This article is part one of a two part series. In the second part, forthcoming, I discuss in detail the differing roles and level of valuation expertise of the investment banker compared to the independent valuation analyst for M&A transactions and litigation.

Introduction

In M&A litigation, the parties to the lawsuit each typically retain an independent valuation analyst (“valuation analyst”), rather than an investment banker, to estimate the fair value of the target company stock and to provide expert testimony.

As illustrated by recent Delaware Chancery Court and Delaware Supreme Court decisions on shareholder appraisal rights, merger and acquisition (“M&A”) disputes often include elements of breach of fiduciary duty by the target company’s board of directors or its special committee. Such alleged breaches often relate to the board’s oversight of the M&A deal process. These disputes may also involve allegations of proxy violations related to inadequate disclosure of material information that investors should have been provided in order to make an informed decision when casting their votes.

This discussion includes specific court cases and focuses on the following topics:

• Events that can lead to M&A disputes and examples of when a court decided that the M&A deal process was flawed
• Examples of when the investment bank’s fee structure led to a flawed deal process
• The use of management-prepared financial projections and examples of when these financial projections were accepted or rejected by a court

Events That May Lead to M&A Disputes

Some observers believe that a robust pre-signing market check may result in a higher final bid, and believe that a post-signing, go-shop period yields little transaction pricing benefit.

This is because any new bidder in a go-shop period has a ticking clock to submit a higher bid. That new bidder often lacks the necessary time to conduct the same level of due diligence that was conducted by earlier bidders.

Deal processes may be considered flawed if there appears to be too much reliance on a go-shop period—rather than the pre-signing period—to extract the highest price. This was one area of dispute in In re Appraisal of Dell Inc.[1]

Legal counsel to shareholders sometimes find it challenging to identify flaws in the deal process prior to the litigation discovery procedure. This is because proxy statements do not always provide sufficient detail about the deal process.

To avert disputes, sometimes proxies provide a detailed timeline of all discussions. The level of disclosure may be an area of contention between counsel who represent entities involved in a transaction and counsel who represent shareholder plaintiffs.

The following discussion summarizes several judicial decisions where the court determined that the M&A deal process was flawed.

Blueblade Capital Opportunities LLC v. Norcraft Companies, Inc.[2]

• The deal price was previously rejected as too low by the target’s board of directors.
• The chief executive officer seemed more interested in obtaining post-merger employment and in receiving payment under a tax receivable agreement than in securing the highest price for the shareholders.
• There was no robust pre-signing market check. No other pre-signing bidders were sought by the board of directors or by the board’s financial adviser.
• The stock was thinly traded, which made the efficient (or semi-efficient) market theory less relevant.
• The go-shop period was fruitless due to the existence of a sizable break-up fee, an unlimited right to match any higher offer, and the right of the suitor to begin tendering shares during the go-shop period.

City of Miami General Employees’ and Sanitation Employees’ Retirement Trust v. C&J Energy Services, Inc.[3]

• C&J Energy Services, Inc. (“C&J”) did not engage in any market check prior to agreeing to merge with Nabors Industries Ltd.
• The C&J board of directors delegated the primary responsibility for negotiations to its chief executive officer.
• No special committee was formed, and four members of the C&J board of directors were guaranteed five-year terms with the merged entity.
• The court enjoined the shareholder vote for another 30 days to further attempt to solicit interest from other bidders. This judicial order was premised on the lack of other bidders emerging during the five months following announcement of the deal. There was no judicial ruling on the fairness of the merger price.

Dunmire v. Farmers & Merchants Bancorp of Western Pennsylvania, Inc.[4]

• The merger was not the product of a robust deal process. The transaction was undertaken at the insistence of the Snyder family, which controlled both Farmers & Merchants Bancorp of Western Pennsylvania, Inc. (“F&M”) and NexTier Bank N.A. (“NexTier”) and stood on both sides of the transaction. No other bidders for F&M were considered.
• The transaction was not conditioned on obtaining the approval of a majority of the minority of F&M stockholders.
• Two of the three members of the special committee had business ties with the Snyders.
• F&M engaged Ambassador Financial Group as its financial adviser, but only to “render an opinion as to the fairness of the exchange ratio that would be proposed by [FinPro] to the NexTier board.”

Flawed Deal Process and Investment Banker Fee Structure

Sometimes the terms of the investment banker compensation can give rise to a flawed deal process. In an article published in the Harvard Law Review, Guhan Subramanian cites one example of a properly structured fee arrangement and one example of an improperly structured fee arrangement for a target company’s investment banker.

In the properly structured fee arrangement example, Subramanian cites Merrill Lynch serving as financial adviser to the Sports Authority, Inc., during its leveraged buyout.[5] The fee was the sum of 0.50 percent of the purchase price up to a price of $36.00 per share and an additional 2 percent above $36.00 per share. The acquirer initially offered $34.00 per share, but Merrill Lynch then negotiated a higher price of $37.25 per share, thereby collecting 2 percent of the incremental $1.25 per share.

In the improperly structured fee arrangement example, Subramanian cites Evercore serving as financial adviser to Dell Inc. during its leveraged buyout. Evercore received a monthly retainer fee of $400,000, a flat fee of $1.5 million for the fairness opinion, and a fee equal to 0.75 percent of the difference between the initial bid during the pre-signing phase and any subsequent higher bid Evercore could obtain during the go-shop period. This structure gave Evercore the incentive, if it opted to do so, to minimize the negotiated price during the pre-signing phase so as to widen the difference between the pre-signing price and any higher price during the go-shop period, upon which the 0.75 percent contingency fee was based.

Use of Management-Prepared Financial Projections

It is generally accepted that the target company’s management is in the best position to prepare company financial projections. This is particularly true if the target company regularly prepares financial projections during its annual planning process. A special committee, formed for the purpose of overseeing the deal process, may amend the financial projections prepared by company management. This may occur when (1) the special committee concludes that the financial projections are either optimistic or pessimistic or (2) multiple sets of financial projections are prepared that are contingent on various scenarios.

There may be occasions when the company financial projections are too optimistic, which can cause a rift in negotiations. In these situations, revisions to the financial projection may be made by the special committee or by the investment banker at the direction of the special committee.

Alternatively, there may be occasions when the target company’s financial projections are too downward-biased. There may be parties who are more focused on closing the deal expeditiously without too much regard for price. Examples of when parties are driven to complete the deal may include (1) a chief executive officer who has negotiated a higher pay package during the deal process to remain with the merged company or (2) an executive of the suitor who also has a board seat with the target company or a close relationship with some of the target’s executives.

The investment bank serving as financial adviser to a target company’s board of directors may assist in making or revising financial projections. This may occur when the target company is not well-versed in making projections. The target company management may provide financial projections based on generally accepted accounting principles (“GAAP”). The banker may convert the GAAP-based net income projections to cash flow projections in order to develop a discounted cash flow valuation. When provided with multiple financial projections, the investment banker or valuation analyst rendering the fairness opinion may apply judgment in determining the reliability of each financial projection.

The following discussion summarizes several judicial decisions where financial projections were an issue in the dispute.

Judicial Rejection of Management Financial Projections

• In re Appraisal of PetSmart Inc.—Vice Chancellor Slights of the Delaware Chancery Court noted that financial projections in prior cases were found to be unreliable when “the company’s use of such projections was unprecedented, where the projections were created in anticipation of litigation, where the projections were created for the purpose of obtaining benefits outside the company’s ordinary course business, where the projections were inconsistent with a corporation’s recent performance, or where the company had a poor history of meetings its projections.”[6]

The Chancery Court also observed that the company management had no history of creating financial projections beyond short-term earnings guidance.

Judicial Acceptance of Management Financial Projections

• Cede & Co. v. Technicolor, Inc.—Chancellor Chandler of the Chancery Court accepted the company financial projections and rejected the petitioner expert’s alteration of those projections, writing that, “When management projections are made in the ordinary course of business, they are generally deemed reliable.”[7]

The judicial opinion also noted that the subject company management had a very good track record of meeting earnings guidance (i.e., financial projections).

Judicial Rejection of Third-Party Financial Projections

• In re Radiology Assocs., Inc.—The Chancery Court rejected the petitioners’ valuation analysis because the prospective financial inputs were too speculative. The Chancery Court reached this conclusion due to the fact that the company management neither created the financial projections nor gave any guidance to the third party that created the projections.[8]\

Judicial Acceptance of Second Set of Projections

• Delaware Open MRI Radiology v. Kessler—Vice Chancellor Strine of the Chancery Court opined about the fairness opinion’s exclusion of financial projections that were based on the company’s expansion plans: “In essence, when the court determines that the company’s business plan as of the merger included specific expansion plans or changes in strategy, those are corporate opportunities that must be considered part of the firm’s value”[9] as a going concern (also citing Cede & Co. v. Technicolor, 684 A.2d 289 at 298-99, and Montgomery Cellular Holding Co., Inc. v. Dobler, 880 A.2d 206 at 222 (Del. 2005)).
• In re United States Cellular Operating Company—Vice Chancellor Parsons of the Chancery Court concluded that financial projections should include reasonably anticipated capital expenditures, stating that “This is not a situation where projecting capital expenditures to account for conversion to 2.5G and 3G is speculative. Industry reports included such expenditures and the Companies themselves ‘anticipated’ it. Therefore, Harris should have incorporated the effects of this expected capital improvement in his projections.”[10]

This decision notes that the company management had no prior experience with preparing long-term financial projections. The fairness opinion was rendered by a firm that worked alongside management developing a set of projections.

Judicial Rejection of Second Set of Projections

• In re PLX Technology Inc. Shareholders Litigation—Vice Chancellor Laster of the Chancery Court rejected the use of a second set of financial projections that were based on growth initiatives. The Chancery Court reached this decision despite the financial projections having been prepared in the ordinary course of business.

In reaching its decision, the Chancery Court reasoned that, “to achieve even higher growth rates, particularly in 2017 and 2018, the December 2013 Projections contemplated a third layer of future revenue. It depended on PLX introducing a new line of ‘outside the box’ products that would use the ExpressFabric technology to connect components located in different computers, such as the multiple servers in a server rack. To succeed with this line of business, PLX would have to enter the hardware market and compete with incumbent players like Cisco.”[11]

[1] In re Appraisal of Dell Inc., C.A. No. 9322-VCL, 2016 WL 3186538 at *38-49 (Del. Ch. May 31, 2016). Numerous academic papers were cited to support the credence that the go-shop period following the pre-signing phase rarely results in topping bids. In general, most transaction price competition occurs before the deal is accepted in principle. One footnote in the Dell opinion cited the following quote from M&A attorney Martin Lipton during an interview of Mr. Lipton by one of the expert witnesses in this matter, Professor Guhan Subramanian: “The ability to bring somebody into a situation [pre-signing phase] is far more important than the extra dollar a share at the back end [go-shop phase]. At the front end, you’re probably talking about 50%. At the back end, you’re talking about 1 or 2 percent.”

[2] C.A. No. 11184-VCS, 2018 WL 3602940 (Del. Ch. July 27, 2018), opinion by Vice Chancellor Slights; synopsis from Jill B. Louis and Rashida Stevens, “Chancery Court Cites Flawed Process in its Resort to Traditional Valuation Methodology,” The National Law Review (September 6, 2018).

[3] C.A. No. 9980-CB, 2018 WL 508583 (Del. Ch. Jan. 23, 2018); synopsis from Yaron Nili, “Delaware Court Preliminarily Enjoins Merger Due to Flawed Sales Process,” Harvard Law School Forum on Corporate Governance (December 7, 2014).

[4] C.A. No. 10589-CB, 2016 WL 6651411 (Del. Ch. Nov. 10, 2016).

[5] Guhan Subramanian, “Deal Process in Management Buyouts,” Harvard Law Review (December 2016): 41.

[6] In re Appraisal of PetSmart, Inc., Consol. C.A. No. 10782-VCS, 2017 WL 2303599 at *32 (Del. Ch. May 26, 2017).

[7] Cede & Co. v. Technicolor, Inc., C.A. No. 7129, 2002 WL 23700218 at *7 (Del Ch. (Dec. 31, 2003, revised July 9, 2004), citing In re Radiology Assocs., Inc. Litig., 611 A.2d 485, 490-91 (Del. Ch. 1991).

[8] In re Radiology Assocs., Inc. Litig., 611 A.2d 485, 490-91 (Del. Ch. 1991).

[9] Delaware Open MRI Radiology v. Kessler, 898 A.2d 290 (Del. Ch. 2006), endnote no. 51.

[10] In re U.S. Cellular Operating Co., No. Civ.A 18696-NC, 2005 WL 43994 at *37 (Del. Ch. Jan. 6, 2005).

[11] In re PLX Technology Inc. Stockholders Litigation, C.A. No. 9880-VCL, 2018 WL 5018353 at *52 (Del. Ch. Oct. 16, 2018).

The substantial powers of the Consumer Financial Protection Bureau (CFPB) have recently received renewed attention following the U.S. Supreme Court’s decision in Seila Law LLC v. CFPB.[1] That case held that the CFPB was unconstitutionally structured and that the director is removable at will by the President.[2] In making that determination, the Court discussed the CFPB’s authority to use “the coercive power of the state to bear on millions of private citizens and businesses, imposing potentially billion-dollar penalties through administrative adjudications and civil actions.”[3] That authority includes the enforcement of a broad prohibition on unfair, deceptive, or abusive acts or practices (UDAAP) in consumer finance transactions.[4] Although the Court reformed the President’s removal authority, the CFPB retains that immense power over vast segments of the economy.

One check Congress placed on the CFPB is a statute of limitations on the CFPB’s UDAAP authority.[5] That statute of limitations runs from three years “after the date of discovery of the violation to which an action relates”[6] (the CFPB SoL). The CFPB has repeatedly sought to limit this check on its power, including by arguing in court that statutes of limitations do not apply to administrative actions,[7] by narrowly interpreting the CFPB SoL in its own administrative decisions,[8] and by arguing for that narrow interpretation in federal court.[9]

This article focuses on the discovery rule in the CFPB SoL. It discusses issues that arise when applying the discovery rule to government actors, explores the potential discovery rule standards, reviews the CFPB’s preferred standard, and concludes that the best reading of the CFPB SoL would apply an inquiry notice standard.

I. Concerns When Applying Discovery Rule to Government Agencies

Applying a statute of limitations and the discovery rule to the government raises statutory interpretation questions and policy concerns not generally present in private litigation. In SEC v. Gabelli, the Supreme Court recognized the challenge of determining when the government knew or should have known of a violation.[10] Questions that arise include (1) who is the relevant government actor when agencies have hundreds of employees, dozens of offices, and multiple layers of leadership; (2) is knowledge of one agency or person attributed to the entire government; (3) what role do agency priorities and resource constraints play in determining when a reasonably diligent agency plaintiff would have discovered a violation; and (4) what discovery process should courts permit for defendants with government plaintiffs and what privileges belong to the government, including law enforcement and deliberative process privileges?[11]

Additionally, unlike an individual victim who relies on apparent injury to learn of a wrong—and does not “live in a state of constant investigation”—an enforcement agency’s “very purpose is to root out” misconduct by regulated entities.[12] Enforcement agencies also have “many legal tools at hand to aid in that pursuit.”[13] Moreover, government agencies seeking civil penalties pursue different relief than private plaintiffs who seek recompense.[14]

The Supreme Court’s recent emphasis of the CFPB’s exceptional coercive power demonstrates the significance of the CFPB’s investigative and punitive authorities.[15] As a result, there is a strong argument that the CFPB SoL should apply relatively broadly. However, the Supreme Court has also, at times, strictly construed statutes of limitations in favor of the government, which introduces tension in the Supreme Court’s jurisprudence on the application of statutes of limitations to government actions.[16]

These considerations serve as a framework for the remaining discussion of the various discovery rule standards and their application to government enforcement actions.

II. The Discovery Rule: Inquiry Notice and Actual or Constructive Notice Standards

“Discovery” has multiple potential meanings, and there are three discovery rule standards: actual knowledge, actual or constructive knowledge, and inquiry notice.

In ordinary usage, “discovery” refers only to actual knowledge and may, in unusual circumstances, refer to only actual knowledge in the context of statutes of limitations.[17] Historically, however, when used in the context of statutes of limitations in litigation between private parties, “discovery” refers to both actual and constructive knowledge.[18] For the actual or constructive knowledge standard, the limitations period begins when the plaintiff obtained actual knowledge or should have obtained knowledge of the facts underlying the claim, which may be sometime after an investigation into the existence of a potential claim begins.[19]

Under the inquiry notice standard, the statute of limitations runs from the date the litigant obtains actual knowledge of the facts giving rise to the action or notice of facts, which in the exercise of reasonable diligence, would have led to actual knowledge.[20] For this standard, notice of facts which ought to trigger an investigation are sufficient to trigger the limitations period, even if the facts underlying the claim are not discovered until some future time.

A. Inquiry Notice Standard

Prior to Gabelli, courts in some circuits applied the inquiry notice standard to enforcement actions for penalties for fraud. For example, in SEC v. Koenig, the Seventh Circuit held that press releases—although not describing the particulars of the conduct giving rise to the claim—were sufficient to put the SEC on notice of the need for inquiry.[21] The court also noted that under some circumstances, a public announcement may not be needed to begin the running of the statute of limitations, such as if the information could already have been found by reasonable inquiry.[22]

SEC v. Fisher[23] also discussed the inquiry notice standard. In Fisher, the SEC filed a complaint on August 9, 2007, alleging violations of securities laws concerning false and misleading financial statements made to investors between 1999 and 2002 about a company’s financial performance related to a performance-based rate plan.[24]

On July 18 and 19, 2002, the company issued a press release disclosing that allegations had been made concerning potential impropriety in connection with the company’s accounting related to the performance-based rate plan.[25] That release indicated that there would be an independent internal investigation.[26] The company released additional information publicly throughout July.[27] On August 14, 2002, the company filed documents with the SEC indicating that prior filings from 2001 were not accurate. Multiple private plaintiffs filed class actions between July and October 2002, and in October the company issued a press release outlining the results of the independent investigation.[28]

The SEC argued that the statute of limitations did not begin to run until October 2002 when the company released the results of the internal investigation because, until then, the SEC did not know all of the facts necessary to file suit.

The court rejected that argument. The court discussed that, if applicable, the discovery rule applied based on when the SEC had learned enough facts to enable it, through further investigation, to sue within the limitations period. Under these facts, that date was July 19, 2002, because on July 18 and 19, 2002, the company issued press releases announcing sufficient facts to “put the Commission on notice that a violation may have occurred.”[30]

The court reasoned that the discovery rule requires a plaintiff to engage in “further investigation” after receiving notice necessary to “incite the [plaintiff] to investigate” and enable the plaintiff to complete the investigation within the limitations period.[31] It does not require the plaintiff to be aware of all facts necessary to bring suit[32]—that is, the investigation occurs “after the limitations clock starts.”[33] The court reasoned that this rule is particularly apt for an agency that has the “ability to conduct an effective investigation.”[34]

As a result, if a court applies the inquiry notice standard to the CFPB SoL, the limitations period begins when the CFPB has actual or constructive knowledge of facts raising sufficient suspicion to cause a reasonable person to investigate to protect his or her legal rights, including public statements regarding the conduct.

B. Actual or Constructive Knowledge: In Context of Private Litigation, Merck & Co. Suggests Inquiry Notice Does Not Apply to Statute Referring to “Discovery”

In Merck & Co., investors sued the drug company for securities fraud, claiming Merck knowingly misrepresented the risks of heart attacks associated with the use of Vioxx.[35] The claims were subject to a statute of limitations from two years “after the discovery of the facts constituting the violation.”[36] The district court had held that certain public studies and statements by the company and the FDA had placed the plaintiffs on inquiry notice “to look further,” thereby triggering the statute of limitations.[37] The Third Circuit reversed, reasoning that although those events constituted “storm warnings,” they “did not suggest much by way of scienter, and consequently did not put the plaintiffs on ‘inquiry notice’ requiring them to investigate more.”[38]

The Supreme Court affirmed under a different interpretation of the statute of limitations. The Court held that the term “discovery” in that statute refers both to the plaintiff’s actual discovery of certain facts, and to facts that a reasonably diligent plaintiff would have discovered, mentioning that courts of appeals “unanimously” agreed.[39]

However, the Court rejected Merck’s arguments, including that “inquiry notice” was sufficient to trigger the statute of limitations.[40] The Court reasoned that inquiry notice referred to a point where the facts would lead a reasonably diligent plaintiff to investigate further, but that this point was “not necessarily” when the plaintiff would already have discovered facts constituting the violation.[41] Yet, the statute referred to “discovery,” and nothing suggested the limitations period could begin sometime before discovery, such as when a reasonable plaintiff would have begun investigating.[42]

Although the Court rejected the inquiry notice standard, it acknowledged that inquiry notice standards “may be useful to the extent they identify a time when the facts would have prompted a reasonably diligent plaintiff to begin investigating.”[43]

Merck & Co provides persuasive statutory interpretation of the term “discovery” under a standard statute of limitations applicable to private parties.

III. Cases Interpreting “Discovery” in the CFPB SoL

Only a few district courts,[44] and no circuit courts, have applied the CFPB SoL, and applications have differed.[45] Importantly, some suggested that an inquiry notice standard may apply, but one required the CFPB to have actual or constructive knowledge of the facts constituting a violation.[46]

In Ocwen, the defendant argued that the three-year CFPB SoL period ran on April 20, 2014, and that the CFPB complaint alleged that Ocwen’s unlawful activity stopped in 2013.[47] The court determined that the date of discovery was the date when the CFPB “obtain[ed] actual knowledge of the facts giving rise to the action or notice of the facts, which in the exercise of reasonable diligence, would have led to actual knowledge.”[48] The complaint did not allege when the CFPB discovered those unlawful activities.[49] As a result, there was a question of fact as to when the limitations period ran.[50] The court denied a motion to dismiss without further discussion of what Ocwen would need to show to satisfy the discovery rule.[51]

Although Ocwen suggests an inquiry notice standard, it does apply that standard to facts. Similarly, NDG Financial[52] uses the same standard, but does not extrapolate on when discovery occurs.[53]

In Nationwide, the court applied an actual or constructive knowledge standard. There, the defendants argued that the statute of limitations began to run on March 3, 2012, when the CFPB received a consumer complaint about misleading marketing.[54] The CFPB filed a complaint related to deceptive marketing over three years later on May 11, 2015.[55] The court rejected the position that “the mere receipt of a consumer complaint can trigger the statute of limitations against [the] CFPB,” finding it “unsupported by authority and . . . unworkable.”[56] Instead, that consumer complaint at most put the CFPB on inquiry notice that it should begin investigating, but did “‘not automatically begin the running of the limitations period.’”[57] For the limitations period to begin to run, the CFPB must have “thereafter discovered or a reasonably diligent plaintiff would have discovered the facts constituting the violation.”[58] Nothing in the record suggested the CFPB “actually discovered the facts, or that a reasonably diligent plaintiff would have discovered the facts, in less than the two-plus months between March 3, 2012 and May 10, 2012.”[59] As a result, the action was not time-barred.[60]

Nationwide provides the most detailed analysis on the meaning of “discovery” in the CFPB SoL, largely relying on Merck & Co. However, in relying on Merck & Co., Nationwide did not address whether the standard applicable in a private right of action should apply identically to the CFPB.

As discussed above, the Supreme Court in Gabelli—citing to Merck & Co.—raised questions about how to apply the discovery rule in the context of a government action, remarking “we have never applied the discovery rule in this context, where the plaintiff is not a defrauded victim seeking recompense, but is instead the Government bringing an enforcement action for civil penalties.”[61] Although the CFPB SoL expressly includes a discovery rule, the Court’s questions in Gabelli suggest a different application may be warranted, especially because the agency may seek civil penalties.[62]

IV. Integrity Advance: A CFPB Administrative Law Judge Rules That the CFPB SoL Is Not Triggered unless the CFPB Had Actual Knowledge

A CFPB Administrative Law Judge (ALJ) decision in Integrity Advance[63] went even further, requiring the CFPB to have actual knowledge to trigger the limitations period.[64] The ALJ first addressed Merck & Co., concluding that it did not discuss “or reasonably extend to the context of a case involving a government agency plaintiff.”[65]

The ALJ then acknowledged that in Gabelli, the Supreme Court “expressed concern” about defendants being exposed to government enforcement actions for an uncertain period and had noted difficulties in applying the discovery rule to government plaintiffs.[66] The ALJ then noted that the CFPB SoL included the word “discovery” but not the phrase “or should have known,” implying that Congress did not intend for constructive discovery to be sufficient. As a result, the ALJ concluded that an actual notice standard applied.[67]

As discussed below, an actual notice standard fails to sufficiently address concerns raised by the Supreme Court regarding the application of discovery standards to government agencies.

V. Applying the Inquiry Notice Standard to the CFPB SoL Creates a Workable Standard That Satisfies the Purpose of the Statute and Accounts for the Government’s Authority to Seek Penalties

The best reading of the CFPB SoL would interpret the statute as imposing an inquiry notice standard on CFPB UDAAP claims.

Generally, an actual or constructive knowledge standard applies where a statute of limitations imposes a discovery rule,[68] but there are occasions when that standard is not appropriate.[69] The CFPB’s own ALJ decision concluded that the CFPB SoL presents such a circumstance due to the difficulties the standard would present in the context of government enforcement actions.[70]

An actual or constructive knowledge standard would incorporate all of the concerns identified by the Gabelli court. Most importantly, an actual or constructive notice standard would not create a “fixed date when exposure to specified government enforcement efforts ends,” thereby “advancing ‘the basic policies of all limitations provisions: repose, elimination of stale claims, and certainty about a plaintiff’s opportunity for recovery and a defendant’s potential liabilities.’”[71]

Much like in Gabelli, defendants would be “exposed to Government enforcement action not only for [three years] after their misdeeds, but for an additional uncertain period into the future. Repose would hinge on speculation about what the government knew, when it knew it, and when it should have known it.”[72] Such a rule “would thwart the basic objective of repose underlying the very notion of the limitations period.”[73]

Even if the actual or constructive knowledge standard achieved the purpose of the discovery rule, it would still be unworkable in the context of a government agency plaintiff.[74] Moreover, the difficulty courts would face in determining when an agency should have discovered sufficient facts is far greater for a private person facing potential litigation. That potential defendant does not have the benefit of compelled discovery of the agency’s knowledge and internal processes until an action is filed, if that material is even discoverable.

Only the inquiry notice standard addresses these issues. As a result, it is the only discovery rule standard that serves the purposes of a statute of limitations in the context of enforcement actions.

An actual knowledge standard presents many of the same challenges as an actual and constructive knowledge standard. A court must still determine when an agency had knowledge, which would include delving into which government official must have the appropriate level of knowledge. The knowledge required would involve analysis of all aspects of the claim, rather than mere awareness of the claim. Most importantly, there would be no fixed date after which a defendant would no longer be exposed to government enforcement action. Instead, that date could be continuously extended until the government is sufficiently aware of all the facts necessary to file a claim. The government could even deliberately set aside certain investigations before learning of sufficient facts to delay the running of the limitations period. Even if a court were to consider such actions as bad faith and estop the government from raising limitations as a defense, differentiating bad faith and questions of resource allocation within an agency would raise difficult questions for courts.

An inquiry notice standard addresses many of those concerns while also accounting for the punitive enforcement role of the CFPB. The limitations period would generally be easily identifiable by the defendant, the government, and the court. Public statements and news articles alerting the agency, the company, and the public to potential wrongdoing are in the public record.[75] Under CFPB procedures, both the CFPB and companies are made aware of consumer complaints filed with the CFPB, and the CFPB incorporates those complaints into a database.[76] Similarly, exam findings are issued to companies and provide a clear line at least for when the CFPB was on notice of a potential issue. As a result, the inquiry notice standard succeeds where the other standards fail—it satisfies the purposes of the Congressionally mandated statute of limitations by providing a workable standard and imposing a fixed limitations period.

[1] Seila Law LLC v. CFPB, 140 S. Ct. 2183 (June 29, 2020).

[2] Id. at 2192.

[3] Id. at 2200–01.

[4] Id. at 2000; 12 U.S.C. § 5536.

[5] 12 U.S.C. § 5564(g).

[6] Id. (“Except as otherwise permitted by law or equity, no action may be brought under [the Consumer Financial Protection Act] more than 3 years after the date of discovery of the violation to which an action relates.”)

[7] PHH Corp. v. CFPB, 839 F.3d 1 (D.C. Cir. 2016).

[8] See e.g., CFPB v. Integrity Advance, LLC, CFPB No. 2015-CFPB-0029, p. 12 (Jan. 24, 2020).

[9] See e.g., CFPB v. Nationwide Biweekly Administration, 2017 WL 3948396 (N.D. Cal. 2017).

[10] Gabelli v. SEC, 568 U.S. 442, 452–53 (2013) (discussing discovery rule standard in Merck & Co. v. Reynolds, 559 U.S. 633 (2010), discussed infra Section II.B).

[11] Id. (noting that where Congress has mandated that the discovery rule applies to the government, it has frequently included other provisions specifically providing for its application, such as identifying the official whose knowledge is relevant).

[12] Id. at 450–51.

[13] Id. at 451 (identifying range of investigative tools including subpoenaing documents and witnesses).

[14] Id.; see also 3M Co. v. Browner, 17 F.3d 1453 (D.C. Cir. 1994) (doubting whether conducting administrative or judicial hearings to determine whether an agency’s enforcement branch adequately lived up to its responsibilities would be a workable or sensible method of administering any statute of limitations).

[15] Seila Law, 140 S. Ct. at 2193; see also 12 U.S.C. §§ 5562–5564.

[16] See e.g., BP America Production Co. v. Burton, 549 U.S. 84 (2006); Badaracco v. C.I.R., 464 U.S. 386, 391–92 (1984).

[17] For example, where a statute had two statutes of limitations drafted at different times, and the first referred to “discovery . . . or after such discovery should have been made,” and the second referred only to “discovery,” the absence of the phrase “or after such discovery should have been made” in the latter arguably showed congressional intent to refer only to actual knowledge and not constructive knowledge. Merck & Co. v. Reynolds, 559 U.S. 663 (2010) (Scalia, J. concurring).

[18] Merck & Co. v. Reynolds, 559 U.S. 663 (2010).

[19] Id.

[20] Fujisawa Pharmaceutical Co. Ltd. v. Kapoor, 155 F.3d 1332 (7th Cir. 1997) (Posner, J.) (explaining that inquiry notice standard applied “not when the fraud occurs, and not when the fraud is discovered, but when (often between the date of occurrence and the date of the discovery of the fraud) the plaintiff learns, or should have learned through the exercise of ordinary diligence in the protection of one’s legal rights, enough facts to enable him by such further investigation as the facts would induce a reasonable person to sue within [the limitations period].”) abrogated by Gabelli v. SEC, 568 U.S. 442 (2013).

[21] SEC v. Koenig, 557 F.3d 736, 739–40 (7th Cir. 2009) abrogated by Gabelli v. SEC, 568 U.S. 442 (2013).

[22] Id. at 740.

[23] SEC v. Fisher, 2018 WL 2062699 (N.D. Ill. 2008) (relying on Fujisawa Pharmaceutical Co. Ltd. v. Kapoor, 155 F.3d 1332 (7th Cir. 1997) (Posner, J.) abrogated by Gabelli v. SEC, 568 U.S. 442 (2013)).

[24] Id. at *1.

[25] Id.

[26] Id.

[27] Id.

[28] Id. at *1–*2, *6.

[29] SEC v. Fisher, 2018 WL 2062699, *5 (N.D. Ill. 2008) (discussing that general rule for private plaintiffs depends as “ill-fitting where, as here, the plaintiff is a federal agency like the SEC.”).

[30] Id. (reviewing specific facts disclosed at that time).

[31] Id.

[32] Id.

[33] Id. at *6.

[34] Id.

[35] Merck & Co., 559 U.S. at 637.

[36] Id. at 648 (citing 28 U.S.C. § 1658).

[37] Id. at 642–43.

[38] Id. (discussing that scienter is necessary element of securities fraud action).

[39] Id. at 644, 647.

[40] Id. at 651.

[41] Merck & Co., 559 U.S. at 651.

[42] Id.

[43] Id. at 653.

[44] CFPB v. Ocwen Fin. Corp., 2019 U.S. Dist LEXIS 152336 *65 (S.D. Fla. Sept. 5, 2019); CFPB v. NDG Fin. Corp, 2016 WL 7188792 (S.D.N.Y. 2016); CFPB v. Think Fin., 2018 WL 3707911 (D. Mont. 2018); CFPB v. Nationwide Biweekly Admin., Inc., 2017 WL 3948396 (N.D. Cal. 2017).

[45] Compare CFPB v. Ocwen Fin. Corp., 2019 U.S. Dist LEXIS 152336 *65 (S.D. Fla. Sept. 5, 2019) with CFPB v. Nationwide Biweekly Admin., 2017 WL 3948396 (N.D. Cal. 2017).

[46] Compare CFPB v. Ocwen Fin. Corp., 2019 U.S. Dist LEXIS 152336 *65 (S.D. Fla. Sept. 5, 2019) with CFPB v. Nationwide Biweekly Admin., 2017 WL 3948396 (N.D. Cal. 2017).

[47] Ocwen Fin. Corp., 2019 U.S. Dist LEXIS 152336 at *66.

[48] Id.

[49] Id.

[50] Id. at *66–*67.

[51] Id.

[52] CFPB v. NDG Fin. Corp, 2016 WL 7188792, *19 (S.D.N.Y. 2016).

[53] Id. Another court denied a motion to dismiss on limitations grounds for multiple reasons without providing a standard. CFPB v. Think Fin., 2018 WL 3707911 (D. Mont. 2018).

[54] CFPB v. Nationwide Biweekly Admin., 2017 WL 3948396, *10 (N.D. Cal. 2017).

[55] Id.

[56] Id.

[57] Id. (quoting Merck & Co. v. Reynolds, 559 U.S. 633, 653 (2010)).

[58] Id.

[59] Id.

[60] Id.

[61] Gabelli, 568 U.S. at 449.

[62] Although not addressed in this article, those facing a CFPB action that seeks civil penalties may argue in the alternative that, even if the CFPB SoL does not apply, a catch-all, five-year statute of limitations related to “any civil fine, penalty, or forfeiture, pecuniary or otherwise” may limit certain CFPB enforcement. 28 U.S.C. § 2462; see Gabelli, 568 U.S. at 445. This article also does not address use of equitable defenses such as laches. Nat’l R.R. Passenger Corp. v. Morgan, 536 U.S. 101, 122 & n.12 (2002) (discussing possibility laches could be applied to sovereign to provide relief to defendants against inordinate delay by agency).

[63] CFPB v. Integrity Advance, LLC, CFPB No. 2015-CFPB-0029 (Jan. 24, 2020).

[64] Id. at 12.

[65] Id. at 16.

[66] Id. at 17.

[67] Id. at 18–19. Note that CFPB ALJ rulings are not binding and are ultimately subject to the director’s decision and appellate review of that decision. 12 C.F.R. §§ 1081.400 et seq.

[68] See Merck & Co., 559 U.S. at 656 (Scalia, J. concurring) (remarking that “in context of statutes of limitations ‘discovery’ has long carried an additional meaning [beyond actual discovery]: it also occurs when a plaintiff, exercising reasonable diligence, should have discovered facts giving rise to his claim”).

[69] Id. (discussing unusual statutory language in context of statute’s history which suggested Congress intended only actual notice standard).

[70] CFPB v. Integrity Advance, LLC, CFPB No. 2015-CFPB-0029, 15–18 (Jan. 24, 2020).

[71] Gabelli, 568 U.S. at 448–49 (noting that statutes of limitations “promote justice by preventing surprises through the revival of claims that have been allowed to slumber until evidence has been lost, memories have faded, and witnesses have disappeared,” which provides “security and stability to human affairs” and makes them “vital to the welfare of society”).

[72] Id. at 452.

[73] Id. (quoting Rotella, 528 U.S. 549, 554 (2000)).

[74] See, supra, Section I.

[75] See e.g., SEC v. Fisher, 2018 WL 2062699 (N.D. Ill. 2008) (relying on corporate press releases to trigger limitations period and finding inquiry notice standard appropriate for government given agency’s “ability to conduct an effective investigation”).

[76] CFPB, Consumer Tools, Learn How the Complaint Process Works (last visited July 29, 2020).

Introduction

Many small businesses, whether restaurants or small shops, are presently closed, and many of their employees are laid off. Currently, the government is lending money to small businesses and unemployed workers for their sustenance then collects the payments from some of the borrowers and the rest from taxes.^[1] Given that not all, or perhaps only a few, small businesses own real estate, they sign notes to repay the loans but can offer no asset backing. Presumably, then, the nation’s financial deficit is growing.^[2] The government adds the aggregate of the loans to the country’s costs and tax collection. However, even though support and politics might rub shoulders, they often harm each other.

1. Is there any other way in which some, if not all, of these loans could be financed by investors? An imperfect model that was tried and succeeded for some time to some extent was the securitization of mortgages.^[3] The good and bad experiences of mortgage securitization could help design a better securitization system for the notes of small businesses and employees.^[4] To be sure, mortgages are more solid backing than notes. In addition, although we have a long track record of recessions, and therefore a good sense of what recovery looks like in the current case, we do not and cannot know what the aftermath of the pandemic will be like. It might well cause a fundamental change to our economy and—just as importantly—changes in people’s habits.

2. The securitization of the notes is not similar to that of mortgages and to mutual funds holding notes. The comparison of securitization of the proposed notes to the securitization of mortgages or to pools (mutual funds) of corporations’ notes is not precise. In fact, the first step of securitization was the pooling of notes, but they were offered by very large corporations.^[5] In addition, there are currently mutual funds that hold relatively small notes issued by corporations. They are fairly safe and help both parties.^[6] In addition, small business investment companies make equity and debt investments in small businesses, and business development companies generally invest in the debt of middle-market companies.^[7]

Small businesses during the pandemic era are different from mortgages during a market decline. Most small businesses do not own real estate, but rather rent their business space. The notes they issue are of relatively small amounts. They may already have outstanding loans. They may not reopen even after the virus is overcome. Supported employees might not return to work for health, age, or other reasons. In sum, the borrowers’ note obligations are fairly risky.

3. Would health recovery bring the same businesses to full life? Not necessarily. Restaurants, for example, may have to share their business with the rising food and cooking suppliers and services. Besides, unlike the quest for home rental or ownership, people may have changed their habits of meeting in restaurants.^[8] Habits take time to form, but once they do, they take time to change or revert to old or other habits. History demonstrates a similar result; for example, the “buggy whip” was necessary and highly used for transportation before cars took over.

4. In sum, the risks associated with loans to small businesses is different from the risks of loans in a traditional recession. To be sure, the government could substitute its direct lending by insuring some of the risk associated with the notes portfolio. That would give lending banks a measure of comfort in that should a wave of bankruptcies occur as a result of these general economic and habitual changes, they would not get caught holding all or most of the bad notes. Another possible support is the government’s guarantee of bank losses, although some of the notes will support not only the banks’ business, but also the small business.

5. What are the benefits in pooling such small notes and selling participations in the pool to investors? Why would investors buy such participations?

The Treasury may help. Let the Treasury give a discount from taxes to such investments. For some investors this might be sufficiently attractive to cover the risk of failures to pay the notes. The benefits of securitizing these notes are numerous not only for one participant, but also for many participants and the entire country.

The notes-issuers will not be worse off, except that they might be subject to bankruptcy rules rather than viewing their obligations as fully enforceable. There is some justification for this reaction, yet the law may offer the borrowers in this case some relaxation as relief, and if the issuers go through banks, the government may allow banks the type of relaxation that would help the borrowers. No law is necessary for these rules because the Treasury has the authority to offer it, provided it is offered to all banks in the same position. In fact, banks currently have some discretion to relax their requirements with respect to any borrower—that is, although banks ordinarily are reluctant to lend to borrowers that are close to bankruptcy, they may set different criteria for this type of borrower.

Investors may be somewhat worse off compared to lending to other businesses; however, (i) their investments are not a donation; (ii) the investment should be given the public recognition it deserves; (iii) the successful revival of any supported business should be publicized; and (iv) the recipients of the money should be given a platform to thank the anonymous buyers of the securitized notes. Pictures could show the opened restaurants and, if they so wish, their owners and workers. These are not and should not be financial rewards, yet they may be valued more than any money rewards. The satisfaction of helping while risking some of one’s money may balance the risk.

However, the donors’ names, whether personal or incorporated or in groups, should not be publicized. If pressure to publicize is great, then it would be allowed only if the donees’ group-members are joined. In sum, business and finance need not be drained of all humanity and the satisfaction of sharing.

In addition, banks should institute appropriate safeguards. The bank should be responsible for the quality of the manager of the pool. In addition, the cost of the pool should not be charged to any other mutual fund or pool.

The conclusion that applies to securitization generally seems to apply to the securitization of notes by workers who lost their jobs and small businesses that had to close down. “[S]ecuritization seems to be going in the right direction at this stage. It allows credit to more risky borrowers but reduces the risks from such borrowers. Securitization also contributes to increased debt by borrowers and intermediaries but reduces such risks to investors.”[9]

6. What is the effect of securitization on monetary controls? When dealing with mortgages, the conclusion was the following:

Securitization renders the Fed’s control over the money supply more complex. However, monetary controls are an art rather than a science. The captain at the helm both guides and is guided by a faulty compass. Since the captain never had a scientific compass, it is doubtful whether the country is worse off today than before the emergence of securitization [of mortgages], technology, and competition.[10]

Conclusion

The model of mortgage securitization is helpful in various ways.

First, it demonstrates how to securitize more complex instruments, such as mortgages. Pooling notes is simpler and has continued to be practiced, providing more experience.

Second, it suggests that the holders of the borrowers’ notes should be the institutions that have the most experience in this function, i.e., the banks, rather than the Treasury, which has some but not as much experience in this function and is charged with and focused on matters other than managing other people’s money and debts.

Third, it is important to manage securitized debts without political and other national pressures, such as the money supply. If we agree that those who need help should not be affected by the financial system’s politics, then let us focus on helping them without any political self-interested and conflicting national interests. We should help those who are suffering from this pandemic, respect them for avoiding a handout, and honor the borrowers who are expected to repay. Let those who are required to pay through taxes or give to charity give the needy ones in this case an equal status—they are parties in a financial deal.

[1] See Kelly Anne Smith, Congress Approved More Funding for the Paycheck Protection Program. Here’s What You Need to Know, Forbes, Apr. 22, 2020 (noting that loans will be forgiven if certain requirements are met).

[2] Cong. Budget Office, Monthly Budget Review for June 2020 (noting that estimated “federal budget deficit in June 2020 was $863 billion, compared with a deficit of $8 billion in the same month last year,” due to “economic disruption caused by the 2020 coronavirus pandemic” and the “federal government’s response to it”).

[3] See, e.g., Stephen L. Schwarcz, The Future of Securitization, 41 Conn. L. Rev. 1313 (2009) (identifying defects with use of securitization). For a detailed treatment of the subject in 2005, see Tamar Frankel, Securitization: Structured Financing, Financial Assets Pools, and Asset-Backed Securities (Ann Taylor Schwing ed., 2d ed. 2005).

[4] See Bd. of Governors of the Fed. Reserve Sys., Report to the Congress on the Availability of Credit to Small Businesses (Sept. 2017) (noting that “securitization of small business loans has the potential to substantially influence the availability of credit to small businesses” and “[p]otential benefits exist for lenders, borrowers, and investors”; “[h]owever, the obstacles to securitizing small business loans are large”).

[5] See What Is the Difference Between Factoring and Securitization?, Companeo (noting that securitization is “better suited to large companies”); see generally Tamar Frankel & Arthur B. Laby, The Regulation of Money Managers (Ann Taylor Schwing ed., 3d ed. 2015); Frankel, supra note 3.

Securitization by pooling involves five steps: (1) making loans; (2) transferring the loans to an entity (a special purpose vehicle or special purpose entity (SPV or SPE), (3) providing credit enhancement for investors, (4) distributing securities issued by the SPV, and (5) making a secondary market in the securities. Frankel, supra note 3, § 2.4, at 55. For a description of the pooling process see id. at 55–56. For a description of a prototype securitization by pooling see id. § 6.4, at 213–14.

The steps of securitization by pooling are subject to regulation. See id. §§ 7.1–12, 9.1 to 9.2.2, 9.6, 9.8–.14 (banking law); id. §§ 7.13–.14, 8.7, 9.18 (standards in the making of loans, including consumer protection and usury laws); id. §§ 7.15–.16, 9.5, 10.1–.16 (bankruptcy and commercial law); id. § 7.17 (regulation of the process of sale and purchase of the loans); id. § 7.18 (prohibitions on referral fees); id. § 7.20 (margin regulations); id. §§ 8.10–.18, 8.22 (tax law); id. § 8.20 (trust law); id. § 8.21 (Employee Retirement Income Security Act of 1974); id. §§ 8.22, 9.3–.4, 9.15–.19, 11.1–.36, 2 id. §§ 12.1 to 13.7 (federal securities laws).

[6]  See, e.g., Short-Term Debt Funds, Coverfox.com (describing short-term debt funds).

[7] FS Investments, Business Development Company (BDC); Andrew Weinberg, Private Equity Will Show Its True Colors in the Covid-19 Recovery, Forbes, July 8, 2020 (defining “middle-market” as firms with annual revenues of $25 million to $1 billion).

[8] See, e.g., Heather Lalley, How Will the COVID-19 Crisis Change Consumer Dining Behavior?, Restaurant Bus. Online, Apr. 10, 2020 (citing poll data suggesting that consumers may have adopted long-term changes in restaurant dining behavior).

[9] Frankel, supra note 3, § 3.12, at 133.

[10] Id. § 3.15, at 137.

North Carolina has a statute providing that the manager of an LLC doing business in North Carolina must on behalf of out-of-state members remit to the state the estimated tax obligations of those out-of-state members. A recent decision from a bankruptcy court, In re North Carolina Tobacco International, LLC, Case No. 17-51077, 2020 WL 4582282 (Bankr. M.D.N.C. Aug. 10, 2020), considered whether an LLC in bankruptcy is obligated to make those tax payments. Spoiler alert—the court said “no.”

North Carolina Tobacco International, LLC (NCTI) was organized in Missouri but did most if not all of its operations in North Carolina. At least two of its four members were not resident in North Carolina. That NCTI was classified as a partnership for purposes of federal and North Carolina state taxation was not in dispute. The North Carolina tax code requires that with respect to each member of an LLC taxed as a partnership, the LLC’s manager is obligated to remit the estimated taxes of the nonresident members.[1] This statute is far from unique; many states have similar mechanisms for collecting taxes on behalf of nonresident partners/members.[2]

In 2017, NCTI sought protection under chapter 11 of the Bankruptcy Code. In early 2018 the case was converted to a case under chapter 7. Thereafter, the chapter 7 trustee effected several sales of NCTI property. Due to the absence of reliable information as to basis, the entire proceeds of the transactions were treated as gain. The opinion does not lay out the path leading to the trustee’s Motion to Determine that the Estate Should Not Remit Pass-Through Taxes on Behalf of Out-of-State Members, and although North Carolina participated and argued against the motion, the individual members on whose behalf the payments would have been made did not.

North Carolina argued that the tax obligation was that of the LLC, not of its members, and that the LLC was obligated to remit the tax payment. “[T]he Department argues that, contrary to traditional principles of flow through taxation, North Carolina has chosen to place the burden of reporting and paying income tax liability of nonresident partners on the manager of the partnership instead of the nonresident members. Based on Personal Tax Bulletins issued by the Department, the Department argues that the obligation to pay nonresident members’ taxes itself creates a separate and distinct tax obligation on the partnership.”[3] The trustee argued that the tax obligation is that of the members and that the LLC may not under the North Carolina LLC Act nor the bankruptcy code expend its resources to satisfy their obligations.

According to Trustee, payment of income tax on behalf of Debtor’s equity interest holders from the assets of the estate would constitute a distribution to the members ahead of the creditors of the LLC, and therefore would violate the distribution priorities mandated in 11 U.S.C. § 726. Under § 726, creditors must be paid prior to any distribution to equity holders. [Footnote 4: This distribution priority does not differ from the winding up of an LLC under North Carolina law. See N.C. Gen. Stat. §§ 57D-6-07(d) and 57D-6-08(2) (2014).] Therefore, Trustee argues that, to the extent N.C. Gen. Stat. § 105-154(d) purports to require payment of member taxes prior to distributions to creditors, it is preempted by the distribution scheme under § 726.[4]

The court’s ultimate holding was not dependent upon either of these paradigms, but the trustee won the day. The court’s analysis focused upon 11 U.S.C. § 346, finding that it preempted the North Carolina statute in question. The decision recited subsection (b) and (c) of section 346, adding emphasis to a portion of (b) as follows:

(b) Whenever the Internal Revenue Code of 1986 provides that no separate taxable estate shall be created in a case concerning a debtor under this title, and the income, gain, loss, deductions, and credits of an estate shall be taxed to or claimed by the debtor, such income, gain, loss, deductions, and credits shall be taxed to or claimed by the debtor under a State or local law imposing a tax on or measured by income and may not be taxed to or claimed by the estate. The trustee shall make such tax returns of income of corporations and of partnerships as are required under any State or local law, but with respect to partnerships, shall make such returns only to the extent such returns are also required to be made under such Code. The estate shall be liable for any tax imposed on such corporation or partnership, but not for any tax imposed on partners or members.

(c) With respect to a partnership or any entity treated as a partnership under a State or local law imposing a tax on or measured by income that is a debtor in a case under this title, any gain or loss resulting from a distribution of property from such partnership, or any distributive share of any income, gain, loss, deduction, or credit of a partner or member that is distributed, or considered distributed, from such partnership, after the commencement of the case, is gain, loss, income, deduction, or credit, as the case may be, of the partner or member . . . . (emphasis and ellipses in original).[5]

Finding preemption, the court explained:

Under federal law, any taxes in this case are taxable to the members and are not imposed on the corporation or partnership. It is well settled that pass-through entities, such as LLCs like Debtor, are not subject to federal taxation at the entity level. As an LLC with more than one member, Debtor is treated as a partnership for federal taxation purposes unless it elects to be treated as a corporation. . . . Income taxes of a pass-through entity like an LLC or S corporation are liabilities of that entity’s members.[6]

From there the court concluded that:

Having determined that any taxes were imposed solely on the nonresident members rather than the LLC under federal law, § 346(b) dictates the result in this case. That section expressly prohibits such taxes from being a liability of the estate. 11 U.S.C. § 346(b) (“The estate shall be liable for any tax imposed on such corporation or partnership, but not for any tax imposed on partners or members.”). Furthermore, the North Carolina statutes and tax bulletins make it abundantly clear that the members at all times remain ultimately liable for the taxes, and the Department does not argue otherwise. Since the members are unquestionably liable for their respective tax obligations, the estate cannot also be liable. Section 346(b) expressly prohibits any dual tax obligation of the members and the estate, providing that the estate shall not be liable for any tax imposed on the members. For these reasons, the Court finds that the estate has no liability for the taxes imposed against the resident or non-resident members of the LLC.[7]

North Carolina is still owed taxes by the nonresident members of NCTI, but it will have to pursue them individually and cannot use the LLC in bankruptcy as its collection mechanism.

[1] See N.C. Gen. Stat. § 105-154(d).

[2] See generally Bruce P. Ely & William T. Thistle II, An Update on the State Tax Treatment of LLCs and LLPs, State Tax Notes (Oct. 28, 2019), at Table 1.

[3] 2020 WL 4582282, *3.

[4] Id. at *2.

[5] Id. at *4.

[6] Id. at *4 (citations omitted).

[7] Id. at *5 (footnote omitted).

Equity Will Not Suffer a Wrong Without a Remedy*

Two business “partners,” whether coshareholders, LLC members, or operating in partnership form, are like spouses in a marriage. At some point, a large percentage of both unions which began in happiness end in acrimonious divorce. Each “partner” in both has a parental claim to the “baby.” Hence, who retains custody becomes a critical issue. Judges with equitable jurisdiction are asked to exercise their broad discretion with as much flexibility as warranted to fashion an appropriate remedy.[1] Equity’s power to fashion a remedy to fit the circumstances is not limited by the express authority granted to courts in statutes that authorize relief for minority oppression or provide other dissolution authority.[2] The Revised Uniform Limited Liability Company Act explicitly provides that it is supplemented by principles of equity.[3]

Cases from different jurisdictions provide nonexclusive suggestions for remedies and lists of factors to be considered when fashioning relief. Trial judges, sitting through the testimony of credible and disingenuous witnesses, in addition to hearing the spoken words that later appear in the transcript, have the benefit of observing demeanor. The partner who comes off as “reprehensible,”[4] “obdurate,”[5] “imperious,”[6] or “entitled”[7] will not fare well with a dedicated judge striving to do the right thing. Conscious of the trial court’s ability to observe, and guided by the breadth of its equitable discretion, appellate courts approve sensible, but sometimes unusual, orders made below.

In a three-shareholder minority oppression case, the New Jersey Supreme Court upheld the “uncommon remedy” of the minority buying out the majority.[8] In another case, where a father and one son defrauded a second son out of his interest in two corporations they then stripped of all value, the trial court recognized that simply restoring the plaintiff to his interests in the corporations was not a meaningful remedy. The court ordered the defendants to buy out the plaintiff at a value determined as of the date of the complaint when the corporations still possessed their assets. The ruling was upheld even though there was no minority oppression to provide the statutory basis for a buy out.[9] The Missouri Supreme Court upheld the trial court’s exercise of discretion designed to avoid duplication of a plaintiff’s recovery when it affirmed valuation discounts applied in determining fair value and adjustment of the valuation date.[10]

Recently, however, the Mississippi Supreme Court appeared to stretch the bounds of equity.[11] Citing precedent approving the concept that issued stock could be cancelled or redeemed, it upheld the chancellor’s decision to transfer shares from the 51-percent majority shareholder to his 49-percent minority partner to achieve joint control. Dissolution, sought by both parties (at the same time as each sought control), was deemed not feasible because the corporation had only one significant asset: a subcontract from which its revenue derived. Although the possibility of deadlock was acknowledged, the chancellor viewed the equity shift as the only viable remedy to avoid continued oppression.

Whether equity’s authority extends to shifting ownership is one for scholars to debate. A practical question is whether it is better to separate two antagonists or force them to live together. One may speculate that the Mississippi chancellor envisioned joint control as a catalyst to facilitate agreement on a retirement plan for the older partner or one buying out the other. The fact that amicable resolution can be achieved with the aid of good business counsel may have prompted the chancellor to add to his order the unusual directive that the corporation retain a corporate attorney and an accountant.

Compelling warring parties to face reality and resolve their differences is not new. In a dispute between two members of an LLC, the Delaware vice chancellor rendered his opinion, but then afforded the two business partners a time to resolve their differences knowing what the court’s order would be.[12]

Unfortunately, separation is inevitable when either party (or his or her lawyer) is irrational or emotionally invested. Long before actions for minority oppression became common, an erudite New Jersey justice had opined that business divorce seems inevitable when the breakdown in the relationship between the partners is irremediable.[13] The quintessential illustration of this is where the actions and litigiousness of the parties made it clear that their relationship was so intractable and acrimonious as to be toxic, resulting in a majority of the Delaware Supreme Court upholding the appointment of a custodian to sell the company and divide the proceeds.[14]

* 2 Pomeroy, Equity Jurisprudence § 423 (5th ed. 1941).

[1] Matajek v. Watsun, 449 N.J. Super. 179 (App. Div. 2017).

[2] Brenner v Berkowitz, 134 N.J. 488 (1993).

[3] Uniform Limited Liability Company Act (2006) (harmonized) (last amended 2013).

[4] Boatright v. A&H Technologies, Inc., 276 So. 3d 687 (Miss. 2020).

[5] Musto v. Vidas, 281 N.J. Super. 548 (App. Div. 1995), cert. denied, 143 N.J. 328 (1996).

[6] Compton v. Paul K. Harding Realty Co., 285 N.E.2d 574, 581 (Ill. App. 1972).

[7] Sipko v. Kroger, Inc., 2020 WL 4811545 (N.J. App. Div. 2020), rem’d, 214 N.J. 364 (2013).

[8] Muellenberg. v. Bikon Corp., 143 N.J. 168 (1996).

[9] Sipko, 2020 WL 4811545.

[10]Robinson v. Langenbach, 599 S.W.3d 167 (Mo. 2020).

[11] Boatright, 276 So.3d 687.

[12] Haley v. Talcott, 864 A.2d 86 (Del. Ch. 2004).

[13] Stark v. Reingold, 18 N.J. 251, 266 (1955).

[14] Shawe v. Elting, 157 A.3d 152 (Del. 2017).

A whole lot has changed in the last seven months, but one thing that seems to remain constant is a common desire to do something—anything—to make a difference. Many lawyers, and all judges, are lucky enough still to have jobs and meaningful work, but we are surrounded by people who don’t. Many individuals and families in our communities that always expected to be able to pay their bills now find themselves unable to do so. Sometimes, those bills are the monthly rent. And sometimes landlords who no longer are able to collect the monthly rent are unable to pay their mortgage and real estate taxes, perhaps for the first time ever.

Of course, individuals and families are not the only ones who may not be able to keep up these days. Small businesses are also struggling; you can see it on a socially distanced walk through any downtown area, whether in my local neighborhood of Brooklyn Heights or a two-stoplight town in a rural community. Many businesses are struggling to hang on, navigating a complicated path to resuming operations safely. Others have shut down, at least temporarily. Some businesses are already lost, with their oval “OPEN” neon signs replaced by large “FOR RENT” signs.

What does any of this have to do with pro bono? The answer is, “a whole lot, in a lot of ways.” Pro bono representation of an individual or small business that otherwise would not have access to legal advice always makes a difference. Not just usually, but always. As we face a triple pandemic of a public health emergency, a significant economic downturn, and a historic national reckoning with the plague of institutional racism, it could not be more important for lawyers individually and the legal profession as a whole to step up to the challenge of providing adequate legal services to those who cannot find or afford them, for so many reasons. Here are just a few.

First, it seems likely that an unprecedented number of individuals won’t be able to pay their monthly bills, including their rent or mortgage. Many states, including New York, have adopted moratoriums on evictions, but these will soon expire. It’s bad enough not to be able to pay the rent or to miss a mortgage payment (or two). But it must be terrifying to face that situation and to have no one to help you identify your options, negotiate with your landlord or the bank, and find the best path forward. Pro bono counsel can help.

There’s another party to each of these relationships: large landlords and mortgage lenders who are well represented by legal counsel. I see many situations in my virtual courtroom where those counsel truly rise to the occasion and embrace a problem-solving approach. After all, a good tenant who has been furloughed, but has good future prospects, may well still be a fundamentally good tenant. The temporary disruption to that landlord-tenant relationship may well be a solvable problem.

However, not every landlord is a large, well-heeled (and well-represented) corporation. Some are family businesses. Much urban housing is small, perhaps a mixed-use building with a few residential and commercial units. Maybe the owners live downstairs and rent one or two floors upstairs, and have their own mortgage to pay, not to mention real estate taxes and utilities. And maybe the owners have never missed a payment or even considered how to respond to a tenant—and neighbor—who can’t pay the rent. Maybe that’s also a solvable problem. Again, pro bono counsel can help.

What about a job loss? News reports tell us that record numbers of individuals are seeking unemployment benefits. What access do they have to federal and other benefits programs designed to sustain businesses through these times? Access to these benefits may require fluency in legal language that comes naturally to lawyers, but not necessarily those who are in need. When a process is frustrating, those who need it most may just give up—and give up hope too. Here as well, pro bono counsel, fluent in the law and not likely to be intimidated by an administrative process, can help.

Perhaps most important, what about that intangible sense that someone—anyone—is on your side? That someone thinks that helping you is their job, and not the other way around? I recall representing pro bono clients in my practice days and seeing the transformative effect of simply greeting them at our firm’s fancy reception desk, walking them to a conference room, asking how they take their coffee or tea (and making a mental note to remember it for the refill), and listening to their narrative until they were done with the whole story, until the answer to the question, “can you tell me more about that?” was a smile and a shake of the head, just as if they were the senior investment banker on the big deal that was headed to litigation. Whatever else that client knew by the end of our meeting, they knew for sure that someone was absolutely in their corner and on their side. Pro bono counsel can do this, too, and so much more.

These are tough days and tough times. More than ever, lots of people and small businesses need recognition and assistance with solving their problems. Some of these problems are existential. Pro bono counsel can help. Please don’t wait—whether it will be your first or your hundred-and-first pro bono case, someone needs your help. Yes, yours. And soon.

The COVID-19 pandemic has made online dispute resolution (ODR) a mainstream feature of appropriate or alternative dispute resolution (ADR). Historically, ODR tended to be used for cases where the cost of in-person meetings or hearings was impractical, or by parties enthusiastic about the use of technology. Now, with the limited ability to travel and hold in-person meetings, ODR has become a necessity.

Parties reluctantly adopting ODR will find it has several benefits, such as being less expensive, greener, and more flexible and convenient for convening parties in disparate locales around the world. On the other hand, ODR results in the loss of in-person interaction that can be critical for building trust and rapport. In addition, some parties may have challenges using or accessing technology, and there is greater risk of unauthorized behaviors, such as attempts to record proceedings or include a third party without permission.

Although ODR can dramatically reduce the difficulty and cost of resolving international disputes, having a California-based neutral meet online with, say, Tokyo- and London-based parties comes with its own tribulations. Where multiple time zones are involved, there may be only a few hours of traditional business time available.

As neutrals with experience mediating and arbitrating with parties located abroad, we have put together this list of three tips to keep in mind.

1. Do More Asynchronously

Give serious consideration to whether an online meeting or hearing is really necessary, and if it is, how it might be made more time efficient. For example, getting the parties to agree to exchange mediation briefs with one another can help ensure that both sides are thinking about the same issues at an early stage. Holding premediation caucuses with each side can be particularly effective because it allows the mediator to master the factual and legal background in advance and identify information gaps that may need to be addressed prior to the main session.

A mediator may also stagger a mediation so that a first party joins online before the second. This can help to avoid the second party sitting around waiting for the mediator to complete an initial discussion with the first party. Of course, mediators should be cognizant that different parties may have different levels of sophistication and familiarity with the process, and should avoid the appearance of giving preference to one party as a result of staggered joining times.

In arbitration, ex parte discussions are generally not allowed, but it may still be possible to simplify or minimize hearings. For example, a live evidentiary hearing is not necessary in many cases, and discovery disputes and motions can often be heard solely on the documents—something to which parties based in civil law jurisdictions will be more accustomed. Another common time-saving device in international disputes is to submit all direct testimony in the form of witness statements and to reserve hearing time for cross-examination. Using a chess-clock system can also help the proceedings stay on track, especially given that countdown timers are more readily visible on a computer screen than in a hearing room.

2. Consider Physical Settings

Neutrals should discuss ODR environments with the parties in advance. This should not only include obvious points such as the prohibition on the presence of unauthorized parties or the recording of the meeting, but also the importance of having a stable internet connection and a home or work environment free of distraction to the extent possible. In the case of mediation, consider in advance whether you wish to speak with the lawyer separately from his or her client. Lawyers and clients often Zoom in together from the same physical space, but this makes it difficult to speak with the lawyer about client control or other issues that would best be discussed separately.

Due to pandemic-related restrictions on movement, a party may be forced to participate in an ODR proceeding with a less than ideal background; therefore, the neutral should make an effort to help resolve this in advance or discuss accommodations. Neutrals should lead by example and ensure they have a stable online connection together with a nondistracting background. Virtual backgrounds can sometimes be distracting, especially when combined with movement.

3. Be Sensitive to Local Conditions and Expectations

No one wants to start a meeting at 4 a.m. or 10 p.m., but that may be the unfortunate necessity of international ODR. Neutrals should be aware of the local times of all participants, and where meetings or hearings on multiple days cannot be held at a mutually convenient time, the time should rotate to avoid disadvantaging any particular party.

Consistent, high-quality internet service cannot be taken for granted in many countries. As a result, parties might experience difficulty accessing the meeting, or their connection might be compromised in ways that make it difficult for others to understand what they are saying. To the extent possible, conduct a test prior to a hearing and give parties the option of appearing by telephone or with their video turned off.

The neutral should also check with the parties in advance on their preferences and availability, being sensitive to local norms. We can think of examples, particularly in developing countries, where parties sometimes have unexpected flexibility to start early, or unusual requirements to end early, in order to avoid long commute times caused by infrastructure constraints. In addition, not all countries observe daylight savings time, and some switch to and from daylight savings time on different days. If the local time changes between when a meeting is set up and when it will occur, it is possible that a party (or the neutral) will show up an hour late. Applications like Outlook and Google Calendar can help prevent this outcome by automating an otherwise error-prone process of calculating time differences.

Systemic racism continues to be embedded in every fabric of our society and, in light of recent events, the world can no longer ignore the disproportionate impacts on African-American and Black communities stemming from systemic racism. In response to the deaths of George Floyd, Ahmaud Arbery, Breonna Taylor, and countless other African-Americans, the leadership of the Business Law Section (“Section”) of the American Bar Association issued a statement in support of Black Lives Matter and to stand, without presumption, in solidarity with the Black community and with all people seeking an end to racism and intolerance. The statement reaffirms the Section’s fundamental commitment to diversity, inclusion, and social justice, and names the Section’s commitment to redouble its efforts to eliminate systemic racism and to advocate for needed legal reforms through the power of business law, business lawyers, and business court judges.

Under Model Rule 8.4(g) of the American Bar Association Rules of Professional Conduct (the “Rule 8.4(g)”), it is professional misconduct for a lawyer to engage in conduct that the lawyer knows or reasonably should know is harassment or discrimination on the basis of race, sex, religion, national origin, ethnicity, disability, age, sexual orientation, gender identity, marital status, or socioeconomic status in conduct related to the practice of law.  

Before the adoption of Section (g), Rule 8.4 already prohibited misconduct related to the practice of law, including violating or attempting to violate the rules, committing certain criminal acts, engaging in dishonesty/fraud/deceit/misrepresentation, engaging in conduct prejudicial to the administration of justice, communicating an ability to influence improperly a government agency, or helping a judicial officer to engage in unethical conduct. Section (g) added to the concept of misconduct, but specifically states that it does not “limit the ability of a lawyer to accept, decline, or withdraw from a representation in accordance with Rule 1.16. This Paragraph does not preclude legitimate advice or advocacy consistent with these Rules.”

Section (g) helps the legal profession by helping with public perception. The community will benefit from a legal system that is fair and unbiased. A positive public perception of an unbiased system assists the operation of the courts and the practice of law. The section also helps lawyers by providing clear definitions and parameters of what is prohibited and setting out guidelines and comments to protect the operation of law practice and right to free speech, thought, association, and religious practice. Consistent rules from jurisdiction to jurisdiction also aid legal practitioners and their clients engaging in interstate business.

Despite the positive benefits of the Model Rule, in the two years following the rule, Vermont was the only state to officially adopt the rule. Several states had either formally or informally declined to adopt or consider adoption. The objections to the rules ranged from “religious liberty” objections to more academic and politically philosophical objections.

In light of current events, including the deaths of George Floyd, Ahmaud Arbery, Breonna Taylor, the push for states to adopt the Model Rule has resurfaced. On July 15, 2020, the Standing Committee on Ethics and Professional Responsibility issued (“Formal Opinion”) offering guidance on the purpose, scope, and application of Model Rule 8.4(g). The Formal Opinion addresses many objections to the adoption of the rule by outlining several representative situations for application of the rule. The Formal Opinion again encourages states to adopt the rule, stating, “Enforcement of Rule 8.4(g) is therefore critical to maintaining the public’s confidence in the impartiality of the legal system and its trust in the legal profession as a whole.”

Anti-racism is the active process of identifying and eliminating racism, and this is a call for action for the legal profession to not stay silent or passive in this movement when the Section has committed to advocate for the elimination of systemic racism. The legal profession must take action to combat the imbalances within the legal profession. The following are some actions that the legal profession can take to address racism and its effect:

• Education. Achieving equity requires understanding not only the current experience of marginalization and oppression but also the broader social structure and how a history of lost opportunities and disenfranchisement have widened the race gap. A lack of education and understanding contributes to bias, which in turn creates barriers and impedes the retention and advancement of diverse lawyers.
• Improving Systems to Reduce Bias. Unconscious bias training at regular intervals should be provided in the workplace. This training is especially important for those in interviewing and hiring positions and decision-making roles for promotions and advancement opportunities. Existing processes should be examined to see how bias affects staffing and advancement. For example, assessing whether the work allocation system is based on objective merits whereby technical skills, judgment, and work ethic will earn placement on challenging, high-profile, and career-advancing files, or whether the system leaves room for subjective preferences based on soft skills and who “fits” in with the team.
• Culture. Key support comes from top-down. Leadership in the workplace should commit to creating a culture where all members can be their authentic self and to taking active and meaningful action to address systemic racism within the legal profession.
• Assessing Data. In-house counsel who are decision-makers when selecting which law firms or service providers to retain can request data related to the demographics of the lawyers at the firm to assess whether the firms are meeting diversity benchmarks and metrics. In-house counsel can also engage in continuous review of existing relationships to determine whether diverse lawyers are billing on their files and in lead counsel roles.

Each of us in the legal profession has a role to play in eliminating systemic racism. Lawyers are advocates at the forefront of change, so let us all take steps in advocating for equity and justice within our profession.

Reopening a business during the pandemic is essential and inevitable, but it will certainly be a daunting process that will require consideration of how workers can be brought on board safely, how customer concerns will be addressed, and how everything can be done in a way that allows the company to survive financially.[1] Larger companies have been investing significant amounts of resources on designing and implementing their reopening plans; however, small businesses don’t have the same resources but still need to address all of the same challenges. In this article, we’re going to take a look at how recommended “big company” strategies can be retooled to meet the needs of your small business clients.

First of all, your clients need to have a reopening plan that takes into legal and regulatory requirements and the specific needs and expectation of their workers. While the owners should be responsible for collecting all the necessary information, creating the plan should be a “family affair” that includes representatives of all of the company’s departments and activities. It is essential to have input from a group of employees who can express the divergent concerns that will inevitably arise in the workforce including views on remote working and scheduling and concerns about preexisting health conditions that increase vulnerability to the virus and caring for family members. For the smallest of businesses, this means everyone can be involved. If that’s not feasible, make sure that the team members are well-connected to other employees and also make sure that there are other means for all employees to provide input and suggestions and submit concerns (e.g., an anonymous hotline).

Each plan will be different; however, reference should be made to guidelines released by federal governmental agencies such as the Centers for Disease Control and Prevention (e.g., CDC Guidance for Businesses and Employers), Occupational Safety and Health Administration and Equal Employment Opportunity Commission, state and local governmental bodies, and any industry-specific protocols and guidance issued by nonprofit and inter-governmental organizations such as the Business & Human Rights Resource Centre, the Institute for Human Rights & Business and the OECD Centre for Responsible Business Conduct. If one exists, the company should participate in any group of similar businesses that may have been formed to share best practices on how to respond to the virus. This can be particularly valuable for smaller businesses that lack the resources for creating a robust plan on their own, but care must be taken to implement suggestions in a manner that is reasonable given the size of the enterprise.

When developing and implementing the plan, the owners should not only involve you, as their attorney, to explain legal requirements and risks, but also secure guidance from workplace health and safety consultants who can assist on preparing the workplace. The plan needs to cover protecting the workspace and lay out the details of a new workplace that is configured to address and reduce the risks associated with the virus. Among the issues and questions that need to be considered are:

• The company’s policies regarding telecommuting, including how the company intends to monitor work hours and performance of employees while they are working outside the office
• Social distancing, personal hygiene, use of masks and other personal protective equipment, reconfiguring workspaces, and cleaning
• Managing and protecting common workspaces such as elevators and breakrooms
• Manipulating work schedules to reduce crowding in the workspace
• Health checks, which should be done by persons who have been properly trained and based on legal advice regarding the types of information that employers can collect from employees, how that information can be used, and how it should be protected to respect workers’ privacy rights
• Protecting employees against risks associated with third parties entering the workplace (e.g., providing that the company’s policies apply to all visitors and requiring that outside sanitation teams follow safety protocols)

In addition to protecting the workplace, consideration needs to be given how and when the available worker talents are deployed. Companies need to consider when they will reopen for business and what activities will be required in order to provide the services that will actually be purchased by customers and clients. The answers to these questions will dictate which of your client’s employees are absolutely necessary to conduct business. Once that group has been identified attention can turn to the best way to deploy them. Can some of them work remotely? Can the company offer flexibility in terms of timing to those employees who must be in the facility to carry out their job activities? Are there any known risks associated with likely worker commuting patterns, such as the need to take long trips on public transportation? Which of the employees have special issues that need to be considered, such as the need to care for children and other family members or legally-protected characteristics and conditions such as age or disability? The company needs to be prepared to comply with reasonable requests for accommodations in a consistent manner and assist workers with exercising their rights related to extended leaves and childcare obligations. When making decisions about which workers to bring back, care must be taken not to act in a manner that might be seen as discriminating against particular groups (e.g., women, workers from certain racial or ethnic groups, or people known to have pre-existing health problems).

The company also needs to have a plan in place in advance to respond to news that an employee has symptoms of the virus or that a member of an employee’s family has virus-related health issues that require that the employee take time off from work to assist with care and maintenance of the household. When these types of situations arise, the company must act carefully but compassionately and document the response following consultation with applicable federal and state laws and regulations related to maintaining confidentiality of an employee’s health situation and sick and family leave. The legal requirements for paid sick and family leave need to be understood, particularly exceptions for smaller employers and for certain types of employees; however, employers may decide to offer more generous benefits. Whatever approach is taken, the rules must be clear and transparent so that employees know when they can leave the workplace due to illness and what they can expect from the company in terms of pay, benefits, and criterion for returning to the workplace once the personal health crisis has passed.

Deliberation, communication, patience, flexibility, and compassion are the essential elements for any plan that your small business client has for reopening its workplace during the pandemic. Trust is essential during this whole process, and company leaders need to be committed to transparency and consistently communicating with workers, customers, and others impacted by the company’s decisions and operations. Assisting clients in reopening in ways that are compliant with laws and voluntary standards of social responsibility is both a challenge and an opportunity for you as a business counselor. Small business owners have been devastated by the economic and social impact of the pandemic and many have understandably lost faith in the ability of their elected officials to provide support and clear guidance.

Business attorneys can play a unique role in filling in the gaps for their clients, serving as advocates for their causes and providing resources that will be valuable to all members of the community. For example, lawyers can collaborate with local bar associations to provide tools and tips for small business owners in the online world such as compiling a list of frequently asked questions and answers for owners accompanied by links to government resources. Now is also the time to visit small business owners in their communities—safely of course—to be sure that the valuable information that you have gets to the people who need it. However, in order to that it is essential that you become and remain informed about developments and there are comprehensive resources available from sources such as Practical Law (Business Reopening and Return to Work Checklist) and FindLaw. This is not something that will simply “disappear”: it is a long-term issue that you will need to integrate into your overall approach to serving you small business clients.

[1] Alan S. Gutterman is the Founding Director of the Sustainable Entrepreneurship Project (www.seproject.org), a California nonprofit public benefit corporation with tax exempt status under IRC section 501(c)(3) formed to teach and support individuals and companies, both startups and mature firms, seeking to create and build sustainable businesses based on purpose, innovation, shared value and respect for people and planet. Alan is also currently a partner of GCA Law Partners LLP in Mountain View, CA and a prolific author of practical guidance and tools for legal and financial professionals, managers, entrepreneurs and investors on topics including sustainable entrepreneurship, leadership and management, business law and transactions, international law and business and technology management. He is the Co-Chair of GP Solo’s Business Law Committee and co-editor and contributing author of several books published by the ABA Business Law Section including The Lawyer’s Corporate Social Responsibility Deskbook, Emerging Companies Guide (3^rd Edition) and Business and Human Rights: A Practitioner’s Guide for Legal Professionals (Forthcoming Fall 2020). More information about Alan and his work is available at the Project’s website and his personal website. A longer version of this article was originally published on May 20, 2020 on the website of the Sustainable Entrepreneurship Project (which includes additional information on sources and other resources).

 The credit reporting system is an integral part of the fabric of consumer credit in the United States. Credit scores, derived from data provided to credit reporting agencies, from creditors of all shapes and sizes, dictate whether a consumer can obtain credit and how much that credit will cost. As such, there is a need for the data furnished to be accurate and complete to ensure the integrity of the system. Enter a global pandemic due to the new coronavirus (“COVID-19”) with businesses shuttered around the country. People have been furloughed, laid off, or otherwise left jobless and unable to pay their bills, circumstances that threaten to cripple the US credit market.

Congress acted by passing the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act” or the “Act”), billed in part as a comprehensive COVID-19 relief plan. Recognizing the importance of consumer credit reporting, the CARES Act included provisions which attempt to protect consumer credit if the consumer enters into an “accommodation” with a furnisher of consumer credit data. An “accommodation” is an agreement to defer one or more payments, make partial payments, forebear delinquent amounts, modify a loan or contract, or receive any other assistance or relief granted by a creditor, to a consumer affected by COVID-19 during the “covered period.” The “covered period” is the period beginning on January 31, 2020 and ending 120 days after the national emergency terminates. Different reporting requirements apply, depending on whether the consumer’s credit obligation is current or delinquent when the furnisher makes an accommodation.

For example, if a furnisher makes an accommodation with respect to one or more payments on a consumer’s credit obligation or account when it is not delinquent, and the consumer makes the payments or is not required to make one or more payments under the accommodation, then the furnisher must report the obligation as “current.” When reporting an account as “current,” a furnisher should consider all of the trade line information they furnish reflecting an account as current or delinquent and cannot simply use a special comment code to report a declared disaster or forbearance. If the obligation or account is delinquent before the accommodation (but not yet charged-off), the furnisher must maintain the delinquent status while the accommodation is in effect and, if the consumer brings the obligation or account current during the accommodation period, the furnisher must report it as current.

The Consumer Financial Protection Bureau (“CFPB” or the “Bureau”) provided the following example in its guidance: “If at the time of the accommodation the furnisher was reporting the consumer as 30 days past due, during the accommodation the furnisher may not report the account as 60 days past due. If during the accommodation the consumer brings the credit obligation or account current, the furnisher must report the credit obligation as current.” Once an accommodation ends, the furnisher must continue to report the time period covered by the accommodation in accordance with the CARES Act protections. For example, the furnisher may not report a consumer who they reported as current during the accommodation as delinquent post-accommodation if payments were made in accordance with the accommodation plan.

Furnishers, who may already be facing operational challenges as a result of remote work and loss of staffing, could face challenges when trying to comply with the Act. The CFPB responded with a policy statement and Frequently Asked Questions guide, indicating it would provide some “flexibility” in its enforcement approach to help furnishers manage these challenges. However, the CFPB warned furnishers that the Bureau still has an expectation of compliance, and that it would be appropriate to evaluate individually the circumstances of each furnisher and its “good faith” efforts to comply.

All of this regulation and guidance leads to a fundamental question, namely whether the CARES Act provisions on credit reporting truly protects the consumer’s credit, and, perhaps more importantly, the consumer’s credit score. Without question, this CARES Act provision should protect a consumer from having a delinquency show on their credit report when they enter into an accommodation. However, the consumer credit report may use a “special comment code,” which would show the debt being in an accommodation plan, such as payment deferral or forbearance. While the CFPB has emphasized that such a code may not fully satisfy the requirement, as the furnisher should look at other data fields to ensure they show the debt as “current,” there is no restriction from inputting an accurate description of the debtor’s current position with the loan. Such a description may in fact be required in order to fully and accurately show the status of the obligation. These descriptions can, and often will, lead to a decrease in a consumer’s credit score. Even if a decrease does not occur, the coding itself could lead to a consumer’s lack of ability to obtain credit, as some creditors will require a number of payments post forbearance, before they will lend new credit.

So, what should a furnisher do? The furnisher must balance their operational challenges, their staffing, and their desire to provide the best customer service they can with the enhanced reporting requirements required by the CARES Act. The furnisher should establish policies and procedures to ensure accommodation plans are appropriately flagged and thus reported correctly. The furnisher should establish a plan to answer a consumer who asks, “Will this accommodation hurt my credit?” so as to not create a false impression of the overall impact on a consumer’s credit health. Finally, the furnisher should document the steps they have taken to comply, and, just as importantly, the operational or technical roadblocks that could prevent full and absolute compliance. These steps will help furnishers mitigate the risks that may result, including litigation and regulatory action.