The Supreme Court of the United States: Law Enforcement Must Afford Hotel Owners Precompliance Review before Performing a Warrantless Search Pursuant to a Municipal Code

July 7th, 2015

The provision of the Los Angeles Municipal Code (“LAMC”) that requires hotel owners to provide guest registries to law enforcement on demand is facially unconstitutional due to its failure to provide hotel owners precompliance review of law enforcement demands. On June 22, 2015, in a 5-4 vote, the Supreme Court of the United States issued its opinion in City of Los Angeles v. Patel, holding that Los Angeles Municipal Code § 41.49(3)(a)  is unconstitutional because “a hotel owner must be afforded an opportunity to have a neutral decision maker [sic] review an officer’s demand to search the registry before he or she faces penalties for failing to comply.” See Patel at 11.

  1. Background

This case confronts the constitutionality of a provision in LAMC that allows law enforcement to search hotel owners’ records without a warrant. Pursuant to the LAMC, hotel owners are required to record information about their guests for a period of 90 days after their guests check out. Section 41.49(3)(a) states that the guest records “shall be made available to any officer of the Los Angeles Police Department for inspection,” provided that “[w]henever possible, the inspection shall be conducted at a time and in a manner that minimizes any interference with the operation of the business.” Under § 11.00(m), a general provision applicable to the entire LAMC, a hotel owner’s failure to provide his or her guest records to law enforcement is a misdemeanor punishable by up to six months in jail and a $1,000 fine.

In Patel, a group of motel operators and a lodging association (collectively “Hotel Owners”) sued the City of Los Angeles (collectively “the City”) in three connected cases claiming that § 41.49(3)(a)  was facially unconstitutional under the Fourth Amendment of the United States Constitution. The District Court ruled in favor of Los Angeles, and found that Hotel Owners lacked standing because they did not have a reasonable expectation of privacy in the guest records subject to inspection. On appeal, the United States Court of Appeals for the Ninth Circuit affirmed the District Court’s ruling on the same grounds. However, the case was reheard before the entire Ninth Circuit en banc, and the Court reversed the District Court finding § 41.49(3)(a)  was facially unconstitutional. The City of Los Angeles appealed and the Supreme Court of the United States decided to review the case.

  1. The Facial Challenge of § 41.49(3)(a)  under the Fourth Amendment

The issues the Supreme Court addressed were “whether facial challenges to statutes can be brought under the Fourth Amendment and, if so, whether [Section § 41.49(3)(a) ] of the Los Angeles Municipal Code is facially invalid.” See Patel at 1. The City of Los Angeles argued under the Court’s standard for granting facial relief, the party seeking facial relief “must establish that no set of circumstances exists under which the [statute] would be valid.” Id. at 7. Thus, because there are instances where warrantless searches are constitutional, the Hotel Owners’ challenge should have failed as a matter of law. In rejecting this argument, the Supreme Court in Patel found that it has both entertained facial challenges under the Fourth Amendment and declared statutes facially invalid under the Fourth Amendment in numerous cases. The Supreme Court in Patel found that the City’s argument was flawed because the standard, endorsed by the City, would preclude relief in every Fourth Amendment facial challenge to a statute authorizing warrantless searches. Instead, the Supreme Court noted that in facial challenges regarding the Fourth Amendment, “the proper focus of the constitutional inquiry is searches that the law actually authorizes, not those for which it is irrelevant.” Id. at 8. In other words, while exceptions to the warrants requirement exist, those recognized exceptions cannot serve as the basis for rejecting a facial challenge. Rather, for a warrantless search statute to pass constitutional muster, the statute must be constitutional in its application, i.e. the search at issue must have been authorized by the statute in question, not an exception to the warrants requirement.

  1. Section 41.49(3)(a) constitutes an “administrative search” and thus is unconstitutional under the Fourth Amendment because it fails to provide for the opportunity to obtain precompliance review before a neutral decisionmaker

When examining the merits of the Hotel Owners’ claim, the Supreme Court in Patel held that § 41.49(3)(a)  was facially unconstitutional because the statute would constitute an administrative search under the Fourth Amendment but fails to provide hotel owners with an opportunity for precompliance review before law enforcement restricts their Fourth Amendment rights. The Supreme Court began by explaining the Fourth Amendment of the United States Constitution protects “[t]he right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures” and “no Warrants shall issue, but upon probable cause.” The Supreme Court has repeatedly found that all warrantless searches are presumptively unreasonable, subject to a few expressly established exceptions. However, the Court noted that where the “primary purpose” of the search is distinguishable from the general interest in crime control, no warrant is required. Here, the Court assumed that the searches authorized by § 41.49 served a “special need” other than criminal investigations, to wit: ensuring compliance with the record keeping requirements. Thus, the Court concluded that the searches authorized by § 41.49 would fall within the “administrative search” exception to the warrants requirement.

In analyzing administrative searches, the Court noted that absent exigent circumstances or consent, for an administrative search to be constitutional, the search must be subject to precompliance review before law enforcement restricts a party’s Fourth Amendment rights by demanding records. The Court defined precompliance review as “an opportunity to have a neutral decisionmaker review an officer’s demand to search [a party’s] registry before he or she faces penalties for failing to comply.” See Patel at 11. Though the Court acknowledged that it has never prescribed exactly what type of precompliance review is sufficient to withstand constitutional muster, it found that the City did not even attempt to argue that § 41.49(3)(a)  granted the Hotel Owners any opportunity for review. Instead, the Court found that if hotel owners refuse to comply, law enforcement can arrest them on the spot. The Court thus determined that hotel owners cannot reasonably decide between relinquishing their records and arrest, and without review, law enforcement can also harass hotel owners by repeatedly and serially demanding the owners’ registries, and hotel owners would have no reasonable choice but to comply.

In finding § 41.49(3)(a) unconstitutional, the Court did provide guidance on what revisions would be needed to make the law constitutionally compliant. For instance, the Supreme Court in Patel found that if law enforcement obtained an administrative subpoena and then performed a search of a hotel’s records, Hotel Owners would be afforded precompliance review. A subpoena is issued by a neutral decision maker and allows a subpoenaed party to “question the reasonableness of the subpoena, before suffering any penalties for refusing to comply with it, by raising objections in an action in district court,” thus, providing for sufficient precompliance review. See Patel at 10.

  1. Hotels are not considered a “highly regulated industry.” Thus, a more relaxed search standard does not apply.

In his dissent, Justice Scalia argued that the hotel industry is highly regulated and § 41.49(3)(a)  is facially valid under the relaxed standard that applies to searches of highly regulated industries. However, the majority in Patel pointed out that the Supreme Court has only identified four industries that “have such a history of government oversight that no reasonable expectation of privacy . . . could exist for a proprietor over the stock of such an enterprise[:]” liquor stores, firearms dealing, mining, and automobile junkyards. See Patel at 14. The Supreme Court in Patel found that, unlike those businesses, hotels do not pose a “clear and significant risk to public welfare.” Id. Therefore, there is no relaxed standard that applies to the search of the hotel industry because, without a “clear and significant risk to public welfare,” the hotel industry should not be considered a highly regulated industry. Id.

Even if the Supreme Court found that hotels are highly regulated, according to the Supreme Court in Patel, § 41.49(3)(a)  would need to meet three additional criteria for the statute to be reasonable under the Fourth Amendment. (1) “[T]here must be a ‘substantial’ government interest that informs the regulatory scheme pursuant to which the inspection is made”; (2) “the warrantless inspections must be ‘necessary’ to further [the] regulatory scheme”; and (3) “the statute’s inspection program in terms of the certainty and regularity of its application, [must] provid[e] a constitutionally adequate substitute for a warrant.” Id. at 16. Here, the Supreme Court found that the second and third criteria were not met, and the statute was facially invalid under the Fourth Amendment.

The second criteria was not met because warrantless inspections of hotel registries are not absolutely necessary. For instance, if law enforcement intends to protect the contents of the registries, they can perform a surprise inspection by obtaining a warrant without giving notice to the hotel owner, and they can guard the registry pending a hearing if a hotel owner objects to a subpoena. Additionally, the third criteria was not met because the statute does not limit the inspection to any certainty and regularity requirements. Section 41.49(3)(a) does not sufficiently limit law enforcement discretion as to the location, time, frequency, or circumstances of the search. Therefore, regardless of the level of regulation of the hotel industry, § 41.49(3)(a)   is not facially valid because the warrantless search of hotel registries are not absolutely necessary and the statute does not constrain the search to any certainty and regularity requirements. The Supreme Court in Patel agreed with the Ninth Circuit that § 41.49(3)(a) is facially invalid because it fails to provide hotel owners an opportunity for precompliance review before the owner must relinquish their guest registry to law enforcement for inspection.

  1. Impact on the Industry

With the Court’s decision in Patel, the LAMC and similarly worded governmental codes must be revised to provide for some measure of precompliance review prior to requiring the disclosure of records to law enforcement. Whether Los Angeles adopts the Supreme Court’s recommendation of using the administrative subpoena scheme to create a constitutionally compliant statute remains to be seen. Regardless of the precompliance review mechanism chosen, the requirement of precompliance review should provide hotel owners with a level of due process to combat what owners may feel are harassing, burdensome, and irrelevant searches of their business records.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in the areas of complex administrative litigation and white collar criminal defense at both the state and federal levels. Should you have any questions or need further assistance, please contact us by email at contact@fuerstlaw.com or telephone at 305.350.5690.

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U.S. Liability for Foreign Affiliate Activities: Foreign Transactions May Result in U.S. Penalties

July 7th, 2015

The following article was written by Stephen Wagner for the Export Compliance Training Institute. Mr. Wagner is a faculty member for the Institute, and frequently lectures and writes on export compliance and enforcement matters. We repost Mr. Wagner’s article here with the Institute’s permission.

Your U.S.-based company is known for its high-end electronic components, which are used by research and development labs around the world.  Some company products are manufactured at the home office in Chicago, Illinois, while other products are produced at an affiliate company’s facility in Malaysia.  Most of your sales, on-site installation services, and customer and product support are performed by affiliated companies which are located in 22 countries throughout the world.

Recently, you were copied on an email indicating that your company’s affiliate in Abu Dhabi secured a lucrative contract for installation, training, and support services with the state-owned gas company in Iran. The email proudly announced that the winning bid was based on “the outstanding cost and supply analysis provided by the Chicago office.” You’ve done some quick due diligence and determined that no U.S. assets will be involved in the contract:  all of the products used in the contract are manufactured by the Malaysian affiliate, all of the personal services (installation, training, and support) will be provided by Emirati (that is, people from Abu Dhabi), and all of the technical information for the contract comes either from Malaysia or Abu Dhabi.

Given that the U.S. is not involved in any way with this contract, are there any regulatory enforcement risks that your company faces in the United States?
Your definition of “not involved in any way,” may be very different than the definition used by the Office of Foreign Assets Control (OFAC) or the U.S. Department of Justice.

Trade with Iran – both commercial and financial transactions – is subject to sanctions from the U.S. government, sanctions which are enforced by OFAC, a unit within the U.S. Department of the Treasury.  Over the past few years, these trade sanctions have eased in some respects and been strengthened in others.  In January 2014, for example, Iran’s actions toward control of its nuclear program resulted in a slight easing of some sanctions.  Before that, however, the Iran Threat Reduction and Syrian Human Rights Act of 2012 (the “Threat Reduction Act”) expanded sanctions to make U.S. entities directly liable for any such transactions and activities that are undertaken by their foreign subsidiaries.  Specifically, “an entity [including partnerships, trusts, joint ventures, associations, corporations and other organizations] owned or controlled by a United States person and established or maintained outside the United States” cannot be involved in any transaction with the Government of Iran if the transaction would be illegal if carried out in the United States or by a U.S. person.

This extension of Iranian sanctions to foreign affiliates of U.S. companies seems to hinge on the words “owned or controlled by.” Under the Threat Reduction Act, a foreign affiliate is only owned or controlled by a U.S. company if the American company (i) holds more than 50% of the affiliate’s equity (i.e., stock), (ii) holds a majority of seats on the board of directors for the affiliate, or (iii) otherwise controls “the actions, policies or personnel decisions” of the foreign affiliate.

So if a foreign affiliate of a U.S. company does not meet any of these tests, can the foreign affiliate conduct trade with Iran?  At this point, the U.S. company has to consider whether it is really involved in the business of the foreign affiliate when it comes to embargoed countries such as Iran.  At this point, the U.S. company has to think of Schlumberger.

In March 2015, the U.S. Department of Justice, together with OFAC and the Bureau of Industry and Security (U.S. Department of Commerce) announced a $232.7 Million penalty against Schlumberger Oilfield Holdings Ltd. (SOHL), a British Virgin Islands company and a wholly-owned subsidiary of Schlumberger Ltd., which is headquartered in Houston, Texas. SOHL pled guilty to conspiring to violate the International Emergency Economic Powers Act (IEEPA) “by willfully facilitating illegal transactions and engaging in trade with Iran and Sudan.” From 2004 through 2010, a business unit of SOHL provided oilfield services to Schlumberger customers in Iran and Sudan.

In the Schlumberger case, although the main contracts with Iran were performed by the foreign affiliate, SOHL employees residing in the United States approved the company’s capital expenditure requests from Iran for the manufacture of new oilfield drilling tools, made and implemented business decisions specifically concerning Iran, and provided certain technical services and expertise in order to maintain drilling equipment located in Iran.  As stated by U.S. Attorney Ronald C. Machen Jr.:

This is a landmark case that puts global corporations on notice that they must respect our trade laws when on American soil[.]  Even if you don’t directly ship goods from the United States to sanctioned countries, you violate our laws when you facilitate trade with those countries from a U.S.-based office building.  [W]hether your employees are from the U.S. or abroad, when they are in the United States, they will abide by our laws or you will be held accountable.

Returning to the fact pattern involving our U.S. electronics manufacturer, even though all of the equipment and technical expertise for the Iranian contract are slated to come from its affiliates in Malaysia and Abu Dhabi, and even though it is not clear whether these affiliates are “owned or controlled by” the U.S. parent company, the contract itself was won with support from the “Chicago office.” This would clearly imply that U.S.-based persons facilitated transactions involving Iran. This level of involvement exposes the U.S. company to enforcement action and legal liabilities.

And the legal liabilities can be great. Under the IEEPA, civil penalties can reach the greater of $250,000 or twice the transaction amount, and criminal penalties can include fines of up to $1,000,000 (per transaction) and imprisonment for not more than 20 years, or both.  (50 U.S.C. § 1705).  In the Schlumberger case, the monetary penalty was $155 Million and an additional $77.6 Million in assets were forfeited to the United States.  Furthermore, SOHL was placed on 3 years’ probation and made to hire an independent consultant who will review the company’s internal sanctions policies, procedures, and company-generated sanctions audit reports.

The bottom line is that a U.S. company with foreign affiliates has to ensure that a rigorous export compliance program extends to the activities of each of those affiliates.  In this digital, interconnected age, because so much information, technical and administrative assistance, and capital resources tends to flow between affiliated companies – both into and out of the United States – in the absence of a strong export compliance program, what a U.S. company doesn’t necessarily know about its foreign affiliates definitely can come back to hurt it.

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Criminal Law Update: Supreme Court Rules that Child’s Statements to Teacher do not Implicate the Sixth Amendment’s Confrontation Clause

July 6th, 2015

On June 18, 2015, the Supreme Court in Ohio v. Clark (slip opinion available here), held that the Sixth Amendment’s Confrontation Clause applies to out-of-court statements by unavailable witnesses to persons other than law enforcements officers. However, while the Court held that such statements are “much less likely to be testimonial than statements to law enforcement officers,” the Court analyzed the statements at issue using the same “relevant circumstances” test it had previously established for analyzing out-of-court statements to law enforcement. In sum, the Court found that to whom the out-of-court declarant was speaking is a relevant consideration in assessing whether the out-of-court statement is “testimonial” in nature, thus triggering the protections of the Sixth Amendment. In its ruling, the Court held that a three-year old’s out-of-court statement to a teacher was not testimonial, and thus, admission of such statements into evidence did not violate the Sixth Amendment. Through this case, the Supreme Court continues to refine the bounds of the Confrontation Clause when dealing with hearsay statements.  In order to fully understand the implications of Ohio v. Clark, a brief primer on recent Supreme Court Confrontation Clause jurisprudence is necessary.

The Confrontation Clause vs. Admissible Hearsay Statements of Unavailable Witnesses

The Sixth Amendment provides that “[i]n all criminal prosecutions, the accused shall enjoy the right . . . to be confronted with the witnesses against him.” This is known as the Confrontation Clause. This clause of the Sixth Amendment allows those standing in a criminal trial the right to cross-examine, question, or confront a witness who is testifying against him.

However, out-of-court statements by unavailable witnesses were historically admissible regardless of whether the out-of-court declarant had ever been subject to cross-examination so long as the statement bore adequate “indicia of reliability.” As Ohio v. Roberts, 448 U.S. 56 (1980) made clear, such reliability could be inferred without more in cases where the out-of-court statement by an unavailable witness fell within a firmly rooted hearsay exception.

The position of the Supreme Court regarding the breadth of the Confrontation Clause was refined inCrawford v. Washington, 541 U.S. 36 (2004), when the Supreme Court “held that the Confrontation Clause generally prohibits the introduction of ‘testimonial statements by a nontestifying witness, unless the witness is ‘unable to testify, and the defendant had had a prior opportunity for cross-examination.’” 541 U.S. at 54. The Supreme Court in Crawford declared that “‘witnesses against the accused” are “‘those who bear testimony’” and testimony is “a solemn declaration or affirmation made for the purpose of establishing or proving some facts.” 541 U.S. at 51. Therefore, the Confrontation Clause, per Crawford, only applies if a witness’s statements are sought to be admitted into court and the witness is unavailable to testify, or the defendant has not had a right to previously cross-exam the unavailable witness. In other words, under Crawford, where an out-of-court declaration is testimonial, the Confrontation Clause prohibits its use at trial unless the declarant is made available for cross-examination regardless of how “reliable” that out-of-court statement may be.

However, the Supreme Court in Crawford failed to define what statements were “testimonial.”  In Davis v. Washington, 547 U.S. 813 (2006) and Hammon v. Indiana, the Supreme Court expanded Crawford to define “testimonial” statements by ruling the following:

[s]tatements are nontestimonial when made in the course of police interrogations under circumstances objectively indicating that a primary purpose of the interrogation is to enable police assistance to meet an ongoing emergency. They are testimonial when the circumstances objectively indicate that there is not such ongoing emergency, and that the primary purpose of the interrogation is to establish or prove past events potentially relevant to later criminal prosecution.

547 U.S. at 822.

This is known as the “Primary Purpose” test. To implicate the Confrontation Clause, a court must decide if the statements given were of the primary purpose to create a record for trial. If the primary purpose was to create a record for trial, then the statements are considered testimonial. If the primary purpose of the statements was not to create a record, then those statements are not considered testimonial. In establishing the primary purpose test, Davis and Hammon help flesh out the Confrontation Clause in relation to persons who are law enforcement officers. However, these cases fail to elucidate the test regarding statements made to those outside of law enforcement.

In the 2011 Supreme Court decision, Michigan v. Bryant, 562 U.S. 344 (2011), the Court further clarified the primary purpose test. The Court held that the primary purpose test is not one-factor determinative. Rather, “[i]n determining whether a declarant’s statements are testimonial, courts should look at all of the relevant circumstances.” 562 U.S. at 369 (emphasis added). The Court in Bryant explained that “all relevant circumstances” matter because “there may be other circumstances aside from ongoing emergencies, when a statement is not procured with a primary purpose of creating an out-of-court substitute for trial testimony.” 562 U.S. at 358. Therefore, ongoing emergencies are a factor, but not the only factor in the primary purpose test. An additional factor is “the informality of the situation and the interrogation.” 562 U.S. at 377. Under Bryant, to apply the primary purpose test, a court must view objectively all relevant circumstances to rule if the purpose of the conversation was to create an out-of-court substitution for trial testimony.  If the Primary Purpose test does not apply thereby not invoking the Sixth Amendment’s Confrontation Clause, then “the admissibility of a statement is the concern of state and federal rules of evidence, not the Confrontation Clause.” 562 U.S. at 358-359.

While the line of Confrontation Clause cases previously discussed help shape the limits of the clause’s implication, the Court until Ohio v. Clark failed to address statements given to individuals outside of law enforcement.

Ohio v. Clark

A Factual Overview:

In March 2010, Darious Clark pimped out his girlfriend—the mother of two young children—to Washington D.C. to prostitute herself. The two young children, a 3-year-old-boy and an 18-month-old girl were left in Clark’s care. Clark sent the oldest child to preschool with a black eye and markings on his body. When his teacher noticed the marks on him, the teacher asked the child what happened. The child responded saying it was Clark who caused them . Upon finding more bruising on the boy, school officials notified the child abuse hotline to alert authorities about the suspected abuse. Clark was subsequently indicted on multiple counts of felonious assault, endangering children, and domestic violence.

At Clark’s trial, “the State introduced [the child’s] statements to his teachers as evidence of Clark’s guilt, but [the child] did not testify.” 576 U.S. at 2. The child did not testify because “under Ohio law, children younger than 10 years old are incompetent to testify if they ‘appear incapable of receiving just impressions of the facts and transactions respecting which they are examined, or relating them truly.” 576 U.S. at 2-3.

Clark motioned the trial court “to exclude testimony about [the child’s] out-of-court statements under the Confrontation Clause.” 576 U.S. at 3. The trial court denied the motion, ruling that the statements were not testimonial. After the jury found Clark guilty on all counts but one, Clark “appealed his conviction, and a state appellate court reversed on the ground that the introduction of [the child’s] out-of-court statements violated the Confrontation Clause.” 576 U.S. at 3. The Supreme Court of Ohio affirmed the state appellate court’s decision stating that “teachers acted as agents of the state” and “the primary purpose of the teachers’ questioning ‘was not to deal with the existing emergency but rather to gather evidence potentially relevant to a subsequent criminal prosecution.’” 576 U.S. at 3.

The Court’s Rationale

The Supreme Court ruled that the statement given by the child was not testimony. In doing so, the Court looked at the earlier precedent set by the Court. The Supreme Court, through its precedent stated “the primary purpose test is a necessary, but not always sufficient, condition for the exclusion of out-of-court statements under the Confrontation Clause.” 576 U.S. at 7. This case is different than the precedent before it though, because the statements given were not given to a law enforcement officer, instead the statements were made to a teacher. Therefore, the Court was “presented with the question [it] [had] repeatedly reserved: whether statements to persons other than law enforcement officers are subject to the Confrontation Clause.” 576 U.S. at 7.

In its holding, the Court did not “adopt a categorical rule excluding” statements to individuals who are not law enforcement officers “from the Sixth Amendment’s reach. Nevertheless, such statements are much less likely to be testimonial than statements to law enforcement officers.” 576 U.S. at 7. Therefore, when considering all of the relevant circumstances before them, the Court found that the child’s “statements clearly were not made with the primary purpose of creating evidence for Clark’s prosecution. Thus, their introduction at trial did not violate the Confrontation Clause.” 576 U.S. at 7.

The Primary Purpose of the Child’s Statements 

When evaluating an out-of-court statement under the Primary Purpose test, the imminence of an ongoing emergency helps determine the context of the statement. The Court found in this instance that the child’s statements “occurred in the context of an ongoing emergency involving suspected child abuse.” 576 U.S. at 7. It was important for the school to determine “whether it was safe to release [the child] to his guardian at the end of the day, they needed to determine who was abusing the child.” 576 U.S. at 8. Using the precedent set forth in Bryant, the Court ruled, “[t]hus the immediate concern was to protect a vulnerable child who needed help . . . [T]he teachers’ questions were meant to identify the abuser in order to protect the victim from future attacks.” 576 U.S. at 8.

The Court noted that there is also “no indication that the primary purpose of the conversation was to gather evidence for Clark’s prosecution.” 576 U.S. at 8. The teachers never eluded to or informed the child what the intent of their questioning was or what the statements made would amount to. Further, the “informal and spontaneous” conversation between the child and the teacher was conducted in the same manner “as a concerned citizen would talk to a child who might be the victim of abuse.” 576 U.S. at 8. The dialogue was in no way formal, as the questioning in Crawford was, the setting was first in a preschool lunchroom and then classroom. The informal atmosphere coupled with the ongoing emergency lead the Court to rule that the primary purpose of the questioning was to protect a child who potentially was a victim of abuse. However, the Court does create dictum when it writes, “[s]tatements by very young children will rarely, if ever, implicate the Confrontation Clause.” 576 U.S. at 9. This statement implies that there may be an age cut off before the Confrontation Clause can be invoked.

Clarke’s Rebuttal

In its opinion, the Court refutes Clark’s effort to analogize teachers with police due to Ohio’s mandatory reporting status. In response, the Court says

[l]ike all good teachers, they undoubtedly would have acted with the same purpose whether or not they had a state-law duty to report abuse. And mandatory reporting statutes alone cannot convert a conversation between a concerned teacher and her students into a law enforcement mission aimed primarily at gathering evidence for a prosecution. 576 U.S. at 11.

Moreover, the Court emphasized that the mandatory reporting law is irrelevant because the child who gave incriminating statements would be unable to testify due to Ohio’s laws of evidence under which, he is deemed incompetent.

The Post-Clark Confrontation Clause

The Supreme Court’s most recent ruling regarding the Confrontation Clause (Ohio v. Clark) adds one more level to the Confrontation Clause scheme. For the first time, the Supreme Court addressed the confrontation clause out of the law enforcement context. While the court fails to adopt a bright-line rule, the court does set some boundaries, to wit:

  1. The primary purpose test is not rigid, and the entire context of the situation must be analyzed.
  2. Statements made to non-law enforcement officers may be subject to the Confrontation Clause, even though such statements are much less likely to be considered testimonial.
  3. The way in which the questioning was conducted (formal v. informal, spontaneous v. planned, location) influences the analysis as to if the statement is considered testimonial.
  4. The relationship between the individual giving the statement and the individual listening matters.
  5. Young children who give statements will likely not implicate the Confrontation Clause because a young child’s understanding of the criminal justice system is not developed.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in the areas of white collar criminal defense, criminal appellate practice, and litigating against the U.S. Department of Justice. Should you have any question or need further assistances, please contact us by email at contact@fuerstlaw.com or telephone at 305.350.5690.

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Natural Products Litigation Update: The FDCA May Not Explicitly Preempt a Judicial Interpretation of the Term “Natural”

July 2nd, 2015

On April, 10, 2015, the United States Court of Appeals for the Ninth Circuit found that the Food, Drug, and Cosmetic Act (“FDCA”) does not explicitly preempt California’s state law causes of action, which provide consumers with remedies for false or misleading cosmetic labels. In Astiana v. The Hain Celestial Group, Inc., a class action suit against The Hain Celestial Group, Inc. and JASON Natural Products (collectively “Hain”), Skye Astiana, Tamar Davis, and Mary Littlehale (collectively “Plaintiffs”) filed a suit alleging that Hain deceived its consumers into purchasing its cosmetics labeled “all natural,” but allegedly contained synthetic and artificial ingredients. (Read the entire Astiana opinion here)

Plaintiffs sought injunctive relief and damages, citing the federal Magnuson-Moss Warranty Act, California’s unfair competition and false advertising laws, and common law theories of fraud and quasi-contract. The district court dismissed the case per the primary jurisdiction doctrine, which allows courts to decide whether a legal claim requires technical or policy answers that should first be addressed by an agency with regulatory authority over an industry, and encourages courts to favor allowing legislatively qualified administrative tribunals to resolve controversies involving technical or policy questions. The relevant issue on appeal was whether “federal preemption or the primary jurisdiction doctrine prevents the district court from deciding when a ‘natural’ label on cosmetic products is false or misleading.” See Astiana at 3-4.

The Ninth Circuit reversed the district court’s dismissal of Plaintiffs’ claims under the primary jurisdiction doctrine. The Ninth Circuit found that the district court correctly invoked the doctrine, but instead of dismissing the case, the district court should have issued a stay to obtain expert guidance from FDA.

Ninth Circuit Decision

Hain manufactures several cosmetic products including moisturizing lotion, deodorant, shampoo, and conditioner. Hain labels these products “All Natural,” “Pure Natural,” or “Pure, Natural & Organic.” Plaintiffs claim that Hain’s cosmetics contain synthetic and artificial ingredients, which include benzyl alcohol and airplane anti-freeze. Although FDA has never regulated the use of the term “natural” on cosmetic products, the FDCA provides a broader requirement that deems cosmetics misbranded if the labeling is “false or misleading.” 21 U.S.C. § 362(a). Additionally, the FDCA states

no State or political subdivision of a State may establish or continue in effect any requirement for labeling or packaging of a cosmetic that is different from or in addition to, or that is otherwise not identical with, a requirement specifically applicable to a particular cosmetic or class of cosmetics. . . . 21 U.S.C. § 379s(a).

The Ninth Circuit in Astiana, nevertheless, found that although the FDCA bars states from creating their own labeling requirements inconsistent with the federal requirements, the FDCA does not bar states from providing remedies for violations of the federal law. The Ninth Circuit further held that FDA’s failure to issue specific regulations for the use of the term “all natural” in cosmetic product labeling does not amount to a decision by the agency to permit a manufacturer to use the term “all natural” without bounds. In fact, in FDA’s Small Business Fact Sheet, the FDA states that, although the agency has not yet established a regulatory definition for the word “natural,” manufacturers should be sure that their “labeling is truthful and not misleading.” The Ninth Circuit found that this statement and the FDCA are consistent and both statements reinforce the court’s determination that “the FDA did not intend to permit indiscriminate use of the word ‘natural’ on cosmetic labels.” See Astiana at 9.

The Ninth Circuit concluded the district court properly invoked the primary jurisdiction doctrine, but erred in dismissing the case, and ruled that the district court should have issued a stay to the proceedings while the parties sought guidance from the FDA. According to the Ninth Circuit, in Clark v. Time Warner Cable, primary jurisdiction is a doctrine that permits courts to determine “that an otherwise cognizable claim implicates technical and policy questions that should be addressed in the first instance by the agency with regulatory authority over the relevant industry rather than by the judicial branch.” (Read the entire Clark opinion here) See Clark at 4700. The Ninth Circuit in Astiana found that the definition of “natural” for cosmetic labeling is “both an area within the FDA’s expertise and a question not yet addressed by the agency.” See Astiana at 12-13. Therefore, obtaining expert advice from FDA is necessary to ensure that a technical question is properly answered by a qualified agency. The agency is only to provide expert advice that would aid the district court in making its determination, not to adjudicate the claims itself.

After the district court dismissed Plaintiffs’ claim, but before appeal, Plaintiffs wrote to FDA, requesting that “FDA render an administrative determination on the meaning of ‘natural’ as applied to personal care products regulated under the FDCA, or advise that the agency declines to make such a determination.” Id. at 11. Plaintiffs argue that, because Hain responded by refusing to make the determination without adequate public participation, Hain declined to take primary jurisdiction over the case. However, the Ninth Circuit found that Plaintiff’s informal letter did not comply with FDA’s citizen petition requirements pursuant to 21 C.F.R. § 10.30 because the district court did not institute an administrative proceeding, but rather dismissed the case before Plaintiffs sent their informal letter to FDA.

Uncertain Future of What “All Natural” Will Mean in the Cosmetic and Food Industry

Three other district courts have invoked the primary jurisdiction doctrine in response to litigation over the use of the term “natural” in food labeling. See In re Gen. Mills, Inc. Kix Cereal Litig., See Barnes v. Campbell Soup Co., See Cox v. Gruma Corp. In a Letter from Department of Health & Human Services (HHS) responding to the district courts’ referrals to FDA, HHS outlined the complexity of regulating the term “natural” on food labels and stated that “priority food public health and safety matters are largely occupying the limited resources that FDA has to address food matters.” See Astiana at 14.  Additionally, FDA “decline[d] to make a determination” at that time with respect to regulating the term “natural” on food labels. Id. at 15. The Ninth Circuit states “[o]n remand, the district court may consider whether events during the pendency of this appeal—including [Plaintiffs’] informal letter, the FDA’s website publication of a Small Business Fact Sheet regarding cosmetics labeling, and the FDA’s response to other courts—affect the need for further proceeding at the FDA or demonstrate that another referral to the agency would be futile,” which indicates that the Court may be willing to grant relief for the misuse of the term “all natural” in cosmetic and food labeling without expert advice from FDA. Id. at 16.

As Hain argues in the case, “Astiana’s suit [can] ultimately require[ ] Hain to remove these allegedly misleading advertising statements from its product labels.” Id. at 8. Nevertheless, the Ninth Circuit found that “such a result does not run afoul the FDCA, which prohibits ‘requirements’ that are ‘different from,’ ‘in addition to,’ or ‘not identical with’ federal rules” because the Court’s determination is merely a remedy for the Plaintiff, not a regulation of Hain’s cosmetic labels. Id.

Ultimately, if Hain is required to cease using “natural” claims on its product labeling as a result of this lawsuit, other companies in the natural products industries could be susceptible to similar consumer litigation.  Due to cases like this one against Hain, and until FDA promulgates a regulatory definition of “natural,” companies in this industry will be at risk of becoming targets of these types of class action lawsuits.

Companies in the cosmetic and food industry will need to stay abreast of these judicial determinations and federal regulatory issues that may affect the way they label their products.  For more information regarding further judicial determinations and how the FDA regulates the use of the term “natural” for cosmetic and food product labels, please contact us at contact@fuerstlaw.com.

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Increasing Regulation for U.S. Foreign Investors

June 24th, 2015

The United States Department of Commerce Bureau of Economic Analysis (BEA) is authorized to conduct benchmark surveys of U.S. direct investment abroad every five years pursuant to the International Investment and Trade in Services Survey Act (P.L. 94-472, 90 Stat. 2059, 22 U.S.C. 3101-3108, as amended –hereinafter “the Act”).  Compliance with the benchmark survey, Form BE-10, has always been mandatory pursuant to the Act, but until November of 2014, it was only required of U.S. persons who received notices from the BEA.  However, following public notice on November 20, 2014 provided via publication in the Federal Registrar of the Final Rule by the BEA, the 2014 survey is now mandatory for all U.S. persons who fall under the specific foreign interest ownership threshold, including any person resident in the United States or subject to the jurisdiction of the United States.  The purpose of the Act is to authorize the President “to collect information on international investment and United States foreign trade in services, whether directly or by affiliates, including related information necessary for assessing the impact of such investment and trade, to authorize the collection and use of information on direct investments owned or controlled directly or indirectly by foreign governments or persons, and to provide analyses of such information to the Congress, the executive agencies, and the general public” (22 U.S.C. 3101).  More specifically, the President is to utilize the data collected “to determine the magnitude and aggregate value of portfolio investment, form of investments, types of investors, nationality of investors and recorded residence of foreign private holders, diversification of holdings by economic sector, and holders of record” (22 U.S.C. 3101).

Background

Form BE-10 can be seen as the latest in a long line of requirements arising out of the federal government’s emphasis on gathering information about U.S. taxpayers’ offshore economic activities.  While many laws requiring U.S. persons to report offshore economic interests have been on the books for decades, the government’s enforcement of these laws, and its effort to add new and stricter requirements, has been much more pronounced since revelations in 2007 that Swiss banking giant UBS had for years affirmatively engaged in efforts to assist U.S. taxpayers in evading their tax obligations under the veil of Swiss bank secrecy laws.  As a result, UBS was fined $780 million and the names of hundreds of UBS depositors were provided to the government.  (See the Department of Justice announcement here).  Since that time, the IRS and the Department of Justice have been active in prosecuting U.S. taxpayers for failing to report income from, or just the existence of, offshore bank and financial accounts and have been pursuing the identity of undeclared U.S. depositors with accounts in Switzerland, Israel, the Caribbean, and elsewhere.  (See related FIDJ blog post here).

Largely in response to the UBS case, Congress passed the Foreign Account Tax Compliance Act (FATCA) in 2010.  While much of the focus regarding FATCA has been centered on its requirement that foreign financial institutions provide information regarding U.S. account holders to the U.S. government or face automatic 30 percent withholding on all U.S. source payments, FATCA also included new filing requirements for U.S. taxpayers holding assets abroad.  In conjunction, the U.S. ramped up its enforcement of preexisting reporting obligations, such as the Foreign Bank Account Report (FBAR) obligation, discussed below.  As it is imperative that all U.S. persons with foreign interests familiarize themselves with the varied forms, the following is a brief summary of the forms and their applicable penalties:

U.S. Department of Commerce

Form BE-10 – Benchmark Survey of U.S. Direct Investment Abroad

Form BE-10A

Form BE-10A is a report that must be submitted by U.S. Reporters with foreign affiliates.  This includes any U.S person or entity, including private funds, which directly or indirectly owned or controlled at least 10 percent of the voting stock of an incorporated foreign business enterprise, or an equivalent interest in an unincorporated foreign business enterprise or fund – at any time during the entity’s 2014 fiscal year.  Irrespective of any equity (financial) interest in the foreign business enterprise, U.S. private fund parents with at least 10 percent voting interest in a foreign business enterprise are required to report.  If the U.S. person is an incorporated business enterprise, the U.S. Reporter is considered the fully consolidated U.S. domestic enterprise excluding foreign branches and all other foreign affiliates.

Form BE-10B

Form BE-10B must be submitted by U.S. Reporters for each foreign affiliate that is a majority-owned foreign affiliate with total assets, sales, or net income were greater than $80 million (positive or negative) during the 2014 fiscal year.

Form BE-10C

Form BE-10C must be submitted by U.S. Reporters for foreign affiliates that were (i) majority-owned foreign affiliates for which total assets, sales, or net income was greater than $25 million (positive or negative), and none of these items was greater than $80 million (positive or negative) at any time during the 2014 fiscal year; (ii) minority-owned foreign affiliates for which total assets, sales, or net income was greater than $25 million at any time during the 2014 fiscal year; or (iii) foreign affiliates for which total assets, sales or operating revenue did not exceed $25 million (positive or negative) at any time during the 2014 fiscal year and that is a foreign affiliate parent of another foreign affiliate being filed on Form BE-10B or BE-10C.

Form BE-10D

Form BE-10D must be submitted by U.S. Reporters for each foreign affiliate for which assets, sales, and net income did not exceed $25 million (positive or negative) at any time during the 2014 fiscal year and the affiliate is not a foreign affiliate parent of another foreign affiliate being filed on Form BE-10B or BE-10C.

The deadline to file the BE-10 reports for U.S. Reporters with fewer than 50 reports was May 29, 2015 and the deadline for U.S. Reporters with more than 50 reports is June 30, 2015.  The deadline for first time filers, however, has been extended to June 30, 2015.  An extension may also be granted by the BEA for those who file a Request for Extension if the request is filed prior to the applicable reporting deadline.  Failure to file the BE-10 report shall subject the U.S. Reporter to a civil penalty of not less than $2,500, and not more than $25,000, and to injunctive relief commanding such person to comply, or both.  A willful failure to report shall be fined not more than $10,000 and, if an individual, may be imprisoned for not more than one year, or both.  Similar fines and/or imprisonment may also be imposed on any convicted officer, director, employee, or agent of any corporation who knowingly participates in such violations (22 U.S.C. 3105), subject to inflationary adjustments.

Form BE-13 – Survey of New Foreign Direct Investment in the United States

On November 21, 2014, just one day following public notice of the new mandatory requirements for Form BE-10, the BEA announced on its website that the survey of new foreign direct investment (Form BE-13) was being reinstated and would also be required of all U.S. entities subject to the reporting requirements, regardless of whether they are contacted by the BEA or not.  The BEA announcement states that Form BE-13 “captures information about new investments made when a foreign investor establishes or acquires a U.S. business (either directly, or indirectly through a U.S. business it already owns) or expands an existing U.S. business.”

Form BE-13A

Form BE-13A must be submitted for a U.S. business enterprise when a foreign entity acquires a voting interest (directly, or indirectly through an existing U.S. affiliate) in that enterprise, segment, or operating unit and (i) the total cost of the acquisition is greater than $3 million, (ii) the U.S. business enterprise will operate as a separate legal entity, and (iii) by this acquisition, at least 10 percent of the voting interest in the acquired entity is now held (directly or indirectly) by the foreign entity.

Form BE-13B

Form BE-13B must be submitted for a U.S. business enterprise when a foreign entity, or an existing U.S. affiliate of a foreign entity, establishes a new legal entity in the United States and (i) the projected total cost to establish the new legal entity is greater than $3 million, and (ii) the foreign entity owns 10 percent or more of the new business enterprise’s voting interest (directly or indirectly).

Form BE-13C

Form BE-13C must be submitted for an existing U.S. affiliate of a foreign parent when it acquires a U.S. business enterprise or segment that it then merges into its operations and the total cost to acquire the business enterprise is greater than $3 million.

Form BE-13D

Form BE-13D must be submitted for an existing U.S. affiliate of a foreign parent when it expands its operations to include a new facility where business is conducted and the projected total cost of the expansion is greater than $3 million.

Form BE-13E

Form BE-13E must be submitted for a U.S. business enterprise that previously filed a Form BE-13B or BE-13D indicating that the established or expanded entity is still under construction.

Form BE-13 is due no later than 45 days after the reportable acquisition is completed, the new legal entity is established, or the expansion is commenced.  Failure to report may subject the U.S. Reporter to a civil penalty of not less than $2,500, and not more than $32,500, and to injunctive relief commanding such person to comply, or both.  Willful failures to report shall be fined not more than $10,000 and, if an individual, may be imprisoned for not more than one year, or both.  Similar fines and/or imprisonment may also be imposed on any officer, director, employee, or agent of any corporation who knowingly participates in such violation, subject to inflationary adjustments.  Claims for Exemption from Form BE-13 may be filed for U.S. business enterprises that meet all of the requirements for filing Forms BE-13A, BE-13B, BE-13C, or BE-13D except the $3 million reporting threshold.

Form BE-12 – Benchmark Survey of Foreign Direct Investment In The United States

Form BE-12 is a benchmark survey of foreign direct investment in the U.S. conducted every five years in lieu of the Annual Survey, described below.  Form BE-12 applies to any U.S. entity in which foreign investors hold at least 10 percent of the voting interests at the end of the reporting calendar year where the entity’s total revenue, total assets, or net income exceeds $60 million.  A Claim for Not Filing may be filed for Form BE-12 if (i) a foreign person did not own 10 percent or more of the voting ownership (or the equivalent) in the U.S business enterprise, (ii) the U.S. business enterprise is fully consolidated or merged into another U.S. affiliate, or (iii) the U.S. business enterprise was liquidated or dissolved.  This survey was recently completed in 2012 and will not be issued again until 2017.

Form BE-12A

Form BE-12A must be submitted for a majority-owned U.S. affiliate with total assets, sales or gross operating revenues, or net income greater than $300 million (positive or negative).

Form BE-12B

Form BE-12B must be submitted for (i) a majority-owned U.S. affiliate with total assets, sales or gross operating revenues, or net income greater than $60 million (positive or negative), but no one of these items was greater than $300 million (positive or negative), and (ii) a minority-owned U.S. affiliate with total assets, sales or gross operating revenues, or net income greater than $60 million (positive or negative).

Form BE-12C

Form BE-12C must be submitted for a U.S. affiliate for which no one of these items was greater than $60 million (positive or negative): total assets, sales or gross operating revenues, and net income.

Form BE-577 – Quarterly Survey of U.S. Direct Investment Abroad required only for those directly contacted by BEA.

Form BE-577 should be submitted for (i) each directly-owned foreign affiliate for which total assets; annual sales or gross operating revenues, excluding sales taxes; or annual net income after provision for foreign income taxes was greater than $60 million (positive or negative) at any time during the affiliate’s fiscal reporting year, and (ii) each indirectly-owned foreign affiliate that met the $60 million threshold and had an intercompany debt balance with the U.S. reporter that exceeded $1 million.  Entities not contacted by BEA have no reporting responsibilities.

Form BE-11 – Annual Survey of U.S. Direct Investment Abroad required only for those directly contacted by BEA.

Form BE-11A

Form BE-11A should be submitted for the fully consolidated U.S. domestic business enterprise of a U.S. reporter that has a reportable foreign affiliate.

Form BE-11B

Form BE-11B should be submitted for a majority-owned foreign affiliate with total assets, sales or gross operating revenues, or net income greater than $60 million (positive or negative).  If the majority-owned affiliate is a foreign affiliate parent of another foreign affiliate being filed on Form BE-11B or BE-11C, Form BE-11B must be filed for the foreign affiliate parent even if total assets, sales or gross operating revenues, or net income did not exceed $60 million (positive or negative).

Form BE-11C

Form BE-11C should be submitted for a minority-owned foreign affiliate with total assets, sales or gross operating revenues, or net income greater than $60 million (positive or negative).  If the minority-owned affiliate is a foreign affiliate parent of another foreign affiliate being filed on Form BE-11C, Form BE-11C must be filed for the foreign affiliate parent even if total assets, sales or gross operating revenues, or net income did not exceed $60 million (positive or negative).

Form BE-11D

Form BE-11D should be submitted for a foreign affiliate established or acquired during the fiscal year with total assets, sales or gross operating revenues, or net income greater than $25 million (positive or negative), but for which no one of these items was greater than $60 million (positive or negative) at the end of, or for, the affiliate’s fiscal year.

Form BE-605 – BEA’s Quarterly Survey of Foreign Direct Investment in the U.S. required only for those directly contacted by BEA.

Form BE-605 should be submitted for every U.S. affiliate for which total assets, annual sales, or gross operating revenues, OR annual net income (not just the foreign parent’s share) were greater than $60 million (positive or negative).  Reports are required even though the U.S. business enterprise may have been established, acquired, liquidated, sold, or inactivated during the reporting period.  Entities not contacted by BEA have no reporting responsibilities.

Form BE-15 – BEA’s Annual Survey of Foreign Direct Investment in the U.S. required only for those directly contacted by BEA.

Form BE-15A

Form BE-15A should be submitted for a majority-owned (exceed 50 percent) U.S. affiliate with total assets, sales or gross operating revenues, or net income greater than $300 million (positive or negative).

Form BE-15B

Form BE-15B should be submitted for 1) a majority-owned (at least 10 percent, but not more than 50 percent) U.S. affiliate with total assets, sales or gross operating revenues, or net income greater than $120 million (positive or negative), but no one

of these items was greater than $300 million (positive or negative) and, 2) a minority-owned U.S. affiliate with total assets, sales or gross operating revenues, or net income greater than $120 million (positive or negative).

Form BE-15C

Form BE-15C should be submitted for a U.S. affiliate with total assets, sales or gross operating revenues, or net income greater than $40 million (positive or negative), but none of these items was greater than $120 million (positive or negative).

Form BE-9 – Quarterly Survey of Foreign Airline Operators’ Revenues and Expenses in the United States required only for those directly contacted by BEA

Form BE-9 is mailed to about 50 persons each quarter.  This quarterly survey collects data from U.S. offices, agents, or other representatives of foreign airline operators that transport passengers or freight and express to or from the United States.  A report is required if the carrier’s total covered revenues or total covered expenses were $5 million or more in the previous year or are expected to be $5 million or more during the current year.

Form BE-29 – Annual Survey of Foreign Ocean Carriers’ Expenses in the United States required only for those directly contacted by BEA

Form BE-29 is mailed to about 85 persons each year.  This annual survey collects data from U.S. agents of foreign ocean carriers who must report all relevant transactions in port services provided by them or obtained by them for foreign carriers and on port services provided by third persons.  A report is required if the U.S. agent handled at least 40 port calls by foreign vessels and if total covered expenses were $250,000 or more in the reporting period.

Form BE-30 – Quarterly Survey of Ocean Freight Revenues and Foreign Expenses of United States Carriers required only for those directly contacted by BEA

Form BE-30 is mailed to about 25 persons each quarter.  The quarterly survey collects data from U.S. airline operators engaged in the international transportation of U.S. export freight and the transportation of freight and passengers between foreign points.  A report is required if the U.S. airline operator’s total covered revenues or total covered expenses were $500,000 or more in the previous year or are expected to be $500,000 or more in the current year.

BE-180 – Benchmark Survey of Financial Services Transactions between U.S. Financial Services Providers and Foreign Persons required only for those directly contacted by BEA

Form BE-180 was mailed to about 6,200 firms in 2009.  The benchmark survey covers financial services transactions (including, payments to, and receipts from) affiliated and unaffiliated foreign persons.  A report is required if in the fiscal year covered by the survey, the U.S. person transacted with a foreign person in any of the covered financial services.  The U.S person is required to provide detailed information by type of service and by country if the U.S person had more than $3 million of receipts or payments in all financial services combined.  If the U.S. person’s total transactions fell below the threshold, estimates of total receipts and total payments must be provided.  In addition, the U.S. person is asked, but not required, to provide an estimate of the total transactions for each type of financial service.

Form BE-185 – Quarterly Survey of Financial Services Transactions between U.S. Financial Services Providers and Foreign Persons required only for those directly contacted by BEA

Form BE-185 is mailed to about 675 firms each quarter.  This quarterly survey covers payments to, and receipts from, affiliated and unaffiliated foreign persons.  A report is required if a U.S. person had (i) receipts from affiliated and unaffiliated foreign persons for all financial services combined of more than $20 million in the previous fiscal year or expects to have receipts of more than $20 million in the current fiscal year or (ii) payments to affiliated and unaffiliated foreign persons for all financial services combined of more than $15 million in the previous fiscal year or expects to have payments of more than $15 million in the current fiscal year.

Form BE-140 – Benchmark Survey of Insurance Transactions by U.S. Insurance Companies With Foreign Persons required only for those directly contacted by BEA

Form BE-140 was mailed to about 1,100 firms in 2008.  This benchmark survey collects data from U.S. insurance companies that have engaged in insurance transactions with foreign persons during the reporting period.  A report is required if a U.S. insurance company had transactions in any of the covered items that were less than $2 million or were more than $2 million in the calendar year covered by the survey.

Form BE-45 – Quarterly Survey of Insurance Transactions by U.S. Insurance Companies with Foreign Persons required only for those directly contacted by BEA

Form BE-45 is mailed to about 550 firms each quarter.  This quarterly survey collects data from U.S. insurance companies that have engaged in insurance transactions with foreign persons during the reporting period.  A report is required if transactions in any of the covered items were less than $8 million or more than $8 million in the previous year or are expected to be in the current calendar year.

Form BE-120 – Benchmark Survey of Transactions in Selected Services and Intellectual Property with Foreign Persons required only for those directly contacted by BEA

Form BE-120 was mailed to about 14,500 persons in 2011.  This benchmark survey collects data from U.S. persons who had transactions (receipts and/or payments) with affiliated and unaffiliated foreign persons during the reporting period.  A report is required if the U.S. person transacted with a foreign person in any of the covered services during the fiscal year.  The U.S. person is required to provide detailed information by type of service and by country if the total transactions (affiliated and unaffiliated) in any of the categories exceeded $2 million for receipts or $1 million for payments.  If the U.S. person’s transactions fell below the threshold, estimates of total receipts and total payments must be provided.  In addition, the U.S. person is asked, but not required, to provide estimates of the total transactions for each type of service.

Form BE-125 – Quarterly Survey of Transactions in Selected Services and Intellectual Property with Foreign Persons required only for those directly contacted by BEA

Form BE-125 is mailed to about 2,000 persons each quarter.  This quarterly survey collects data from U.S. persons who had transactions (receipts and/or payments) with affiliated and unaffiliated foreign persons during the reporting period.  A report is required if a U.S. person had (i) receipts from affiliated and unaffiliated foreign persons in any of the covered categories of more than $6 million in the previous fiscal year or expects to have receipts of more than $6 million in the current fiscal year or (ii) payments to affiliated and unaffiliated foreign persons in any of the covered categories of more than $4 million in the previous fiscal year or expects to have payments of more than $4 million in the current fiscal year.

Form BE-150 – Quarterly Survey of Payment Card and Bank Card Transactions Related to International Travel

Form BE-150 is filed by all U.S. credit card companies and by debit networks that are based on personal identification numbers.  These companies are required to report (i) transactions between U.S. cardholders traveling abroad and foreign businesses and (ii) transactions between foreign cardholders traveling in the United States and U.S. businesses.

Internal Revenue Service

Form 926

Under Internal Revenue Code (IRC) §6038B, each United States person (generally defined for Form 926 and the other forms described herein as a citizen or resident of the United States, or a domestic entity (i.e. partnership, corporation, estate, or trust formed under the laws of the United States)) who transfers property to a foreign corporation in an exchange described in IRC §§332, 351, 354, 355, 356, or 361, or a corporation that makes a distribution described in IRC §336 (i.e. a liquidating distribution) to a non-U.S. person must report the transfer to the IRS on Form 926.  This provision is intended to provide the U.S. government with information regarding capitalization, liquidation, or reorganization of a foreign corporation in which a U.S. person holds an interest.

Any U.S. person who fails to provide notice of the transfers to foreign persons as described above may be liable for a penalty equal to 10 percent of the fair market value of the property transferred, valued at the time of the exchange.  The taxpayer may also be required to recognize gain on the transaction even if the transaction would have been a non-recognition event in the normal course.

Form 3520

U.S. persons must file Form 3520 to report certain transactions with foreign trusts, ownership of foreign grantor trusts, and receipt of certain large gifts or bequests from certain foreign persons.  A separate Form 3520 must be filed with respect to each foreign trust or gift.

Failure to file the form can lead to penalties equal to the greater of $10,000, 35% of the gross value of any property transferred to a foreign trust during the year, 35% of the gross value of the distributions received from a foreign trust during the year, or 5% of the gross value of the portion of the trust’s assets treated as owned by a U.S. person in a foreign grantor trust.

Form 3520-A

Form 3520-A is the annual information return of a foreign trust (i.e. a trust formed under the laws of a foreign country, and subject to the courts of a different country) with at least one U.S. owner.  The form requires submission of information about the foreign trust, its U.S. beneficiaries, and any “U.S. person”who is treated as an owner of any portion of the foreign trust.  A foreign trust with a U.S. owner must file Form 3520-A in order to satisfy their annual information reporting requirements under IRC §6048(b).

A U.S. owner is subject to an initial penalty equal to the greater of $10,000 or 5% of the gross value of the portion of the foreign trust’s assets treated as owned by the U.S. person at the close of that tax year, if the foreign trust does not timely file the form, or files an incomplete or incorrect form.

Form 5471

IRC §6046 requires each of the following to file Form 5471, setting forth certain information with respect to a foreign corporation:

  • Each United States citizen or resident who becomes an officer or director of a foreign corporation if a United States person own 10 percent or more of the total combined voting power of all classes of stock of the foreign corporation entitled to vote, or 10 percent or more the total value of the stock of the foreign corporation.
  • Each United States person who acquires stock and, either when added to any stock owned on the date of such acquisition or without regard to stock owned on the date of such acquisition, owns 10 percent or more of the total combined voting power of all classes of stock of a foreign corporation entitled to vote, or 10 percent or more the total value of the stock of a foreign corporation.
  • Each person who is treated as a United States shareholder under IRC §953(c).
  • Each person who becomes a United States person while owning 10 percent or more of the total combined voting power of all classes of stock of a foreign corporation entitled to vote, or 10 percent or more the total value of the stock of a foreign corporation.

In determining ownership percentages, complex rules regarding attribution of ownership from family members or related entities apply, creating a trap for unwary taxpayers who look only to interests held in their name in determining their reporting obligations.  Form 5471 must be filed for each foreign corporation that gives rise to a reporting obligation.  Failure to file Form 5471 may lead to penalties of $10,000 for each failure.  Further, failure to file the form may compromise opportunities to take advantage of the foreign tax credit and may lead to criminal prosecution.

Form 8621

U.S. persons holding interests in passive foreign investment companies (PFICs) must report such interests, as well as any PFIC distributions, each year on Form 8621.  PFICs are foreign corporations whose assets are primarily devoted to the generation of passive income (interest, dividends, etc.).  A separate form must be filed for each PFIC in which the U.S. person has an interest.  Furthermore, PFIC distributions, i.e. dividends or dispositional gains, are taxed differently (and more punitively) than typical dividends or capital gains.

Form 8865

If a U.S. person holds an interest in a foreign partnership, there is good chance that person will have to file Form 8865.  The form is used to report the information required under IRC §6038 (reporting with respect to controlled foreign partnerships—where U.S. persons own more than 50 percent of the partnership), IRC §6038B (reporting of transfers to foreign partnerships), and IRC §6046A (reporting of acquisitions, dispositions, and changes in foreign partnership interests).  Form 8865 sets forth several categories of interest holders who must file the form and requires different schedules, statements, and information, depending on the category of filer.  As with the other forms discussed, failure to file a timely and accurate Form 8865 may lead to penalties of $10,000 for each failure and may lead to criminal prosecution.

Form 8938

Pursuant to IRC §6038D, any U.S. person who, during any taxable year, holds a specified interest in a specified foreign financial asset is required to attach to his individual income tax return (i.e. Form 1040), specific information regarding those assets on Form 8938.  While the filing thresholds for Form 8938 can be quite complex, generally U.S. persons living in the U.S. must file Form 8938 if their offshore financial assets (bank accounts, investment accounts, interests in foreign entities, and most other financial assets) exceeds $50,000 for a single tax return filer and $75,000 for joint tax return filers.  These thresholds rise when the U.S. taxpayer resides abroad.  Failure to file Form 8938 may lead to penalties of $10,000 per failure and criminal penalties.  Form 8938 in many circumstances is redundant with the FBAR filing obligation, but filing Form 8938 does not relieve the FBAR filing obligation, and vice versa.

FinCEN Form 114 (FBAR)

FBARs must be filed by any U.S. person that has signatory authority over, or a financial interest in, a foreign bank account(s) with a value exceeding $10,000 at any time during the preceding taxable year.  A financial interest means a person that is either the legal title holder of the account or someone who can (either independently or in conjunction with another) direct the disposition of the account assets.  The $10,000 threshold cannot be circumvented by keeping multiple accounts; all account values are aggregated.  While most of the forms discussed above are required to be filed with a taxpayer’s tax return (except for 3520 and 3520-A, which must be filed separately with the Ogden, Utah IRS service center), the FBAR must be filed online with the Bank Secrecy Act’s e-filing website, and is due by June 30 for the previous taxable year (i.e., FBARs for 2014 are due on June 30, 2015).

A $10,000 penalty is imposed for non-willful failures to file an FBAR.  For willful failures, the penalties can reach 50% of the maximum account value each year.  Strict application of this rule can lead to penalties far in excess of the account value.  Schedule B of Form 1040 requires taxpayers to affirmatively state whether they had a financial interest in, or signatory authority over, a foreign bank account during the previous year.  The presence of that question, no matter how it is answered, severely hurts any argument that a failure to file an FBAR was not willful.  (See related FIDJ FBAR blog posts here).

Other Penalties

In addition to giving rise to independent monetary penalties, failure to file Forms 5471, 3520, 3520-A, 926, 8938, or 8865 will extend the statute of limitations for making an assessment of tax with respect to the entire return, whether or not the assessed deficiency relates to the unfiled form.  IRC § 6501(d)(8).  Further, if there is a deficiency that arises out of income relating to an unfiled form, a penalty of 40% can be assessed in addition to the deficiency.  IRC § 6662(j).

Given the overlap of the various filing requirements, failing to abide by these filing requirements in just a single year can lead to huge penalties or worse.  For instance, if a taxpayer has a single offshore investment account with $400,000 in it, he will have to file an FBAR, a Form 8938, and, in some circumstances, a Form 8621 to report interests in PFICs.  Failure to do so in just a single year gives rise to almost automatic penalties of $20,000, plus additional penalties if there is any unreported income attributable to the account.  Further, the statute of limitations for the entire return will not begin to run until all forms are filed.

Years of abuse by U.S. taxpayers of foreign bank secrecy laws coupled with an increased desire to generate revenue has led to the situation we are in today.  If a U.S. person has economic interests abroad, almost invariably they have an obligation to report the interest, often on more than one form.  As shown by Form BE-10A, agencies beyond just the IRS or the Department of Treasury are beginning to impose reporting obligations with respect to foreign investment.  It is essential that taxpayers in that position seek experienced counsel to guide them through the various filing requirements.  The old adage “an ounce of prevention is worth a pound of cure” has never been more apt.

The attorneys at Fuerst Ittleman David & Joseph specialize in the complexities faced by U.S. taxpayers investing, operating business, or holding assets abroad, with a particular focus on the tax implications of those activities.  Please contact us by email at contact@fuerstlaw.com or telephone at 305.350.5690 with any questions regarding this article or any other issues on which we might provide legal assistance.

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FTC Advertising Law Update: FTC Issues Updated FAQs to Endorsement Guides

June 24th, 2015

On May 29, 2015, The U.S. Federal Trade Commission (“FTC”) issued an updated “Frequently Asked Questions” (“FAQs”) guide on advertisement endorsements. These FAQs include regulatory guidance on how endorsements may be made via social media. (To read the FTC’s announcement please click here.) Endorsements are advertising messages conveying third-party opinions or experiences and are used by advertisers to promote products or services to consumers. Like most advertising, endorsements are regulated by the FTC. The new FAQs, “What People Are Asking,” supplements FTC’s 2009 Endorsement Guide on the same subject in large to address social media advertising and address many of the same legal issues articulated in the 2009 Endorsement Guides. As made clear by FTC, first, all endorsements must meet the standard of “truthful and not misleading.” Second, disclosure of the relationship between the endorser and the company must be clear and conspicuous. Finally, if the endorser promotes an experience that is not backed by evidence or is not normally achieved, clear and conspicuous disclosure is needed. (To read the entire FAQs please click here.)

The FTC monitors the world of social media, including Facebook, Twitter, YouTube, and Instagram. Companies that promote products through the use of endorsements on social media must be acutely aware of how this type of advertising is regulated. The same Truth In Advertisinglaws that apply to traditional types of media such as television and magazines apply to social media as well. Per these laws, advertisements must be truthful, not misleading, and backed by evidence when appropriate. Companies engaging in a quid-pro-quo relationship with an endorser are subject to these same standards.

“What People Are Asking” is an updated compilation of answers to general questions the FTC has received since issuing the 2009 Endorsement Guides. The updated FAQs expand on topics previously addressed and offer advice on how to apply the Endorsement Guides to new forms of social media advertising. Here are a few points of emphasis:

  • The FTC “is only concerned about endorsements that are made on behalf of a sponsoring advertiser.” Therefore, endorsements not solicited or where no relationship exists between the endorsee and the endorser are not subject to FTC’s guides. However, if an endorser works for an advertiser or receives something in exchange for the endorsement, then the Endorsement Guides apply.
  • Social media platforms that allow individuals to “like” a product (i.e. Facebook) are not considered endorsement. However, a company buying fake “likes” could subject the company to enforcement action. Enforcement action may ensue from purchasing fake “likes” because advertisements account for a substantial portion of Facebook’s revenue, and if fake “likes” can be bought through a “click farm” the advertisement may be deemed to be deceptive and misleading and subject to an FTC enforcement action. (To read more on click farms please click here.)
  • Platforms with character limits (i.e. Twitter) are not exempt from disclosure. The FTC “isn’t mandating specific wording for [endorsement] disclosures,” but suggests supplementing the endorsement with a hashtag like “#ad” or “Promotion” would be sufficient.
  • YouTube is a platform that is primarily video based, and endorsements on YouTube must be clear and conspicuous. The FTC suggests multiple, periodic disclosures because a disclosure only at the beginning or end of the stream could easily be dismissed.
  • Endorsements must reflect the honest opinions or experiences of the endorser. Endorsers cannot talk about an experience with a product if they have not tried it, and they cannot write a positive review if they thought the product was terrible.
  • An employee of a company endorsing one of its products must disclose his/her relationship with the company.
  • Companies need to have reasonable programs in place to train and monitor members of their network of bloggers and social media promoters. These programs should include explaining proper disclosure, explaining what can and cannot be said about a product, and searching their social media network periodically to monitor and remove what is being said.

Advertising on the internet and through social media can be tricky. Not only should companies follow FTC’s guidances, companies should be aware of the Federal Drug Administration’s (“FDA”) internet presence. Along with the FTC, the FDA too scours the internet searching for companies who are  impermissibly promoting or advertising drugs, medical devices, and the countless other products which fall within the FDA’s jurisdiction. (To read the FDA’s draft guidance document Internet/Social Media Platforms please click here.)

The FTC closely monitors endorsements on the internet. Companies using endorsements through social media should be aware of how to comply with FTC’s guidances to avoid penalties. Companies can comply by abiding by the Truth In Advertising Laws, the 2009 Endorsement Guides, and the updated FAQs while using social media and a third party to promote their products. Companies should ensure their advertisements either published in-house, or through endorsements, abide by FTC’s regulations and guides.

Fuerst Ittleman David & Joseph, PL will continue to monitor any developments with the FTC’s Endorsement Guides. The attorneys in our Food, Drug, and Life Sciences practice group are experienced in assisting regulated industry to ensure that products are marketed and advertised in compliance with all applicable federal laws and regulations. For more information, please call us at (305) 350-5690 or email us at contact@fuerstlaw.com.

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White Collar Criminal Defense Update: Second Circuit Emphasizes Constitutional Right to Impartial Jury, Upholds High Standard to Prove Waiver

June 23rd, 2015

The Government must prove by a preponderance of the evidence that a defendant has waived his Sixth Amendment right to an impartial jury, which is a heavier burden than one might expect after the Second Circuit’s decision in United States v. Parse, available here. In Parse, after a juror revealed her hidden agenda, the District Court and the parties discovered multiple lies she concealed during voir dire and the trial. However, the District Court found that the criminal defendant’s (David Parse) attorneys knew, or should have known, about the lies based on previous research on the juror, and therefore concluded that Parse waived his right to an impartial jury. The District Court refused to grant his motion for a new trial despite granting it for his codefendants. The Second Circuit reversed and held that the District Court clearly erred when it refused to order a new trial after the juror’s strategic manipulation because such a refusal would seriously affect the “fairness, integrity, and public reputation of judicial proceedings” when there was no evidence proving the lawyers or Parse knew the juror was lying.

Background

Parse was a broker employed by an investment banking firm. He and others were indicted and charged with conspiracy to defraud the U.S. and to commit mail fraud, wire fraud, and tax evasion in violation of 18 U.S.C. § 371, among other tax-related offenses. He was tried along with his codefendants, and following the three-month trial the jury returned a split verdict for Parse. Parse was found guilty on substantive mail fraud and obstruction charges but not guilty on the four other counts against him.

Months after the verdict, all four codefendants moved under Federal Rule of Criminal Procedure 33 for a new trial on the ground that Catherine M. Conrad, Juror No. 1, had lied and withheld information in voir dire and during the trial. These motions were sparked by a letter Conrad sent to the Government praising its work in the trial. She also told the Government that she had been holding out for days during deliberation trying to convince other jurors to convict Parse. After this letter, the subsequent motions, and an evidentiary hearing, the District Court released an opinion finding Conrad had “lied extensively during voir dire and concealed important information about her background.”

To begin, the only information Conrad revealed to the voir dire survey questions was that her father works as an immigration officer and that she was a plaintiff in a personal injury negligence case. She was silent as to questions about criminal history, relatives who are attorneys, and many other basic questions that would indicate bias. During individual questioning she also stated that she had lived at the same address her whole life and she was currently a stay-at-home wife with a college education. Among the lies the District Court discovered: Conrad’s occupation as a lawyer and subsequent suspension from the profession for professional misconduct, her multiple previous arrests for everything from shoplifting to DUI to aggravated harassment, her apartment located at a different address than she claimed, and her career criminal husband, who has been convicted of at least nine criminal offenses and incarcerated. During an evidentiary hearing Conrad also made multiple biased statements, such as “[Defendants are] fricken crooks and they should be in jail and you know that.” She also told the Court that she lied to make herself more “marketable” as a juror. The District Court found she was biased against the defendants and a pathological liar. The District Court then granted the codefendants’ motions for a new trial, but not Parse’s.

District Court’s Denial of a New Trial for Parse

In short, the District Court determined that Parse’s attorneys either knew, or should have known through due diligence, that Conrad was lying. Accordingly, the District Court ruled that Parse waived his constitutional right to an impartial jury. In support of its holding, the District Court cited several exchanges occurring before voir dire, during closing arguments, and after the verdict. First, it cited several email exchanges where Parse’s attorneys discussed Google searches that revealed information about a suspended lawyer who also went by the name Catherine M. Conrad. Parse’s attorneys felt it could not be the same person because it would have required blatant lying in voir dire, and therefore chose not to pursue it further. Next, the law firm disclosed further research conducted during closing arguments after Conrad had submitted a note to the Court. During that search, a paralegal discovered the Suspension Orders suspending Conrad from practicing law in New York in both 2007 and 2010. The paralegal also produced a Westlaw Report that contained information about Conrad’s previous address and her involvement in a civil lawsuit. Again, the team concluded it was “inconceivable” that Conrad lied during voir dire. Finally, after the post-verdict letter, another Google search matched Conrad’s telephone number to one associated with the suspended attorney, and that was the first time the attorneys said they really suspected it was the same person. A two-week investigation looking at property records, Conrad’s husband’s criminal records, and marriage records confirmed suspicions.

The District Court was displeased and asked the attorneys if the law firm would have ever disclosed their previous research and findings had the court/Government not inquired. The District Court based the attorneys’ supposed knowledge of Conrad’s lies on evidence such as an email exchange that occurred the same day jury deliberations began where a paralegal wrote, “Jesus, I do think that it’s her,” when discussing the connection between Conrad and the suspended attorney. The District Court said this showed the attorneys had actionable intelligence that she was an imposter. Therefore, Parse waived his rights through the actions (or failed actions) of his attorneys.

Second Circuit Reverses

The Second Circuit vehemently disagreed with the District Court’s holding, and instead held that Parse should have been granted a new trial on the ground that he was deprived of the right to a trial before an impartial jury. The Second Circuit conceded that had the defendant known prior to the end of the trial that a prospective juror had given false voir dire responses and did not reveal the disqualifying falsehoods to the court, “the interest of justice” would not require a new trial under Rule 33. However, the Court referenced a two-part test to help it decide whether the District Court should have granted a motion for a new trial based on juror nondisclosure or misstatements. Citing McDonough Pwr. Equip. v. Greenwood, 464 U.S. 548, 556 (1984), available here, the Court held the party must first show that “a juror failed to answer honestly a material question in voir dire,” and secondly, must show that “a correct response would have provided a valid basis for challenge.” Both prongs were easily met in this case.

The Second Circuit reviewed the District Court’s decision by an abuse of discretion standard, and here it determined the District Court erred as a matter of law by holding Parse waived his rights. The Court wrote that a waiver must be knowing, intelligent, and made with awareness of the likely consequences, which is not what occurred in Parse’s proceedings before the District Court. The Second Circuit also noted that the District Court had no evidence that Parse himself knew about Conrad’s misrepresentations, but regardless the Court believed the District Court erred in ruling that Parse’s attorneys had knowledge in the first place. The Second Circuit stated that not every failure to object or to advance a given argument constitutes a waiver, and especially because Conrad “presented herself as an entirely different person,” any finding that Parse’s attorneys knew prior to trial that she was the same as the suspended attorney was erroneous.

Overall, the Second Circuit acknowledged that Parse’s attorneys could have asked the court to pose additional questions to Conrad, but the Court held that their failure to do so or pursue additional information sufficient to reveal her misrepresentation did not provide an appropriate basis for the District Court’s finding that Parse’s lawyers knew the truth about Conrad and waived Parse’s right to an impartial jury.

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The takeaway from the Second Circuit’s decision is its emphasis on Parse’s constitutional right to an impartial jury trial, and how far the Court believes that right extends. Even though Parse’s attorneys were able to find some information on Conrad and could very well have further inquired as to the discrepancies, they did not, but that did not mean that Parse waived his Sixth Amendment rights. While the Court did not address specifically whether Parse could waive his rights through his attorneys even if he did not have any personal knowledge of Conrad’s lies, this case still implies a high standard for proving waiver. Holding the Government to a preponderance of the evidence standard for proving waiver better values defendants’ constitutional rights.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in the areas of complex civil and administrative litigation at both the state and federal levels, white collar criminal defense, as well as tax and tax litigation. Should you have any questions or need further assistance, please contact us by email at contact@fuerstlaw.com or telephone at 305.350.5690.

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Tax Litigation Update: Ninth Circuit Enforces Two-Prong Test to Determine Transferee Tax Liability

June 23rd, 2015

On June 8, 2015, the United States Court of Appeal for the Ninth Circuit reversed the decision of the United States Tax Court after the Tax Court failed to apply the correct legal standard to determine transferee tax liability, which resulted in an improper determination to disregard the form of a transaction. In Slone Revocable Trust v. Cir., available here, the Ninth Circuit presented the correct test to impose tax liability on a transferee. The test, which the Court applied from Comm’r v. Stern, 357 U.S. 39 (1958), available here, requires asking both:

  1. Is the party a “transferee” under 26 U.S.C. § 6901 and federal tax law?
  2. Is the party substantively liable for the transferor’s unpaid taxes under state law?

The Ninth Circuit held that the Tax Court erroneously analyzed both prongs, and therefore remanded the case back to Tax Court for proper determination.

Background

The Slone Revocable Trust case involved two sales related to Slone Broadcasting Co., a radio broadcasting business. In the first sale, Slone Broadcasting Co. sold almost all of its assets to Citadel Broadcasting Co. for $45 million. Slone Broadcasting realized a capital gain of about $38.6 million, which carried with it an income tax liability of $15.3 million. After the sale, no distributions were made to the shareholders. Slone Broadcasting made its first federal income tax payment three months after the sale for $3.1 million.

Before the transaction closed, Fortrend International, LLC proposed a merger deal with Slone wherein Fortrend would purchase all of Slone Broadcasting’s shares for $29.8 million. Fortrend then offered to restructure Slone to engage in the asset recovery business. Slone Broadcasting’s tax attorney green-lighted the deal, but the shareholders continued to ask for information regarding the methods Fortrend would use to reduce the shareholders’ tax liability. Fortrend only said the methods were “proprietary” and assured Slone that the transaction would not be “listed” pursuant to IRS Notice 2001-51, 2001-2 C.B. 190. Slone Broadcasting’s shareholders sold their shares to another company, Berlinetta Inc. (later known as Arizona Media) for $33 million. Several years later Arizona Media was administratively dissolved for failure to file an annual report.

The IRS ultimately sent notices of liability to the former shareholders of Slone Broadcasting for a tax deficiency in the amount of $13.5 million, along with a penalty of $2.7 million and interest of $7.3 million. The notice said the shareholders were liable as “transferees” of the assets. The IRS aimed to disregard the form of the shareholders’ sale of stock to Berlinetta, but the Tax Court concluded that the form of the stock sale should be respected, rejecting the IRS’s theory.

Properly Applying Stern

The Commissioner of the IRS can assess tax liability against a taxpayer who is the transferee of assets of a taxpayer who owes income tax under 26 U.S.C. § 6901. The Court noted that while federal law addresses the procedure for collecting tax liabilities from a transferee, state law determines whether that transferee is substantively liable. This is where the Ninth Circuit brought in the Stern test, which is a two-prong inquiry the Court uses to determine transferee tax liability

In the first prong, which asks whether the party is a transferee under federal law, a transferee can be a “done, heir, legatee, devisee, or distributee,” but can also be a “shareholder of a dissolved corporation” under 26 C.F.R. § 301.6901-1(b). As for the second prong, the Stern test asks about substantive liability, and while it depends on the law of the state where the transfer occurred, the test typically requires showing that the transferee had “actual or constructive knowledge of the entire scheme that renders its exchange with the debtor fraudulent.”

If the form of stock sale transaction between the shareholders and Berlinetta is respected, the shareholders did not receive a liquidating distribution and therefore are not transferees of the assets. Thus, the question was whether the Tax Court erred in respecting the form. The Commissioner argued that the Tax Court erred in analyzing the first prong of the Stern test, and the Ninth Circuit agreed.

The Ninth Circuit held that case law requires courts to consider both subjective and objective factors in characterizing a transaction for tax purposes. This test turns on whether the taxpayer has shown a business purpose other than tax avoidance, and whether the transaction had economic substance beyond the creation of tax benefits. The Court related this idea to the “economic substance doctrine,” and the “substance-over-form doctrine” as part of similar common law which looks at the transaction’s business purpose and economic reality. If an analysis of these factors leads to the conclusion that the transaction has no non-tax business purpose or economic substance, then the form of the transaction should be disregarded.

With all of this in mind, what was the Tax Court’s mistake, exactly? The Ninth Circuit found that the court did not address either subjective or objective factors in characterizing the transaction, as it did not determine any business purpose or economic substance. The Ninth Circuit held that the Tax Court mainly focused on evidence of the shareholders’ lack of actual or constructive knowledge of the tax evasion scheme. It only used this evidence to conclude the form of the sale should be respected under the first prong of the Stern test, but did not use it to analyze shareholders’ liability under the state law in the second prong.

The Commissioner argued that the Tax Court should have found the transaction to be liquidating in substance, just a “shell with nothing but cash and significant tax liabilities.” The Slone Broadcasting shareholders disagreed, arguing that they had potential to acquire another radio station and no improper motivations for the sale. The shareholders also pointed to Fortrend’s debt recovery proposal as evidence of economic substance. The Ninth Circuit felt it could not resolve the dispute because the Tax Court failed to apply the proper test in the first place.

Remand

The Ninth Circuit instructed the Tax Court to apply relevant subjective and objective factors to determine whether the Commissioner erred in disregarding the form of the transaction in order to impose tax liability on shareholders as “transferees” in the first prong, and instructed the court to analyze whether the shareholders were substantively liable under state law in the second prong.

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The takeaway from the Ninth Circuit’s decision is that the Courts of Appeal will require the Tax Court, and the taxpayers litigating in the Tax Court, to apply the proper test and introduce into the record sufficient evidence to justify and support a taxpayer’s claim that he/she should not be subject to transferee liability.  While not a total win for the IRS, neither is it a total loss for the taxpayer. Both parties are now left to, again, try the case before the Tax Court, which must determine whether the taxpayer is subject to transferee liability.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax and tax litigation.  They will continue to monitor developments in this area of the law. If you have any questions, an attorney can be reached by emailing us at contact@fuerstlaw.com or by calling 305.350.5690.

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When Export Crosses the Line: Hidden Foreign Corrupt Practice Act (FCPA) Violations can Hurt You

June 22nd, 2015

The following article was written by Stephen Wagner for the Export Compliance Training Institute. Mr. Wagner is a faculty member for the Institute, and frequently lectures and writes on export compliance and enforcement matters. We repost Mr. Wagner’s article here with the Institute’s permission.

Your company exports and ships its products all over the world through a small, local third-party logistics provider.
The export manager at the shipping company, who is a close personal friend, has been handling your company’s products for years and has been doing a perfect job. The products arrive at your foreign customer locations on-time, without problems, and you just pay the invoices for the shipping costs without question. In fact, international shipping is the one part of your company’s operations at which you have never needed to take a second look.

Until today… Today two special agents from Homeland Security Investigations (HSI) arrived at your office to ask about your company’s export activities. They were vague about the nature of the investigation, but asked a lot of questions about your shipping practices.  As they were leaving, they handed you a subpoena for five years’ of export records. You started gathering your documents together and now, reviewing your export shipping invoices for the first time in years, you see line items and charges for a “Customs Clearance Fee” in certain countries and an “Import Commission” in other countries. When you called your friend at the shipping company to ask about these charges, he said that the receiving shipping companies in these countries must pay these fees “so your products can sail through customs.”

What are you really seeing, when you look at these charges?

Depending on the exact nature of these payments, you may end up seeing federal criminal charges.

The Foreign Corrupt Practices Act, as amended (15 U.S.C. §§ 78dd-1, et seq.) (“FCPA”), was enacted in 1977 and makes it illegal for U.S. companies (including their foreign affiliates) to make payments to foreign government officials.  The “anti-bribery provisions” of the FCPA prohibit “any offer, payment, promise to pay, or authorization of the payment of money … directly or indirectly, to a foreign official to influence the foreign official in his or her official capacity, induce the foreign official to do or omit to do an act in violation of his or her lawful duty, or to secure any improper advantage[.]”  15 U.S.C. § 78dd-1(a).  Additionally, the “accounting provisions” of the FCPA require companies whose securities are listed in the United States to “make and keep books and records that accurately and fairly reflect the transactions of the corporation” and “devise and maintain an adequate system of internal accounting controls[.]”  15 U.S.C. § 78m(b)(2).

Yet the world of international business is not so black and white.  There are myriad court cases, attorney general opinions, and legal theories that seek to define a “foreign official.”  While someone working for a foreign government (like a uniformed foreign customs officer) is clearly such an “official,” what about employees of a nationalized, or government-owned, company?  What about employees of private companies that conduct government functions (such as processing customs paperwork) under a contract with the government?  What about agents, consultants, or lobbyists who “grease” the foreign government processes on your behalf?

Furthermore, recognizing that sometimes payments must be made to foreign government officials just to move paperwork along or obtain routine approvals, the anti-bribery provisions of the FCPA contain an exception for “facilitating payments.”  This narrow exception applies to payments made for non-discretionary actions, like processing customs paperwork or import permit applications; actions which would take place even without the payments, but would probably take much longer to occur.

Therefore, looking at your company’s “Customs Clearance Fee” or “Import Commission,” several critical questions arise:  who is being paid, and for what?

Even if you think you have found the logical answers to these questions, you will need to consult with your company’s general counsel or a qualified outside attorney, because you may not be able to interpret these answers correctly.  Indeed, sometimes the law does not apply logically to the way businesses operate, and sometimes the language used in the statutes and regulations can be ambiguous or subject to multiple interpretations.  For example, if you think the “fee” or “commission” would qualify as a facilitating payment, the U.S. government’s FCPA Guidance warns, “while the payment may qualify as an exception to the FCPA’s anti-bribery provisions, it may violate other laws, both in Foreign Country and elsewhere.  In addition, if the payment is not accurately recorded, it could violate the FCPA’s books and records provision.”

And you cannot stop your investigation with just these “fees” and “commissions,” because no federal government investigation will stop there either.  Many exporters may pay intermediaries to obtain business in foreign countries.  Whether these payments to “middlemen” are labeled as “sales commissions” or “distribution fees” or “licensing payments,” they may all still be bribes as that term is interpreted by enforcement agencies under the FCPA.

As an example of how broadly the FCPA can be interpreted, in May 2014 a federal appeals court ruled in the case of United States v. Esquenazi (752 F.3d 912 (11th Cir. 2014)), that the FCPA’s definition of “foreign official,” which includes “any officer or employee of a foreign government or any department, agency, or instrumentality thereof,” also includes officials working for “an entity controlled by the government of a foreign country that performs a function the controlling government treats as its own.”  Esquenazi, 752 F.3d at 925.  Therefore, if your company is doing business with a foreign state-owned or state-controlled business, certain payments to officials of that foreign company could be illegal under the FCPA because such businesses can be interpreted as being “instrumentalities” of the foreign government.

It is also important to note that FCPA enforcement is expected to be on the rise in 2015.  Violations of the FCPA can result in criminal and/or civil charges from the U.S. Department of Justice (DOJ) and (if your company is a “reporting company” under the Securities Exchange Act of 1934) civil or administrative cases from the U.S. Securities and Exchange Commission (SEC).  While enforcement actions by these two agencies had been relatively stable over the last three years, there has been a recent uptick in the number of potential FCPA violations reported to the U.S. government.  This is due in large part to stronger anti-corruption laws and enforcement measures around the globe, which is increasing corporate awareness of anti-bribery issues.  As companies are reporting more to the enforcement agencies, actions under the FCPA should increase as well.

And the stakes in FCPA compliance measures and enforcement actions can be enormous.  For 2014, the average value of monetary resolutions in government FCPA enforcement actions against corporations was over $150 Million.  And those are just the fines and penalties.  On the compliance side the costs can be staggering for businesses as well.  In one well publicized case, Walmart self-reported possible FCPA violations to the DOJ and SEC after a New York Times investigation.  According to filings with the SEC, Walmart is now spending between $10 Million and $35 Million per quarter for its “global [anti-bribery and anti-corruption] compliance program and organizational enhancements.”  In its fiscal 2014 Global Compliance Program Report, Walmart reported it had spent an overall total of $439 million in legal fees and other costs associated with the on-going investigations of alleged FCPA violations, and to revamp its global compliance protocol.

While smaller companies may not have the breadth of operations (and the financial resources) of Walmart, having an effective and robust FCPA compliance program is just as critical.  A combination of a strong, written program together with its robust use and periodic audits can help prevent exactly the type of situation that has befallen the company in the scenario above.  Moreover, an effective FCPA program can be a critical factor in mitigating possible penalties in any FCPA enforcement action that may arise.

So what does this mean for your company?  In the short-term, you should conduct an immediate self-assessment to check foreign transactions for both export violations and FCPA violations.  It is common for a company lacking in FCPA internal controls to also be lacking in effective export controls and vice versa.  (You also need to have legal counsel carefully review all of the responsive subpoena documents for possible export and/or FCPA violations.)  In the long-term, your company must become more vigilant with respect to FCPA issues.  Your company’s overall compliance program must address anti-corruption and anti-bribery programs, just as company contracts with foreign entities or with respect to export-related operations should contain standard provisions requiring FCPA compliance.

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Marijuana Regulatory Update: FDA Concludes CBD Products Are Not Dietary Supplements

June 17th, 2015

In its recently published “FDA and Marijuana: Questions and Answers,” the U.S. Food and Drug Administration (FDA) announced that products containing cannabidiol (CBD), a non-narcotic component of Cannabis sativa, cannot be marketed as dietary supplements because CBD is the subject of an FDA regulated clinical investigation. FDA’s conclusion could be problematic for the growing number of companies marketing and distributing cannabis-based products in states that have legalized marijuana. If these companies continue to market products containing CBD as dietary supplements, FDA could launch enforcement actions against them based upon the allegation that they are selling unapproved new drugs.

How is CBD regulated?

The entire Cannabis plant is listed as a Schedule 1 substance by the Drug Enforcement Administration’s Office of Diversion Control, making trade of any component of the plant illegal in nearly all circumstances under federal law. However, twenty-three states and the District of Columbia have passed laws allowing the use of medical marijuana within their borders. Additionally, voters in four states—Alaska, Colorado, Oregon, and Washington—and the District of Columbia have passed initiatives allowing recreational use of marijuana within their borders. These laws have created a market for an entirely new industry of products containing cannabis-derived substances including foods and dietary supplements. Although FDA has remained largely silent on how products containing cannabis-derived substances are regulated under federal law, it has recently published its policy that products containing CBD cannot be marketed as dietary supplements.

What is a dietary supplement?

Dietary supplements are defined and regulated pursuant to the federal Food, Drug, and Cosmetic Act (FDCA) (21 USC § 321(ff)) as a type of food product intended to supplement the diet that contains one or more dietary ingredients. Dietary ingredients include vitamins, minerals, herbs, botanicals, amino acids, concentrates, metabolites, constituents, and extracts.

To be lawfully marketed as a dietary supplement under the FDCA, a product must essentially meet four criteria: the product must (1) be intended to be ingested orally, (2) not be represented for use a conventional food or sole item of a meal or diet, (3) be labeled as a dietary supplement, and (4) contain one or more compliant dietary ingredients.

The FDCA, along with its related regulations, dictate what constitutes a compliant dietary ingredient that can lawfully be included in the formula of a dietary supplement. We will focus here on one such provision of the FDCA, 21 USC § 321(ff)(3)(B)(ii).

21 USC § 321(ff)(3)(B)(ii)

Many vitamins, minerals, herb, botanicals, and other similar articles are permissible dietary ingredients under the FDCA. However, the FDCA prohibits the use in dietary supplements of certain articles that are the subject of research for pharmaceutical uses. Specifically, the FDCA states that dietary supplements cannot contain:

an article authorized for investigation as a new drug, antibiotic, or biological for which substantial clinical investigations have been instituted and for which the existence of such investigations has been made public, which was not before such approval, certification, licensing, or authorization marketed as a dietary supplement or as a food unless the Secretary, in the Secretary’s discretion, has issued a regulation, after notice and comment, finding that the article would be lawful under this chapter. (21 USC § 321(ff)(3)(B)(ii).)

This provision prohibits articles studied under an investigational new drug application (IND) from use in dietary supplements if those articles were not marketed as part of a dietary supplement or food prior to the start of the study or research. In order to bring a new pharmaceutical to market in the United States, the sponsor of the pharmaceutical product must go through FDA’s IND process. Once a sponsor’s IND is approved by FDA, the sponsor can begin clinical trials into the safety and efficacy of that drug product for human beings for a specific intended use. Most approved INDs are publically available on www.ClinicalTrials.gov.

The Pyridoxamine Example

Applying this FDCA prohibition, in 2009, FDA responded to a citizen petition filed on behalf of a pharmaceutical company studying the effects of pyridoxamine, a type of vitamin B6, for diabetic nephropathy. (Read FDA’s 2009 response here.) FDA determined that products containing pyridoxamine could not be dietary supplements lawfully marketed within the FDCA because pyridoxamine was authorized for investigation as a new drug pursuant to a publically announced clinical trial. The FDA concluded that no independent, verifiable evidence existed showing pyridoxamine had been marketed as a food or dietary supplement prior to implementation of the clinical investigation into the article. Consequently, companies marketing pyridoxamine supplements could no longer lawfully do so. These companies were forced to remove those products from the market or risk enforcement action by FDA.

In FDA’s response to the citizen petition, the agency further clarified the types of articles included under 21 USC § 321(ff)(3)(B)(ii). FDA determined that an “article authorized for investigation as a new drug” includes both the active ingredient, like pyridoxamine hydrocholoride, as well as the active moiety, like pyridoxamine. (See FDA’s definition of ‘active moiety’ here.) FDA used its conclusion in this pyridoxamine case as an example in its 2011 guidance document, “Draft Guidance for Industry: Dietary Supplements: New Dietary Ingredient Notifications and Related Issues,” which can be read in full by clicking here, stating:

[A]ssume that Substance A, which is a constituent of a plant and has never been marketed as an article of food or as a dietary supplement, is a botanical dietary ingredient under section 201(ff)(1)(C) of the FD&C Act. A drug company is studying a salt of Substance A, “Substance A hydrochloride,” as an investigational new drug under an IND. In this situation, the relevant article for purposes of whether Substance A can be used in a dietary supplement is not Substance A hydrochloride, but Substance A itself, because Substance A is the active moiety that is being studied for its possible therapeutic action. Any compound that delivers Substance A is excluded from being used in a dietary supplement.

FDA’s determination with regard to pyridoxamine expands the number and types of articles that cannot be included as compliant dietary ingredients in dietary supplement formulations.

Why did FDA conclude products containing CBD are not dietary supplements?

FDA’s recently released Q&A page states:

Based on available evidence, FDA has concluded that cannabidiol products are excluded from the dietary supplement definition under section 201(ff)(3)(B)(ii) of the FD&C Act. Under that provision, if a substance (such as cannabidiol) has been authorized for investigation as a new drug for which substantial clinical investigations have been instituted and for which the existence of such investigations has been made public, then products containing that substance are outside the definition of a dietary supplement. There is an exception if the substance was “marketed as” a dietary supplement or as a conventional food before the new drug investigations were authorized; however, based on available evidence, FDA has concluded that this is not the case for cannabidiol.

It is likely that FDA reached this conclusion because GW Pharmaceuticals began a clinical trial in 2013 under an FDA-approved IND to study a pure, synthetic form of CBD for the treatment of childhood epilepsy. FDA has concluded that without evidence of prior marketing of CBD as part of a supplement or food product, GW Pharmaceuticals’ IND application prohibits any manufacturer from marketing a dietary supplement with CBD as an ingredient. However, FDA does indicate that it will consider any evidence submitted to demonstrate that prior to the IND filing, the ingredient was marketed as part of a supplement or food product. FDA’s recent announcement states “[i]nterested parties may present the agency with any evidence that they think has bearing on this issue.”

What does this mean for dietary supplements containing CBD?

Uncertainty surrounds the future of dietary supplements containing CBD. FDA’s current policy is clear in that products containing CBD cannot be marketed as dietary supplements. However, that policy could change should an entity or individual submit evidence to FDA that CBD has been marketed as part of a food or dietary supplement prior to the start of GW Pharmaceutical’s clinical trial in 2013.

Alternatively, if a dietary supplement manufacturer were to demonstrate that the CBD that is the subject of GW Pharmaceutical’s clinical trial is somehow different from the CBD that is utilized in the marketed supplements, the prohibition of 21 USC § 321(ff)(3)(B)(ii) may not apply. (Other new dietary ingredient regulations and policies would likely then apply but that will be the subject of a future post.) Given FDA’s determination in the pyridoxamine this case would be very difficult position to take as the agency’s current policy would exclude any compound that delivers CBD, including CBD and any derivatives of CBD.

Will FDA use the CBD determination as a basis for enforcement actions?

In the agency’s “FDA and Marijuana: Questions and Answers,” the following question and answer are offered:

  1. Will FDA take enforcement action regarding cannabidiol products that are marketed as dietary supplements?
  1. When a product is in violation of the FD&C Act, FDA considers many factors in deciding whether or not to initiate an enforcement action. Those factors include, among other things, agency resources and the threat to the public health. FDA also may consult with its federal and state partners in making decisions about whether to initiate a federal enforcement action.

Without providing a clear answer to the question, FDA has indicated that it is preserving its authority to take enforcement action against companies that market dietary supplements containing CBD.

In February of 2015, FDA issued warning letters to six companies marketing products claiming to contain CBD (interestingly, FDA notes that some of these were products were tested and shown to not actually contain CBD). However, the violations cited in these letters related primarily to the claims made about the products and the intended uses these companies ascribed to the various CBD products. These warning letters did not cite 21 USC § 321(ff)(3)(B)(ii) as a reason for issuance of the letters.

An FDA warning letter is “issued only for violations of regulatory significance,” which are “violations that may lead to enforcement action” if not corrected swiftly. (FDA Regulatory Procedures Manual 4-1.) Recipients of warning letters are typically granted 10-15 days to correct violations and respond to FDA. Failure to correct such violations or respond to the agency could result in more sever enforcement actions, like injunctions, seizures, and other penalties.

FDA has not yet utilized enforcement mechanisms applying this policy prohibiting CBD in dietary supplements based on 21 USC § 321(ff)(3)(B)(ii). Further, the agency has yet to determine if it will utilize enforcement mechanisms as the market for different products containing marijuana and marijuana derivatives continues to expand. If adverse events stemming from these types of products are reported directly to FDA or through state health agencies, FDA could take action against companies distributing and manufacturing these products. Likewise, if companies or institutions engaged in clinical investigations engage in market discipline, petitioning FDA to actively prohibit the use of CBD in supplements pursuant to  21 USC § 321(ff)(3)(B)(ii), the manufacture and distribution of these types of products will be negatively affected, like the case pyridoxamine in 2009.

Companies in the growing marijuana products industry will need to stay abreast of these federal regulatory issues and aware of possible enforcement actions to prepare for and, hopefully, avoid adverse consequences.  For more information regarding how the FDA regulates the use of CBD in dietary supplements and other products, please contact us at contact@fuerstlaw.com.

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