By the end of 2025, more than half of the largest 30 U.S. accounting firms will have either sold an ownership stake or part of their business to private-equity investors, up from zero in 2020, said Allan Koltin, chief executive at advisory firm Koltin Consulting Group.
—Mark Maurer, “Private Equity’s Ties to Companies’ Auditors Have Never Been Closer. That Worries Some Regulators.”[1]
Persistent market volatility, high inflation levels, and lack of investor confidence have challenged, among other things, mergers and acquisitions processes and the debt capital markets over the past few years. Private equity sponsors have responded in part by seeking to penetrate new sectors for platform acquisitions. Professional services firms have become one such target, driven by large profit margins, sustained growth, and strong cash flows. This article focuses on accounting firms, a subset of professional service providers and a popular target of sponsored investment via leveraged buyout (or “LBO”). As competition to acquire quality assets and accordingly, provide related financing, remains fierce, this article will discuss material considerations for lenders in connection with the financing of audit and accountancy businesses.
A Rising Trend
According to S&P Global, November 2024 “saw a surge” in private equity– and venture capital–backed transactions in the accounting and audit sector.[2] In fact, in the period from October 1 through November 30, 2024, seven deals were done in the sector, compared to six deals for the entire fourth quarter of 2023.[3] By way of further example, according to the Financial Times, in 2024 alone, Hellman & Friedman agreed to purchase a controlling portion of the equity interests in Baker Tilly; New Mountain Capital purchased the U.S. operations of Grant Thornton; Investcorp and PSP Investments purchased PKF O’Connor Davies; and a Centerbridge Partners–led consortium of investors purchased a majority of equity in Carr, Riggs & Ingram.[4]
Attractive Targets
Accounting firms are attractive targets for private equity investment for several reasons. The “fragmented”[5] character of the professional accounting industry presents consolidation opportunities as well as the potential to scale business, a hallmark of private equity’s investment thesis. Furthermore, private equity sponsors may be able to strategically acquire and roll up current and future targets, often centralizing shared services and functions, thereby lowering costs and maximizing profits, which, in turn, ultimately maximizes limited partner returns. Accounting firms’ business is also fairly reliable and stable, usually with predictable income streams and the potential to expand into advisory services to augment profits.[6] Some industry observers predict private equity investment in the accounting sector may allow firms to deploy capital into new areas like enhanced technology and artificial intelligence, each of which theoretically might, consequently, promote consistency, efficiency, and lower costs.[7]
Top Three Considerations for Lenders and Their Counsel
In light of popularity of accounting and audit firm acquisitions, we offer the following top three considerations for lenders considering financing the same: (1) structuring, (2) auditor independence and regulatory considerations, and (3) management services agreements (“MSAs”) and/or administrative services agreements (“ASAs”).
1. Structuring
The alternative practice structure is ideal for businesses looking for external investment. Firms governed by alternative practice structure regimes are typically split between the advisory arm (“AdvisoryCo”) and the accounting business (“AttestCo”). Under a credit facility, AdvisoryCo is usually the borrower and AttestCo is a non-guarantor restricted subsidiary. It is therefore crucial for lenders and their counsel to appreciate how transactions between AdvisoryCo and AttestCo are governed and what rights and restrictions apply to targets’ partners and/or employees.
Importantly, accounting firm employment and partnership agreements often contain non-compete, non-solicitation, mandatory retirement, and other similar restrictions on partners and employees. As alternative practice structures may vary from firm to firm, a thorough review of relevant partnership and employment agreements, operating agreements, and other governing documents should be undertaken—most crucially, the MSA and/or the ASA (discussed below).
2. Auditor Independence
Accounting firms are typically subject to the U.S. Securities and Exchange Commission’s (“SEC”) and Public Company Accounting Oversight Board’s auditor independence rules and other similar regulations. Due to the broad reach and scope of such rules, financing arrangements may impair independence. Company and sponsor’s counsel should conduct a thorough independence analysis and confirm no issues; lenders’ counsel should expressly inquire about this during legal diligence. Lenders should push for credit agreement representations and warranties to the effect that the financing transaction does not violate the SEC’s Rule 2-01 under Regulation S-X or other applicable laws, as it may be detrimental to the underlying financing to have AdvisoryCo deemed an “associated entity” of AttestCo.
3. MSAs/ASAs
Alternative practice structures and the two entity silos are governed via MSAs or ASAs. The MSA or ASA, as applicable, spells out the agreements between AdvisoryCo and AttestCo. For example, such agreements will provide that AttestCo provides only accounting services and that AdvisoryCo provides—importantly, for a fee—administrative and “back-office” services to AttestCo (think personnel management, information technology and other tech services, billing and accounts, and so on).
It is imperative that lenders and their counsel obtain, review, and understand the relevant MSA or ASA. Key focus areas of such review include the following:
Fee for services: What is the scope of the fee and related services? When is such fee paid?
Termination fee: To which party is it payable? Are there any exclusions to payment of such fee?
Because MSAs/ASAs are key strategic assets of AdvisoryCo borrowers, credit agreement provisions should be tailored accordingly. For example, lenders should consider appropriate representations and warranties as to the effectiveness of MSAs/ASAs, fulsome events of default for termination of MSAs/ASAs, and a covenant restricting modifications of MSAs/ASAs adverse to the interests of the lenders. Lenders may also wish to consider restrictions on transferring MSAs/ASAs outside the ring-fenced loan party group and include reporting requirements.
Conclusion
As accounting firm LBO financings become increasingly commonplace, the body of relevant credit documentation that may serve as precedent for future transactions is growing. Sponsors, wishing to preserve their forms and ensure consistency across their portfolio companies, may resist bespoke constructs. Yet, lenders must be wary of cookie-cutter approaches and not lose sight of the fact that accounting firms (and other professional services firms) are no ordinary targets. Credit documentation must be diligently negotiated and be grounded in a firm understanding of the often-complex corporate and partnership structures and complex web of regulations to which each unique accounting firm is subject.
Mark Maurer, Private Equity’s Ties to Companies’ Auditors Have Never Been Closer. That Worries Some Regulators, Wall St. J. (Oct. 30, 2024). ↑
Shortly following his inauguration in January, President Donald J. Trump signed a flurry of executive orders implementing a wide array of administration policies. One of the executive orders, entitled “Ending Illegal Discrimination and Restoring Merit-Based Opportunity” (“DEI EO”), is designed to ban both public- and private-sector programs encouraging diversity, equity, and inclusion (“DEI”). Another, entitled “Ending Radical and Wasteful Government DEI Programs and Preferencing” (“EJ EO”), terminates environmental justice programs within the executive branch and targets federal contractors and grant recipients that advance DEI and environmental justice by instructing each federal agency to “terminate, to the maximum extent allowed by law, all . . . ‘equity-related’ grants or contracts.”
Shortly following her confirmation by the U.S. Senate, on February 5, Attorney General Pam Bondi issued a pair of memoranda to U.S. Department of Justice (“DOJ”) personnel, directing the Department to eliminate internal practices related to DEI and environmental justice and directing various elements of the DOJ to “investigate, eliminate, and penalize” private companies and universities (including nonprofits) that have “illegal” DEI programs. She instructed DOJ officials to enforce federal civil rights laws to abandon what she called “illegal discrimination and preferences,” outlining strategies such as launching criminal and civil investigations. These directives were issued to implement the president’s earlier executive orders.
While the concepts of these executive orders and DOJ enforcement memoranda were not surprising, given widespread criticism of DEI and other programs considered “woke” by the political right, the text of the directives surprised many with their explicit mentions of private sector and nonprofit organizations, many of which have long-established programs dedicated to DEI efforts. Some others are organized with DEI as a central tenet or purpose. The new directives have raised many concerns among nonprofit executives about the legality of both legacy and emerging DEI efforts and the status of their organizations’ funding secured through federal grants, cooperative agreements, contracts, and loans.
At a minimum, these directives signal the administration’s intent to pressure private-sector organizations regarding their DEI practices. A more expansive view of them foreshadows an aggressive effort to challenge DEI programs through lawsuits and regulations targeting organizations perceived as ideological and political enemies of the current administration and its policies.
Of immediate concern to many nonprofit recipients of federal grants, cooperative agreements, and contracts are the requirements in the DEI EO for such recipients to affirmatively certify that their organization (i) “does not operate any programs promoting DEI that violate any applicable Federal anti-discrimination laws” and (ii) is in compliance with all federal anti-discrimination laws that are “material to the government’s payment decisions for purposes of” establishing federal False Claims Act liability.
Executive orders carry the force of law. They are legally binding and can be enforced, both within the executive branch and against other entities. Executive orders traditionally carry out existing powers of the president and implement existing law, rather than creating new law, and often dictate how the executive branch will operate by directing departments and agencies to carry out certain initiatives. Given the executive branch’s vast bureaucracy and spending, executive orders have traditionally been a powerful policymaking tool for presidents to test or implement new economic and social policy. Executive orders are subject to judicial review by federal courts and can be revoked by the sitting president (including successors).
DEI Executive Order
The January 21 DEI EO’s stated purpose is to end “pernicious discrimination.” It directs federal departments and agencies to terminate “all discriminatory and illegal” DEI programs and practices and declares that DEI programs and practices are illegal” and “dangerous.” Both the executive orders and the DOJ directives contain cursory citations to the federal Civil Rights Act of 1964 and the U.S. Supreme Court’s 2023 decision in Students for Fair Admissions, Inc. v. President and Fellows of Harvard College as supporting the conclusion that DEI programs, broadly speaking, are illegal.
Notably, the DEI EO and the DOJ directives also took aim at DEI efforts in the private sector, attempting to extend the order’s reach beyond the typical province of executive orders of federal agencies and federal award recipients. The DEI EO directed agency heads to “take all appropriate action” to “advance in the private sector the policy of individual initiative, excellence, and hard work.” The order directs federal agencies to submit recommendations for enforcement of civil rights laws, including by identifying “discriminatory DEI practitioners” and by recommending investigations and potential litigation related to DEI programs of “publicly traded corporations, large non-profit corporations or associations, foundations with assets of 500 million dollars or more, State and local bar and medical associations, and institutions of higher education with endowments over 1 billion dollars.” The explicit reference to nonprofit organizations and associations has generated concern among nonprofit and association executives, and a rush to evaluate whether any DEI practices could be considered “discriminatory.” One of the DOJ directives similarly directed DOJ’s Civil Rights Division to recommend enforcement actions and “other appropriate measures to encourage the private sector to end illegal discrimination and preferences.” Among the recommendations the attorney general requested are “proposals for criminal investigations and for up to nine potential civil compliance investigations.”
Environmental Justice Executive Order
Like the DEI EO, the EJ EO directs federal agencies to terminate federally funded DEI programs and initiatives—including through nonprofits that receive federal grants or contracts—and extends the culling to include agency efforts to promote environmental justice. The intent of the EJ EO seems to be to claw back parts of the Biden administration’s environmental regulations, as well as portions of the federal Infrastructure Investment and Jobs Act and the Inflation Reduction Act that provided funding for environmental justice programs.
Although there is some clear overlap in the subject matter of the EJ EO and the DEI EO, the EJ EO goes further than the DEI EO by targeting federal contractors and grant recipients. It directs agencies to provide the White House Office of Management and Budget (“OMB”) with a list of federal contractors who have provided DEI training to federal agencies, as well as federal grantees who received federal funding “to provide or advance DEI, DEIA, or ‘environmental justice’” programs. Although the EJ EO does not direct that litigation or enforcement actions be taken against these grantees or contractors, the intent of the executive order seems clear: to achieve compliance with its goals by the mere threat of including these organizations on an administration list of supposed transgressors.
Also of note is that on January 27, OMB took the extreme step of “pausing” all federal grants, cooperative agreements, and loans, putting mission-driven nonprofits in critical areas—including public health, environmental protection, immigration, international development, and others—at risk of losing funding that they rely on to carry out their missions. While the administration reversed its “pause” shortly after its issuance, and multiple federal courts have since enjoined the action, the executive orders remain in full force and effect.
Related Litigation
On February 21, a federal judge in Maryland issued a nationwide preliminary injunction against portions of the DEI EO and EJ EO, ruling that portions of the orders were likely to violate the First Amendment’s Free Speech Clause because those portions constituted impermissible content and viewpoint discrimination. The injunction also found that portions of the executive orders were likely to violate the Fifth Amendment because they are unconstitutionally vague.
The trend in private litigation against private-sector DEI programs, which increased in the wake of Students for Fair Admissions, has continued following the president’s executive orders. As a recent example, on March 5, a nonprofit group called Do No Harm, a watchdog group that describes itself as mobilized around “protecting healthcare from the disastrous consequences of identity politics,” filed a complaint in federal district court against the nonprofit 501(c)(3) American Chemical Society (“ACS”), seeking to enjoin ACS from operating the ACS Scholars Program, a scholarship program for students from historically underrepresented groups in the chemical sciences. Only Black, Hispanic, and Indigenous American applicants are eligible for the scholarships. Do No Harm alleged that the program violated Section 1981 of the Civil Rights Act of 1866, which prohibits discrimination on the basis of race in making and enforcing contracts. The suit also alleges violations of Title VI of the Civil Rights Act of 1964, which prohibits discrimination on the basis of race, color, and national origin in programs that receive federal financial assistance. To that end, the suit claims that ACS’s federal tax exemption under Section 501(c)(3) (due to the ability to receive tax-deductible charitable contributions) is a form of federal financial assistance that brings ACS’s scholarship program within the scope of Title VI. Note that the antidiscrimination reach of Title VI is not limited only to race and contracts and is in fact far broader.
Practical Considerations
Unfortunately, the DEI EO and the EJ EO do little to elaborate on what they view as “discriminatory” and “illegal.” Additionally, the EJ EO and DOJ directives somewhat obscure the consequences of being on an administration “list” of organizations providing DEI training or programming for the federal government, although the clear implication is the loss of federal funds. While both executive orders and the DOJ directives make oblique references to statutes and court decisions, they do not examine them in depth, nor do they indicate which elements of a DEI program would make it discriminatory or illegal, adding to the lack of clarity regarding the legal risk and the anxiety of nonprofit leaders. Recent administrative actions have been so broad as to imply that innocuous textual references to diverse groups are evidence of illegal activity prohibited by the executive orders. For instance, according to recent reporting, staff at the National Science Foundation (“NSF”) have reviewed thousands of active science research projects using a list of flagged keywords (such as “women,” “diversity,” “minority,” “institutional,” “historically,” and “socioeconomic,” among dozens of others), to determine if the projects include activities that violate the new executive orders. Scientists who receive NSF funding were already put on notice to cease any activities that do not comply with the executive orders. In this context, nonprofit executives who have concerns about the legality of DEI programs should consult experienced legal counsel to further examine their legal risk and discuss potential mitigation strategies.
Aside from concerns related to federal funding, many nonprofits are concerned that their federal tax-exempt status may be at risk due to DEI-related activities. Although there has not been any evidence of DOJ or the Internal Revenue Service (“IRS”) challenging nonprofit organizations’ federal tax exemptions on this basis, such concerns have been raised by claims made in private litigation framing 501(c)(3) tax-exempt status as a form of federal financial assistance, thus bringing such organizations under the ambit of Title VI of the federal Civil Rights Act of 1964, which has a much broader reach—with even more alarming adverse consequences—for these entities. Beyond this argument, it is not inconceivable that a “weaponized” IRS or DOJ could seek to revoke the tax-exempt status of any tax-exempt organization that it believes is primarily engaged in activities—such as “illegal DEI”— that it believes are contrary to public policy. There is some precedent in case law for such arguments. If the IRS and/or DOJ were to go down this path, the potential adverse implications for some tax-exempt organizations are sweeping.
Even in this time of uncertainty, there are several steps nonprofit executives can take to understand their legal risk related to DEI initiatives. These steps all require a degree of self-awareness of an organization’s values and culture, as well as a careful examination of organizational finances, legal risk, and public profile.
Know your values. Some nonprofits are organized for the specific purpose of supporting certain racial, ethnic, religious, or gender groups, or other groups, in a way that may be considered “DEI” by the Trump administration. For these organizations, there may be a direct conflict between their organizational purposes and the dictates of the executive orders and DOJ directives. Don’t be too quick to abandon a central tenet of your organization without careful consideration, but examine whether certain less drastic steps can be taken to mitigate risk. For instance, many nonprofits are scrubbing their public-facing websites to remove any DEI-related references.
Examine your funding streams. Organizations that do not rely on federal awards for their operations are much more insulated from these executive orders and potential DOJ enforcement than ones that do. If your organization does receive federal funds, and it has a constellation of subsidiaries and affiliates, identify which entity or entities house the federally funded programs and the DEI or environmental justice programs that put you at risk under the executive orders, and do what you can to insulate the other entities accordingly. Also, begin examining funding alternatives, such as private foundation grants, that may allow you to fulfill your mission and meet your funding needs.
Scrutinize your DEI initiatives. Take a hard look at your DEI-related initiatives to ensure that they are consistent with current law, and consult experienced legal counsel for assistance. The federal Civil Rights Act of 1964, mentioned in the DEI EO, is only one of the laws implicated by such programs. As discussed above, also very relevant is Section 1981 of the federal Civil Rights Act of 1866, which has been used to launch legal attacks on programs from nonprofits and other entities that restrict eligibility for certain grants, scholarships, fellowships, and other opportunities to certain races, among other protected characteristics. Other laws implicated could include state public accommodations laws and state education and employment laws. Several states have passed anti-DEI laws covering employment, state grants, and education that need to be taken into account, such as the Florida law that prohibits private nonprofit and other employers from providing any DEI-related training to their Florida-based employees. See our prior article on mitigating risks of DEIA programs for a more expansive discussion of these issues.
Assess your culture. Have a good understanding of the level of support for DEI-related initiatives within your nonprofit organization and among your members, donors, grantors, and other stakeholders. Understand your organization’s risk tolerance, budget, values, public profile, and ability to withstand legal challenges and the significant costs that often accompany them (some of which may not be covered by insurance). Be able to identify any potentially controversial programs as a way to anticipate legal and regulatory challenges, and consider what interim changes can be made in order to mitigate risk and make your organization less of a target in the current climate.
Most of the administration’s directives in this area (and others) are already the subject of legal challenges in the courts—some of which have found early success—but the fate of that litigation, much of which is likely to work its way up to the U.S. Supreme Court, is uncertain. While many legal experts believe that a number of the new directives are unlawful, relying on such presumptions can carry with it a high degree of risk.
Although the new administration’s actions have instilled fear and uncertainty in many in the nonprofit community, these early actions may prove to be the catalysts that encourage nonprofits to take necessary protective actions. The Trump administration has given nonprofit organizations an early opportunity to galvanize themselves against potential adverse legal and regulatory consequences. By taking early prophylactic steps against these threats, nonprofits will be better positioned to defend themselves for the next four years while maintaining progress toward their missions.
The views expressed herein are solely those of the authors and are not necessarily those of the authors’ firm, the American Bar Association, or the Business Law Section.
On February 17, 2025,[2] the U.S. District Court for the Eastern District of Texas, before which is pending the Smith v. U.S. Department of the Treasury dispute, lifted the preliminary injunction it issued January 7, 2025, against the Reporting Rules[3] adopted pursuant to the Corporate Transparency Act (“CTA”),[4] thereby clearing the way for enforcement of the CTA and its filing obligations. With that action, the last pending judicial barrier to broad enforcement of the CTA’s reporting obligations was lifted, and its general enforcement recommenced.
That was, however, far from the final development with respect to the implementation of the CTA. Rather, over the first weekend of March, the government and a variety of public officials, including the current chief executive of the United States, issued a series of pronouncements as to the CTA’s reach and enforcement that ultimately foreshadow the intention to abdicate much of its enforcement. The same week, another federal district court became the first to find that the CTA violates the Fourth Amendment right against unreasonable search and seizure.
The Smith Preliminary Injunction and the New March 21 Filing Deadline
To recap, as previously reviewed in detail,[5] even while the nationwide preliminary injunction issued by the district court in Texas Top Cop Shop, Inc. v. McHenry (formerly Texas Top Cop Shop, Inc. v. Garland) (“TTCS”)[6] was in effect and challenges thereto were proceeding, the Smith court issued a preliminary injunction against enforcement of the CTA, with that relief being restricted to the parties to the suit before the court, and a nationwide injunction against the Reporting Rules.[7] On January 23, 2025, the Supreme Court lifted the TTCS preliminary injunction. In response to the government’s motion to stay the Smith preliminary injunction pending appeal,[8] to which the plaintiffs filed a response,[9] on February 18, 2025, the Smith court lifted its preliminary injunction as to both the CTA and the Reporting Rules.
In furtherance of the undertaking it made in its motion to stay the preliminary injunction pending appeal,[10] the Financial Crimes Enforcement Network (“FinCEN”) announced on February 18, 2025, that it was granting reporting companies until March 21, 2025, to bring current all outstanding filing obligations.[11] Further, the directive as to the new filing deadline “bridges” the companies that would have fallen into any of the gaps that otherwise existed, an example being companies whose obligation to file an initial or an updated beneficial ownership information report (“BOIR”) would have fallen on February 18 or 19, 2025.
Under the Reporting Rules,[12] reporting companies preexisting January 1, 2024, were afforded until “not later than” January 1, 2025, within which to file an initial BOIR.[13] Companies created on or after January 1, 2024, and before January 1, 2025, were afforded ninety days within which to file an initial BOIR.[14] For companies created on or after January 1, 2025, they are afforded thirty days within which to file an initial BOIR.[15] Once a BOIR has been filed, a reporting company has thirty days within which to file an update as to any change in the submitted information.[16]
Between the TTCS and Smith injunctions, except for a brief period while the TTCS injunction was stayed and until that stay was lifted, those deadlines were on hold from the December 3, 2024, granting of the TTCS preliminary injunction through the February 18, 2025, lifting of the Smith injunction. In that period, there arose filing deadlines for companies preexisting January 1, 2024; companies created on or after September 4, 2024; and updates to previously filed BOIRs.[17]
Application of the March 21, 2025, Deadline
The examples below will help to understand how—in the face of these on-again, off-again injunctions and prior reporting periods for initial and updated BOIRs for companies created at various times—the new March 21 deadline was intended to apply. We use the phrase was intended to apply instead of will apply because shortly after the FinCEN Notice dated February 18 that instituted the March 21 deadline, FinCEN published a press release rescinding that deadline (see “And Then the Seventy-Two Hours of Mayhem,” below).
Examples of application of the March 21, 2025, deadline:
ABC Inc. was created on September 4, 2024; its initial BOIR was due not later than December 3, 2024. That day, the TTCS preliminary injunction was issued, and no filing was made. That initial BOIR would have been due not later than March 21, 2025.
XYZ LLC was created on December 31, 2022; its initial BOIR was due not later than January 1, 2025. With the TTCS preliminary injunction then in effect, no filing was made, and after it was lifted, no action was taken with regard to the Smith injunction. That initial BOIR would have been due not later than March 21, 2025.
DEF LLC was created on December 31, 2024; its initial BOIR was due not later than March 31, 2025. The March 21, 2025, deadline is eighty days after its creation, and DEF would have been afforded the full ninety days of the Reporting Rules within which to file its initial BOIR.
GHI Inc. was incorporated on January 1, 2025; its initial BOIR was due before January 31, 2025. However, as of that day, the Smith injunction was in place, and no action was taken. That initial BOIR would have been due not later than March 21, 2025.
JKL Inc. was created on March 1, 2024, and filed its initial BOIR on May 1, 2024; that report identified Laura as a beneficial owner, a position she held as a senior officer of the company. On December 1, 2024, Laura resigned her position, and she ceased to have any relationship with the company; an updated BOIR was due by the end of the month. However, with the TTCS and then the Smith injunctions in place, no updated BOIR was filed. JKL would have had until March 21, 2025, to file an updated BOIR deleting any reference to Laura as a beneficial owner and otherwise updating the filed information to address, if applicable, her replacement in that role.
MNO LLC was created on January 1, 2022; while its initial BOIR was not due until January 1, 2025, it filed its initial BOIR on June 1, 2024. On November 15, 2024, a senior officer of the LLC resigned and ceased to be a beneficial owner of MNO. The company was due to file an updated BOIR not later than December 15, 2024. With the TTCS injunction in place, no filing was made. That BOIR update would have been due not later than March 21, 2025.
“True, Correct, and Complete”
It bears noting that simply filing a report that was held in abeyance during the period that the CTA and Reporting Rules were enjoined is not necessarily the entirety of a company’s obligations. A BOIR must, as of its filing, be “true, correct, and complete.”[18] Counsel and other filers who are “sitting on” filings need to confirm that the information set forth therein remains accurate as of the filing date. If inaccurate information is inadvertently filed, there is a ninety-day period within which to file a correction.[19]
Another application of the requirement that a BOIR be “true, correct, and complete” is that certain changes in already-filed information that took place during the pendency of either or both of the TTCS and Smith preliminary injunctions will never be reported. For example, assume VWX Corp. was created on December 1, 2024, and its initial BOIR would have been due not later than March 1, 2025. Its initial president was Mary, but she resigned from that role on December 31, 2024. Keith took that role on an interim basis on January 1, 2025, and resigned on March 15, 2025, when Laura took the reins. When VWX would have filed its initial BOIR on March 21, it would have identified Laura as a beneficial owner (senior officer) and not reported either Mary or Keith as having been a senior officer of the company.
The Other CTA Cases
Of course, TTCS and Smith are not the only cases in which the constitutionality of the CTA and the Reporting Rules has been challenged; they are simply the cases in which injunctive relief in favor of a group larger than the plaintiffs has been granted. While both TTCS and Smith continue, there are a number of other disputes at various stages.
National Small Business United
The “granddaddy” of suits challenging the CTA is National Small Business United v. Yellen; on March 1, 2024, the district court found that the CTA is unconstitutional as outside the bounds of Congress’s authority under the Commerce Clause.[20] That decision was appealed to the U.S. Court of Appeals for the Eleventh Circuit, and oral argument was held on September 27, 2024. As of this writing, no decision has been delivered. Recently both the government and the plaintiffs delivered letters to the Eleventh Circuit requesting the court to rule in favor of their respective positions.[21]
Firestone and Community Ass’ns Institute
In both Firestone v. Yellen and Community Ass’ns Institute v. Yellen, the respective district courts denied requests for a preliminary injunction against the enforcement of the CTA.[22] These decisions are on appeal to, respectively, the U.S. Court of Appeals for the Ninth and the Fourth Circuits.
Hotze
In Hotze v. U.S. Department of the Treasury, the third of the CTA lawsuits pending in Texas, the district court denied the plaintiffs’ request for a preliminary injunction in part because the TTCS injunction was at the time already in place.[23] As the TTCS and Smith injunctions were seriatim lifted, the plaintiffs returned to the Hotze court and restated their request for injunctive relief,[24] efforts that have been (at least as of this writing) unavailing. On March 6, 2025, the Hotze court issued an order providing in part:
On March 2, 2025, the U.S. Department of the Treasury issued a statement that it will “not enforce any penalties or fines associated with the beneficial ownership information reporting rule under the existing regulatory deadlines,” and would further “not enforce any penalties or fines against U.S. citizens or domestic reporting companies or their beneficial owners after the forthcoming rule changes take effect.” Press Release, U.S. Dep’t Treasury, Treasury Department Announces Suspension of Enforcement of Corporate Transparency Act Against U.S. Citizens and Domestic Reporting Companies (Mar. 2, 2025), https://home.treasury.gov/news/pressreleases/sb0038. The statement also noted that the Treasury “will further be issuing a proposed rulemaking that will narrow the scope of the rule to foreign reporting companies only.” Id.
In light of the foregoing statement, the parties are ORDERED to submit a joint brief, not to exceed five double-spaced pages, addressing how the Treasury’s statement bears on the instant case on or before Friday, March 14, 2025.[25]
Midwest Ass’n of Housing Cooperatives
In Midwest Ass’n of Housing Cooperatives v. Bessent, the plaintiffs seek a declaration that housing cooperatives are exempt from the CTA irrespective of their organizational structure.[26] On November 26, 2024, a curious order was entered in this case. Subsequent to a status conference held to discuss matters including the Plaintiffs’ Emergency Motion for Declaratory Relief, or Alternatively, Preliminary Injunctive Relief,[27] and responding to the government’s request to hold the case in abeyance pending the decision of the Eleventh Circuit in National Small Business United, the court agreed to the request for an abeyance “provided the government refrain from arresting, jailing, imprisoning, or imposing civil penalties against plaintiffs or individuals affiliated with plaintiffs for any violation of the statute during the period of abeyance.”[28]
Boyle
In Boyle v. Bessent, on February 14, 2025, the district court found that the CTA is constitutional and within Congress’s authority under the Commerce Clause.[29] However, in the course of its decision finding that the CTA was enacted within the scope of Congress’s authority under the Commerce Clause, the Boyle court made a number of observations as to the penalty provisions of the Reporting Rules, suggesting that those penalty provisions that are beyond the scope of the statute itself are unauthorized and without authority.[30] The word suggesting rather than holding is important because the case may be made that the entirety of this discussion is dicta in that the Boyle court did not hold that the regulatory penalty provisions are invalid even as it upheld the validity of the CTA itself, and the legitimacy of those regulatory penalty provisions was not an element of the court’s determination as to the statute’s legitimacy.
Small Business Ass’n of Michigan
Then, in Small Business Ass’n of Michigan v. Yellen, on March 3, 2025, the district court struck down the CTA as an unconstitutional violation of the Fourth Amendment protection against unreasonable search and seizure.[31] While this argument had been presented to other courts and either rejected or left undecided as unnecessary to rule upon,[32] the Small Business Ass’n of Michigan court squarely addressed it and determined:
The CTA may have good intentions but the road it chooses to pursue them paves over all reasonable limits. The CTA’s reporting requirements reach indiscriminately across the smallest players in the economy to extract and archive a trove of personal data explicitly for future law enforcement purposes at an expected cost to the reporting players of almost $22 billion in the first year alone. The Fourth Amendment prohibits such an unreasonable search.[33]
The court went on to write: “In the Court’s view, this massive collection of personally identifying data for law enforcement, costing providers billions of dollars, amounts to an unreasonable search in violation of the Fourth Amendment.”[34] The relief granted is restricted to the parties to that action.[35]
In a letter to the Eleventh Circuit in National Small Business United, the government argued that the Small Business Ass’n of Michigan decision is flawed, signaling that an appeal is likely:
We write to respond to plaintiffs’ letter regarding the district court’s decision in Small Business Ass’n of Michigan v. Bessent, No. 24-cv-314, 2025 WL 704287 (W.D. Mich. Mar. 3, 2025) (“SBAM”) and to inform this Court about recent regulatory developments. In SBAM, the Western District of Michigan held that the CTA is inconsistent with the Fourth Amendment and permanently enjoined the government from enforcing the statute against the plaintiffs there. For the reasons given in the government’s briefing in this case, see Reply Br. 17-23, that decision is incorrect. Notably, the district court failed to reconcile its decision with the large number of state and federal reporting requirements that have long been understood as raising no constitutional concern. And the SBAM decision is an outlier: multiple district courts have recognized, in rejecting preliminary injunction motions, that Fourth Amendment challenges to the CTA are unlikely to succeed, and the district court in this case did not reach plaintiffs’ Fourth Amendment claim. See Firestone v. U.S. Dep’t of Treasury, No. 3:24-cv-1034-SI, 2024 WL 4250192, *10 (D. Or. Sept. 20, 2024); Community Ass’ns Inst. v. U.S. Dep’t of Treasury, No. 1:24-cv-1597, 2024 WL 4571412, *8-9 (E.D. Va. Oct. 24, 2024).[36]
And Then the Seventy-Two Hours of Mayhem
All the back-and-forth of injunctions and stays, culminating in the March 21 deadline, was a whiplash of events—but then things got really weird.
February 27 FinCEN Press Release
On Thursday, February 27, 2025, after the close of business in Washington, D.C., FinCEN published the following press release:
FinCEN Not Issuing Fines or Penalties in Connection with Beneficial Ownership Information Reporting Deadlines
WASHINGTON––Today, FinCEN announced that it will not issue any fines or penalties or take any other enforcement actions against any companies based on any failure to file or update beneficial ownership information (BOI) reports pursuant to the Corporate Transparency Act by the current deadlines. No fines or penalties will be issued, and no enforcement actions will be taken, until a forthcoming interim final rule becomes effective and the new relevant due dates in the interim final rule have passed. This announcement continues Treasury’s commitment to reducing regulatory burden on businesses, as well as prioritizing under the Corporate Transparency Act reporting of BOI for those entities that pose the most significant law enforcement and national security risks.
No later than March 21, 2025, FinCEN intends to issue an interim final rule that extends BOI reporting deadlines, recognizing the need to provide new guidance and clarity as quickly as possible, while ensuring that BOI that is highly useful to important national security, intelligence, and law enforcement activities is reported.
FinCEN also intends to solicit public comment on potential revisions to existing BOI reporting requirements. FinCEN will consider those comments as part of a notice of proposed rulemaking anticipated to be issued later this year to minimize burden on small businesses while ensuring that BOI is highly useful to important national security, intelligence, and law enforcement activities, as well to determine what, if any, modifications to the deadlines referenced here should be considered.[37]
The February 27 press release had the immediate effect of setting aside the previously announced March 21 deadline for bringing all filings current while signaling that an as-yet-undefined modification of the reporting regime would be detailed in a forthcoming (stated to be not later than March 21, 2025) “interim final rule.” In addition, while modifications of the existing regulatory scheme would be considered, not once but twice it was said that the view remained that “BOI is highly useful to important national security, intelligence, and law enforcement activities.” This seems entirely reasonable—the authors can easily list any number of changes to the Reporting Rules that would address problems thereunder but that would not impact the efficacy of the desired database.[38]
March 2 Treasury Department Press Release
Then, on Sunday, March 2, 2025, the entire program was unsettled when the U.S. Department of the Treasury (not FinCEN) issued the following press release:
Treasury Department Announces Suspension of Enforcement of Corporate Transparency Act Against U.S. Citizens and Domestic Reporting Companies
The Treasury Department is announcing today that, with respect to the Corporate Transparency Act, not only will it not enforce any penalties or fines associated with the beneficial ownership information reporting rule under the existing regulatory deadlines, but it will further not enforce any penalties or fines against U.S. citizens or domestic reporting companies or their beneficial owners after the forthcoming rule changes take effect either. The Treasury Department will further be issuing a proposed rulemaking that will narrow the scope of the rule to foreign reporting companies only. Treasury takes this step in the interest of supporting hard-working American taxpayers and small businesses and ensuring that the rule is appropriately tailored to advance the public interest.
“This is a victory for common sense,” said U.S. Secretary of the Treasury Scott Bessent. “Today’s action is part of President Trump’s bold agenda to unleash American prosperity by reining in burdensome regulations, in particular for small businesses that are the backbone of the American economy.”[39]
Even while this press release was published, the FinCEN website continued through at least the morning of Monday, March 10, 2025, to feature the February 18 FinCEN Notice setting the March 21 filing deadline, raising clear questions as to what is now the source for authoritative guidance as to the CTA and filing deadlines, if any.
Exactly how would be effected the “proposed rulemaking” pursuant to which the enforcement of the CTA would be “narrow[ed]” to only foreign reporting companies is unclear. At this point in time, it is unknown whether foreign reporting company will continue to have the same meaning as is ascribed by the CTA and the current Reporting Rules.[40] Might it mean instead both an entity formed outside the United States and also a domestic organization with owners (however defined) who are not U.S. persons?[41] If not, a major purpose of the CTA—namely circumscribing the use of domestic U.S.-formed entities for nefarious purposes—will be emasculated. In a March 10, 2025, letter penned by Senators Whitehouse and Grassley, they asked Secretary Bessent that and related questions, including:
We request that you provide us the legal basis for the Treasury Department’s policy decision to categorically suspend enforcement of the CTA’s reporting requirements for all U.S. citizens and domestic reporting companies. In addition, we request that you provide us with information about how you intend to satisfy the policy goals of the CTA. As part of your response, please address the following questions:
Has the Treasury Department followed or initiated the process required by the CTA to exclude an entity or class of entities from its reporting requirements?
What steps has Treasury taken to ensure that any change in the practice or rulemaking governing BOI reporting fulfills the law enforcement and national security purposes of the CTA?[42]
A Statutory Scheme Upended
But there is a broader question—namely, how the Treasury Department and/or FinCEN can publish and apply regulations so at odds with the statutory system. The CTA applies its reporting requirements to “reporting companies,” a set comprised of “domestic reporting companies” and “foreign reporting companies.”[43] Absent abject and intentional blindness to the statutory scheme, application of the CTA’s reporting requirements to only foreign reporting companies does more than substantial violence to the statutory scheme, one whose validity this administration has argued to various courts.[44]
Further, it is not clear that there is a univocal message being conveyed by FinCEN and the Treasury Department—and even the White House. Nearly coincident with the publication of the Treasury Department press release, the current chief executive of the United States published a “Truth” on the Truth Social network:
Exciting news! The Treasury Department has announced that they are suspending all enforcement of the outrageous and invasive Beneficial Ownership Information (BOI) reporting requirement for U.S. Citizens. This Biden rule has been an absolute disaster for Small Businesses Nationwide. Furthermore, Treasury is now finalizing an Emergency Regulation to formally suspend this rule for American businesses. The economic menace of BOI reporting will soon be no more.[45]
With a hat tip to Chip More[46] for this formatting, the various messages convey the following:
Publication
Domestic Reporting Companies
Foreign Reporting Companies
U.S. Citizens as Beneficial Owners
Foreign Citizens as Beneficial Owners
FinCEN Notice of Feb. 18, 2025
Accrued BOIRs due not later than March 21, 2025
Accrued BOIRs due not later than March 21, 2025
Not mentioned
Not mentioned
FinCEN Press Release of Feb. 27, 2025
No penalties, fines, or enforcement actions at least until new rule is published
No penalties, fines, or enforcement actions at least until new rule is published
Not mentioned
Not mentioned
Treasury Department Press Release of March 2, 2025
No penalties/fines
Unclear whether penalties/fines/ enforcement are suspended for foreign reporting companies until revised regulations are issued.
No penalties/fines
New rule will presumably still apply to foreign citizens that are associated with foreign reporting companies. Unclear whether new rule will enforce penalties against foreign citizens that are beneficial owners of domestic reporting companies.
Presidential “Truth” of March 2, 2025
All enforcement suspended on “American businesses”
Not explicitly mentioned
All enforcement suspended on “American businesses”
Not explicitly mentioned
Perhaps by the time this article is published the messages will be reconciled, and it will be clear that there is an adult in the room directing a clear modification of the CTA’s reporting regimen in a format that is consistent with the statute and may be relied upon by those who are advising clients on CTA compliance. For the practicing bar and the millions of companies both subject to and endeavoring to comply with the CTA, it should never have come to this. Regardless, all indications are that the government will continue to argue for the constitutionality of the CTA, irrespective of whether it is in its current or a modified form. For example, in a March 7, 2025, reply brief in TTCS, the government wrote:
The government’s recent announcement that it will “issu[e] a proposed rulemaking that will narrow the scope of the [reporting requirements] to foreign reporting companies only” and that it will not “enforce any penalties or fines against U.S. citizens or domestic reporting companies or their beneficial owners” underscores that an injunction is not warranted. Department of Treasury, Treasury Department Announces Suspension of Enforcement of Corporate Transparency Act Against U.S. Citizens and Domestic Reporting Companies (Mar. 2, 2025), https://perma.cc/73RD-HT6R. The government’s efforts to implement the CTA in a calibrated way do not justify plaintiffs’ request for an injunction stripping the government of authority to implement the statute at all.[47]
What Does It All Mean?
As of now, the CTA is not dead; the various messages that have been released are consistent in promising that it will in some modified form remain in place for foreign entities, a set of filers that, going forward, may be defined differently from the definition with which we are already familiar. As for domestic entities and beneficial owners, the penalty provisions of the law will not be enforced—which leaves unresolved a huge number of questions, not all of which will be addressed in the forthcoming rules (interim or otherwise), including the following:
What is the effect of not enforcing the penalties? There is a marked difference between no penalty and a penalty not enforced. Will the penalties set by the CTA (as contrasted with the penalty provisions of the Reporting Rules, as discussed above in the context of the Boyle decision) continue to accrue[48] to the effect that a future administration may decide to enforce the penalties, particularly against an identified bad actor? Recall that, generally speaking, estoppel may not be asserted against the government.[49] Against that uncertainty, what reserves should companies that do not make a voluntary BOIR filing set aside against the potential exposure, and how is this potential penalty to be treated in due diligence and future acquisitions?
May attorneys, consistent with their ethical obligations, advise that the CTA may be ignored? In response to client inquiries to the effect “So I don’t have to do anything, right?,” attorneys are going to be challenged to explain the legal effect of a “no enforcement” declaration set forth in a press release vis-à-vis an existing statutory penalty. In the face of the obligation to properly advise clients in order for them to make informed decisions,[50] attorneys are going to wrestle with the scope of the discussion and the recommended course of action.
What will be the treatment going forward of the beneficial ownership information already in the CTA database? Attorneys and others have already been fielding the question of whether information filed in the database may be removed and whether the database will be deleted. As of this time, there is no mechanism by which filed information may be removed, and there has been no suggestion that the database will be “wiped.”[51]
If the CTA is invalid in the face of the Fourth Amendment, is reference to the database going to give rise to “fruit of the poisonous tree” defenses? This issue is well beyond the ken of the authors, each of whom practices or teaches in the area of business organization law and is without practical experience in the intricacies of the Fourth Amendment. That said, based upon an at best cursory review of the hornbook law, as an exclusionary rule, evidence derived from improper government action is excludable as evidence in a proceeding brought by the government.[52] While there are exceptions to the principle, if the information in the CTA database is utilized in the course of an investigation, no doubt the defense will seek an exclusion based upon an allegation that the CTA’s database was created in violation of the Fourth Amendment.
How will the database impact the CDD obligations of banks and financial institutions? The intention was that beginning in the spring of 2025, banks and other financial institutions, with customer consent, would be able to access the CTA database in order to discharge their customer due diligence (“know your customer”) (“CDD”) obligations. Whether this facility will have much, if any, utility with a significantly truncated database remains to be seen. If a particular financial institution desired to do so, presumably it could condition opening and maintaining an account upon the customer making a voluntary filing of a BOIR (with a contractual obligation to maintain its accuracy), which it would rely upon to satisfy the CDD obligation.[53] In the absence of such a system, presumably banks and other financial institutions will continue to have direct CDD obligations that entail collecting and maintaining the necessary information. There may also be consideration of expanding the beneficial owner definitions of the extant CDD rules to more closely mimic those currently existing under the CTA and the Reporting Rules.
How will CTA developments affect state beneficial ownership reporting systems? States have considered, and New York has adopted, a state-level reporting system similar in certain respects to the CTA.[54] An analogous proposal is currently pending before the Massachusetts legislature.[55] Whether the significant restriction of the federal CTA will either encourage or discourage the adoption of state-level equivalents remains to be seen. If the reasoning of Small Business Ass’n of Michigan is upheld on appeal (assuming there is an appeal), it may undercut the ability of a state to adopt such a reporting regimen.
In closing, we await word of the new regime promised by March 21.
Samuel Clemens (a/k/a Mark Twain). The quote is often misstated as “The reports of my death are greatly exaggerated.” ↑
While the order was dated February 17, 2025, a federal holiday, it was not electronically posted until February 18, 2025. ↑
31 U.S.C. § 5336. For a review of the CTA generally, see Larry E. Ribstein, Robert R. Keatinge & Thomas E. Rutledge, Ribstein and Keatinge on Limited Liability Companies, at ch. 4A (Nov. 2024). ↑
Plaintiffs’ Response to Motion for Stay Pending Appeal, Smith, No. 6:24-cv-336 (Doc. No. 35). ↑
Defendants’ Motion for Stay Pending Appeal, Smith, No. 6:24-cv-336, at 1 (“If the stay is granted, the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) intends to extend the Corporate Transparency Act (CTA) compliance deadline for thirty days. During that period, FinCEN will assess whether it is appropriate to modify the CTA’s reporting requirements to alleviate the burden on low-risk entities while prioritizing enforcement to address the most significant risks to U.S. national security. Staying the grant of preliminary relief will help facilitate that process.”); id. at 6 (“As a matter of policy, Treasury continues to assess the potential burden of the Final Rule. If this Court grants the stay, FinCEN intends to announce that it will extend the compliance deadline for thirty days. During that period, FinCEN intends to assess its potential options to prioritize reporting for those entities that pose the most significant national security risks while providing relief to lower-risk entities and, if warranted, amending the Final Rule. The existence of the § 705 stay of the Final Rule should not be permitted to frustrate Treasury’s efforts to implement the extant Final Rule or to modify it, as warranted.”). ↑
WASHINGTON, D.C. — With the February 18, 2025, decision by the U.S. District Court for the Eastern District of Texas in Smith, et al. v. U.S. Department of the Treasury, et al., 6:24-cv-00336 (E.D. Tex.), beneficial ownership information (BOI) reporting requirements under the Corporate Transparency Act (CTA) are once again back in effect. However, because the Department of the Treasury (Treasury) recognizes that reporting companies may need additional time to comply with their BOI reporting obligations, FinCEN is generally extending the deadline 30 calendar days from February 19, 2025, for most companies.
Notably, in keeping with Treasury’s commitment to reducing regulatory burden on businesses, during this 30-day period FinCEN will assess its options to further modify deadlines, while prioritizing reporting for those entities that pose the most significant national security risks. FinCEN also intends to initiate a process this year to revise the BOI reporting rule to reduce burden for lower-risk entities, including many U.S. small businesses.
Updated Deadlines
For the vast majority of reporting companies, the new deadline to file an initial, updated, and/or corrected BOI report is now March 21, 2025. FinCEN will provide an update before then of any further modification of this deadline, recognizing that reporting companies may need additional time to comply with their BOI reporting obligations once this update is provided.
Reporting companies that were previously given a reporting deadline later than the March 21, 2025 deadline must file their initial BOI report by that later deadline. For example, if a company’s reporting deadline is in April 2025 because it qualifies for certain disaster relief extensions, it should follow the April deadline, not the March deadline.
As indicated in the alert titled “Notice Regarding National Small Business United v. Yellen, No. 5:22-cv-01448 (N.D. Ala.)”, Plaintiffs in National Small Business United v. Yellen, No. 5:22-cv01448 (N.D. Ala.)—namely, Isaac Winkles, reporting companies for which Isaac Winkles is the beneficial owner or applicant, the National Small Business Association, and members of the National Small Business Association (as of March 1, 2024)—are not currently required to report their beneficial ownership information to FinCEN at this time.
Reporting companies can report their beneficial ownership information directly to FinCEN, free of charge, using FinCEN’s E-Filing system available at https://boiefiling.fincen.gov. More information is available at fincen.gov/boi. ↑
This summation relates to a domestic reporting company; equivalent requirements apply as to foreign reporting companies first registered in the relevant time period. ↑
Not considered herein are certain federal disaster zone declarations for which additional time has been afforded for CTA submissions. ↑
31 C.F.R. § 1010.380(b) (“Each [BOIR] shall be filed with FinCEN in the form and manner that FinCEN shall prescribe in the forms and instructions for such report or application, and each person filing such report or application shall certify that the report or application is true, correct, and complete.” (emphasis added)). ↑
Nat’l Small Bus. United v. Yellen, 721 F. Supp. 3d 1260 (N.D. Ala. 2024), appeal filed, Nat’l Small Bus. United v. U.S. Dep’t of the Treasury, No. 24-10736 (11th Cir. Mar. 11, 2024). ↑
Feb. 21, 2025, Letter from the Government, Nat’l Small Bus. United, No. 24-10736 (Doc. No. 109-1); Feb. 24, 2025, Letter from the Plaintiffs, Nat’l Small Bus. United, No. 24-10736 (Doc. No. 110-1). ↑
Hotze v. U.S. Dep’t of the Treasury, No. 2:24-cv-00210-Z (N.D. Tex. Dec. 30, 2024) (order denying preliminary injunction). ↑
Plaintiffs’ Brief in Support of Their Renewed Expedited Motion for Preliminary Injunction, Hotze, No. 2:24-cv-00210-Z (Feb. 24, 2025) (Doc. No. 44-1). ↑
Order Setting Deadline/Hearing, Hotze, No. 2:24-cv-00210-Z (Doc. No. 46). ↑
Midwest Ass’n of Hous. Coops. v. Bessent, No. 2:24-cv-12949 (E.D. Mich. filed Nov. 5, 2024). ↑
Plaintiffs’ Emergency Motion for Declaratory Relief, or Alternatively, Preliminary Injunctive Relief, Midwest Ass’n of Hous. Coops., No. 2:24-cv-12949 (Doc. No. 17). ↑
Order Regarding Plaintiff’s Emergency Motion for Declaratory Relief, or Alternatively, Preliminary Injunctive Relief, Midwest Ass’n of Hous. Coops., No. 2:24-cv-12949 (Doc. No. 26). ↑
Boyle v. Bessent, __ F. Supp. 3d__, 2025 WL 509519 (D. Me. Feb. 14, 2025). ↑
Seeid. at *1 (“The Court now addresses the Fourth Amendment issues for the parties in the case and concludes that Plaintiffs are entitled to judgment as a matter of law declaring the CTA Reporting Rules a violation of the Fourth Amendment and enjoining operation of the CTA as to Plaintiffs and their members in the case.”). ↑
Mar. 7, 2025, Letter from the Government, Nat’l Small Bus. United v. U.S. Dep’t of the Treasury, No. 24-10736 (11th Cir. Mar. 11, 2024) (Doc. No. 112). ↑
See,e.g., Robert R. Keatinge & Thomas E. Rutledge, Impossible Things: Compliance with the Corporate Transparency Act When Beneficial Owners or Company Applicants Are Nonresponsive, Bus. L. Today (Dec. 16, 2024). Additional recommendations might include a mechanism for reporting that a beneficial owner does not have and is not in a position to acquire any of the required forms of identification and permitting members of a “group,” as defined in section 414 of the Internal Revenue Code, to aggregate employee counts for purposes of satisfying the large operating company exemption set forth at 31 C.F.R. § 1010.380(c)(2)(xxi)(A). ↑
See Plaintiffs’ Request for an Injunction, Tex. Top Cop Shop, Inc. v. Bondi, No. 24-40792 (5th Cir. Mar. 11, 2024) (Doc. No. 301). ↑
Recall that the statutory $500 per diem civil penalty (31 U.S.C. § 5336((h)(1)) has been adjusted for inflation to be $606 per day. See Houston et al., The Corporate Transparency Act Is Still on Pause, supra note 5, at n.25. ↑
See, e.g., Deborah H. Eisen, Schweiker v. Hansen: Equitable Estoppel Against the Government, 67 Cornell L. Rev. 609 (1982) (“Traditionally, courts have refused to apply [estoppel] against the government, holding that ‘erroneous, unauthorized, or illegal acts or advice’ of government agents are insufficient bases for estoppel.”) (citations omitted); Fred Ansell, Unauthorized Conduct of Government Agents: A Restrictive Rule of Equitable Estoppel Against the Government, 53 U. Chi. L. Rev. 1026, 1027 (1986) (“Although the Court has not categorically stated that equitable estoppel will never be applied against the government, it has consistently and without exception reversed lower court decisions estopping the government in such circumstances.”); see alsoDep’t of Just., Civil Resource Manual § 209 (last visited Mar. 5, 2025):
The general rule is that the federal government may not be equitably estopped from enforcing public laws, even though private parties may suffer hardship as a result in particular cases. Office of Personnel Management v. Richmond, 496 U.S. 414 (1990); Heckler v. Community Health Services of Crawford County, Inc., 467 U.S. 51 (1984); INS v. Miranda, 459 U.S. 14 (1982); Schweiker v. Hansen, 450 U.S. 785 (1981); Federal Crop Ins. Corp. v. Merrill, 332 U.S. 380 (1947). No decision of the Supreme Court holds that equitable estoppel lies against the government in any circumstance. However, in several instances the court has expressly declined to determine whether the government could be estopped in a case involving serious affirmative misconduct by government employees. See, e.g., Heckler v. Community Health Services, supra; INS v. Miranda, supra. ↑
See, e.g., Ky. S. Ct. Rule 3.130(1.4)(b) (“A lawyer shall explain a matter to the extent reasonably necessary to permit the client to make informed decisions regarding the representation.”); see also, e.g., Ky. S. Ct. Rule 3.130(1.1) (“A lawyer shall provide competent representation to a client. Competent representation requires the legal knowledge, skill, thoroughness and preparation reasonably necessary for the representation.”). ↑
According to Alan Stachura and Maria Perez-Hodges of Wolters Kluwer, CT Corporation, FinCEN has reported that of the 15.5 million initial or updated BOIRs received by March 12, 2025, 6.4 million were filed after December 3, 2024 (the date on which the first injunction in the progression of hiatuses that have postponed the obligation to make initial BOIR filings was issued), and five hundred thousand of them were filed after February 28, 2025 (the day after the FinCEN announcement that effectively delayed the March 21, 2025 deadline and a few days before the Treasury press release indicating that that the requirement that domestic companies and individuals file initial and updated BOIRs from domestic companies and individuals will be eliminated). These numbers demonstrate two things. First, that irrespective of the former January 1, 2025, required filing date (which had been announced in November 2022) for the estimated 32 million reporting companies that existed before January 1, 2024, less than a third (considerably less, taking into account that a significant percentage of the 9.1 million BOIRs may have been filed for companies that were created or registered in 2024), had filed. Second, that many companies, perhaps frustrated by the on-again/off-again status of the CTA, had determined to go ahead and file a BOIR notwithstanding the delayed effective date and the advice of many professionals to prepare to file, but hold off on filing, until the final status of the CTA became clear. ↑
See also Nardone v. United States, 308 U.S. 338 (1939). ↑
Likely such a contractual requirement to comply with a filing obligation in order to open an account would satisfy the determination made in Small Business Ass’n of Michigan, but that would need to be litigated in order to have any certainty. ↑
As to the New York statute, see, e.g., Ribstein et al., supra note 4, § 4A:35. Washington, D.C. has a statute that is currently in effect. Id. ↑
This is the third installment in the Year in Governance Series from the In-House Subcommittee of the ABA Business Law Section’s Corporate Governance Committee. Each month, the series will share key tips on a different corporate governance topic. To get involved in the Corporate Governance Committee, please visit the committee’s webpage.
A message from Kathy Jaffari: “As Chair of the Corporate Governance Committee, I would like to extend my sincere appreciation to the authors for this publication. The Corporate Governance Committee has ongoing opportunities for writing and volunteering with various projects, whether it’s an article you want to publish or a CLE that you want to present. Our Committee is dedicated to helping you promote informative resources for corporate governance practitioners. You may contact me at [email protected] to get involved.”
Boards are dynamic, and having a reasonable level of director turnover is healthy and expected. Regular board evaluation and succession planning are essential and complementary processes to maintain a board that is relevant and effective over time. Taking a strategic approach and a long-term view can also protect against block turnover, which can be disruptive to board effectiveness.
Strategy drives board composition. A company’s regularly refreshed strategy should determine what skills and capabilities need to be represented on the board. Some skill requirements are (or are becoming) universally essential (e.g., financial, executive leadership, and technology experience). Some may be critical depending on company strategy (e.g., regulatory, geopolitical, digital, M&A, or industry expertise). The list of desired skills and experience should be refreshed periodically and should be a metric against which board composition is assessed, ultimately driving future recruitment.
Get full board buy-in. It is important that all directors understand and support the “skills matrix” and how its elements are assessed (e.g., how much experience is required to substantiate that a director has a particular qualification). Such buy-in is critical if use of the matrix might result in a long-serving director not being renominated because their qualifications are no longer a high priority. Be clear with directors that substantiation criteria will be applied rigorously and that it is not expected that directors will “check all boxes.”
Design board evaluation to maximize its value. Practice varies in how board evaluations are conducted—whether in writing, such as via a portal; through an interview led by, for example, the lead director, the general counsel, or an outside advisor; or through a combination of written responses and interviews. Consider which approach would elicit the most candid and useful input from directors. What is appropriate in normal times might be different from what is appropriate in times of transition or crisis. It is important that directors trust the evaluation process, which includes knowing who has access to the results and how the results are used.
Evaluate the board comprehensively. Beyond director qualifications, the board evaluation should examine board structure (including committee structure), composition, leadership, agenda relevance, communication, meeting conduct, quality of materials, quality of discussions, cognitive diversity, and other factors relevant to whether the board is functioning well to support and oversee the company. It is a good idea to have an activism advisor critically assess the board’s vulnerability to an activist asserting that the board is deficient.
Individual director evaluations are important. Even if a director brings important skills and experience, if they do not participate constructively, the company is not best served. Individual director evaluations provide a structure for peer directors to provide feedback on one another. Care should be taken to design and use these evaluations in a way that does not create vulnerabilities or discord. With universal proxy, activists can target individual directors for replacement. This makes rigorous evaluations even more important, but activists’ work is made easier if they’re able to access records of critical feedback on targeted directors, particularly if no action was taken to address the criticism.
Track planned turnover. Many companies have term or age limits on director service. It is good to track planned retirement dates when planning for committee rotations, committee leadership changes, and board needs for essential skills or qualifications that might be lost when directors retire. In addition, think through scenarios for different directors departing at different times; this helps avoid a gap in committee or leadership coverage.
Anticipate unplanned turnover. For various reasons, directors might leave the board in advance of mandatory retirement. Some such departures can be anticipated via candid conversations among directors, whereas other departures might be unexpected. At least annually, the chair or lead director should inquire about the tenure goals of each director so that those individual goals can be incorporated into succession planning.
Plan ahead for committee composition and leadership as well as board leadership. Strong leadership at both the committee and board level is essential to overall board effectiveness. Refreshment planning should consider succession in key leadership roles as well as periodic rotation of committee service for all directors. Candid conversations with directors about their leadership and committee assignment interests helps avoid surprise or misunderstanding. Be cognizant of director independence requirements for certain committees when planning.
Leverage outside advisors. Search firms can be valuable resources for identifying future directors with particular skills and capabilities, and they have access to word-of-mouth information about how candidates conduct themselves in the boardroom. Since recruitment can take time, it may be helpful to have external experts help you stay current on potential candidates. To go one step further, companies can keep a “bench” of candidates that have already been interviewed and are ready to step in if the need arises.
Be flexible. The “supply” market for board candidates is as dynamic as the “demand” market. If a well-qualified director becomes available, it might be wise to increase board size to bring them aboard ahead of when the need arises, particularly if a subsequent vacancy is foreseen.
The views expressed in this article are solely those of the authors and not their respective employers, firms or clients.
In the past several years, the rise of mass arbitration has transformed the landscape of dispute resolution, reshaping how consumers and other individuals attempt to exert pressure on companies collectively. A mass arbitration is where many individual claimants use the same or coordinated counsel to bring individual arbitrations against a company based on identical or similar facts. Mass arbitration is not inherently improper but has in recent years been subject to gamesmanship, as some lawyers have sought to leverage the arbitration filing fees that businesses must pay.
Here’s how this has worked: Claimants’ lawyers solicit and enroll thousands of clients, typically through an online marketing process. They then file (or threaten to file) all the arbitrations simultaneously, triggering the target company’s immediate obligation to pay significant up-front fees. The goal has been to pressure companies to settle, notwithstanding the merits of the underlying claims. Because the settlement pressure increases with the number of filed or threatened claims, there is a powerful incentive for claimants’ lawyers to focus on the quantity of claims without meaningful regard to their quality.
Arbitration providers, such as the American Arbitration Association (“AAA”) and JAMS, did not have rules and fee schedules tailored for mass arbitration when it first became popular. These providers have since adapted to manage the influx of mass arbitrations, including by implementing new rules, procedures, and fee schedules aimed at resolving mass arbitrations more efficiently and mitigating strategies that some claimants’ lawyers have employed to coerce large settlements. In this article, we discuss this transformation and how businesses that use arbitration agreements can mitigate the exposure resulting from mass arbitration.
Practical Example of How Up-Front Fees Can Be Coercive
We first consider the amount of up-front fees that a business would pay under arbitration rules that are not tailored to administer mass arbitrations to help drive home why these arbitrations can exert so much pressure on businesses. If consumers filed 1,000 arbitrations, under the AAA’s Consumer Arbitration Rules and its fee schedule, the business’s share of the nonrefundable filing fee would be $375,000 or $500,000 ($375 or $500 per case), and its share of the nonrefundable case management fee would be $1,400,000 or $1,775,000 ($1,400 or $1,775 per case), depending on the number of arbitrators. So, in total, the business would have to pay between $1,775,000 and $2,275,000 in up-front fees—that is, before an arbitrator is even seated (see table 1 below). The claimant’s filing fees are also significant but pale in comparison to the business’s fees. In any event, claimants sometimes argue that the business is responsible for paying the claimants’ share of filing fees under contract or other theories.
Table 1. AAA Consumer Arbitration Rules: Distribution of Up-Front Arbitration Fees
Fees
Claimant’s Share
Business’s Share
Filing Fee
$225
$375 or $500
Case Management Fee
None
$1,400 or $1,775
1,000 Arbitrations
$225,000
$1,775,000 to $2,275,000
AAA’s New Mass Arbitration Rules
The AAA recently issued Mass Arbitration Supplementary Rules, which apply to any mass arbitrations filed after January 2024.[1] The rules apply when twenty-five or more similar arbitration demands are filed, regardless of whether the cases are filed simultaneously. A notable feature of these rules is aimed at requiring claimants’ counsel to more thoroughly vet clients and their claims before filing a mass arbitration. Lawyers have sometimes filed cases on behalf of claimants without sufficient proof that the claimants entered into an arbitration agreement.[2] And observers have reported that claimants are sometimes fictitious, and their claims are duplicative.[3]
Affirmation of Truthful Information and Appointment of Process Arbitrators
The AAA’s new rules impose barriers to these practices. First, claimants’ counsel filing a mass arbitration must “include an affirmation that the information provided for each individual case is true and correct to the best of the [lawyer’s] knowledge.”[4] Lawyers who violate this duty could be subject to Rule 11–type sanctions. Second, the new rules allow the AAA to appoint a “process arbitrator” to resolve administrative issues after the payment of an initiation fee of $11,250.[5] As discussed more below, under the new rules, no matter how many arbitrations are filed, the initiation fee is the only up-front fee. The claimant’s share of the fee is $3,125, and the business’s share is $8,125.
The administrative matters that process arbitrators are authorized to decide include the following:
whether the claimants complied with the AAA’s filing requirements, any contractually imposed filing requirements, or any conditions precedent under the parties’ contract;
disputes regarding payment of administrative fees, arbitrator compensation, and expenses;
whether particular cases should be excluded from the mass arbitration;
the “merits arbitrator” selection process for the individual arbitrations;
if the cases should proceed in small claims court instead of arbitration;
whether the merits arbitrators should hold a hearing or decide the disputes based on written submissions (called a “documents-only proceeding”);
what rules should apply in the arbitration;
the location of hearings by the merits arbitrators; and
other nonmerits issues affecting case administration, such as the way arbitration should proceed to a hearing.[6]
Process arbitrators are also empowered to decide fact-specific disputes for individual arbitrations, such as whether the allegations in a demand fall within the scope of an arbitration agreement. A process arbitrator deciding these issues is required to issue a reasoned decision, which binds the merits arbitrators absent an abuse of discretion by the process arbitrator. The business must compensate the process arbitrators at their published hourly rates.
Mediation
The AAA’s new rules require that the parties initiate a global mediation of the mass arbitration under the AAA mediation rules within 120 days after the AAA’s confirmation that the claimants meet the AAA filing requirements. The AAA administratively appoints the mediator unless the parties agree on one. While the rules allow any party to unilaterally opt out of mediation, the AAA may still appoint a mediator to facilitate discussions between the parties on processes to resolve the cases more efficiently. Indeed, the applicability section of the new rules encourages parties to agree to “processes for the efficient resolution of those cases.”[7] As we discuss below, one option is the use of a “bellwether” process like multidistrict litigation (“MDL”), and a mediation after a resolution of the “test” arbitrations.
New Fee Schedule
As noted above, the AAA replaced filing fees with a flat $11,250 initiation fee. This fee remains constant regardless of how many cases are included in a mass arbitration (see table 2 below).
Table 2. New AAA Mass Arbitration Rules: Distribution of Initiation Fee
Total AAA Up-Front Fees for 25 or More Similar Arbitrations
Claimant’s Share
$3,125
Business’s Share
$8,125
The AAA also eliminated the case management fee. Instead, the parties are now responsible for what the AAA calls a “per case fee” for any case that proceeds past the process arbitrator’s review or otherwise survives the initiation stage. As shown in table 3 below, the per case fee starts at $125 for claimants and $325 for businesses; the fees decrease as the number of arbitrations increases. The initiation fee is credited toward the per case fees.
Table 3. New AAA Mass Arbitration Rules: Per Case Fees
First 500 Cases
Cases 501 to 1,500
Cases 1,501 to 3,000
Cases 3,001 and Beyond
Claimant’s Share
$125
$75
$75
$75
Business’s Share
$325
$250
$175
$100
The AAA also charges an “arbitrator appointment fee” for any case that proceeds to appointing a merits arbitrator. The fee is $50 per case for the claimants and $450 per case for the business if the AAA appoints the arbitrator, or $75 per case for the claimants and $600 per case for the business if a list-and-rank process is used by the parties to select the arbitrator.
The merits arbitrators are paid $300 per hour in consumer cases, and they are compensated at their normal hourly rates in employment cases. In prior fee schedules, merits arbitrators received a flat fee of $2,500 per day for a hearing and $1,500 for documents-only cases. The AAA typically charges the arbitrator compensation to the business based on the merits arbitrator’s estimated study and hearing hours after the arbitrator holds a scheduling conference.
The last fee that the AAA charges is what it calls a “final fee.” The AAA bills this fee to the business when an evidentiary hearing is scheduled or the final submission date for a documents-only proceeding is set. This fee is $600 per case in consumer cases and $750 per case in employment cases.
The fees for each case are shown in table 4 below.
Table 4. New AAA Mass Arbitration Rules: Arbitrator Appointment Fee, Final Fee, and Merits and Process Arbitrator Fees
Fees
Claimant’s Share
Business’s Share
Arbitrator Appointment Fee
$50 or $75
$450 or $600
Final Fee
None
$600 or $750
Merits Arbitrator
None
$300 per hour
Process Arbitrator
None
Published hourly rate
While the AAA’s new rules mitigate a business’s exposure, its changes do not entirely eliminate the significant costs to litigate mass arbitrations. Assume, for example, that a process arbitrator’s fee is $500 per hour and that it will take twenty hours to administer the mass arbitration. Also assume that the process arbitrator determines that 500 arbitrations should proceed past initiation stage, the parties agree that the mass arbitration will proceed with the AAA appointing merits arbitrators in batches of fifty arbitrations, and that each merits arbitrator estimates after the scheduling conference that it will take thirty hours to handle each case. For starters, the costs that the business incurs before any of the first fifty cases go to hearing could reach nearly $50,000: the initiation fee is $8,125, so the per case fee for the fifty cases is $8,125 (when accounting for the credit from the initiation fee); the arbitrator appointment fee for fifty cases is $22,500; and the process arbitrator fee is $10,000. The price to administer all 500 cases in this scenario if all of them go to hearing (adding in the final fees and the total arbitrator compensation) could be over $5 million. This amount, of course, does not include attorneys’ fees.
Other Arbitration Administrators’ Rules
Shortly after the AAA adopted its new rules, JAMS issued its new Mass Arbitration Procedures and Guidelines and fee schedule, effective May 2024. The JAMS rules apply when seventy-five or more individual claimants file against the same party or related parties and if those claimants are represented by either the same law firm or law firms acting in coordination. Unlike the AAA rules, the JAMS rules only apply where the procedures are expressly adopted in a pre- or post-dispute agreement.
However, like the AAA rules, the JAMS rules contain procedures that appear directed at lawyers filing inappropriate demands. Particularly, the JAMS rules require that claimants’ counsel submit an arbitration agreement for each claimant; that the demand include the first and last name, the physical address, and the email address of each claimant; and that each demand “be accompanied by a sworn declaration from counsel averring that the information in the [d]emand is true and correct to the best of the representative’s knowledge.”[8]
The JAMS rules also authorize the provider to designate a “process administrator” to hear and determine preliminary and administrative matters, making it possible for businesses to challenge baseless demands at the outset of the arbitration.[9] The only fee that the parties must pay at the outset, no matter how many cases are filed, is a single, nonrefundable filing fee of $7,500, up to $2,500 of which the claimant may be required to pay. Before this change, JAMS charged filing fees on a per-case basis, which allowed claimants’ counsel the potential to leverage the fees.
Process administrators are empowered to decide the following:
whether the parties have met the applicable filing requirements;
whether any conditions precedent have been met and, if not, how they can be met;
which demands should be included in the mass arbitration;
which rules apply to the proceedings;
whether to batch, consolidate, or otherwise group the arbitrations or claims—whether for purposes of discovery, arbitrator appointments, merits hearings, or otherwise;
the location of the merits hearings; and
any other nonmerits issues affecting case administration.[10]
The process administrator, as with the AAA, may also make administrative determinations based on the specific facts of an arbitration. Such administrative determinations must be included in a decision containing the reasoning for the determination.
In addition to the filing fee discussed above, the business must pay the process administrator’s hourly rate. The business is also responsible for paying an “appointment fee” for any arbitration that survives the process administrator’s review or is otherwise deemed administratively appropriate. The appointment fee is $2,000 for two-party cases and $3,500 for cases with three or more parties. Notably different from the AAA fee schedule, the JAMS appointment fee is per appointment, not per case. This distinction is important from a cost-savings perspective because merits arbitrators often decide a group of cases.
Finally, the business must pay a “case management fee” equal to 13 percent of the arbitrator’s estimated professional fees. The JAMS fees are shown in table 5 below.
Table 5. New JAMS Mass Arbitration Rules: Fees
Fees
Claimant’s Share
Business’s Share
Filing Fee
$2,500
$5,000
Appointment Fee
None
$2,000 or $3,500
Process Administrator
None
Published hourly rate
Case Management Fee
None
13% of the total fees of the process administrator and/or merits arbitrator
Merits Arbitrator
None
Published hourly rate
In sum, while JAMS’s new fee schedule significantly reduces fees assessed up front, the fees for a mass arbitration can still be substantial because the business must pay professional fees for the process administrator and merits arbitrator, as well as case management fees assessed at a percentage of the overall professional fees. Also, unlike the AAA rules, the JAMS rules do not include a mediation requirement.
Notably, the AAA rules and the JAMS rules do not include bellwether procedures like some of the other arbitration providers, such as FedArb, New Era ADR, and CPR. For this process, the parties arbitrate a batch of test cases that they jointly select, with the other cases suspended and tolled by agreement. While certain arbitration providers include this process, AAA and JAMS anticipate that the parties will agree upon an efficient method to resolve the arbitrations post-dispute.
What Should Businesses Do?
Businesses should revisit their arbitration agreements, given these revisions to the providers’ mass arbitration–focused rules. If JAMS is the arbitration provider, the business needs to revise the arbitration agreement to expressly incorporate the Mass Arbitration Procedures and Guidelines as the procedures that govern any mass arbitration.
The business may also consider adding other procedures to the arbitration agreement to facilitate a mass arbitration’s fair and efficient resolution. For instance, a provision in the arbitration agreement requiring that claimants provide notice of a dispute and participate in an informal settlement conference before filing an arbitration could aid in resolving disputes quickly. The business may also consider bellwether procedures. As noted above, some arbitration providers have inserted similar processes into their mass arbitration procedures.
It is crucial, however, to consult counsel when making changes to an arbitration agreement as this is a complex task that requires a deep understanding of the constantly evolving law regarding the enforceability of arbitration agreements.
See Wallrich v. Samsung Elecs. Am., Inc., 106 F.4th 609, 618–20 (7th Cir. 2024). ↑
See Letter from Jaime Huff, Vice President and Counsel, Public Policy, CJAC, to Enrique Zuniga, Public Trust Liaison, State Bar of California, Hoeg v. Samsung Elecs. Am., Inc., No. 1:23-cv-01951 (N.D. Ill. Aug. 28, 2023), ECF No. 44-4. ↑
As we enter 2025, the Canadian mergers and acquisitions (“M&A”) landscape is poised for a dynamic year. Building on the momentum from a resurgent 2024, which saw the total value of deals rise by US$51.4 billion from 2023 despite a slight decrease in the number of transactions, dealmakers are optimistic about robust activity across sectors. However, this optimism is tempered by regulatory scrutiny, geopolitical uncertainty, and the need for agility in navigating complex transactions. For private equity (“PE”) firms, strategic buyers, and legal practitioners, 2025 presents opportunities and challenges that demand creativity, careful planning, and a nimble approach.
Macroeconomic Stability Fuels Confidence, Driving M&A Activity in 2025
The second half of 2024 saw significant macroeconomic improvements that set the stage for increased dealmaking in 2025.
Interest rate cuts by the Bank of Canada and the U.S. Federal Reserve stabilized financing conditions, making debt-fueled transactions more feasible. This helped narrow valuation gaps between buyers and sellers, which had hampered deal activity in prior years.
Currency dynamics will continue to influence cross-border transactions. A stronger U.S. dollar, particularly after Trump’s reelection, has made U.S. assets more expensive for Canadian buyers but has also increased the appeal of Canadian assets for U.S. investors, especially in sectors like critical minerals and technology.
While inflation eased in late 2024, its lingering effects on supply chains remain a key factor in valuation models, with buyers prioritizing resilience and reliability. These considerations are expected to shape transaction structures and pricing in 2025.
Sector-Specific Opportunities
Technology and AI
Technology continues to drive M&A activity, fueled by explosive growth in artificial intelligence (“AI”). Companies are racing to acquire AI capabilities, proprietary data, and supporting infrastructure such as data centers and energy grids to remain competitive. Both strategic buyers and PE firms are aggressively pursuing deals in this space, with AI-related acquisitions expected to dominate headlines in 2025.
Critical Minerals and Energy Transition
Canada’s leadership in critical minerals, such as lithium and copper, positions it as a global hub for M&A in the energy transition. These materials are essential for electric vehicle (“EV”) batteries and renewable energy projects, and federal incentives have only bolstered activity in this space. Geopolitical concerns over supply chain security are expected to keep the minerals sector a focal point for domestic and international investors.
Health Care and Biotech
The health-care sector offers a mix of opportunities and challenges. Pharmaceuticals and medical technology are poised for growth due to aging demographics and innovation, but PE involvement in health-care services continues to face scrutiny at the provincial level, reflecting ongoing regulatory challenges.
Energy and Natural Resources
Rising global energy demand, coupled with Canada’s abundant resources, is expected to drive consolidation in oil and gas. Liquefied natural gas infrastructure, particularly for European exports, presents significant growth opportunities. Meanwhile, Canada’s renewable energy projects remain attractive for sustainability-focused investors.
Private Equity’s Continued Dominance
PE firms are expected to play a pivotal role in Canada’s M&A activity in 2025. With record levels of dry powder (over $2.9 trillion globally), PE firms are under pressure to deploy capital. Platform acquisitions and add-ons will remain popular strategies, particularly in sectors like technology, health care, and infrastructure.
A backlog of portfolio companies held longer than usual is expected to spur a wave of PE exits. Firms are exploring creative solutions, such as dual-track processes (sale and initial public offering (“IPO”)) and partial exits, to meet investor demands for liquidity. The secondaries market, which has matured significantly in recent years, will also provide alternative pathways for PE firms to achieve liquidity.
Regulatory and Geopolitical Complexity
Heightened Scrutiny
Regulatory regimes will continue to pose challenges for dealmakers in 2025. Canada’s Competition Bureau has intensified scrutiny of large transactions, especially in concentrated industries like technology and critical minerals. This has lengthened deal timelines and raised execution costs, making early regulatory planning essential.
Globally, the proliferation of foreign direct investment regimes adds complexity to cross-border transactions. For deals involving sensitive sectors, such as semiconductors or cybersecurity, national security reviews will remain a significant hurdle.
The Impact of Trump’s Tariff Threats
The proposed 25 percent tariffs on Canadian imports by the Trump administration have introduced uncertainty into cross-border transactions. Many Canadian companies are pursuing defensive acquisitions in the United States to establish a local presence and to mitigate tariff risks, underscoring the need for adaptive strategies in the face of geopolitical challenges.
Valuation Trends and Creative Deal Structures
Valuation dynamics will play a central role in shaping Canadian M&A activity in 2025. High-growth sectors like technology, health care, and critical minerals will command premium valuations, while manufacturing may see more moderate activity. To address lingering uncertainties, dealmakers are leveraging innovative structures, including:
Earnouts and contingent value rights. These tools allow buyers and sellers to bridge valuation gaps by tying payments to future performance.
Deferred payments and minority equity rollovers. These structures align buyer and seller interests and mitigate risk.
Representation and warranty insurance (“RWI”). RWI has become a mainstay in PE transactions, offering risk mitigation and streamlining negotiations.
The Role of Shareholder Activism
Shareholder activism is expected to intensify in 2025 as M&A activity accelerates. Activists are likely to pressure companies to pursue strategic transactions to unlock value, with cross-border activism on the rise. While environmental, social, and governance (“ESG”) issues may take a back seat to financial performance, activism aimed at spurring M&A will remain a key driver of activity.
Conclusion: Seizing the Opportunities of 2025
Canada’s M&A landscape in 2025 is set to offer significant opportunities for growth and transformation. Success will require creativity, agility, and thoughtful planning. Whether you’re a PE investor deploying capital, a strategic buyer pursuing transformative acquisitions, or a business navigating the complexities of cross-border transactions, preparation and adaptability will be key. Early engagement with regulators, robust due diligence, and innovative transaction structures will be critical to navigating the challenges ahead.
An intellectual property (“IP”) portfolio may include patent assets, copyrighted works, trademarks, and trade secrets. Understanding ownership, title, and cloud on title (e.g., third-party rights) of IP assets is of key importance in review and initial valuation of a target portfolio. In particular, understanding specific party ownership and any intervening third-party rights of patent assets and copyright assets is a focal point in IP due diligence. This understanding emanates from title searches through the U.S. Patent and Trademark Office (“USPTO”) online database, examination of the chain of title via the USPTO Abstract of Title, and an audit of software assets for open source software (“OSS”) license terms.
Chain of Title
For U.S. patent applications and U.S. granted patents, the USPTO Assignment Recordation Branch has an online database, the Patent Assignment Search, that allows one to search for recorded title.[1] The online search may be performed based on assignee name (e.g., employer company), assignor name (e.g., employee inventor), application number, patent number, application publication number, or reel/frame numbers (if known).
The search results in a listing called an “Abstract of Title” for the given patent asset (patent application or granted patent). The listing shows recorded conveyances or transfers of patent rights; security interests (liens) against the patent rights; and, if any, forgiveness of the security interests. The sequence (date order) of the recorded component parts in the Abstract of Title informs the searcher of the so-called title and any intervening third-party rights in the patent asset.
Under U.S. patent laws, patent rights begin with or originally vest in the named inventors of the corresponding patent application. Assignment of each inventor’s rights to an assignee (e.g., by employees under employment contract obligations to assign such rights to their employer corporate entity) is typically a first “leg” in the chain of title. A typical example of a second “leg” in the chain of title is a company-to-company assignment from the initial employer corporate entity to a merging or acquiring entity. Another example one may find in the Abstract of Title is recordal of a third party’s interest or intervening rights in the patent asset. Third-party rights may be in the form of a lien, mortgage, or other security interest where the subject patent or patent application is used as collateral to secure the loan or debt.
It is important that the conveyance documents (original assignments by inventors, merger/acquisition documents in pertinent part, loans with a security interest) be recorded at the USPTO Assignment Recordation Branch against each affected U.S. patent, U.S. patent application, and Patent Cooperation Treaty (“PCT”) international patent application. Such recordal provides notice to the public of one’s patent rights or interests therein. An interest in a patent asset may be statutorily void against a subsequent purchaser or mortgagee unless that interest is recorded at the USPTO within three months from the conveyance/assignment/grant of rights, or prior to the date of such subsequent purchase or mortgage.[2]
OSS Licenses
OSS and OSS licenses provide another source of IP rights. Specifically, OSS licenses convey patent and copyright use rights to programmer users, end users, and third-party beneficiaries. In the due diligence review of a target IP portfolio, both the software assets created by the portfolio owner and the software assets used (imported) by the portfolio owner should be evaluated. The corresponding software code of these software assets should be audited to determine which OSS licenses apply and, in turn, what, if any, patent use rights exist per the OSS licenses. Note that there are likely patent use rights granted to the portfolio owner as well as patent use rights granted by the portfolio owner under the OSS licenses at play. The latter has potentially far-reaching impact (third-party beneficiary use rights) on the portfolio owner’s patent assets.
Conclusion
In conducting IP due diligence on a target portfolio, a thorough review and assessment of ownership and title should encompass the following steps:
Search USPTO assignment records. Review recorded title transfers in the USPTO Patent Assignment Search to identify any gaps in the chain of title during the diligence period (ensuring title changes were recorded within three months of assignment or prior to any subsequent transactions).
Examine the chain of title. Investigate the USPTO Abstract of Title to identify any third-party rights, such as security interests or liens, that could affect ownership.
Audit software assets for OSS license terms. Review open-source software licenses to determine if any terms grant third parties (or third-party beneficiaries) rights to patent assets in the target portfolio, potentially limiting the portfolio owner’s control over certain IP assets.
Given the increasing prevalence of OSS licensing, IP due diligence now requires additional scrutiny. Patent attorneys with expertise in both computer science and OSS licensing are uniquely equipped to address these complex issues. Their combined knowledge of software engineering and intellectual property law enables them to navigate the intricate and ever-evolving challenges in this space with greater precision and insight.
This article is Part VI of the Musings on Contracts series by Glenn D. West, which explores the unique contract law issues the author has been contemplating, some focused on the specifics of M&A practice, and some just random.
An asset purchase agreement (“APA”) contains the following survival clause:
Survival. Subject to the limitations and other provisions of this Agreement, the representation and warranties contained herein shall survive the Closing Date and shall remain in full force and effect until the date that is twelve (12) months from the Closing Date. None of the covenants or other agreements contained in this Agreement shall survive the Closing Date other than those which by their terms contemplate performance after the Closing Date, and each such surviving covenant and agreement shall survive the Closing for the period contemplated by its terms. Notwithstanding the foregoing, any claims asserted in good faith with reasonable specificity (to the extent known at such time) and in writing by notice from the non-breaching party to the breaching party prior to the expiration date of the applicable survival period shall not thereafter be barred by the expiration of such survival period and such claims shall survive until finally resolved.[1]
Questions:
Assuming the buyer failed to provide notice of a claim prior to the closing, does this clause preclude the buyer from asserting a claim against the seller based upon an alleged breach by the seller of the preclosing covenant to conduct the target business in the ordinary course?
Assuming the buyer failed to give notice of a claim within twelve months after the closing, does this clause preclude the buyer from asserting a claim against the seller based upon an alleged breach of the seller’s contractual representation regarding the financial statements of the target business?
On its face the answer to both questions should be yes, right? Obviously, the preclosing covenant regarding operation of the target business did not contemplate performance by the seller after the closing date. If the financial statement representation only survived the closing for twelve months and no notice of an alleged breach had been given before that time, doesn’t that mean the seller is home free?
Well, if Delaware law applied, that may well be the correct answer (although best practices would still be to make the clause a lot clearer).[2] But this particular APA was governed by Ohio law, not Delaware law—and a recent decision by a federal district court applying Ohio law, Bidwell Family Corp. v. Shape Corp.,[3] declared that the answer to these questions was a definitive no!
Survival: Specificity Important to Get the Result You Want
Why? Well it’s pretty simple, really. Saying a covenant, representation, or warranty “survives” the closing for some specified period assumes that it would otherwise die absent that declaration of survival (and, more importantly, that the death of the covenant, representation, or warranty would also preclude bringing any remedies for its breach after that death even though the breach occurred while it was still alive). While there is Delaware law indicating that “[a]bsent contract language providing to the contrary, pre-closing representations about the acquired property interest become ineffective post-closing under the same rationale that causes representations about real property to merge with a warranty deed,”[4] I am not sure I would place much reliance on that. Instead, if you want to be certain that all representations and warranties do not survive (and any attendant remedies for their prior breach are unavailable post-closing), I suggest saying so in unequivocal language, even in Delaware.
But when you do want certain representations and warranties (and perhaps covenants) not only to survive but also to restrict the available period during which an action can be commenced for their breach (to a period shorter than the otherwise applicable statute of limitations), does simply saying that they “survive” for a specific period do the trick?
Bidwell: “Unequivocal Language” Required to Create Contractual Statute of Limitations
In Bidwell, applying Ohio law, the court focused on the fact that the clause in question “imposed no independent time limit on when [the Buyer] could bring indemnifications claims.”[5] According to the court, if the reference to “survival” was intended to actually constitute a “contractual statute of limitations,” then there needed to be “unequivocal language” to do so under Ohio law.[6] Turning to the survival clause in the APA, the court said:
[T]he APA . . . lacks the “unequivocal language[]” . . . required under Ohio law to limit the time period in which [the Buyer] could make its indemnification claims. The [Sellers] argue that the APA does contain such unequivocal language, pointing to the final sentence of § 9.01 which provides that claims notified “prior to the expiration date of the applicable survival period shall not thereafter be barred by the expiration of such survival period and such claims shall survive until finally resolved.” . . . The only thing this sentence says unequivocally is that claims notified prior to expiration of the survival period will survive; while the inference could reasonably be drawn that claims not so notified will not survive, the contract does not “unequivocally” say so.[7]
Ouch!
But none of this should be new. We were talking about the need for more explicit language in our survival provisions at least a decade ago at M&A Committee meetings of the ABA’s Business Law Section.
Jurisdictional Variety and Unequivocal Language
There are apparently several states that require “unequivocal language” specifying that the survival provision is, in fact, an agreed contractual statute of limitations shorter than the otherwise applicable one.
While Delaware might be somewhat less fussy, I would caution that we should assume otherwise. Don’t forget that a Delaware court also declared that there were no “magic words” required to disclaim reliance on extra-contractual representations, but subsequent cases seem to require just that.[8]
And don’t forget that even when choosing Delaware law to govern your agreement, a case filed in another state could well apply its statute of limitations to the claim (because statutes of limitations are procedural, not substantive, law).[9]If that were to occur, would that forum court, even purporting to apply Delaware law to the agreement, interpret the survival clause consistent with Delaware’s apparently more liberal approach, or would the forum court instead require the “unequivocal language” required by forum law, absent explicit language in the choice of law clause choosing Delaware’s statutes of limitations as applicable?
Moreover, when you are selecting another jurisdiction’s law as the governing law of your acquisition agreement, please remember that several states have specific statutes that restrict the period for which a contractually shorter statute of limitations is permissible[10]—so even unequivocal language will not always do the trick.
Examples of Effective Clauses
As examples of clauses that seem to do a fairly good job of addressing these issues (assuming there is no state law prohibition on shortening the otherwise applicable statute of limitations, and without suggesting that both examples couldn’t use some improvement), see the clauses below, which were plucked randomly from recently filed private company acquisition agreements.
Example of a “no survival” clause:
Section 10.1. Survival. The Parties, intending to modify any applicable statute of limitations, agree that, except in the case of claims solely against Seller for Fraud, (a) (i) the representations and warranties contained in this Agreement and in any certificate delivered hereunder and (ii) the covenants and agreements set forth herein that require performance at or prior to Closing, shall, in each of (i) and (ii), terminate effective as of the Closing without the need for any further action by any Person and shall not survive the Closing for any purpose whatsoever, and thereafter there shall be no liability or obligation on the part of, nor shall any claim be made by, any party or any of their respective Affiliates or Non-Parties in respect thereof, in connection therewith or related thereto and (b) the covenants and agreements set forth herein that require performance after the Closing shall survive in accordance with their respective terms, if any, until fully performed. This Article X shall survive the Closing. The Parties specifically and unambiguously intend that the survival periods that are set forth in this Section 10.1 shall replace any statute of limitations that would otherwise be applicable. Notwithstanding anything to the contrary contained in this Agreement, nothing in this Agreement, including the limitations on survival set forth in this Section 10.1 shall limit the rights of Buyer or any Affiliate thereof under the R&W Insurance Policy, which shall be solely governed by the rights as set forth thereunder.[11]
Example of a “limited survival” clause (clause (b) being the important clarification):
9.1 Survival
(a) Subject to Section 9.1(b), each representation and warranty contained in ARTICLE IV and ARTICLE V (other than the Seller Fundamental Representations and the Purchaser Fundamental Representations) shall survive the Closing and shall terminate on the twelve (12) month anniversary of the Closing Date. The Specified Representations shall survive the Closing and remain in full force and effect until the expiration of the applicable statute of limitations (taking into account any extensions or waivers thereof), and the Seller Fundamental Representations and the Purchaser Fundamental Representations shall survive the Closing and remain in full force and effect indefinitely after the Closing Date; provided, that the expiration of any of the terms set out in this Section 9.1(a) shall not affect the rights of a Party to seek recovery of Losses arising out of Fraud. The covenants and agreements contained in this Agreement shall survive until performance in accordance with their terms.
(b) Notwithstanding anything herein to the contrary, the obligations to indemnify and hold harmless a Person pursuant to this ARTICLE IX in respect of a breach of representation or warranty, covenant or agreement shall terminate on the applicable survival termination date (as set forth in Section 9.1(a)), unless an Indemnified Party shall have made a claim for indemnification pursuant to Section 9.2 or Section 9.3, subject to the terms and conditions of this ARTICLE IX (or Section 6.8(d), as applicable), prior to such survival termination date, as applicable, including by delivering an Indemnification Claim Notice or Third Party Indemnification Claim, as applicable, to the Indemnifying Party. Notwithstanding anything herein to the contrary, if an Indemnified Party has made a claim for indemnification pursuant to Section 9.2 or Section 9.3 and delivered an Indemnification Claim Notice or Third Party Indemnification Claim, as applicable, to the Indemnifying Party prior to such survival termination date, then such claim (and only such claim), if then unresolved, shall not be extinguished by the passage of the deadlines set forth in Section 9.1(a).[12]
Remember, as transactional lawyers, we need to be continuously learning and remembering what we have learned. There is more to the practice than just being a document processor.
Bidwell Fam. Corp. v. Shape Corp., 2024 WL 5262944, at n.15 (S.D. Ohio Dec. 31, 2024) (quoting APA § 9.01). ↑
See GRT, Inc. v. Marathon GTF Tech., Ltd., 2011 WL 2682898, at *11–13 (Del. Ch. July 11, 2011). ↑
Bear Stearns Mortg. Funding Trust 2006–SL1 v. EMC Mortg. LLC, 2015 WL 139731, at *14 (Del. Ch. Jan. 12, 2015). For those interested in the merger doctrine as applied to real estate transactions, see Peter E. Fisch & Salvatore Gogliormella, Applying Merger Doctrine to Contracts for Sale of Real Estate, N.Y. L.J. (July 30, 2024). ↑
See Will Pugh, Getting What You Bargained For: Avoiding Legal Uncertainty in Survival Clauses for a Seller’s Representations and Warranties in M&A Purchase Agreements, 12 J. Bus. Entrepreneurship & L. 1 (2019). ↑
Legal departments are positioned to become as essential to business success as research and development, sales, marketing, human resources, and finance. As companies grapple with evolving, complex compliance requirements and emerging technologies, a robust legal operations function can transform legal departments from perceived cost centers and bottlenecks into strategic business partners.
The Evolution of Legal Operations
Legal departments of a generation ago primarily focused on risk management and controlling outside counsel spend. As business became increasingly global and complex, regulatory requirements and legal challenges multiplied in scope and complexity. Attorneys began working more with other professionals like statisticians, accountants, financial analysts, subject matter experts, and jury consultants. Some honed their skills in project management, while others pursued expertise in legal technology and data science, with e-discovery on the front line of it all.
Savvy legal professionals recognized that incorporating emerging technologies and business principles could dramatically improve their efficiency and sophistication. Over time, these trailblazers realized that achieving the correct combination of people, processes and technology was a comprehensive discipline that could be a force multiplier for attorneys tasked with doing more with less. The idea of running a legal department as a business became known as legal operations. Today, legal operations professionals bring critical expertise in strategic planning, change management, and financial oversight to legal practice.
Risk and Transformation
Corporate legal departments face complicated regulatory compliance requirements, and the acceleration of digital transformation has created new risk categories such as data privacy, algorithmic bias, and cybersecurity threats. Data management has evolved from a technical administrative issue into a strategic legal imperative due to privacy regulations such as Europe’s General Data Protection Regulation (“GDPR”) and the California Consumer Privacy Act (“CCPA”). The rise of generative artificial intelligence presents both opportunities and compliance challenges.
Four key strategic areas demonstrate how legal operations can improve legal departments by placing responsibility for many of the nonlegal aspects of their operations with professionals experienced, focused, and equipped to handle them. This allows company attorneys to narrow their attention to understanding the business and its goals and providing strategic legal counsel in service of achieving those goals while minimizing legal risks.
Business Intelligence: Speaking the Language of Data Legal departments comfortable with collecting and interpreting vast amounts of data across their functions use metrics to identify trends such as areas of inefficiency or expensive cost centers to address. Indeed, the value of data intelligence is gaining recognition throughout the legal community. Proficiency in this area allows legal departments to identify and address emerging risks, quantify the department’s impact on business objectives, demonstrate value through metrics that resonate with business leaders, and leverage predictive analytics to proactively manage risk.
Strategic Planning: Going from Reactive to Proactive Long-term planning allows legal departments to better understand their role in the company’s success and gain recognition for their contributions. Establishing strategic plans helps legal teams align activities with company-wide goals, anticipate needs based on business growth trajectories, and shift from crisis response mode to strategic risk management.
Service Delivery Models: Optimizing for Business Speed By building relationships with legal service providers beyond traditional law firms and strategically leveraging the right mix of talent and technology, legal departments can confidently direct work to the optimal resources when opportunities and challenges arise. Proactively designing flexible service delivery models allows legal teams to identify cost-effective, scalable, and efficient approaches for routine legal needs. Once implemented, bespoke service models let attorneys focus on providing high-value strategic guidance to the business rather than staying buried in repetitive tasks.
Technology: Enabling Business at Scale By leveraging technology with appropriate guardrails, legal departments can strategically deploy artificial intelligence (“AI”) to help with tasks in regulatory compliance, contract analysis, and due diligence. AI tools can be trained to assist with specific workflows, such as identifying and summarizing regulatory updates and updating relevant policies and controls, or monitoring high-risk customer profiles and transactions and conducting due diligence to comply with anti-money-laundering regulations. No-code automation and contract life cycle management solutions can support self-service tools for high-volume, low-risk agreements like nondisclosure agreements. As legal departments explore deploying AI-enabled solutions, they should develop robust policies, processes, and oversight frameworks that include validation, independent verification of output, and appropriate security protocols to ensure lawyers’ ethical transition from an execution oversight role to a strategic advisory one.
Achieving Strategic Partnership
To serve as a true strategic business partner, legal departments should prioritize:
proactively identifying emerging risks and opportunities before they impact the business
efficiently scaling legal services in alignment with business growth
building scalable frameworks that allow for quick, consistent decision-making across the organization
leading strategic initiatives in critical areas such as privacy, cybersecurity, and AI governance
When legal operations functions successfully implement these four key strategies, attorneys shift from reactive problem-solving to proactive business guidance. This transition provides them the time to gain a deeper understanding of their business units’ goals and the ability to more strategically counsel on the advancement of those objectives while managing risk.
The Future of Legal Operations
Integrating legal operations within a legal department requires investment in the right mix of people, processes, and technology. Change management expertise is critical to driving adoption both within the legal department and across the business departments that interact with legal. Legal operations leaders must understand both emerging technologies and traditional legal processes. Ideally, they have a solid commitment to continuous improvement and innovation, change management experience, tenacity, and the gravitas to manage changes across the organization effectively.
Mastering emerging technologies to meet regulatory requirements and to facilitate the legal department guiding the business through legal risks remains a key component of legal operations. AI-powered tools promise to revolutionize compliance monitoring, contract management, due diligence, and more. At the same time, these advances bring new challenges in AI governance, algorithm bias detection, and ethical technology deployment, to name a few.
When leveraging new technology, including generative AI tools, legal teams must first gain a reasonable understanding of the technology and ensure that appropriate safeguards are in place, including implementing robust processes for oversight and error correction and upholding ethical obligations around data confidentiality, client communications, and security. Proactively addressing these areas allows legal departments to maintain control, accuracy, and professional responsibilities when harnessing the power of technology in creating efficient workflows.
Building Community and Standards
Various legal operations communities and organizations have formed as the area has matured. The Corporate Legal Operations Consortium (“CLOC”), LegalOps.com, Legal Data Intelligence, and others help define the industry, provide a community for professional collaboration, and set industry standards. These communities are increasingly focused on developing frameworks for data privacy standards, AI governance, and cybersecurity best practices, and they can be valuable resources for the legal operations community.
Adding a robust legal operations function to a legal department empowers the business to navigate the complex, technology-driven business landscape of today. By transforming legal from a cost center to a strategic partner, legal operations helps an enterprise to proactively manage risk, responsibly harness new technologies, and stay ahead of evolving compliance requirements. In an era of unprecedented change, the legal department’s ability to adapt and lead is not just a marker of success but a competitive necessity. Prescient organizations that invest in legal operations capabilities position themselves for long-term, sustainable growth.
The Eastern District of Pennsylvania Bankruptcy Conference (“EDPABC”) is a nonprofit organization that was formed in 1988 to promote the education and interests of its members and the citizens of the Commonwealth of Pennsylvania residing in the ten counties within the United States District Court for the Eastern District of Pennsylvania. Members include lawyers, other professionals, and paraprofessionals who specialize in the practice of Bankruptcy and Creditors’ Rights law in the Eastern District of Pennsylvania. Please visit EDPABC’s website, www.pabankruptcy.org, for more information or to join the organization.
Materials Preview
Each year, the EDPABC’s Education Committee formulates challenging hypotheticals based on recent case law. At the EDPABC’s Annual Forum, typically held in late March/early April each year, professors from local law schools facilitate lively discussions among EDPABC members about the hypotheticals in small-group breakout sessions. The hypotheticals are always engaging—and sometimes deliberately ambiguous—to mirror the complexity of everyday practice and foster debate among even the most seasoned bankruptcy professionals.
The hypotheticals are accompanied by summaries of the underlying case law and other relevant authorities inspiring the fact patterns. The summaries are intended to give readers insights into how similar issues have been argued before and decided by the courts and to inform their answers to the questions presented in the hypotheticals.
This hypothetical from a previous Forum, titled “The Greasy Spoon,” describes the fictional bankruptcy of a small restaurant chain in the wake of the COVID-19 pandemic. The hypothetical raises questions around the intersection of adversary proceedings in bankruptcy court and mandatory arbitration provisions, as well as the enforceability of prepetition guarantees in connection with postpetition liabilities.
The Greasy Spoon: Case Problem
The Greasy Spoon, LLC (“Company”) is a Pennsylvania limited liability company based in Montgomery County, Pennsylvania, that has two members, Bob and Brian Greasy, a father and his son. Through the Company, the Greasys owned and operated three restaurants in and around Norristown, Pennsylvania.
When the COVID-19 pandemic hit in March of 2020, the Company was initially able to weather the storm, obtaining Paycheck Protection Program (“PPP”) loans, dipping into savings, and hanging on through the initial wave of shutdowns. However, as the pandemic wore on, the Company found itself in an ever more precarious financial situation due to a decided lack of outdoor seating at its three locations as well as limited takeout operations. As the pandemic headed into its second year, the Company’s losses ballooned, and the Greasys wondered how much longer they could hang on. Finally, on June 15, 2021, a fire broke out in the East Norriton restaurant, the Company’s most popular location, severely damaging the kitchen and necessitating a closing so that repairs could be made. In addition, the Company found it increasingly difficult to retain and hire new staff because of COVID-related staffing shortages. As a result of the loss of revenues and staffing difficulties, the Company decided that it could no longer continue; and on July 7, 2021, the Company shuttered the two remaining locations and filed for protection under Chapter 11 of the Bankruptcy Code in the U.S. Bankruptcy Court for the Eastern District of Pennsylvania. As of the petition date, the Company had a number of long-standing contracts with vendors providing goods and/or services to their restaurants.
Problem #1
Several years earlier, in an effort to manage costs and ensure twenty-four-hour service coverage, the Company entered into an agreement (“Services Agreement”) with Hot Air HVAC Company, a Delaware limited liability company operating out of Laurel Hill, New Jersey. Pursuant to the Hot Air Services Agreement, the Company would pay a monthly subscription fee of $1,000. In exchange, Hot Air would manage all of the Company’s heating, ventilation, and air-conditioning (“HVAC”) needs, which included maintenance of the Company’s oven vents as well as its heating and air-conditioning systems. Whenever a maintenance issue would arise, the Company would contact Hot Air, which contracted with local HVAC repairmen and would send a repairman out to immediately assess and begin making any necessary repairs. The Services Agreement contained the following provision:
In the event of a dispute between the Company and the Customer (the “Parties”) that arises from this Agreement or the services provided hereunder including, but not limited to, a payment dispute, the Parties agree to submit their dispute to binding arbitration under the authority of the Federal Arbitration Act and in accordance with the Commercial Arbitration Rules of the American Arbitration Association.
In the year preceding the bankruptcy, the Company had fallen behind on any number of payables. Among other things, the Company failed to timely make its monthly service payments under the Services Agreement with Hot Air. As of June 2021, the Company was approximately four months in arrears. On June 12, the oven vent at the East Norriton location suddenly stopped working during the busy Saturday morning breakfast lunch. Frantic to keep its most profitable location operating on its busiest day, Brian called Hot Air with a service request—but Hot Air informed Brian that until the Company paid its past-due service fees, Hot Air would not send anyone out to the location. As a result, over the phone, Brian paid the $4,000 for the four months of past-due invoices. Within a couple of hours, Hot Air sent out one of its subcontractors, who inspected and repaired the oven vent in time to salvage the Saturday evening dinner rush.
After the Company filed for bankruptcy protection, it quickly filed a number of motions seeking to reject executory contracts that were no longer needed now that the restaurants had closed. Among others, the Company filed a motion to reject the Hot Air Services Agreement, which the bankruptcy court granted as unopposed.
A couple of months after filing for bankruptcy protection, the Company learned that the subcontractor sent out by Hot Air had failed to properly wire a replacement fan in the oven vent, which was the cause of the devastating fire that had occurred just several days later. After considering its options, the Company filed an adversary complaint in the bankruptcy court against Hot Air, asserting claims for negligence and breach of contract and damages in the amount of $20,000. In addition, the Company asserted a preference claim under section 547 of the Bankruptcy Code, seeking to recover the $4,000 paid to Hot Air on June 12.
Hot Air timely filed a motion to dismiss for failure to state a claim, which was denied. After the motion to dismiss was denied and approximately three months after the complaint was filed, Hot Air filed an answer with affirmative defenses; the parties then engaged in some initial discovery, serving interrogatories, requests for documents, and requests for admissions. Thereafter, Hot Air served initial responses to the Company’s discovery requests and filed a motion to compel discovery after the Company failed to serve any responses.
Two months after filing its answer and shortly after it served discovery responses and filed its motion to compel discovery, Hot Air filed a motion to compel arbitration and to stay the adversary proceeding based on the arbitration clause. Hot Air argued that there is a strong federal policy favoring the enforcement of arbitration clauses. It further noted that it had not filed a proof of claim in the bankruptcy.
The Company argued that the arbitration clause was no longer enforceable because the Company had rejected the Services Agreement and a party cannot pursue specific performance from a trustee or debtor in possession. Accordingly, the Company asserted, Hot Air could not compel arbitration. Further, the Company argued, the adversary complaint also included a preference claim against Hot Air that is a core matter under the Bankruptcy Code. Accordingly, the Company reasoned that the bankruptcy court clearly had jurisdiction over Hot Air with respect to the preference claim and that the dispute should not be bifurcated, with some claims subject to arbitration and others remaining before the bankruptcy court. Such bifurcation, the Company asserted, would be inefficient and unduly burdensome to the bankruptcy estate. The Company also argued that to the extent that the arbitration clause could still be invoked, Hot Air had waived arbitration by failing to object to the rejection of the Services Agreement, filing an answer that failed to raise arbitration as a defense, engaging in discovery, and not raising the arbitration issue at all for several months.
Hot Air countered that whether or not the preference claim was “core” was immaterial because the claim had its genesis in a payment made by the Company to Hot Air under the Services Agreement, and any payment disputes under the Services Agreement are subject to arbitration. Accordingly, Hot Air argued, the claims did not need to be bifurcated at all, and the bankruptcy court should order that they all be arbitrated.
Questions for Problem #1
Taking into account the parties’ arguments and relevant case law, should the bankruptcy court grant the motion to compel arbitration and order the parties to arbitration, notwithstanding the fact that the Company rejected the Services Agreement? Does it matter whether it is the debtor or the counterparty to a rejected contract that is seeking to compel arbitration?
Putting aside the rejection of the Services Agreement, did Hot Air waive its rights under the arbitration clause by answering the complaint, participating in discovery, and waiting several months to file the motion to compel arbitration?
Assume that Hot Air is also owed money for unpaid service charges and that, upon rejection of the Services Agreement, Hot Air filed a proof of claim for the service charges as well as liquidated rejection damages. Does Hot Air’s filing a proof of claim change the analysis on whether or not the court should compel arbitration?
If the court orders the parties to arbitration, should the arbitration be limited to the negligence and breach of contract claims, or should it include the preference claim? If the court bifurcates the claims, should it stay the preference action until conclusion of the arbitration?
Summary of Legal Authorities for Problem #1
Highland Capital Management, L.P. v. Dondero (In re Highland Capital Management, L.P.)[1]
Background
The debtor, Highland Capital Management, L.P., commenced four separate adversary proceedings to collect tens of millions of dollars owed to it under certain promissory notes (collectively, “Note Adversary Proceedings”). Each note obligor was closely related to Highland’s former president, who himself was an obligor on three of the notes. The Note Adversary Proceedings were originally brought as breach of contract actions, but after the defendants raised certain affirmative defenses, the debtor amended its complaints to add claims for fraudulent transfers, declaratory judgments as to certain provisions of the debtor’s limited partnership agreement, breach of fiduciary duties, and aiding and abetting said breaches of fiduciary duties.
Thereafter, the former president, his wife, and a family trust that was one of the debtor’s largest partners (collectively, “Movants”) filed motions to compel arbitration relying on a mandatory arbitration provision in the limited partnership agreement, which also restricted the scope of discovery. They also sought to stay the litigation with respect to concededly nonarbitrable claims pending the completion of arbitration.
The debtor had previously rejected the limited partnership agreement under section 365 of the Bankruptcy Code. The debtor asserted, among other things, that (i) the rejection of the limited partnership agreement excused the debtor from mandatory arbitration, and (ii) the Movants had waived the right to arbitration by not invoking it earlier in the litigation. The debtor further argued that arbitration of some, but not all, of the debtor’s claims would be inefficient and a waste of resources.
Analysis
The court acknowledged the “wealth of federal case law dictating the strong federal policy undergirding the Federal Arbitration Act (“FAA”).”[2] The court noted that “the FAA reflects a liberal federal policy favoring arbitration and requires arbitration agreements to be rigorously enforced according to their terms.”[3] However, noting that other courts have wrestled with whether bankruptcy courts can treat arbitration provisions as “less mandatory” than other courts, the court observed that “bankruptcy cases are not like other lawsuits; they are multi-faceted, multi-party, and fast-moving.”[4] The court also explained that one of the primary purposes of bankruptcy is to provide a centralized forum for a debtor and creditors to resolve their claims in an orderly fashion.
The court pointed out that some courts, in determining whether to enforce arbitration provisions, apply a “core versus noncore” analysis. Those courts, when presented with a noncore dispute, find that they generally must enforce mandatory arbitration provisions. In contrast, when presented with a core dispute, they employ a test derived from the U.S. Supreme Court’s decision in Shearson/American Express, Inc. v. McMahon.[5] Under that test, a party seeking to avoid arbitration must show in enacting the relevant statute that Congress intended to preclude arbitration. Such a showing must be made based on (i) the statute’s text, (ii) its legislative history, or (iii) an inherent conflict and the underlying purpose of the statute.
However, the primary issue presented by the debtor was one that, according to the court, few other courts have addressed—namely, whether a contract counterparty can force a debtor to engage in arbitration where the underlying contract has been rejected. Relying primarily on a U.S. Court of Appeals for the Fifth Circuit decision involving a federal receivership, Janvey v. Alguire (discussed below),[6] the court concluded that the debtor could not be compelled to engage in arbitration under the rejected limited partnership agreement. According to the Janvey court, an arbitration provision is a classic executory contract with performance due on both sides since neither party has performed an arbitration provision when one party seeks to enforce it. Looking to bankruptcy jurisprudence, the Janvey court determined that it could not order arbitration under a rejected contract because injured parties under a rejected contract cannot insist on specific performance by a trustee.
The court noted that although Janvey involved a federal receivership and not a bankruptcy case, the Fifth Circuit looked almost exclusively to bankruptcy law. The court found the Fifth Circuit’s analysis in Janvey persuasive and potentially binding. The court noted that under section 365, “if a bankruptcy trustee rejects an executory contract, the rejection, of course, constitutes a breach of the contract and subjects the estate to a claim for money damages on behalf of the injured party.”[7] However, the court also concluded that the injured party cannot insist on specific performance by the trustee. “Instead, the injured party is treated as having a prepetition claim for damages arising as if the breach occurred immediately before the filing of the bankruptcy petition.”[8]
The question then becomes whether such prepetition claim must be liquidated through arbitration. According to the court, most courts dealing with arbitration provisions do not analyze them as classic executory contracts even though, in the view of Professor Westbrook, that’s exactly what they are.[9] Although arbitration provisions generally survive a contract, executory obligations may be avoided by a trustee under section 365; and, accordingly, because specific performance is not available against a trustee, arbitration provisions remain subject to rejection.
In following the Janvey court’s reasoning, the Highland Capital court rejected the reasoning of the bankruptcy court in In re Fleming Cos. (discussed below), which held that rejection does not prevent a party from enforcing an arbitration provision in the rejected contract.[10] The court noted that in Fleming, it was the debtor demanding arbitration, which the court found to be a significant distinction.
With respect to the debtor’s argument that the Movants had waived arbitration, the court noted that the Note Adversary Proceedings were filed in January 2021 and that, thereafter, the Movants had engaged in the litigation for eight or nine months before moving to enforce the arbitration provisions. Among other things, they had filed answers with affirmative defenses, moved to withdraw the reference, and attended hearings—all without ever raising the issue of arbitration. Moreover, they had served significant discovery far outside the scope permitted by the arbitration provisions. The court concluded that although courts in the Fifth Circuit often impose a presumption against waiving the right to arbitration, under the circumstances, the Movants’ belated attempt to enforce arbitration was prejudicial to the debtor.
Madison Foods, Inc. v. Fleming Cos. (In re Fleming Cos.)[11]
Background
The debtor filed a motion to compel arbitration and stay any related nonarbitrable claims. The debtor was a nationwide wholesale supplier of food and grocery products. The plaintiff had purchased a grocery store from the debtor prepetition. In connection with the sale, the plaintiff and the debtor entered into a facility standby agreement (“FSA”) containing an arbitration clause, as well as a number of related agreements and promissory notes. The debtor soon after filed a voluntary Chapter 11 petition and sought authority from the bankruptcy court to sell substantially all of its assets, including the notes, to a third-party buyer (“Buyer”). The debtor also rejected the FSA pursuant to section 365 of the Bankruptcy Code.
Thereafter, the plaintiff filed an adversary complaint against the debtor and the Buyer requesting various forms of relief, alleging that the notes were unenforceable due to fraud, breach of contract, and promissory estoppel. In response, the debtor moved to compel arbitration under the FSA, which provided that “[a]ll disputes . . . including any matter relating to this Agreement, shall be resolved by final binding arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration Association.”[12] Both the Buyer and the plaintiff opposed arbitration.
The Buyer and the plaintiff asserted, among other things, that (1) the debtor waived arbitration by previously seeking a determination on an issue involving the FSA, and (2) the debtor breached the agreement by rejecting it pursuant to section 365.
Analysis
The court rejected the plaintiff and Buyer’s argument that arbitration had been waived. Although the debtor, in connection with the sale of its assets, had previously requested a determination of the enforceability of the consequential damages provision of the FSA, the court had refused to make such a determination, finding that the debtor was seeking an advisory opinion. Accordingly, the court determined that the plaintiff and the Buyer had failed to demonstrate any prejudice, which the U.S. Court of Appeals for the Third Circuit has established “is the touchstone for determining whether the right to arbitration has been waived.”[13]
On the issue of whether rejection of the FSA barred any effort by the debtor to compel arbitration, the court found that it did not. The court distinguished a case relied upon by the plaintiff and the Buyer that held that a debtor who rejected a contract could not thereafter sue for breach of contract under the agreement but could maintain a suit in equity for the return of funds that had not been earned by the defendant. In contrast, the court concluded, the debtor in Fleming was not seeking to compel payment or any substantive performance under the FSA but was only seeking to compel arbitration under the terms of the FSA.
The court looked to other decisions holding that a party can compel arbitration despite a rejection or breach of the underlying agreement, including the decision in Southeastern Pennsylvania Transportation Authority v. AWS Remediation, Inc. (discussed below).[14] The court found that rejection of a contract will not void an arbitration clause, in part because “[a]ny different conclusion would allow a party to avoid arbitration at will simply by breaching the contract.”[15] In addition, the court rejected an argument that resolution of the issue should turn on whether it is the nonbreaching party who is seeking to compel arbitration, observing that “[b]oth parties agreed to the method of dispute resolution and both parties should be able to take advantage of it.”[16] Accordingly, the court granted the debtor’s motion to compel arbitration and also stayed the nonarbitrable claims on grounds of judicial economy and to avoid inconsistent rulings.
Mintze v. American Financial Services, Inc. (In re Mintze)[17]
Background
In a Chapter 13 case, after a lender filed a proof of claim, the debtor brought an adversary proceeding to enforce a purported prepetition rescission of a loan agreement. The underlying loan agreement contained an arbitration clause that covered all claims and disputes arising out of or related to the loan. The creditor moved to compel arbitration. The parties stipulated that the matter was a “core” proceeding, and the bankruptcy court had found that because it was a core matter, it had discretion to deny arbitration. The district court affirmed.
Analysis
On appeal, the Third Circuit reversed, holding that the core versus noncore distinction has no bearing on whether a bankruptcy court has discretion to deny enforcement of an arbitration agreement. Rather, under McMahon, regardless of whether a dispute is core or noncore, the party opposing enforcement of the arbitration agreement has the burden of demonstrating congressional intent to preclude arbitration for the statutory rights at issue through (1) the statute’s text, (2) the statute’s legislative history, or (3) an inherent conflict between arbitration and the statute’s underlying purposes. The Third Circuit noted the strong federal policy in favor of arbitration. The court observed that the McMahon test establishes a high burden for the party opposing arbitration.
The court rejected the debtor’s argument that its decision in Hays & Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc.[18] stood for the proposition that a bankruptcy court lacks discretion to deny arbitration only in noncore matters. In Hays, the Third Circuit considered whether the Bankruptcy Code conflicts with the FAA “‘in such a way as to bestow upon a district court discretion to decline to enforce an arbitration agreement’ with respect to a trustee’s claims.”[19] The Third Circuit in Mintze noted that it held in Hays that “where a party seeks to enforce a debtor-derivative pre-petition contract claim, a court does not have the discretion to deny enforcement of an otherwise applicable arbitration clause.”[20] In Mintze, the Third Circuit clarified that the decision in Hays did not rest on the distinction between core and noncore proceedings, but rather “sought to distinguish between causes of action derived from the debtor and bankruptcy actions that the Bankruptcy Code created for the benefit of the creditors of the estate.”[21] Accordingly, the standard adopted in Hays and derived from the McMahon decision does not turn on the core versus noncore distinction.
The Third Circuit then went on to consider whether the debtor had satisfied her burden of establishing congressional intent to preclude arbitration. Finding no such intent in the statutory text or legislative history of the Bankruptcy Code, the Third Circuit analyzed whether there was an inherent conflict between arbitration and the Bankruptcy Code. The bankruptcy court had found that resolution of the debtor’s contract rescission claim would have an effect on the rights of other creditors that was sufficient to create an inherent conflict, but the Third Circuit disagreed. The debtor’s claims did not arise under the Bankruptcy Code, and, accordingly, with no bankruptcy issue to be decided by the bankruptcy court, there could be no conflict between arbitration and the Bankruptcy Code. In sum, the Third Circuit concluded that the bankruptcy court lacked discretion to deny arbitration. “The FAA mandates enforcement of arbitration when applicable unless Congressional intent to the contrary is established.”[22] Having failed to demonstrate such intent, the debtor’s attempt to avoid arbitration was denied.
The Janvey decision, relied upon heavily by the bankruptcy court in Highland Capital (summarized above), arose in the context of an SEC-imposed receivership over several related entities. As part of the receivership, the receiver initiated suits against certain former employees asserting claims for fraudulent transfer and unjust enrichment. The employees then filed motions to compel arbitration. The motions were litigated up to the Fifth Circuit twice on issues related to the arbitration agreements before again being remanded to the district court to determine “whether the Receiver is bound by the arbitration clauses.”[24]
Analysis
Acknowledging the broad federal policy in favor of arbitration and the Supreme Court’s holding in McMahon, the court noted that there was little case law regarding the FAA and federal equity receiverships. The court examined the historical relationship between federal equity receiverships and bankruptcy law and determined that “because equity receivership law and bankruptcy law share similar roots regarding their successor rights, the Court will supplement the sparse equity receivership law by also examining relevant bankruptcy law.”[25]
The court then determined that the receiver could be bound by the arbitration agreements and considered whether the receiver had the right to reject the arbitration agreements. Analogizing to bankruptcy law, the court adopted the Countryman material breach test for determining whether a contract is an executory contract that may be rejected. Under that test, a contract is executory if either party’s failure to complete performance would constitute a material breach. The court concluded that “arbitration agreements must be analyzed as separate executory contracts, based on the nature of the agreement as well as arbitration caselaw regarding severability.”[26] The court, again relying on bankruptcy case law, found that upon rejection of an executory contract, the injured party cannot compel specific performance by a trustee. Finding that the receiver could and did reject the arbitration provisions, the court opined that forcing the receiver to adopt the arbitration provisions would be an unjust result, imposing a financial burden on the estate and valuing arbitration agreements above other contracts.
In light of the dearth of case law analyzing federal equity receiverships and arbitration agreements, the court looked to bankruptcy jurisprudence to determine whether arbitration of the receiver’s claims would conflict with the federal equity receivership statutory scheme. The court then discussed the Third Circuit’s analysis in Hays, noting that the Fifth Circuit had previously adopted the reasoning in Hays in determining that “where a core proceeding involves adjudication of federal bankruptcy rights wholly divorced from inherited contractual claims, the importance of the federal bankruptcy forum provided by the Code is at its zenith.”[27] Thus, the Fifth Circuit held that where a cause of action is not derivative of prepetition legal rights possessed by a debtor, the bankruptcy courts have discretion to determine whether arbitration is inconsistent with the Bankruptcy Code.
After examining the statutory history of federal equity receiverships, the court explained that the objectives of the receivership were equivalent to the objectives of the Bankruptcy Code—that is, “to marshal assets, preserve value, equitably distribute to creditors, and, either reorganize, if possible, or orderly liquidate.”[28] The court determined that “[f]or a bankruptcy court to be afforded discretion in refusing to enforce an arbitration clause, there must be a specific conflict with a central purpose of the Bankruptcy Code in arbitrating the particular claims at issue.”[29] The court held that there was a conflict because, among other things, the fraudulent transfer claims (i) would allow the receiver to protect creditors, (ii) were brought pursuant to federal statutes that gave the receiver special jurisdictional authorization, and (iii) were likely not viable outside of the receivership. Thus, the court determined that it had significant discretion and denied arbitration as contrary to the purposes of the receivership.
Camac Fund, L.P. v. McPherson (In re McPherson)[30]
Background
A creditor moved for stay relief to arbitrate claims against the Chapter 11 debtor pursuant to an arbitration clause in a prepetition funding agreement. Prepetition, the creditor had invoked the arbitration clause. The debtor filed a response disputing the enforceability of the arbitration clause before filing for Chapter 11 relief. The debtor then brought an adversary proceeding against the creditor, and the creditor requested that the bankruptcy court abstain from or stay the adversary proceeding in favor of the pending prepetition arbitration. The debtor asserted that all of the issues in the litigation overlapped with his reorganizational efforts such that the bankruptcy court should resolve the entire dispute between the parties. The creditor asserted that the arbitrator could resolve most, if not all, of the issues, and the bankruptcy court could then resolve the administration of any resulting claims.
Analysis
The court acknowledged that there was some merit to the debtor’s position that the Bankruptcy Code is intended “to facilitate a timely, cost-effective resolution of all claims asserted against a debtor,” which would be undermined by arbitration.[31] Nevertheless, although the court noted that it might be a “suboptimal” outcome, the court held that applicable law required bifurcation of the claims between the bankruptcy case and the prepetition arbitration matter.[32]
In considering the interplay between the FAA and the Bankruptcy Code, the court explained that “[t]he FAA and the Code both are grounded in important policy considerations concerning efficiency and fairness.”[33] On the one hand, the FAA reflects a strong federal policy in favor of arbitration that “reflects the reality that, at least in contracts subject to negotiation, the arbitration clause may be a critical piece of the parties’ bargain and integral to their cost-benefit analysis of the contract itself.”[34] On the other hand, the Bankruptcy Code “is not party- or contract-specific but seeks to balance the rights of many parties with many different contracts, rights, and interests involving a single debtor.”[35]
The court then acknowledged the applicability of the McMahon analysis and noted that some courts start the analysis by first determining whether the dispute involves core or noncore claims. However, the court also recognized that the core/noncore distinction is “not mechanically dispositive” and that matters involving a mix of core and noncore issues require additional analysis.[36] The court agreed with the line of cases holding that where a core claim is involved, bankruptcy courts have wider discretion to deny arbitration.
Finding that the dispute at hand involved both core and noncore claims, the court bifurcated the core and noncore claims, ordering the noncore claims to arbitration. Although the court expressed concerns that arbitration of the noncore claims carried the risk of interfering with the debtor’s reorganization efforts and could result in conflicting results, the court concluded that it was bound by U.S. Court of Appeals for the Fourth Circuit precedent strongly favoring arbitration. The court noted that had the bankruptcy been filed prior to the initiation of arbitration, the court might have come to a different conclusion.
In Hoxworth, the Third Circuit articulated standards for determining when a party has waived arbitration. Among other things, the court considered whether the defendants had waived their right to compel arbitration by actively litigating the case for almost a year prior to filing their motion to compel arbitration. Citing Gavlik Construction Co. v. H.F. Campbell Co., the Third Circuit noted that “prejudice is the touchstone for determining whether the right to arbitrate has been waived.”[38] The court observed that other courts have found that prejudice exists where a party substantially invokes “the litigation machinery” before pursuing arbitration.[39] Relevant factors include the timeliness or lack thereof of a motion to arbitrate, the degree to which the party seeking arbitration has contested the merits of its opponents’ claims, whether that party has informed its adversary of its intention to seek arbitration, the extent of its nonmerits motion practice, its assent to the district court’s pretrial orders, and the extent to which both parties have engaged in discovery.
Analysis
In Hoxworth, the Third Circuit affirmed the district court’s denial of arbitration on waiver grounds where the defendants had participated in numerous pretrial proceedings over more than eleven months; moved to dismiss the complaint for failure to state a claim; filed a motion to disqualify the plaintiff’s counsel; took depositions of the plaintiffs that would not have been available in arbitration; inadequately answered discovery requests, prompting additional motion practice; objected to a motion for class certification; and only moved to compel arbitration after their motion to dismiss was denied and the plaintiff’s motion to compel discovery was granted.
Nova Hut A.S. v. Kaiser Group International Inc. (In re Kaiser Group International, Inc.)[40]
Background
The appellant purchaser (“Nova”), who was sued by appellee debtors (collectively, “Kaiser”) in an adversary proceeding, appealed from the orders of the bankruptcy court denying its motions to stay the proceedings, to compel arbitration, and to dismiss the debtors’ third amended complaint. The bankruptcy court had denied arbitration on the basis that by filing a proof of claim in the bankruptcy case and pursuing litigation against a nondebtor affiliate in the Netherlands, Nova had waived arbitration. Nova filed a proof of claim but only invoked arbitration after the debtor objected to the proof of claim.
Analysis
The court reversed the bankruptcy court’s denial of arbitration, noting that “[t]he Third Circuit has recognized that prejudice is ‘the touchstone for determining whether the right to arbitrate has been waived.’”[41] The court found that in denying the arbitration, the bankruptcy court had not addressed whether Kaiser had established prejudice. Here, although Nova filed a proof of claim and did not seek arbitration until Kaiser filed an adversary proceeding, Nova never answered the complaint and moved for arbitration each time Kaiser amended its complaint. In addition, Kaiser did not demonstrate that any delay in pursuing arbitration was unreasonable or resulted in prejudice. Similarly, although Nova had initiated litigation against a nondebtor affiliate in the Netherlands, Kaiser failed to make any showing of actual prejudice, and it appeared that there was no discovery or litigation advantage for Nova.
Southeastern Pennsylvania Transportation Authority v. AWS Remediation, Inc.[42]
Background
On cross-motions for summary judgment, where the plaintiff had requested a declaratory judgment that a contract dispute between the parties was not subject to arbitration and the defendant sought to enforce a mandatory arbitration clause, the district court found in favor of the defendant and ordered arbitration.
Here, Amtrack and Southeastern Pennsylvania Transportation Authority (“Rail Companies”) had entered into a contract for environmental consulting with the debtor, a nonparty to the litigation, which subcontracted with the defendant to provide labor and materials. The defendant was not a party to the agreement, which contained a mandatory arbitration clause. In January 2002, the Rail Companies terminated the contract with the debtor, which then filed for bankruptcy relief. The bankruptcy court granted the debtor’s motion to reject the agreement. However, the bankruptcy court also approved the debtor’s sale of the accounts receivable owed to it by the Rail Companies under the contract to the defendant, which then filed a demand for arbitration in order to collect the receivables, leading to the filing of the adversary proceeding.
Analysis
After first determining that the debtor’s arbitration rights had been assigned to the defendant, the court turned to whether the Rail Companies’ prepetition termination of the agreement and the debtor’s postpetition rejection of the contract barred enforcement of the arbitration provisions. The court rejected the Rail Companies’ argument that an arbitration provision dies with the underlying contract. “While a rejection or termination of an agreement may affect the arbitrability of events that occur after the date of termination or rejection, it cannot change the remedial limitations applied to pre-rejection events.”[43] The court concluded that allowing a party to avoid arbitration by terminating a contract would render mandatory arbitration provisions illusory and that the same rationale applies to a debtor’s rejection of a contract in bankruptcy. The court also noted that the Rail Companies had undermined their own arguments by previously seeking a modification of the asset purchase agreement to allow them to pursue set-asides arising under the agreement, finding that it would be unfair to allow the Rail Companies to pursue set-asides under the agreement but bar the defendant from invoking its arbitration provisions.
Problem #2
Since 2010, the Company had contracted with Cream of the Crop Dairy (“Cream of the Crop”) for the provision of all of the Company’s dairy needs, including both dairy products and various refrigerator units for storing the Company’s dairy inventory. In 2012, at Cream of the Crop’s request, Bob signed an “Unconditional and Continuing Guaranty,” which provided thus:
Guarantor, for and in consideration of [Cream of the Crop’s] extension of credit to [the Company], hereby personally guarantees prompt payment of any and all obligations of the Company to Seller whether now existing or hereinafter incurred. Guarantor expressly binds himself to pay on demand any sum that is due from the Company to Seller whenever Company fails timely to pay the same. Guarantor expressly acknowledges and agrees that this guaranty shall be an absolute, continuing and irrevocable guaranty for such indebtedness to the Company.
In 2017, Bob filed a no-asset Chapter 7 bankruptcy case in order to address significant outstanding credit card debt. Although Bob had some assets, including his interest in the Company, all of his assets were either exempt or represented collateral for debts. As a result, shortly after the Chapter 7 case was filed and Bob’s 341 meeting concluded, Bob received a discharge, the Chapter 7 trustee filed a report of no distribution, and the Chapter 7 case was closed. However, Bob never scheduled his guaranty obligation to Cream of the Crop, believing it was unnecessary because at the time there were no outstanding amounts due from the Company to Cream of the Crop. Accordingly, Cream of the Crop never received formal notice of the Chapter 7 case.
In the several months preceding the Company’s Chapter 11 filing, the Company had received several shipments of dairy products for which it had not tendered payment, as well as several sliding-door dairy refrigerators to replace aging units at each of its locations. As a result, when the Company filed the Chapter 11 case, the Company held outstanding invoices from Cream of the Crop reflecting approximately $26,000 due and owing to Cream of the Crop. It was only after the Company filed for Chapter 11 protection and Cream of the Crop received notice as a creditor of the Company that Cream of the Crop undertook its own investigation and discovered Bob’s Chapter 7 case from several years prior.
Realizing that it was unlikely that its unsecured claim would be paid in full in the Company’s Chapter 11 case, Cream of the Crop moved to reopen Bob’s Chapter 7 case and then filed an adversary complaint seeking (i) a declaration that the postpetition invoices for goods provided to the Company created fresh liabilities under the guaranty that were not discharged in Bob’s Chapter 7 case (“Count I”) and (ii) a judgment against Bob for the debts incurred by the Company (“Count II”). Cream of the Crop took the position that Bob’s Chapter 7 discharge did not extinguish his liability for the postpetition extensions because such liabilities arose postpetition.
Bob objected to Cream of the Crop’s attempt to impose liability, asserting that all debts arising under the guaranty, whether matured or contingent, were discharged in 2017. Bob also asserted that, notwithstanding his failure to schedule Cream of the Crop in his Chapter 7 schedules, at some point Cream of the Crop became aware of the bankruptcy: the Company’s general manager was aware and informed the Company’s vendors, and many of the vendors requested new payment terms after the Chapter 7 case concluded. Cream of the Crop insisted that it had no knowledge of the Chapter 7 case until 2021, after the Company filed the Chapter 11 case. It asserted that debt owing to Cream of the Crop was nondischargeable under section 523(a)(3) of the Bankruptcy Code and, therefore, was not discharged under section 727(b) of the Bankruptcy Code. Cream of the Crop moved for summary judgment.
Questions for Problem #2
Did Cream of the Crop’s claim against Bob arise prior to or after his Chapter 7 case?
Why is or is not the debt giving rise to Cream of the Crop’s claim against Bob nondischargeable pursuant to section 523(a)(3) of the Bankruptcy Code?
Was the debt discharged under section 727(b) of the Bankruptcy Code?
Assume the court finds that Cream of the Crop’s claims arose prior to the Chapter 7 case and thus were dischargeable. Given the dispute over whether Cream of the Crop had notice of the Chapter 7 case, can the court grant summary judgment in favor of either party?
Does the bankruptcy court have jurisdiction over Count II?
Summary of Legal Authorities for Problem #2
Jeld-Wen, Inc. v. Van Brunt (In re Grossman’s Inc.)[44]
Background
The successor in interest to a reorganized Chapter 11 debtor brought an adversary proceeding to enjoin the prosecution of asbestos-related claims asserted against it as well as a determination that its liability for such claims had been discharged. In 1977, the appellee remodeled her home using products containing asbestos, which were purchased from a home improvement retailer called Grossman’s (“debtor”). In 1997, the debtor filed for protection under Chapter 11. The debtor provided notice of its claims bar date by publication, but there was no specific reference to potential future asbestos liability. The debtor’s Chapter 11 plan was confirmed in December 1997. The appellee did not file a proof of claim because she was unaware that she had any claim. It was not until she was diagnosed with mesothelioma in 2007 that she filed an action against the debtor’s successor. The successor moved to reopen the Chapter 11 case for a determination that its liability on the claims had been discharged.
Relying on Third Circuit precedent, the bankruptcy court held that the debtor’s confirmed Chapter 11 plan did not discharge the claims because they arose after the petition date. In Avellino & Bienes v. M. Frenville Co. (In re M. Frenville Co.),[45] the Third Circuit had held that a “claim,” as defined by the Bankruptcy Code, arises when the underlying state law cause of action accrues. Because applicable New York law provides that an asbestos-related personal injury cause of action does not accrue until the injury manifests itself, the appellee’s claim did not accrue until after the debtor’s bankruptcy had been filed. The district court affirmed.
Analysis
On appeal in Grossman’s, the Third Circuit reexamined its decision in Frenville, which involved a litigation brought by four banks against the debtor’s former accountants, alleging that the accountants had recklessly prepared the debtor’s prepetition financial statements and seeking damages for the resulting losses. The accounting firm then filed an adversary complaint in the bankruptcy court seeking relief from the automatic stay to implead the debtor as a third-party defendant in order to seek indemnification. In Frenville, the bankruptcy court and the district court both found that the automatic stay barred the adversary proceeding, but the Third Circuit reversed on appeal. It held that the automatic stay, which applies only to prepetition claims, was inapplicable to the action because, under New York law, the accounting firm’s claim for indemnification did not arise until after the banks filed suit. In Frenville, the Third Circuit established the “accrual test” for determining when a “claim” arises under the Bankruptcy Code. Under the accrual test, the existence of a claim depends on (1) whether the claimant possesses a right to payment and (2) when that right arose, as determined by reference to applicable nonbankruptcy law.
In Grossman’s, the Third Circuit acknowledged that both the bankruptcy court and the district court had correctly applied the accrual test to determine that the appellee’s claims arose postpetition when she became ill, not prepetition when she purchased the offending products. However, the Third Circuit concluded that it should abandon the accrual test. The court noted that the other courts of appeal had uniformly declined to follow Frenville, which had been described as “one of the most criticized and least followed precedents decided under the current Bankruptcy Code.”[46] Those courts criticized Frenville for its conflict with the Bankruptcy Code’s “expansive” treatment of the definition of claim, noting that both congressional reports and the U.S. Supreme Court have indicated that the term should be afforded the broadest possible scope.[47] The Third Circuit agreed that “[t]he accrual test in Frenville does not account for the fact that a ‘claim’ can exist under the Code before a right to payment exists under state law.”[48]
Considering the implications of when a claim arises under the Bankruptcy Code—including the effect that such a determination has on both the automatic stay and dischargeability of claims—and noting, in particular, the significant due process issues at play, the Third Circuit looked to the reasoning of other courts and explained that there are generally two lines of cases on the issue. The first line of cases applies the “conduct test,” under which a claim arises when the acts or conduct giving rise to the claim occur, not when the injury caused by the conduct manifests itself. The second line of cases applies the “prepetition relationship test,” under which a claim arises from a debtor’s prepetition conduct, but only where there is also some prepetition relationship. The prepetition relationship test is intended to allay due process concerns—namely, that under the conduct test, a claim could be discharged without the creditor ever receiving notice.
After examining the various approaches taken by courts on the issue, the Third Circuit noted that “there seems to be something approaching a consensus among the courts that a prerequisite for recognizing a ‘claim’ is that the claimant’s exposure to a product giving rise to the ‘claim’ occurred pre-petition.”[49] The Third Circuit then held that “a ‘claim’ arises when an individual is exposed pre-petition to a product or other conduct giving rise to an injury, which underlies a ‘right to payment’ under the Bankruptcy Code.”[50]
Reinhart FoodService L.L.C. v. Schlundt (In re Schlundt)[51]
Background
In 2003, the debtor signed a personal guaranty in favor of Reinhart FoodService L.L.C. (“Reinhart”), guarantying his business’s debts under a supply agreement with Reinhart. The guaranty contained the following language:
I, David Schlundt, for and in consideration of your extending credit at my request to The Refuge, LLC personally guarantee prompt payment of any obligation of the Company to Reinhart FoodService, Inc. (“Seller”), whether now existing or hereinafter incurred, and I further agree to bind myself to pay on demand any sum which is due by the Company to Seller whenever the Company fails to pay same. It is understood that this guaranty shall be an absolute, continuing and irrevocable guaranty for such indebtedness of the Company.[52]
In 2014, the debtor and his wife filed for protection under Chapter 7 of the Bankruptcy Code. The Chapter 7 case was a no-asset case, no bar date was ever set, and the debtor received a discharge. The debtor never scheduled Reinhart as a creditor. The debtor asserted that Reinhart must have learned of the bankruptcy while it was pending or shortly after. Reinhart asserted that it did not learn of the bankruptcy until 2018 and that had it known earlier it would have required new security.
In 2018, the debtor’s business obtained additional goods and services from Reinhart but shuttered its operations without ever paying its approximately $36,000 debt to Reinhart. Reinhart sought to reopen the debtor’s Chapter 7 case to obtain a declaratory judgment that the credit advances constituted a fresh liability under the guaranty such that the debtor’s liability was not discharged in the prior Chapter 7 case. Reinhart moved for summary judgment, and the debtor objected, asserting that all amounts due under the personal guaranty, whether matured or contingent, were discharged in 2014.
Reinhart initially sought a declaration that the debt was nondischargeable pursuant to section 523(a)(3) but thereafter adjusted its argument, relying solely on section 727(b). In sum, Reinhart asserted that the debtor’s liability for the 2018 invoices instead arose at the time Reinhart extended credit. The debtor argued that the 2014 discharge extinguished any and all personal liability to Reinhart and, in the alternative, that there were genuine issues of material fact regarding Reinhart’s lack of notice.
Analysis
The court noted that two views have developed on this issue regarding prepetition guaranties. The first view holds that a debtor’s discharge does not extinguish personal liability for postpetition credit extensions. The second view holds that all debts, including postpetition liabilities, arising under a prepetition guaranty are contingent claims that may be discharged in bankruptcy.
The court noted that the U.S. Court of Appeals for the Seventh Circuit has adopted the “conduct test” for determining whether a claim arose prepetition or postpetition.[53] Under that test, the date that the claim arose is determined by looking to the conduct that gave rise to the claim. The court determined that under Seventh Circuit precedent, the conduct that gives rise to a claim under a contract is generally the signing of the contract; and, therefore, liability arises on the date that a contract is signed. The court found that this is most consistent with the Bankruptcy Code’s definitions of claim and debt and that, “under most circumstances, finding that a claim arose ‘at the earliest point possible’ will best serve the policy goals underlying the bankruptcy process.”[54] Although some courts also require a prepetition relationship in order to address due process concerns, the Seventh Circuit has not determined whether such relationship is always required.
In this case, the court found that even under the relationship inquiry, Reinhart’s claim arose prepetition because he had a prepetition relationship with the debtor. In distinguishing cases relied upon by Reinhart, the court noted that in each of those cases the court relied primarily on state law and that, although not necessarily identified by name, those courts utilized the accrual theory instead of the conduct test. The court, “mindful that the bankruptcy discharge is meant to afford debtors a fresh start,” concluded that the earliest conduct between the debtor and Reinhart was the signing of the guaranty and, accordingly, the debt was dischargeable in 2014.[55]
With respect to notice, the court determined that it did not need to make any factual determination. Reinhart could not state a claim for relief because under the plain language of section 523(a)(3), in a no-asset, no-bar-date bankruptcy case, “garden variety debts” do not fall within the scope of section 523(a)(3).[56]
Russo v. HD Supply Electrical, Ltd. (In re Russo)[57]
Background
In June 2011, the debtor’s company (“Company”) executed a credit application with the defendant (“HD Supply”), and the debtor executed a “Continuing Personal Guaranty.” In November 2011, the debtor filed for relief under Chapter 7 of the Bankruptcy Code. The debtor scheduled HD Supply as a general unsecured creditor, although he never formally revoked his guaranty and there was some dispute over whether HD Supply received notice of the bankruptcy. In March 2012, the debtor obtained his discharge. Thereafter, HD Supply delivered over $20,000 in products to the Company. After the Company failed to pay for the products, HD Supply sent a collection letter to the Company demanding payment and stating that the debtor was personally liable. The debtor filed an adversary complaint alleging that HD Supply violated the discharge injunction by sending the demand letters, and both parties moved for summary judgment. HD Supply argued that the continuing nature of the guaranty encompassed all future transactions and that because the debtor never revoked the guaranty in writing, he remained liable for post-discharge obligations incurred by the Company.
Analysis
The court noted that “[c]ourts have recognized that a personal guaranty is the classic example of a contingent liability because the guarantor’s liability is triggered only if the principal obligor has failed to satisfy its debt.”[58] Accordingly, the court found that on the date that the debtor filed for bankruptcy, HD Supply held a contingent claim against the debtor for any future indebtedness that the Company might incur but fail to pay. Even though the future indebtedness had not been incurred at the time of the bankruptcy case, the claim itself existed by virtue of the debtor’s prepetition execution of the guaranty. The court observed that other courts have come to the same conclusion, including one that stated that courts “universally recognize that claims are contingent as to liability if the debt is one which the debtor will be called upon to pay only upon the occurrence or happening of a future event.”[59] The future events that triggered the debtor’s liability were HD Supply’s postpetition extensions of credit and the Company’s failure to pay. Upon notice of the bankruptcy, HD Supply could have demanded a new personal guaranty. The court rejected any assertion that a debtor’s liability under a guaranty does not arise until the credit to the principal obligor is actually extended, finding that such an interpretation would “conflict[] with the broad definition of ‘claim’ [in the Bankruptcy Code] and is contrary to the very notion of a continuing guaranty.”[60]
However, although the court granted summary judgment in favor of the debtor as to whether HD Supply’s claim was subject to discharge, the court denied summary judgment in favor of the debtor as to whether HD Supply had actual notice of the bankruptcy. The court concluded that HD Supply’s alleged lack of notice was relevant to the issue of whether the claim was actually discharged under 11 U.S.C. § 523(a)(3).
The debtor and his wife filed for Chapter 7 relief in December 2004 and received a discharge in March 2005. In 1997, the debtor had signed a personal guaranty with a building supply company pursuant to which he guaranteed the debts of his drywall company. Five years after the bankruptcy, the supplier filed suit against the debtor to enforce the guaranty. A couple of months later, the debtor moved to reopen the Chapter 7 case and sought damages for violation of the discharge injunction. The court granted the motion, and the supplier moved for reconsideration.
Analysis
The court noted that Congress gave the terms debt and claim “the broadest possible definitions so as to enable the debtor to deal with all legal obligations in a bankruptcy case.”[62] Although “[t]he term ‘contingent’ is not defined in the Bankruptcy Code, . . . courts have concluded that contingent claims are those in which a debtor will be required to pay only upon the occurrence of a future event triggering the debtor’s liability.”[63] Accordingly, because claim is defined to include “contingent” claims under the Bankruptcy Code, “a right to payment that is not yet enforceable under non-bankruptcy law at the time of the bankruptcy filing may still constitute a claim that is dischargeable in the bankruptcy case.”[64]
Quoting In re Pennypacker,[65] the court observed that “[g]enerally, ‘[t]he classic example of a contingent debt is a guaranty because the guarantor has no liability unless and until the principal defaults.’”[66] Looking to other cases, the court explained that “a broad definition of claim allows a bankruptcy court to deal fairly and comprehensively with all creditors in the case and, without which, a debtor’s ability to reorganize would be seriously threatened by the survival of lingering remote claims and potential litigation rooted in the debtor’s prepetition conduct.”[67]
Relying primarily on the broad definitions of debt and claim in the Bankruptcy Code, the court rejected other courts’ analysis to the contrary and held that the debtor’s liability under the guaranty, including for postpetition extensions of credit, had been discharged in the Chapter 7 case.
Republic Bank of California v. Getzoff (In re Getzoff)[68]
Background
In November 1991, the accounting firm (“Firm”) owned by the debtor signed a promissory note and obtained a loan for $250,000 from the Republic Bank of California (“Bank”). On the same day, the debtor signed a continuing guaranty of the Firm’s obligations under the note. Under the guaranty, the debtor promised to pay any and all indebtedness owing from the Firm to the Bank, including
any and all advances, debts, obligations and liabilities of Borrowers or any one or more of them, heretofore, now, or hereafter made, incurred or created, whether voluntary or involuntary and however arising, whether direct or acquired by Bank, by assignment or succession, whether due or not due, absolute or contingent, liquidated or unliquidated, determined or undetermined . . . .[69]
In April 1992, the debtor and his wife filed for protection under Chapter 7 of the Bankruptcy Code. In May 1992, the Bank and the Firm entered into an agreement pursuant to which the indebtedness under the original note was reduced to $213,000 and the loan was extended. On the same date, the parties entered into a new note, and the debtor executed a new guaranty identical in form to the original guaranty. In December 1992, the Bank asked the debtor to execute a reaffirmation agreement, but the debtor did not comply. The Firm made payments on the new note until July 1993. In January 1994, the Firm and the Bank agreed to stipulate to a judgment allowing the Firm to extend the date for repayment until April 1998. However, after the documents were prepared, the debtor asserted that his personal guaranty had been discharged, so the Bank filed an adversary complaint seeking a declaration from the bankruptcy court that the second guaranty was a postpetition obligation that had not been discharged. Both parties filed motions for summary judgment.
The bankruptcy court granted summary judgment in favor of the debtor. The bankruptcy court concluded that the Bank had given additional consideration in exchange for the second guaranty. However, the court held that execution of the second guaranty was an improper attempt to reaffirm discharged debt without following the requirements of section 524(c) and (d) of the Bankruptcy Code.
Analysis
On appeal, the U.S. Court of Appeals for the Ninth Circuit Bankruptcy Appellate Panel (“BAP”) noted that a debtor may voluntarily repay a discharged debt and may also enter into an agreement with a creditor to reaffirm an otherwise dischargeable debt. However, in order for such agreement to be enforceable, it must be made in compliance with section 524(c) and (d) of the Bankruptcy Code, which encompasses five requirements:
the agreement must be made prior to discharge;
the agreement must advise the debtor that the reaffirmation may be rescinded up to sixty days after it is filed;
the agreement must be filed with the court;
the debtor cannot already have rescinded the agreement within the proper time frame; and
the agreement must be in the best interest of the debtor.[70]
The purpose of these requirements is to protect debtors from creditor coercion, and reaffirmation agreements are not favored by the courts. Accordingly, any reaffirmation agreement that does not comply fully with section 524 is void and unenforceable.
Here, the Bank acknowledged that it had not complied with section 524. However, the Bank argued that the second guaranty was not a promise to repay a discharged debt. Instead, it was a new promise in consideration for the Bank’s promise to extend the terms of the loan to the debtor’s Firm. According to the Bank, since section 727 only discharges prepetition debt, the second guaranty was not discharged because it arose after the debtor’s bankruptcy was filed.
The BAP disagreed, noting not only the broadness of the definition of debt under the Bankruptcy Code but also the broadness of the scope of debts covered by the first guaranty itself. In other words, prepetition, the first guaranty made the debtor contingently liable for any obligation “now or hereafter made” to the Bank; and, accordingly, such debt was discharged.[71] Further, the second note was merely a continuation of the first note; and by executing the second guaranty, the debtor effectively assumed the continuing guaranty obligation that had been discharged in his Chapter 7 case. Because he could not do so without following the requirements of section 524, the Bank could not recover that discharged debt.
Although the bankruptcy court here found that there was new consideration, the BAP found that under section 524(c), if the debtor’s consideration is based in whole or in part on a discharged debt, then a reaffirmation agreement must be filed with the court. The fact that the Bank gave new consideration was immaterial where the debtor’s new consideration was a promise to pay discharged debt.
Orlandi v. Leavitt Family Ltd. Partnership (In re Orlandi)[72]
Background
The debtor owned an entity called Studio 26 Salon, Inc. (“Studio 26”), which in September 2005 entered into a commercial lease with the defendant (“Landlord”). The debtor also executed a personal guaranty of the lease. In July 2008, the debtor and his wife filed for protection under Chapter 7 of the Bankruptcy Code, and they received a discharge in November 2008. In March 2011, after exercising a five-year extension option under the lease, Studio 26 vacated the space prior to the expiration of the lease, and the Landlord sued the debtor in state court for almost $25,000 in unpaid rent. The debtor answered in state court, asserting his bankruptcy discharge as an affirmative defense. Thereafter, the debtor filed a motion to reopen his bankruptcy case, which was granted in November 2016, resulting in a stay of the state court litigation. In January 2017, the debtor filed an adversary complaint against the Landlord, asserting that his guaranty had been discharged and that the Landlord had violated the discharge injunction.
The Landlord filed a motion for summary judgment asserting that the lease extension renewed the personal guaranty and that the lease extension contained a survivability clause that superseded the bankruptcy filing and discharge. The bankruptcy court denied the motion for summary judgment and, following trial, entered judgment in favor of the debtor.
Analysis
On appeal, the U.S. Court of Appeals for the Sixth Circuit BAP agreed with the bankruptcy court. Like other courts considering the issue, the BAP stated that whether the personal guaranty was discharged turned on whether it constituted a prepetition debt under the Bankruptcy Code. The BAP also noted that there are two lines of cases on the issue, with some courts concluding that absent some affirmative action by a debtor to revoke a guaranty, a guaranty may be enforced as to obligations incurred postpetition, and with other courts concluding that a prepetition guaranty is a contingent claim that is discharged in bankruptcy. The BAP agreed with the latter line of cases, noting that the terms debt and claim, as defined in the Bankruptcy Code, are afforded the broadest interpretations available in order to ensure the promise of a fresh start.
One distinguishing feature of this case is that, unlike many other similar cases, there was no dispute that the debtor had scheduled the guaranty in his bankruptcy case and that the Landlord had notice of the bankruptcy. The BAP opined that when the lease extension was executed, the Landlord should have requested that the debtor reaffirm the guaranty or execute a new guaranty. The BAP did not address whether a newly executed guaranty would run afoul of section 524(c).
David Osbourn and Michael Shaffer (together, “Debtors”) were part owners of St. James Electric, LLC (“St. James”). In 2011, St. James submitted a credit application to plaintiff Dulles Electric (“Dulles”) to obtain credit for future purchases. The Debtors each signed a personal guaranty pursuant to which they guaranteed the debts owed by St. James to Dulles. In November 2013, each of the Debtors filed a petition for relief under Chapter 7 of the Bankruptcy Code. They each obtained a discharge in February 2014. Neither expressly revoked their personal guaranties. Thereafter, St. James continued to operate, and Dulles continued to supply materials on credit. In March 2015, St. James filed a petition for relief under Chapter 7 of the Bankruptcy Code, scheduling a debt owed to Dulles in the amount of $20,000. No assets were available, and the case was closed in May 2015. Thereafter, Dulles reopened the Debtors’ Chapter 7 cases and filed adversary complaints against each of the Debtors, seeking declaratory judgments that their personal guaranties were not discharged.
Analysis
The bankruptcy court first noted that the Fourth Circuit follows the conduct test for determining when a debt arises—namely, that a debt arises when the conduct giving rise to the debt occurs. However, the court explained that “[a]lthough the existence of a claim is determined by the Bankruptcy Code, the timing of the creation of the liability is determined by nonbankruptcy law.”[74]
The court discussed the distinction between a “restricted guaranty” and a “continuing guaranty” under Virginia law, noting that the distinction is important in bankruptcy cases.[75] The court concluded that under a continuing guaranty, each transaction is considered a separate, unilateral contract; and, accordingly, the contingent liability arises when the loan is made, not when the guaranty is executed. “Logically, the conduct which gives rise to the contractual obligation can only occur if credit is extended and a default occurs.”[76] Therefore, the signing of a guaranty by itself does not obligate a guarantor if credit is never extended. “Under a continuing guaranty, it is unknown what future extensions may be made and thus the liability as of the signing of the guaranty is not ascertainable.”[77] Accordingly, the court held that the debts at issue did not arise until the credit was extended and therefore had not been discharged.
National Lumber Co. v. Reardon (In re Reardon)[78]
Background
In December 2009, the debtors, James and Jeanine Reardon (together, “Debtors”) filed a joint petition for relief under Chapter 7 of the Bankruptcy Code. The Chapter 7 trustee filed a report of no distribution, and the case was closed in July 2010. In September 2015, the Debtors moved to reopen their case to amend their schedules to add previously omitted creditors—namely, National Lumber Company (“National”)—and the motion was granted. Thereafter, National filed an adversary complaint alleging that in 2007 the Debtors delivered two personal guaranties with respect to extensions of credit by National to Beechwood Village Realty Trust (“Trust”). The complaint further alleged that the Debtors had never revoked the guaranties, did not schedule National as a creditor, and did not provide notice to National of the bankruptcy; and that in reliance on the personal guaranties, National had extended postpetition credit to the Trust in the amount of $775,000, of which $56,000 remained outstanding.
In March 2007, the Trust, as borrower, had entered into a construction loan agreement with National, as lender, in the principal amount of $230,000, in order to complete a model home at a development owned by the Trust. The Debtors signed a guaranty for the loan. It was undisputed that the construction loan had been paid in full. It was also undisputed that following the filing of the Debtors’ bankruptcy, National had sold goods to the Trust for which there remained a balance of $56,000. National sought (i) a declaration that the Debtors’ liability for the postpetition advances was not discharged and (ii) a money judgment against the Debtors for the amount due.
The Debtors admitted to executing the guaranty. They further admitted that they did not schedule National as a creditor, asserting that the omission was inadvertent. The Debtors alleged that National nevertheless had notice of the bankruptcy and denied that National had relied on the guaranty in extending additional credit to Beechwood. The Debtors also asserted the affirmative defense that the bankruptcy discharged any liability that they had under the continuing guaranty.
Analysis
Following a trial, the bankruptcy court determined that it did not have jurisdiction over National’s request for a money judgment but found that it did have jurisdiction to determine whether the Debtors’ obligations under the guaranty were extinguished by their discharge. The court summarized the primary issue thus: “With respect to a debtor’s liability under a prepetition guaranty for a postpetition extension of credit, the question is whether the debt arose when the guaranty was executed or when credit was later extended to the principal obligor.”[79] The court agreed with the reasoning of In re Jordan[80] that the question of when a debt arises is one of federal law, but its determination is informed by state law. The court found that under Massachusetts law, a continuing guaranty is seen as “giving rise to a divisible series of individual transactions, with liability for each extension of credit arising at the time of its extension.”[81] However, the court concluded that based on its terms, the guaranty at issue was actually a restricted guaranty that was limited to amounts due under the construction loan.
The debtor filed an adversary complaint against Isabella Bank Corp. (“Bank”) alleging that the Bank violated his discharge injunction. The Bank moved for summary judgment. The debtor owned a family medical practice (“Practice”). The Practice had a lending relationship with the Bank going back to 2002, with the debtor guarantying all indebtedness owing from the Practice to the Bank. The debtor and his wife filed for relief under Chapter 7 in February 2005. At the time, the Practice’s indebtedness to the Bank consisted of a $50,000 term loan and a $100,000 line of credit. In June 2005, the Bank renewed the line of credit when it came due and required the debtor to execute a new guaranty, only days after he had received his discharge. The term loan would not come due until 2009.
Fifteen months after the renewal, the line of credit had expired, and the Practice was unable to pay it down. As a result, the Bank consolidated the line of credit and the term loan into a new term note with a maturity date of September 2011. At the same time, the Bank required the debtor to execute a new guaranty. A few weeks later, the Practice ceased operations; and, thereafter, the debtor made seventeen regular payments before advising the Bank that he would no longer make any more payments. The Bank then began demanding payment, which the debtor contended violated his discharge injunction.
Analysis
The court began by pointing out that although section 727(b) of the Bankruptcy Code generally discharges all prepetition debt, a debtor may nonetheless enter into an agreement to pay such debt provided such agreement satisfies the requirements of section 524(c) of the Bankruptcy Code. The debtor asserted that his discharge relieved him of any liability under his prepetition guaranties and that the two postpetition guaranties that he executed were unenforceable because they were reaffirmation agreements that failed to comply with the requirements of section 524(c). The Bank contended that the postpetition guaranties were not reaffirmation agreements because they did not and could not have complied with section 524(c); furthermore, the Bank contended that the postpetition guaranties were enforceable because the Bank had provided new consideration in the form of extending the terms of the loans.
The court noted that section 524(c) is “not artfully drafted” and, “[i]ndeed, it would appear that a comma and an ‘and’ are missing.”[83] However, the court determined that section 524(c) nonetheless clearly prohibits connecting postpetition agreements with previously discharged debt other than as permitted therein. In other words, although a lender is free to enter into a lending relationship with a newly discharged debtor, section 524(c) strictly prohibits creditors from using a new loan to leverage payment of a previously discharged debt. The court observed that the parties had focused on whether the postpetition guaranties were subject to the requirements of section 524(c), but the court explained that it first needed to determine the implications of the prepetition guaranties because whether the postpetition guaranties were unenforceable reaffirmation agreements would be totally irrelevant if the discharge did not extinguish the debtor’s liability under the prepetition guaranties for the Bank’s alleged extension of postpetition credit.
The court rejected the reasoning of the Ninth Circuit BAP in Getzoff that the broad definition of claim in the Bankruptcy Code means that a debtor’s discharge extends to postpetition advances of credit under a prepetition guaranty. The court described such reasoning as “problematic” because it would permit the debtor to guaranty a hypothetical new equipment loan had he never previously guaranteed any obligations but render unenforceable any guaranty for such new equipment had the Bank had the “unfortunate foresight” to include future indebtedness under the prepetition guaranties.[84] According to the court, since a reaffirmation agreement must be entered into prior to discharge, the Bank would have had to have realized during the relatively short time frame of the debtor’s bankruptcy that it would need a reaffirmation agreement if it ever intended to extend additional credit postpetition. From the court’s perspective, the more practical resolution would be to require a debtor to affirmatively revoke a continuing guaranty in order to escape liability for future advances. Thus, the debtor had a choice to make—postpetition, he simply could revoke the guaranty and risk the possibility that the Bank would not extend new credit to the Practice.
However, the court also concluded that the Bank never made a new loan with respect to the prepetition term loan but simply modified the loan when it consolidated the unmatured term loan with the extended line of credit. Since the debtor’s obligation on the term loan arose prepetition and had not been reaffirmed pursuant to section 524(c), the court denied summary judgment and allowed the debtor to proceed with his claims with respect to the term loan.
11 U.S.C. § 101(12)
The term “debt” means liability on a claim.
11 U.S.C. § 101(5)
The term “claim” means—
right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or
right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.
11 U.S.C. § 523(a)(3)
A discharge under section 727, 1141, 1192, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—
. . .
(3) neither listed nor scheduled under section 521(a)(1) of this title, with the name, if known to the debtor, of the creditor to whom such debt is owed, in time to permit—
if such debt is not of a kind specified in paragraph (2), (4), or (6) of this subsection, timely filing a proof of claim, unless such creditor had notice or actual knowledge of the case in time for such timely filing; or
if such debt is of a kind specified in paragraph (2), (4), or (6) of this subsection, timely filing of a proof of claim and timely request for a determination of dischargeability of such debt under one of such paragraphs, unless such creditor had notice or actual knowledge of the case in time for such timely filing and request[.]
11 U.S.C. § 727(b)
Except as provided in section 523 of this title, a discharge under subsection (a) of this section discharges the debtor from all debts that arose before the date of the order for relief under this chapter, and any liability on a claim that is determined under section 502 of this title as if such claim had arisen before the commencement of the case, whether or not a proof of claim based on any such debt or liability is filed under section 501 of this title, and whether or not a claim based on any such debt or liability is allowed under section 502 of this title.
11 U.S.C. § 524(c) and (d)
(c) An agreement between a holder of a claim and the debtor, the consideration for which, in whole or in part, is based on a debt that is dischargeable in a case under this title is enforceable only to any extent enforceable under applicable nonbankruptcy law, whether or not discharge of such debt is waived, only if—
such agreement was made before the granting of the discharge under section 727, 1141, 1192, 1228, or 1328 of this title;
the debtor received the disclosures described in subsection (k) at or before the time at which the debtor signed the agreement;
such agreement has been filed with the court and, if applicable, accompanied by a declaration or an affidavit of the attorney that represented the debtor during the course of negotiating an agreement under this subsection, which states that—
such agreement represents a fully informed and voluntary agreement by the debtor;
such agreement does not impose an undue hardship on the debtor or a dependent of the debtor; and
the attorney fully advised the debtor of the legal effect and consequences of—
an agreement of the kind specified in this subsection; and
any default under such an agreement;
the debtor has not rescinded such agreement at any time prior to discharge or within sixty days after such agreement is filed with the court, whichever occurs later, by giving notice of rescission to the holder of such claim;
the provisions of subsection (d) of this section have been complied with; and
in a case concerning an individual who was not represented by an attorney during the course of negotiating an agreement under this subsection, the court approves such agreement as—
not imposing an undue hardship on the debtor or a dependent of the debtor; and
in the best interest of the debtor.
Subparagraph (A) shall not apply to the extent that such debt is a consumer debt secured by real property.
(d) In a case concerning an individual, when the court has determined whether to grant or not to grant a discharge under section 727, 1141, 1192, 1228, or 1328 of this title, the court may hold a hearing at which the debtor shall appear in person. At any such hearing, the court shall inform the debtor that a discharge has been granted or the reason why a discharge has not been granted. If a discharge has been granted and if the debtor desires to make an agreement of the kind specified in subsection (c) of this section and was not represented by an attorney during the course of negotiating such agreement, then the court shall hold a hearing at which the debtor shall appear in person and at such hearing the court shall—
inform the debtor—
that such an agreement is not required under this title, under nonbankruptcy law, or under any agreement not made in accordance with the provisions of subsection (c) of this section; and
of the legal effect and consequences of—
an agreement of the kind specified in subsection (c) of this section; and
a default under such an agreement; and
determine whether the agreement that the debtor desires to make complies with the requirements of subsection (c)(6) of this section, if the consideration for such agreement is based in whole or in part on a consumer debt that is not secured by real property of the debtor.
No. 19-34054-sgj11, Adv. No. 21-03003-sgi, 2021 WL 5769320 (Bankr. N.D. Tex. Dec. 3, 2021) (memorandum opinion and order denying arbitration request and related relief). ↑
