitt

In an ex parte Application for Leave to Serve John Doe Summonses dated November 17, 2016, the Internal Revenue Service requested of the United States District Court for the Northern District of California the authority to obtain the records of Coinbase, Inc. a bitcoin exchange located in San Francisco.

By its own terms, the request is speculative, relying on an undefined “likelihood” that the resulting summons will yield information identifying persons who have not properly filed or paid taxes due the United States. The only defined term upon which the request is based is IRS Notice 2014-21, which described the Services views on virtual currencies and offered the position that bitcoin (and similar devices) are not “currency” but, rather, are property under 26 U.S.C. §1221. Although the Notice reached this conclusion without analysis or authority, it is probably correct, at least for the moment. Only because bitcoins neither circulate nor are they customarily used and accepted as money in the country in which they are issued, they do not meet the definition of currency in the Bank Secrecy Act. 31 CFR 1010.100(m). Presumably, Treasury adopts this definition for tax purposes.

The request has alarmed the cryptocurrency community because it comes in the wake of absolutely nothing. No criminal case, claims of interviews with only three taxpayers who said they has used virtual currencies as a means of evading taxes, and not even a named suspect in the summons request. The report of the Treasury Inspector General for Tax Administration dated September 21, 2016 observes three critical issues:

  1. The IRS has no strategy concerning virtual currency;
  2. The Criminal Investigation unit of the IRS has undertaken no effort to inquire in matters concerning the improper reporting of bitcoin; and
  3. Notice 2014-21, so far the IRS’s only formal articulation of its position regarding bitcoin, characterizes bitcoin as property, not as currency, although the device is commonly accepted as currency by over 100 major organizations including Subway, Microsoft, Reddit, and Expedia. Many users of bitcoin are likely unaware of the Notice or uncertain of its arcane meaning.

Thus, for the IRS to use as its opening salvo into the matter of virtual currency what is described by its target as a “sweeping fishing expedition” gives every participant in a cutting edge technology pause to consider if the IRS should be able to leverage that enterprise to make up ground in its own investigative dilemmas. In short, should Coinbase become an involuntary source of data for the government absent more evidence supporting a wholesale compromise of the privacy of their customers’ information?

Enforcement in the Second Circuit of FINRA Pre-Hearing Subpoenas and Discovery Orders

Posted on by Liam Mennitt

In a Financial Industry Regulatory Authority (“FINRA”) arbitration under either the Consumer or Industry Arbitration Rules, there are two mechanisms for seeking discovery.  For parties and non-parties who are not FINRA members, FINRA Rules 12512 and 13512, authorize an arbitrator to issue a subpoena for production of documents.  For parties and FINRA members, FINRA Rules 12513 and 13513, authorize an arbitrator to issue an arbitration order (not a subpoena) for the production of documents. However it is unlikely that a party seeking enforcement of either the subpoena or the order issued by a FINRA arbitration panel will find relief in the court system. But that doesn’t leave enforcement out of reach.

Parties and Non-Parties who are not FINRA members

FINRA Rules 12512 and 13512 authorize an arbitrator to issue subpoenas for the production of documents. FINRA Rules 12512(a)(1) and 13512(a)(1).  If the subpoena is not complied with, the next step for most litigators would be to move to enforce the subpoena in Federal District Court.  However such an action is unlikely to be successful.

There is split among the Circuits but the Second Circuit interprets the Federal Arbitration Act (“FAA”) Section 7 as prohibiting enforcement of subpoenas for pre-hearing discovery.  See Life Receivables Trust v. Syndicate 102 at Lloyd’s of London, 549 F.3d 210, 212 (2d Cir. 2008).  However the Second Circuit court made it clear that,

[i]nterpreting section 7 according to its plain meaning “does not leave arbitrators powerless” to order the production of documents. Hay Group v. E.B.S. Acquisition Corp., 360 F.3d 404, 413 (3d Cir. 2004) (Chertoff, J., concurring). On the contrary, arbitrators may, consistent with section 7, order “any person” to produce documents so long as that person is called as a witness at a hearing. 9 U.S.C. § 7. Peachtree concedes as much, admitting that “Syndicate 102 could obtain access to the requested documents by having the arbitration panel subpoena Peachtree to appear before the panel and produce the documents.” In Stolt-Nielsen, we held that arbitral section 7 authority is not limited to witnesses at merits hearings, but extends to hearings covering a variety of preliminary matters. 430 F.3d at 577-79. As then-Judge Chertoff noted in his concurring opinion in Hay Group, the inconvenience of making a personal appearance may cause the testifying witness to “deliver the documents and waive presence.” 360 F.3d at 413 (Chertoff, J., concurring). Arbitrators also “have the power to compel a third-party witness to appear with documents before a single arbitrator, who can then adjourn the proceedings.” Id. at 413. Section 7’s presence requirement, however, forces the party seeking the non-party discovery — and the arbitrators authorizing it — to consider whether production is truly necessary. See id. at 414. Separately, we note that where the non-party to the arbitration is a party to the arbitration agreement, there may be instances where formal joinder is appropriate, enabling arbitrators to exercise their contractual jurisdiction over parties before them. In sum, arbitrators possess a variety of tools to compel discovery from non-parties. However, those relying on section 7 of the FAA must do so according to its plain text, which requires that documents be produced by a testifying witness.

Life Receivables Trust v. Syndicate 102 at Lloyd’s of London, 549 F.3d 210, 218, (2d Cir. N.Y. 2008).  To obtain the aid of the Court system, the Second Circuit quoting from the Third Circuit clearly indicates that the arbitrators must order an appearance in some fashion of the object of the subpoena.  Accordingly if such an appearance is ordered, then Section 7 of the FAA is no longer a prohibition against the production of the documents even if it is a pre-hearing appearance.

Parties and FINRA Members

FINRA Rules 12513 and 13513 authorize an arbitrator to issue a discovery order for the production of documents.  If the discovery order is not complied with there is no opportunity to turn to the court system for enforcement relief because there was no actual subpoena issued.  However, turning to FINRA’s Department of Enforcement is likely to be successful.

Enforcement of a pre-hearing discovery order, issued to a non-party FINRA member under FINRA rule 13513, is largely an issue of first impression. By way of background, FINRA Rule 13513 went into effect in its current form on February 18, 2013.  Since that time there does not appear to have been any enforcement action by the FINRA Department of Enforcement for its violation.  However, there is at least one enforcement action for violation of a party’s discovery obligations in an arbitration proceeding.  See In Re Westrock Advisors.  It is a violation of FINRA Rule IM-13000 to fail to comply with any rule of the arbitration code and specifically for failure to produce a document:

It may be deemed conduct inconsistent with just and equitable principles of trade and a violation of Rule 2010 for a member or a person associated with a member to:

… (c) fail to appear or to produce any document in his possession or control as directed pursuant to provisions of the Code;…

In Westrock Advisors failure to comply with discovery orders was censured and a $50,000 fine was imposed.
Conclusion

Accordingly, enforcement of a subpoena or discovery order without use of the Court system is both possible and likely to be successful in obtaining documents in pre-hearing discovery from parties, non-parties, FINRA members and Non-FINRA members alike.

SEC Cuts Back on the Use of Administrative Law Judges

Posted on by Liam Mennitt

In the past two years, the SEC has drastically reduced the number of contested cases it has sent to its internal administrative law judges (“ALJs”). The number of cases sent to these judges had been increasing since 2010, when the SEC gained new powers under the Dodd-Frank Act.

From then on, and especially after the SEC decided in 2014 to expand the use of the ALJs to contested cases for crimes such as insider trading, members of the legal community have argued that it would be very hard for these judges to remain unbiased given the fact that one of the parties in every case they review is responsible for their income — in a much more direct way than a state or federal court judge. Additionally, the ALJs were generally appointed by a lower-level employee than one might expect (an issue which has led to Constitutional challenges, which are outside the scope of this article).

The Wall Street Journal analyzed the cases sent to the ALJs from October 2010 to March 2015, and found the SEC won 90% of these cases. While this could be attributed to the fact that the SEC does a thorough job investigating before charging defendants with a crime, the fact that the SEC was victorious only 69% of the time in federal courts casts some doubt on this. In fact, the Wall Street Journal has reported that in spring of 2015, the SEC director of enforcement, Andrew Ceresney, shifted the policy of the Commission back to putting contested cases in federal court. Since then, the SEC has been using the federal court system for contested charges. From October 2014 to September 2015, the SEC used the ALJs in 28% of the contested cases, whereas the year before ALJs heard 43%.

Preserving Loan Treatment of S Corporation Payments from Shareholders

Posted on by Liam Mennitt

The sense of control and informality of operations experienced by shareholders of S corporations is a robust bridge for entrepreneurs, providing them an accessible connection between their personal and work lives, without the constraints of a board of directors, awkward motions and resolutions, and the pesky documentation requirements attorneys seem to impose on entrepreneurs in some other forms of business.

Among the most prevalent and cherished characteristics of S corporations is the perception  by their owners that the income tax transparency of the S corporation translates into the interchangeability of the corporation with the shareholders for all tax purposes.

On August 24, 2016, the Tax Court filed a Memorandum decision providing a good review of the standards for characterization of transfers between shareholders and close corporations as either loans or capital contributions. Tax attorneys see, all too often, shareholders, partners and other principals receive large and unexpected tax bills, with penalties and interest added, resulting from incomplete or inaccurate application of the rules associated with capital contributions and loans to businesses they control. Virtually without exception, the taxpayer is caught by surprise.

In Scott Singer Installations, Inc., T.C. Memo 2016-161 (August 24, 2016), the sole shareholder and sole officer of an S corporation loaned over $1 million to his corporation over about a 5 year period. During the same period, the company paid the shareholder’s personal expenses by paying his creditors directly.

All of the cash advances by the shareholder were reported as shareholder loans on the corporation’s books of account and on the Form 1120S. There were, however, no promissory notes executed and no interest charged.  (A discussion of the correct way to calculate and document interest charges under the tax rules is beyond the scope of this article.)

The IRS audited the books and records of the corporation and concluded that the payment by the corporation of its shareholder’s expenses was taxable income to the shareholder, and, further, subject to employment withholding taxes. The IRS further concluded the advances made by the shareholder were contributions to capital. While such treatment would have the effect, among other things, of increasing the shareholder’s basis in the corporation, it would also generally render the repayments of the advances as return of capital, rather than debt repayment, and the interest portion would not be recognized for tax purposes.

With regard to the advances, the Tax Court weighed the factors associated in law to determine of there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention was consistent with the economic reality of creating a debtor-creditor relationship. The court found the fact that the corporation consistently carried the advances as outstanding loans on its ledger. It further found that the consistency of the corporation’s payments expense payments for its shareholder, even when the corporation was losing money, supported the conclusion that such payments were debt service and not ordinary income.

The Tax Court’s discussion calls to mind the nonexclusive 13 part test typically used in evaluating the nature of transfers to closely held corporations:

  1. The names given to the documents that would be evidence of the purported loans;
  2. The presence or absence of a fixed maturity date;
  3. The likely source of repayment;
  4. The right to enforce payments;
  5. Participation in management as a result of the advances;
  6. Subordination of the purported loans to the loans of the corporation’s creditors;
  7. The intent of the parties;
  8. The capitalization of the corporation;
  9. The ability of the corporation to obtain financing from outside sources;
  10. Thinness of capital structure in relation to debt;
  11. Use to which the funds were put;
  12. The failure of the corporation to repay; and
  13. The risk involved in making the transfers. (Calumet Indus., Inc., (1990) 95 TC 25795 TC 257)

These tests are, of course, factual, and weighted differently in each case. Hence, it is incumbent on shareholders of S corporations to assure, through clear, written and contemporaneous documentation, consistently prepared and maintained, that the elements of the creditor-debtor relationship are demonstrated in cases where the shareholder is lending money to the corporation.

This article is not intended as legal or tax advice and is a discussion of general principles only. The reader should consult with a qualified professional concerning his or her specific circumstances before taking any action.

The Facebook-FTC Settlement and the Future of Privacy Regulation

Posted on by Liam Mennitt

In the wake of a landmark Federal Trade Commission (FTC) settlement imposed on the social media giant Facebook, it is fair to speculate whether other companies will be forced to pay hefty fines and prioritize compliance with privacy standards in order to escape punishing federal regulation. The settlement, which was announced on Wednesday, July 24th, compels Facebook to pay a five billion dollar fine, the largest ever penalty leveled on a social media company in connection with privacy violations.1 Though the fine is relatively trivial in the context of Zuckerberg and co.’s multi-billion dollar annual earnings, the settlement also forces Facebook to “submit to quarterly certifications from the FTC to acknowledge that the company is in compliance with the [settlement’s] privacy program,” a major defeat for a company whose business model revolves around the collection and analysis of user data.2 The settlement also forces Facebook to reform its corporate structure and submit to oversight from an internal “privacy committee” tasked with ensuring the integrity of user data, among other impositions.2

All in all, the settlement is important not so much for its impact on Facebook as its implications for legal scrutiny of other technology companies. Although the federal government lacks the congressional mandate required to more expansively scrutinize the privacy standards of technology companies, such a mandate may well be in the offing, especially considering that political interest in privacy violations is cresting among members of both parties. Moreover, even if Congress elects not to craft a comprehensive online privacy law, future settlements imposed by the FTC could cripple rival companies lacking the social media giant’s seemingly inexhaustible resources.

Although the FTC settlement represented a major shift in the regulatory landscape, social media companies innocent of the sort of grave violations committed by Facebook can rest easy for the moment, given that the agency must target offending companies one-by-one in the absence of a sweeping congressional privacy mandate. In fact, the sort of stringent legal protections for user data commonplace in the European Union have not yet been approved by American lawmakers, who have so far refrained from devising a tough privacy law in the mold of the E.U.’s General Data Protection Regulation. Specifically, the European regulation requires social media companies to “inform users about their data practices and receive explicit permission before collecting any personal information,” a level of government oversight unheard-of stateside.3 Without the sweeping powers afforded to their European counterparts, American regulators have chosen to target serious individual offenses – like the unauthorized collection of user data by third party programs that sparked the inquiry into Facebook.2

But it would be a mistake to assume that the legal and political landscape will become more favorable to technology companies in the foreseeable future. Conservatives and liberals alike have entered into an uneasy alliance to promote a stringent new privacy law,4 and both Marco Rubio and Ron Wyden – lawmakers on distinct poles of the ideological spectrum – have proposed new regulations on social media giants.5 As a consequence of broad-based political support for privacy restrictions, future settlements reached with technology companies are bound to be at least as costly as the one recently reached with Facebook – a prospect that should trouble smaller companies that lack the ability to maintain profitability in the wake of a federal crackdown. Although federal regulation may prove burdensome and costly, compliance seems to be the vastly more preferable alternative.

 

 

  1. https://www.ftc.gov/news-events/press-releases/2019/07/ftc-imposes-5-billion-penalty-sweeping-new-privacy-restrictions
  2. https://www.cnbc.com/2019/07/24/facebook-to-pay-5-billion-for-privacy-lapses-ftc-announces.html
  3. https://www.nytimes.com/2019/06/08/opinion/sunday/privacy-congress-facebook-google.html
  4. https://www.nytimes.com/2019/07/14/technology/big-tech-strange-bedfellows.html
  5. https://blog.malwarebytes.com/security-world/privacy-security-world/2019/03/what-congress-means-when-it-talks-about-data-privacy-legislation/