HeadNotes

By David L. Glass

HeadNotes

A primary mission of the Business Law Section has always been to promote business-friendly legislation for New York State. It is no secret that New York has been losing jobs, people and industry to other states, and at least in part this is due to the state’s sometimes unwelcoming posture to new businesses as well as its higher taxes and more burdensome consumer protection and other regulations. Case in point: as this issue went to press, Governor Hochul had not yet indicated whether she would sign new legislation, the LLC Transparency Act (LLCTA), passed by the state Legislature in June 2023. The federal Corporate Transparency Act (CTA), which takes effect in 2024, requires millions of businesses to disclose to the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) beneficial ownership information to aid in the detection of money laundering and terrorist financing. The state LLCTA is similar in intent but goes beyond the CTA in an important respect: it would make available to the public personal information that would be kept strictly confidential under the CTA. Primarily for this reason the LLCTA has been opposed by the section, on the grounds that it would create a further and unnecessary burden on new business formations and would drive new businesses to incorporate elsewhere. Last summer the section filed a memorandum in opposition with the governor. Our lead article, discussed below, explains the LLCTA and discusses its implications.

Another trend spreading across the nation of which business lawyers should be aware is the adoption by states—seven states, at this writing, including New York—of commercial finance disclosure laws. While they differ in some respects, these laws all are essentially designed to bring loans to small businesses under the same types of disclosure rules that apply to consumer loans under the federal Truth in Lending Act (TiLA). Typically, they apply to business loans of less than $500,000, although some states have a higher threshold. The New York State Department of Financial Services (DFS) has published regulations to implement the state’s version. Whether you are representing a small business or a lender, you need to be up to speed on how it affects your client and what you need to do to comply. This issue contains an article by the attorneys of Paul Hastings that is a useful summary and comparison of the state laws enacted to date.

Meanwhile, a case is pending in the Supreme Court that could have a major impact on consumer financial protection laws currently on the book. The case challenges the constitutionality of the funding structure of the Consumer Financial Protection Bureau (CFPB), which was created under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Consumer Financial Protection Bureau v. Community Financial Services Ass’n of America, docket no. 22-558, argued Oct. 3, 2023). If the funding structure is found to be unconstitutional all the CFPB’s actions to date, including numerous consumer financial regulations, could be invalidated. The CFPB was the brainchild of Elizabeth Warren, then a Harvard Law professor and now a senator (D-MA). Before its creation consumer protection in the financial services arena had long been a hodgepodge of federal and state laws that were often inconsistent and promoted forum-shopping by financial businesses seeking to minimize their obligations in this area. The degree of protection a consumer would receive in a financial transaction was determined by the type of entity from which the service was acquired as much as by the service itself. As an example, there is no sound reason for a home buyer to receive less protection in obtaining a mortgage from a lightly regulated state mortgage broker or banker than from a more highly regulated national or state-chartered bank. In principle, therefore, the CFPB makes sense. In effect, it consolidated the rule-making and enforcement function for consumer financial products in one place, assuring consistency of treatment and setting minimum standards for each type of product. Under Dodd-Frank, states are generally permitted to provide greater, but not lesser, protections than the minimum under federal law, and the CFPB can effectively preempt a state law that it determines does not meet minimum federal standards.

The CFPB was controversial from the beginning, not the least due to its unique structure and funding mechanism. The Obama administration and the Democrats in Congress wanted to assure that a future Republican administration—the Dodd-Frank Act passed without a single Republican vote—could not undermine the CFPB by cutting its funding or firing its director. Accordingly, the legislation provided that the CFPB be run by a single director—not a governing board, as with most other federal financial agencies—with plenary power to make and enforce rules. Furthermore, the director could not be removed from office for at least five years, except for cause. On the funding side, they took the CFPB completely out of the normal congressional appropriations process by providing that it would be part of the Federal Reserve System for funding purposes, even though the Fed would have no ability to control its budget or its operations. To clarify, the Fed is charged with managing the money supply by buying and selling U.S. government securities, and it holds trillions of dollars’ worth of these securities on its balance sheet, which it acquires with money it prints itself. It thus earns a large “profit” on these holdings, which by law it returns to the treasury each year. Thus, by burying the CFPB’s budget within the Fed, what it spends in a given year is simply subtracted from the funds returned to the treasury and is not subject to congressional scrutiny or oversight.

In an earlier case, the courts struck down the director appointment provision as unconstitutional; an executive agency must have either a governing board or an individual head who can be fired at will by the president. However, since the director appointment provision was severable from the rest of the legislation, only that provision was invalidated; the CFPB’s rulemakings and other actions remained in effect. Given the composition of the current court it seems more probable than not that the funding structure will be held invalid, but whether such a holding would invalidate all of the CFPB’s actions to date remains unclear. Assuming the decision comes down in the next few months, the next issue of the Journal will have a full article discussing the decision and its implications for consumer financial protection.

As noted, the LLCTA is the current hot button for New York business lawyers. Accordingly, this issue leads off with a discussion of that law and its implications. In “Business Lawyers, the Corporate Transparency Act and New York State’s Response,” Thomas Pitegoff explains the requirements of both the federal CTA and the state’s LLCTA. Both are aimed at identifying the true beneficial owners of private businesses, in order to combat money laundering and other financial crimes. But the most significant difference is that while both would create a data base of beneficial ownership information, that information would remain strictly confidential under the CTA, but would be available to the public under the LLCTA—yet another reason for businesses to choose to organize in a state other than New York. As noted, when we went to press Governor Hochul had not indicated whether she will sign the LLCTA into law; if she does so, it would take effect one year thereafter. But the CTA takes effect on January 12, 2024 in any event. The author clearly and concisely explains which entities will be subject to these laws, and what is required to comply. Mr. Pitegoff is a principal with the firm Offit Kurman and is the immediate past chair of the Business Law Section. An earlier version of this article was published in the August 2, 2023 issue of the New York Law Journal.

The CTA also will significantly increase the cost and complexity of what is already one of the most costly and highest risk compliance areas for nearly all financial institutions: anti-money laundering (AML). Especially since the passage of the USA PATRIOT Act post-9/11, AML has been a priority focus of the financial regulators, in an ever-increasing attempt to prevent use of the financial system for laundering of illegal transactions and financing of terrorism. Banks and other financial institutions have been assessed massive fines and other penalties, even in the absence of actual money laundering, where their regulators judge their systems to be inadequate. Yet as draconian as the penalties may be, requirements for compliance are often unclear and enforcement may seem arbitrary. In “How Much Is Too Much? The Corporate Transparency Act and the Burden of Anti-Money Laundering Laws on Financial Institutions,” Zoe Huber reviews recent statutory and regulation changes aimed at both enhancing the effectiveness of AML and lessening the compliance burdens where possible. Among other changes she reviews the impact of the CTA, which mandates full disclosure by substantially all corporations and other business entities of their true beneficial owners, to prevent the use of dummy or shell companies to disguise illicit transactions. Along the way, she provides a thorough and well-researched review of the AML laws and what they require. Ms. Huber is a candidate for the J.D. degree in 2024 at Albany Law School.

In promoting new business formation, the state of Delaware has always been New York’s primary competition, due to its stable and predictable corporate law, efficient registration procedures, and well respected Court of Chancery. Nonetheless, New York offers some advantages as well, especially if the corporation has its only office in New York. In “The Soft Sands of Rehoboth Beach vs. The Bright Lights of Broadway,” Joseph Cuomo and Caroline Frisoni offer a practical guide to assist businesses and their attorneys in making this decision. Mr. Cuomo is a partner and Ms. Frisoni an associate at Forchelli Deegan Terrana LLP in Uniondale.

Another ongoing issue in corporate law is the concept of “piercing the corporate veil”—i.e., when and under what circumstances will a court look through the corporate structure, designed to assure limited liability, and impose personal liability on the owners for acts of the corporation? Veil-piercing generally is not favored, in that it undermines the concept of limited liability and thus may discourage risk-taking and third-party investment in the business. In “Standardizing the Corporate Veil Phenomenon,” Taylor Duffy analyzes the way courts have applied the corporate veil doctrine and the reasoning they apply when they determine to pierce the veil. In general, piercing will not be allowed unless the owner’s control of the entity is so complete that it effectively has no separate existence, and the owner has perpetrated a fraud, wrong or injustice that harmed the plaintiff. But courts have often been subjective in applying the doctrine under varying fact scenarios. They have also applied the doctrine in community property states, to assure that the spouse of an owner is not deprived of property to which they are entitled under the law. Ms. Duffy argues for an approach that distinguishes the relative roles of the different owners of the entity—i.e., the veil might be pierced against a person who exercised dominant control but not a passive minority shareholder. Along the way, she sets out a thorough and cogent history and analysis of the veil-piercing doctrine that will be useful for any practitioner who represents closely held businesses. Ms. Duffy graduated in 2023 from the William S. Boyd School of Law at the University of Nevada, Las Vegas and is currently a law clerk for the Honorable Linda Marquis of the Eighth Judicial Circuit.

As noted, among the states there is a fast-developing trend toward requiring disclosures by lenders to small businesses, similar to those required for lenders to consumers under the federal Truth in Lending Act (TiLA). Earlier this year Florida and Connecticut became the sixth and seventh states to do so, joining California, Georgia, New York, Utah, and Virginia. Similar legislation is pending in other states. While these laws are broadly similar in purpose, they differ in important respects, and the rules regarding the entities and types of transactions to which they apply are often complex. In “Finance Providers Need To Be Aware of New Commercial Finance Disclosure Laws,” Molly Swartz and Stephen Sepinuck provide a concise summary of the provisions of these statutes—including, importantly, which lenders are and are not exempt—and how they differ, including a useful table that allows for side-by-side comparison. Ms. Swartz is a partner and Mr. Sepinuck special UCC advisor at Paul Hastings LLP. Mr. Sepinuck is also the reporter for the ULC Study Committee on Commercial Financing Disclosures.

For the past 15 years, each issue of the Journal has been graced with a clear, cogent and entertaining article by Evan Stewart on some aspect of legal ethics, and invariably a sharing of his boundless knowledge of and enthusiasm for popular music of the 50’s, 60’s and beyond. This issue is no exception. In “(You Make Me Feel Like) A Natural Witness” (riffing, of course, on the Carole King song “Natural Woman” made popular by Aretha Franklin), Mr. Stewart takes on the tricky question of what does, and does not, constitute appropriate preparation of a witness for her trial testimony. In particular, the dramatic change in work settings resulting from the pandemic has raised new potential for misconduct, with each party and its attorney, as well as the court itself, in separate remote locations. Earlier this year the American Bar Association (ABA) issued Formal Opinion 508, primarily to address this question. Noting that the courts have held that an attorney has an ethical obligation to properly prepare her witness, Mr. Stewart clearly lays out the boundaries of appropriate witness preparation and the danger to attorneys who cross the line—as illustrated by two recent high profile cases involving Trump administration witnesses called to testify before the January 6 Congressional Committee. In earlier issues of the Journal, Mr. Stewart addressed the differences between witness preparation practices in the U.S. and the U.K. (summer 2013) and the dangers inherent in the practice of witness “scripting” (summer 2014). A partner of Cohen Gresser LLP, Mr. Stewart received the NYSBA’s prestigious Sanford Levy Professional Ethics Award in 2016.

With the rapid expansion of the market for digital assets such as bitcoin, an ongoing area of controversy has been the treatment of these assets under federal securities law. In July, the District Court for the Southern District of New York rendered a key decision that is an important step toward clarifying the legal status of digital assets. In “Ripple Labs: District Court Holds That Direct Digital Token Sales Constituted Investment Contracts Under Howey, but Other Transactions Did Not,” the attorneys of Skadden, Arps discuss the court’s decision in SEC v. Ripple Labs, Inc., which developed and manages a digital asset exchange network operating on the XRP Ledger blockchain. When launched, the XRP Ledger produced a fixed supply of 100 billion XRP tokens. These were distributed in three ways: directly to institutional buyers; “programmatic sales” made on secondary digital asset trading platforms; and transfers to individual persons and entities as payment for services. Ripple did not register any of these transactions with the SEC, as would be required if they were “securities” as defined. The question presented was whether any of these transactions were “investment contracts” under the Supreme Court’s Howey doctrine. The authors explain how the court reached its decision—that the institutional sales were investment contracts, and therefore “securities” subject to registration, while the other transactions were not—and review the implications for the numerous other enforcement actions the SEC has brought in this area.

Another changing area of securities law involves shareholder derivative suits, in which one or more shareholders bring suit in the name of the corporation against its officers, directors, or others who have breached their duties and thus harmed the corporation. With shareholder activism on the rise, corporations have increasingly turned to forum selection clauses in their bylaws as a means of blocking these suits—specifically, seeking to transfer them to the Delaware courts, which are presumptively more corporation-friendly, to avoid multi-jurisdictional lawsuits. A recent trend has been to expand these by-law provisions to cover claims under federal law as well. In “Checkmate, Your Move, Shareholders: Can Forum-Selection Clauses Preclude Derivative Claims?” Dina Khedr discusses the split between the Seventh and Ninth federal circuits in two 2022 cases—the former holding that the corporation’s forum-selection bylaw could not apply to a derivative claim under the Securities Exchange Act, the latter that it could. She argues that the Supreme Court should resolve the split, in the process ensuring that shareholders are not left without a forum in which to litigate derivative claims. Along the way, she provides a thorough and well-researched background on the securities laws, derivative claims thereunder, and the development of the forum-selection doctrine in the federal and Delaware courts. Ms. Khedr is a student in the J.D. program at Brooklyn Law School.

No issue of the Journal would be complete without the incomparable “Inside the Courts.” For more than ten years, readers of the Journal have relied upon “Inside the Courts” as a thorough yet concise compilation of virtually all pending litigation that has implications for securities law or business law generally. It is an invaluable guide not just for litigators, but for all business lawyers who want to keep abreast of potential changes in the case law that could affect their clients. The editors remain grateful as always to the attorneys of Skadden, Arps for their generosity in sharing this outstanding resource with our readers.