The statute colloquially known as the Bank Secrecy Act^[1] provides for assessment of civil money penalties (“CMPs”) in a variety of contexts. One of these is foreign financial accounts. Any United States person^[2] with a financial interest in or signature authority over a foreign financial account (including a bank account, brokerage account, mutual fund, trust, or other type of foreign financial account) containing more than $10,000 is required under the BSA^[3] to report the account annually to the Treasury Department by electronically filing a Report of Foreign Bank and Financial Accounts (FBAR) on Financial Crimes Enforcement Network (FinCEN) Report 114.^[4]

A recent decision of the U.S. Supreme Court, Bittner v. United States, has eliminated some uncertainties in this area.^[5]

Background

FBAR is a calendar year report and must be filed on or before June 30 of the year following the calendar year being reported. The person filing must maintain records of the account(s) in question for five years and be prepared to make them available for inspection.^[6]

The requisite contents for the filing are:

1. the account number (or other designation) of the foreign account and the name in which it is maintained;
2. the name and address of the foreign bank or other person where the account is maintained; and
3. the type of account and its maximum value during the annual reporting period.^[7]

The FBAR filing requirement applies to all United States persons with direct and certain indirect interests in, or signature authority over, a foreign financial account where the aggregate value of such accounts in any year exceeds $10,000.

Certain filing exceptions are available, including for the following United States persons or foreign financial accounts:

• Certain foreign financial accounts jointly owned by spouses
• United States persons included in a consolidated FBAR
• Correspondent/Nostro^[8] accounts
• Foreign financial accounts owned by a governmental entity
• Foreign financial accounts owned by an international financial institution
• Owners and beneficiaries of U.S. Individual Retirement Accounts (“IRAs”)
• Participants in and beneficiaries of tax-qualified retirement plans
• Certain individuals with signature authority over, but no financial interest in, a foreign financial account^[9]
• Trust beneficiaries (but only if a U.S. person reports the account on an FBAR filed on behalf of the trust)
• Foreign financial accounts maintained on a United States military banking facility

A complete detailing of available exceptions is available in the FBAR instructions.^[10]

The Treasury may assess a CMP^[11] of up to $10,000^[12] for any nonwillful^[13] violation of any provision of the FBAR statute.^[14] A question on which the practice of the Internal Revenue Service (IRS) has been inconsistent—and on which the lower federal courts have split^[15]—is whether separate penalties or only one penalty should apply to a taxpayer who has multiple overseas accounts that should be described in the annual FBAR filing. In other words, is the $10,000 maximum CMP per FBAR report or per foreign bank account?

The question was recently resolved by the U.S. Supreme Court.^[16] The case involved an immigrant from Rumania who became a naturalized U.S. citizen^[17] and returned to Rumania after the fall of the communist regime to take advantage of business opportunities. He maintained 272 foreign bank accounts in Rumania. He conducted his business for several years unaware that he was subject to the FBAR reporting requirements for all of those accounts, even though he was not at the time residing in the United States. Once he became aware of this requirement, he hired an accountant to prepare and file FBARs for tax years 2007 through 2011. The IRS imposed a $2.72 million penalty on the theory that each and every undisclosed foreign account constituted a separate violation.

The Supreme Court held that a person who nonwillfully fails to file FBARs is subject to a maximum CMP of $10,000 for each FBAR report—i.e., per report, not per account. For a decision on such a relatively minor—and certainly technical—question of statutory interpretation,^[18] the Court was surprisingly split 5–4. The case has garnered little attention thus far. The few press accounts that have appeared have largely focused two extraneous details. One was the minor disruption of the oral argument (back in November 2022) by three abortion rights demonstrators in the Courtroom (who may have been disappointed that the Justices seemed unperturbed by the disruption). The other was the “strange bedfellows” aspect of the votes on the case, which found Justice Alito misaligned with Justice Thomas and Justice Jackson disagreeing with Justices Kagan and Sotomayor.

Writing for the majority, Justice Gorsuch relied on the plain language of the BSA. Section 5314 focuses on the legal duty to file reports, which must include various kinds of information about an individual’s foreign “transaction[s] or relationship[s].” Justice Gorsuch’s opinion trenchantly observed, “Section 5314 does not speak of accounts or their number. The word ‘account’ does not even appear. Instead, the relevant legal duty is the duty to file reports.”^[19] Violation of § 5314’s reporting obligation is binary, the majority concluded: One files a report “in the way and to the extent the Secretary prescribes,” or one does not; multiple willful errors may establish a violation of §5314 but even a single mistake, willful or not, constitutes a § 5314 violation.

The Treasury’s position was that because Congress explicitly authorized per-account penalties for certain willful violations,^[20] the Court should infer that Congress meant to do the same for analogous nonwillful violations. That position was rejected, however, as incompatible with the well-known canon of statutory construction expressio unius est exclusio alterius. In the willful violations provision, § 5321(a)(5)(D), and in the “due to reasonable cause” exception in § 5321(a)(5)(B)(ii), Congress explicitly contemplated penalties on a per-account basis, thereby demonstrating that Congress knew how to do that but deliberately chose different language in § 5321(a)(5)(B)(i).^[21]

The legislative history supported this conclusion. As originally enacted (in 1970), the BSA included penalties only for willful violations. In 1986, Congress authorized the imposition of penalties on a per-account basis for certain willful violations. When the BSA was amended again in 2004 to authorize penalties for nonwillful violations, Congress could have—but did not—simply use language from its 1986 amendment to extend per-account penalties for nonwillful violations.^[22]

Finally, the majority found the per-account interpretation as applied to nonwillful violations to be incompatible with the purpose of the FBAR provisions, i.e., to require certain reports and records to assist the government in various criminal and tax intelligence initiatives. That information-seeking purpose was fully effected with a per-report interpretation. To rule otherwise and allow aggregation of nonwillful violations on a per-account basis could lead to an absurd result: A willful violator would incur a lesser penalty than a nonwillful violator.

The dissent, authored by Justice Barrett,^[23] highlighted the language in § 5314 requiring FBAR reporting when an individual has a relationship with a foreign financial agency or an account with a foreign bank. That statutory focus on the relationship, the dissent argued, compelled the conclusion that it was each relationship that triggers a separate penalty for nonwillful violation.

That interpretation, although the dissenting Justices seem not to have noticed, would still leave an ambiguity: Is the “relationship” for this purpose with the institution maintaining the account, or the account itself? In other words, one could persuasively argue that 272 accounts at one bank would constitute but a single “relationship.”

Justice Gorsuch’s majority opinion concluded with a brief segment^[24] (joined only by Justice Jackson) relying on the rule of lenity, under which, as earlier cases repeatedly explain, “statutes imposing penalties are to be ‘construed strictly’ against the government and in favor of individuals.” A major purpose of the rule of lenity, Justice Gorsuch wrote, is to ensure that taxpayers have “a fair warning … in language that the common world will understand, of what the law intends to do,” an ideal that he contrasted with the absence of any “discuss[ion of] per-account penalties for nonwillful violations” in the statute, together with the government’s “own public guidance documents [that] have seemingly warned of per-report, not per-account, penalties.” Justice Gorsuch emphasized the criminal consequences of the government’s interpretation, which would change the criminal exposure in this case from a $250,000 fine and five years in prison to a $68 million fine and 1,360 years in prison—all for nonwillful violations of the BSA.

1. The actual name is the Currency and Foreign Transactions Reporting Act of 1970, Pub. L. No. 91-508, 84 Stat. 1114 (1970) (codified as amended in scattered sections of 12, 18, and 31 U.S.C.) [hereinafter referred to as the “BSA”]. ↑

2. As used in any BSA regulation, the term “person” includes both natural and juridical persons, including “Indian tribe[s] (as that term is defined in the Indian Gaming Regulatory Act), and all entities cognizable as legal personalities.” 31 C.F.R. § 1010.100(mm). Thus a U.S. person encompasses U.S. citizens; U.S. residents; entities, including but not limited to, corporations, partnerships, or limited liability companies, created or organized in the United States or under the laws of the United States; and trusts or estates formed under the laws of the United States. ↑

3. 31 U.S.C. § 5314(a). ↑

4. This electronic report supersedes former Form TD F 90-22.1 and may only be completed online using FinCEN’s BSA e-Filing System. ↑

5. Bittner v. United States, No. 21-1195 (U.S. February 28, 2023). ↑

6. 31 C.F.R. § 1010.420. ↑

7. Id. ↑

8. A “Nostro” account is an account held by a bank in a foreign currency at another bank. Derived from the Latin word for “ours,” Nostro accounts are frequently used to facilitate foreign exchange and international trade transactions. ↑

9. These include the following: (1) An officer or employee of a financial institution that is examined by any of the three federal bank regulatory agencies or the National Credit Union Administration is not required to report signature authority over a foreign financial account owned or maintained by the financial institution. (2) An officer or employee of a financial institution that is registered with and examined by the SEC or the CFTC is not required to report signature authority over a foreign financial account owned or maintained by the financial institution. (3) An officer or employee of an “Authorized Service Provider” is not required to report signature authority over a foreign financial account that is owned or maintained by an investment company registered with the SEC. (“Authorized Service Provider” means an entity that is registered with and examined by the SEC and provides services to an investment company registered under the Investment Company Act of 1940, as amended, 15 U.S.C. § 80a-1 et seq.). (4) An officer or employee of an entity that has a class of equity securities listed (or American depository receipts listed) on any United States national securities exchange is not required to report signature authority over a foreign financial account of such entity. (5) An officer or employee of a United States subsidiary is not required to report signature authority over a foreign financial account of the subsidiary if its United States parent has a class of equity securities listed on any United States national securities exchange and the subsidiary is included in a consolidated FBAR report of the United States parent. (6) An officer or employee of an entity that has a class of equity securities registered (or American depository receipts in respect of equity securities registered) under section 12(g) of the Securities Exchange Act of 1934, as amended, 15 U.S.C. § 78a et seq., is not required to report signature authority over a foreign financial account of such entity. ↑

10. See, e.g., FinCEN, BSA Electronic Filing System, Individuals Filing the Report of Foreign Bank & Financial Accounts (FBARs). ↑

11. 31 U.S.C. § 5321(a)(5)(A) ↑

12. 31 U.S.C. § 5321(a)(5)(B)(i). No penalty may be assessed, however, if the violation was “due to reasonable cause” and the amount of the transaction or the balance in the account at the time of the transaction was properly reported. Id. § 5321(a)(5)(B)(ii)(I)–(II). ↑

13. A willful violation or willfully causing a violation of any provision of 31 U.S.C. § 5314 does not enjoy the “due to reasonable cause” exception of § 5321(a)(5)(B)(ii) and is subject to an enhanced penalty of up to $100,000 or 50% of a statutorily defined penalty assessment, whichever is greater. Id. § 5321(a)(5)(C). That statutorily defined penalty is, in the case of a violation involving a transaction, the amount of the transaction, id. § 5321(a)(5)(D)(i), and, in the case of a violation involving the failure to report the existence of an account or any identifying information required to be provided in respect of the account, the balance in the account at the time of the violation (i.e., potential forfeiture of the account balance), id. § 5321(a)(5)(D)(ii). ↑

14. 31 U.S.C. § 5314. ↑

15. Compare Bittner v. United States, 19 F.4th 734 (5th Cir. 2021), with United States v. Boyd, 991 F.3d 1077 (9th Cir. 2021). ↑

16. Bittner v. United States, No. 21-1195 (U.S. February 28, 2023). ↑

17. The taxpayer actually had dual citizenship: U.S. and Rumania. ↑

18. There was a minor constitutional component in terms of the application to these CMPs of the “rule of lenity.” That rule has due process origins and demands that people must have fair notice of what is proscribed by law before they can be punished for violating it. Only two Justices signed on to that portion of the 5–4 majority opinion, however. ↑

19. Bittner, slip op. at 5. ↑

20. See 31 U.S.C. § 5321(a)(5)(D). ↑

21. Bittner., slip op. at 6–8. The Court also noted the inconsistent positions the Treasury Department has taken in its guidance purporting to interpret the provision as a per-report penalty. In a 2010 proposed rulemaking, for instance, the Treasury Department indicated that a person who nonwillfully fails to properly file an FBAR faces a civil penalty “not to exceed $10,000.” Id., slip op. at 9–10. ↑

22. Id., slip op. at 10–12. ↑

23. Id. (Barrett, J., with Thomas, Sotomayor, and Kagan, JJ., dissenting). ↑

24. Bittner, slip op. at 14–16. ↑

I recently wrote for the ABA’s Business Law Today about structured legal fees for lawyers in “Plaintiff Lawyer Tax Benefits Other Lawyers Don’t Get.” For nearly 30 years, plaintiff lawyers have been structuring their contingent legal fees based on the seminal tax case of Childs v. Commissioner.^[1] Only contingent fees can be structured, and their basic idea is to convert an anticipated lump sum contingent fee into a stream of payments. Payments over time can flatten the peaks and valleys of a lawyer’s income and reduce the need to borrow to finance cases.

An annuity company or third party doles out the payments, so a legal fee structure is a little like a tax-deferred installment plan. It doesn’t rely on the credit-worthiness of the defendant or the client, and it can grow pre- rather than post-tax. The contingent fee lawyer must document the deferral of the legal fee before settlement (although immediately before the settlement is okay), can structure some or all, and can call for payment over any number of years, or life. Some companies even allow borrowing.

Whether the structure involves annuities or securities, the format and documents are important, but done properly, it has not been controversial with the IRS. The tax case uniformly cited as establishing the bona fides of attorney fee structures is Childs, and over the last several decades the IRS has often cited it favorably. But in December 2022, the IRS released Generic Legal Advice Memorandum AM 2022-007^[2] (a “GLAM”).

The GLAM does not address the precise fact pattern in Childs or call for it to be overturned. Indeed, the hypothetical facts the IRS addresses in the GLAM are somewhat narrow. However, it is safest to read the IRS missive as a general attack on structured legal fees and as a roadmap for what the IRS may argue in audits. Even so, the GLAM is not binding on any taxpayer and is not published authority, unlike an IRS Revenue Ruling, a Treasury Regulation, or a tax case like Childs.

The GLAM is lengthy (25 pages single-spaced), and makes four arguments why the hypothetical structured fee the GLAM describes should not work in the IRS’s opinion. The IRS says it would violate the assignment of income doctrine, the economic benefit doctrine, and section 83 of the tax code (an IRS argument the Tax Court and 11^th Circuit rejected in Childs), and that it is a deferred compensation plan violating section 409A of the tax code. Section 409A says some compensation deferred under regular tax rules should nevertheless be currently taxed if it fails to comply with certain rules.

This last argument regarding section 409A is the biggest surprise, for the Treasury Regulations under Section 409A say that the entire provision does not apply to independent contractors who have two or more customers or clients, among other requirements that are usually satisfied for structured fees. Since the time the relevant Treasury Regulation was released in 2007, it has been widely understood to exempt structured legal fees, since most lawyers have two or more clients. In any case, it is not yet clear if the IRS will have any success with its new positions on certain structured legal fees.

Much of the IRS’s discussion seems to rely on distinguishing its hypothetical from the facts in Childs’ structured fee. This suggests that the IRS may face bigger challenges if it tries to attack structured fees more universally. In any event, the GLAM indicates that the IRS is less comfortable with structured legal fees (or at least with some of them) than was previously thought.

So should lawyers continue structuring fees given this IRS shot across the bow? Most tax advisers would probably say yes, and that is my personal answer. But the GLAM does suggest that paying attention to the specific details and documents is important. Of course, most people are never audited, and that is true for lawyers and structured fees too.

But the release of the GLAM by the IRS suggests that if you happen to be audited, there may be more pushback than was previously thought, particularly if your fee structure looks like low-hanging fruit to the IRS. On that point, it is worth asking how the IRS will identify fee structures, since they are often not reported on a tax return until the installment payments are reported and taxed. But if a lawyer’s legal fee deferral is audited, the IRS may make these arguments. That does not mean the IRS will win, and the specific facts and documents in question are going to matter.

IRS audits can be resolved at the audit stage, where the best result is the IRS saying there is no change. The GLAM may make that happy result more difficult now, depending on the facts and documents. Many IRS audits are resolved a step beyond audit at IRS Appeals. IRS Appeals is still part of the IRS system, but it is independent and tries, usually successfully, to resolve disputes between auditors and taxpayers, often by settlement.

It is even possible that we will end up with another tax case reprising the issues discussed in Childs, though if that occurs, it will take years. And like any tax case, it will be based on the facts and documents in that particular case. In the meantime, in my view, there is no reason that plaintiff lawyers or the structured settlement industry need to stop structuring legal fees, as long as they dot their i’s and cross their t’s.

In fact, some structured settlement brokers report that they are seeing a decided uptick in legal fee structures. Ironically, perhaps the GLAM has made some lawyers aware of structured fees for the first time, which is likely not the result the IRS intended. Some lawyers say the GLAM suggests that someday the IRS will take away structured fees, so they want to take advantage of them before it is too late. In any event, if you are a plaintiff lawyer, it is a good time to get some tax advice about these developments.

Robert W. Wood is a tax lawyer and managing partner at Wood LLP. He can be reached at [email protected]. This discussion is not intended as legal advice.

1. 103 T.C. 634 (1994), aff’d without opinion, 89 F3rd 856 (11^th Cir. 1996). ↑

2. Available at: https://www.irs.gov/pub/lanoa/am-2022-007-508v.pdf. ↑

The recent collapse of two large regional banks, and the expedited sale of Credit Suisse due to similar challenges, have left many in the financial services industry uncertain about the future. What should we understand about what happened, and what it might mean for the future of finance?

What Happened?

As everyone has now read about repeatedly, Silicon Valley Bank (SVB) collapsed due to a “run on the bank” involving customers withdrawing (or attempting to withdraw) their funds simultaneously. The run was prompted by fears that SVB could not honor withdrawals due to the decline in market value of long-term treasuries and other long-term assets. The decline in the value of these assets occurred due to the rise in interest rates over the past year, which has caused fixed income investments with lower interest rates to have a lower market value. Signature Bank was shut down by the New York Department of Financial Services and the Federal Deposit Insurance Corporation (FDIC) due to related concerns. At the time of the SVB collapse, the FDIC followed its protocols regarding the shutdown of a depository institution that is not subject to a systemic risk exception. This included shutting down SVB on Friday, March 10, 2023, establishing a new national bank, and guaranteeing access on Monday, March 13, for any deposits up to the FDIC insurance limit. That limit is presently $250,000 per depositor. As to any amounts in excess of $250,000, the FDIC noted an advance dividend would be paid later that week based upon assets sold, and the remaining amounts would be handled through the FDIC’s receivership process.

To put it mildly, SVB depositors and commentators exploded on social media regarding the potential loss or delayed access to significant amounts of business capital, with some noting various companies would be unable to make payroll without access to the funds in their operating accounts. As we now know, the Treasury, Federal Reserve, and FDIC invoked the systemic risk exception for both SVB and Signature Bank on Sunday, March 12, which enabled the agencies to guarantee all deposits of the banks. This exception is designed to enable federal agencies to prevent the adverse economic consequences of broader financial instability.

The Federal Reserve also established a new Bank Term Funding Program designed to provide liquidity to banks. The program allows banks to borrow money secured by U.S. treasuries, agency debt, mortgage-backed securities, and other qualifying assets as collateral. The program also allows banks to borrow funds based upon the par value of the assets, not the lower market value.

The Crystal Ball: What (Regulations) Will Come?

The U.S. banking system functions on consumer confidence that the money will be there when depositors need it. The past month introduced what some have called a new variation on a longstanding risk: a social media-fueled bank run. FDIC insurance was designed to be the primary hedge against bank runs, but it proved inadequate in SVB’s case. This was in significant part due to the low level of FDIC insurance when compared to the capital required to operate a business and the concentration of deposits in a single institution by deposit holders. These facts lead to a couple of potential legislative changes.

First, lawmakers are already proposing bills to increase the FDIC insurance limits. Second, lawmakers and regulators will have to grapple with how to deal with what some have called a social media bank run. (It is worth noting, however, that some commentators minimize social media’s role in adding fuel to the fire.) The federal agencies’ response implies that they will backstop deposits well beyond the largest banks, but it is unclear where (and whether) the agencies could stop if smaller banks face financial difficulties as well. Although the present response is designed to prevent the agencies from needing to answer this question now by backstopping other regional depository institutions, policymakers will have to address what to do in the future if additional bank runs occur.

Regulatory agencies will likely also increase their focus on managing interest rate risk on depository institution balance sheets. Regulatory agencies have faced significant criticism for failing to detect what some refer to as an obvious balance sheet concern caused by the combination of demand deposits that can be withdrawn immediately and long-term government securities pledged to be held to maturity. In response, the agencies will likely increase the urgency of examinations and stress testing focused on the impact of rising interest rates on depository institution balance sheets.

Some lawmakers have already proposed restoring Dodd-Frank’s stress testing of banks above the $50 billion threshold after these standards were reduced several years ago. We will have to see how far the changes will go. Regulators can force depository institutions to amass a fortress-like balance sheet of short-term treasuries, but those assets pay lower interest rates. Likewise, those requirements only go so far before banking products start to become more expensive for customers and lawmakers call for lower-cost banking products.

The Department of Justice (DOJ) Antitrust Division recently suffered another setback in its most recent effort to secure criminal convictions for labor-side violations of Section 1 of the Sherman Act. Having finally secured a successful criminal conviction, which came by way of a plea deal and with a deferred prosecution agreement, the DOJ proceeded to trial in Maine against four home health executives who the government alleged had conspired to enter into a no-poach agreement and fix wages paid to home health aides. After a two-week trial, the jury acquitted all four of the defendants, marking the third time the DOJ has failed to convince a jury to convict defendants for alleged Section 1 violations in the labor market.

U.S.A v. Faysal Kalayaf Manahe, Yaser Aali, Ammar Alkinani, and Quasim Saesah

On January 27, 2022, a federal grand jury in the U.S. District Court for the District of Maine issued a nine-page indictment, charging Faysal Kalayaf Manahe, Yaser Aali, Ammar Alkinani, and Quasim Saesah (defendants) with one count each of engaging in a conspiracy to violate Section 1 of the Sherman Act.^[1] Per the indictment, the defendants entered into an agreement to fix the wages paid to personal support specialists (PSS) employed by their respective home health agencies by agreeing not to hire each other’s workers and to fix their wages at $15 or $16 an hour.^[2] The alleged two-month conspiracy was supposedly carried out through various virtual and in-person meetings, and both encrypted and nonencrypted messaging apps.^[3] The DOJ alleged the defendants’ agreement constituted a per se violation of Section 1.^[4]

Motion to Dismiss

In May 2022, defendant Faysal Kalayaf Manahe filed a motion to dismiss the indictment,^[5] which was joined by the other defendants.^[6] The defendants asserted multiple arguments for why the indictment should be dismissed, including that the indictment failed to state a per se violation of Section 1, and that the alleged agreement reached by the defendants was an ancillary restraint subject to the rule of reason that was not pleaded in the indictment.^[7]

The DOJ opposed the motion to dismiss, arguing the alleged no-poach agreement was a classic example of a horizontal restraint of trade, long held to violate Section 1.^[8] It further argued that there was no reason to create an exception to the per se rule for no-poach agreements, and that the defendants’ ancillary-restraint argument lacked merit.^[9]

Ultimately, the district court denied the defendants’ motion. The court reasoned that the indictment adequately alleged a per se illegal horizontal conspiracy.^[10] The court noted that the defendants were correct “that they have a valid defense to the per se rule if they can show that any restraint resulting from the alleged agreement was ancillary to efficiency-enhancing economic activity.” However, the court ruled that the defendants had the burden of making a factual showing to support that argument at trial, and therefore denied the motion to dismiss.^[11]

Jury Acquits

Following a two-week trial, on March 22, 2023, the jury acquitted all four of the defendants.^[12] Despite the introduction of evidence in the form of messages and recorded meetings that revealed the defendants discussed an agreement to pay all PSS workers $15 or $16 an hour, it appears the prosecution failed to convince the jury that an agreement was ever actually reached or acted upon by any of the defendants. Part of the prosecution’s difficulty likely stemmed from the fact that in practice, the defendants never reduced the PSS workers’ wages—they actually paid them $18 or $19 an hour. Further, while the alleged agreement was reduced to writing, the writing was never signed by any of the defendants. Notably, the defendants—all of whom were immigrants from Iraq—argued that in their culture, the only way to confirm an agreement is to sign a formal written contract.

This third acquittal may also indicate a more fundamental challenge the DOJ is facing: convincing juries that people should face jail time for agreeing not to solicit and hire competitors’ employees. The DOJ’s record appears to support this theory. To date, the DOJ is zero for three in securing a criminal conviction from a jury for a violation of Section 1 related to a no-poach agreement. The DOJ’s sole conviction in this arena was against VDA OC LLC and came via a plea deal.^[13] Notably, even that conviction was not a complete success, as its prosecution against VDA’s former manager Ryan Hee resulted in a deferred prosecution agreement and not a criminal conviction.^[14]

Conclusion

Businesses should not expect this most recent loss to slow down the DOJ’s enforcement actions. Despite the DOJ’s difficulty in securing jury convictions, the guilty plea by VDA and the Biden administration’s stated policy of trying to protect employees from what it perceives to be unreasonable restraints suggest that the DOJ will continue to indict businesses and individuals for alleged Section 1 violations involving no-poach agreements or wage fixing. Accordingly, clients should be careful when seeking to limit the movement of their employees in agreement with competitors or discussing their employees’ pay with competitors.

Related Cases Worth Watching

Opening arguments have begun in U.S. v. Mahesh Patel, Robert Harvey, Harpreet Wasan, Steven Houghtaling, Tom Edwards, and Gary Prus.^[15] There, the defendants are each charged with one count of conspiracy in restraint of trade in violation of Section 1. The government alleges that each of the defendants, who managed or otherwise controlled the hiring decisions at various unnamed companies, entered into a no-poach agreement regarding their employed aerospace engineers.^[16] Notably, the court recently denied the DOJ’s motion in limine, seeking to prevent the defendants from arguing the procompetitive benefits of the alleged agreement.^[17] While the court agreed that such evidence could not be used to argue that the agreement had procompetitive benefits because the DOJ alleged a per se violation, the court ultimately ruled that the evidence could be used to rebut the allegations that the defendants “joined the charged conspiracy, whether the conspiracy existed as alleged, and whether defendants had the requisite intent to join the conspiracy.”^[18] Time will tell if this ruling will further hinder the DOJ’s attempt to convince a jury to deliver the DOJ its first Section 1 conviction following a trial.

1. United States v. Manahe, No. 2:22-cr-00013-JAW (D. Me. Jan. 27, 2022), ECF No. 1. ↑

2. Id. at ¶¶ 1–18. ↑

3. Id. at 17. ↑

4. Id. at 15. ↑

5. No. 2:22-cr-00013-JAW (D. Me. May 31, 2022), ECF No. 79. ↑

6. No. 2:22-cr-00013-JAW (D. Me. May 31, 2022), ECF No. 77; No. 2:22-cr-00013-JAW (D. Me. June 1, 2022), ECF No. 81; No. 2:22-cr-00013-JAW (D. Me. June 6, 2022), ECF No. 82. ↑

7. No. 2:22-cr-00013-JAW, at 1–2 (D. Me. May 31, 2022), ECF No. 79. The defendants also argued that the application of the per se rule against criminal defendants was unconstitutional because it instructed juries that certain facts presumptively established an element of a crime and because it rendered the Sherman Act unconstitutionally vague. ↑

8. No. 2:22-cr-00013-JAW, at 4–7 (D. Me. June 21, 2022), ECF No. 89. ↑

9. Id. at 7–16. ↑

10. No. 2:22-cr-00013-JAW, at 13 (D. Me. Aug. 8, 2022), ECF No. 112. ↑

11. Id. at 13–14; The court also rejected the defendants’ constitutionality challenges. Id. at 22. ↑

12. No. 2:22-cr-00013-JAW (D. Me. Mar. 22, 2023), ECF No. 247. ↑

13. Id. ↑

14. Id. ↑

15. No. 3:21-cr-00220-VAB (D. Conn. 2021). ↑

16. No. 3:21-cr-00220-VAB, at 2–5 (D. Conn. Dec. 2, 2022), ECF No. 257. ↑

17. No. 3:21-cr-00220-VAB, at 13–18 (D. Conn. Mar. 27, 2023), ECF No. 457. ↑

18. Id. ↑

The Federal Trade Commission (“FTC”) continues to pursue its campaign against non-compete clauses. On January 5, 2023, the FTC voted 3–1 to publish a notice of proposed rulemaking, which, if implemented, would bar employers from entering into non-compete agreements with their workers and require employers to rescind existing non-compete restrictions with current and former workers. Originally, the deadline for submitting comments was March 20, 2023. Recently, the FTC voted 4–0 to extend the public comment period for an additional thirty days following numerous requests from the public. As such, the FTC will now accept comments on the proposed rule until April 19, 2023.

Although all four current commissioners voted to approve the extension, Commissioner Christine S. Wilson—the sole Republican—filed a concurring statement regarding the extension. Commissioner Wilson explained that because of the number of requests the FTC had received to extend the comment period by thirty days and the fact that the proposed rule “is a departure from hundreds of years of precedent and would prohibit conduct that 47 states allow,” she would have supported a longer, sixty-day extension. Commissioner Wilson additionally encouraged the public to submit comments on the proposed rule.

To date, the FTC has received more than 16,000 comments related to the proposed rule, a number that is sure to climb over the coming days.

Scope of the Proposed Rule

The proposed rule supersedes state laws that are less protective of employees, but keeps in effect state law that provides employees greater protection. The proposed rule excludes franchisees from the definition of “worker” and has a single, limited exception that applies to the sale of a business.

First, the FTC’s proposed rule would effectively ban worker non-compete provisions by deeming them an “unfair method of competition” under Section 5 of the FTC Act. The proposed rule would make it unlawful for employers to enter into or keep in place any non-compete provisions with current or former workers. Non-compete provisions are defined as contract terms that “prevent[] . . . worker[s] from seeking or accepting employment” or “operating a business” after their employment with the employer ends.

The proposed rule does not apply to customer or employee non-solicitation provisions or generally to confidentiality or non-disclosure agreements. The proposed rule applies a functional test for determining whether a clause is covered by the rule. A provision is considered a “de facto” non-compete provision if it “has the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer.” The proposed rule includes as an example of a de facto non-compete term a “non-disclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment with the employer.”

The proposed rule defines the term “worker” very broadly to include any “natural person who works, whether paid or unpaid, for an employer,” including “independent contractor[s], extern[s], intern[s], volunteer[s], apprentice[s], or sole proprietor[s] who provide a service to a client or customer.”

Notice Obligations Imposed by the Proposed Rule

If the rule becomes effective, employers who have existing non-compete provisions that violate the rule would be required to affirmatively rescind existing non-compete clauses with current workers and give individualized notice to workers that they are no longer subject to the non-compete clause. Employers would also be required to rescind non-compete clauses in effect with former workers, and give former workers notice of such rescission as long as the employer has the former worker’s contact information readily available. Employers would be prohibited from representing to a worker that the worker is covered by a non-compete clause when the employer has no good-faith basis to believe the worker is subject to an enforceable non-compete clause.

Exception for Sale of Business

The proposed rule provides a single, limited exception related to the sale of a business. The exception provides that the rule “shall not apply to a non-compete clause that is entered into by a person who is selling a business entity or otherwise disposing of all of the person’s ownership interest in the business entity.” The exception applies, however, only to a person who owns at least a 25% ownership interest in a business entity at the time the person enters into the non-compete clause. The proposed rule is unclear as to whether the exception applies to existing non-compete terms applied to future sales of a business or only to non-compete terms entered into at the time of the sale.

Relation to State Laws

The proposed rule provides that it supersedes any state statute, regulation, order, or judicial interpretation that is inconsistent with the proposed rule. A state statute, regulation, order, or interpretation is not inconsistent with the proposed rule, however, if it provides greater protections to workers than the proposed rule. As a result, the proposed rule would essentially set a floor for worker protection against non-compete agreements but also keep in effect state and federal law that provides workers greater protection.

Public Comment

The FTC’s extended comment period on the proposed rule runs until April 19. The FTC has asked specifically for comments on several different alternatives to this non-compete ban, such as whether non-compete clauses between employers and senior executives should be subjected to a different rule than non-compete clauses between employers and other workers. The FTC also seeks comments on the possible benefits and costs of the proposed rule, the impact of the proposed rule on businesses, and possible compliance costs should the proposed rule be implemented. Commissioner Wilson’s recent and original statements seek to strongly encourage commenters to submit their views on the proposed rule.

Compliance Date

The proposed rule would establish a separate effective date and compliance date. The proposed rule’s effective date will be sixty days after the final rule is published in the Federal Register. The compliance date will be 180 days after the final rule is published in the Federal Register.

The time between the effective date and the compliance date is the “compliance period,” during which employers will need to be prepared to comply with the proposed rule’s provisions by the compliance date.

Effect on Congress

The FTC’s proposed rule has also sparked movement within Congress. In response to the proposed rule, Sen. Chris Murphy (D-Conn.) reintroduced the Workforce Mobility Act (the “Act”), which was cosponsored by Sens. Todd Young (R-Ind.), Tim Kaine (D-Va.), and Kevin Cramer (R-N.D.). This Act had been previously introduced to Congress in 2018, 2019, and 2021 but stalled each time. The Act, like the proposed rule, seeks to ban the enforcement of non-competes across the United States. However, the Act differs from the proposed rule in many ways. Of note, the Act would not retroactively ban non-compete agreements, whereas the FTC proposed rule would apply to all existing and future non-compete agreements.

The Act is currently sitting in committees for additional review.

What Does This Mean for Employers?

Employers should carefully monitor the status of the proposed rule. It will likely face significant legal challenges, and its fate is far from certain. Employers should consider, however, conducting an audit of their non-compete agreements and practices with respect to such agreements to determine whether and to what extent they may be impacted should the proposed rule become the law of the land.

For example, employers who have previously relied primarily on non-compete restrictions to prevent unfair competition or theft of trade secrets may consider strengthening or modifying their non-solicitation and non-disclosure restrictions. Specifically, employers should evaluate their confidentiality agreements, which are often very broad, to evaluate the risk that they may be considered “de facto non-competes” that are invalidated by the proposed rule and ensure that they comply with the antitrust laws. Employers may also consider conducting an audit to evaluate and identify vulnerabilities within their organization in the event that key current and former employees suddenly have unenforceable non-compete restrictions. Having a contingency plan in place now could save resources and potentially prevent significant impacts to the bottom line.

Additionally, although Section 5 of the FTC Act applies to “persons, partnerships, or corporations,” its definition of the term “corporation” covers only entities “organized to carry on business for [their] own profit or that of [their] members.” Therefore, arguably, the proposed rule would not apply to nonprofit entities. The courts, however, apply a fact-sensitive analysis, suggesting that the nonprofit legal status of an entity is not dispositive of Section 5’s applicability. Further, the FTC can also challenge non-competes under other antitrust statutes, such as the Sherman Act. Nonprofits should tread carefully given the other tools available to the FTC and other state and federal authorities and the apparent skepticism toward non-competes.

Should the proposed rule be adopted in its current state, this will also place much greater importance on policing corporate confidential and trade secret information, as companies would lose the ability to prevent former employees from immediately going to work for a direct competitor. This provides additional incentive for companies to proactively take stock of their confidentiality practices and agreements to ensure they are fully prepared in the event the proposed rule is implemented in its current form by the FTC.

It was the spring semester of 1983 when I took the introductory Business Associations (“BA”) class at the University of Texas Law School. As a second-year student who knew nothing about business associations—and who was scared stiff of the professor, Robert W. Hamilton—I didn’t foresee spending most of the next 40 years in a career devoted to the subject, first in law practice, then in teaching. But that’s what happened.

In spring 2023, as I transition to emeritus law professor status at Drake University, I remain a BA student in many respects. I regularly consult with attorneys in my home state (Iowa) on business law matters, serve on the Iowa State Bar Association’s Business Law Section Council and its Legislative Committee, present CLEs, and maintain a treatise on business organizations.^[1] As I reflect on changes in the field over the past four decades, the details far exceed the scope permitted in a magazine column. This article instead covers several trends I’ve observed during my years as a BA student, providing, I hope, a forest perspective on some of the trees that comprise modern business entity law.

Increasing Statutory Complexity

In 1983, my study of statutory law in the BA course was largely confined to three acts: the Uniform Partnership Act (1914) (“UPA”), the Uniform Limited Partnership Act (1976) (“ULPA”), and the Model Business Corporation Act (“MBCA”). The latter had just been comprehensively redrafted for the first time since 1950, with my professor serving as Reporter.^[2] These same statutes still guided most states’ business associations laws when I began teaching BA at Drake in 1992.

Critically, each act was relatively short. The UPA ran 6,500 words, while the ULPA, including a minor 1985 revision, totaled just 4,000 words. The MBCA was a bit longer but still manageable. Given the relatively simple statutory architecture, in a four-credit BA course I could survey most provisions in each of the three acts, along with interpretative case law. I was also able to contrast parts of Delaware corporate law with the MBCA, and to introduce “baby business” and accounting concepts, as well as some securities law basics.

By the 2021–22 school year, my last year of full-time teaching, the instructor’s task in BA was considerably more challenging because the length and complexity of statutory business associations law had increased dramatically. At 32,000 words, the UPA (1997/2013) was five times as long as the original act.^[3] The ULPA (2001/2013) ran 35,000 words—eight times its original length.^[4] The Uniform Limited Liability Company Act (“ULLCA”), a newer and critical business entity statute, had grown from roughly 17,000 words in 1996 to 31,000 words in its latest version, ULLCA (2006/2013).^[5] Not to be outdone, the most recent version of the MBCA clocked in at roughly 62,000 words.^[6]

Although it’s tempting to conclude these modern business associations codes are needlessly prolix, several other trends I’ve observed over the past 40 years help explain the acts’ increased length and complexity.

Economic Perspectives Prevail

Brevity was an appealing feature of older business associations codes, but many provisions in those acts were prescriptive, allowing little or no variation from statutory norms. Scholars began to substitute economic analysis for social and regulatory conceptions of business associations as early as the 1930s, and by the 1980s these views were ascendant and increasingly influential with policymakers.^[7] A preference for private ordering over regulation has reshaped the direction of business associations statutes ever since.

Today, whether one organizes a partnership, a limited liability company (“LLC”), or a corporation, business associations codes provide only default rules for many internal matters. Owners of a business entity are thus generally free to tailor the entity’s governance template through partnership or operating agreements, corporate charter or bylaw provisions, and/or secondary contracts.

This emphasis on contractual freedom comes at a price, of course. Modern business entity codes are longer than their former counterparts, in part because they must spell out detailed boundaries for permitted governance variations, as well as “opt-out” or “opt-in” procedures for firms that want to use them.^[8]

Limits on Judicial Regulation

Statutory business associations law was also relatively simple in the early 1980s because judicial decisions filled many gaps. As an example, case law—not statutes—traditionally defined the scope of corporate director and officer fiduciary duties, attendant liability and damage risks, and the permissible boundaries for judicial review, like the business judgment rule. The same was true for litigation involving partners of general and limited partnerships.

Both fiduciary duties and the business judgment rule remain key precepts of modern business associations law. And judges remain involved in their development, though far more in Delaware than in other states. But concerns about perceived judicial overreach triggered changes starting in the mid-1980s, and governing codes began to incorporate nuanced yet complex statutory provisions that constrain the role courts play in business entity disputes.^[9]

For example, following statutory trends first launched in Delaware in 1986 and consistent with private ordering themes described earlier, the MBCA has, since 1990, allowed corporations to exculpate directors against damage claims for duty of care violations with an optional charter provision.^[10] Unincorporated entity acts have embraced similar innovations for partnerships and LLCs.^[11] In 1998, the MBCA added complex and lengthy provisions regulating the permissible scope of claims against directors for monetary damages, including grounds for suit and burdens of proof on both claims and defenses.^[12]

Current statutory innovations designed to reduce litigation risks for corporations and their fiduciaries include procedures for ratification of defective corporate actions, advance approval or waiver procedures for duty of loyalty claims, enhanced indemnification rights for fiduciaries, and limits on permissible litigation forums.^[13] As with other statutory governance options in modern business associations law, the enabling provisions are often both lengthy and complex.

Although most statutory innovations have reduced the potential for judicial involvement in business entity disputes, developments for closely held organizations go both ways. On the one hand, modern statutes authorizing specialized management arrangements and exit planning for privately held corporations have reduced the occasion for judicial challenges to such plans.^[14] On the other hand, new statutory oppression remedies in most jurisdictions now supplement or replace minority owner fiduciary protections derived from case law and are available for both closely held LLCs and corporations.^[15]

Entity Proliferation

The three acts I studied when taking BA in 1983—the UPA, the ULPA, and the MBCA—also described the primary entity options available to business lawyers and their clients at that time: partnerships, limited partnerships, and corporations, with the potential addition of “professional” or “Subchapter S” options for the latter. Available entity choices have since increased dramatically because of two near-simultaneous developments in the late 1980s.

The first was a 1988 revenue ruling authorizing pass-through taxation for owners (“members”) of an LLC—a novel entity then available in only two states—offering limited liability to all participants, along with flexible options for company management.^[16] The second was legislation allowing new limited liability versions of partnerships, a product of malpractice litigation against partners in Texas law firms and national accounting firms in the wake of the savings and loan crisis of 1988.^[17]

As a result of these developments, by the mid-1990s all states had amended their business entity codes to encompass these new options, including limited liability partnerships (“LLPs”), limited liability limited partnerships (“LLLPs”), and LLCs, as well as “professional” variations of new entities, like PLLPs and PLLCs. This expanded entity menu necessarily added to the complexity of statutory business associations law, including new provisions in partnership acts governing LLPs and LLLPs, additional freestanding codes (LLC acts), and, in recent years, supplemental legislation authorizing “series” LLCs.

As acceptance of these novel entity choices has grown over the past three decades—with the LLC the clear favorite for closely held firms—that growth has also fueled added complexity for business associations case law as long-established doctrines, like veil piercing and other exceptions to limited liability, and even traditional creditor remedies, like charging orders, are relitigated in new contexts.^[18] That trend will surely continue as benefit corporations, now available in 34 states, and other new entity options join the mix.^[19]

Technological and Transactional Flexibility

As in other legal fields, many changes in business associations laws over the past few decades were designed to accommodate technological innovations. In corporate law, for example, former requirements for filing paper documents now encompass electronic equivalents.^[20] Sanctioned notice processes have also evolved from paper to electronic systems.^[21] And these changes extend well beyond documents and recordkeeping. When I studied BA in 1983, statutes authorizing directors to meet through a conference telephone call—a then-recent innovation—seemed “as fur as they could go,” to paraphrase Oscar Hammerstein.^[22] But today’s corporation acts go much further, including authorization for fully remote shareholder meetings.^[23]

Modern business associations laws also offer considerable flexibility with respect to transactional formalities, including permissive rules for organic changes. For example, in the 1980s, a partnership that reorganized as a corporation might need to first dissolve or take other steps to transfer assets and liabilities to a newly formed corporate entity. Today that partnership could conduct a cross-entity merger or a single-step “conversion” to the corporate form.^[24] In the 1980s, if a corporation wanted to change its governing law, the company organized a new corporation in the foreign state and then merged into it. Today a corporation or unincorporated entity can typically conduct a “domestication” transaction that changes its governing jurisdiction in a single step.^[25]

Conclusion

Despite all the changes I’ve seen over the past 40 years, the agency law foundations on which business associations are constructed haven’t changed at all. Nor have the fundamental purposes of business associations law: to mediate conflicts that inevitably arise in the life of a business entity between owners and managers, between majority owners and minority owners, and between the entity and third parties.

At the moment, everything old is new again, at least in some quarters. Debates concerning the proper objectives of business associations—debates that began in the 1930s and seemed settled in recent years—now rage anew in fights over corporate missions that include environmental, social, and governance (“ESG”) considerations. As Yogi Berra famously said, “It’s tough to make predictions, especially about the future.” While I wait to see what happens, my mantra is the same as when I took my first BA class in spring 1983: Take good notes!

Doré is the Richard M. and Anita Calkins Distinguished Professor of Law Emeritus, Drake University Law School. Professor Doré’s contact information at Drake is [email protected].

1. Matthew G. Doré, 5 & 6 Iowa Practice—Business Organizations (Thomson Reuters 2022–23) (latest annual edition). ↑

2. For a history of the Model Business Corporation Act’s evolution from 1928 through 2000, see Richard A. Booth, A Chronology of the MBCA, 56 Bus. Law. 63 (2000). ↑

3. Unif. P’ship Act (1997) (Unif. L. Comm’n, amended 2013). ↑

4. Unif. Ltd. P’ship Act (2001) (Unif. L. Comm’n, amended 2013). ↑

5. Unif. Ltd. Liab. Co. Act (2006) (Unif. L. Comm’n, amended 2013). ↑

6. Model Bus. Corp. Act (Am. Bar Ass’n 2020 rev., updated online Sept. 2021). ↑

7. See, e.g., Frank A. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law (1991) (an early, influential work). ↑

8. See, e.g., Model Bus. Corp. Act § 7.04(b)–(g) (optional procedures whereby corporate shareholders can act outside of a meeting with less than unanimous consent); Unif. Ltd. Liab. Co. Act § 105 (describing scope, function, and limitations of operating agreements). ↑

9. Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), which held that directors were not sufficiently informed when approving a corporate merger and thus not protected by the business judgment rule, is often cited as a catalyst for changes that followed. See, e.g., Bernard F. Sharfman, The Enduring Legacy of Smith v. Van Gorkom, 33 Del. J. Corp. L. 287 (2008). ↑

10. See Del. Code Ann. tit. 8 § 102(b)(7); Model Bus. Corp. Act § 2.02(b)(4). ↑

11. See, e.g., Unif. Ltd. Liab. Company Act § 105(d)(3)); Unif. Part. Act § 105(d) (1997) (Unif. L. Comm’n, amended 2013). ↑

12. Model Bus. Corp. Act §§ 8.30–.31. ↑

13. Id. §§ 1.45–.52, 2.02(b)(5)–(6), 2.08, 8.60–.63. ↑

14. Id. §§ 6.27, 7.32. ↑

15. Id. §§ 14.30–.34; Unif. Ltd. Liab. Company Act § 701(a)(4)(C)(ii). ↑

16. Rev. Rul. 88-76, 1988-2 C.B. 360. ↑

17. See Robert W. Hamilton, Registered Limited Liability Partnerships: Present at the Birth (Nearly), 66 Colo. L. Rev. 1065 (1995). ↑

18. For example, courts have had to decide whether and to what extent well-established judicial exceptions to limited liability apply in the new limited liability settings. See Matthew G. Doré, What, Me Worry? Tort Liability Risks for Participants in LLCs, 11 U.C.–Davis Bus. L.J. 267 (2011). For an overview of recent developments concerning charging orders issues, see Daniel S. Kleinberger, What Is a Charging Order and Why Should a Business Lawyer Care?, Bus. L. Today (Mar. 6, 2019). ↑

19. See, e.g., Christopher D. Hampson, Bankruptcy & the Benefit Corporation, 96 Am. Bankr. L.J. 93 (2022) (considering how traditional bankruptcy principles should apply to benefit corporations). ↑

20. See, e.g., Model Bus. Corp. Act §§ 1.20, 1.40 (defining “filing” rules for “documents” and encompassing both paper and electronic records). ↑

21. Id. § 1.41 (providing rules for notices and other communications). ↑

22. Oscar Hammerstein II, Kansas City, Oklahoma (1943) (“Ev’rythin’s up to date in Kansas City. They’ve gone about as fur as they could go.”). ↑

23. Model Bus. Corp. Act § 7.09 (permitting remote participation in shareholder meetings). ↑

24. Unif. Part. Act §§ 1121–26; 1141–46 (authorizing merger and conversion transactions). ↑

25. See, e.g., Model Bus. Corp. Act §§ 9.01–.24. In fact, one of the stated reasons for the 2016, or “fourth,” edition of the MBCA was to recognize and facilitate inter-entity transfers and to coordinate with unincorporated business association acts. ↑

The Mendes Hershman Student Writing Contest is a highly regarded legal writing competition that encourages and rewards law students for their outstanding writing on business law topics. Papers are judged on research and analysis, choice of topic, writing style, originality, and contribution to the literature available on the topic. The distinguished former Business Law Section Chair Mendes Hershman (1974–1975) lends his name to this legacy. Read the abstract of this year’s third-place winner, Max Londberg of University of Cincinnati College of Law, Class of 2023, below. Visit the University of Cincinnati Law Review website to read the full article, published in Volume 91.

Colorblind ideology has hindered the purpose of Title VII, which declared it unlawful to refuse to hire a job applicant because of their race, sex, or other traits. Recent federal court decisions have continued this trend, diminishing legitimate discrimination claims by failing to properly recognize one manifestation of racism and sexism in hiring. This form of bias surfaces when employers adjust their stated hiring criteria, de-emphasizing certain job applicant traits, such as education, held by a marginalized candidate, while emphasizing other traits, such as relevant experience, held by a non-marginalized candidate. Robust empirical research supports that such criteria shifting is motivated by an applicant’s gender or race. In numerous studies, participants hire marginalized candidates when race and gender are concealed but fail to hire them when such traits are revealed. They often rationalize their discrimination, and thus maintain a self-image of fairness, by invoking hiring criteria that they, consciously or not, manipulated to benefit non-marginalized candidates.

Several federal courts have failed to properly recognize this manifestation of discrimination, despite its identification in the social science literature. This piece provides an analysis of these cases interspersed with empirical findings, which together illustrate how inconsistent hiring criteria unlawfully hamper marginalized candidates, leading to adverse employment decisions based on protected traits. Courts must improve their analysis of this form of evidence. When a Title VII plaintiff demonstrates the presence of inconsistent hiring criteria, and when an employer hires an applicant outside the plaintiff’s protected class, courts should rarely grant employer motions for summary judgment. Decisions to the contrary contravene summary judgment standards and the scope of Title VII.

As the legal market moves through the first quarter of 2023, predictions from the team at Reveal-Brainspace have already become a reality—with many more ups and downs to come. From macro headwinds to advancements in AI and Web3 tech, the AI and LegalTech experts at Reveal have outlined the biggest moves that are already taking shape and the focus areas that will be taking much of legal practitioners’ attention for the rest of the year. One thing will stay consistent during 2023: AI will continue to have a multiplying effect on the legal vertical now and well into the future.

Overall market trends in LegalTech

The use of AI for eDiscovery is set to continue its rapid growth, driven by the successes experienced by early adopters in corporate legal departments, law firms, and legal services providers worldwide. The proliferation of artificial intelligence (machine learning (ML), natural language processing (NLP), ethical AI, AI-generated art, etc.) is a key driver of this growth, and 2023 will see a continued wave of AI adoption fueled by cost pressures and the need to accelerate time to evidence and insight. The increasing volume, variety, and velocity of data is also making AI a necessity rather than just a nice-to-have option.

In the area of eDiscovery, the growth and proliferation of new data types will drive innovation and create challenges for legal professionals. Direct connectors and data visualization purposes designed for these new data formats will take center stage in 2023, as more communication formats that don’t fit the traditional four corners of a page gain traction and legal professionals move towards modern eDiscovery.

In the business of law, Alternative Legal Service Providers (ALSPs) will likely continue to consolidate in 2023, in response to both economic pressures and the desire to expand their offerings beyond eDiscovery. More players are expected to enter the fields of information governance, compliance, and cyber functions to get closer to the data and remain stickier with their clients.

Massive advances in eDiscovery technology and use-cases

The mission to perfect AI-powered eDiscovery technology will continue, while new use cases will explode. We’re already experiencing this as we begin Q2 2023. eDiscovery technology will likely expand beyond its traditional boundaries as organizations look to leverage its power in areas such as cybersecurity incident response, privacy, information governance, and much more. Businesses and legal professionals will increasingly turn to the unstructured data analytics within eDiscovery to solve a range of challenges around human-generated and AI-generated data.

If you need any evidence of this already taking place, look no further than the explosion of generative AI tools like ChatGPT and DALL-E. These tools are going to be a major focus area for legal practitioners—creating new considerations and use cases for advanced eDiscovery solutions in a variety of situations.

Additionally, the technology underlying Web3 will continue to proliferate and raise complex legal questions, despite the slow rate of adoption of the Metaverse. For example, the conversion of real-world assets into digital ones with NFTs raises questions about the extent that real-world rights carry into augmented or virtual reality. As Metaverse or Web3 devices become less expensive and the user experience becomes more accessible, adoption and legal questions will continue to grow.

Softening of M&A activity

After several years of robust M&A activity, the market is expected to experience a dramatic slowdown in 2023, driven primarily by economic headwinds. If the global economy continues to experience a period of slow growth or uncertainty, it may make companies cautious about making new investments or acquisitions, with the LegalTech space no exception to the rule.

However, while M&A is softening, it will certainly remain relevant. The activity that will take place will be extremely deliberate, strategic, and meaningful to the companies involved. This is good for the industry, as it gives the entire space time to think, rethink, and make well-informed decisions.

Economic headwinds will drive AI-powered innovation in order to do more with less

While the economic uncertainty will likely affect M&A activity for the remainder of the year, it is simultaneously is driving greater adoption of legal technology to control budgets. Challenges in securing tech budgets may lead to corporate legal departments outsourcing to ALSPs that can provide access to the AI-powered tools they may not be able to directly procure in 2023. eDiscovery is expected to see increased use of AI to reduce document review costs in 2023.

The force multiplier effect of legal AI means it may see widespread adoption as practice groups and legal departments must do more with less. Crisis often is the most fertile time for organizational transformation, and 2023 is no different.

The growing importance of social considerations (the “S” in ESG) has appeared in numerous headlines, as companies learn the hard way that cutting corners in areas like supply chain and human capital does not pay off in the long run. In the past two years, a number of Fortune 500 companies have had to pay out large sums to mitigate the consequences of their poor choices surrounding overseas production. In this article we focus on the “S” aspects of ESG with regards to conducting M&A due diligence, and what companies should evaluate prior to approving an M&A deal.

As discussed in our prior ESG in M&A article, a large number of investors believe that companies with strong ESG initiatives are more lucrative investments, pose less risk, and are better positioned for the long term. Moreover, because of the SEC’s announced plan^[1] to create an ESG reporting framework that would complement the current financial reporting framework, targets with higher ESG scores are perceived, in many cases, as having higher market value. Environmental and governance aspects of ESG seem to be easier to measure, which may explain why companies find it easier to tackle those issues first. Acquirers often overlook the social aspects of ESG metrics, which can result in minimal evaluation of social issues during ESG due diligence.

The “S” part of ESG is a broad topic that covers a wide range of social issues; diversity and inclusion, fair pay, workplace safety and environment, employee turnover, company ethics, and reputation are among the factors that are evaluated when assessing a company’s “social” health in ESG metrics. Increasingly, we have seen companies reevaluating their production practices to address supply chain hiccups and questionable labor practices. Many companies have had significant problems resulting from cargo crime,^[2] the invasion of Ukraine,^[3] the growth of e-commerce, sudden shortages, centralized inventory, and a patchwork of logistics,^[4] all of which are significant supply chain problems that fall under the “S” in ESG. We will examine a few of these issues more closely.

1. Supply Chain Risks

Since the beginning of the COVID-19 pandemic, companies have been suffering frequent and major disruptions to global supply chains. Prominent examples include shortages of lumber to build houses and of semiconductor chips for vehicles and mobile phones. To address these issues, manufacturing companies often sought out alternative suppliers. The manufacturers often failed to conduct proper vetting of such alternative suppliers and in many cases wound up with less reputable vendors as a result. In some cases, improperly vetted alternative vendors may be less transparent with their “social” practices and also less ethical in general. Vendor practices are increasingly “broadcast” worldwide via online and social platforms such as TikTok and Instagram. The questionable practices of suppliers—after coming to light—are often viewed by third parties as a reflection of the manufacturer’s practices and ethics, with the publishers of ESG ratings, and sometimes even litigants, holding the manufacturer accountable for its vendors’ practices. Some of the examples of ethical issues in supply chains are:

• corruption and bribery;
• unsafe labor conditions;
• non-living wages or forced labor;
• child labor;
• cargo crime;
• environmental harm; and
• discriminatory work environment.

To combat these issues and demonstrate their commitment to social and environmental performance, more businesses are looking to third-party certification processes. For example, many companies dealing with these issues choose to become “B Corp” certified. B Corp certification of for-profit companies is offered by the B Labs Global. The designation confirms that a business is meeting high standards of verified performance, accountability, and transparency on factors from employee benefits and charitable giving to supply chain practices and input materials. As of September 2022, there were 5,697 certified B Corporations across 158 industries in 85 countries. Among some of the best known B Corp certified companies are Ben & Jerry’s,^[5] TOMS,^[6] and Patagonia.^[7] Many of these companies also donate their products to charity to match purchases by consumers. For example, for every pair of TOMS shoes purchased, a pair of new shoes is given to a child in need in partnership with humanitarian organizations.

According to Accenture Strategy’s Global Consumer Pulse Research, more than 60% of surveyed consumers closely consider a company’s ethical values and authenticity before a purchase. Moreover, the research showed that 42% of consumers “stopped doing business with a company because of its words or actions about a social issue.”^[8]

To illustrate this with a real-world example, a confectioner was struggling to ensure that harvesting the ingredients it used, like cocoa and soy, did not contribute to deforestation. Also, several confectioners were accused of child labor issues in recent years, and were named in a lawsuit over child labor in cocoa production countries. As a result, the company made changes, such as setting strict policies on deforestation and promising to train all of its buyers on human rights issues. Child labor, forced labor, deforestation, women’s rights, and living wages were among the most pressing human rights issues across the value chain for these companies. Another real-world case that attracted headlines was the investigation of fashion retailer Boohoo, which was accused of being aware of its suppliers underpaying their staff and exposing workers to life-threatening risks in their workplaces.^[9] As a result, multiple online retailers removed Boohoo’s products from their websites.^[10]

Some companies have chosen an alternative solution to supply chain social concerns: bringing manufacturing in house. However, the high costs, risks, and logistics associated with this option mean it is not always a feasible choice to address supplier concerns.

2. M&A Due Diligence and Supply Chain Risks

The great difficulty with addressing these social and ethical issues is that they are often not discussed or uncovered in the M&A process until the company becomes a defendant in a lawsuit, the subject of an investigation, or the object of press or social media attention. At that point, the company has already suffered severe damage to its reputation due to actions taken by another party, not to mention potential exposure to monetary damages resulting from pre-closing actions. It is hard to measure many of these practices when they are defined differently across industries and from country to country. It also requires significant corporate resources to monitor each vendor and each of their sites. Nevertheless, with the growing pressure from customers and investors, ethical production is a critical component to have a successful and sustainable business in the 21^st century.

So, how should a buyer assess a target company’s approach to social compliance in its supply chain? Buyers should confirm that the target company is communicating regularly and often with its vendors and conducting periodic site visits, if possible. It is a good idea for a company to include its ESG standards in its supplier contracts to ensure that the company’s ESG policies have been clearly communicated and vendors know its expectations in that regard. Another good practice is to ask whether the target uses supply chain mapping to maintain awareness of its production sites and those of its vendors. With effective supply chain mapping, a company divides its vendors into different categories, which can allow it to see weak points in its supply chain and avoid incurring costly issues.

What impact do social issues have for potential buyers and targets in M&A transactions? To start with, buyers need to be aware of the prevalence and impact of these issues and be proactive in identifying and evaluating them. According to a study conducted by Accenture during the early months of the COVID-19 pandemic, 94% of Fortune 1000 companies are seeing supply chain disruptions, 75% of companies have had “negative or strongly negative impacts” on their business, and 55% of companies plan to downgrade their growth outlook or have already done so.^[11] Based on a survey conducted by Datasite of 200 UK-based dealmakers, almost 20% stated that supply chain problems were the cause of at least one deal falling apart in 2021, and 22% identified supply chain issues as the number one cause that would trigger an M&A deal to fall through in 2022.^[12] Many companies that had order backlogs of one to two months prior to COVID-19 now have increased their estimate of the backlog by up to four times.^[13] For instance, a target that had backups for almost every component in their products but one key part with no alternate supplier had to be taken down from the market due to potential buyers’ concern.^[14] Such a potential outcome suggests that targets also would be well advised to conduct thorough internal due diligence on these topics prior to going to market.

3. Fair Labor Practices and Unionization

Fair labor practices are another important aspect of the social responsibility portion of ESG. More U.S. stakeholders are urging companies to improve labor practices and working environments. If a company’s ESG policies assert that they ensure equitable labor practices, they may face scrutiny if they fail to actively address workplace issues with their suppliers. Moreover, the recent resurgence of unionization activities is evidence of its importance. Unionization offers additional protection and benefits for employees, but can also pose extra costs and burdens on employers; oftentimes a company’s response to these activities is perceived as an indicator of a company’s labor practices and hence a part of its ESG assessment. A Starbucks store in Buffalo, New York, became the first Starbucks location in the U.S. to unionize in 2021.^[15] Since then, over 270 Starbucks stores have unionized.^[16] Starbucks, like other food and beverage companies, is bracing for the impact of the threat of higher labor costs due to unionization, and has also faced national scrutiny for its response to workers’ attempts to unionize.^[17]

In addition to the growing unionization in the U.S., more and more companies are addressing safe labor practices in their non-U.S. factories. One example of such an effort was the result of the tragic accident in Rana Plaza, a factory in Bangladesh that collapsed in 2013 killing over 1,100 people. Workers had noticed cracks in the structure before the building collapsed and begged not to be sent inside, but they were rebuffed by their employers.^[18] The collapse of the eight-story building, which housed five garment factories supplying at least 29 global brands, remains one of the deadliest industrial accidents to date.^[19] Such a “mass industrial homicide,” as union leaders called it, drew the attention of global organizations that took action to create safer working standards. These standards now show up in retailers’ ESG reports.

However, despite the aforementioned efforts to improve the conditions of factories in Bangladesh and other countries with significant garment sectors, the working environment for many employees remains far from ideal. A 2020 U.S. Senate Report titled “Seven Years After Rana Plaza, Significant Challenges Remain” discusses the unsafe practices of these factories, especially during the COVID-19 pandemic.^[20] The report found that in factories that remained in operation during the pandemic, workers were forced to work without adequate precautions, leaving them and their families at great risk of COVID-19 infection.^[21]

More recently, a fire at the Nandan Denim factory in India killed seven people in 2020.^[22] According to the Nandan Denim website, it is the biggest denim producer in India.^[23] The manufacturer sells jeans to more than twenty countries for many high street brands, and import data showed shipments entering the United States from the factory just one month before the fire occurred. Unfortunately, the Nandan Denim fire is not a rarity, as fires in retail factories are not an uncommon occurrence.^[24] Such occurrences can lead to damaged reputations as well as an influx of civil lawsuits and a criminal investigation. Following the Nandan Denim incident, the production facility came to a halt, and the director, general manager, and fire safety officer of Nandan Denim were taken into police custody. Additionally, six individuals from the factory’s parent group were charged with homicide and negligence.^[25]

In light of these frequent tragedies, more and more U.S. stakeholders are asking companies to improve their labor practices and working environments, with some even supporting union organization activity. Employers that don’t actively inquire into the workplace issues of their suppliers may find themselves under scrutiny if their ESG policies state that the company ensures fair labor practices outside of the United States. Further, where a company represents that it strives to ensure fair labor practices for its vendors, taking action to oppose union organization in the U.S. may be seen as inconsistent with such claimed commitment to fair labor practices.

4. ESG Due Diligence

It is advisable for buyers in M&A transactions to conduct due diligence investigations regarding ESG practices of the target not only to determine whether there are potential risks, but also to ensure that the target will integrate well into the buyer’s own ESG practices and policies. A buyer should request information on whether there have been recent changes in supply chain vendors and suppliers of the target company. Also, a buyer should gain an understanding of how the target company monitors its supply chain and review its applicable contracts. Specifically, a buyer should look into whether there are any contractual requirements outlining ESG expectations in a target’s agreements with vendors and suppliers. Furthermore, buyers should visit physical sites, review compliance certificates, and provide questionnaires in order to be better aware of a target’s supply chain practices. Some industries are likely to have more significant exposure to ESG issues in the supply chain than others, particularly businesses in the automotive, semiconductors, industrials, and retail industries. Lastly, even after conducting appropriate ESG due diligence, a buyer should consider including ESG-related provisions in the purchase agreement. These clauses can include ESG representation and warranties, closing conditions, and ESG-specific indemnities. Such provisions can go hand-in-hand with (and often enhance) a thorough diligence process to give the buyer the best chance of avoiding post-closing losses.

1. Allisson Herren Lee, “A Climate for Change: Meeting Investor Demand for Climate and ESG Information at the SEC,” U.S. Securities and Exchange Commission, March 15, 2021. (The SEC has “begun to take critical steps toward a comprehensive ESG disclosure framework aimed at producing the consistent, comparable, and reliable data that investors need.”) ↑

2. Rachel Layne, “Clogged U.S. supply chains lead to cargo theft,” CBS News, November 2, 2021. ↑

3. Knut Alicke et al., “Supply chains: To build resilience, manage proactively,” McKinsey & Company, May 23, 2022. ↑

4. Kyle VanGoethem, “What Are the 5 Biggest Supply Chain Issues Today?” Stord, May 3, 2022. ↑

5. “Ben & Jerry’s Joins the B Corp Movement,” Ben & Jerry’s, last accessed April 4, 2023. ↑

6. “TOMS, Certified B Corporation,” B Lab Global Site, last accessed April 4, 2023. ↑

7. “Patagonia Works, Certified B Corporation,” B Lab Global Site, last accessed April 4, 2023. ↑

8. Rachel Barton et al., “From me to we: The rise of the purpose-led brand,” Accenture, December 5, 2018. ↑

9. Archie Bland, “Boohoo knew of Leicester factory failings, says report,” The Guardian, September 25, 2022. ↑

10. Don-Alvin Adegeest, “Zalando, Next and Asos stop selling Boohoo brands after damning report,” Fashionunited, July 8, 2020. ↑

11. “Building supply chain resilience: What to do now and next during COVID-19,” Accenture, March 17, 2020. ↑

12. Datasite contributor, “Rising Inflation and Supply Chain Challenges: Will EMEA M&A Deals Be at Risk in 2022?” City A.M., February 17, 2022. ↑

13. Al Statz, “How Supply Chain Issues are Complicating M&A Dealmaking,” Exit Strategies, February 2, 2022. ↑

14. Id. ↑

15. Mary Yang, “Starbucks union organizing gave labor a jolt of energy in 2022,” NPR, December 9, 2022. ↑

16. “278+ STORES UNIONIZED AND 41,000+ UNION SUPPORTERS IN SOLIDARITY!” Starbucks Workers United, accessed January 30, 2023. ↑

17. Justin Stabley, “Why scrutiny of Starbucks’ alleged union violations is boiling over now,” PBS NewsHour, March 29, 2023. ↑

18. Michael Safi et al., “Rana Plaza, five years on: safety of workers hangs in balance in Bangladesh,” The Guardian, April 24, 2018. ↑

19. Shams Rahman and Aswini Yadlapalli “Years after the Rana Plaza tragedy, Bangladesh’s garment workers are still bottom of the pile,” The Conversation, April 22, 2021. ↑

20. A Minority Staff Report, 116^th Cong., “Seven Years After Rana Plaza, Significant Challenges Remain,” 116–17 (2020). ↑

21. “Bangladesh: Seven years on from Rana Plaza factory collapse, garment workers’ lives at risk again amid COVID-19,” Business & Human Rights Resource Center, April 24, 2020. ↑

22. Tara Donaldson, “Fire Kills Seven in Indian Factory that Made Denim For Major US Brands,” Rivet, February 10, 2020. ↑

23. “Nandan One World With Denim,” Nandan, accessed January 2, 2023. ↑

24. Express News Service, “Fire breaks out in footwear factory in Delhi’s Narela Industrial Area; no casualties yet, say officials,” The Indian Express, November 5, 2022. ↑

25. Clean Clothes Campaign, Deadly Indian Factory Fire Again Shows Need for Preventive Safety Measures and Justice for Workers, International Labor Rights Forum, February 17, 2020. ↑

We have seen a tsunami of cryptocurrency exchange bankruptcies—FTX, Celsius, and Voyager, to name a few. Often, disputes arise among stakeholders in these bankruptcy cases regarding whether cryptocurrency maintained by a customer with an exchange in a pure custody relationship is property of the customer or property of the bankruptcy estate. Usually the litigation turns on the account agreement, including what are often referred to as the “Terms of Service,” entered into between the customer and the exchange, and the application of nonstatutory common law contract and property law principles. Given the uncertainty evidenced by this litigation and out of concern for customer protection, federal and state regulators have called for greater clarity on the issue through new regulation or, given the lack of clear regulatory authority, legislation. Yet many customers, exchanges, regulators, and legislatures seem to be unaware of an already existing statutory tool for addressing and resolving the issue: Article 8 of the Uniform Commercial Code (“UCC”).

UCC Article 8: The Basics

The UCC, promulgated by the American Law Institute and the Uniform Law Commission, has been enacted in substantially uniform form by every state of the United States and the District of Columbia. Article 8 of the UCC provides a statutory scheme for the holding and transfer of investment securities, whether held directly by an investor from an issuer (so-called directly held securities) or held indirectly by an investor through a bank, broker, or other custodian acting for its customers, including the investor (so-called indirectly held securities). Of relevance here is the system for holding indirectly held securities (“indirect holding system”).

While the primary focus of Article 8 is generally on investment securities, Article 8’s indirect holding system provisions, contained in Part 5 of Article 8, can apply more broadly to any so-called financial assets as defined under Article 8. “Securities,” as defined in Article 8 (which may not coincide with the definition of securities under securities and other laws), are by definition financial assets. However, any other asset that the securities intermediary and its customer agree to treat as a financial asset is also a financial asset under Article 8 and is therefore within the scope of Article 8’s indirect holding system provisions. The agreement by which the exchange and the customer agree to treat an asset as a financial asset under Article 8 is referred to herein as a “financial asset election.”

Once the financial asset election is made and the financial asset is credited to the customer’s “securities account” at the securities intermediary, the customer (referred to in Article 8 as the “entitlement holder”) obtains a proprietary interest in, and contractual and statutory rights against the securities intermediary with respect to, the financial asset. That proprietary interest and contractual right are, together, referred to in Article 8 as a “security entitlement.”

A securities intermediary has a duty under Article 8, among other duties, at all times to maintain sufficient financial assets of each type to satisfy security entitlements to financial assets of that type. And, of chief importance here, financial assets to which the entitlement holder has a security entitlement are generally not property of the securities intermediary and are generally not subject to the claims of the securities intermediary’s creditors under Article 8.

Application of UCC Article 8 to Cryptocurrency in an Indirect Holding System

A cryptocurrency exchange could be a securities intermediary under Article 8, with the cryptocurrency held for the customer being treated as a financial asset credited to a securities account of the customer at the exchange under a financial asset election included in the account agreement. If that were the case, the cryptocurrency would generally not be property of the exchange and generally not be subject to the claims of the exchange’s creditors. If the exchange became a debtor under the Bankruptcy Code, absent contrary terms in the account agreement, the financial asset election under Article 8 would reduce, if not entirely eliminate, the need to litigate the terms of the account agreement over whether the cryptocurrency is customer or exchange property. This is because Article 8 states so clearly that financial assets maintained by a securities intermediary for its customer are generally not the securities intermediary’s property and are generally not subject to the claims of the securities intermediary’s creditors. In other words, in this circumstance, the cryptocurrency would be property of the customer rather than property of the exchange.

A securities intermediary is a person that in the ordinary course of its business maintains securities accounts for others and is acting in that capacity. It is true that the most common examples of securities intermediaries are clearing corporations holding securities for their participants, banks acting as securities custodians, and brokers holding securities on behalf of their customers. But nothing in the definition of the term securities intermediary as used in Article 8 limits securities intermediaries to clearing corporations, banks, or brokers. In addition, because a securities account is an account to which a financial asset is or may be credited in accordance with an agreement under which the person maintaining the account undertakes to treat the person for whom the account is maintained as entitled to exercise the rights that comprise the financial asset, and the definition of financial asset is not limited to “securities” as defined in Article 8, a person may be a securities intermediary even if that person does not credit securities to the account. Rather, the securities accounts that a securities intermediary maintains may consist exclusively of assets that the securities intermediary has agreed to treat as financial assets—even if the financial assets are not securities.

The assets could, indeed, be cryptocurrencies. In 2022, the American Law Institute and the Uniform Law Commission promulgated amendments to the UCC providing rules for digital assets, referred to in a new Article 12 of the UCC as “controllable electronic records.” Controllable electronic records include most cryptocurrencies. The Official Comments to the 2022 amendments, including amendments to Article 8, confirm that a cryptocurrency exchange can be a securities intermediary under Article 8. Furthermore, under the 2022 amendments, a controllable electronic record maintained by a customer with an exchange can be a financial asset if there is a financial asset election under Article 8.

Examples of other assets treated as financial assets that are sometimes credited to a securities account and that are not securities include negotiable instruments, banker’s acceptances, certificates of deposit, and cleared swap agreements.^[1] It is not necessary that the cryptocurrency be considered a security or commodity under other law for the asset to be a financial asset under Article 8.

Moreover, the indirect holding provisions of Article 8 are technologically neutral. To obtain financial asset status, it would not matter whether the cryptocurrency is maintained by the exchange on-chain or off-chain or whether the customer has its own private keys to any wallet maintained by the exchange for the customer but with the exchange having ultimate control over the cryptocurrency.

The policy rationale for this broad and flexible interpretation of Article 8 in the context of the indirect holding system is explained in Article 8 itself. The Prefatory Note to Article 8 states, “Rapid innovation is perhaps the only constant characteristic of the securities and financial markets. The rules of Revised Article 8 are intended to be sufficiently flexible to accommodate new developments.”^[2] And the Official Comments to Article 8 provide, “That question [of the scope of Part 5 of Article 8] turns in large measure on whether it makes sense to apply the Part 5 rules to the relationship.”^[3] Here, the rules of the indirect holding system fit well when the financial asset election is made. The customer obtains the benefits of the duties of a securities intermediary, set forth in Part 5 of Article 8, owed to the customer by the exchange—including the duty of the exchange to maintain sufficient cryptocurrency of each type to satisfy all customer security entitlements to the cryptocurrency of that type. The exchange assumes the Part 5 duties with the ability to modify those duties, to the extent permitted by Part 5 of Article 8, with the agreement of the customer. And, as is the case with indirectly held investment securities, cryptocurrencies held as financial assets credited to the securities accounts of customers generally are not subject to the claims of the exchange’s creditors. There is no obvious policy reason not to permit the exchange and the customer to agree to the benefits and burdens of the indirect holding provisions of Article 8.

Of course, some cryptocurrency exchanges may commingle their proprietary cryptocurrency with cryptocurrency of customers as part of a single fungible bulk. An exchange doing so does not in any way alter the result under Article 8 if there is a financial asset election. Article 8 contains no provision that requires a securities intermediary to segregate proprietary financial assets from customer financial assets. The key is for the books and records of the securities intermediary to reflect what quantity of financial assets of which type is subject to security entitlements and which customers hold the respective security entitlements. If there is a shortfall in the cryptocurrency necessary to satisfy security entitlements to the cryptocurrency of any type, the customers’ rights under their security entitlements will generally be superior to the proprietary interests of the exchange in the cryptocurrency of that type.

UCC Article 8 and Bankruptcy of a Cryptocurrency Exchange

Although there is so far no bankruptcy case addressing the issue, there is no reason why Article 8’s protections for customers’ cryptocurrency should not be recognized if the exchange were to become a debtor under the Bankruptcy Code. Based on the holding from the U.S. Supreme Court in Butner v. United States,^[4] the extent of a bankruptcy debtor’s interest in property is determined under applicable non-insolvency law, absent a compelling federal interest to the contrary—and there is no compelling federal interest why the applicable nonbankruptcy provisions of Article 8, after giving effect to financial asset election under Article 8, should not apply to determine the limitations of the exchange’s interest in the cryptocurrency maintained by the exchange for the customer. The interest of any creditor of the exchange would generally be similarly limited.

At most, the exchange’s interest would be limited to mere nominal title, which should not be problematic in the exchange’s bankruptcy case. Under Bankruptcy Code §§ 541(a)(1) and (d), the exchange’s nominal title is includable in the bankruptcy estate of the exchange. However, the bankruptcy estate’s nominal title in the cryptocurrency would remain subject to the limitations on the rights of the exchange as a securities intermediary, described above. The customer as the entitlement holder would have a security entitlement with respect to the cryptocurrency. Despite the exchange’s nominal title to the cryptocurrency, under Bankruptcy Code §§ 541(a)(1) and (d) the security entitlement itself remains the property of the customer and would not be included in the exchange’s bankruptcy estate. The customer may need relief from the automatic stay, and the assistance of the bankruptcy court in the bankruptcy case, for the cryptocurrency to be delivered out to another exchange or to the customer directly. If there is a shortfall in the cryptocurrency of the same type available to satisfy the security entitlements of all customers to cryptocurrency of that type, the customers would bear the shortfall ratably, and each customer would be treated as a general unsecured creditor of the exchange to the extent of the customer’s ratable share of the shortfall.

Caveats

To be sure, a cryptocurrency exchange and its customers making a financial asset election is not a panacea for what many see as the risks of owning cryptocurrency, or for the lack of regulation of cryptocurrency exchanges. A financial asset election under Article 8 in and of itself cannot prevent fraud, self-dealing, or even poor record-keeping by an exchange—or be a substitute for regulation of cryptocurrency as a security, commodity, or otherwise or for regulation of a cryptocurrency exchange as a money transmitter or other licensee. Moreover, the Article 8 protections, even with a financial asset election, may not apply under choice-of-law rules contained in Article 8 or in the Hague Securities Convention, when the customer permits the exchange to use the cryptocurrency for the exchange’s own benefit (including where the customer is promised a return from the exchange’s use of the cryptocurrency), or in exceptional circumstances referred to in Article 8.

Conclusion

Article 8 is clear and flexible, built to practically accommodate areas of expanding economic activity such as the emergence of cryptocurrency exchanges. Cryptocurrency exchanges and their customers should seriously consider the benefits of a financial asset election, and regulators and legislators should seriously consider requiring cryptocurrency exchanges to build a financial asset election into their Terms of Service or other account agreement provisions. An example of a statute requiring a financial asset election is the Uniform Law Commission’s proposed Supplemental Commercial Law for the Uniform Regulation of Virtual-Currency Businesses Act.^[5] The comments to that proposed supplemental act go into greater detail on the substantive provisions of Article 8 and related choice-of-law rules applicable to a financial asset election.

Carl S. Bjerre is the Kaapcke Professor of Business Law at the University of Oregon School of Law. Sandra M. Rocks is counsel emeritus at Cleary, Gottlieb, Steen & Hamilton LLP. Edwin E. Smith is a partner at Morgan, Lewis & Bockius LLP. Steven O. Weise is a partner at Proskauer Rose LLP. The views expressed in this article are the personal views of the authors and not of their respective organizations.

1. See generally Flener v. Alexander (In re Alexander), 429 B.R. 876 (Bankr. W.D. Ky. 2010), aff’d, Case No. 11-5054, 2011 WL 9961118 (6th Cir. Dec. 14, 2011) (treating a bank certificate of deposit as a financial asset credited to a securities account); Wells Fargo Bank, N.A. v. Est. of Malkin, 278 A.3d 53 (Del. 2022) (treating an insurance policy as a financial asset credited to a securities account). ↑

2. U.C.C. art. 8, prefatory n. (Am. L. Inst. & Unif. L. Comm’n 1994). ↑

3. Id. official cmts. ↑

4. 440 U.S. 48 (1979). ↑

5. Supplemental Commercial Law for the Uniform Regulation of Virtual-Currency Businesses Act (Unif. L. Comm’n 2017), https://www.uniformlaws.org/committees/community-home?CommunityKey=fc398fb5-2885-4efb-a3bb-508650106f95. ↑