Companies of all sizes, and especially e-commerce companies, have been hit by waves of demand letters and lawsuits over the past decade alleging that websites and (increasingly) mobile applications are inaccessible to individuals with disabilities. Most of these cases tend to result in early settlements and few go to trial because businesses tend to have limited affirmative defenses and the cost of litigating typically far outweighs the cost of settlement.
While digital accessibility litigation continues to proliferate, the U.S. Department of Justice (“DOJ”) has not yet promulgated a clear technical accessibility standard through regulations or regulatory guidance under Title III of the Americans with Disabilities Act (“ADA”), which applies to public accommodations (i.e., businesses that offer goods and services to the public). As a result, many businesses seek to comply with the Web Content Accessibility Guidelines (“WCAG”), which are an international standard that has been referenced in some of the DOJ’s consent decrees, as well as court orders. While companies could apply any technical accessibility standard that meets the “effective communication” requirement of Title III of the ADA, they have expressed a desire for certainty in knowing that the standard they use will meet the DOJ’s expectations, should they need to defend it in litigation. Certainty concerning a technical accessibility standard can only be achieved through the DOJ amending its Title III regulations or issuing regulatory guidance.
This article explains the current regulatory environment, the state of digital accessibility litigation, and potential legislative solutions to the challenges they pose, as well as steps that businesses can take to mitigate the risk of lawsuits.
Background
The ADA, which was enacted in 1990, was the first comprehensive federal civil rights law protecting the rights of individuals with disabilities. The ADA consists of several titles, and the law is enforced by the DOJ and private plaintiffs.[1] Title III applies to “public accommodations,”[2] which generally means businesses that offer products and services to the public. While twelve categories of businesses are specified under both the law and the DOJ’s regulations implementing Title III of the ADA,[3] the term public accommodation is broadly construed.
Title III prohibits public accommodations from discriminating against individuals with disabilities in offering goods and services. Title III also requires public accommodations to ensure effective communications with individuals with disabilities, including providing auxiliary aids and services to them, if needed, in an accessible format and in a timely manner. Accessible electronic and information technologies, such as websites and mobile applications, are examples of auxiliary aids.
The DOJ and Judicial Enforcement of Title III
At the time the ADA was enacted, websites did not widely exist. However, in 1996, the DOJ issued an advisory opinion stating that public accommodations must make their websites accessible to individuals with disabilities in order to provide effective communication in compliance with Title III of the ADA.[4] The DOJ then actively pursued enforcement of Title III against public accommodations, alleging inaccessible websites through litigation resulting in consent orders, and the agency also filed amicus briefs and statements of interest in other cases.
Subsequently, many federal and state courts have interpreted Title III of the ADA, as well as corollary state laws like California’s Unruh Civil Rights Act and New York’s Human Rights Law, to apply to websites. Although there are inconsistencies among judicial decisions concerning whether websites qualify as public accommodations under the ADA and applicable state laws, more federal and state courts than not have sided with plaintiffs in requiring businesses to make their websites accessible. Therefore, as a general matter, companies must make their websites—just like physical spaces—accessible to individuals with disabilities under Title III of the ADA.
Lack of a Uniform Technical Accessibility Standard
However, the DOJ has never established a uniform technical accessibility standard through either regulations or guidance for companies to follow to ensure that websites and other digital assets are accessible to individuals with disabilities, despite efforts by the agency to do so through two advance notices of proposed rulemaking issued during the 2010–2016 era. Nonetheless, the DOJ has undertaken enforcement actions against companies for inaccessible websites under the theory that the company failed to comply with the “effective communication” requirement of Title III of the ADA. In addition, over the past eight to ten years, private litigation alleging that business digital assets are inaccessible has proliferated. Plaintiffs’ attorneys frequently allege violations of both the ADA and corollary state laws, which often permit damages—unlike the ADA, which only permits injunctive relief.
As previously noted, in addition to the DOJ citing the WCAG, an international, voluntary technical standard, in some of its consent orders,[5] court orders and settlements have cited the WCAG standard.[6] As a result, companies have increasingly relied on the WCAG standard to make digital assets accessible. The current WCAG standard is 2.2, and that standard continues to evolve every few years, with WCAG 3.0 on the horizon.[7] Most companies seek to comply with the intermediate conformance criteria AA, known as Level AA, although some companies are still complying with the prior version, WCAG 2.1 AA.
DOJ ADA Guidance and Enforcement Under Different Administrations
The DOJ has sought to enforce website accessibility under Title III of the ADA during Democratic administrations, and the agency was fairly active during the Biden era. Specifically, in 2022, the DOJ issued guidance on making websites accessible.[8] However, the guidance did not contain any technical standard for accessibility, and it did not break any new ground in providing useful guidance for companies. Then, in 2024, the DOJ issued final regulations containing accessibility requirements for websites and mobile applications of state and local governments under Title II of the ADA, which cite WCAG 2.1 AA as the required technical standard.[9] While experts expected that the DOJ likely would use the Title II rulemaking as a model for amending the agency’s Title III regulations to similarly specify WCAG 2.1 AA as the required technical accessibility standard for public accommodations, the Biden administration ran out of time to pursue that initiative.
In the current political environment, we do not expect the DOJ to amend its Title III regulations during the next four years. Furthermore, we do not expect much enforcement activity from the DOJ under Title III since enforcement of civil rights laws, such as the ADA, has been deprioritized by the current administration. Unfortunately, the lack of enforcement by the DOJ will continue to perpetuate and increase private litigation risk for businesses.
Litigation Risk
Of the top one million home pages on the internet, 95 percent have accessibility barriers that interfere with the ability of people with disabilities to use them, according to a 2025 report by WebAIM.[10] These barriers have spawned a flood of litigation under Title III of the ADA since 2016, with nearly 2,500 federal lawsuits being filed across the United States in 2024, according to law firm Seyfarth Shaw.[11] Based on the pace of filings this year, 2025 appears likely to top that number by nearly 20 percent, with 2,019 lawsuits already filed during the first half of 2025, according to UsableNet.[12] Most cases are filed in New York and Florida, where plaintiffs can receive damages. California, where damages are also available, saw fewer federal lawsuits in 2024. But federal lawsuits were also filed in Illinois, Minnesota, and Pennsylvania. Plaintiffs also are filing more frequently in state courts, rather than federal courts, because state laws often permit damages, unlike the ADA, which only permits injunctive relief. In addition to websites, more cases are challenging the inaccessibility of mobile applications.
The main legal issue arising in litigation is whether online-only businesses without a physical “place of public accommodation” (i.e., a brick-and-mortar location) are covered by Title III of the ADA. Only the U.S. Court of Appeals for the Ninth Circuit has directly addressed the issue, finding that businesses’ websites are covered if they have a “nexus” with a physical place. But other circuits have foreshadowed their approaches, with the U.S. Court of Appeals for the First, Second, and Seventh Circuits indicating that Title III may cover the websites of online-only businesses, and the U.S. Court of Appeals for the Third and Sixth Circuits indicating that Title III only covers the websites of businesses with a nexus to a physical place.
There has been some question about which technical accessibility standard meets the “effective communication” obligation under Title III of the ADA. Courts, the DOJ, and other federal agencies have variously applied the WCAG 2.0 or 2.1 AA standard. As previously noted, in 2024, the DOJ released new regulations under Title II of the ADA, which require state and local governments to ensure that their websites comply with WCAG 2.1 AA. Courts in Title III cases may apply the same standard to business websites.
While most accessibility cases begin with a demand letter, some plaintiffs choose to go straight to court by filing a complaint. Some cases are styled as class actions, including nationwide class actions, which may be subject to the U.S. Supreme Court’s recent decision in Trump v. CASA casting doubt on the ability of lower courts to issue nationwide injunctions.[13] The vast majority of cases result in settlements, often with the company agreeing to make its website and mobile application accessible within a certain period of time and paying the plaintiff’s attorney fees and damages.
Because businesses with inaccessible websites have few defenses and paying a relatively small amount to a plaintiff is much less costly than paying to defend the lawsuit (and potentially the plaintiff’s lawyers if the business loses), very few cases go to trial. The one defense that has been successful in a few cases is the assertion that the plaintiff does not have standing to challenge the inaccessibility of the website because they are ineligible to access the business, cannot demonstrate that the alleged barriers actually interfered with their use of the site, or cannot show that they intend to visit the website in the future.
Potential Federal Legislative Solutions
Over the past eight years, members of Congress have introduced multiple bills to address how businesses can fix accessibility barriers under Title III of the ADA without immediately being sued.
Notice and Opportunity to Cure Legislation
Several of the bills have created procedural steps for plaintiffs, such as providing notice to a business of the alleged accessibility issues and allowing time for the business to remediate those deficiencies before litigation can proceed, as a means of providing a “safe harbor” for businesses from litigation. This “notice and opportunity to cure” legislative model has been framed by bill sponsors and advocates as a potential way to encourage efficient and timely resolution by businesses of accessibility barriers while minimizing lawsuits. On the other hand, disability rights organizations have raised concerns that delaying enforcement could result in prolonged barriers for people with disabilities. However, bills containing the “notice and opportunity to cure” approach have not gained sufficient bipartisan support to proceed to a floor vote in previous sessions of Congress.
The Latest Federal Legislation: A National Digital Accessibility Standard
On May 14, 2025, Representative Pete Sessions (R-TX) introduced H.R. 3417, the Websites and Software Applications Accessibility Act of 2025, bipartisan legislation that seeks to establish uniform federal accessibility standards for websites and software applications.[14] Supported by the National Federation of the Blind and other disability rights advocacy organizations, this bill aims to clarify digital accessibility standards for a wide range of entities, including employers, public accommodations, and commercial providers. Key features of the bill include:
affirming that digital spaces, whether or not tied to physical locations, are covered under Title III of the ADA;
directing the DOJ and the Equal Employment Opportunity Commission to develop specific, enforceable accessibility standards for websites and mobile applications (each federal agency must issue proposed rules within twelve months and final rules in twenty-four months; those federal agencies must then update the rules every three years to reflect evolving technology); and
creating a framework for supporting small businesses through technical assistance and grant opportunities.
The primary emphasis of H.R. 3417 is on setting clear, enforceable standards to improve digital access for individuals with disabilities. The bill does not include provisions for a “notice and opportunity to cure” process or similar business-focused litigation protections, but instead permits individuals with disabilities to continue to file lawsuits against companies with inaccessible digital assets. While the introduction of H.R. 3417, if enacted, would mark a significant step toward national digital accessibility standards, the rulemaking process takes time, and it does not contain a safe harbor from litigation for businesses in the interim.
The Path Forward
Digital accessibility is widely recognized as a civil rights issue, and the evolving legislative landscape reflects ongoing efforts to balance accessibility, provide clarity concerning technical accessibility requirements, and ensure compliance with Title III of the ADA.
Regardless of the outcome for H.R. 3417 or other federal legislation, prioritizing inclusive digital design and following recognized standards such as WCAG remain best practices for businesses seeking to provide equitable digital experiences and reduce legal risk.
Best Practices for Digital Accessibility Risk Management
Despite the increasing risk of litigation, there are many steps that businesses can—and should—take now to make their websites and mobile applications fully accessible to individuals with disabilities, as well as to mitigate the risk of receiving a demand letter or lawsuit. Best practices to mitigate accessibility legal risks include the following:
Ensure that digital assets are accessible through inclusive design and remediation. Businesses should build new websites or mobile applications by integrating appropriate programming code into the site/application that conforms with WCAG 2.2 AA to ensure accessibility. For existing websites and mobile applications, businesses should ensure that such digital assets are fully accessible to individuals with disabilities by hiring a qualified website accessibility consulting company to conduct an assessment. Reputable accessibility consultants use a three-prong approach consisting of an automated scan, review of programming code, and user testing by individuals with disabilities. If accessibility deficiencies are found, then they should be remediated to conform to the WCAG 2.2 AA standard. After digital assets are remediated, a monitoring routine should be implemented to ensure that accessibility is maintained—typically through the purchase of monitoring software.
Develop an ADA risk management program. A comprehensive ADA risk management program is necessary for effectively managing Title III compliance risks and can serve as an affirmative defense if a company is sued. Key elements of an ADA risk management program to consider implementing include the following:
Post an accessibility statement on digital assets underscoring the business’s commitment to accessibility and providing appropriate contact information (e.g., 800 number and email address) where individuals with disabilities can seek assistance with technical barriers.
Develop and implement a digital assets compliance policy.
Appoint an accessibility coordinator to oversee digital asset accessibility compliance efforts across the business.
Establish a cross-functional committee, led by the accessibility coordinator, to coordinate accessibility efforts across the business. Accessibility committee members should include legal, compliance, marketing, product, and technology staff, at a minimum.
Ensure that employees receive appropriate training:
Provide technical training to developer staff to ensure that they understand how to properly code to ensure accessibility and remediate accessibility issues when identified.
Provide substantive compliance training on Title III of the ADA to legal and compliance, marketing, product, and technology staff.
Train customer service agents to identify key terms and promptly respond to individuals with disabilities’ requests for technical assistance when encountering barriers on websites or mobile applications.
Develop and implement procedures to ensure consistency in customer service processes for individuals with disabilities and provide warm handoffs to technical staff who can assist with any digital barriers that such individuals may encounter.
As a side note, we do not recommend using a widget or overlay to achieve compliance with Title III of the ADA. Widgets and overlays have become popular in recent years as a “quick fix” because they create an alternative, seemingly accessible version of a website and are relatively inexpensive. In our view, these tools do not comply with the letter or spirit of Title III of the ADA because they create a “separate but equal” experience for individuals with disabilities. Moreover, these tools do not correct code-level accessibility deficiencies and often create barriers with screen readers used by the blind. As a result, approximately 25 percent of lawsuits in 2024 were brought against companies that used widgets and overlays.[15] Therefore, these types of tools often fall short of delivering true digital accessibility.[16] Simply put, there is no “silver bullet” to avoid doing the hard work of evaluating the accessibility of websites and mobile applications, remediating any deficiencies, and then maintaining accessible digital assets to achieve compliance with Title III of the ADA and corollary state laws.
Doing the Right Thing—Legally and for Business Growth
While it is important for companies that offer goods and services to the public to comply with accessibility requirements under Title III of the ADA and reduce legal risk, it is even more important for businesses to do the right thing for individuals with disabilities by making digital assets fully accessible to them. Plus, it makes good business sense. According to the U.S. Centers for Disease Control and Prevention, 28.7 percent of adults, or more than one in four, in the United States have some type of disability.[17] That translates to approximately 70 million adults who have disabilities. Therefore, when digital assets are inaccessible, over one-quarter of U.S. consumers, who could be potential customers, are excluded from access to a business’s goods and services.
This article is related to a CLE program that took place during the ABA Business Law Section’s 2025 Spring Meeting. To learn more about this topic, listen to a recording of the program, free for members.
42 U.S.C. § 12101 et seq. Other titles of the ADA include Title I, which prohibits discrimination in employment and is enforced by the Equal Employment Opportunity Commission. Title II applies to state and local government entities, and it protects qualified individuals with disabilities from discrimination on the basis of disability in services, programs, and activities provided by state and local governments. ↑
Payan v. L.A. Cmty. Coll. Dist., No. 2:17-cv-01697-SVW-SK (C.D. Cal. Feb. 29, 2024), ECF No. 613 (order regarding final injunction) (citing WCAG 2.1 Level AA); Andrews v. Blick Art Materials, LLC, 286 F. Supp. 3d 365 (E.D.N.Y. 2017) (citing WCAG 2.0 Level AA); Gil v. Winn-Dixie Stores, Inc., 257 F. Supp. 3d 1340 (S.D. Fla. 2017) (citing WCAG 2.0) (vacated on other grounds). ↑
The first public working draft of WCAG 3.0 was released on January 21, 2021. According to the Worldwide Web Consortium (“W3C”), which promulgates the WCAG standards, WCAG 3.0 remains in working draft form, and a release date has not yet been set. Therefore, W3C’s issuance of WCAG 3.0 is likely still several years away. ↑
Nondiscrimination on the Basis of Disability; Accessibility of Web Information and Services of State and Local Government Entities, 89 Fed. Reg. 31,320 (June 24, 2024) (U.S. Dep’t of Just. Final Rule). ↑
Jason Taylor, Usablenet, 2025 Midyear Digital Accessibility Lawsuit Report (July 9, 2025). The report covers all cases filed across the eleven federal circuit courts under Title III of the ADA, as well as cases filed in key state courts, including California, Florida, and New York. ↑
H.R. 3417 is cosponsored by Representatives Steny Hoyer (D-MD), Darren Soto (D-FL), Randy Weber Sr. (R-TX), Shri Thanedar (D-MI), and Greg Landsman (D-OH). ↑
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
§ I. Patent Cases
LKQ Corp. v. GM Global Tech. Ops. LLC, 102 F.4th 1280 (Fed. Cir. 2024)
Facts: This case addresses the standard for determining the obviousness for design patents.
LKQ Corporation challenged the validity of GM Global Technology Operations LLC’s design patent for a vehicle part, asserting that the patent was obvious under 35 U.S.C. § 103. The Patent Trial and Appeal Board (PTAB) upheld the patent’s validity, applying the Rosen-Durling test, which requires using a primary reference that is “basically the same” as the claimed design to establish obviousness as the start of the obviousness analysis. LKQ appealed, arguing that the Rosen-Durling test was incompatible with the Supreme Court’s flexible approach to obviousness set forth in KSR Int’l Co. v. Teleflex Inc., 550 U.S. 398 (2007).
Held: Sitting en banc, the Federal Circuit overruled the Rosen-Durling test and adopted “a more flexible” approach for assessing design patent obviousness.
Reasoning: The Federal Circuit concluded that the Rosen-Durling test was at odds with 35 U.S.C. § 103’s “broad and flexible standard” and the Supreme Court’s precedent in KSR and Graham that provide “a more flexible approach” when determining obviousness. The court noted that the Rosen-Durling framework imposed unnecessary constraints by requiring a primary reference that is “basically the same” as the claimed design, potentially overlooking the broader context of the prior art.
The Federal Circuit determined that the framework for assessing obviousness in utility patents, as articulated in Graham v. John Deere Co., 383 U.S. 1 (1966), was equally applicable to design patents. The Federal Circuit then provided guidance for applying the Graham factors to design patents.
First, one “consider[s] the ‘scope and content of the prior art’ within the knowledge of an ordinary designer in the field of the design.” The Federal Circuit affirmed that for design patents, as for utility patents, a “reference qualifies as prior art for an obviousness determination only when it is analogous to the claimed invention.” However, the court declined to “delineate the full and precise contours of the analogous art test for design patents.” The court stated that “[p]rior art designs for the same field of endeavor as the article of manufacture will be analogous,” but did “not foreclose that other art could also be analogous.”
Second, one “determin[es] the differences between the prior art designs and the design claim at issue.” The Federal Circuit’s approach “casts aside a threshold ‘similarity’ requirement.” Instead, one “compare[s] the visual appearance of the claimed design with prior art designs . . . from the perspective of an ordinary designer in the field of the article of manufacture.”
Third, one determines “the level of ordinary skill in the pertinent art.” Fourth, as with utility patents, secondary considerations of non-obviousness, such as commercial success, industry praise, and copying, should also be evaluated.
The Federal Circuit reaffirmed that the obviousness analysis for design patents “focuses on the visual impression of the claimed design as a whole and not on selected individual features.” The court stated that “[t]he primary and secondary references need not be ‘so related’ such that features in one would suggest application of those features in the other, but they must both be analogous art to the patented design.” Finally, the court explained that “the motivation to combine these references need not come from the references themselves.”
Brumfield v. IBG LLC, 97 F.4th 854 (Fed. Cir. 2024)
Facts: This case addresses the potential for recovering damages based on foreign sales in U.S. patent infringement cases.
Brumfield sued IBG LLC for patent infringement related to software user interfaces used in commodity trading. At trial, Brumfield’s expert testified that royalties from IBG’s foreign sales were included in the damages calculation because these sales were a direct result of IBG’s domestic infringing activities. The district court excluded this testimony, agreeing with IBG that foreign sales were beyond the scope of recoverable damages under U.S. patent law. Brumfield appealed to the Federal Circuit.
Held: The Federal Circuit held that damages for foreign sales were not recoverable in this case because Brumfield had not identified a sufficient causal link to domestic infringement.
Reasoning: The Federal Circuit relied heavily on the Supreme Court’s reasoning in WesternGeco LLC v. ION Geophysical Corp., 585 U.S. 407 (2018), which allowed the recovery of lost profits for foreign sales stemming from domestic acts of infringement under 35 U.S.C. § 271(f)(2). Although WesternGeco specifically addressed lost profits and a statutory provision targeting components supplied abroad, the Federal Circuit found the case instructive for reasonable royalty damages for infringement under § 271(a). The Federal Circuit emphasized that the territoriality principle of U.S. patent law does not categorically preclude consideration of foreign sales if those sales are tied to domestic infringing activity.
The court explained that the patentee can show entitlement to damages for foreign conduct when the patentee establishes a “causal” connection between the foreign conduct and domestic infringement. To increase reasonable-royalty damages based on foreign, non-infringing conduct, the patentee must, at a minimum, show why that “foreign conduct increases the value of the domestic infringement itself.”
To attempt to establish such a causal connection between the foreign conduct and domestic infringement, Brumfield argued that IBG’s foreign sales of the accused software were directly enabled by allegedly infringing acts of designing, testing, and developing software in the U.S. However, the Federal Circuit found that the relevant patent claims were not directed to software. Rather, the claims were directed to the tangible computer readable medium (such as a flash drive) to which the software is encoded. Therefore, the Federal Circuit found that IBG’s designing, testing, and developing software in the U.S. were not acts of infringement, and, thus, were legally insufficient to establish the necessary causal connection to support damages calculations based on foreign conduct. Thus, the Federal Circuit affirmed the district court’s exclusion of IBG’s foreign sales from a calculation of damages.
EcoFactor, Inc. v. Google LLC, 104 F.4th 243 (Fed. Cir. 2024)
Facts: This case concerns the reliability and admissibility of expert testimony regarding patent damages. It is an important case to watch, as the Federal Circuit recently granted Google’s petition for rehearing en banc and vacated the panel decision, meaning that the full Federal Circuit will rehear the case and possibly reach a different result or use different reasoning than the panel decision discussed below.
Patent owner EcoFactor sued Google for patent infringement over Google’s smart thermostat products. At trial, the jury found that Google infringed and awarded EcoFactor damages.
EcoFactor’s damages expert, Mr. Kennedy, used a standard hypothetical negotiation approach for calculating reasonable royalty damages, where he analyzed the effect of three license agreements EcoFactor previously entered into with third-party smart thermostat manufacturers. Each of those prior agreements stated that the licensee would pay EcoFactor a lump sum amount “based on what EcoFactor believes is a reasonable royalty calculation of [$X] per-unit.” (The amount of the per-unit royalty is redacted from the opinion because it is confidential business information under a protective order.)
Google moved for a new trial on damages, arguing that Kennedy’s damages opinion should have been excluded from trial for being speculative and unreliable. The district court denied the motion. Google appealed to the Federal Circuit.
Held: Prior license agreements containing a lump sum payment “based on” a royalty rate may provide evidence of a reasonable royalty rate.
Reasoning: The Federal Circuit panel—affirming the district court’s decision to deny Google’s motion for a new damages trial—explained that while all damages approximations involve some degree of uncertainty, the admissibility inquiry centers on whether the methodology employed is reliable.
Google first argued that Kennedy’s proposed royalty rate was “plucked . . . out of nowhere.” The Federal Circuit panel disagreed, finding that Kennedy adequately based his proposed royalty rate on (1) the three existing license agreements and (2) the testimony of EcoFactor’s CEO that the lump sum in each of those three license agreements had been calculated using the $X royalty rate.
Google also argued that Kennedy’s damages testimony should have been excluded because the three licenses were not comparable to the hypothetically negotiated agreement between Google and EcoFactor. According to Google, the three license agreements were for EcoFactor’s entire patent portfolio, whereas EcoFactor asserted only one patent against Google. However, the Federal Circuit panel found that Kennedy accounted for such differences. Kennedy acknowledged at trial that Google would argue that the three license agreements included EcoFactor’s entire patent portfolio, and thus the $X royalty rate should be decreased. But Kennedy then explained another factor would have put upward pressure on the hypothetically negotiated rate. Specifically, while each of the three license agreements were settlements whose royalty rate reflected a risk that EcoFactor’s patents would be found not infringed or invalid, the hypothetical negotiation assumes that the asserted patent was infringed and valid. The Federal Circuit panel explained that the precise degree of comparability was a factual issue left for the jury—not a question of admissibility.
Dissent: Judge Prost dissented in part, specifically dissenting from the decision to affirm the district court’s denial of Google’s motion for a new trial. Judge Prost reasoned that the $X royalty rate rests on EcoFactor’s “self-serving” recitals in the three prior license agreements, Kennedy’s analysis is unreliable, and the $X royalty rate has no basis in the record and includes the value of unasserted patents.
Contour IP Holding LLC v. GoPro, Inc., 113 F.4th 1373 (Fed. Cir. 2024)
Facts: The Supreme Court has held that abstract ideas, natural laws, and phenomena of nature are ineligible for patenting under 35 U.S.C. § 101. This case applies the Supreme Court’s test in Alice Corp. Pty. v. CLS Bank Int’l, 573 U.S. 208 (2014) to determine whether the patent claims at issue recite merely a patent-ineligible abstract idea.
Contour sued GoPro, accusing several of GoPro’s point-of-view (“POV”) digital video cameras of infringing Contour’s patents. The asserted patents disclose a hands-free, POV video camera “configured for remote image acquisition control and viewing.” The patent specification explains that often in sports applications, such as skiing, a POV camera is “mounted in a location that does not permit the user to easily see the camera.” In these instances, the user is unable to review what is being recorded in real time or adjust recording settings, such as light level and audio settings. To address these problems, the patents describe implementing wireless technology in the POV camera that allows the camera to send real time information to a remote device, such as a cell phone. From this remote device, the user can see what is being recorded by the camera and make real time adjustments to the recording settings.
The patent specifications describe an example of the asserted claims called the “dual recording” embodiment. In that example, the patents disclose that the camera is configured to generate video recordings “in two formats, high quality and low quality, in which the lower quality file is streamed” to the remote device. This system achieves real time playback on the remote device without exceeding wireless connection bandwidth, while the higher quality version of the recording is saved on the camera for later viewing.
GoPro argued on summary judgment that the asserted claims were patent ineligible under Section 101 because they claim an abstract idea. The district court agreed with GoPro. In the first step of the Alice test, the court found that the representative claim was directed to the abstract idea of “creating and transmitting video (at two different resolutions) and adjusting the videos’ settings remotely.” In the second step, the court concluded that the claim recited only functional, results-oriented language with no indication that the physical components behave in any way other than their basic, generic tasks. Contour appealed to the Federal Circuit.
Held: Contour’s claims are patent eligible under Section 101 because the patent specification describes improving technology through specific technological means and the claims reflect that improvement.
Reasoning: Applying step one of the Alice test, the Federal Circuit characterized the scope of the asserted claims as “an improved POV camera.” The Federal Circuit explained that the asserted claims “require specific, technological means—parallel data stream recording with the low-quality recording wirelessly transferred to a remote device—that in turn provide a technological improvement to the real time viewing capabilities of a POV camera’s recordings on a remote device.”
The Federal Circuit explained that the district court’s Alice analysis “characterizes the claims at an impermissibly high level of generality.” This “generalized articulation” of the claims “all but ensured the incorrect conclusion that the claims were drawn to an abstract idea.” For example, the Federal Circuit rejected GoPro’s argument that Contour’s claims “are simply directed to the abstract idea of wireless network communication.” Instead, the claims enable the claimed POV camera to “operate differently than it otherwise could.”
The Federal Circuit also rejected GoPro’s argument that the claims “simply employ known or conventional components that existed in the prior art at the time of the invention.” Rather, the “dual embodiment” claimed by Contour was not “a long-known or fundamental practice supporting patent ineligibility.”
Because it concluded at Alice step one that the claims “are directed to a technological solution to a technological problem,” the Federal Circuit found that the claims are patent-eligible without needing to proceed to the second step of the Alice test.
Allergan USA, Inc. v. MSN Labs. Private Ltd., 111 F.4th 1358 (Fed. Cir. 2024)
Background: Patent applicants can file patent applications that have the same specification as, and claim priority to the filing date of, an earlier patent application. An earlier application to which a later application claims priority is called a parent and the later application is called a child. In prior cases, the courts developed a legal doctrine called “obviousness-type double patenting” to restrict patent applicants from extending their patent protection by obtaining obvious variants of patent claims in different patents with different expiration dates. Patent term adjustment extends the expiration date of a patent under certain circumstances when examination of the patent was delayed.
Facts: This case concerns whether obviousness-type double patenting can invalidate a first-filed, first-issued patent that expires earlier than a child patent due to patent term adjustment.
In 2019, Sun Pharmaceutical Industries (Sun) submitted an Abbreviated New Drug Application (ANDA) seeking FDA approval to market and sell a generic version of Viberzi®. Allergan then sued Sun, alleging that the filing of Sun’s ANDA directly infringed one of Allergan’s patents, which had over 1,000 days added to its expiration date because of patent term adjustment. While the litigation was pending, the Patent Office issued new patents that were continuation patent applications of the issued patent (child patents). Sun argued that the later-expiring parent patent was invalid for obviousness-type double patenting over the child patents. The district court found the parent patent invalid for obviousness-type double patenting. The district court concluded that the later expiration date from the patent term adjustment led to an unjust extension of patent term, violating the principles of obviousness-type double patenting. Allergan appealed.
Held: A first-filed, first-issued, later-expiring patent claim cannot be invalidated for obvious-type double patenting based on a later-filed, later-issued, earlier-expiring child patent when the patents share a common priority date.
Reasoning: The Federal Circuit explained that the purpose of obviousness-type double patenting is to prevent patentees from obtaining a second patent on a patentably indistinct invention to effectively extend the life of a first patent to that subject matter. The court further explained that the parent patent, in this case, is undoubtedly the first patent, whether measured by filing date or issuance date. Thus, the patent-term-adjusted term of the parent patent does not implicate obviousness-type double patenting because the parent patent is not a “second, later expiring patent for the same invention.”
The Federal Circuit noted the parent patent defined the initial scope of exclusivity for the invention, and the child patents derived from the same original application but were filed later. The Federal Circuit explained that the parent patent cannot be invalidated by the child patents merely because the parent patent had a longer term due to patent term adjustment. Invalidating earlier-filed patents in this scenario would undermine the purpose of patent term adjustment, which is to compensate for delays in patent prosecution, and would create an unjust scenario where a patent owner would lose the benefit of a duly awarded extension.
The Federal Circuit distinguished a prior case that held that a later-issued but earlier-expiring patent can qualify as an obviousness-type double patenting reference to invalidate an earlier-issued but later-expiring patent. The Federal Circuit explained that the case focused on issuance dates, not filing dates. In the earlier case, the challenged claims of the asserted patent were filed after, claimed a later priority date than, and expired after the reference claims, which resulted in an unwarranted extension of patent term for an invention that had already been the subject of an earlier-filed, earlier-expiring claim. In contrast, Allergan’s asserted claim was filed before, shared a priority date with, and issued before the reference claims of the patents asserted for obviousness-type double patenting. Thus, because Allergan’s asserted patent was the first patent in its family to be filed and to issue, it did not extend any period of exclusivity on the claimed subject matter.
Accordingly, the Federal Circuit reversed the district court’s finding of obviousness-type double patenting.
Facts: This case relates to the printed matter doctrine, under which a patent claim limitation is not afforded patentable weight when it claims the contents of information.
Ingenico filed petitions for inter partes review at the patent office challenging the validity of many claims in three of IOENGINE’s patents. Ingenico argued that several claim limitations requiring “encrypted communications” and “program code” were entitled to no patentable weight under the printed matter doctrine. The Board agreed with Ingenico, finding that these limitations were subject to the printed matter doctrine because they claimed the content of information being communicated. The Board relied on this finding to determine that claims reciting these limitations were anticipated by prior art. IOENGINE appealed.
Held: Claim limitations requiring encrypted communications or download of program code are not subject to the printed matter doctrine because they are directed to the act of communication itself, not the content of the communication.
Reasoning: The Federal Circuit applied a two-step test for whether the claim limitations at issue should be accorded patentable weight under the printed matter doctrine. The first step is determining whether a claim limitation is directed to printed matter. If the first step is not satisfied, the inquiry ends there. Only if the first step is satisfied should a court proceed to step two and consider whether the printed matter should nevertheless be afforded patentable weight.
The Federal Circuit first looked to whether the limitation reciting the “transmission of encrypted communications” claimed printed matter. The printed matter doctrine is implicated when a limitation “claims the content of information.” The Federal Circuit explained the “fact there is a communication itself is not content; content is what the communication actually says.” The Federal Circuit further explained that the form of communication, such as whether the communication is encrypted, is not content. The Federal Circuit concluded that the “transmission of encrypted communications” limitations did not claim the content of the communication, and, thus, were not directed to printed matter.
The Federal Circuit then analyzed the limitations reciting the download of “program code.” Similarly, the Federal Circuit reasoned these limitations claimed the act of communication itself, not the content of what is communicated in the program code. Thus, the “program code” limitations were not directed to printed matter.
Because the limitations reciting “encrypted communications” and “program code” were not “claimed . . . for the content they communicate, they are not printed matter.” Accordingly, the Federal Circuit did not need to proceed to the second step. Because Ingenico’s only ground of invalidity relied on their printed-matter argument, the Court reversed the Board’s invalidity determination as to the claims at issue.
Facts: This case contrasts a 35 U.S.C. § 102(b)(2)(B) public disclosureby the inventor, which prevents some later disclosures of the same subject matter from being treated as prior art to invalidate a patent claim, from a 35 U.S.C. § 102(a)(1) public use, which generally is prior art.
Kaijet petitioned for inter partes review challenging claims of a patent owned by Sanho on grounds that the claims were obvious. Each obviousness combination included a U.S. patent application publication known as Kuo, which had an effective filing date before the Sanho patent.
Before the effective filing date of the Kuo reference, the inventor of the challenged patent had offered to sell a “HyperDrive” device to Sanho’s owner. Shortly thereafter, an agreement was reached to sell 15,000 HyperDrive devices to Sanho, but no sale was completed before the Kuo reference’s effective filing date. Sanho argued that, because the HyperDrive device embodied the invention of the challenged patent, it should qualify as a disclosure by the inventor under Section 102(b)(2)(B) thereby disqualifying the Kuo reference as prior art. The Board disagreed, holding that the sale was not a Section 102(b)(2)(B) public disclosure. Accordingly, the Board found all challenged claims invalid as obvious. Sanho appealed to the Federal Circuit.
Held: An invention is not “publicly disclosed” under 35 U.S.C. § 102(b)(2)(B) by the inventor’s private sale, even though a third party’s private sale may constitute an invalidating “public use” under 35 U.S.C. § 102(a)(1).
Reasoning: The Federal Circuit explained that placing a device that embodies an invention on sale does not necessarily publicly disclose the invention under Section 102(b)(2)(B). First, the Federal Circuit looked to the language of the relevant statute. The court reasoned that the distinct use of “disclosed” in one section and “publicly disclosed” in another “suggests that Congress intended the phrases to have different meanings” and that the narrower term, “publicly disclosed” should encompass a “narrower subset of ‘disclosures.’”
Second, the Federal Circuit looked to the purpose of the exception provided in Section 102(b)(2)(B). The court explained the purpose of this section is to protect an inventor “who discloses his invention to the public before filing a patent application” by making it available to the public. The exception is not intended to protect an inventor who, to the contrary, keeps the invention private. Sanho’s proposed interpretation that a private sale falls within this exception runs contrary to the “purposes of the statutory scheme” and is inconsistent with reading the statute “as a whole.”
The Federal Circuit then briefly turned to the legislative history which further supported that “‘public disclosure’ requires that the invention be made available to the public.”
Lastly, the Federal Circuit addressed Sanho’s argument that “‘publicly disclosed’ incorporates earlier judicial interpretation of the word ‘public’ in the context of invalidating ‘public use.’” The court reasoned that no evidence supports that Congress intended such an interpretation. Moreover, the distinct terms “publicly disclosed” and “public use” are found in distinct sections that “serve fundamentally different purposes.” Thus, although public disclosure could result from public use, the two are not equivalent.
Applying its reasoning to the facts of this case, the Court held that the sale of HyperDrive devices “did not ‘publicly disclose’ the relevant subject matter.” Rather, the sale constituted only a private sale to Sanho and “there was no teaching of the features of the invention to others beyond Sanho.” Therefore, the Federal Circuit affirmed the Board’s finding that Kuo is prior art and that the challenged claims would have been obvious.
§ II. Copyright Cases
Warner Chappell Music, Inc. v. Nealy, 601 U.S. 366 (2024)
Facts: This case resolves a circuit split regarding time limitations on monetary recovery for copyright infringement claims under the Copyright Act.
In 2018, plaintiff and copyright holder Nealy sued Warner Chappell for copyright infringement, claiming infringing activity dated back to 2008—ten years before he sued.
The Copyright Act’s statute of limitations provides that a copyright owner must bring an infringement claim within three years of its accrual. See 17 U.S.C. § 507(b). Thus, to show that his claims were timely, Nealy invoked the “discovery rule,” under which a claim accrues when the plaintiff discovers, or with due diligence, should have discovered, the infringing activity.
In the District Court, Warner Chappell accepted that the discovery rule governed the timeliness issue but argued that Nealy could only recover damages for infringing acts occurring in the last three years. The District Court agreed with Warner Chappell, relying on a Second Circuit case limiting monetary relief to three years prior to filing. The Eleventh Circuit reversed, rejecting the notion of a three-year damages bar on a timely claim.
Held: In a 6–3 decision, the Supreme Court held that the Copyright Act entitles a copyright owner to obtain monetary relief for any timely infringement claim, regardless of when the infringement occurred. For purposes of its decision, the Court assumed the discovery rule applied because Warner Chappell had not challenged the rule’s applicability. The majority declined to decide whether the discovery rule applies to copyright infringement claims generally.
Reasoning: The majority first analyzed the text of the Copyright Act. Finding that the Act’s remedial sections do not provide a time limit on monetary recovery, the majority held that a copyright owner possessing a timely claim is entitled to damages, no matter when the infringement occurred.
The majority next distinguished the Supreme Court’s earlier decision in Petrella v. Metro-Goldwyn-Mayer, Inc., 572 U.S. 663 (2014), which stated that the Copyright Act’s statute of limitations allows plaintiffs “to gain retrospective relief running only three years back from” the filing of suit. Id. at 672. However, in Petrella, the plaintiff had long known of the defendant’s infringement, and, thus, could not have relied on the discovery rule. Thus, the plaintiff in Petrella could not recover for infringements occurring more than three years prior because her claims were untimely, rather than due to a statutory bar.
Dissent: Justice Gorsuch dissented, joined by Justices Thomas and Alito. The dissent criticized the majority for “sidestep[ping] the logically antecedent question” of whether application of the discovery rule is proper. The dissent reasoned that traditionally, discovery rules were only applicable in cases of fraud or concealment, and thus should not be applied to run-of-the-mill copyright cases.
Philpot v. Independent Journal Review, 92 F.4th 252 (4th Cir. 2024); Griner v. King, 104 F.4th 1 (8th Cir. 2024); Hachette Book Grp., Inc. v. Internet Archive, 115 F.4th 163 (2d Cir. 2024); Keck v. Mix Creative Learning Ctr., LLC, 116 F.4th 448 (5th Cir. 2024)
Facts: In these cases, four different circuit courts apply the Supreme Court’s 2023 decision in Andy Warhol Foundation for the Visual Arts, Inc. v. Goldsmith, 598 U.S. 508 (2023) regarding transformative use, a component of fair use.
The plaintiffs in each case are copyright holders suing for unauthorized use of their copyrighted works. In Philpot, a photographer sued a news website for using his photograph of a famous musician in an online article. In Griner, the owner of an internet meme template photograph sued a former congressman’s campaign committee for posting a version of the meme on a campaign website and social media. In Hachette, book publishers sued a nonprofit digital library, challenging the library’s practice of scanning print copies of publishers’ books to create digital copies and lending those digital copies to users. In Keck, an artist sued an art studio for using his artworks in art kits for children.
Held: In Philpot, Griner, and Hachette, the courts held that defendants’ uses were not transformative and were not fair uses. In Keck, the Fifth Circuit held that the studio’s use was transformative in nature and constituted fair use.
Reasoning: Each of the circuit courts examined whether defendants’ use of the copyrighted work was “transformative” in light of Warhol.
In Philpot, the Fourth Circuit likened defendant IJR’s use of a photo of famous musician Ted Nugent to the magazine’s use of Orange Prince in Warhol. Referring to the Supreme Court’s reasoning that “[a] typical use of a celebrity photograph is to accompany stories about the celebrity,” the Fourth Circuit noted that IJR had less of a case for “transformative use” than in Warhol because unlike the orange drubbing in Warhol, IJR did not alter the Nugent photo beyond cropping the negative space.
In Griner, the Eight Circuit found that the campaign committee’s use of the “Success Kid” meme photograph was a commercial use without a further purpose, different character, or compelling justification. The court rejected the campaign committee’s stated justification—that creating and disseminating a meme on social media is a common occurrence—as non-compelling, especially in light of the commercial nature of the use.
In Hachette, the Second Circuit found that the defendant’s practice of digitizing print copies of books to lend was not transformative, because the underlying purpose of making the works available was still the same. The court found that the “digital copies do not provide criticism, commentary, or information about the originals,” or “add something new, with a further purpose or different character.”
In contrast, in Keck, the Fifth Circuit found that defendant Mix Creative’s use of an artist’s dog-theme artworks was transformative. The court rejected Keck’s framing of the issue as “the online, e-commerce sales of Keck’s entire works.” Instead, the court found that Mix Creative used the artworks for an educational purpose that was significantly different than the original, decorative purpose of Keck’s works. Mix Creative’s kits included not just prints of the artworks, but also lesson plans, PowerPoint slides, and materials for students to create their own art, inspired by Keck’s. Thus, Mix Creative used the art for what it and the additional materials could teach students, rather than for its inherent expressive value.
In each case, the party that won on the “transformative use” factor won on the overarching issue of fair use.
§ III. Trademark Cases
Vidal v. Elster, 602 U.S. 286 (2024)
Facts: This case concerns the protections of the First Amendment and the registrability of a trademark in contravention of section 2(c) of the Lanham Act.
Applicant Elster sought to register TRUMP TOO SMALL for use on shirts and hats. Elster indicated that this mark stemmed from an exchange between Donald Trump and Senator Marco Rubio during the 2016 presidential primary debate and aims to “convey[] that some features of President Trump and his policies are diminutive.” The Examining Attorney refused the application on two grounds: under Section 2(c) of the Lanham Act which prohibits registration of a mark that “comprises a name . . . identifying a particular living individual” without the individual’s “written consent”; and Section 2(a) of the Lanham Act, which bars registration of trademarks that “falsely suggest a connection with persons, living or dead.” Elster appealed the refusal, asserting that the mark was political commentary, so refusal infringed on his First Amendment rights as content-based discrimination.
The Trademark Trial and Appeal Board (“Board”) affirmed the Examining Attorney’s refusal solely on Section 2(c). The Board noted the government’s compelling interest to protect the named individual’s rights of privacy and publicity. Elster appealed.
The Federal Circuit overturned the Board’s decision, holding that the refusal to register Elster’s TRUMP TOO SMALL mark under Section 2(c) violated the First Amendment, in that such a refusal restricted the expression of criticism of a public official in the mark’s content.
The United States petitioned the Supreme Court to hear the case, and the Supreme Court granted certiorari on June 5, 2023.
Held: The Supreme Court held unanimously that the USPTO did not violate the First Amendment when it refused registration to the TRUMP TOO SMALL mark because prohibiting the registration of a trademark which contains a living person’s name, without their consent, is not a viewpoint-based regulation.
Reasoning: While content-based regulation of speech is generally presumed to be unconstitutional, the Court had not previously decided whether heightened scrutiny would extend to a content-based but viewpoint-neutral restriction such as a trademark registration. Writing the principal opinion, Justice Thomas noted that the “names clause has deep roots in our legal tradition” and that the decision sought to uphold the tradition of preventing trademark applicants, through the trademark register, from effectively precluding individuals from using their own names in commerce.
The separate opinions, amidst the unanimous decision, showed less deference to historical tradition. Justice Kavanaugh and Chief Justice Roberts joined most of Thomas’s opinion, but Kavanaugh specified that both considered the viable possibility of “a viewpoint-neutral, content-based trademark restriction” being found constitutional “even absent such historical pedigree.”
Justice Barrett, joined in large part by Justices Jackson, Kagan, and Sotomayor, stressed the misguided nature of relying on history and tradition as the major context for the decision, posing that any free speech restrictions within the trademark registration system should be permissible if such restrictions “are reasonable in light of the trademark system’s purpose of facilitating source identification.”
Justice Sotomayor found that the names clause is permissible and constitutional because it merely places reasonable conditions on additional government benefits, which are conferred through a trademark registration, based on the content of the speech. Sotomayor noted that the USPTO’s refusal to register Elster’s mark did not prevent Elster from communicating his message or restrict his mode of expression, it only prevented him from “registering a mark asserting exclusive rights in another person’s name without their written consent.”
Crocs v. Effervescent, 119 F.4th 1 (Fed. Cir. 2024)
Facts: This case concerns whether claiming that an unpatented product feature is “patented,” “proprietary,” or “exclusive” violates Section 43(a)(1)(B) of the Lanham Act, which primarily involves protections against false advertising.
Crocs sued U.S.A. Dawgs, Inc. and several other competitor shoe distributors (collectively, “Dawgs”) for patent infringement. Dawgs filed a counterclaim against Crocs alleging false advertising violations of Section 43(a) of the Lanham Act. The counterclaim alleged that Crocs advertised its footwear products as being made of a “patented,” “proprietary,” and “exclusive” material called “Croslite” without possessing a patent directed to that material. Dawgs alleged that Crocs’ statements deceived consumers into believing that competitor footwear products were made of inferior material compared to Crocs’ products. Crocs moved for summary judgement that Dawgs’ counterclaim was legally barred, and the district court granted Crocs’ motion. The district court concluded that the terms “patented,” “proprietary,” and “exclusive” were claims of inventorship or authorship and not claims regarding the nature, characteristics, or qualities of products as required by Section 43(a)(1)(B) of the Lanham Act. Dawgs appealed.
Held: A party may violate Section 43(a)(1)(B) of the Lanham Act when it falsely claims that it possesses a patent on a product feature and advertises that product feature in a manner than causes consumers to be misled about the nature, characteristics, or qualities of its product.
Reasoning: The Federal Circuit distinguished Supreme Court and Federal Circuit case law that held that mere claims of authorship (such as claiming to be the creator of a product) or inventorship (such as claiming a product is “innovative”) do not violate Section 43(a)(1)(B). The Federal Circuit explained that a claim that a product feature is “patented” is not solely an expression of innovation, and, thus, authorship. The Federal Circuit further explained that Crocs’ promotional materials included statements that its purportedly patented features had numerous tangible benefits found in all of Crocs’ shoe products. Further, Dawgs alleged that Crocs’ statements referring to the advantages of its purportedly patented features caused “consumers to believe that Crocs’ molded footwear is made of a material that is different than any other footwear,” and, thus, deceived “consumers into believing that all other molded footwear . . . is made of inferior material compared to Crocs’ molded footwear.”
Accordingly, the Federal Circuit found that Dawgs had “timely presented a theory under Section 43(a)(1)(B) of the Lanham Act linking Crocs’ alleged misrepresentations in commercial advertisements to the nature, characteristics, or qualities of Crocs’ shoes.” Thus finding that the district court erred in granting summary judgment against Dawgs’ Lanham Act counterclaim, the Federal Circuit reversed and remanded for further proceedings.
On July 24, the Department of Justice (“DOJ”) and Federal Trade Commission (“FTC”) held the second of three listening sessions focused on competition in the pharmaceutical marketplace.
FTC Chair Andrew Ferguson began the session by noting the agency’s aggressive approach to combating anticompetitive practices related to pharmaceuticals. Specifically, he pointed to FTC warning letters sent to pharmaceutical companies disputing the propriety of more than two hundred patent listings in the Orange Book of the Food and Drug Administration (“FDA”). He also made clear that the agency plans to complete its 6(b) study of pharmacy benefit managers (“PBMs”), which should inform potential legislative and future enforcement actions aimed at combating anticompetitive conduct in the prescription drug markets. Finally, Chair Ferguson stated that incumbent PBMs and manufacturers appear to use government laws and regulations designed to promote competition and reduce costs to shield themselves from competition, resulting in higher costs for consumers.
The two panels then discussed various structural issues affecting competition, including increased consolidation, lack of transparency, and overlapping regulatory structures.
Panel 1: “Benefit and Formulary Practices and Regulations that Harm Drug Competition”
The first panel discussed business relationships among pharmaceutical manufacturers, PBMs, group purchasing organizations (“GPOs”), and health care payors.
Many panelists voiced concerns about the lack of transparency in PBM pricing and negotiations, noting how PBMs may be incentivized to favor products with higher list prices and higher rebates. One panelist discussed PBMs’ use of offshore GPOs, contending that the GPOs do not comply with industry standards. Another panelist suggested that pharmacy reimbursements should be tied to acquisition costs. The panelists generally encouraged increased transparency at all levels of the supply chain, especially at the PBM level, and favored pass-through pricing models.
The session also addressed growing vertical consolidation in the pharmaceutical supply chain, with a focus on the vertical integration of PBMs with insurers, administrative services organizations, and GPOs. In recent years, all three of the largest PBMs have integrated with major health care insurers, administrative services providers, and pharmacies. Some panelists expressed concern that vertically integrated healthcare entities may disadvantage industry rivals by steering business to their integrated PBMs and pharmacies through exclusive contracting. They suggested that such steering should subject vertically integrated entities to antitrust scrutiny. Further, panelists expressed concerns that GPOs “engage in predatory practices” by overcharging and underpaying generic manufacturers.
Panel 2: “Improper Orange Book Listings and Other Regulatory Abuse by Pharmaceutical Companies to Impede Competition”
The second panel focused on the Hatch-Waxman regulatory scheme and how pharmaceutical manufacturers may exploit a complex regulatory system to delay or deter competition. One panelist focused on improper Orange Book listings, a hot topic in recent litigation and a focus of the FTC. She explained how improperly listed patents can harm competition by subjecting generic companies to an automatic thirty-month stay of regulatory approval.
The panelists also discussed so-called “patent thickets”—dense groups of overlapping patents used to cover a single product—especially in the biologic space. While one panelist argued that patents are no more prevalent in life sciences than in other industries, another highlighted that those other industries are distinguishable because of cross-licensing, and focused on the expense and delay that arise when a brand enforces multiple nearly identical patents for the same product. That panelist highlighted current legislation that would allow brands to assert only one patent per terminally disclaimed group.
Some panelists also asserted that branded drug manufacturers improperly use citizen petitions to the FDA to attempt to delay or deter generic competition. They expressed that, while citizen petitions can constitute constitutionally protected speech, and may be appropriate to raise legitimate safety concerns, sham petitioning can delay generic competition and usurp FDA time that would otherwise be devoted to helping generic products reach the market.
Throughout the session, panelists reflected on the many overlapping regulatory schemes and responsible agencies that govern pharmaceutical patenting, approval, and competition, and how manufacturers may be able to exploit areas of overlap due to knowledge gaps among agencies. They noted that, given the wealth of specialized agency knowledge in this field, overlapping regulatory schemes may be a strength—so long as the various agencies understand each other’s work and form strong inter-agency lines of communication.
Focus on Biologics
Participants across both panels were generally united on one issue: the need to reform the regulatory process and educate patients and providers to promote the use of biosimilars and interchangeable biosimilars as alternatives to expensive brand biologics. The panelists generally opined that the distinction between biosimilars and interchangeable biosimilars is unnecessary or counterintuitive. They called for a single regulatory pathway for biosimilars that would allow approved biosimilars to be automatically substituted by pharmacies, without prescriber intervention. Further, panelists emphasized the need to educate patients and prescribers about the safety and efficacy of biosimilars.
When an insured is pursuing a representation and warranty insurance (“RWI”) claim, a critical consideration is whether diminution in value damages (“DIV Damages”) can be asserted as Loss covered by the RWI policy.[1] This article, being published in four parts, discusses Delaware mergers and acquisitions (“M&A”) damages law regarding DIV Damages and describes how an insured can pursue them as part of an RWI claim.
This is Part II of this article; it addresses the evolution of cases involving DIV Damages calculated using a discounted cash flow methodology (“DCF Methodology”) under Delaware M&A damages law. Part I of this article addressed (i) the principal differences between DIV Damages calculated using a multiple of EBITDA methodology (“MOE Methodology”) and DIV Damages calculated using a DCF Methodology and (ii) the evolution of cases involving DIV Damages calculated using an MOE Methodology under Delaware M&A damages law. Part III of this article will discuss the requirements for a DIV Damages award as part of an RWI claim. Part IV of this article will discuss the limitations on, and other matters regarding, a DIV Damages award as part of an RWI claim.
Each part of this article contains practice tips for attorneys for insureds seeking recovery of DIV Damages as part of an RWI claim.
Calculating DIV Damages Using a DCF Methodology Rather Than an MOE Methodology
Several different situations exist in which DIV Damages calculated using a DCF Methodology may be preferable to, or even required instead of, DIV Damages calculated using an MOE Methodology. These principally include the following:
when the buyer used a DCF Methodology to calculate the purchase price it offered or paid for the target business
when the buyer is trying to claim the loss of future profits, including future synergistic profits, of the target business through DIV Damages
when the revenues or expenses impacted by the R&W Breach (or by the fraudulent misrepresentation or deceit, in the case of noncontractual representations[2]) were not reflected in the Measurement Period EBITDA but were reflected in the projected financial results of the target business
A discounted cash flow methodology[3] can also be used to calculate damages in other scenarios, such as (i) when a prospective seller jilts a prospective buyer by breaching one or more of its binding covenants in a letter of intent or an Acquisition Agreement, or (ii) when a prospective joint venturer or joint development party jilts its prospective counterparty by breaching one or more of its binding covenants in a letter of intent or a joint venture agreement or joint development agreement. However, in those scenarios, the discounted cash flow methodology is being used to calculate the jilted buyer’s or jilted counterparty’s damages in the form of lost anticipated profits resulting from such breach or breaches rather than DIV Damages, and RWI coverage is not implicated because of the absence of an R&W Breach covered by an RWI policy.[4]
While there are differences between DIV Damages calculated using a DCF Methodology versus those calculated using an MOE Methodology, it is still important for attorneys for an insured that is pursuing DIV Damages calculated using either methodology to be familiar with the case law involving the other methodology.[5]
Evolution of Cases Involving DIV Damages Calculated Using a DCF Methodology Under Delaware M&A Damages Law
The Case That Began the Line: Tamv.Spitzer
The seminal case involving DIV Damages calculated using a DCF Methodology under Delaware M&A damages law is the 1995 Delaware Chancery Court case of Tamv.Spitzer.[6]Tam involved the sale of the assets of a business known as Data Works, a data processing company owned by Lisa A. Spitzer, to Tam Management, Inc., a corporation owned by Coretta C. Tam, for a purchase price of $103,500. The purchase price was calculated by Tam’s accountant, Robert L. Siegfried Jr., using a DCF Methodology and certain valuation data.[7]
After finding that Spitzer had committed fraud with respect to the sale of Data Works to Tam by failing to disclose the erosion of the business and the impending loss of Data Works’ largest customer, St. Francis Hospital, Vice Chancellor Jacobs awarded Tam DIV Damages of $45,290, based on the difference between (i) the valuation of the Data Works business as represented to Tam, in the form of the purchase price paid by Tam to acquire the assets of the target business, and (ii) the valuation of the Data Works business without St. Francis Hospital as a customer, with the valuation in each case calculated using the same DCF Methodology and valuation data that Siegfried had used in calculating the purchase price paid by Tam for the target business, but excluding the St. Francis Hospital business in the latter calculation.[8]
In support of the award of DIV Damages to Tam, Vice Chancellor Jacobs made a number of factual and legal findings, including the following:
Tam was entitled to “damages measured by the ‘benefit of the bargain,’ i.e., the difference between the actual and the represented values of the object of the transaction.”[9]
“The only credible valuation of Data Works without St. Francis is that of Siegfried, who employed the same discounted cash flow methodology and valuation data he had previously used to arrive at the 1991 purchase price, but then deducted the revenue and expenses attributable to St. Francis. By that method, Siegfried arrived at an adjusted value for Data Works of $58,210.”[10]
“Spitzer offer[ed] no independent, alternative valuation of her own. Instead, she rest[ed] upon her challenges to certain of Siegfried’s valuation assumptions.”[11]
“Because Spitzer has offered no credible alternative to the valuation performed by Siegfried, and has not demonstrated that Siegfried’s valuation assumptions were either unreasonable or erroneous as a matter of law, I accept Siegfried’s valuation of $58,210 as the actual value of Data Works at the time of the sale to Tam. Because Tam overpaid for Data Works by $45,290 ($103,500 – $58,210), the $103,500 purchase price must be downwardly adjusted by that amount, to $58,210.”[12]
Tam continues to stand as the preeminent Delaware M&A damages law case involving an award of DIV Damages calculated using a DCF Methodology.[13]
The Case That Was Reversed on Other Grounds: S.C. Johnsonv. DowBrands
A Delaware M&A damages law case involving DIV Damages calculated using a DCF Methodology and relying on Tam is the 2003 U.S. District Court for the District of Delaware case of S.C. Johnson & Son, Inc. v. DowBrands, Inc.[14]S.C. Johnson involved the sale by DowBrands of a home products business (principally, plastic bags and wraps) to S.C. Johnson for an aggregate purchase price of $1.125 billion, which was calculated using a DCF Methodology.[15] Judge Farnan held that (i) DowBrands had committed fraudulent misrepresentation with respect to diversion to the United States of Latin American revenues of the target business, notwithstanding (a) the inclusion in the Acquisition Agreement of an independent review provision with respect to S.C. Johnson’s due diligence of the target business and (b) DowBrands’ contentions with respect to S.C. Johnson’s lack of reasonable reliance on DowBrands’ purported noncontractual representations regarding such diversion; and (ii) as a result, S.C. Johnson was entitled to DIV Damages in the form of the difference between (a) the value of the target business as represented to S.C. Johnson, in the form of the purchase price it paid to acquire the target business, and (b) the value of the target business after “backing out” the value of the Latin American portion of the target business.[16]
However, the U.S. Court of Appeals for the Third Circuit reversed Judge Farnan’s holding of justifiable reliance by S.C. Johnson on DowBrands’ purported noncontractual representations with respect to the Latin American portion of the target business, thereby reversing the holding that DowBrands had committed fraudulent misrepresentation with respect to the Latin American portion of the target business.[17] As a result, Judge Farnan’s holding with respect to DIV Damages was rendered inapplicable.
Because the Third Circuit’s reversal of Judge Farnan’s fraudulent misrepresentation holding in S.C.Johnson means that his DIV Damages holding has no precedential import, S.C. Johnson may be overlooked in the line of cases beginning with Tam. Nevertheless, Judge Farnan’s factual and legal findings with respect to DIV Damages calculated using a DCF Methodology are still instructive for practitioners evaluating an RWI claim including such DIV Damages. Among such findings were the following:
“[S.C. Johnson] was harmed as a result of DowBrands’ misrepresentations regarding the profitability of the Latin American business, and therefore, is entitled to the benefit of its bargain. . . . The . . . most commonly accepted measure [of damages for fraud or deceit under Delaware law] is the benefit of the bargain rule, [u]nder [which] the plaintiff recovers the difference between the actual and represented values of the object of the transaction.”[18]
S.C. Johnson calculated its damages by using the same DCF Methodology it had used in preparing its final bid for the target business, to arrive at a $23.6 million figure for the Latin American portion of the target business lost due to DowBrands’ fraudulent misrepresentations.[19]
However, because S.C. Johnson’s final bid of $1.125 billion was only 93 percent of the $1.2 billion valuation of the target business that S.C. Johnson had calculated in preparing its final bid, Judge Farnan proportionately reduced S.C. Johnson’s $23.6 million figure to $21.948 million as its DIV Damages (in other words, Judge Farnan proportionately reduced the DIV Damages award to correspond to the purchase price that S.C. Johnson paid DowBrands for the entire target business).[20]
The fact that S.C. Johnson did not make any sales of the target business products in Latin America in the five months, and sold less than $1 million of plastic bags and wraps in the seventeen months, after the Acquisition was considered persuasive evidence of the effect of diversion on the Latin American portion of the target business.[21]
None of the following contentions by DowBrands merited a reduction of the DIV Damages award to S.C. Johnson:
S.C. Johnson had “improperly assumed that the diverted sales were worth nothing at all”
S.C. Johnson would not have reduced its bid for the target business by $23.6 million had it known of the diversion because its bid already was $63.4 million below its calculated valuation for the entire target business and because the purchase price that S.C. Johnson paid was within the range of purchase prices authorized by its board of directors
the overall target business sales and operating profit reported in the first full calendar year after the Acquisition were $45 million and $14 million, respectively, above what S.C. Johnson had anticipated.[22]
In summary, while the Third Circuit’s reversal of Judge Farnan’s holding regarding fraudulent misrepresentation rendered his DIV Damages holding of no precedential import, his findings described above may still be instructive to an insured that is evaluating the assertion of DIV Damages as part of an RWI claim, particularly if calculated using a DCF Methodology.
The Case in Which the Buyer’s Assertion of Synergistic Losses Was Rejected: NetAppv.Cinelli
This brings us to the 2023 Delaware Chancery Court case of NetApp, Inc.v.Cinelli.[23]NetApp involved the sale by Albert E. Cinelli and other equity holders of Cloud Jumper, LLC, a company that provided virtual desktop infrastructure, storage, and data management across cloud-based programs, to NetApp, Inc., for a purchase price of $35 million.[24]
After holding that the target Cloud Jumper had committed R&W Breaches and fraud with respect to a number of representations and warranties in the Acquisition Agreement, centered around Cloud Jumper’s failure to disclose that it had been recording internal software transactions as if they were sales to unrelated external customers, Vice Chancellor Will devoted the remainder of her opinion in NetApp to the appropriate measure and quantification of damages to NetApp with respect to the R&W Breaches and fraud.[25]
Both NetApp and Cinelli proposed an award of DIV Damages based on the difference between the value of Cloud Jumper as represented and the value of Cloud Jumper after giving effect to the R&W Breaches and fraud. What makes the NetApp case unusual and therefore significant is that the buyer NetApp chose not to treat the purchase price it had paid to acquire Cloud Jumper as the value of Cloud Jumper as represented,[26] but instead chose to treat a DCF Methodology valuation of the future synergistic value to NetApp of Cloud Jumper as the value of Cloud Jumper as represented.[27] In essence, NetApp was contending that Cloud Jumper was worth more to NetApp than the purchase price NetApp paid to acquire Cloud Jumper because of the synergies that NetApp anticipated achieving in the future operation of Cloud Jumper as part of NetApp (discounted to present value by the application of a discount factor).
It is important to note that Vice Chancellor Will did not simply reject out of hand NetApp’s assertion that Cloud Jumper was worth more to NetApp than it had paid to acquire Cloud Jumper because of such synergies. Instead, Vice Chancellor Will found that NetApp’s synergistic DCF Methodology valuation of Cloud Jumper did not satisfy applicable Delaware M&A damages law, both because (i) the valuation was speculative, and thus did not meet the certainty limitation of applicable law,[28] and because (ii) the loss of synergies that NetApp was asserting was not the proximate result of the R&W Breaches and fraud committed by Cloud Jumper, at least not in its entirety.[29]
After rejecting NetApp’s assertion of synergistic DIV Damages of $37.7 million calculated using a DCF Methodology, Vice Chancellor Will did award NetApp DIV Damages of approximately $4.6 million, based on the difference between (i) the purchase price paid by NetApp to acquire Cloud Jumper, treating that as the as-represented value of Cloud Jumper, and (ii) the defendants’ expert’s calculation of the actual value of Cloud Jumper using a multiple of revenues methodology derived from guideline comparable public companies’ stock values and reported revenues.[30]
NetApp continues to stand as the preeminent case under Delaware M&A damages law rejecting an assertion of lost synergies as DIV Damages.
Practice Tips for Attorneys for Insureds
In the policy arrangement and negotiation phase, consider the following:
Ensure that “diminution in value,” “multiple of EBITDA,” “multiplier damages,” “lost profits,” or the like are not excluded by the definition of Loss in the policy or in an exclusion to the policy (whether or not set forth in the “Exclusions” clause of the policy).
Ensure that any provision in the Acquisition Agreement that purports to disclaim or waive “diminution in value,” “multiple of EBITDA,” “multiplier damages,” ”lost profits,” or the like, or “consequential” or “indirect” damages or the like, is excluded from application under the policy (for example, as “Limitation Provisions” to be disregarded for purposes of the policy).
Try to ensure that the mitigation provision of the policy only requires “mitigation to the extent required by law” or the like, and that reasonable costs and expenses incurred in pursuing mitigation efforts are treated as Loss under the policy.[31]
This article is the second in the RWI Practice Insights series by John T. Capetta.
This article focuses on buyer-side RWI policies and U.S. law (principally Delaware case law). For purposes of this article:
DIV Damages are a form of expectation damages in which the amount of the damages is the difference between (i) the value of the target business as represented to the buyer, almost always the purchase price paid for the target business by the buyer, and (ii) the value of the target business after giving effect to the diminution in the target business resulting from a breach of the Acquisition Agreement representations and warranties (“R&W Breach”) or from fraudulent misrepresentation or deceit regarding the target business.
Although there are other methods to calculate DIV Damages, this article focuses on those calculated by using either (i) in the case of a multiple of EBITDA methodology (“MOE Methodology”), (a) an actual or deemed shortfall in the EBITDA of the target business for a specified measurement period (“Measurement Period EBITDA”) caused by the R&W Breach or the fraudulent misrepresentation or deceit, times (b) the multiple applied by the insured to the Measurement Period EBITDA in determining the purchase price to pay for the target business; or (ii) in the case of a discounted cash flow methodology (“DCF Methodology”), the loss of future cash flows and of terminal value over a specified period caused by the R&W Breach or the fraudulent misrepresentation or deceit, discounted to present value by the application of a discount factor.
As used in this article:
the term Loss has the definition set forth in the RWI policy;
the term Acquisition Agreement includes stock purchase agreements, merger agreements, asset purchase agreements, and other types of business combination agreements by which a buyer acquires a target business from a seller;
the term Acquisition refers to the business combination contemplated by the Acquisition Agreement;
the term the buyer and the term the insured are often used interchangeably;
the term target and the term target business are used interchangeably;
the term R&W Breach also includes a claim under an RWI policy with respect to a tax indemnification provision in the Acquisition Agreement; and
the phrase without required disclosure by the seller refers to a failure by the seller to make a disclosure to the buyer even though required to do so by a representation and warranty in the Acquisition Agreement.
At least two of the leading Delaware M&A damages law cases involving DIV Damages calculated using a DCF Methodology concerned a holding of fraudulent misrepresentation or deceit with respect to noncontractual representations regarding the target business, with the court also holding that no breach of representation or warranty in the Acquisition Agreement had occurred relevant to DIV Damages. Although the M&A damages case law regarding DIV Damages applies to either a breach of representation and warranty in the Acquisition Agreement or to fraudulent misrepresentation or deceit with respect to a noncontractual representation regarding the target business, an RWI claim can only be made with respect to an R&W Breach covered by the RWI policy. ↑
The phrase “discounted cash flow methodology” is used here and subsequently in this Part II rather than the defined term “DCF Methodology” to differentiate the use of that methodology to calculate damages in contexts not involving the calculation of DIV Damages, such as the calculation of lost anticipated profits. ↑
This distinction between DIV Damages and lost profits damages can be critical in a situation in which the Acquisition Agreement contains a waiver by the buyer of “lost profits” or “consequential or indirect damages.” See, e.g., Powers v. Stanley Black & Decker, Inc., 137 F. Supp. 3d 358, 385–86 (S.D.N.Y. 2015) (under New York M&A damages law, DIV Damages are not “lost profits” or “consequential or indirect damages”). Note, however, if such a waiver is not applicable to recovery under an RWI policy, and the policy itself does not exclude such damages, this distinction may not be relevant to the insured. ↑
For example, as will be discussed in Part III and Part IV of this article, the requirements for and the limitations on DIV Damages are addressed in cases under Delaware M&A damages law involving DIV Damages calculated using either type of methodology, MOE or DCF. ↑
Tam v. Spitzer, No. 12538, 1995 WL 510043 (Del. Ch. Aug. 17, 1995). ↑
Id. Forensic accountants often refer to this as running the DCF analysis “with” and “without” the revenues or expenses in question to ascertain the difference. ↑
For an example of a recent case involving the use of a DCF Methodology to calculate DIV Damages, seeSurf’s Up Legacy Partners, LLC v. Virgin Fest, LLC, No. N19C-11-092, 2024 WL 1596021 (Del. Super. Ct. Apr. 12, 2024). ↑
Id. Indeed, the buyer NetApp unsuccessfully argued that using the purchase price it paid to acquire Cloud Jumper as the as-represented value of Cloud Jumper would only measure NetApp’s out-of-pocket damages, not its expectation damages. Id.↑
Id. at *29. Because Cloud Jumper was not profitable, an MOE Methodology could not be used. ↑
It is a judgment call whether or not to try to expressly include in the RWI policy’s mitigation provision the treatment of costs and expenses incurred in unsuccessfully attempting to mitigate losses as Loss covered by the policy. Particularly if applicable law may allow for the recovery of such costs and expenses, discretion may be the better part of valor in resisting trying for such an express inclusion since it may only cause the RWI carrier or its counsel to expressly exclude such costs and expenses. ↑
Paul Hastings LLP 200 Park Avenue New York, NY 10166 (212) 318-6971 phone (212) 752-2281 fax [email protected]
Rachel Wu Hankinson
Paul Hastings LLP 515 South Flower Street, Twenty-Fifth Floor Los Angeles, CA 90071 (213) 683-6063 phone (213) 627-0705 fax [email protected]
Eleventh Circuit Brooke M. Wilner
2050 M Street NW Washington, DC 20036 (202) 551-1918 phone (202) 551-1705 fax [email protected]
Jack Bilbrough
Paul Hastings LLP 200 Park Avenue New York, NY 10166 (212) 318-6324 phone (212) 319-4090 fax [email protected]
DC Circuit Brit Seifert
Paul Hastings LLP 4655 Executive Drive, Suite 350 San Diego, CA 92121 (858) 458-3003 phone (858) 458-3103 fax [email protected]
Introduction
This year we have seen notable updates to trade secret and employee mobility laws, with a continued trend toward limiting noncompete agreements and expanding legislative efforts to regulate restrictive covenants across various industries. These changes highlight the ongoing development of trade secret and restrictive covenants laws in response to the continued shift towards a globalized market. To that end, 2024 saw updates to trade secret laws addressing key issues impacting the use of restrictive covenants with respect to healthcare professionals. While Rhode Island banned noncompete agreements for advanced practice registered nurses, other states clarified the enforcement of restrictive covenants in this industry.
Updates in this area have clarified the parameters of trade secret protection, particularly concerning the interstate application of state noncompete laws and the Federal Trade Commission’s April 2024 Final Rule. Various Circuits and courts have declined to uniformly restrict noncompete agreements, instead issuing rulings that reinforce state-specific approaches to enforceability, choice-of-law provisions, and geographic limitations.
As businesses navigate the increasing complexities of the marketplace, the evolving framework for trade secrets and employee mobility laws provides critical guidance for businesses in safeguarding their valuable assets. This Trade Secrets and Employee Mobility chapter provides an overview of the key developments for 2024, highlighting the implications for businesses and practitioners.
First Circuit
In 2024, two notable cases came out of the First Circuit. The first case resulted in the largest trade secret verdict to date under the Defend Trade Secrets Act (DTSA). The second case challenged California’s authority to invalidate noncompete agreements signed outside the state. On the legislative front, Rhode Island banned noncompete agreements for advanced practice registered nurses (see R.I. Gen. Laws § 5-34-50). However, the governor vetoed a bill that would have prohibited all noncompete agreements. Similarly, Maine’s governor vetoed legislation that would have significantly restricted the use of noncompete agreements.
In Insulet Corp. v EOFlow, Co. Ltd., No. 23-11780-FDS (D. Mass. 2024), a Massachusetts jury awarded $452 million in damages to Insulet in a trade secret misappropriation case. Insulet is the maker of a wearable insulin pump called OmniPod. In 2017, six employees left to join EOFlow, a maker of wearable drug delivery systems. EOFlow’s competing product, EOPatch 2, was released in South Korea in 2019, and Europe in 2022. Insulet inspected the EOPatch 2 in February 2023, concluded that its trade secrets related to OmniPod’s design history, CAD files, and occlusion detection algorithms were misappropriated, and promptly filed suit against its former employees and EOFlow.
Insulet faced a significant statute of limitations hurdle. In 2018, Insulet attended a conference where the EOPatch 2 was demonstrated. However, the jury found that the limitations clock did not start ticking until Insulet inspected the device in 2023.
The damages award is also notable for two reasons other than its dollar amount. First, it demonstrates the ability under the DTSA to recover damages based on sales of infringing products outside of the U.S. when “an act in furtherance” of misappropriation occurs in the U.S. Second, the jury was asked to provide an advisory opinion on the amount of punitive damages that should be awarded for willful and malicious misappropriation. While the decision to award punitive damages and their amount is often reserved for the judge, juries are increasingly being asked to provide advisory opinions on these matters.
California law’s ability to invalidate a noncompete agreement negotiated, performed, and governed by the law of another state was tested for the first time in Draft Kings, Inc. v. Hermalyn, 118 F. 4th 416 (1st Cir. 2024). Hermalyn, a DraftKings, Inc. executive, left for a similar position with rival Fanatics, Inc. that required him to live and work in Los Angeles. The Massachusetts federal district court found Hermalyn’s noncompete agreement with DraftKings was enforceable under Massachusetts law (the agreement had a Massachusetts choice of law provision) and enjoined him from competing against DraftKings. Hermalyn appealed, arguing that California law should apply because he had become a California resident. Unlike Massachusetts law, California bans noncompetes “regardless of where the contract with signed” and “whether . . . the employment was maintained outside of California.” See Cal. Bus. & Prof. Code §16600.5(a), (b). If applicable, California law would have invalidated Hermalyn’s noncompete. The First Circuit Court of Appeals affirmed the application of Massachusetts law, concluding that California did not have a materially greater interest in pursuing its noncompete public policy. This case raises questions about whether simply relocating an employee to California can effectively invalidate an otherwise enforceable noncompete agreement executed outside of California.
Second Circuit
In 2024, the Second Circuit did not significantly change how courts address noncompete and trade secret litigation. However, three New York cases stood out.
New York
Restrictive Covenants
Spotlight Ticket Management, Inc., et al. v. James Daigle, No. 23-CV-10035 (JPO), 2024 WL 3966900 (S.D.N.Y. Aug. 28, 2024). Spotlight Ticket Management (“Spotlight”) and SSSI Acquisition, Inc. (“SSSI”) sued James Daigle (“Daigle”), a former Spotlight employee, for breach of contract, breach of the implied warranty of good faith and fair dealing, and tortious interference with prospective business relations based on Daigle’s alleged violations of restrictive covenants that were part of a sale of business as well as an employee separation agreement. The Court granted in part and denied in part Daigle’s motion to dismiss. The Court reasoned that Daigle incorrectly interpreted BDO Seidman v. Hirschberg, 93 N.Y.2d 382 (1999) to “impose an affirmative pleading requirement, insisting that a plaintiff seeking to enforce a restrictive covenant ‘plead[ ] . . . an absence of overreaching [or] coercive use of dominant bargaining power[,] or show that it has in good faith sought to protect a legitimate business interest’ when BDO Seidman imposes no such rule.” (internal citation omitted).
Non-Recruitment Clause
St. Joseph’s Hospital Health Center v. American Anesthesiology of Syracuse, P.C., et al., No. 5:24-CV-276 (BKS/ML), 2024 WL 4930688 (N.D.N.Y. Dec. 2, 2024). St. Joseph’s Hospital Health Center (“St. Joseph’s”) sued American Anesthesiology of Syracuse, P.C., American Anesthesiology, Inc., NMSC II, LLC, and North American Partners in Anesthesiology, L.L.P. (collectively “NAPA”), asserting antitrust claims under the Sherman Act, 15 U.S.C. § 1 et seq. and the Donnelly Act, N.Y. Gen. Bus. Law § 340 as well as a breach of contract claim based on a non-recruitment clause in the parties’ business agreement. NAPA subsequently filed counterclaims alleging breach of contract, tortious interference with a contract, and claims for injunctive and declaratory relief. The Court granted in part and denied in part St. Joseph’s motion to dismiss counterclaims and denied NAPA’s partial motion to dismiss.
The Court explained that in the Second Circuit a “restrictive covenant preventing an employee from pursuing his livelihood” differs from an “anti-raiding provision in a commercial agreement between two sophisticated parties,” and that anti-raiding provisions/non-recruitment clauses are typically more reasonable. Omni Consulting Group, Inc. v. Pilgrim’s Pride Corp., 488 F. App’x 478, 480 (2d Cir. 2012). The Court concluded that the nonsolicitation clause at issue here posed a hardship and “[w]hether the non-solicitation clause at issue here was reasonable will rest ‘on the particular facts and circumstances giving context to the agreement.’” Reed Elsevier v. TransUnion Holding Co., Inc., No. 13-cv-8739, 2014 WL 97317, at *7, 2014 U.S. Dist. LEXIS 2640 (S.D.N.Y. Jan. 8, 2014) (quoting BDO Seidman).
Misappropriation of Trade Secrets
Rocket Pharmaceuticals., Inc. v. Lexeo Therapeutics, Inc., et al., No. 23-CV-9000, 2024 WL 3835264 (S.D.N.Y. Aug. 14, 2024). Rocket Pharmaceuticals, Inc. (“Rocket”) sued Lexeo Therapeutics, Inc. (“Lexeo”) and two employees that left Rocket to work at Lexeo. Rocket asserted trade secret misappropriation under the Defend Trade Secrets Act (“DTSA”), 18 U.S.C. § 1836(b)-(c), and New York law. Rocket also asserted breach of contract against the individuals, tortious interference with contractual relations against Lexeo, and unfair competition against all defendants. The Court denied Lexeo and the employees’ motion to dismiss. Although the Second Circuit has yet to define the required specificity for trade secret misappropriation claims, the Court found the complaint appropriately identified the purported trade secrets and related misappropriation by plausibly alleging the employees transferred thousands of emails and documents containing identified trade secrets to their personal computer, person email, and USB drives prior to leaving Rocket.
Third Circuit
Over the last year, the Third Circuit has seen two significant developments in the laws relating to employee mobility and restrictive covenants.
Beginning on January 1, 2025, Pennsylvania’s Fair Contracting for Health Care Practitioners Act went into effect. While limited in scope, the Act has a major impact: prohibiting most new noncompete covenants for “health care practitioners” after the Act’s effective date. As defined by the Act, covered “health care practitioners” includes medical doctors, osteopaths, certified registered nurse anesthetists, certified registered nurse practitioners, and physician assistants. However, the Act includes several exceptions, including most notably, a carveout allowing for enforcement of noncompete covenants covering health care practitioners so long as the noncompete does not last for more than one year and the health care practitioner was not fired by the employer.
Outside of the statutory realm, the Third Circuit saw a major decision regarding the enforceability of certain restrictive covenants. In January 2024, the Delaware Supreme Court issued its ruling in Cantor Fitzgerald, L.P. v. Ainslie, ultimately finding that “forfeiture for competition” clauses are enforceable. Cantor Fitzgerald, L.P. v. Ainslie, 312 A.3d 674, 692 (Del. 2024). The Court reasoned that such clauses are not actually a restraint of trade, and instead, they are actually a “condition precedent” which excuses the employer from future payment obligations. Cantor Fitzgerald, L.P., 312 A.3d at 687. The Court also noted that because forfeiture for competition clauses are not a restraint of trade, they do not need to meet Delaware’s regular standards for enforcing a restrictive covenant, which includes a review whether such restrictive covenants are “reasonable in geographic scope and temporal duration, advance legitimate economic interests of the party seeking enforcement, and survive a balancing of the equities.” Cantor Fitzgerald, L.P., 312 A.3d at 684.
Fourth Circuit
The Fourth Circuit has seen some developments relating to noncompetes in the last year. In 2023, Maryland prohibited noncompete and conflict of interest clauses in employment contracts for workers earning 150 percent or less of the minimum wage. In 2024, the state expanded these prohibitions through HB 1388, which targeted such provisions in employment contracts for licensed veterinary practitioners, veterinary technicians, and licensed health care professionals providing direct patient care. On June 1, 2024, the law voided any noncompete and conflict of interest provisions in employment contracts for licensed veterinary practitioners and technicians. Restrictions on such clauses for health care professionals providing direct patient care are divided by salary and apply to all contracts executed on or after July 1, 2025. These provisions will be unenforceable for such professionals earning salaries of $350,000 or less. For healthcare professionals earning salaries exceeding $350,000, these provisions will no longer be enforceable if they exceed one year from the last date of employment or have a geographic scope of greater than 10 miles from the professional’s primary place of employment. Finally, for healthcare professionals earning salaries exceeding $350,000, employers will be required to inform patients upon request of a former employee’s new place of practice.
The Fourth Circuit also had a notable case relating to the misappropriation of trade secrets. In Pegasystems Inc. v. Appian Corp., No. 1399-22-4 (July 30, 2024), a jury had found that Pegasystems, Inc. (“Pegasystems”) had used improper means to misappropriate trade secrets from Appian Corporation (“Appian”). The jury awarded over two billion dollars—the largest damages verdict in the history of the Commonwealth of Virginia. Pegasystems appealed, contending that as a matter of law, there was insufficient evidence that it had misappropriated any trade secrets. While the Court of Appeals of Virginia rejected Pegasystems’ argument that it was entitled to judgment as a matter of law, the appellate court found that “the trial court committed a series of errors that require [the court] to reverse the judgment as to Appian’s trade secret claims.” First, the appellate court noted that the trial court improperly instructed the jury as to Appian’s burden in demonstrating damages causation from the misappropriation by instructing the jury to apply a burden-shifting approach. This created a presumption that Appian’s trade secrets were the but-for cause of all of Pegasystems’ sales. Second, the appellate court found that the trial court erred in foreclosing Pegasystems from presenting its own damages evidence as to total sales, which was consequential given the burden-shifting instruction on damages. The appellate court concluded that this “exponentially increased the likelihood of a runaway damages verdict that had no correlation to proximate cause.” The appellate court remanded this matter for a new trial. While this case is under the Virginia Uniform Trade Secrets Act, it is instructive as to the use of jury instructions and evidentiary issues in trade secret cases.
Fifth Circuit
The Fifth Circuit was closely watched this past year for noncompete law because of the high-profile case Ryan, LLC v. Federal Trade Commission (FTC), No. 3:24-CV-00986 (N.D. Tex. Aug. 20, 2024). This case challenged the enforceability of the FTC’s April 2024 Final Rule, which sought to ban post-employment noncompete agreements nationwide. The U.S. District Court for the Northern District of Texas held that the FTC lacked statutory authority to promulgate such a rule and that the rule was arbitrary and capricious under the Administrative Procedure Act. The court enjoined enforcement of the Final Rule nationwide, but the FTC has appealed this ruling to the Fifth Circuit.
Two Louisiana Court of Appeal decisions provided further guidance on the enforceability of restrictive covenants in Louisiana. In Arthur J. Gallagher & Co. v. Annison, So.3d 1089 (La.App. 1 Cir., 2024), the court clarified that a prospective employee may sign a noncompete agreement if it expressly contains an effective date on or after the employee’s first day of work. In Brown & Root Industrial Services, LLC v. Farris, 392 So.3d 424 (La.App. 1 Cir., 2024), the court held that a nonsolicitation of employees provision is not subject to the Louisiana noncompete statute but must be reasonable in duration and scope to be enforceable. The court concluded that the nonsolicitation of employees covenant at issue was unenforceable because it lacked any durational limit.
Louisiana enacted new noncompete legislation (S.B. 165; Act 273, modifying La. Rev. Stat. § 23:921; eff. Jan. 1, 2025), which limits noncompetes for primary care physicians to three years from the effective date of the initial agreement and five years for all other physicians. Noncompetes also cannot exceed two years from the termination of employment and are limited to the parish of principal practice and two contiguous parishes where the employer carries on a similar business. Mississippi and Texas saw failed legislation that would have limited the use of noncompetes for healthcare providers and physicians, respectively, although the Texas legislation is expected to be reconsidered.
Two Texas federal district court cases showed the importance of secrecy efforts and ensuring clarity in settlement agreements to protect trade secrets. In Thompson Safety LLC v. Jones, No. 4:24-cv-2483 (S.D. Tex., Sept. 6, 2024) the court ruled against the plaintiff, a fire extinguisher servicing business, in its motion for a preliminary injunction. The court found that the alleged trade secrets, including pricing information and customer lists, were ascertainable through publicly available sources. Specifically, the customers freely disclosed prices they paid for plaintiff’s services, and the relationship between the plaintiff and customers must be disclosed on tags attached to fire extinguishers that the plaintiff installs or services. In MSHB Restaurant, LLC v. Nepal Business Investment, LLC, No. 4:24-cv-1973 (S.D. Tex., Nov. 15, 2024) the court allowed the plaintiff to amend its complaint to add a fraudulent concealment claim and denied the defendants’ motion to dismiss. The court found that the misappropriation of trade secrets claims were not time-barred because the alleged misappropriation occurred after a prior settlement agreement; thus there was no continuing misappropriation of settled claims. Additionally, the court rejected defendants’ argument that the settlement agreement’s broad release covered future claims, emphasizing that the agreement did not grant permission to use plaintiff’s trade secrets.
Sixth Circuit
Over the past year, the Sixth Circuit rendered notable verdicts pertaining to trade secret and employee noncompete statutes.
The Sixth Circuit recently addressed the interplay between the Ohio Uniform Trade Secrets Act (OUTSA) and breach of contract claims. A recurring issue of the Uniform Trade Secrets Act (UTSA) has been whether violations of the UTSA can be alleged alongside breach of contract claims or whether the UTSA preempts breach of contract claims, given that the statute is meant to provide an exclusive legal remedy for the misappropriation of trade secrets. In Metron Nutraceuticals, LLC. v. Cook, No. 23-3596, 2024 WL 3877388 (6th Cir. Aug. 20, 2024) the Sixth Circuit addressed this question when a nutritional supplement company sued defendants for both violating the OUTSA and breach of contract. The supplement company had developed a supplement, which it asserted to be a trade secret, then made various consultants sign a nondisclosure agreement before sharing details of the supplement with them. Metron alleged that one consultant, Cook, developed a product that appropriated its proprietary formula. The trial court dismissed the breach of contract claim on summary judgment because of preemption by OUTSA. But the Sixth Circuit reversed. The Sixth Circuit found that because the language of OUTSA allows for breach of contract remedies, it would be impractical and untenable for the statute to preempt breach of contract claims. The appellate court also took into consideration the primary aim of the UTSA as a means of creating consistency across states, and how the trial court’s interpretation would have made Ohio an outlier in this regard. The Sixth Circuit’s ruling reaffirmed the significance of breach of contract claims for protecting trade secrets.
Additionally, the Sixth Circuit made a long-awaited ruling upon the NLRB’s McLaren Macomb decision. Nat’l Lab. Rels. Bd. v. Macomb, No. 23-1335, 2024 WL 4240545 (6th Cir. Sept. 19, 2024). In June 2020, the McLaren Macomb hospital had furloughed 11 employees and directly discussed terms of severance agreements with them without first bargaining or consulting their union. While an Administrative Law Judge ruled that the broad confidentiality and nondisparagement provisions in these severance agreements were lawful, the NLRB ruled otherwise. The NLRB decided that nondisparagement clauses in severance agreements with nonsupervisory employees violate Section 7 of the National Labor Relations Act, which protects the right of employees to engage in concerted activity for their mutual aid and protection. The Sixth Circuit took up the review of the NLRB’s decision this year. The Sixth Circuit easily affirmed that the hospital’s actions were unlawful. But it decided this based on only violations of the employees’ Section 7 rights, without taking a stance on the pressing question of the case: the validity of the severance language itself. The Sixth Circuit did not resolve whether confidentiality and nondisparagement clauses in severance agreements are valid. This remains an uncertainty which employers will want to consider when drafting language in their severance agreements. The NLRB may continue to find broad confidentiality and nondisparagement clauses in severance agreements to nonsupervisory employees to be unlawful, given that the Sixth Circuit did not explicitly decide otherwise.
Seventh Circuit
Over the past year, the Seventh Circuit has seen expanded protections for employees against post-employment restrictive covenants through case law, as well as newly enacted laws. Illinois recently amended the Illinois Freedom to Work Act to include amendments that limit the enforceability of noncompetes and nonsolicits in specific industries. First, under Senate Bill 2737, noncompetes and nonsolicits for mental health professionals serving veterans and first responders are unenforceable if it “is likely to result in an increase in cost or difficulty for any veteran or first responder seeking mental health services.” Second, Senate Bill 2770 provides that noncompetes and nonsolicits are void with respect to individuals employed in construction, whether the individual is covered by a collective bargaining agreement or not. These amendments are effective as of January 1, 2025. Similarly, in 2023, Indiana enacted a law restricting the enforceability of both existing and future noncompetes for physicians that became effective July 1, 2023.
The Indiana Court of Appeals recently considered whether a former executive’s noncompete was enforceable where it prohibited her from working for any competitor in any capacity. In MED-1 Solutions, LLC. V. Taylor, No. 24A-PL-450, 2024 WL 4876906 (Ind. Ct. App. Nov. 25, 2024), the employer brought an action against a former COO alleging breach of the covenant not to compete. The noncompete agreement barred the former COO—in plain language, the court noted—from becoming employed in any role for a business that performs the same services as MED-1. The court rejected this language and found the covenant unenforceable because, inter alia, the scope of activity restricted was overly broad. Notably, the court emphasized, “We have found covenants not to compete prohibiting an employee from working for a competitor in any capacity or from competing with portions of the business with which the employee was never associated to be unreasonable because they extend beyond the scope of the employer’s legitimate interests.”
In Midwest Lending Corp v. Horton and PrimeLending Co. (220 N.E.3d 422, 468 Ill. Dec. 114), an Appellate Court of Illinois weighed in on the heavily litigated issue of what constitutes valid consideration for a post-employment restrictive covenant to be enforceable. In this case, the employer—Midwest—brought suit against a former employee for the breach of a confidentiality agreement and a nonsolicitation agreement. Midwest’s argument, inter alia, was that a pre-employment “signing bonus” constituted valid consideration for the nonsolicitation agreement. The court rejected this argument, finding that there was no consideration because the nonsolicitation agreement itself expressly limited the scope “to the subject matter hereof” instead of expressly mentioning and identifying the pre-employment payment as consideration.
In a recent case, Motorola Solutions, Inc. v. Hytera Communications Corporation Ltd, 108 F.4th 458 (7th Cir. July 2, 2024), the Seventh Circuit Court of Appeals held that the Defend Trade Secrets Act (“DTSA”) has extraterritorial reach and that the law applies to conduct occurring outside of the U.S. if “an act in furtherance of the offense was committed in the United States.” In this case, Motorola filed suit against Hytera, a Chinese competitor. Its claims, which included violations of the DTSA and the Illinois Trade Secrets Act, stemmed from Hytera’s hiring of multiple engineers from Motorola, who allegedly stole trade secrets and source code on their way out the door, and then used the stolen information and code to create competing products. At trial in the Northern District of Illinois, a jury awarded compensatory and punitive damages, which were subsequently reduced by the district court. Hytera appealed as to damages. The appellate court held, as a matter of first impression, that the DTSA does apply extraterritorially so long as “an act in furtherance of the offense was committed in the United States,” and allowed Motorola to recover Hytera’s foreign sales on that basis. In its ruling, the court noted that while an act in furtherance of the offense needed to be committed in the U.S. to allow for recovery of foreign sales, the act in furtherance need not be a “completed act of domestic misappropriation” and the rule did not “impose a specific causation requirement.”
Additionally, in My Fav Electronics, Inc. v. Currie, 24-c-1959, 2024 WL 4528330 (N.D. Ill. Oct. 18, 2024), a district court in Illinois complicated matters on the topic of whether inevitable disclosure relief is available under the DTSA. The inevitable disclosure doctrine seeks to protect trade secrets by providing a legal remedy—the court may prevent a former employee from working in a position where it is deemed inevitable that trade secrets from their previous employer will be revealed or used. In this case, the former employees joined a competitor, and strong evidence indicated the use of the previous company’s confidential information. The Court found that the inevitable disclosure doctrine supported granting a preliminary injunction on the defendant, even though the parties did not negotiate a noncompete agreement.
Eighth Circuit
Over the past year, the Eighth Circuit has seen expansion in statutory movements against noncompete and nonsolicitation laws. Yet, courts have stayed the course without rapidly increasing or decreasing the enforcement of such restrictive covenants.
In 2023, Iowa expanded its noncompete laws to cover mental health professionals. See Iowa Code § 135Q.1. In 2024, House File 2391, a bill proposing modifications of requirements for healthcare employment agencies, would have applied Iowa’s noncompete laws to health care technology platforms. Though it died in committee, the bill would have prohibited healthcare agencies that utilize technology platforms to deliver their services from restricting the employment opportunities of agency workers through noncompete clauses. H.F. 2391, 90th Gen. Assemb. (2024). In May 2024, Governor Walz of Minnesota approved S.F. 3852, which functions to ban service providers from restricting, restraining, or prohibiting customers from directly or indirectly soliciting or hiring an employee of the service provider. Minn. Stat. § 3852 (2024). The bill primarily targets staffing agencies and grants customers the ability to hire employees they were connected with through an agency.
There are a couple of interesting cases that have been decided in 2024. In Cigna Corp. v. Bricker, 103 F.4th 1336 (8th Cir. 2024), the Eighth Circuit took on the question of whether businesses can be deemed to be in competition if they are serving virtually the same customers but have separate business models. Bricker, an accomplished executive, changed teams when she moved from Cigna Corporation to CVS Pharmacy, Inc. in 2023. Id. at 1341. Cigna immediately moved to block her transition, as she had signed a noncompete agreement during her time at Cigna. Id. at 1342. The fight was centered on the question of whether Cigna and CVS could actually be considered business competitors—Cigna focuses on home-delivery of prescription medications while CVS is a brick-and-mortar pharmacy. Id. The Eighth Circuit ultimately upheld the noncompete agreement, finding that even though there may have been an attempt to distinguish the types of customers that both businesses serve, the customers they were competing for were in fact drawn from the same base. Id. at 1345.
In Constructors, Inc. v. Butler, No. 4:22-CV-3217, 2024 U.S. Dist. LEXIS 57432, at *13 (D. Neb. Mar. 29, 2024), the District of Nebraska dismissed a Racketeer Influenced and Corrupt Organizations Act (“RICO”) claim based on allegations of trade secret theft. Plaintiffs, Constructors, Inc. and NEBCO Inc., filed suit against Ted Butler, a former corporate officer, and his alleged accomplices, accusing them of misappropriating confidential information. Id. at *3–6. After resigning from his position, Butler allegedly took confidential documents and proprietary information from plaintiffs to assist in the establishment of a new company he joined after his resignation. Id. at *3. Plaintiffs claimed that defendants, leveraging the stolen information, engaged in a series of fraudulent activities to divert business away from plaintiffs, thereby breaching their fiduciary duties and stealing corporate opportunities. Id. at *3–6. The central focus of the motion to dismiss was the plaintiffs’ RICO claim, which alleged that the defendants’ actions—specifically the theft of trade secrets and other fraudulent schemes—constituted a racketeering activity. Id. at *11–12. The court found that the plaintiffs’ RICO claim lacked sufficient allegations of continuity. Id. at *11. RICO plaintiffs must demonstrate not just isolated instances of illegal conduct, but either (1) a continuous and ongoing pattern of criminal activity over time or (2) a pattern of related criminal activity that occurred over a period of time lasting at least one year. Id. at *11. While plaintiffs argued that the defendants’ repeated misuse of stolen trade secrets qualified as this pattern, the court disagreed. Rather, the court found that plaintiffs’ vague allegations amounted to isolated acts that did not constitute criminal racketeering activity, let alone a pattern of criminal racketeering activity. Id. at *12. As a result, the RICO claim was dismissed.
Ninth Circuit
Case law in the Ninth Circuit remains largely unchanged with respect to matters regarding employee mobility, restrictive covenants, and trade secrets. That said, there were two matters of first impression around the awarding of damages in trade secret cases that were addressed by courts in the Ninth Circuit during 2024:
In Applied Medical Distribution Corp. v. Jarrells, 100 Cal.App.5th 556 (2024), the California Court of Appeal for the Fourth District addressed whether a plaintiff may recover the costs of stopping or mitigating the misappropriation of trade secrets under the California Uniform Trade Secrets Act. There, the defendant objected at trial to the plaintiff’s damages expert’s inclusion of $80,000 in fees the Plaintiff paid to its forensic computer expert in the calculation of the plaintiff’s damages. The trial court sustained the objection on the ground that “expert fees traditionally and typically are not an item of damage that is recoverable in litigation, but rather, it’s a cost of the litigation, which may or may not be recoverable at the end of the case by the prevailing party.” Id. at 587.
The Court of Appeal noted that “[n]o California case addresses whether ‘actual loss caused by misappropriation’” under California’s UTSA “includes the cost of investigating trade secret misappropriation,” and that the UTSA’s permitting of “an award of costs to include fees paid to retained experts to prepare for or testify at trial after a ‘willful and malicious’ finding” was a “strong indication that the Legislature did not intend such fees to be awarded as ‘actual loss[es]’ caused by misappropriation” under the California UTSA.
Additionally, the Court noted that there was a nationwide split on whether expert fees are awardable as “actual loss” damages: “A number of courts in other jurisdictions, applying the Uniform Act, have drawn a distinction between expenses incurred to investigate a possible misappropriation and expenses incurred to stop or mitigate the misappropriation, and have held only the latter are recoverable damages.” By contrast, “[o]ther jurisdictions have held that any expenses incurred to investigate potential misappropriation are recoverable as ‘actual loss’ damages.” Id. at 588–99.
Ultimately, the Court of Appeals adopted the narrower interpretation and held that “a plaintiff may recover, as damages on a claim of misappropriation under the California UTSA, the costs of stopping or mitigating the misappropriation, but not the costs of investigating to determine whether and how any misappropriation occurred.” Id. at 590.
In EchoSpan, Inc. v. Medallia, Inc., 2024 WL 3431337 (N.D. Cal. July 2, 2024), the U.S. District Court for the Northern District of California addressed whether plaintiff must apportion damages among trade secrets. According to the Court, this was an issue on which “[t]he Ninth Circuit has not ruled.” There, following an 8-day trial, EchoSpan proved that Medallia misappropriated one of EchoSpan’s trade secrets and the jury awarded EchoSpan over $25 million. The issue was that EchoSpan had sued over nine separate trade secrets (two of which never went to the jury) and sought damages for them all as one group. The Court concluded that the jury could not distill damages for the whole group of nine down to one because EchoSpan had failed to apportion those damages. Consequently, the Court granted Medallia’s motion for judgment as a matter of law on damages.
In reaching this conclusion, the Northern District embraced the ruling in O2 Micro Int’l Ltd. v. Monolithic Power Sys., Inc., 399 F.Supp.2d 1064 (N.D. Cal, 2005), aff’d, 221 F.App’x 996 (Fed. Cir. 2007)—calling it “a near-perfect bullseye”—and distinguished the matter from Caudill Seed & Warehouse Co. v. Jarrow Formulas, Inc., 53 F.4th 368 (6th Cir. 2022) on the grounds that the evidence submitted fell “far short of the ‘options’ presented” to the jury there. Id. at *9.
Outside of damages, courts also addressed the application of statutes in Washington and Oregon to noncompete provisions in employment agreements:
In Culver v. 3M Company, 2024 WL 2279293 (W.D. Was. May 20, 2024), the U.S. District Court for the Western District of Washington concluded that amendments to RCW §49.62.080 that went into effect in June 2024 do not appear to apply retroactively.
In Isosceles Holdings, LLC v. Alliance Environmental Group, LLC, 2024 WL 279008 (D. Or. Jan. 25, 2024) the U.S. District Court for the District of Oregon held that ORS § 15.360 was not designed to override a choice of law provision and apply to make all noncompetition agreements voidable.
Beyond these matters, however, the applicable law remained relatively unchanged.
Tenth Circuit
The Governor of Colorado signed House Bill 24-1324, titled “Attorney General Restrictive Employment Agreements,” putting into place a law to toughen protections for employees who are subject to unreasonable contracts that require repayment to employers for education and training expenses upon termination of employment (Training Repayment Agreement Provisions, or “TRAPs”). The new law, effective as of August 7, 2024, attempts to curb potential abuses by employers who use TRAPs to exact repayments or employ penalties that are not reasonably tethered to the actual training expenses incurred by the employer. Potentials for abuse typically occur when an employer attempts to collect amounts in excess for the investment cost in training the employee, seeks repayment well after the training was completed, demands repayment where training provided did not result in transferrable skills to another employer (no actual certification for the employee), or imposes burdensome repayment terms. The new law expands upon previous restrictions in the state of Colorado for TRAPs and increases penalties for violating agreements. Specifically, the new bill considers TRAPs to be a “consumer credit sale” under Colorado Consumer Credit Code (which imposes specific requirements and enforcement mechanisms), grants the Attorney General enforcement authority and the ability to promulgate rules to implement and enforce the new bill, and provides recovery that may be three times the amount of the attempted recovery by the employer.
A court in the Tenth Circuit state of Oklahoma underscored that plaintiffs must provide clarity when asserting a trade secret claim in the case of Double Eagle Alloys, Inc. v. Michael Hooper; Ace Alloys, LLC, 19-cv-243-JDR-CDL (N.D. Okla. June 25, 2024). Here, plaintiff filed against a former employee and a competitor, alleging that the employee’s notes from his time working for plaintiff, as well as over 2,600 digitally downloaded files, constituted trade secrets. Although litigation lasted for over five years, the Northern District of Oklahoma ultimately dismissed plaintiff’s lawsuit, citing decisions from several circuits (including the 1st, 7th and 10th Circuits) to assert that vague, overly inclusive “catchall” language to describe what constitutes a trade secret did not evidence the need for afforded protections. The Oklahoma court further reasoned that the lack of specificity would allow plaintiffs to “shift[] the goalposts (or fail[] to define them)” during litigation and would render defendants ineffective, as the ability to defend becomes virtually unbounded. The case is now on appeal before the U.S. Court of Appeals for the Tenth Circuit, whose review may very well set the tone for how meticulous trade secret claims will need to be moving forward.
Eleventh Circuit
Employment and Noncompete Agreements
In 2023, the Eleventh Circuit affirmed a Georgia district court’s decision to “blue pencil,” i.e., judicially rewrite, a noncompetition agreement by altering its geographic scope. Baldwin v. Express Oil Change, LLC, 584 F. Supp. 3d 1253, 1266 (N.D. Ga. 2022) aff’d in relevant part and vacated in part, 87 F.4th 1292 (11th Cir. 2023). A year later, in Acousti, a Georgia district court refused to blue-pencil a seemingly comparable noncompete to alter its geographic scope, averring that it had “inadequate information about the scope of Acousti’s business,” and that doing so “would require rewriting the [n]on-[c]ompete [c]lause or supplying additional material terms,” which the court was unwilling to do. Acousti Engr. of Fla. v. Jernigan, No. 1:23-CV-02917-VMC, 2024 WL 4535279, at *6 (N.D. Ga. Aug. 27, 2024). The Acousti opinion is thus at least somewhat at odds with the broad language the Eleventh Circuit used in affirming Baldwin in 2023, where it emphasized that “Georgia common law bolsters our conclusion that the district court’s blue-pencil authority authorized it to reduce the geographic scope of the covenant.”
On the state side, the Georgia Supreme Court determined, in a landmark ruling, that restrictive covenants can be “geographically reasonable” within the meaning of the Georgia Restrictive Covenants Act (“GRCA”) without explicit geographic limitations. North American Senior Benefits, LLC v. Wimmer, 319 Ga. 641 (2024). Previously, Georgia courts had interpreted that requirement of the GRCA to mean that boundary-less restrictive employment covenants were inherently unreasonable. See, e.g., CarpetCare Multiservices v. Carle, 347 Ga. App. 497, 819 S.E.2d 894 (2018) (holding as unenforceable a provision that did not have an express geographic restriction). In Wimmer, the Georgia Supreme Court unanimously applied a different standard for reasonableness of a geographic competition limitation. Specifically, the Court held that the question of whether a given covenant is reasonable in geographic area under the GRCA “is not dependent on whether its geographic scope is expressly stated,” but instead turns on the individual facts and circumstances of each case. Wimmer, 319 Ga. at 649. This decision meaningfully relaxes the restrictions on drafting an enforceable restrictive covenant under Georgia law.
Trade Secrets
In a long-running dispute between a life insurance software company and its competitors, the Eleventh Circuit affirmed the district court’s determination that the competitors misappropriated the company’s trade secret, its database of insurance quotes. In Compulife Software Inc. v. Newman, the Eleventh Circuit affirmed the district court’s conclusion that the misappropriators used improper means to acquire Compulife’s trade secret by “scraping,” i.e., using software to automatically extract data. 111 F.4th 1147 (11th Cir. 2024). The court explained that, although “scraping” (and its related concept “crawling”) are often used perfectly legitimately, the defendants improperly “copied the order of Compulife’s copyrighted code and used that code to commit a scraping attack,” thereby using improper means to acquire the trade secret. And although the exact number of stolen insurance quotes (and therefore the total percentage of the database stolen) could not be determined, the evidence of record showed that in the months after the scraping attack, Compulife’s revenue and number of recurring customers declined. This was enough, in the Court’s view, to affirm the district court’s finding that the defendants had indeed acquired Compulife’s trade secret. In a partial win for Compulife,[1] the Eleventh Circuit therefore affirmed that the defendants were jointly and severally liable for their misappropriation of Compulife’s trade secret. Compulife’s win, however, was not without a drawback. Compulife had sought repayment from one of the defendant’s insurers under an agreement that required the insurer to indemnify the defendant for certain conduct. In a related case released the same day, the Eleventh Circuit explained that the relevant insurance agreement only obligated the insurer to indemnify the misappropriation defendant for negligent acts. But because the court had determined the defendant’s acts were intentional, Compulife could not seek payment from the defendant’s insurer under that agreement. Compulife Software Inc. v. Zurich Am. Ins. Co., No. 22-12909, 2024 WL 3618439 (11th Cir. Aug. 1, 2024).
DC Circuit
Key employee mobility cases over the past year in the District of Columbia could best be summed up as “back to the basics,” serving as a reminder of the importance of careful drafting when pleading claims in litigation based on trade secrets, noncompetes, and confidential information, as well as when crafting enforceable liquidated damages provisions related to restrictive covenants in employee contracts.
Litigation involving myriad legal claims related to employee mobility issues continued in Clevinger v. Advocacy Holdings, Inc., 2024 U.S. Dist. LEXIS 120712 (D.D.C. July 10, 2024), a case in which Advocacy’s CEO had resigned to join a competing company, resulting in Advocacy obtaining a TRO that was extended three times. In this decision, the court delivered a series of rulings on dueling motions to dismiss multiple noncompete and trade secret causes of action, providing reminders of key standards for setting forth viable claims that can withstand early dismissal. These include the following: (1) The D.C. Non-Compete Clarification Amendment Act of 2022 only regulates noncompetes executed “on or after October 1, 2022,” not before that date; (2) the two basic elements of trade secret misappropriation—the existence of trade secrets and their misappropriation—are identical under the federal Defend Trade Secrets Act and the D.C. Uniform Trade Secrets Act, and Advocacy properly alleged both by pleading that its former CEO took confidential plans to redesign an online platform and customer “contact lists” when he resigned and started a competitor company; (3) a claim specifically under subsection (a)(5)(A) of the federal Computer Fraud and Abuse Act does not turn on proper access to protected computers, but punishes intentionally causing damage without authorization as the CEO was alleged to have done by deleting multiple company user accounts and associated email, files, calendar entries and contacts; and (4) the D.C. Consumer Protection Procedures Act applies only to consumer-merchant relationships and authorizes suits only by consumers or organizations acting on their behalf, none of which was involved in this case.
In HIRECounsel DC, LLC v. Connolly, 2024 U.S. Dist. LEXIS 134835 * (D.D.C. July 31, 2024), the District Court granted summary judgment against HIRECounsel, a legal staffing firm, against its former Managing Director of Client Relations who had signed a one-year noncompete agreement, resigned, and days later began work with a competitor. Yet the court rejected the claim for liquidated damages based on breach of Connolly’s noncompete agreement as an unenforceable penalty. Liquidated damages clauses are enforceable under D.C. law if they are crafted to have a reasonable relation to any probable damage that would follow a breach—typically based on the former employer’s lost profits—as of the time the parties contracted. Yet HIRECounsel’s contract simply stated liquidated damages would be “significant and difficult to ascertain” and set forth the arbitrary amount of $40,000 per breach along with alternative calculations “unmoored” from any relationship to lost profits. Separately, no genuine issue of material fact existed as to whether HIRECounsel could establish actual damages on its claims for breach of noncompete and confidentiality provisions and for misappropriation of trade secrets under the D.C. Uniformed Trade Secrets Act. No proof existed to show that HIRECounsel suffered damages, including no showing that Connolly’s involvement at the competitor with certain HIRECounsel clients had impacted its business, or that such clients were exclusive to HIRECounsel, and no testimony that a client had stopped working with HIRECounsel and gone to Connolly’s new employer. All claims were dismissed, and the case closed.
Although the Eleventh Circuit affirmed the district court’s favorable determinations for Compulife related to the trade secret issues, the court remanded the case in part for the district court to further address issues of copyright infringement. ↑
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§ 5.1. Introduction
Laws and regulations relating to cannabis and the cannabis industry continue to evolve at a rapid pace. The current state of cannabis law is both confusing and complex. In order to put the latest developments in context, an explanation of the current state of the law regarding marijuana is in order.
The starting point is the Controlled Substances Act, 21 U.S.C. § 801 et. seq. (“CSA”), passed in 1970 to regulate the manufacture, use, and distribution of certain controlled substances for medical, scientific and industrial purposes and to prevent these substances from being used for illegal purposes. The CSA classified various drugs and chemicals into five categories, or schedules. Marijuana, along with heroin, cocaine, LSD and other substances, was placed on the most restrictive schedule, Schedule 1. The CSA prohibits the manufacture, distribution, sale possession or use of marijuana. The Drug Enforcement Agency has agreed to review the current scheduling of marijuana from Schedule 1 to less restrictive Schedule 3. Hearing on rescheduling originally slated to take place in December 2024 have been delayed until 2025. In the meantime, different groups have sued the DEA both to stop rescheduling and to challenge being excluded from the hearings.
The CSA also operates to prohibit the transportation of marijuana across state lines, even between states that have passed laws legalizing marijuana, as well as international borders, so the interstate and international transportation of marijuana remains illegal.
Despite the existence of the CSA, as of today, forty-one states plus the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands have laws legalizing marijuana for medical use, and twenty-four of those states, plus D.C. and Guam have legalized marijuana for recreational use, as well. According to one source, 54% of the US population lives in states with legal recreational adult use marijuana and 74% of the US population lives in states where marijuana is legal for either medial or recreational use. There have been some setbacks, however. In the 2024 election cycle, legislation to legalize adult use marijuana failed in Florida, North Dakota and South Dakota. Since the CSA is the law of the land, the question remains as to how states can “legalize” marijuana consistent with the preemption doctrine.
The laws relating to marijuana and hemp became very complicated at the end of 2018, with the passage of the Agricultural Improvement Act of 2018, also known as the Farm Bill. One provision of the Farm Bill legalized hemp at the federal level. It is important to understand that both hemp and marijuana come from the same species of plant, Cannabis sativa L., and both were included in the definition of marijuana in the CSA. Both marijuana and hemp contain a number of chemical compounds, the two most known of which are THC (the psychoactive compound) and CBD. The legal difference is that hemp contains less than 3% THC. Part of the confusion revolves around the other chemical compound, CBD, which is extremely popular and ubiquitous in the marketplace. CBD comes from both hemp and marijuana. Further complicating the situation is that there is no standard for measuring THC content in a cannabis plant, so what might be classified as hemp by one state might be classified as marijuana by a different state.
One development that has further complicated the laws regarding hemp is the emergence of intoxicating hemp, hemp from which psychoactive substances are derived to create a variety of intoxicating consumer products. Federal law on intoxicating hemp is unclear, and states are all over the place in how they deal with intoxicating hemp products.
While hemp is technically legal under federal law, the Food and Drug Administration maintains jurisdiction over hemp (and therefore CBD) to the extent it is marketed as a food or dietary supplement or as a drug. The FDA, however, declined to issue regulations on CBD as a food supplement due to what it referred to as “safety concerns.” Also, the state statutory and regulatory framework for hemp and CBD derived from hemp remains very confusing and is rapidly evolving.
This section will focus on recent case law developments in cannabis.
§ 5.2. Bankruptcy
In re Callaway, 663 B.R. 109 (Bankr. N.D. Cal. 2024)
Date: June 26, 2024
Facts: On February 12, 2024, an individual Debtor filed for chapter 7. The bankruptcy estate largely only included ownership of cannabis dispensaries and claims for distributions from one of the cannabis dispensaries. The bankruptcy estate did not list any tangible assets that bear a connection to marijuana that are covered by the CSA and does not include the Debtor’s post-petition income from the marijuana business. Creditor and United States Trustee for Region 17 filed Motions to Dismiss the case pursuant to 11 U.S.C. 707(a) alleging only that the chapter 7 trustee cannot lawfully administer assets in this case because the Debtor’s business involves cannabis and thus administration would violate the Controlled Substances Act.
Held: The Court denied the Dismissal Motions.
Reasoning: The Court finds there is no basis for dismissal from chapter 7 where the only cause asserted is that the Debtor owned interests in marijuana businesses when he filed and thus the chapter 7 trustee will have difficulty administering the bankruptcy estate. The Court further reasons that the possible sales of intangibles related to marijuana, but not directly referenced in the Controlled Substances Act, such as contractual rights, domain names relating to marijuana and ownership interests in LLCs, are not enough to bar the debtor from chapter 7 relief as they are not necessarily equivalent to administering marijuana assets. For the ownership interest in the marijuana businesses that Debtor holds singly, the Court reasons that since the Debtor is the named operator of the marijuana business, the trustee may cease operations. For the ownership interests where the Debtor is a minority owner, the Court reasons that (i) the potential sale of a membership interest in an LLC is just that rather than the proceeds of a marijuana business; and (ii) a claim for proceeds are a claim for entitlements owed to holder of ownership interests rather than a claim for proceeds of marijuana business. The Court buttresses this decision by explaining that under California law, shareholders only have an expectancy interest in corporate property and earnings. The Court also distinguishes this case from other chapter 7 cases by reasoning that (i) the Debtor does not receive rental income from the marijuana business; (ii) the Debtor does not cultivate marijuana; and (iii) the trustee would not have to administer tangible marijuana assets held by the businesses.
In re Blumsack, 657 B.R. 505 (B.A.P. 1st Cir. 2024)
Date: March 5, 2024
Facts: A United States Trustee (UST) objected to the confirmation of a Chapter 13 plan filed by a debtor who was a cannabis dispensary worker in Massachusetts. Particularly, the debtor’s filed plan proposed paying off creditors with funding sourced by his income from working at the dispensary. The UST moved to dismiss the case, arguing that the debtor was engaged in criminal activity proscribed by the federal Controlled Substances Act (CSA) by virtue of his employment in the marijuana industry. The United States Bankruptcy Court for the district of Massachusetts denied the confirmation and dismissed the case. The debtor appealed.
Held: Motion to Dismiss affirmed, but not for reasons based on the categorical prohibition of individuals employed in the cannabis industry seeking Chapter 13 relief.
Reasoning: The nature of a debtor’s employment in the cannabis industry, by itself, does not categorically render the debtor unable to file a Chapter 13 petition in good faith, for plan-confirmation purposes. This is because Congress has not articulated a “zero-tolerance” policy that requires dismissal of a bankruptcy case involving violation of the CSA. However, a Chapter 13 plan must be filed in good faith. Here, the debtor lacked good faith in his plan proposal, which consisted of paying creditors a certain amount every month that was funded by his income from his work at the dispensary. This proposal was not in good faith because the plan would have placed the UST in the untenable position of knowingly administering assets derived from illegal activity under federal criminal law. In fact, bankruptcy relief is generally unavailable where the trustee will be required to possess and administer assets that are illegal under the CSA or constitute proceeds of activity criminalized by the CSA.
Furthermore, when given the chance to re-file the proposal with a different means of funding the plan than his income from the dispensary, the debtor failed to provide alternative sources of funding. Thus, the plan proposal was not proposed in good faith and the bankruptcy court did not abuse its discretion in denying the debtor an opportunity to file a modified plan. In sum, although the bankruptcy court erred in fashioning a rule of law that categorically prohibits an individual employed in the cannabis industry from seeking Chapter 13 relief, this debtor’s case was properly dismissed for cause.
Facts: Defendant orally agreed to pay Plaintiff a $100,000.00 bonus if Plaintiff harvested 1,400 pounds of dry cannabis crop. Defendant did not honor the agreement and Plaintiff sued for breach of contract. The trial Court found that Defendant breached the contract and ordered $100,000.00 in damages. On appeal, Defendant asserted the contract is void under the illegal contract defense.
Held: Trial court decision reversed.
Reasoning: The Court of Appeals of Texas found that the contract is illegal under federal law and is therefore unenforceable. The Court reasoned that the contract is illegal because the Plaintiff contracted to manufacture marijuana, an activity which is illegal under the Controlled Substances Act (CSA). The Court noted that the legality of manufacturing marijuana under Oregon law is irrelevant because Oregon law itself gives the Controlled Substances Act preemptive authority. This means the contract could not be performed legally and is therefore unenforceable in the absence of an exception. The pari delicto exception was found to be inapplicable because both parties knew that manufacturing marijuana was illegal when they entered into the contract.
The public policy exception was found to be inapplicable because Congress has a strong public policy underpinning the Controlled Substances Act. The public policy set forth by Congress is to protect general health and welfare by conquering drug abuse and controlling the traffic in controlled substances. Plaintiff alleges that the public policy exception should still apply because the difference between the federal government’s de jure and de facto public policy renders federal public policy ambiguous. The Court rejects Plaintiff’s assertion of ambiguity in the federal public policy for two reasons. First, Plaintiff incorrectly treats discretionary acts by members of the executive branch as alterations in public policy. The Court explains that Congress is the final authority as to public policy. Second, the acts of Congress that Plaintiff asserts establish ambiguity relate only to medical marijuana and thus do not apply to recreational marijuana cases like this one.
Plaintiff asserts that the illegality defense should be limited to cases where it is the remedy sought that requires a violation of law. The Court found this argument to be inconsistent with Texas law. In Texas, if the illegal act and contractual obligation to pay are inseparable, then they “must fall together.” As the Court explains, the right to payment here arose from the manufacture of marijuana. Furthermore, the Court rejected Plaintiff’s argument that the contract should be enforceable to prevent BRCC from obtaining a windfall. The reasoning is that Texas illegality law does not grant much weight to the windfall argument when the parties are in pari delicto.
Finally, Plaintiff cites cases where federal courts held that the illegality of the marijuana business is not a valid defense to a Fair Labor Standards Act (FLSA) claim. The Court distinguishes these cases by reasoning that this is not a FLSA claim and the FLSA does not require this bonus. Rather, the obligation to pay arises from a contract and the illegality defense does apply to contract cases.
Facts: Plaintiff set up a plan to avoid the residency requirement in the Colorado marijuana regulatory regime without changing its domicile. The plan was organized as follows: (i) a resident owner obtained the marijuana license; (ii) the resident owner owned and operated the business on paper; (iii) Plaintiffs (domiciled in Florida) provided the funding and actually ran the business; and (iv) the parties agreed that Plaintiff would buy the business if and when the Colorado Marijuana Enforcement Division (MED) approved them for their own licenses in Colorado. MED was only aware that Plaintiff was an unsecured creditor of the business. In 2018, Plaintiff replaced the resident owner with the Defendants who agreed to the same terms. The Defendant filed a change of ownership application that explained Plaintiff’s intent to acquire the company. The MED withheld approval until Plaintiff’s future ownership was removed. The approved application contained an unsecured promissory note for the purchase price. When the residency requirement was lifted, Defendants refused to transfer the business to Plaintiff. Lawsuits ensued. The trial court denied all relief to both parties. Plaintiff appealed the Trial Court’s decision to (i) apply the doctrine of unclean hands to preclude equitable relief and (ii) decline to enforce the promissory note on the basis of illegality.
Held: The decision of the trial court to deny relief is affirmed.
Reasoning: The Court upholds the Trial Court’s decision to deny equitable relief based on the doctrine of unclean hands. The Court rejected Plaintiff’s defense that they were relying on the advice of their counsel because their attorney advised them of the risks. Plaintiff also argued tha the doctrine of unclean hands is inapplicable because they were merely an unsecured creditor rather than an illegal undisclosed owner. The Court finds that Plaintiff was an undisclosed owner reasoning that (i) the Plaintiff acted as the owner in practice; (ii) the Plaintiff’s behavior falls under the relevant Colorado regulations’ definition of owner and (iii) the agreement of the parties entitled Plaintiff to ownership rather than repayment of the debt. Finally, Plaintiff argued that the Trial Court’s decision creates a substantial injustice because it grants the Defendants, who were also wrongdoers, a substantial windfall. The Court rejects this argument by reiterating that equitable remedy is not available to a party with unclean hands.
The Court upholds the decision of the trial court to deny enforcement of the promissory note. The Court applies the rule that agreements which violate the law or a regulatory scheme are unenforceable because their enforcement would violate public policy. The Court considers the promissory note to be such an agreement because it was essential in furthering the illegal arrangement that violated the Colorado regulatory scheme and therefore cannot be separated from it.
Bartch v. Barch, 111 F.4th 1043 (10th Cir. 2024)
Date: July 29, 2024
Facts: The Parties were partners in a marijuana business licensed to operate in Maryland. Creditor relinquished his ownership in the business after Debtor agreed Creditor would be able to rejoin later. Debtor did not uphold this agreement and blocked Creditor’s efforts to rejoin. Creditor sued for breach of contract. Debtor did not assert the defense of contract illegality and the district court found Debtor liable for breach of contract. Creditor was awarded a judgment of $6.4 million against Debtor.
When Debtor failed voluntarily to pay any of the damages, Creditor sought enforcement of the judgement in the District Courts for the District of Maryland and the District of Colorado. On May 9, 2023, the District Court of Colorado ordered Debtor to (i) sell their equity interests in the business; (ii) direct the proceeds to Debtor until the judgment is satisfied and (iii) not take any action that would undermine value. On June 29, 2023, Debtor appealed the District of Colorado’s judgment enforcement order.
On September 5, 2023, Debtor moved the district court to reconsider the judgment under Federal Rule of Civil Procedure 60(b)(4). The Court denied the motion. Debtor also appeals this judgment.
Held: The district court’s original judgment reconsideration order is upheld. The district court’s judgment enforcement order is remanded to district court.
Regarding the judgment enforcement order, the Court rejects Debtor’s arguments that Creditor lacks standing and the district court lacked authority. However, the Court vacates the order and remands for the district court to consider whether the order violates public policy.
Reasoning:
Original Judgment Reconsideration Order
Debtor argues that the Court should find the original judgment was void because Creditor lacked standing as the redress sought would violate the Controlled Substances Act. The Court rejects this argument and upholds the original judgment reasoning that finality relief is available only for a total want of jurisdiction or a violation of due process. The Court rules that Debtor’s argument is not actually a standing argument. Rather, Debtor is just trying to frame the contract illegality defense as a standing issue to make it fit as a lack of jurisdiction. The Court rules that Debtor’s failure to assert the contract illegality defense before is not a reason to reverse the district court’s decision. In addition, the Court reasons that the standing argument fails because: (i) Creditor had standing and (ii) the judgment does not require Debtor to violate the law because it does not specify the damages must be paid from a particular source.
Judgment Enforcement Order
Debtor argues the district court lacked authority to enter the judgment enforcement order under C.R.C.P. 69(g) for two reasons. The first is that a charging order is the exclusive remedy for applying LLC member’s equity interest to a judgment. The Court finds that the case law is unclear and decides that the Colorado Supreme Court would not find that a charging order is the exclusive remedy. The second argument Debtor makes is that they lacked sufficient control over the business’s equity for the court to order them to divest it since they cannot freely divest it. The Court finds that Debtor has sufficient possession as actual possession is not required under C.R.C.P. 69(g) and the order accounted for their limitations.
Debtor appeals from the judgment enforcement order arguing that Creditor lacked standing because the order would violate the Controlled Substances Act. The Court rules that the Creditor meets the test for standing and notes that the property specified in the order does not affect standing.
The Court rejects Debtor’s argument that Creditor lacked standing because the order would violate the Controlled Substances Act by reasoning that the Creditor meets the test for standing. The Court notes that the property specified in the order does not affect standing.
Debtor also alleges that the order violates the CSA and therefore would violate public policy. The Court decides that while the order does not specifically require the Debtor to cultivate, sell or process marijuana in violation of the CSA, more information is needed to decide if the order would effectively require them to do so. The Court acknowledges that the order would be invalid if the district court finds the order violates public policy. The Court notes that the requirement not to undermine value of the equity may require Debtors to cultivate, process or sell marijuana.
Subsequent Developments: As of January 2025, the remand is still under consideration by the Colorado Trial Court. At present, the Colorado trial court has taken these actions to resolve the case: (i) held a status conference that ended with an order requiring the parties to submit briefs; (ii) ordered that if Debtor liquidates any of his interests or the business’ holdings then the proceeds from that liquidation must be given to Creditor and (iii) ordered Debtor not to encumber their interests in the business. On December 17, 2024, the United States District Court for the District of Maryland granted the Creditor’s motion for release of funds held in Court’s registry and denied Creditor’s request for a rehearing as moot.
Bartch v. Barch, 721 F.Supp.3d 380 (D. Md. 2024)
Date: March 5, 2024
Facts: The facts are the same as above. When Debtor failed to make voluntary payments for the damages, Creditor sought enforcement of the judgement in the District of Maryland. The Court granted Creditor a charging order against Debtor’s membership interests in the business on May 16, 2023. Debtor moved to vacate the charging order.
Held: Debtor’s motion is denied.
Reasoning: Debtor argues that the Court lacked subject matter jurisdiction to enter the charging order directing the business to give Debtor’s payments to Creditor because those payments come from the sale of a federally illegal substance. The Court rejects this argument because (i) Debtor’s cited case law is not applicable; (ii) Creditor has standing and (iii) even if Courts could not enforced a contract based on a cannabis business, the fact that the order is related to cannabis does not preclude the court from enforcing a valid judgment of another court.
The Court rejects Debtor’s claim that the charging order is an extraordinary circumstance that merits relief under 60(b)(b) because it facilitates ongoing violations of the CSA and thus relief is necessary to accomplish justice. Their reasoning is that the lack of agreement among courts on how to treat cases concerning marijuana businesses that are legal in their states does not rise to the level of an extraordinary circumstance.
Facts: Fejes, a Federal Aviation Administration (FAA) licensed pilot and owner of an Alaskan marijuana cultivation facility, transported marijuana by aircraft within Alaska. The consumption and sale of marijuana is legal in Alaska. However, marijuana is still a controlled substance under federal law. In some remote parts of Alaska, aircraft are the only mode of delivering goods, including marijuana. Nonetheless, the FAA revoked Fejes’s pilot certificate under 49 U.S.C.A. § 44710(b)(2), which mandates that the FAA Administrator “shall” revoke a certificate when a pilot knowingly uses an aircraft for an activity punishable by more than a year’s imprisonment under a federal or state controlled substance law. Correspondingly, distributing marijuana via aircraft is a federal crime under 21 U.S.C. § 841(a), punishable by a term of imprisonment for more than one year. Fejes appealed the Administrator’s order to an Administrative Law Judge and the National Transportation Safety Board, admitting that he piloted an aircraft to distribute marijuana within Alaska, but argued that his conduct fell outside of § 44710(b)(2)’s reach. Both respectively affirmed the revocation. Fejes petitioned the ninth circuit court for review.
Held: Petition for Review denied.
Reasoning: The court held that the intrastate transportation of marijuana had sufficient effect on interstate commerce to fall within scope of Congress’ power under the Commerce Clause. This is because the Commerce Clause covers: (1) “the use of the channels of interstate commerce,” (2) the protection of “instrumentalities of interstate commerce,” and (3) “activities having a substantial relation to interstate commerce.” The court finds that “the interstate transportation routes through which persons and goods move” are “channels of commerce.” Similarly, navigable airspace is an interstate route through which goods move. Aircraft is also an instrumentality of interstate commerce. Furthermore, growing marijuana for personal use had a substantial effect on interstate commerce. Thus, this case fell within the scope of § 44710(b)(2)’s reach.
Additionally, Fejes argued that: (1) the FAA abused its discretion by revoking his pilot certificate when his conduct did not fall into enforcement priority categories identified in a memorandum from the then-Deputy Attorney General, on marijuana-related prosecutions; (2) § 44710(b)(2) requires a conviction before the FAA can revoke a certificate; and (3) § 44710(b)(2) requires the individual to know that his or her activity was punishable under the law.
The court found clear fault in all of those arguments. Fejes’s first argument failed because an agency’s enforcement discretion is generally not judicially reviewable. In fact, the court found agencies have enforcement discretion because an agency generally cannot act against each technical violation of the statute it is charged with enforcing. Essentially, an agency is far better equipped than the courts to deal with variables involved in the proper ordering of its priorities; and even upon review of the agency’s actions, the court finds that the FAA did not exceed its statutory power by revoking the pilot license. The second argument failed because the court found that an actual conviction of an activity punishable by more than a year’s imprisonment under federal controlled substances law is unnecessary for certificate revocation. Lastly, the third argument failed because the court concluded that Fejes was not required to know his activity was punishable by law, only that he knowingly engaged in the activity that is punishable. Fejes admitted to knowingly engaging in his act. Accordingly, the FAA’s revocation was not an abuse of discretion.
Cocroft v. Graham, 122 F.4th 176 (5th Cir. 2024)
Date: November 22, 2024
Facts: The owner of a medical-marijuana dispensary and the dispensary itself brought a § 1983 action against the Commissioner of the Mississippi Department of Revenue, the Mississippi Alcoholic Beverage Control Bureau, and the Mississippi Department of Health, in their official capacities. The plaintiffs alleged that Mississippi’s near-total restriction on the advertising of medical marijuana violated the plaintiffs’ First Amendment free speech rights. The plaintiffs claim that Mississippi’s rules prevent them from effectively reaching new customers, informing the public about Mississippi’s medical marijuana program, and informing the public about the dispensary’s location, product, and prices. The plaintiffs revealed that if it were not for the restriction, they would advertise through print, broadcast, and other media. The United States District Court for the Northern District of Mississippi granted the defendants’ Motion to Dismiss. The plaintiffs appealed.
Held: Motion to Dismiss affirmed.
Reasoning: Speech that is commercial receives no First Amendment protection if the underlying commercial conduct is illegal. The court recognized that under Mississippi state law, the sale and use of marijuana for certain medical purposes is authorized. However, the advertisement of medical marijuana is strictly regulated to listings in business directories, appropriate signage on dispensary property, advertisements on the dispensary website, and sponsorship for advocacy events and non-profit charity. However, the plaintiffs took issue with the fact that the state law prohibited dispensaries from advertising and marketing in any broadcast, electronic, and print media. The prohibition against distributing mass text and email communications, displaying medical cannabis products in public view, paying for reviews, and endorsements were also parts of state legislation that the plaintiffs took issue with.
By contrast, the federal Controlled Substances Act (CSA), prohibits the sale of marijuana altogether. Consequently, the Supremacy Clause establishes that federal law supersedes state law. Thus, the CSA is the reigning law in Mississippi, regardless of state law. Therefore, marijuana is illegal in Mississippi, and the state will not face a constitutional obstacle for restricting commercial speech relating to all unlawful transactions concerning the sale of it. In conclusion, the state is authorized to prevent the advertisement of medical marijuana under the Supremacy Clause.
§ 5.5. Patents
§ 5.5.1. Staying Overlapping Patent Claims and Trade Dress Claims
Sunshine Enclosures LLC v. Final Bell Corp., 2:23-cv-08466-CAS (AGRx) (C.D. Cal. Oct. 18, 2024)
Date: October 18, 2024
Facts: Sunshine Enclosures specializes in innovative packaging, and it filed suit against Final Bell for patent infringement of its ’604 design patent, and for trade dress infringement over the same design. Final Bell offers outsourcing services for packaging and finishing cannabis-infused products using “state-of-the-art hardware and child-resistant packaging.” Final Bell filed for reexamination of the ’604 design patent at the U.S. Patent and Trademark Office (USPTO) based on prior art references not considered before. Final Bell then sought to stay proceedings on all claims in the lawsuit, pending the reexamination of the ’604 patent by the PTO. The parties agreed that the claim for patent infringement should be stayed, but they disagreed about the remaining claims, including those relating to trade dress infringement.
Held: Stay was granted for all claims in the lawsuit because the design patent reexamination would simplify the remaining issues in the case. Trade dress protection requires that the trade dress be unique, which would be addressed by the reexamination of the ’604 design patent.
Reasoning: The Court weighed all of the factors regarding staying litigation: (1) stage of litigation, (2) simplification of issues, and (3) undue prejudice to the non-moving party. In discussing the “simplification of the issues” factor, the Court considered whether the patent claim and the other claims have overlapping issues. The defendant argued that plaintiff’s trade dress claims “arise from the allegedly patented products that are covered under its patent claim” and are thus “intertwined.” In opposition, the plaintiff argued that most of its claims are non-patent related and thus “‘will be completely unaffected by the patent reexamination proceedings.’”
The defendant argued that because the trade dress claims require that the packaging at issue has “acquired distinctiveness, meaning it serves to identify the source of the product,” an invalidation of the patent due to prior art “implies that the design was already known and in use before the patent was filed.” Plaintiff argued the defendant was conflating novelty and obviousness, and that obviousness does not undermine the distinctiveness required for a trade dress claim, as a finding that the design was not novel might. The court found that because the ’604 design patent is for the same packaging that is at issue for the trade dress claims, the patent infringement and trade dress claims are sufficiently related. The Court contrasted the facts of this case with Mophie, Inc. v. uNu Elecs. Inc., 8:13-cv-01705-CAS (JCGx) (C.D. Cal. Dec. 1, 2014), which found that it was “unclear how claims relating to nonfunctional trade dress design elements, packaging, and naming of products [were] ‘intertwined’ with the patents in suit,” which were utility patents, not design patents. Mophie, 2014 U.S. Dist. LEXIS 166930, 2014 WL 6775768, at *7.
§ 5.5.2. Judgement as a Matter of Law and Apportionment by Activities Inside versus Outside the United States
Shopify Inc. v. Express Mobile, Inc., No. 19-439-RGA (D. Del. May 17, 2024)
Date: May 17, 2024
Facts: After a five-day trial, the jury found that Shopify infringed all of the asserted claims and awarded Express Mobile $40 million in damages. Shopify sought judgement as a matter of law (JMOL) for non-infringement of the asserted patent claims and a new trial. The asserted claims related to technology that allows merchants to build their own online websites. While Shopify’s servers are generally in the U.S., Shopify’s servers and stores for Canadian cannabis stores are hosted outside of the United States.
Held:
JMOL motion: Shopify’s JMOL motion was granted. The evidence the jury heard with regard to infringement was unclear, and the Court found that there was insufficient evidence to support a finding of infringement. The Court found that there was insufficient evidence for the jury to find infringement because the evidence did not show that Shopify’s system has a singular UI object that both receives input values and displays output values.
Damages: The revenue from Canadian cannabis stores could be included in the calculation of the $40 million dollar damage award, as the jury could reasonably conclude that Canadian cannabis servers led to a de minimis contribution to Shopify’s total revenues.
Reasoning:
JMOL motion: At the core of the parties’ disagreement is whether a “defined UI object,” as claimed, can include multiple UI objects. “A defined UI object” was not interpreted prior to the trial or raised at the trial, so any argument based on its interpretation was considered moot. Without testimony identifying Shopify’s product pages as “defined UI objects,” the jury had no basis to find that there were any defined UI objects that both received input values and produced output values.
Damages: Since only infringing activities inside the United States are actionable, Shopify argues that the royalty base included revenues from non-infringing conduct, and therefore the damages award was too high. The jury heard evidence that the servers outside of the U.S. were only for restricted goods sold in Canada, so the Court found that they could conclude that if there was any error, and if a proper objection was preserved, the error was de minimis and had no impact on the amount of damages awarded.
§ 5.5.3. Attorney Fees
Townsend v. Brooks Sports, Inc., No. 2:17-cv-01322-LK (W.D. Wash. Mar. 31, 2024)
Date: March 31, 2024
Facts: Herbert E. Townsend sued Brooks Sports, Inc. for infringing claim 1 of his U.S. Patent No. 7,490,416 (the ’416 Patent), which covers a running shoe with a midsole containing a dilatant compound for improved cushioning and energy return. Brooks Sports counterclaimed for a declaratory judgment of noninfringement and invalidity. The case was initially filed in the Middle District of Florida but was transferred to the Western District of Washington. Brooks Sports successfully petitioned for inter partes review (IPR) of the ’416 Patent, and the Patent Trial and Appeal Board (PTAB) found claim 1 unpatentable. The Federal Circuit affirmed this decision.
Held: The court denied Brooks Sports’ motion for over $1 million in attorney fees under Section 285 of the Patent Act. The court found that Townsend’s conduct did not make the case exceptional, which is required for awarding attorney fees.
Reasoning:
Pre-Suit Investigation: The court found that Townsend conducted an adequate pre-suit investigation. His patent counsel performed a good faith infringement analysis based on Brooks Sports’ advertisements and marketing materials, which described the Brooks DNA material in a manner consistent with the ’416 Patent’s dilatant compound.
Strength of Claim 1: Although the PTAB found claim 1 unpatentable, the court noted that not all of Brooks Sports’ challenges to the claim were successful. The court emphasized that the reasonableness of Townsend’s position, not the ultimate outcome, is what matters for determining exceptionality.
Litigation Conduct: The court did not find Townsend’s litigation conduct to be unreasonable. His opposition to the motion to transfer venue was based on a legitimate interpretation of the law, and his actions during discovery were typical of litigation disputes.
Overall, the court concluded that the case did not stand out from other patent infringement cases in a way that would justify awarding attorney fees to Brooks Sports.
United Cannabis Corp. v. Pure Hemp Collective Inc., 66 F. 4th 1362 (Fed. Cir. 2023)
Date: May 8, 2023
Facts: United Cannabis Corp. (“UCANN”) sued Pure Hemp Collective Inc. (“Pure Hemp”) for infringement of its U.S. Patent ’9,730,911 (the “’911 Patent”). The ’911 Patent claims specific formulations of cannabis extracts including THC, defined during claim construction as the decarboxylated form of tetrahydrocannabinolic acid (THCa). Pure Hemp sought an early dismissal on the basis that the asserted claims were invalid under 35 U.S.C. § 101. Pure Hemp argued that the ’911 Patent claimed the natural phenomenon of cannabinoids, terpenes, and flavonoids included in the cannabis plant, and was therefore invalid. However, the District Court denied the motion, finding the ’911 Patent was directed to a non-naturally occurring delivery method of naturally occurring chemicals in non-naturally occurring proportions and concentrations.
The District Court held a Markman hearing and construed the disputed terms of the ’911 Patent’s asserted claims. UCANN filed for bankruptcy shortly after the Markman Order issued. A joint Stipulation of Dismissal, which was silent regarding attorney’s fees, was filed and granted. Pure Hemp then sought attorney’s fees, which were denied. Pure Hemp appealed, seeking reversal on the grounds that the District Court did not find: (1) Pure Hemp to be the prevailing party; (2) the undisputed facts established inequitable conduct; and (3) UCANN’s attorneys had a conflict of interest meriting sanctions.
Held: The Court found that while Pure Hemp was the prevailing party, the case was not exceptional. The District Court was affirmed, and attorney’s fees were denied.
Reasoning: Pure Hemp was found to be the prevailing party because UCANN’s efforts to impose liability on Pure Hemp failed. Pure Hemp rebuffed UCANN’s lawsuit and successfully had the infringement claims dismissed with prejudice. The Court found that dismissal with prejudice has sufficient judicial imprimatur to make Pure Hemp a prevailing party. Because Pure Hemp successfully argued it was the prevailing party, the Court found the appeal was not frivolous. Therefore, UCANN’s request for sanctions was denied. However, the District Court’s mistake in finding Pure Hemp was not a prevailing party was harmless as the case was affirmed as unexceptional.
Pure Hemp explicitly did not ask for any evidentiary hearings on its counterclaim of inequitable conduct—even informing the District Court that Pure Hemp did not seek a hearing. Instead, Pure Hemp pointed to the undisputed facts in an attempt to satisfy its burden. However, the Court identified genuine disputes of facts regarding both elements needed to establish inequitable conduct. The Court of Appeals declined Pure Hemp’s invitation to make its own findings of fact. And so, Pure Hemp’s argument failed.
Pure Hemp’s final argument for reversal was found to be waived because Pure Hemp failed to cite the Rule on which its conflict contention was based before the District Court. Therefore, the Court found the argument was waived. Nevertheless, the Court found the predominant feature of Pure Hemp’s argument was the lack of evidence and noted the argument would have been rejected on the merits.
§ 5.6. Real Estate
Aldot Holding Corp. v. Ninth Ave. Organic Deli & Convenience Corp., 83 Misc. 3d 1269(A) (Civ. Ct. N.Y. Cnty., Aug. 9, 2024)
Date: August 9, 2024
Facts: In this case the court addressed a dispute over the illegal use of leased premises for the unlicensed retail sale of cannabis. Aldot Holding Corporation, the petitioner and landlord (the “Landlord”), sought to recover possession of the premises located at 852 9th Avenue, New York, NY 10019, from the respondent, Ninth Avenue Organic Deli & Convenience Corp. d/b/a Herbal House (the “Tenant”). The Landlord filed a holdover petition on April 22, 2024, alleging that the respondent was using the premises for the unlicensed sale of cannabis. The Tenant filed an answer with counterclaims on May 10, 2024. Both parties moved for summary judgment. The Landlord provided evidence, including affidavits, lease agreements, and photographs, to support its claim of illegal use. The Tenant argued that it had not received proper notice and that the Landlord had waived any default by accepting rent.
Held: The court granted the Landlord’s cross motion for summary judgment, awarding a final judgment of possession of the premises to the Landlord and issuing a warrant of eviction. The Tenant’s motion for summary judgment was denied. The court also dismissed the Tenant’s counterclaims based on a lease provision that waived the right to interpose counterclaims in a summary proceeding for possession. The Landlord’s request for a money judgment was denied without prejudice due to lack of supporting documentation.
Reasoning: The court found that the Landlord had made a prima facie case of illegal use of the premises by providing sufficient evidence, including affidavits and photographs, showing that the Tenant was selling cannabis products without a license. The Tenant failed to produce sufficient evidence to rebut the Landlord’s prima facie case. The court determined that a termination notice was not required for an illegal use proceeding unless a governing regulatory scheme required it, which was not the case here. The Tenant’s argument regarding improper service was rejected due to lack of evidence. The court also rejected the Tenant’s argument that the Landlord waived any default by accepting rent, as the only rent paid was for March 2024. The court found that the Tenant’s illegal use of the premises violated the lease agreement, which required compliance with all laws and regulations, and granted a final judgement of possession of the premises to Landlord and ordered an eviction of the Tenant.
Lasa Extract, LLC v. Town of Suffield Zoning Bd. of Appeals, No. HHD-CV-236166972-S (Conn. Super Ct., Apr. 10, 2024)
Date: April 10, 2024
Facts: In the case the court examined whether the cultivation and processing of cannabis could be considered a lawful continuation of a nonconforming use of property previously used for cultivating and processing hemp. Here, Lasa Extract, LLC and The Crosswalk, LLC (the “Plaintiffs”) owned and operated a property in Suffield, Connecticut, used for cultivating and processing hemp. The property, located in an R-45 residential zone, had been used for manufacturing tobacco products since the 1920s, which was deemed a nonconforming use. In 2019, the town’s zoning enforcement officer (the “ZEO”) determined that processing hemp was similar enough to tobacco processing to be allowed as a continuation of the nonconforming use. Plaintiff then used the property to grow Cannabis sativa L. plants and process them into hemp oil, which initially contained THC levels above 0.3 percent. The THC concentration was then reduced by adding coconut oil to comply with legal limits for hemp. In 2021, Connecticut legalized the adult recreational use of marijuana and established a regulatory regime for licensing the micro-cultivation of cannabis. In 2022, Plaintiff sought to expand its operations to include cannabis cultivation and processing, arguing that it was a continuation of the existing nonconforming use. The ZEO denied this request, and the Zoning Board of Appeals (the “ZBA”) upheld the decision, leading to the Plaintiffs’ appeal.
Held: The court reversed the ZBA’s decision, allowing the plaintiffs to cultivate and process cannabis on the property as a lawful continuation of the existing nonconforming use. The court found that the ZBA acted unreasonably and contrary to law in affirming the ZEO’s determination.
Reasoning: The court’s reasoning focused on whether the cultivation and processing of cannabis would change the character of the property’s use. The court noted that both hemp and cannabis come from the same plant, Cannabis sativa L., and that the only difference between them is the concentration of THC. The court found that the existing process of extracting hemp oil already involved producing cannabis-level THC concentrations, which were then diluted to legal hemp levels. Therefore, the proposed use of the property for cannabis cultivation and processing did not fundamentally change the character of the use. The court decision specifically distinguishes this case from the legal precedent cited by the ZBA, including Salerni v. Scheuy (finding that the permitted sale of beer only in a restaurant does not permit expansion to the sale of all liquors, as they are two kinds of business), Macaluso v. Zoning Board of Appeals (held that the sale of liquor in a package store is an enterprise of substantially greater magnitude than the sale of liquor in a drug store), and Helicopter Associates, Inc. v. Stamford (finding that expansion of a helipad from the unlicensed maximum of 36 flights per year to an unlimited use was deemed a fundamental change to the character of the existing use), but determined that those cases did not support the ZBA’s broad interpretation that differing statutory treatment alone (here, hemp vs. cannabis) constituted a change in character. The court concluded that the administrative record did not contain substantial evidence that cultivating and processing cannabis for wholesale and mail order sales (specifically providing that retail sales would not be permitted) would change the character of the existing nonconforming use and that the ZBA’s decision was unreasonable and contrary to law.
§ 5.7. State Law
Peridot Tree WA Inc. v. Washington State Liquor and Cannabis Control Bd., No. 3:23-cv-06111-TMC (W.D. Wash., Jan. 5, 2024)
Date: January 5, 2024
Facts: Washington established a social equity program designed to award retail cannabis licenses to parties who experienced detrimental impacts when cannabis was illegal in the state. This program assessed candidates based on a set of eligibility criteria and a scoring rubric. To qualify, candidates also needed to have resided in Washington for at least six months. Plaintiff’s application was rejected because he did not meet the residency requirement despite the fact that he was otherwise an ideal candidate for the program. Plaintiff (i) claims the program’s residency program violates the dormant commerce clause because it discriminates against out of state applicants and (ii) moved for injunctive relief to enjoin the Cannabis board from issuing licenses to successful applicants.
Held: Plaintiff’s motion for a preliminary injunction denied.
Reasoning: The Court rejects Plaintiff’s motion for preliminary injunction finding that Plaintiff’s possibility of irreparable harm does not outweigh the hardship to the Defendants, the public and interested parties if the injunction were to pass. First, the Court ruled that it is possible, but not likely that Plaintiff would suffer irreparable harm without the injunction. The only irreparable harm here that might be sufficient is Plaintiff’s argument that a constitutional violation is de facto an irreparable harm. However, the constitutional violation alleged here is that the residency requirement violates the CC. The Court ruled that Plaintiff likely cannot use the dormant Commerce Clause (CC) to assert a constitutional right to participate in the cannabis market because the CC does not protect a right to participate in a federally illegal interstate market. The Court found that the injunction would impose significant harms on the selected applicants of the program.
Cocroft v. Graham, 122 F.4th 176 (5th Cir. 2024)
Date: November 22, 2024
Facts: Plaintiff, a medical-marijuana dispensary, appealed the trial court’s decision to dismiss their First Amendment challenge to the near complete ban on medical marijuana advertisements.
Held: Judgment of dismissal is affirmed.
Reasoning: The Court finds that the Mississippi commercial speech restrictions do not violate the First Amendment because: (i) the First Amendment does not protect commercial speech where the underlying commercial conduct is illegal; (ii) medical marihuana is illegal under federal law and (iii) an activity is not a “lawful activity” for purposes of commercial speech if it violates federal law even where the activity is legal under the applicable state law. The Court rejects Plaintiff’s argument that the First Amendment does not authorize states to exercise its concomitant power to regulate commercial speech related to federally regulated transactions when that state itself has not also independently prohibited the transaction. Their reasoning is that this argument is unsupported by law and that the distinction Plaintiff attempts to draw is constitutionally irrelevant.
§ 5.8. Tax
Robust Missouri Dispensary 3, LLC v. St. Louis County, No. ED112642 (Mo. Ct. App. E.D, Nov. 12, 2024)
Date: November 12, 2024
Facts: The Missouri Constitution provides that “the governing body of any local government is authorized to impose, by ordinance or order, an additional sales tax in an amount not to exceed three percent on all tangible personal property retail sales of adult use marijuana sold in such political subdivision.” In 2023, Plaintiff paid the 3% retail sales tax imposed by the City of Florissant (an incorporated city). Then Plaintiff received a tax change notification letter requiring them to also pay a 3% retail sales tax to St. Louis County. Plaintiff filed a declaratory judgment suit alleging that the Missouri Constitution (i) does not authorize a county to declare an additional sales tax on a dispensary within an incorporated town, city or village and (ii) only allows counties to install retail taxes in unincorporated regions. Defendants filed motions for summary judgment. Plaintiff appealed the circuit court’s ruling that St. Louis County and St. Charles Counties impositions of 3 percent retail sales taxes on marijuana dispensaries in their counties are constitutional under Article XIV of the Missouri Constitution.
Held: The Court reverses the circuit court’s ruling, sustaining the Counties’ motions for summary judgment and overruling Plaintiff’s motion for summary judgment. The Court enjoins the practice of collecting retail sales taxes by multiple local governments.
Reasoning: The Court reverses the circuit court’s judgment, reasoning that “local government” as used in Article XIV of the Missouri Constitution means the village, town or city in an incorporated area and the county in an unincorporated area. The Court further rejects the Defendants’ arguments that the Missouri Constitution makes not only incorporated cities, towns and villages but also counties the local government in incorporated areas and that a county’s ability to tax unincorporated areas should mean that they are able to tax anywhere in their geographical boundaries. The reasoning is that these arguments do not align with the plain language of the section.
Facts: Petitioner is a medical cannabis dispensary in the state of California that would have received deductions on its 2016 tax return if not for Section 280E. Petitioner filed a petition for redetermination of its tax deficiency on the basis that (i) Section 280E is not constitutional because it is an unapportioned direct tax or an excessive fine in violation of the Eighth Amendment; and (ii) the Controlled Substances Act is not constitutional when applied to intrastate cultivation and distribution of cannabis that is legal in that state.
Held: The Internal Revenue Commissioner’s motion for summary judgment was granted, and the taxpayer’s motion for summary judgment was denied.
Reasoning: The Court rejected Petitioner’s arguments that 280E and the Controlled Substances Act are unconstitutional based on precedent.
§ 5.9. Trademarks
§ 5.9.1. Unlawful Use and Invalidating Trademark Applications
Ashh Inc. v. DJ Imp. Inc., No. 4:21-cv-03169 (S.D. Tex. Dec. 21, 2022)
Date: December 21, 2022
Facts: Ashh Inc. (“Ashh”) distributes vaporizer pens and batteries under its OOZE trademark. Ashh alleged that DJ Import Inc. (“DJ”) infringed its trademark by offering counterfeit vaporizer batteries and chargers under the trademark OOZE. DJ moved for summary judgment on the grounds that Ashh’s trademark rights were invalid because the goods are used in connection with unlawful products.
The court recognized that the Fifth Circuit has not adopted the “unlawful use” doctrine for trademarks. The doctrine stems from the recognition that trademarks are invalid under the Lanham Act if used in commerce in connection with unlawful goods. And so, the issue was whether Ashh’s goods are illegal under federal law.
The parties disagreed whether Ashh’s goods are “drug paraphernalia” as defined in 21 U.S. Code § 863 (“Section 863”). Drug paraphernalia are illegal goods under federal law.
Held: Motion for summary judgement denied because fact issue existed as to whether Ashh’s goods are drug paraphernalia.
Reasoning: Subsection (d) of Section 863 defines drug paraphernalia as products “primarily intended or designed for use” in manufacturing, ingesting, or inhaling illicit drugs, including marijuana. Subsection (e) of Section 863 lists several factors to determine whether goods are drug paraphernalia including instructions and descriptive materials on the item; advertising concerning the item’s use; the existence and scope of legitimate uses of the item; and expert testimony concerning the item’s use.
The court considered evidence showing Ashh’s OOZE goods are primarily used for ingesting marijuana, including: articles and social media posts showing a connection between OOZE goods and the marijuana industry; the statement of an expert that concluded Ashh’s OOZE goods are primarily used with marijuana; and the fact that Customs and Border Patrol had seized Ashh’s OOZE goods as drug paraphernalia. Ashh alleged that its OOZE goods may be used to consume marijuana. But offered manuals and webpages showing the goods may be used for lawful purposes, e.g., ingesting essential oils and hemp derived CBD. Because an issue of material fact existed as to whether OOZE vaporizers are drug paraphernalia, the court denied DJ’s motion for summary judgment.
Facts: Cosmic Crusaders, LLC, and Lewis Davidson (collectively “Appellants”) appealed the final order of the Trademark Trial and Appeal Board (the “Board”) granting Laverne J. Andrusiek’s (“Andrusiek”) petition to cancel Appellants registration for the CAPTAIN CANNABIS trademark for comic books. Appellants argued that the Board erred in determining that the parties had tried the issue of Andrusiek’s analogous trademark use to establish priority in the CAPTAIN CANNABIS mark and the evidence did not support that Andrusiek established priority.
Both parties use the CAPTAIN CANNABIS mark in connection with comic books. Lewis Davidson filed an application for the CAPTAIN CANNABIS mark with the United States Patent and Trademark Office on April 2, 2014, based on intent to use. This allowed Appellants to use the filing date as its constructive first use date, i.e., priority date, of the mark. Conversely, Andrusiek could establish priority as early as 2006 based on analogous trademark use and engaged in actual trademark use in 2017.
Held: The court affirmed the Board’s decision because it found that the Board did not abuse its discretion by considering the analogous trademark use issue and the record supported the findings regarding analogous trademark use.
Reasoning: The court noted that a party may rely on analogous trademark use to establish priority if the uses create an association in the minds of consumers between the mark and the goods despite the absence of “technical” or “actual” trademark use. Andrusiek’s petition to cancel Appellants’ registration included claims of marketing activities, i.e., analogous trademark use, on the one hand and bona fide commercial trade, i.e., technical trademark use, on the other. The Board also read Andrusiek’s reference to “common-law usage” in the petition to encompass both technical and analogous use. Taking the petition as a whole, the court held that Appellants were provided fair notice of the claims at issue. And so, the Board did not abuse its discretion when considering Andrusiek’s analogous use to establish priority.
Appellants also argued that the analogous use was not sufficient to impact the purchasing public and Andrusiek did not engage in actual trademark use within a reasonable time of the analogous use. Regarding the first argument, Appellants relied on Federal Circuit precedent that held a mark displayed to seven customers for a handful of print articles was insufficient to establish analogous use. T.A.B. Sys. v. Pactel Teletrac, 77 F.3d 1372 (Fed. Cir. 1996). But the court noted that T.A.B. emphasizes that direct evidence of a public association is not required and indirect evidence regarding a mark’s use in advertisements, brochures, newspapers, and trade publications may be sufficient to establish analogous trademark use. As to the second argument, Appellants argued that use of the CAPTAIN CANNABIS mark as the title of a single comic book was insufficient for actual trademark use. This is because trademark rights are typically not provided for the title of a single creative work.
The Board had relied on Andrusiek’s use of the CAPTAIN CANNABIS mark at trade shows, in social media posts, and in news and magazine articles associating the mark with Andrusiek to support analogous use. The court determined that the record was amply greater than that in T.A.B. Also, the Board relied on Andrusiek’s use of the CAPTAIN CANNABIS mark on a series of creative works namely, a movie, a screenplay, and a comic book. This led to the conclusion that the mark was used as more than a title of a single creative work and supported actual trademark use. And so, the court held that the Board did not abuse its discretion and affirmed the appeal.
§ 5.9.3. Attorney’s Fees and Non-Exceptional Trademark Claims
Edible IP, LLC v. MC Brands, LLC, No. 20-cv-05840 (N.D. Ill. Sept. 28, 2023)
Date: September 28, 2023
Facts: Edible IP, LLC, and Edible Arrangements (collectively, “Edible”) brought an action for trademark infringement and unfair competition under the Lanham Act against MC Brands, LLC, and Green Thumb Industries Inc. (collectively “GTI”) alleging the GTI infringed Edible’s rights in its EDIBLE and INCREDIBLE EDIBLES trademarks. GTI filed counterclaims requesting a declaration that Edible’s marks were generic and not entitled to trademark protection, its use of edibles was descriptive and therefore non-infringing, and there was no likelihood of confusion between GTI’s use of EDIBLES or INCREDIBLES and Edibles’ marks. The parties entered into a stipulation of dismissal of the case whereby Edible agreed to dismissal with prejudice and GTI agreed to dismissal of its counterclaims without prejudice. Subsequently, GTI moved for an award of attorney’s fees under 15 U.S.C. § 1117(a) (“Section 1117(a)”).
Edible owns several registrations for its EDIBLE mark for fruit, flowers, and candy, and arrangements thereof. It also registered its INCREDIBLE EDIBLES mark for similar arrangements as well as dietary and nutritional supplements. The additional goods were an attempt to enter a new market for CBD. Edibles first applied to register the INCREDIBLE EDIBLES mark in 2015. GTI uses its INCREDIBLES mark in connection with chocolates and candies that contain marijuana. And it alleged to have done so since 2010.
After dismissal, GTI moved for an award of attorney’s fees alleging that Edible’s choice to litigate the matter was objectively unreasonable and Edible’s litigation conduct made the case exceptional.
Held: The motion for attorney’s fees was denied because Edible’s claims were not objectively unreasonable, and its litigation conduct did not make the case exceptional.
Reasoning: Section 1117(a) allows a court to award attorney’s fees to a prevailing party in exceptional cases. The court noted that an exceptional case is one that stands out from others with respect to the substantive strength of a party’s litigation position or the unreasonable manner in which the case was litigated.
GTI argued that Edible’s litigation position was objectively unreasonable because Edible: did not have rights in the cannabis industry at the time of filing of the lawsuit, knew the term “edible” was generic in the cannabis industry, did little to promote its goods between 2010 and 2019, and did not provide credible evidence of likelihood of confusion. The court noted that Edible intended to expand to the CBD market by way of its application to register INCREDIBLE EDIBLES for CBD-related goods. Edible relied on its rights in both EDIBLE and INCREDIBLE EDIBLES as the basis for its claims. The former could arguably be generic in the cannabis industry while the inclusion of the term INCREDIBLE would perhaps make the INCREDIBLE EDIBLES mark at least descriptive. The court determined that Edible’s delay in promoting CBD products was in part because CBD remained a controlled substance until the enactment of the 2018 Farm Bill. Finally, the court determined that Edible’s inability to produce evidence of a likelihood of confusion did not make the case so weak as to label it frivolous or objectively unreasonable.
GTI also argued that Edible’s litigation conduct made the case exceptional because it delayed key discovery. Edible sought extensions of fact discovery six times, GTI filed five motions to compel Edible to produce discovery, Edible failed to disclose relevant witnesses in its Rule 26 disclosures, and allegedly sought deposition of GTI’s CEO for an improper purpose. Nevertheless, GTI admitted that it had obtained over one hundred thousand pages of documents during discovery. The court did not side with GTI on all of its motions to compel, which suggests that Edible did not have unreasonable positions on all discovery disputes. The court also found that Edible set forth a sufficient basis to depose GTI’s CEO.
In sum, the court did not find the case exceptional based on Edibles litigation position or conduct. And so, the court denied GTI’s motion to award attorney’s fees.
Ak Futures LLC v. TBH Supply LLC, No. 8:23-cv-01030-JVS-ADS (C.D. Cal. Oct. 11, 2023)
Date: October 11, 2023
Facts: Delta-9 Tetrahydrocannabinol (“THC”) is the primary psychoactive cannabinoid responsible for the “high” associated with marijuana. But other cannabinoids, like Delta-8 THC also have psychoactive effects. The 2018 Farm Bill kept marijuana illegal and defined it based on its Delta-9 THC concentration: “the plant Cannabis sativa L. and any part of that plant, including . . . all derivatives, extracts, cannabinoids, . . . with a delta-9 tetrahydrocannabinol concentration of not more than 0.3 percent on a dry weight basis.”
Ak Futures, LLC (“Futures”) began selling disposable vaporizers for Delta-8 THC under its CAKE trademark in October 2020. TBH Supply LLC (“TBH”) began selling cannabis products, including vaporizers, under its CAKE SHE HITS DIFFERENTLY trademark on September 15, 2020. Futures brought this action for false designation of origin and unfair competition under the Lanham Act and moved for a preliminary injunction. Both parties provided competing declarations concerning the lawfulness of the goods offered under the respective marks. And so, each party alleged that the other had not established trademark rights in their respective marks because the goods offered under the marks are unlawful.
Held: The motion for preliminary injunction was denied because Futures did not establish a likelihood of success on the merits.
Reasoning: Futures argued that TBH’s goods are unlawful because of the high potency of up to 84% THC included in its goods. But it did not rely specifically on the Delta-9 THC concentration of TBH’s goods. Futures also argued that TBH’s distribution of its products is unlawful because it is not licensed by the California Department of Cannabis Control (“CDCC”). But TBH alleged that it sells its CAKE SHE HITS DIFFERENT branded goods to its sister company, which is licensed by the CDCC, and that its goods are in total compliance with the CDCC’s regulations.
TBH obtained samples of Futures’ CAKE products and had them tested by third parties for their Delta-9 THC concentration. These tests disclosed that the CAKE branded goods included Delta-9 THC concentrations above 0.3%, which would make them unlawful under the Farm Bill. However, Futures’ independent testing disclosed that its goods were in compliance with the Farm Bill. Also, Futures argued that TBH did not use laboratories that comply with the USDA’S rules for Hemp Analytical Testing. And so, the results were therefore unreliable.
The court determined that Futures would only be successful if TBH’s goods are unlawful, and its CAKE goods are in compliance with the Farm Bill. Because a credibility determination concerning the parties’ competing declarations was not proper on a motion for preliminary injunction, the court denied Futures’ motion.
§ 5.9.4. Unlawful Use and Invalidating Trademark Applications
Facts: BBK Tobacco & Foods LLP (“BBK”) distributes rolling papers and other smoking-related products under its RAW trademark. Central Coast Agriculture, Inc. (“Central”) began selling cannabis products under its RAW GARDEN trademark and sought to register the mark with the United States Patent and Trademark Office (“USPTO”). BBK alleged that Central’s use of the RAW GARDEN mark infringed on BBK’s rights in its RAW trademark and brought several claims against Central, including trademark infringement. BBK also sought to cancel four of Central’s trademark applications for the RAW GARDEN mark based on a lack of bona fide intent to use the RAW GARDEN mark. Central filed counterclaims and sought to cancel BBK’s registrations for its RAW mark based on unlawful use. The district court entered summary judgement in favor of BBK on its claim to invalidate Central’s applications.
Held: The Ninth Circuit affirmed the district’s court grant of summary judgement.
Reasoning: The court held that that when an action involves a registered trademark, a district court has jurisdiction to consider challenges to trademark applications of parties to the action. The court cited 15 U.S.C. § 1119, which states that “any action involving a registered mark the court may determine the right to registration, order the cancelation of registrations, in whole or in part, restore canceled registrations, and otherwise rectify the register with respect to the registrations of any party to the action.”
The court found that “determine the right to registration” and “rectify the register” includes the power to determine disputes over trademark applications because a challenge to an application affects the applicant’s right to a registration. Accordingly, the plain language of § 1119 grants a district court jurisdiction to consider challenges to the trademark applications of a party to the action if the action involves a registered mark.
Because the action involved BBK’s registered mark, the district court had jurisdiction to “determine the right to registration” of Central’s applications.
The district court determined that Central lacked a bone fide intent to use its mark in commerce because its goods were illegal under federal law. Therefore, it ordered invalidation of the applications at the USPTO. Because the district court had jurisdiction pursuant to § 1119, the Ninth Circuit affirmed.
§ 5.9.5. Fraud and Goods Related to Cannabis
TIW Holdings LLC v. Hotbox Farms LLC, No. 3:24-cv-00126-AN (D. Or. Sep. 30, 2024)
Date: September 30, 2024
Facts: TIW Holdings LLC (“TIW”) began using the trademarks HOTBOX, HOTBOX 7500, and PUFF HOTBOX 7500 (“TIW Marks”) in connection with e-cigarettes and e-liquid products. TIW licenses the TIW Marks to Puff Labs, LLC (“Puff”), which is a wholesaler, distributor, and retailer of the goods offered under the TIW Marks. TIW and Puff Labs (“Plaintiffs”) alleged that use of the TIW Marks commenced in June 2022.
Hotbox Farms LLC (“Hotbox”) sells marijuana and non-marijuana goods under its HOTBOX trademark. Hotbox registered its HOTBOX mark with the USPTO for among other things, stickers, clothing, buttons, lighters, and corresponding retail services. Hotbox’s constructive use date of its HOTBOX mark was the filing date included in its intent to use based application, October 28, 2020.
Plaintiffs brought the action alleging that Hotbox committed fraud on the USPTO during the registration process of its HOTBOX mark and sought a declaratory judgement that the TIW Marks did not infringe Hotbox’s mark. Plaintiffs alleged that Hotbox purposefully withheld from the USPTO that it sells cannabis goods. Plaintiffs also alleged that Hotbox applied stickers to BIC branded lighters to obtain the HOTBOX registration and USPTO records established that Hotbox stated the HOTBOX mark was “printed” on each lighter.
Hotbox filed counterclaims alleging federal trademark and unfair competition and common law trademark infringement. Plaintiffs moved to dismiss the counterclaims because of Hotbox’s alleged fraud.
Held: The court denied Plaintiffs’ motion to dismiss because the heavy burden of demonstrating fraud was not met and Hotbox sufficiently plead likelihood of confusion.
Reasoning: The court held that the evidence regarding the stickers affixed to lighters was insufficient to meet the “heavy burden” of demonstrating fraud. The court noted that Hotbox alleged that its business includes the sale of marijuana and non-marijuana products. Further, the non-marijuana products are sold in Oregon to customers that include Idaho residents that travel over the nearby border. The court held that these allegations were sufficient to plausibly plead use in commerce.
The court noted that it was evident from the pleadings that the TIW Marks and the HOTBOX mark were similar. Moreover, Hotbox alleged that its lighters were “substantially related” to Plaintiffs’ e-cigarettes and the parties target consumers include smokers and vapers. The pleadings therefore addressed several of the factors to determine a likelihood of confusion, including similarity of the marks, relatedness of the goods, and target consumers.
Accordingly, the court held that Hotbox sufficiently plead that it had a valid and protectable trademark registration and a claim of likelihood of confusion.
§ 5.9.6. Establishing Valid Trademark Rights
Ak Futures LLC v. TBH Supply LLC, No. 8:23-cv-01030-JVS-ADS (C.D. Cal. Jan. 19, 2024)
Date: January 19, 2024
Facts: AK Futures, LLC (“AK”) sells vaporizes containing the cannabinoid Delta-8 THC under its CAKE mark. TBH Supply LLC (“TBH”) sells cannabis products under its CAKE SHE HITS DIFFERENT mark. TBH allegedly licenses its mark to third parties to distribute and sell CAKE SHE HITS DIFFERENT goods in California and Arizona in state-licensed retail shops. AK brought this action alleging that TBH infringed its rights in its CAKE mark. In its first amended complaint, TBH brought four counterclaims including California and Arizona trademark infringement. AK filed a motion to dismiss TBH’s counterclaims.
Held: The court granted AK’s motion because TBH could not establish trademark rights in its CAKE SHE HITS DIFFERENT mark.
Reasoning: TBH did not own federal or state registrations or applications for its CAKE SHE HITS DIFFERENT mark. Therefore, TBH would have to rely on unregistered common law trademark rights to succeed on its counterclaims.
In TBH’s initial complaint, it alleged that it manufactured and distributed CAKE SHE HITS DIFFERENT goods that contain Delta-9 THC. In its amended complaint TBH sought to clarify its original allegations. TBH subsequently alleged that it sells empty CAKE SHE HITS DIFFERENT vaporizers to licensed third parties that fill the goods with Delta-9 THC. The court found the amended counterclaims implausible because TBH’s amended allegations directly contradicted its unambiguous admissions in the first complaint that its goods contain Delta-9 THC. The court concluded that TBH’s CAKE SHE HITS mark is used in connection with Delta-9 THC goods.
Delta-9 THC is illegal under federal law. Because TBH’s CAKE SHE HITS DIFFERENT goods are used with a federally illegal substance, it could not lawfully use its mark in federal commerce. Further, public records established that TBH did not hold state-required licenses to manufacture or distribute cannabis goods in California or Arizona. Accordingly, the court held that TBH could not establish federal or state trademark rights in its CAKE SHE HITS DIFFERENT mark and granted AK’s motion to dismiss.
Many aspects of the work of a United States federal judge are profoundly gratifying. Sometimes, they are almost overwhelmingly so. I became a United States bankruptcy judge, sitting in the Eastern District of New York, in Brooklyn, more than twenty years ago, and in that time, I have presided over more than 56,000 cases filed in our court, from no-asset Chapter 7 bankruptcy cases to multibillion-dollar global corporate Chapter 11 restructurings. Many cases are filed by large or middle market businesses that need the restructuring toolkit to get through a bumpy patch. Others are filed by small and even micro businesses, and entrepreneurs, for the same reasons. And still others—many others—are filed by individuals or couples who are seeking a fresh start, or to save their home through a Chapter 13 repayment plan. When these cases succeed, everyone wins. Homes and jobs are saved, and creditors get paid.
But as satisfying as that work is, if you ask me—or most any federal judge—what they find to be the most gratifying aspect of their work, the answer may surprise you: For me, and for many of my colleagues, the judicial work that may move us to tears of joy is presiding at a naturalization ceremony.
A naturalization ceremony is the final step on the path to becoming a United States citizen. That path is a long one, and it requires hard work and determination. An immigration lawyer could explain what is involved; and an immigration judge may well have a role. But in many federal judicial districts, and certainly here in the Brooklyn courthouse of the Eastern District of New York—encompassing Brooklyn and Queens, two of the most diverse counties in the country, as well as Staten Island—that last step is an oath administered in a federal courthouse, by a federal judge. And we hold these ceremonies four days a week, fifty-two weeks of the year.
There might be fifty new citizens in the courtroom—or more than two hundred and fifty. It’s the rule of law in action—working for individuals, families, communities, and the country. I have been privileged to swear in thousands of new citizens, from sixty or more countries of origin. And every time, it’s special.
When I enter the ceremonial courtroom, a court officer calls out, “All rise!” Usually, when I take the bench, I smile, greet the parties, and say, “Please be seated”—but not on this occasion. Instead, the citizenship candidates remain standing, and the ceremony begins with the Oath of Allegiance. This Oath includes a promise made by each new citizen, to “support and defend the Constitution and laws of the United States of America against all enemies, foreign and domestic.” At the close of the Oath, the new citizen declares that they “take this obligation freely, without any mental reservation or purpose of evasion.” Then, we clap, and maybe we cry a little bit, and as the newest United States citizens, we recite together the Pledge of Allegiance.
Many years ago, when I first presided at a naturalization ceremony, I decided that I had three things I wanted to say—and over the nearly twenty years since then, these have three things have not changed. They are congratulations, and thank you, and welcome.
I begin with congratulations, and I say, “Congratulations, my brothers and sisters, my fellow American citizens, on the great honor that you have achieved today by becoming citizens of the United States of America. You have worked hard for this honor—you have earned it—and you deserve it. This is your day—enjoy it! This is your country—cherish it!—as your newly adopted country cherishes you.”
Next is, thank you! “Thank you, my brothers and sisters, my fellow American citizens, for your gift to our country of your citizenship. What do I mean by your gift? My country is now our country. Your culture is now part of our culture. Your history, your traditions, now enrich America’s history and traditions. We are all richer together as a country because of you. Each of you. All of you.”
And then I reflect on the promises kept that each one of those new American citizens represents: “You are the fulfillment of a very important promise that another group of immigrants made more than 200 years ago in the United States Constitution. What promise was that? The promise made in Article I of the Constitution that Congress would establish a uniform rule of naturalization, so that anyone who wished, and wanted, and worked, to become an American citizen could do so, and have a day for themselves like today is for you. That promise means that every person who arrives on these shores has the opportunity to become as much an American as the person whose parents, or grandparents, or great-grandparents were born here. So you are the measure and the fulfillment of the promise made by the founders of our country, immigrants themselves. By your oath of allegiance today, you keep that promise in the Constitution alive.”
Finally, the heart and soul of a naturalization ceremony is not only the promises kept, but the promises made. I remind them that “today, you also made a promise—you pledged allegiance to these United States. You promised to be outspoken advocates of liberty, and justice—not just for some, but for all. Not only when it is easy, but when it is hard. To be a full citizen in our democracy, you must embrace it. Do not let others make decisions for you! Study the issues, and vote! When you care deeply about an issue, write the mayor, your city council person, your representative, your senator. Write the president! Serve on a jury, maybe in this very building. Your voice counts—but only if you use it. Your voice can make a difference—but only when it can be heard.”
At my very first naturalization ceremonies, there were often children—and even grandchildren—in attendance. Sometimes I have invited them to join me on the big bench in the ceremonial courtroom. Always, whether they are in the courtroom or just in the thoughts of the new citizens, I speak to them too: “Finally, a special word to the children: could you please stand? You are the future. You are the love, and the light, and the energy, and the enthusiasm, of our country. You inspire your families, your teachers, your neighbors. Today, you inspire me. To your parents, you are the best part of every day. You are the beacon and the promise of peace, and of better days ahead. I welcome you especially, and I have great hopes for you in your adopted country.”
And then I welcome them, with all of the warmth that I can muster, and maybe again a tear or two. “So, from my head and from my heart, on behalf of all of the citizens who you join today in these United States, congratulations, and thank you, and welcome. You will be wonderful and wise citizens, and I am so proud and happy to share this day with you.”
Finally, I want them to know that they have left nothing behind—but instead, they have brought everything that makes them who they are to our neighborhoods and communities as the newest citizens of the United States. So, I read out the names of their countries of origin in alphabetical order, beginning with Afghanistan, Albania, Angola, and Australia, all the way to Venezuela, Yemen, Yugoslavia, and Zimbabwe. As I read the name of each citizen’s home country, they rise. And when I finish, I say one more country’s name—their adopted country, our shared country, the United States of America. More tears, maybe. And when everyone in the courtroom is standing, we sing together, loudly if not well, our national anthem.
This article is part of a series on the rule of law and its importance for business lawyers created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.
Snell & Wilmer L.L.P. 675 15th Street, Suite 2500 Denver, CO 80202 303.635.2085 [email protected]
Byeongsook Seo is a member of Snell & Wilmer L.L.P.’s commercial litigation practice. He represents clients in handling complex and, often, heated disputes related to failed business ventures and disputes among business partners, executives, owners, and directors. Byeongsook is a member and Vice-Chair of the Business Divorce Subcommittee of the ABA Business Law Section Committee on Business and Corporate Litigation. His honors include Colorado Super Lawyers, Litigation Counsel of America Fellow, and The Best Lawyers in America. Byeongsook graduated from the United States Air Force Academy and obtained his law degree from the University of Denver, Sturm College of Law.
Contributors
Yitzchak L. Besser
Stevens & Lee, P.A. 919 N. Market Street, Suite 1300 Wilmington, DE 19801 302.425.3301 [email protected]
Kyle A. Cooper
Tabet DiVito & Rothstein LLC 209 S. LaSalle St., Suite 700 Chicago, IL 60604 312.762.9495 [email protected]
Melissa Donimirski
Stevens & Lee, P.A. 919 N. Market Street, Suite 1300 Wilmington, DE 19801 302.425.2608 [email protected]
Janel M. Dressen
Anthony Ostlund Louwagie Dressen & Boylan P.A. 90 South 7th Street 3600 Wells Fargo Center Minneapolis, MN 55402 612.492.8245 [email protected]
Jennifer Hadley Catero
Snell & Wilmer L.L.P. One East Washington Street, Suite 2700 Phoenix, AZ 85004 602.382.6371 [email protected]
Brian C. Haussmann
Tabet DiVito & Rothstein LLC 209 S. LaSalle St., Suite 700 Chicago, IL 60604 312.762.9471 [email protected]
Eric C. Milby
Lundy Beldecos & Milby 450 N. Narberth Ave, Suite 200 Narberth Lower Merion, PA 19072 610.668.0770 [email protected]
Oderah C. Nwaeze
Faegre Drinker Biddle & Reath LLP One Logan Square, Suite 2000 Philadelphia, Pennsylvania 19103 215.988.1172 [email protected]
Tyson Prisbrey
Snell & Wilmer L.L.P. 15 West South Temple, Suite 1200 Salt Lake City, UT 84101 801.257.1815 [email protected]
Emma Sander
Aronberg Goldgehn 225 W. Washington St., Suite 2800 Chicago, IL 60606 312.755.3133 [email protected]
John C. Sciaccotta
Aronberg Goldgehn 225 W. Washington St., Suite 2800 Chicago, IL 60606 312.755.3180 [email protected]
Victor Vital
Haynes Boone, LLP. 2801 N. Harwood Street, Suite 2300 Dallas, TX 7520 214.651.5329 [email protected]
Yitzchak L. Besser
Yitzchak L. Besser is a member of Stevens & Lee’s Litigation Department, assisting its teams with a range of due diligence, trial, and research matters. He has handled case analysis and draft opinions in an array of federal criminal and civil matters at both the appellate and trial court levels. Prior to joining Stevens & Lee, Yitzchak served as a staff attorney with the U.S. Court of Appeals for the Third Circuit. He also served as a judicial law clerk for the Hon. Glen H. Davidson of the U.S. District Court for the Northern District of Mississippi. He graduated magna cum laude from the University of Baltimore School of Law and received his undergraduate degree from New York University.
Kyle A. Cooper
Kyle Cooper is a business litigation partner at Tabet DiVito & Rothstein in Chicago, Illinois, where he focuses on complex business disputes and commercial litigation. He is a highly skilled and dedicated litigator with extensive experience in both federal and state courts. Since 2021, he has been recognized annually as a Super Lawyers Rising Star. Beyond his litigation practice, Kyle serves as outside general counsel for several businesses, providing strategic legal and business advice on a variety of matters. He is also actively engaged in civic matters and currently serves as the president of the Chicago Police Board.
Melissa Donimirski
Melissa N. Donimirski is a partner with Stevens & Lee in Wilmington, Delaware. She concentrates her practice in the area of corporate and commercial litigation in the Delaware Court of Chancery and has been involved with many of the leading business divorce cases in that Court. Melissa is a Co-Vice-Chair of the Business Divorce Subcommittee of the ABA Business Law Section, Business and Corporate Litigation Committee. She received her undergraduate degree from Bryn Mawr College and her law degree from the Delaware Law School of Widener University. Melissa has also co-edited and co-authored a treatise on business divorce, Litigating the Business Divorce, which is published by Bloomberg BNA.
Janel M. Dressen
Janel Dressen has over twenty-three years of experience as a business trial lawyer and is the CEO of her business litigation boutique law firm in Minneapolis, Minnesota. Ms. Dressen’s clients, co-workers, colleagues and competitors remark that she is a tenacious business litigator who will advocate tirelessly and creatively to resolve her client’s business disputes. She has been named as one of the “Top 50 Women Minnesota Super Lawyers” since 2019. Janel has an impressive list of significant victories for her clients, both plaintiffs and defendants. While she represents business owners and businesses in all types of complex business disputes, her “sweet spot” involves shareholder, ownership, fiduciary duty, owner/executive employment and business valuation disputes, i.e., “business divorces” for closely held and private businesses, business owners and executives.
Jennifer Hadley Catero
Jennifer Hadley Catero is based in Snell & Wilmer’s Phoenix office where she serves as Co-Chair of the firm’s Corporate Governance Litigation Group. Jennifer handles complex commercial litigation with an emphasis on corporate governance litigation, banking, consumer financial services and securities litigation, shareholder derivative litigation, D&O litigation, class actions and internal investigations. Jennifer also advises clients on compliance issues regarding consumer financial products and services. Jennifer has been named one of the top 100 Lawyers in Arizona and repeatedly named to The Best Lawyers in America for Commercial Litigation.
Brian C. Haussmann
Brian C. Haussmann is a partner at Tabet DiVito & Rothstein, LLC, a litigation boutique in Chicago, Illinois. Brian is a trial lawyer and business litigator who focuses on disputes between owners and other stakeholders in privately held businesses. He often litigates and resolves disputes involving the dissolution of private companies (sometimes referred to as “business divorces”), partner, owner, and shareholder rights, fiduciary duty claims, corporate governance, fraud and other business torts, and contracts. Brian is also active in his community and the legal profession generally. He currently serves on the Board of Managers for the Chicago Bar Association (CBA) and is Co-Chair of the Business Divorce and Complex Ownership Disputes Committee of the CBA. Brian also serves on the governing board of Legal Aid Chicago, the largest provider in Chicago of free legal services to those living in poverty.
Eric C. Milby
Eric Milby is a shareholder at Lundy Beldecos and Milby with offices in the Philadelphia area. For more than 25 years, he has focused his practice on Business Divorce, regularly handling direct and derivative disputes between business owners including control disputes, minority oppression, information demands, misappropriation, withholding distributions/phantom income, usurpation of corporate opportunities and other contractual and fiduciary duties. Eric regularly speaks on Business Divorce topics, is rated AV Preeminent by Martindale-Hubbel and has been selected by SuperLawyers annually since 2012. Eric is the immediate past chair of the Philadelphia Business Litigation committee and the incoming co-Chair of the ABA Business Divorce subcommittee.
Oderah C. Nwaeze
Oderah C. Nwaeze is an experienced trial attorney who helps clients resolve complex corporate and commercial disputes. For over a decade, he has led or worked on matters involving shareholder rights; actions arising under Delaware General Corporation Law and Delaware common law; lawsuits stemming from mergers, acquisitions and other corporate transactions; business divorces; and breach-of-contract matters. To be specific, Oderah has experience with “books-and-records” demands and litigation, actions to compel an annual meeting, stockholder appraisal litigation, derivative lawsuits, and judicial dissolution of an entity.
Tyson Prisbrey
Tyson Prisbrey is based in Snell & Wilmer L.L.P.’s Salt Lake City, Utah office and is a member of the firm’s commercial litigation practice group. He focuses his practice in complex commercial and corporate litigation, including litigation in corporate governance and general contractual disputes. He has experience advising public and private companies in disputes stemming from mergers and acquisitions, corporate financing, corporate control, and alternative entity dissolutions. Prior to joining Snell & Wilmer, Tyson gained significant experience in representing clients in the Delaware Court of Chancery litigating commercial and corporate governance matters.
Emma Sander
Emma is an Associate in Aronberg Goldgehn’s Business Litigation and Insurance Coverage practice groups. She represents clients, from individuals to large businesses, in breach of contract cases, fraud cases, regulatory matters, and other disputes.
John C. Sciaccotta
John C. Sciaccotta, Esq., Sr., Partner at Aronberg Goldgehn in Chicago serves on the firm’s executive management committee. John has litigated and resolved numerous complex business divorce cases. He is the President Elect of the Chicago Bar Association (will be installed as President in June of 2024). John is also an Arbitrator and Mediator of complex commercial disputes.
Victor Vital
Victor Vital is the Global Chair of Haynes Boone’s Trials Practice Group. Clients turn to Victor to handle high-stakes trials of all kinds, matters that are consequential such as cases involving significant dollar amounts and cases with the potential to damage major reputations or brands. Because of his broad trial experience, clients and lawyers turn to Victor regardless of the subject matter when they need a trial lawyer for their important cases. Victor is ranked in Band 1 by Chambers USA, Chambers and Partners, for Litigation: Trial Lawyers, 2024. Clients report to Chambers that Victor is “very versatile and can handle a lot of types of cases.” Victor’s trials and verdicts have been nationally recognized. For instance, he secured a jury verdict in a business dispute that was listed in the National Law Journal Top 100 list. Another one of his jury verdicts was listed in the Courtroom View Network’s list of Top 10 Most Impressive Defense Verdicts of 2022.
§ 4.1. Introduction
The term “business divorce” includes disputes that cause business partners/investors to end their partnership, situations that require owners to separate, or circumstances where a business partner/investor wishes to change the composition of management. This chapter provides summaries of developments related to such business divorce matters that arose from October 1, 2023, to September 30, 2024, from thirteen states.
Contributors to this chapter used their best judgment in selecting business divorce cases to summarize. We then organized the summaries, first by subject matter, then by jurisdiction. This chapter, however, is not meant to be comprehensive.
The reader should be mindful of how any case in this chapter is cited. Some jurisdictions prohibit courts and parties from citing or relying on opinions not certified for publication. To the extent unpublished cases are summarized, the reader should always consult local rules and authority to ensure the unpublished cases can serve as relevant and permissible precedent. The reader should also be mindful that this chapter provides a “snapshot” of developments within a single year. Any development in a particular year covered by this chapter may be altered by legislation or cases in subsequent years.
We hope this chapter assists the reader in understanding recent developments in business divorces.
§ 4.2. Access to Books and Records
§ 4.2.1. Pennsylvania
SWRP, LLC, v. Westwood Condominium Association Inc., 2024 WL 4601603. In an unreported opinion, the Pennsylvania Commonwealth Court reversed the trial court’s order permitting SWRP, LLC (“SWRP”), a member of the nonprofit Westwood Condominium Association (“Westwood”), to inspect redacted records of Westwood. SWRP sought the records that Westwood was required to maintain for the stated purpose to “unveil any mismanagement of [Westwood’s] operations.” Under the Pennsylvania Nonprofit Corporation Law, “[e]very nonprofit corporation shall keep minutes of the proceedings of the incorporators, members, the directors and any other body, and a membership register. The corporation shall also keep appropriate, complete and accurate books or records of account.” The trial court, directed Westwood to release the W-2 forms of all employees with “all information except name, address, title and gross/net incomes redacted.” The trial court did not order the release of the names of all members in good standing. Westwood did not challenge SWRP’s stated purpose for the inspection so the only issues on appeal were whether email addresses and phone numbers constitute part of the member register that is subject to inspection and whether a member is in good standing is subject to inspection under the Nonprofit Corporation Law. The Court remanded for the trial court to consider whether (i) Westwood could place limits or conditions on the inspections based on the members right to privacy and (ii) disclosing whether a member is in good standing is limited by considerations of privacy, privilege, or confidentiality or by the Fair Debt Collection Practices Act, and the Fair Credit Extension Uniformity Act.
Edenfield v. ECM Energy Services Inc., 300 A.3d 506 (Pa. Super. 2023). Plaintiff Edenfield appealed from an order denying his demand to inspect the records of ECM Energy Services, Inc. (“ECM”) and AdTrak 360 LLC (“AdTrak”). As to ECM, the court rejected Edenfield’s argument that the language of the statue permitting a shareholder to inspect the books and records did not preclude access by former shareholders and found that the plain language of the statute, defining shareholder as “record owner of shares of a corporation” meant only current shareholders. As such, Edenfield lacked standing to demand inspection of the books and records of ECM. As for AdTrak, a Delaware corporation, it was dormant and had closed its offices in Pennsylvania. At the trial court level, AdTrak had given a Pennsylvania accountant access to the QuickBooks records and permitted the accountant to access and supply records accessible from Pennsylvania to Edenfield. The court, however, did not require AdTrak to collect and produce records from Delaware. The Superior Court balanced public policies explaining that “while our courts will not take jurisdiction for the purpose of a regulating or interfering with the internal affairs of a foreign corporation, it is equally well settled that the granting of a right to inspect a foreign corporation’s books and records, which are within the jurisdiction, does not so offend.” Because the court concluded that AdTrak was neither operating nor storing records in Pennsylvania, it affirmed the trial court’s decision not to compel additional records finding that Pennsylvania lacked jurisdiction to do more.
§ 4.2.2. Texas
Gilbreath v. Horan, 682 S.W.3d 454 (Tex. App.—Houston [1st Dist.] 2023, pet. denied), reh’g denied (Apr. 20, 2023). In 1964, Wesley Gilbreath, Sr., the patriarch of the Gilbreath family, founded an advertising company focused on constructing, owning, and leasing billboards throughout Texas and parts of Louisiana. The company was first a sole proprietorship, but was later incorporated, and then converted into a family limited partnership. In 2000, a Texas limited liability company was formed in connection with the corporate conversion to act as the general partner. Over the years, Wesley Gilbreath transferred his original ownership interests in the business in equal parts to his six children through nearly identical irrevocable trusts. The Gilbreath family business then consisted of nine Texas limited partnerships, each with a general partner organized as a Texas limited liability company. The general partner LLCs were managed by a Board of Managers, consisting of four of Wesley’s children, each serving a lifetime appointment. The various trusts were each limited partners in the limited partnerships, each owning a one-sixth interest.
Shortly after Wesley’s passing, his daughter Lisa began asking questions about her father’s will, the various trusts, and the business overall. Lisa expressed concerns that one of the business entities had been paying for personal and nonbusiness expenses. Lisa accused her siblings of taking “millions of dollars,” informed her siblings that she would hold them to the highest fiduciary responsibility and made various requests to inspect company books and records. The situation deteriorated, and eventually prolonged litigation ensued.
In the trial court, Lisa pleaded in part for a declaration of her rights to access company books and records and for prospective injunctive relief. She also sought declarations that her siblings had failed to provide her with access to the relevant records in the past and pleaded for costs and damages resulting from those breaches. The trial court entered a declaratory judgment in Lisa’s favor and granted injunctive relief based on Lisa’s contractual and statutory claims for access to the books and records.
On appeal, the defendants articulated several challenges to the trial court’s adjudication of the books and records issues. First, defendants argued that because Lisa received the requested books and records before trial, the trial court lacked subject matter jurisdiction to enter the declaratory judgment because there was no justiciable controversy among the parties. Second, defendants argued that there was no evidence that Lisa had not been provided with the books and records to which she was entitled. Third, defendants argued that the jury questions concerning books and records were submitted with respect to a breach of contract claim and that the jury’s answers were “immaterial” because they were not tied to any damage question. Fourth, defendants argued that Lisa was not entitled to declaratory relief because she “couched her books and records claims, in part, in terms of a breach of the limited partnership agreements” and her claims for declaratory relief were based on the same theories. And fifth, defendants argued that various limitation-of-liability clauses in the limited partnership agreements precluded any finding of wrongdoing against the general partners—and further that Lisa never “properly pleaded any of those legal theories.”
The court of appeals was not persuaded by any of these arguments, and so overruled defendants’ challenge to the books and records claims. As to the first issue, the court of appeals reasoned that Lisa’s request for declaratory relief was not moot because it was—at least in part—prospective. Lisa requested a declaration that she had the right to access the books and records under the partnership agreements and Texas law prior to the litigation, but also in the future. As to the second issue, the court of appeals determined that there was some testimonial evidence that Lisa’s access to the pertinent books and records had been restricted. As to the third issue, the court of appeals determined that the jury questions in dispute “were material because the jury’s answers to those questions formed the basis of the injunctive relief the trial court granted, specifically the questions of imminent harm.” As to the fourth issue, the court of appeals concluded that Lisa’s claims that the defendants violated her statutory rights would not have been the proper subject of a breach of contract claim, and did not encompass issues already before the court. Moreover, Lisa did not seek damages for a breach of contract claim. Lastly, as to the fifth issue, the court of appeals reasoned that because the theories of “fraud, deceit, or a wrongful taking” and “gross negligence, bad faith, [and] willful breach” were pleaded by the general partners as part of their affirmative defenses and presented to the jury at their request, it was not necessary for Lisa to plead these affirmative defenses or any exceptions to the same. Additionally, according to the court of appeals, to the extent that the defendants contended that the limitation-of-liability clauses precluded Lisa’s declaratory judgment action, nothing in the clauses precluded such relief.
§ 4.3. Business Judgment Rule
§ 4.3.1. Pennsylvania
Matthew Serota, Derivatively on Behalf of London Towne Homeowners Association v. Matthew J. Mager, 304 A.3d 828 (Pa. Commw. Ct. 2023). Receiver appointed for homeowners’ association was entitled to deference under the Business Judgment Rule where receiver was disinterested, prepared written report, was independent, conducted adequate investigation and rationally believed his decision was in the HOA’s best interest. The court’s decision was based, in part, on a determination that any potential benefit would be negligible. The court reasoned that the receiver should be entitled to the same deference as the non-functioning executive board that the receiver was appointed to replace.
§ 4.4. Dissolution
§ 4.4.1. Delaware
Walter v. McManus, C.A. No. 2024-0412-NAC (Del. Ch. June 7, 2024) (ORDER). The Court of Chancery held that Petitioner Andrew C. Walter sufficiently pleaded the existence of convincing factors for judicial dissolution, and therefore denied Respondent Geraldine F. McManus’s Motion to Dismiss Walter’s Verified Petition for Judicial Dissolution.
Walter and McManus each owned a 50% interest in Class A Membership Interest of Granger Management Holdings LLC (“Granger” or “the Company”). Citing Fisk Ventures, LLC v. Segal, 2009 WL 73957 (Del. Ch.), aff’d, 984 A.2d 124 (Del. 2009), the Court noted that “convincing factors” for judicial dissolution include circumstances in which there is a board-level voting deadlock and the operating agreement gives no means of navigating around said deadlock. The Court found that Walter had well-pleaded such circumstances.
It further stated that a deadlocked LLC need not be “metaphorically ablaze” and that a deadlock over “serious managerial issues, such as strategic visions,” is sufficient for pleading a judicial dissolution claim. The Court also rejected McManus’s arguments that (1) Walter needed to allege additional deadlocked votes and (2) dismissal of his Petition was warranted because he could sell his interest to a third party.
Gibson v. Konick, 2024 WL 3370927 (Del. Ch. Jul. 10, 2024). The Court of Chancery ordered the dissolution of 23 West Bayard Street, LLC (the “Company”) under 6 Del. C. § 18-802 and appointed a liquidating trustee. The Court also ruled on various issues related to the membership interests and claims for indemnification and advancement.
The Company was formed in August 2020 to own residential property in Fenwick Island, Delaware. Plaintiff and Defendant are the Company’s only members, and Defendant is the Company’s sole manager. At some point the parties’ personal relationship deteriorated, leading to increased hostility. Plaintiff asserted that Defendant excluded her from management, failed to provide annual reports, and did not maintain proper financial transparency. And although she contributed significantly to property improvements and loan payments, Plaintiff was denied access to property and financial records. Plaintiff further claimed that Defendant failed to maintain the property or complete agreed-upon improvements, impacting its market value.
Because the Company’s LLC Agreement lacked a mechanism for resolving disputes or allowing Plaintiff to withdraw or transfer her interest, Plaintiff filed suit, seeking: (a) judicial dissolution of the Company; (b) declaratory judgment that Plaintiff was entitled to a 50% interest in the Company; (c) a decision as to Plaintiff’s entitlement to indemnification or advancement; and (d) specific performance of fiduciary duties.
The Court found that the LLC was deadlocked, with the two members unable to agree on critical management and operational decisions, justifying judicial dissolution under 6 Del. C. § 18-802. Accordingly, the Court ordered the dissolution of the LLC and appointed a liquidating trustee to manage the process. Plaintiff originally claimed that she and Defendant held equal 50% interests in the LLC, but based on the parties’ conduct and respective contributions, the Court of Chancery concluded that Plaintiff’s and Defendant’s membership interests were 39.49% and 60.51%, respectively. The Court denied Plaintiff’s request for declaratory judgment on indemnification or advancement because the LLC Agreement did not provide for such entitlements. Consistent with that, Defendant was not authorized to indemnify himself or advance his legal fees using LLC funds because that would be a misuse of the Company’s financial resources. The Court of Chancery found that neither party was entitled to recover for personal or renovation-related services rendered to the Company.
Benoliel v. Bombard, 2024 WL 3044641 (Del. Ch. Jun 15, 2024) (Order). The Court of Chancery granted the motion to dismiss the Verified Petition for Judicial Dissolution under 6 Del. C. § 18-802. The Court found that Petitioner failed to state a claim upon which relief could be granted.
GH Channel Holding LLC (“HoldCo”) was created as a passive holding company with its primary purpose being ownership and oversight of its subsidiary, OpCo. OpCo was responsible for the actual business operations, including managing agreements and financial transactions. HoldCo is equally owned by two families: the Franco Family and the Bombard brothers. HoldCo’s board of directors is comprised of two directors, one appointed by each family, requiring consensus for any action.
Due in part to distrust of Respondent’s family, Petitioner sought judicial dissolution of HoldCo, alleging that the company was in a deadlock and lacked an equitable exit mechanism, making it impracticable for the company to continue its business in conformity with its operating agreement. Petitioner highlighted three main areas of disagreement: (1) keeping minutes; (2) retaining an accountant for evaluating transactions; and (3) whether to amend OpCo’s operating agreement.
The Court analyzed whether the actions that cannot be carried out due to deadlock are essential to the company’s business purpose. In doing so, it emphasized that HoldCo’s purpose was limited and primarily passive, with governance and operational matters being the responsibility of OpCo’s board. Ultimately, the Court found that Petitioner’s claims did not sufficiently demonstrate that HoldCo could not carry out its business because of the stalemate. In particular, the Court of Chancery concluded that:
The failure to keep minutes did not frustrate HoldCo’s business purpose;
the retention of an accountant was beyond HoldCo’s purpose and pertained to OpCo; and
the potential to amend OpCo’s operating agreement eliminated likelihood of actual deadlock.
The Court also noted that because Petitioner’s allegations regarding governance and operational issues were mainly related to OpCo, those issues did not justify the dissolution of HoldCo. Without factual allegations sufficient to establish that the alleged deadlock impeded HoldCo’s ability to carry out its business, the Court dismissed, with prejudice, Petitioner’s request for judicial dissolution.
§ 4.4.2. Massachusetts
Clarke v. Murphy, 104 Mass. App. Ct. 1118 (2024), review denied, 494 Mass. 1108 (2024). This case arose from the dissolution of a partnership between two individuals who co-owned a property through a trust and operated a catering business on the premises. The partnership agreement stipulated that one partner provided the initial capital investment for the trust, while the other partner’s contributions would increase over time through rent payments made by the catering business.
Over the years, disputes emerged regarding financial management, unpaid rent and ownership interests. One partner alleged breaches of fiduciary duties, failure to meet financial obligations and misuse of partnership assets. The other partner sought dissolution of the partnership and an equitable division of proceeds from the property sale.
The trial court ruled in favor of the partner seeking dissolution, finding that they had fulfilled their financial obligations under the partnership agreement. Specifically, the court determined that the partner had met their role as a guarantor for the trust’s promissory note and mortgage. It also rejected claims regarding unpaid rent, as the parties had orally agreed to waive certain payments during periods of financial difficulty. Furthermore, the court concluded that the sale of catering equipment and fixtures did not harm the partnership, as the proceeds were properly accounted. The court dissolved the partnership, ordered the sale of the property and directed that the proceeds be equally divided.
On appeal, the Massachusetts Appeals Court affirmed these findings. It emphasized that the partnership agreements were correctly interpreted and that the partner’s actions complied with their obligations. The appellate court also dismissed additional claims for damages, concluding that they were unsupported or resolved by the terms of the dissolution.
§ 4.4.3. New Jersey
AC Ocean Walk, LLC v. Blue Ocean Waters, LLC, 478 N.J. Super. 515, 316 A.3d 955 (App. Div. 2024). In this interlocutory appeal, the Appellate Court addressed several matters of first impression in New Jersey: (1) whether a failure to respond warranted dissociation from a partnership under the Uniform Partnership Act and (2) what the proper effective date of dissolution of a partnership is.
In 2018, Plaintiff, AC Ocean Walk partnered with Defendants to operate clubs, sharing ownership and financial responsibilities, including renovation costs, pre-opening expenses, and covering revenue shortfalls for lease payments. Disputes arose over renovation costs, financial contributions, recordkeeping, and control. In 2020, Plaintiff sent a breach notice alleging that Defendants failed to meet financial obligations, owed over $2.4 million, and warned of termination if the breaches were not cured. After receiving no response, Plaintiffs filed a complaint in February of 2021 seeking judicial dissociation and damages. In January 2023, the court granted judicial dissociation and dissolution, citing the Defendants’ silence as evidence of their inability to meet partnership obligations.
Defendant partner’s conduct in not responding to plaintiff partner’s notice of breach of partnership agreement warranted dissociation from the partnership under the Uniform Partnership Act (UPA), although trial court did not find that defendant breached partnership agreement; defendant’s refusal to respond to notice of breach after two years of unquestionable discord in partnership prejudicially affected business and made it impracticable for partnership to continue, and defendant’s conduct evinced irreparable deterioration of the partnership relationship and impasse regarding important business because of lack of communication between partners.
Further, judicial dissolution is also allowed under the same “not reasonably practicable standard” that applies to the dissociation of individual partners. However, the Court did find that the dissolution effective date was incorrect. The “presumptive” dissolution date is the date it is ordered by a court according to the UPA. There was no New Jersey precedent addressing this matter, so again the Court looked to other jurisdictions. Case law indicated there is nothing in the statute that permits retroactive dissociation, and dissociation occurs when a partner is “actually expelled.” Even though Defendants enjoyed no powers, they were “formally” still a partner until the date of dissolution. This confirmed the effective date should be the date of the dissociation order and should not be backdated.
§ 4.4.4. Pennsylvania
Estate of Caruso v. Caruso, 322 A.3d 885, 897–98 (Pa. 2024). Widow of partner in general partnership sought to enforce buy-out provision in the partnership agreement requiring a surviving partner to buy out the interest of a decedent partner within 90 days after death. Husband died in 2003, and the remaining partner did not seek to buy his share of the partnership, nor did widow, as executrix, seek to enforce it. The estate was finalized in 2006. Widow remained a 50% owner but became dissatisfied and, in 2013, she filed a lawsuit to compel access to information and participation in the operation of the partnership. But, in 2015 the surviving partner died, and widow sought to exercise the buy-out provision against the surviving partners estate, tendering a check for the book value of his interest. The estate of the surviving partner refused the check arguing that the partnership dissolved when the first partner died, and the current partnership was not bound by the partnership agreement. The court agreed and rejected the lower courts’ conclusion that widow acquired her husband’s rights under the Partnership Agreement, or put another way, that she “stepped into his shoes.” Rather, the court found that caselaw does not support the argument that a party steps into the shoes of an existing partner unless that party has been explicitly assigned the rights under the partnership agreement. Here, widow could not force a buyout upon the death of the remaining shareholder.
Toth v. Toth, 324 A.3d 469 (Pa. Super. 2024). In Toth, the court granted dissolution and ordered a detailed plan of dissolution under the court’s statutory authority to fashion equitable relief where the management of the company was hopelessly deadlocked. The court declined Appellant’s request that the court use its equitable power to force a buyout of Appellee because Appellants had engaged in considerable wrongful conduct, including trying to reorganize the company as a Florida entity with them in control, locking Appellee out of the company offices, email and computers, and spreading rumors within the company that Appellee was mentally unwell. The court found that granting the Appellant’s request for a forced buyout would have effectively given them the result they sought to achieve through their wrongful conduct.
§ 4.4.5. Texas
Holdridge v. Wallace Ryne, O.D., P.C., No. 02-23-00420-CV, 2024 WL 3455838 (Tex. App.—Fort Worth July 18, 2024, no pet.). Lyons and Ryne co-owned an eyecare partnership where Holdridge worked. Lyons also owned a related surgical center that worked together with the eyecare partnership, transferred its income to that partnership, and relied on it for administrative functions. As Ryne’s retirement neared, he, Lyons, and Holdridge entered a contract which provided for Lyons’s purchase of Ryne’s 50% interest in the eyecare partnership for the “partnership fair market value” and for Lyons’s subsequent sale of half of that interest to Holdridge. The parties later disputed the meaning of “partnership fair market value” and things deteriorated from there. Following a bench trial, the court—among taking other actions and making other declarations—dissolved the eyecare partnership.
The court of appeals, among other actions, reversed the trial court’s order of dissolution. The trial court originally dissolved the partnership in large part due to the actions of one partner that were alleged to have created a “toxic” or “poisonous” workplace. The court of appeals determined that, while “‘[t]oxic’ workplaces are no doubt unpleasant . . . they do not warrant the extraordinarily harsh remedy of judicial dissolution. See Nerium SkinCare, Inc. v. Nerium Int’l, LLC, No. 3:16-CV-1217-B, 2018 WL 2323243, at *7 (recognizing that ‘[S]ection 11.314 requires more than just a disagreement between owners’ and holding ‘strained relationship’ did not conclusively establish grounds for dissolution when owners disagreed regarding scope of products sold by company).”
The court of appeals further articulated that, “[g]iven Texas’s longstanding commitment to the promotion of economic development and the freedom of contract, courts are loath to shut down profitable, contract-governed businesses by judicial fiat.” In the court’s view, the Texas Legislature had provided limited grounds on which such involuntary dissolution is permitted, and, in this case, there was no evidence to satisfy any of those grounds. See Tex. Bus. Orgs. Code Ann. § 11.314. Hence, the evidence was legally insufficient to support the trial court’s dissolution of the partnership.
Jafar v. Beach & Beaches, Inc., No. 01-22-00412-CV, 2024 WL 3107684 (Tex. App.—Houston [1st Dist.] June 25, 2024, no pet.). Two partners jointly purchased a gas station and convenience store business but later had a falling out which resulted in litigation. At the end of the trial court proceedings, the court judicially dissolved the partnership and ordered that the business as well as the land on which the business sat be equitably partitioned. The trial court then determined that one partner owned 49% of the business and 15% of the land, while the other partner owned 51% of the business and 85% of the land. After concluding that an order “compelling the sale of the property would be futile,” the trial court ordered that the partner with greater interest in the business and land could purchase the interests of the other partner. The trial court also allowed the “total amount of all judgments” awarded to the purchasing partner to offset the purchase price.
On appeal, the parties focused on two statutory bases for the dissolution and subsequent compulsory sale—the Texas Property Code and the Texas Business Organizations Code. The court of appeals first determined that the trial court’s order of partition and compulsory sale were not supported by Tex. Prop. Code § 23.001, which contemplates partition by sale. See alsoTex. R. Civ. P. 770. The court of appeals then determined that Tex. Bus. Org. Code § 11.314 and § 11.054 similarly did not support the trial court’s order of partition and compulsory sale because “construing Section 11.054 to permit the trial court to force a sale of [one partner’s] interests to [another partner] would directly conflict with the requirements of a winding up process under Section 11.052.” Lastly, the court of appeals held that the purchasing partner in this case could not rely on Tex. Bus. Org. Code § 152.602 (providing that a partnership has an automatic right to redeem a partner’s interest if a partner wrongfully withdraws) because the purchasing partner made no claim to expel his partner from the partnership. Instead, quite to the contrary, his counterclaim was for “dissolution.” Accordingly, the court of appeals reversed and remanded in part.
§ 4.5. Special Litigation Committee
§ 4.5.1. Pennsylvania
MBA Development, LP v. Miller, 316 A.3d 51 (Pa. 2024). Statute permitted judicial review of the decisions of a special litigation committee (“SLC”). Limited partner could not compel mandatory arbitration of his challenges to the SLC determination under the partnership agreement’s arbitration clause because the partnership agreement incorporated the provisions of the Pennsylvania Uniform Limited Partnership Act that clearly and unambiguously calls for “judicial” review of SLC determinations.
§ 4.6. Jurisdiction, Venue, and Standing
§ 4.6.1. California
Lew-Williams v. Petrosian, 320 Cal. Rptr. 3d 59 (2024). Physician’s surviving spouse and physician’s professional corporation filed suit against physician’s former business partner and others, arising out of defendants’ alleged embezzlement of physician’s and corporation’s funds. The trial court granted defendants’ motion to compel arbitration, and then subsequently issued order to show cause after plaintiffs failed to initiate arbitration and dismissed complaint for plaintiffs’ failure to arbitrate. Plaintiffs appealed. The appellate court reversed the dismissal because once the trial court issued order compelling arbitration of plaintiffs’ claims, it lacked jurisdiction to dismiss for failure to prosecute. If a party fails to diligently prosecute an arbitration, the appropriate remedy is for the opposing party to seek relief in the arbitration proceeding (and, if necessary, the opposing party may need to initiate the arbitration for this purpose).
§ 4.6.2. Pennsylvania
Larikov, LLC v. Cao, 314 A.3d 1283 (Pa. Super. 2024). In Larikov, the court dismissed the appellant’s fourth amended complaint finding that appellant, a purchaser of the LLC’s interests, did not have standing under the Pennsylvania Uniform Limited Liability Company Act. First the court found that because the LLC operating Agreement had no provisions governing the transfer of membership interests; therefore, statutory provisions apply. The court then noted that “one of the most fundamental characteristics of limited liability company law [is] its fidelity to the ‘pick your partner’ principle.” Under that principle, an LLC member cannot transfer membership rights and obligations to a third party other than the statutory defined “transferable interest” unless expressly provided for in the operating agreement. A transferable interest entitles the member to distributions but not to participate in company management.
§ 4.6.3. Texas
Wendt v. Moore, No. 01-23-00128-CV, 2024 WL 3528437 (Tex. App.—Houston [1st Dist.] July 25, 2024, no pet.). This case arose from a dispute among four sisters over management of a family partnership and ownership of land used for farming. Laurel sued her sisters—Evalyn, Amilee, and Jackie—for breach of fiduciary duty, fraud, embezzlement/theft, and breach of contract. Evalyn, Amilee, and Jackie moved for summary judgment, arguing that Laurel’s claims were barred by res judicata because they were, or could have been, litigated in a prior suit between the parties in Fort Bend County. Shortly before the summary judgment hearing, Laurel amended her petition to raise new factual allegations and claims. The trial court granted summary judgment and dismissed Laurel’s claims with prejudice.
On appeal, Laurel contended that (1) the trial court’s judgment, which was based on res judicata, improperly failed to reflect that it was “subservient to any final decision” made by another appellate court in its review of the Fort Bend County judgment; (2) the trial court erred by granting summary judgment and dismissing Laurel’s claims because her amended petition raised factual allegations and claims that were not addressed by the summary judgment motion; and (3) the trial court erroneously failed to recognize that Laurel’s breach of contract claim could not have been litigated in the Fort Bend County suit because that claim was not ripe until after the Fort Bend County court rendered its judgment against Laurel.
The court of appeals overruled Laurel’s first and third issues but agreed with Laurel that her second amended petition raised new factual allegations and claims that were not raised in her first amended petition and were not addressed in her sisters’ summary judgment motion. Accordingly, the court of appeals held that the trial court erred to the extent that it granted summary judgment on Laurel’s breach of fiduciary duty and embezzlement/theft claims based on certain allegations.
§ 4.6.4. Utah
Reed v. Tintic Consolidated Metals, LLC, 2024 WL 3952760 (D. Utah Aug. 27, 2024). The court found that the law of the forum state governed whether a cancelled LLC could be sued for tort liability, not the law of the state under which the LLC was originally organized.
In a claim resulting from a workplace injury, the plaintiff sued the former operators of a mine located in Utah in state court. The former operators of the mine were Delaware LLCs. Months before the plaintiff brought suit, the two Delaware LLCs were acquired by a Canadian corporation. The defendant, the Canadian corporation, removed the lawsuit to federal court, asserting diversity jurisdiction. The plaintiff moved to remand the case because the defendant failed to assert the citizenship of the Delaware LLCs. The defendant contended that it could satisfy the diversity jurisdiction requirement without alleging the citizenship of the Delaware LLCs because those entities were cancelled a few months before plaintiff initiated the lawsuit. Indeed, defendant claimed, under Delaware law, a plaintiff cannot establish a cause of action against a cancelled LLC. The court disagreed because the defendant failed to demonstrate that under Utah law a cancelled LLC is immune from suit. A cancelled LLC’s tort liability to a third party is not an internal affair. Just as Delaware could not confer nationwide tort immunity to LLCs formed under Delaware law, it may not eliminate liability for a cancelled LLC or set the conditions for bringing a lawsuit for a tort committed in another state. While Delaware law governs the procedure for cancelling a Delaware LLC, the effect that cancellation has on third-party plaintiffs asserting tort claims against the cancelled LLC is controlled by the law of the forum state.
§ 4.7. Claims and Issues in Business Divorce Cases
§ 4.7.1. Alternative Entities
§ 4.7.1.1. Delaware
Gurney-Goldman v. Goldman, 321 A.3d 559 (Del. Ch. 2024). In a matter of first impression, the Court of Chancery determined that under 6 Del. C. § 18-705: (1) the estate of a deceased member of an LLC does not automatically become a member and instead only holds an assignee interest, and (2) the executor of the estate can, for the purpose of administering and settling the estate, exercise the member rights associated with the member interest. The Court stated that, as interpreted above, § 18-705 reflects a compromise between two policies: the non-mandatory pick-your-partner principle and a desire to treat an LLC member fairly after an adverse life event.
The case relates to the estate of billionaire real estate mogul Sol Goldman, who left behind four children: Jane, Diane, Amy, and Allan. Each child ended up with a 25% member interest in the two LLCs managing the Goldman family empire’s real estate holdings. Sol chose Jane and Allan to serve as co-executors, and the two eventually transitioned into ongoing roles managing the family business. When Allan died, he appointed his son Steven as executor of his estate. Steven sought to step into his father’s position with the business, but Jane rebuffed his efforts and viewed herself as the sole, remaining decisionmaker.
Amy and Stephen subsequently sought to exercise put rights that they held under the operating agreement for one of the LLCs managing the family’s property. After securing a third-party appraisal, Jane offered to redeem 5% of Amy and Steven’s equity for $91 million. Amy and Steven considered this figure to be facially inadequate, and attempts to settle the dispute foundered. Amy and Steven brought a lawsuit in New York state court against Jane and Diane, and then initiated the instant case in Delaware seeking declaratory relief as to the above-referenced issues.
To solve the question of whether the estate was a member or an assignee, the Court noted that an LLC member interest is personal property that transfers by operation of law to the estate. Thus, under the Delaware Limited Liability Company Act (the “LLC Act”), the recipient of a member interest only receives the rights of an assignee. In seeking to interpret the language of § 18-705 of the LLC Act, the Court turned to the history of analogous limited partnership law, and revealed a steady expansion of the scenarios in which a personal representative could exercise rights.
This statutory progression supported a plain-language reading of § 18-705 that authorizes a personal representative to exercise full governance for a proper purpose. The Court discussed the possibility that this statutory interpretation may clash with the pick-your-partner principle—which states that one is generally entitled to choose their own business associates in a closely held enterprise like an LLC—and held that, to the extent § 18-705 conflicts with this principle, the statute controls. Consequently, even where an estate remains an assignee, the executor of the estate can nevertheless exercise the governance rights that a member possessed, so long as the executor acts for the proper purpose of settling the estate or administering its affairs.
§ 4.7.2. Breach of Contract
§ 4.7.2.1. Colorado
Bartch v. Barch, 111 F.4th 1043 (10th Cir. 2024). Former co-owner of limited liability company (“LLC”), a marijuana business licensed to operate under Maryland law, brought action against LLC’s president and president’s corporation, which owned minority membership share in LLC, for breach of contract and other claims. President and his company never raised illegality as an affirmative defense. The trial court entered judgment in favor of co-owner on contract claim, awarding him $6.4 million in damages. The president and president’s corporation never appealed this judgement or paid the judgment. Co-owner sought to enforce judgment, and the trial court granted relief, ordering defendants to use best efforts to sell corporation’s equity interest in LLC, to turn over proceeds from any such sale, and to avoid devaluing equity until sale (“Judgment Enforcement Order”). Defendants appealed, and pending appeal, moved for relief from judgment on ground that it was void, arguing district court lacked subject matter jurisdiction to enter original judgment which compelled violation of Controlled Substances Act (“CSA”). The trial court denied motion, and defendants appealed. Appeals were consolidated.
This case presented a question about the nature and extent to which a federal court may act to resolve a dispute related to a marijuana business that operates legally under state law. The Circuit Court first determined that an illegality defense goes to whether co-owner had a meritorious contract claim, not whether co-owner has standing. President and his company, therefore, did not properly challenge jurisdiction of the original jurisdiction.
Under Colorado state law, C.R.C.P. 69(g), a creditor may request that a court order a debtor “to apply [certain] property . . . towards satisfaction of [a] judgment.” Since federal courts follow state procedures when enforcing a federal money judgment, the Circuit Court ruled that the trial court had authority to enter the Judgment Enforcement Order. However, the Circuit Court remanded the question of whether compliance of the Judgment Enforcement Order can be accomplished without violating the CSA because the Judgment Enforcement Order is a form of injunctive relief which is subject to equitable considerations, including public policy concerns about violating the CSA, which makes it a crime “to manufacture, distribute, or dispense, or possess with intent to manufacture, distribute, or dispense, a controlled substance.” 21 U.S.C. § 841(a)(1). Marijuana is a Schedule I controlled substance.
§ 4.7.2.2. Delaware
Sunder Energy, LLC v. Jackson, 305 A.3d 723 (Del. Ch. 2023). The Court of Chancery refused to enter a preliminary injunction against Sunder Energy, LLC’s (“Sunder”) co-founder and former head of sales, Tyler Jackson, enjoining him from breaching the restrictive covenants contained in Sunder’s LLC Agreement.
In Fall 2019, two of Sunder’s co-founders had a law firm draft an LLC agreement that included broad restrictive covenants without involving the other co-founders in the process. The operating agreement contained restrictive covenants prohibiting Jackson from: (1) engaging in competitive activities; (2) soliciting Sunder’s current and former employees and contractors; (3) engaging with Sunder’s customers; and (4) influencing Sunder stakeholders to terminate their relationship with Sunder (together, the “Restrictive Covenants”). The LLC agreement was presented to the minority members on New Year’s Eve without proper disclosures noting that the LLC agreement would alter their rights and internal governance dramatically. Nevertheless, Sunder sought to enjoin Jackson pursuant to the LLC agreement’s terms.
The Court denied Sunder’s motion for a preliminary injunction, finding that Sunder did not demonstrate a reasonable probability of success on the merits due to the overbreadth and unreasonable nature of the restrictive covenants and the breach of fiduciary duty by Sunder’s co-founders. Delaware courts do not automatically enforce restrictive covenants. Instead, such covenants are scrutinized to determine whether they are reasonable in geographic scope and temporal duration, advance a legitimate economic interest, and balance the equities involved.
In this case, the Court of Chancery found the Restrictive Covenants to be overly broad and unreasonable because, among other things, the noncompete and non-solicitation provisions purported to restrict Jackson from working in the entire door-to-door sales industry without regard to whether Sunder markets or sells similar product. The LLC Agreement also purported to prohibit Jackson from working with any current or former Sunder employee or independent contractor irrespective of why the person left Sunder’s employ or the industry in which Jackson might work with such person. In addition, the Restrictive Covenants as written may apply in perpetuity. Worse yet, the Restrictive Covenants were embedded in the LLC agreement without proper disclosure or explanation to the minority members, constituting a breach of fiduciary duty by Sunder’s majority members.
Davis v. Tristar Claims Management Services, Inc., 2024 WL 885440 (Del. Super. Ct. Feb. 29, 2024). In this case, the Delaware Court of Chancery ruled in favor of Tristar Claims Management Services, Inc. (“Tristar”), granting its motion for judgment on the pleadings, finding that Tristar did not breach what was essentially an earn-out provision in the subject Asset Purchase Agreement.
In 2017, James Paul Davis and Thomas Williams (referred to as “Sellers”) sold the assets of their insurance business (“PCS”) to Matrix Absence Management, Inc. (“Matrix”) through an Asset Purchase Agreement (the “APA”). Under the APA, Sellers received cash consideration of $10,000, and each signed five-year Employment Agreement with Matrix. The Employment Agreement entitled Sellers to salary, benefits, bonuses, and performance payments based on revenue growth and operating profit growth during a five-year period. For the performance payments to be triggered, operating profit growth must exceed 8%. PCS did not produce any profits until the fifth year after it was sold to Matrix. In 2021, Tristar acquired Matrix, assuming the latter’s obligations to Sellers under the APA.
Sellers sued Tristar for breach of contract, asserting that they were entitled to $3,195,896 after achieving the operating profit growth required under the APA in the fifth year following PCS’s sale to Matrix. Tristar, Matrix successor-in-interest, disagreed, arguing that there could be no recognizable increase in profit in a year following one where there were no profits. Sellers also claimed that Tristar violated the Delaware Wage Payment and Collection Act by withholding the same performance payments.
The Court of Chancery construed the APA’s definition of Operating Profit Growth to be an increase in operating profit made in one year in relation to the operating profit of the next, presupposing that profits must have been recorded in each year in order for an increase to be considered Operating Profit Growth. The Court additionally took judicial notice of the commonly accepted method of calculating percentage increase, where 0% profit in the preceding year results in a 0% profit increase in the following year, even where a net profit is posted. Accordingly, the Court ruled in Tristar’s favor, finding that the operation profit growth condition was not satisfied because PCS did not have profit in the fourth year.
§ 4.7.2.3. Florida
N. Bay Green Investments, LLC v. Cold Pressed Raw Holdings, LLC, 388 So. 3d 266 (Fla. Dist. Ct. App. 2024). In case, the Florida Third District Court of Appeal affirmed the trial court’s final judgment in favor of Cold Pressed Raw Holdings, LLC (“CPR Holdings”), which included awarding damages and attorneys’ fees. The appellate court also addressed a cross-appeal regarding the trial court’s decisions on the election of remedies and the dismissal of certain counterclaims. This case involves a dispute between LLC members who agreed to dissolve their business, after one of the members failed to satisfy the terms of the dissolution.
In this case, CPR Holdings and Defendants/Appellants North Bay Green Investments, LLC (“North Bay”) entered into a joint venture agreement involving the operation of a business manufacturing organic juices—Green Holdings, LLC (“Green Holdings”). The joint venture faced operational challenges due to various disputes over management of and financial obligations to the joint venture. As a result, the parties later decided to end the joint venture, executing a Settlement Agreement that included terms for payments and the transfer of ownership interests. Under the Settlement Agreement, CPR Holdings transferred its 50% ownership interest in Green Holdings to North Bay, and in return, North Bay agreed to pay CPR Holdings $200,000 in installments pursuant to a promissory note.
North Bay, however, failed to make the first payment under the Promissory Note, so CPR Holdings filed a breach of contract claim. In turn, North Bay filed a fraudulent inducement counterclaim seeking recission of the Settlement Agreement because CPR Holdings allegedly failed to transfer certain of its assets to North Bay. Based on the same alleged conduct, North Bay also asserted that CPR Holdings breached its fiduciary duties and the implied covenant of good faith and fair dealing.
The trial court found in CPR Holding’s favor on several counts, after concluding that North Bay breached the Settlement Agreement and the Promissory Note because it failed to make certain payments required by those agreements. That court also found that North Bay was not entitled to money damages because it elected to sue for recission of contract, therefore waiving the right to money damages. And North Bay’s counterclaims for fraudulent inducement and breach of fiduciary duty were dismissed because they were not adequately supported by the evidence. Finally, because CPR Holdings prevailed on its claims, the trial court awarded attorneys’ fees, as contemplated by the Settlement Agreement. The appellate court affirmed each of the foregoing holdings.
§ 4.7.2.4. Massachusetts
Basani v. Cygilant, Inc., 104 Mass. App. Ct. 1109 (2024). This case concerned a protracted conflict between two minority shareholders and the cybersecurity company they founded. In 2019, the shareholders stepped down from operational roles but retained a 28.14% interest in the company’s preferred stock and contractual rights designed to protect their interests. These rights included veto powers over certain equity financing transactions and provisions to prevent stock dilution.
In 2020, the company sought additional operating capital through equity financing, which required the consent of its minority shareholders. The shareholders refused to grant their consent or waive their anti-dilution rights, citing inadequate financial disclosures and claiming that the proposed financing would harm their interests. Instead, they demanded that the company buy out their shares. When the company rejected the buyout proposal, it pursued alternative financing at a higher cost. As a result, the shareholders filed a breach of contract lawsuit against the company. The company filed counterclaims, accusing the shareholders of acting in bad faith by withholding their consent to the equity financing.
The Massachusetts Appeals Court affirmed the dismissal of the company’s counterclaims. It held that under applicable Delaware law, fiduciary duties arise only for shareholders who exercise actual control over the corporation’s affairs. As minority shareholders, the individuals lacked control over the company’s board or strategic decisions. The court also determined that the shareholders’ actions—refusing to waive contractual rights and requesting further disclosures—were a proper exercise of the protections provided to them under their stock agreements.
§ 4.7.2.5. New York
Behler v. Kai-Shing Tao, 227 A.D.3d 121 (2024). Plaintiff and defendant entered into an oral agreement in which plaintiff would invest $3 million in an LLC with the opportunity to cash out of his investment upon certain conditions being met. When a condition was met, plaintiff demanded he be cashed out, but defendant refused. After the oral agreement was executed and before plaintiff’s demand, the LLC agreement was amended, which included membership interest and distribution clauses. The amended LLC agreement also contained an integration and merger clause. The court held that, pursuant to Delaware law, the amended LLC agreement, by virtue of the merger clause, superseded the oral agreement. The plaintiff, as a member, was bound by the LLC agreement. The court also denied the plaintiff’s claim for promissory estoppel because the LLC agreement governed.
§ 4.7.3. Breach of Fiduciary Duty
§ 4.7.3.1. Delaware
In re Sears Hometown and Outlet Stores, Inc. Stockholder Litig., 309 A.3d 474 (Del. Ch. 2024). The Court of Chancery held that a majority shareholder did not breach his fiduciary duties as a controlling stockholder where he believed in good faith that his actions were in the best interests of the subject company. The Court further held, however, that the transaction pushed through by the majority stockholder was not entirely fair and therefore awarded damages to the minority stockholders.
Sears Hometown and Outlet Stores, Inc. (“SHOS” or “the Company”) conducted business through two segments: (1) the Sears Hometown and Hardware Segment (“Hometown”) and (2) the Sears Outlet Segment (“Outlet”). A committee of independent directors sought to liquidate Hometown and continue operating Outlet. The Company’s controlling stockholder, believing that the liquidation plan would destroy the Company’s value, used his voting power as the controlling stockholder to adopt a bylaw that required that any Hometown liquidation plan receive approval from 90% of the Board at two separate votes taken at least thirty business days apart.
The controller also removed two members of the Board—thereby removing them from the committee as well—and replaced them with two individuals that would likely support his plan even though there were no direct ties between them and the controller. The sole remaining member of the committee and the controller subsequently agreed to an end-stage transaction that eliminated the minority stockholders’ interests in the Company.
A group of minority stockholders filed a complaint against the controller arguing that he breached his fiduciary duties by blocking the liquidation plan. The Court of Chancery held that when exercising stockholder-level voting power, a controller owes (1) a duty of good faith that demands that the controller not intentionally harm the corporation or its minority stockholders and (2) a duty of care that demands that the controller not harm the corporation or its minority stockholders through grossly negligent action. However, a controller is not required to meet the higher standards demanded of directors, who must act affirmatively to promote the best interests of the corporation and must subjectively believe that the actions they take further that objective.
The Court also established that enhanced scrutiny is the appropriate standard of review in cases where “the controller took actions that invaded the space typically reserved for the board of directors.” The Court then held that the controller acted consistent with his fiduciary duties by blocking the liquidation plan, since he (1) believed in good faith that the plan was fundamentally flawed and (2) had sufficient information to make an assessment that was not grossly negligent.
But the Court found that the end-stage transaction failed to meet the requirements of the entire fairness standard, even though the controller sincerely believed that the transaction was fair. The Court noted that when a conflict transaction is not entirely fair, a self-dealing fiduciary is liable without regard to his or her mental state. It therefore awarded damages to the minority stockholders equal to the difference between what they received through the transaction and the fair value of the Company.
Lebanon Cty. Employees’ Retirement Fund v. Collis, 311 A.3d 773 (Del. 2023). The Supreme Court of Delaware reversed and remanded a decision by the Court of Chancery in which the lower court found that the plaintiffs had sufficiently articulated a claim under In re Caremark Intern. Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), but nevertheless dismissed their complaint after concluding that demand would not have been futile, and the plaintiffs therefore lacked standing.
After AmerisourceBergen Corporation (“AmerisourceBergen” or “the Company”) incurred liability for over $6 billion in a 2021 global settlement related to the Company’s role in the opioid epidemic, the stockholder plaintiffs filed a derivative suit in the Court of Chancery alleging that the company’s directors and officers failed to adopt oversight measures and reasonable policies for preventing the unlawful distribution of opioids. Plaintiffs did not serve a demand on the board prior to filing suit.
The Court of Chancery found that the plaintiffs had sufficiently articulated a claim under Caremark, but dismissed their complaint having determined that demand would not have been futile due to a holding by the United States District Court for the Southern District of West Virginia in opioid-related multidistrict litigation in which that court found that AmerisourceBergen had complied with the law on preventing the diversion of controlled substances. As a result, the Court of Chancery reasoned that the Board did not face a substantial likelihood of liability under the pleaded claims. The West Virginia decision was issued after the plaintiffs had filed their complaint.
On appeal, the Delaware Supreme Court determined that the Court of Chancery had erred by using D.R.E. 202—which provides for judicial notice of law—to effectively adopt the factual findings of another court adjudicating another case, and thereby accept a contradictory version of the well-pleaded facts in the plaintiffs’ complaint, which are presumed to be true under Delaware’s rules of procedure. Furthermore, the Supreme Court found that the Court of Chancery’s reliance on the West Virginia Decision changed the date at which demand futility should be considered to a date six months after the filing of the complaint. Such a change impermissibly deviated from the precedent established in Rales v. Blasband, 634 A.2d 927 (Del. 1993), that demand futility is evaluated as of the time the complaint is filed.
§ 4.7.3.2. Florida
Kinchla v. Ran Investments, LLC, 2024 WL 4096229 (Fla. App. 6 Dist. Sept. 6, 2024). The District Court of Appeal of Florida, Sixth District, affirmed in part and reversed in part the trial court’s decision regarding claims of breach of fiduciary duty, breach of the operating agreement, and indemnification. The appellate court remanded for entry of a revised damages award. This case arose after an LLC member failed to make the capital contributions required and interfered with the LLC’s business opportunity.
Kilgore Properties, LLC (“Kilgore”) was formed to develop and sell real property. Its members were Mark 48, LLC (“Mark 48”), who held a 35% ownership interest, and Nanlann, Inc. (“Nanlann”), which held a 65% ownership interest. Under Kilgore’s operating agreement, Mark 48 was obligated to make a $350,000 capital contribution, but it failed to do so.
Kilgore obtained a mortgage loan to acquire property to be developed and sold. But when Kilgore attempted to sell the property to Saibaba of Orlando, Inc. (“Saibaba”) for $1.6 million, but Mark 48 objected. Mark 48’s alleged conduct caused the sale to fall through, resulting in financial losses for Kilgore when it could not pay its mortgage and defaulted on the loan. Nanlann then filed an action to dissolve Kilgore and force the sale of its property. During litigation, Kilgore’s property was sold to LG 2121 S. Orange, LLC (“LG”) for $1.75 million, and the amounts owned on the mortgage were paid from the proceeds. Having to delay the property’s sale caused Kilgore to pay an additional $173,927 to the bank.
Based on the foregoing facts, Nanlann asserted three claims against Mark 48 and its sole member, Mark Kinchla: (1) breached its fiduciary duty by objecting to the sale of Kilgore’s property to Saibaba; (2) breached the Operating Agreement by failing to make the required $350,000 capital contribution; and (3) failed to make its capital contribution, entitling Nanlann to indemnification. The trial court found in Nanlann’s favor with respect to all three claims, entering judgment against Mark 48 and awarding damages to Nanlann for its breach of contract and fiduciary duty. The trial court also pierced the corporate veil, holding Kinchla personally liable for Mark 48’s misconduct.
The Florida appellate court affirmed the trial court’s rulings on Nanlann’s breach of fiduciary duty and contract claims, but the appellate court reversed the indemnification decision, after finding that Nanlann’s claim was time-barred. The appellate court also found that the trial court was right to pierce the corporate veil and hold Kinchla personably liable for Mark 48’s wrongdoing.
§ 4.7.3.3. Massachusetts
Barr v. Swenson, 104 Mass. App. Ct. 1117 (2024), review denied, 494 Mass. 1108 (2024). This case involved a dispute among shareholders of a closely held family corporation that operates a motel. The plaintiff, a minority shareholder, alleged that her uncles, who served as the corporation’s only board members, breached their fiduciary duties.
The conflict arose when one of the uncle’s children decided to sell shares in the company. Under the corporation’s bylaws, shareholders were required to first offer their shares to the corporation before selling them to another party. However, the company’s bylaws also provided that the board could waive this requirement, which the board routinely did.
In keeping with this practice, the company’s board waived this requirement with respect to the child’s sale of shares. This enabled one of the uncle’s children to sell their shares to the other uncle’s family members, who were also shareholders of the corporation, at $85,000 per share. The plaintiff had previously expressed interest in purchasing shares and claimed she was willing to pay $100,000 per share. She argued that the board’s decision deprived the corporation of a potential profit and accused her uncles of breaching their fiduciary duties. She also alleged that one of the uncles diverted corporate resources to other motels owned by his family.
The Massachusetts Appeals Court upheld the dismissal of the plaintiff’s claims. In doing so, it ruled that the plaintiff failed to establish actionable harm. Her theory, that the company could have profited by buying the shares at an artificially low price and reselling them at a higher price, was, according to the appellate court, speculative and unsupported by corporate law. The court emphasized that fiduciary duties require directors to act in the best interests of the corporation and shareholders but do not obligate them to design transactions that exploit shareholders for corporate gain. Additionally, the court found no evidence to support the plaintiff’s allegations of resource diversion.
§ 4.7.3.4. Minnesota
Absolute Sports Cards, LLC v. Thornton, 2024 WL 4260268 (Minn. Ct. App. Sept. 23, 2024). In considering the duty of loyalty, including the duty not to compete that members owe to one another in a limited liability company, the Minnesota Court of Appeals found that a term of the parties’ Operating Agreement was “manifestly unreasonable” and therefore it was unenforceable and void in Absolute Sports Cards, LLC v. Thornton, 2024 WL 4260268 (Minn. Ct. App. Sept. 23, 2024). The three members of the LLC, which was formed to trade sports cards and other sports memorabilia, agreed to the terms of an Operating Agreement that both prohibited the members from competing with the company while members and for two years thereafter and provided that the noncompetition obligations did not “apply to or be binding upon any Member’s same or similar business in existence at the time of the execution of this Agreement.” Id. at 1. Following formation of the company, two of the three members ended their individual sports- collectibles businesses and transferred their inventory and the proceeds from the final sales to the company. The third member, the defendant in the action, did not stop his individual sports collectible business. The two members ultimately removed the defendant member from the company primarily because he would not discontinue operating his individual competing business.
In defense of his competition, defendant-member argued that the Operating Agreement allowed him to compete. The company argued that the competition exception provided in the Operating Agreement, which they also agreed to, was “manifestly unreasonable” under Minn. Stat. § 322C.0110, subd. 4(1)(iii), which allows members of an LLC to restrict or eliminate the duty to refrain from competing with the company so long as the restriction or limitation is not “manifestly unreasonable.” Ultimately, the Minnesota Court of Appeals held that the “purported agreement to eliminate the members’ duty not to compete with ASC is manifestly unreasonable and, therefore, void” reasoning that the scope of the non-competition obligations in the Operating Agreement were “comprehensive” and the exception to the competition restrictions created an “irreconcilable conflict.” Id. at *3.
For further discussion of Absolute Sports Cards, LLC. v. Thornton, see also sections herein relating to damages.
§ 4.7.4. Civil Theft/Conversion
§ 4.7.4.1. Delaware
Gulf Aviation Services Group WLL D/B/A/ United Aviation v. Wilmington Trust Company, C.A. No. N20C-05-128 AML CCLD, 2023 WL 9118772 (Del. Super. Ct. Dec. 29, 2023). The Delaware Superior Court found that Plaintiff Gulf Aviation Services (“Gulf”) satisfied its burden with respect to its conversion claim, in that Defendant Wilmington Trust Company (“WTC”) had wrongfully sold Gulf’s helicopter after the legal title was passed to WTC through a Trust Agreement.
Gulf had placed its air ambulance helicopter in a trust with WTC as trustee so that Gulf could operate the helicopter under an FAA registration overseas. After the relationship between Gulf and WTC fell apart, the trust agreement was terminated. Subsequently, WTC transferred the helicopter to a third party, who claimed to have an ownership interest in the helicopter pursuant to a foreign court’s order, without investigation of the third party’s claim or notice to Gulf.
The Court held that Gulf’s conversion claim was not a breach of contract claim improperly bootstrapped onto a tort claim because (1) WTC’s powers under the Trust Agreement terminated before it sold the helicopter and (2) Gulf’s claim arose from general common law tort principles independent of any contractual relationship between the parties. The Court also noted that demand for the return of the property is not required before pursuing a conversion claim when the claim arises from the disposal of the property through a lease, pledge, or sale. After articulating these principles, the Court found that WTC was liable for converting the helicopter through a wrongful sale following WTC’s resignation from its position as the Owner Trustee and the termination of its rights to sell the helicopter under the Trust Agreement.
With respect to valuation, the Court noted that the ruling in Segovia v. Equities First Holdings, LLC, 2008 WL 2251218 (Del. Supr. May 30, 2008), “does not stand for the broader proposition that the amount of any encumbrance must be subtracted from the converted property’s fair market value.” It then rejected WTC’s argument that the amount of any third-party encumbrance must be subtracted from the property’s fair market value and noted that Segovia was distinguishable because it related to a loan made by the defendant in that case.
The Court also found that, with respect to WTC’s counterclaim for breach of contract, (1) Gulf had failed to plead the statute of limitations as an affirmative defense under 10 Del. C. § 8106, and (2) was liable for breaching the Trust Agreement by failing to pay WTC’s fees from 2010 to 2015.
Lastly, the Court held that WTC’s indemnification claim for costs and attorneys’ fees failed because (1) litigants in Delaware are generally responsible for their own litigation costs and (2) the relevant section of the Trust Agreement did not explicitly and unequivocally operate as a fee-shifting provision for litigation.
§ 4.7.5. Declaratory/Equitable/Statutory Relief
§ 4.7.5.1. California
Samuelian et al. v. Life Generations Healthcare, LLC, et al., 104 Cal. App. 5th 331 (Cal. Ct. App. 2024). The California Court of Appeals held that a noncompetition provision included in an operating agreement adopted after the sale of a partial business interest cannot be considered inherently anticompetitive under Cal. Bus. & Prof. Code, § 16600, subd. (a) and must be scrutinized under the reasonableness standard to determine whether it has any procompetitive benefits, in light of the selling owner’s continuing connection to the business. When applying this standard, courts can assess the reasonableness of any contractual fiduciary duties imposed on a member in a member-managed or manager-managed company through the adoption of an operating agreement.
The Court’s ruling here does not nullify the rule, articulated in Ixchel Pharma, LLC v. Biogen, Inc., 9 Cal. 5th 1130 (Cal. 2020), that noncompetition restraints following the sale of a business interest are invalid per se. Instead, the Court concluded that this rule related to circumstances in which noncompetition restraints following the sale of an entire business do not contain any goodwill, such as where the seller did not own a substantial interest in the company or where goodwill was not included in the sale price.
§ 4.7.5.2. Delaware
In re Triple S Minerals Resources Corporation, C.A. No. 2024-0262-JTL (Del. Ch. Mar. 20, 2024) (Order). The Court of Chancery denied the petition by Tronox LLC (“Tronox”), the sole stockholder of Triple S Minerals Resources Corporation (“Triple S”), for the appointment of a limited purpose receiver for the dissolved Delaware corporation, Triple S.
Even after it was allegedly dissolved, Triple S still held assets, specifically a royalty interest in Canadian mineral exploration properties originally acquired in 1997. Tronox executed a royalty purchase agreement to sell its royalty interest and claimed that appointing a receiver was necessary to meet certain closing conditions of the purchase agreement. Accordingly, Tronox filed a verified petition seeking the appointment of a receiver under Section 279 of the Delaware General Corporation Law (“DGCL”) to manage Triple S’s dissolution and transfer its remaining assets, including a royalty interest in Canadian mineral exploration properties. Tronox also moved to expedite the proceeding because of deadlines associated with the royalty purchase agreement and proposed a Tronox officer as the receiver.
The Court denied Tronox’s petition, finding that the petition and the affidavit of Tronox’s officer did not provide sufficient factual information about the proposed receiver to assess their suitability. Among other failings, the petition failed to identify an agent for service of process in Delaware and did not comply with Court of Chancery Rule 150, requiring the receiver to be a Delaware resident or seek an exemption under Rule 148. The petition also failed to address whether service of process on other potentially interested parties, such as B2Gold Corp., was warranted.
The Court of Chancery ordered Tronox to supplement the record with the needed detail about the proposed receiver and to identify all assets that the receiver would transfer.
§ 4.7.5.3. Florida
Ganiban v. McManus, 372 So. 3d 319 (Fla. Dist. Ct. App. 2023). The District Court of Appeal of Florida, Fifth District, dismissed the petition for certiorari review as moot and held that the motion for reconsideration did not toll the deadline to file the petition. This case involves a dispute among physicians in an optometry practice over their respective ownership interests in entities related to their practice and investments.
Plaintiff/Respondent Dr. James N. McManus initially sued Defendants/Petitioners Dr. Gary J. Ganiban, Dr. Michael N. Mandese, Dr. Jason K. Darlington, Dr. Eric Straut, and Dr. Hetal Vaishnav to resolve disputes over (1) their respective ownership interests in corporate entities formed to manage and operate their optometry practices and related investments and (2) Defendants/Petitioners’ alleged breaches of fiduciary duty. Plaintiff/Respondent also sought to enjoin Defendants/Petitioners’ allegedly improper efforts to dissolve and wind down the entities in which the parties share ownership.
While Plaintiff/Respondent’s motion for injunctive relief was pending, the parties agreed to a court order to maintain the “status quo” for a period of 100 days to allow for a potential resolution or until the court could hear the preliminary injunction motion. The trial court granted Plaintiff/Respondent’s motion to preserve the status quo, and the related order prevented Defendants/Petitioners from terminating or not renewing Plaintiff/Respondent’s employment contract so that he could continue to see patients and run his practice. The trial court also held Defendants/Petitioners in contempt for violating a prior court order related to preserving the status quo.
Defendants/Petitioners filed a petition for certiorari to review the trial court’s rulings. The appellate court found that the petition for certiorari was moot because the 180-day extension period in the status quo order had expired, and the trial court had denied Plaintiff/Respondent’s renewed motion for a preliminary injunction. The appellate court further held that Defendants/Petitioners’ motion for reconsideration of the contempt order did not toll the 30-day deadline to file a petition for writ of certiorari. Since the petition for certiorari was not filed within this timeframe, the appellate court dismissed the petition for lack of jurisdiction.
Haskell v. PCP Grp., LLC, 386 So. 3d 644 (Fla. Dist. Ct. App. 2024). The District Court of Appeal of Florida, Second District, reversed the trial court’s summary judgment in favor of PCP Group, LLC, and remanded with instructions to enter final summary judgment in favor of Unni Haskell. This case arose after the plaintiff received ownership interests in an LLC as part of her divorce settlement, and the LLC attempted to force her to sell the ownership interest back to the company.
In this case, Unni Haskell was awarded membership units in PCP Group, LLC (“PCP”), as part of the resolution of divorce proceedings with John Haskell, her former husband. John Haskell initially failed to transfer his PCP units to Unni Haskell, attempting to sell those units to another member of PCP. The divorce court invalidated that sale, and Unni Haskell was declared the rightful owner of the units.
PCP responded by filing a declaratory judgment action against Unni Haskell, arguing that PCP’s operating agreement required Unni Haskell to sell her units back to PCP under its “Deemed Offers to Sell” (“DOTS”) provision. That provision states that “[n]otwithstanding anything in [the operating agreement] . . . the Company and the Non-Selling Class A Members shall have the right to purchase” all of a member’s units, even if the member or his or her spouse are transferring units pursuant to a court-ordered property settlement agreement, after a divorce. The DOTS provision also required the member to give written notice to PCP and the non-selling Class A members in the event of a divorce, or other triggering event.
The trial court granted summary judgment in favor of PCP, requiring Unni Haskell to sell her units back to the company. Unni Haskell appealed, and applying de novo review, the appellate court concluded that the DOTS provision did not apply to Unni Haskell’s situation since the transfer of ownership had already been completed through the divorce judgment. That court found that the DOTS provision language imposed obligations on a member seeking to transfer his units, not on the transferee, after the transfer has been completed. Because Unni Haskell was the undisputed owner of the membership units at issue, the DOTS provision did not impose a burden on her to sell the units back to PCP. The appellate court further concluded that interpreting the DOTS provision to require Unni Haskell to sell her units to PCP would rewrite the operating agreement, which was not permissible.
The appellate court reversed the summary judgment in favor of PCP and remanded the case with instructions for the trial court to enter final summary judgment in favor of Unni Haskell.
§ 4.7.5.4. Illinois
Machnicki v. Nowobilski, 2024 IL App (3d) 230306-U (Feb. 29, 2024). Plaintiff Richard Machnicki and defendant John Nowobilski each owned 50% of the shares of Northstar Foods, Inc., a meat processing business. The corporation had three directors—Richard, John, and John’s wife Donna. John and Donna were the corporation’s only officers and were primarily responsible for its operations.
While the business was quite successful, the relationship between Richard and John deteriorated. Disputes arose as to, among other things, director and officer compensation and certain real estate-related matters. Richard requested books and records pursuant to section 7.75 of the Business Corporation Act of 1983, but John refused to provide the requested records.
Richard filed suit, claiming misuse of corporate funds and seeking books and records. Among other claims, he asserted a derivative claim for oppression under section 12.56 of the Business Corporation Act. John filed a counterclaim. He, too, asserted oppression under section 12.56 of the Business Corporation Act, and he sought an order valuing the company and requiring a buyout.
During the litigation, the company received a letter of intent (LOI) from a third-party to purchase the company’s assets for $30 million. John refused to share the LOI with Richard, however, and Richard refused to agree to the proposed sale.
John thereafter filed a motion for a preliminary injunction. He argued the shareholders were deadlocked and sought an order forcing a company sale or a buyout of shares.
Following an evidentiary hearing, the circuit court granted John’s motion for a preliminary injunction. In its order, the court found that the fair value of the company was $35 million and ordered John to buy out Richard’s interest for $17.5 million. Richard filed an interlocutory appeal.
On appeal, Richard argued that the preliminary injunction order was improper because it altered the status quo and because the parties did not have the opportunity for full discovery or a trial regarding the fair value of the company.
The appellate court agreed. It reversed the circuit court’s preliminary injunction order. The appellate court noted that a preliminary injunction should ordinarily preserve the status quo pending a final resolution on the merits of the case. The court noted that a preliminary injunction may alter the status quo in rare circumstances where maintaining it would cause irreparable harm to the company. In this case, however, it found that the company was performing well and that John was free to sell his 50% interest to any third party. It therefore held that there was no compelling reason to change the parties’ relationship by forcing a buyout without conducting a full trial regarding the fair value of the company.
Casas v. Ferrarini, 2024 IL App (1st) 220511-U (Mar. 29, 2024). Plaintiff Christopher Casas and defendant Marco Ferrarini operated multiple businesses together, including a restaurant, a coffee shop, and a vintage motorcycle dealership. The businesses were conducted through FerCas, LLC, an Illinois limited liability company. Casas owned his interest in FerCas through KS&T, a sole proprietorship that was later registered as an LLC. Ferrarini owned his interest through MLL, Ltd., an Illinois corporation. Both companies were identified in FerCas’s founding documents as members of FerCas.
Eventually, MLL purported to notify KS&T that it was dissociated from FerCas because KS&T had never been legally formed as an Illinois LLC, as the parties had intended when they began the business. Ferrarini used this as a basis to exclude Casas from the business.
Casas brought suit, individually and derivatively on behalf of FerCas. He sought a declaratory judgment as to his ownership in FerCas through KS&T, judicial supervision of the windup of FerCas pursuant to section 35-4 of the Illinois Limited Liability Company Act, an accounting, and damages for alleged breaches of contract, breaches of fiduciary duty, and unjust enrichment.
The circuit court granted summary judgment on standing. It found that although KS&T was not a registered entity at the beginning of the parties’ relationship, it could be considered a sole proprietorship, and that Casas was entitled to exercise KS&T’s rights and receive its benefits as a member of FerCas. The circuit court further found that by excluding Casas from the business on this basis, Ferrarini had violated his fiduciary and other legal obligations to Casas.
The case proceeded to trial on damages. The circuit court awarded compensatory damages of approximately $1.6 million and punitive damages of double that amount.
The appellate court affirmed the circuit court’s judgment. After addressing a number of purported procedural errors, the court turned to the damages award. Defendant argued that the award of compensatory damages was against the manifest weight of evidence because it failed to account for certain expenses of the business. The circuit court, however, relied on the fact that defendant withheld documents in discovery and that plaintiff deducted the expenses to which he had access from his proposed award. The appellate court affirmed, holding that the award was sufficiently based on the available evidence.
The appellate court also affirmed the circuit court’s award of punitive damages. The appellate court relied on the circuit court’s findings that Ferrarini’s exclusion of Casas from the business was “willful and outrageous” and that it was done so that Ferrarini could use the business as his personal “piggy bank.”
Kodryan v. Lukaszewicz, 2023 IL App (1st) 231280-U (Nov. 9, 2023). Plaintiff Edward Kodryan and defendant Daniel Lukaszewicz were each 50% owners and the sole members and managers of NorthShore Car Center, LLC. Formed in 2017, NorthShore offered automotive repair and car wash services.
By 2020, the members’ relationship had deteriorated. In his complaint, Kodryan alleged that Lukaszewicz denied Kodryan access to the company’s bank accounts and financial information, that he obtained a loan without Kodryan’s consent and the Lukaszewicz was making personal use of company assets. Kodryan asserted a claim for breach of fiduciary. He sought dissolution of the company and an accounting.
Lukaszewicz counterclaimed, alleging that Kodryan withdrew company funds for personal use and otherwise wasted company resources. He also sought dissolution and an accounting.
During the litigation, the appellate court permitted Kodryan to amend his complaint to add allegations that Lukaszewicz withdrew company funds from its accounts, that certain assets were unaccounted for, and that Lukaszewicz had begun operating a separate business at the same location under the name “NorthShore Car Care.”
Kodryan sought appointment of a receiver. Following briefing and argument, the appellate court granted the motion to appoint a receiver. Thereafter, the parties suggested potential receivers and the Court entered an order appointing one. Lukaszewicz thereafter filed a notice of interlocutory appeal.
The appellate court first determined that the appeal was timely because the time within which to appeal ran from the order appointing a specific receiver, rather than the earlier order granting the motion to appoint a receiver.
The appellate court next turned to the merits. It noted that a motion to appoint a receiver is a drastic remedy, available only in cases of “urgent necessity.” Lukaszewicz argued that the circuit court abused its discretion in appointing a receiver because (1) it failed to make detailed findings in its written order, and (2) it did not conduct an evidentiary hearing.
The appellate court rejected these arguments and affirmed the circuit court. It held that because there was no transcript of the hearing at which the receiver was appointed, it could not determine the circuit court had failed to make the requisite findings. The court also rejected the argument that an evidentiary hearing was required. It found it significant that Kodryan had attached affidavits and documents showing that Lukaszewicz was running a competing business out of their facility. This, the court held, was sufficient to support the circuit court’s order.
§ 4.7.5.5. New Jersey
Patel v. New Jersey Dep’t of Treasury, Div. of Revenue & Enter. Servs., 479 N.J. Super. 26, 318 A.3d 685 (App. Div. 2024). This case resolved a matter of first impression in New Jersey: the proper way to rescind a certificate of dissolution and termination of a New Jersey LLC filed erroneously and without authorization. In this action, a sole member of an LLC filed a complaint against the Division of Revenue and Enterprise Services to compel it to reinstate the LLC. The Department terminated the LLC in response to a former member’s filing of a certificate of dissolution and termination. The remaining member alleged this was done without authorization and asked that the LLC be reinstated to prevent loss of its business licenses.
New Jersey has no statutory authority on LLCs to resolve the issue or authorize the Department of Treasury to perform a recission. Despite the silence on the matter in the LLC statutory scheme, the Court reasoned the longstanding principle of statutory interpretation is to construe laws in a “sensible manner,” which at times may mean interpreting “literal contents of a statute in a manner that advances its manifest purposes.” Here, the Court found that the manifest purpose of the RULLCA “is to assure that the filings with the Division concerning the status of an LLC are up-to-date and duly authorized,” which imposes an obligation to correct erroneous information. All counsel in this matter agreed there should be a clear avenue to pursue rescission of a dissolution and termination on equitable grounds in the instance, such as this one, where the certificate is filed improperly. The Court held that the appropriate mechanism to do so is through civil action in trial court. Accordingly, this matter was remanded to the trial court for further proceedings and findings of fact.
§ 4.7.5.6. New York
Weinstein v. Wallace, 219 N.Y.S.3d 172 (2024). The plaintiff and his siblings executed an operating agreement for a funeral services business. The operating agreement designated the plaintiff’s brother as the manager of the company. The plaintiff and his brother eventually each owned 50% of the membership interest in the company. The plaintiff instituted this action after his brother died to be declared the sole voting member and manager of the company. The court held that the operating agreement unambiguously provided that a deceased member’s estate shall have all of the rights of the member, which would include voting rights. Therefore, the deceased’s estate became a voting member of the company. Plaintiff also did not become the manager of the company upon his brother’s death as the operating agreement required a manager be elected by the members.
§ 4.7.5.7. Pennsylvania
In re Mt. Vernon Tenants Association, Inc., 322 A.3d 1002 (Pa. Commw. Ct. 2024). A board member, Lundy, filed a Complaint for Dissolution and applied for the appointment of a receiver. The trial court granted the application for appointment of a receiver on grounds not included in the application and the association appealed. The Commonwealth Court held that the trial court was not limited to considering only the grounds raised in the application and affirmed the appointment of the receiver.
§ 4.7.5.8. Texas
Multi-Hous. Tax Credit Partners XXXI v. White Settlement Senior Living, LLC, No. 05-22-00721-CV, 2024 WL 301916 (Tex. App.—Dallas Jan. 26, 2024, pet. denied). The partnership was formed and organized to construct, own, operate, and sell residential units in a housing property to qualify for federal tax credits pursuant to the low-income housing tax credit program. The governing document—the limited partnership agreement—included an option provision for White Settlement Senior Living, LLC to purchase Multi-Housing Tax Credit Partners XXXI’s interest in the partnership. The partnership agreement also included an arbitration provision. White Settlement exercised its option, a valuation dispute ensued, the parties engaged in contested arbitration, and an appeal followed.
On appeal, Multi-Housing Tax Credit Partners argued in part that White Settlement Senior Living, LLC’s “unclean hands” supported a conclusion that it breached its fiduciary duties. The court of appeals, however, noted that the arbitrator’s award included findings that there was no evidence that the parties had a special relationship establishing a fiduciary duty. Instead, “[b]oth sides [were] sophisticated business entities represented by numerous attorneys and experts in the field. The industry involved here [was] one where sharp dealing is the norm and no expectation arises that good faith and fair dealing is the standard when it comes to compliance with contractual obligations.”
Chow v. McIntyre, No. 01-21-00658-CV, 2023 WL 7778602 (Tex. App.—Houston [1st Dist.] Nov. 16, 2023, no pet.). The parties were members and managers of two companies that own and operate a business park. The parties settled an internal business dispute by executing an agreement under which one group of parties had the right to buy out another group at a specified price within 60 days. If the first group failed to do so, the second group was obligated to buy the first group out at a specified price. A buyout never occurred by either group. The first group then filed a suit in which they alleged that the second group breached the settlement agreement by unreasonably refusing to cooperate in settlement—thwarting their attempted buyout. The second group countersued alleging that the first group had breached the agreement by refusing to be bought out after failing to complete a timely buyout themselves.
The parties’ breach-of-contract claims were tried to a jury, which sided with the second group. The parties did not submit a question on damages to the jury. Instead, based on the jury’s finding, the second group asked the court to enforce the settlement agreement through the equitable remedy of specific performance (i.e., they requested a judgment compelling the first group to sell their interests at the specified price). The first group opposed specific performance by arguing that the second group had not complied with the terms of the agreement and also by arguing that the second group’s “unclean hands” precluded them from invoking or obtaining equitable relief of any kind. The trial court rendered judgment that both parties take nothing on their respective claims. The trial court also denied all requests for attorney’s fees and all other requested relief. Both sides appealed.
The court of appeals upheld the jury’s findings after determining that the evidence was factually sufficient to support the jury’s verdict. As to the “unclean hands” argument, the court of appeals determined that, reduced to its essence, the first group’s position was that the trial court could deny specific performance to the second group because they breached the settlement agreement, even though the jury found otherwise. However, even an admitted breach of contract—in and of itself—will not generally support an invocation of the unclean hands doctrine. E.g., Stewart Beach Condo. Homeowners Ass’n, Inc. v. Gili N Prop Invs., LLC, 481 S.W.3d 336, 351–52; LDF Constr. v. Bryan, 324 S.W.3d 137, 149–50 (Tex. App.—Waco 2010, no pet.). Here, in stark contrast, the jury found that the second group did not breach the settlement agreement, and the court of appeals separately affirmed that verdict. Hence, the court of appeals determined, the “the trial court could not rely on the doctrine of unclean hands to deny [the second group] specific performance without abusing its discretion.” Accordingly, the court of appeals reversed and rendered in part.
§ 4.7.6. Statute of Limitations
§ 4.7.6.1. Nevada
Urb. Outfitters, Inc. v. Dermody Operating Co., LLC, 705 F. Supp. 3d 1174, 1177 (D. Nev. 2023). The federal district court declined to read into the statute of limitations on post-dissolution actions the “discovery rule”—wherein the three-year limitation commenced only after discovery of the claim—and found that the three-year limitation commenced the day of the corporation’s dissolution.
In a breach of contract action involving the construction of a distribution center, which was completed in 2012, plaintiff brought claims against the developer and the general contractor in 2021. The developer brought third-party claims against a subcontractor for indemnification and contribution. The subcontractor, however, dissolved as a corporation in 2014. In response to the third-party claim, the subcontractor filed a motion to dismiss contending that the three-year statute of limitations commenced the date of the subcontractor’s dissolution and therefore the claims were time barred. The subcontractor argued that the plain language of the statute requires any cause of action against a dissolved corporation be commenced within three years of its dissolution. In response, the developer claimed that because it did not learn of any alleged harm until it was sued, the applicable statute of limitation did not begin to run until the developer “discovered” the facts giving rise to the claims. The court agreed with the subcontractor and found that the third-party claims were time barred. While other statutes of limitation apply the discovery rule, i.e., the clock begins when plaintiff learns or should have learned about the claim, such language is notably absent in the statute of limitation on post-dissolution actions. Had the legislature intended for the deadline to bring post-dissolution claims well beyond three years, as the developer advocates, the statute would have included the discovery rule. Moreover, the legislative minutes provided helpful insight wherein the stated goal was to have an absolute stop-date on when claims may be brought post-dissolution.
§ 4.7.6.2. Pennsylvania
Matthew Serota, Derivatively on Behalf of London Towne Homeowners Association v. Matthew J. Mager, 304 A.3d 828 (Pa. Commw. Ct. 2023). Two-year statute of limitations for interference with contractual relations against member of a homeowner’s association was tolled by the derivative demand letter.
§ 4.8. Valuation and Damages
§ 4.8.1.1. California
Shah v. Skillz Inc., 320 Cal. Rptr. 3d 175 (2024). Former employee brought action against employer, a startup, for breach of contract, retaliation, and wrongful termination, alleging employer lacked cause to terminate him two years before its initial public offering (“IPO”) and thereby wrongfully prevented him from exercising stock options. Following trial and grant of employer’s motion for directed verdict as to claims for retaliation and wrongful termination, the trial court entered judgment on jury’s verdict awarding employee $11,557,173 for breach of contract, then denied employer’s motion for judgment notwithstanding the verdict (“JNOV”), denied its motion for new trial on condition that employee accept remittitur in the amount opined by the company’s expert witness or $4,358,358, and after employee did so, entered amended judgment for employee in such amount. Employee appealed and employer cross-appealed on several grounds, including the appropriate measure of damages. Employer appealed the damages awarded as being contrary to law because they were not measured as of the date of breach. While the employee contended that the jury verdict in excess of $11.5 million should be reinstated because of errors in the trial court’s new trial orders and remittitur, which predicated on the opinion of employee’s expert who opined that value is based on employee holding on to shares from his option until after the IPO.
The Court of Appeals ruled that damages for lost stock options in a breach of contract action may be measured from a date other than the date of breach based on equitable considerations, including whether a reasonably available market for the stock exists at the time of breach. The appellate court found that at the time of the employee’s termination, the shares in the company, a private company, could not be sold on the open market. There was no public market for those shares until the IPO. Meanwhile, the record showed that the employee joined the company with hopes that the company goes public. The trial court using the price of company stock after the IPO is essentially the equivalent of the benefits of bargain the employee agreed to and deemed proper. A contrary ruling under these circumstances would allow a private startup company to take away stock options earned by a terminated employee with relative impunity before the company has been sold or goes public because the financial consequences of doing so would be negligible. The appellate court was aware of no California case law that contemplates such an inequitable result solely because the employee is limited to breach of contract damages.
§ 4.8.1.2. Illinois
Schultz v. Sinav Ltd., 2024 IL (4th) 230366 (Apr. 5, 2024). Plaintiffs were the minority owners in a Delaware limited liability company, Illinois River Energy Holdings, LLC (IREIH or the “company”), which was formed to operate an ethanol plan in Rochelle, Illinois. Plaintiffs brought suit against the majority owner, GTL Resources USA (GTL USA) following a cash-out merger in which GTL USA acquired all interests in the company. Following the merger, GTL sold the company to a third-party.
Plaintiff also sued four individual members of the company’s board of managers appointed by GTL USA, together with certain investors and merger-related entities that facilitated the two corporate transactions. Plaintiffs did not seek to unwind the transactions. Rather, they sought only damages.
Following two bench trials, the circuit court found that the majority owner and board members breached their fiduciary duties to the plaintiffs in approving the cash-out merger. The circuit court held that the appropriate remedy was compensatory damages, which were computed by determining the fair value of the shares before the merger ($2.78 per share) and subtracting the price obtained in the merger ($1.10 per share). This resulted in a damages award of approximately $11.9 million.
The circuit court also held that the investor and merger-related defendants were not liable for tortious interference, among other claims. Both plaintiffs and certain defendants appealed.
On appeal, the appellate court focused on four issues: (1) the contractual and common law duties owed to plaintiffs by the defendants; (2) whether liability was established; (3) the appropriate remedy; and (4) the valuation of the company as it related to plaintiffs’ remedy.
The appellate court held that GTL USA controlled the cash-out merger and that while it owed no express contractual duty to the minority under the company’s operating agreement, it owed common law fiduciary duties. Relying on decisions of the Delaware Supreme Court and Delaware Court of Chancery, the appellate court applied the “entire fairness” doctrine, under which the majority owner in a cash-out merger bears the burden of demonstrating that the merger was the result of a fair process and that it obtained a fair price for the company’s shares. The court affirmed the circuit court’s decision that GTL USA failed to meet this burden, and it affirmed judgment on liability against it.
Likewise, the appellate court affirmed the circuit court’s finding that GTL USA’s individually appointed board members violated their legal duties to the minority owners. However, the court remanded for a determination of whether the individual defendants were excused from paying damages under exculpatory language in the company’s operating agreement.
As to the measure of damages, the appellate court remanded for the circuit court to consider whether rescissory damages were appropriate or whether such damages—in the form of an increased price of the stock after the merger—should be taken into account in assessing the compensatory damages to be awarded to the plaintiffs.
On valuation, the appellate court rejected plaintiffs’ argument that the circuit court was required to appoint an independent appraiser. Although the rulings were moot because the court ordered a new trial on damages, the appellate court also noted that the circuit court’s reliance on a discounted cash flow method of valuing the company’s shares, and its calculation of the weighted cost of capital rate, were not per se unreasonable.
Finally, the appellate court held that because certain investor-defendants and merger-related defendants were not party to the company’s operating agreement, which contained a jury-trial waiver, the circuit erred in striking plaintiffs’ jury demand against those defendants. It therefore reversed the circuit court’s judgment in favor of those defendants on plaintiffs’ claim for tortious interference with contract, and it remanded the case for a jury trial on that claim.
§ 4.8.1.3. Minnesota
Absolute Sports Cards, LLC v. Thornton, 2024 WL 4260268 (Minn. Ct. App. Sept. 23, 2024). Appellant and two other men formed Absolute Sports Cards, LLC (“ASC”) for the purpose of trading sports cards and other sports collectibles in 2016. They executed an Operating Agreement that included a broad prohibition against competing with ASC while a member and for the following two years after membership ends. However, a separate provision in the Operating Agreement stated that the competition prohibition would not be applicable to any member’s “same or similar business in existence at the time of the execution of the Agreement.”
After executing the Operating Agreement, the other two members concluded their sports-collectibles businesses and transferred inventory to ASC. Appellant did not do so and continued to operate his own business without transferring any of his sales to ASC. In 2018, the other two members voted to remove Appellant because of his competition with ASC.
ASC initiated an action against the competing member alleging competition in violation of the Operating Agreement, seeking expulsion, damages, and an injunction. The competing member argued that the district court abused its discretion in awarding lost profits as damages. Appellant also disputed the district court’s valuation of his share on the effective date of his expulsion.
The Minnesota Court of Appeals rejected the competing member’s arguments. ASC did not need to use the exact phrase “lost profits” in the pleadings. Because ASC alleged the competing member breached the Operating Agreement and requested the amount “equal to the amount [the competing member] derived by competing with the Company,” the Court found this sufficient to put the competing member on notice. The competing member also disputed the calculation of the award because it was based on his competing company’s sales. The district court found that the causal link was sufficient, because he otherwise would have sold those cards through ASC as his fellow ASC members did.
The competing member also contended that the district court erred in its choice of valuation date for his membership interest as of the effective date the other members voted to remove him from the company arguing that he was still a member at that point until there was a judicial order removing him. The Court found no error because the competing member did not contribute to the growth from the date he was voted out by the other members until the court-ordered expulsion. The Court reasoned that the competing member “should not be able to capitalize upon gains and value realized during [the] lawsuit.”
For further discussion of Absolute Sports Cards, LLC v. Thornton, see also sections herein relating to breach of fiduciary duty.
§ 4.8.1.4. Texas
Hernandez v. Ayala, No. 05-23-00549-CV, 2024 WL 3040409 (Tex. App.—Dallas June 18, 2024, no pet.). Hernandez and Ayala purchased a farm together in 2014. According to Hernandez, the farm belonged to Hernandez. Hernandez believed that Ayala was just a cosigner and had no idea Ayala’s name was on the deed, or that he owned fifty percent of the farm, until the underlying dispute arose in 2021. According to Ayala, they intended to purchase the farm together, as Hernandez was helping him with cattle on his land nearby and they thought it would be a good investment.
Following a dispute in 2021, the parties discussed Hernandez purchasing the farm from Ayala, but Ayala believed the offers were too low and communication stopped between them. Ayala went out to the farm to discuss the matter, but the gates were locked, and he could not enter the property. He retained counsel, and counsel sent a demand letter stating that Ayala was offering to sell his one-half interest in the farm for $250,000 in lieu of pursuing litigation. Hernandez did not accept Ayala’s offer and filed suit to recover the farm.
Ayala filed a separate suit against Hernandez, alleging claims for breach of fiduciary duty, conversion, and theft of property. Specifically, Ayala alleged that Hernandez breached his fiduciary duties by seizing partnership property, locking Ayala out of partnership assets, taking partnership funds for personal use, and seeking to deny the partnership after openly participating and benefiting from the partnership. Ayala further alleged that the breach injured him by depriving him of the benefits of the partnership, which resulted in lost revenues and opportunities of at least $250,000. Ayala also sought to partition the partnership property by sale, as the buildings and improvements could not be physically divided, and for expulsion of Hernandez from the partnership or the dissolution of the partnership. Hernandez answered, generally denying all allegations asserted by Ayala and specifically denying that a partnership existed between the parties.
The jury found that a partnership, as well as a relationship of trust, existed between the parties and that Ayala complied with his fiduciary duty to Hernandez, but that Hernandez did not comply with his duties owed to both Ayala and the partnership. The jury found that $104,000 would fairly and reasonably compensate Ayala for his damages that were proximately caused by the conduct of Hernandez. The jury further found that Hernandez was liable for theft and conversion; however, found $0 in damages for each of those causes of action. The trial court ordered the partnership to be dissolved and appointed a receiver to dispose of the real and personal property in dispute.
The court of appeals held that the evidence was legally insufficient to support the award of damages—and so reversed and rendered. During the trial, Ayala was asked to list the partnership assets he believed remained on the property when he was locked out, and counsel asked him how much he thought each item was worth. He listed many items—and estimated each item’s value—but provided no basis for nearly all the valuations.
The court explained that, generally, market value is established through expert testimony. See Reid Rd. Mun. Util. Dist. No. 2 v. Speedy Stop Food Stores, Ltd., 337 S.W.3d 846, 851–52 (Tex. 2011). However, a property owner may testify to property value if certain requirements are met. The Supreme Court of Texas has explained:
Because property owner testimony is the functional equivalent of expert testimony, it must be judged by the same standards. Thus, as with expert testimony, property valuations may not be based solely on a property owner’s ipse dixit. An owner may not simply echo the phrase “market value” and state a number to substantiate his diminished value claim; he must provide the factual basis on which his opinion rests. This burden is not onerous, particularly in light of the resources available today. Evidence of price paid, nearby sales, tax valuations, appraisals, online resources, and any other relevant factors may be offered to support the claim.
Nat. Gas Pipeline Co. of Am. v. Justiss, 397 S.W.3d 150, 159 (Tex. 2012). This requirement is typically met if the property owner testifies that he is familiar with the market value of his property. Id. at 155–56. However, failure to meet this standard renders the evidence of value legally insufficient, even when unchallenged by the opposing party, because it amounts to no evidence at all. Id. at 156–58. Because Ayala provided no basis for his valuations, and because he did not testify that he was familiar with the market value of the property or otherwise explain how he determined the value of each item, his testimony was insufficient to support the award of damages.
The unanimous June 5, 2025, U.S. Supreme Court decision in Ames v. Ohio Department of Youth Services struck down a standard that required a heightened burden of proof for plaintiffs in reverse discrimination cases.[1] This decision, along with recent private and government actions, has brought reverse discrimination into the spotlight. Among many examples, theories of reverse discrimination have been given priority in recent executive orders and federal government action about diversity, equity, and inclusion (“DEI”) programs;[2] the Department of Justice’s (“DOJ”) Civil Rights Fraud Initiative;[3] the DOJ’s investigation into the City of Chicago for discrimination based on race;[4] litigation concerning Special Purpose Credit Programs;[5] and a recent reverse discrimination case brought by the Missouri attorney general against Starbucks.[6]
Reverse discrimination cases involve claims that nonminority individuals were discriminated against “on the basis of race, or other characteristics or attributes.”[7] A key theory used in recent reverse discrimination litigation is that DEI and affirmative action programs assume without a basis that members of minority groups are unfairly disadvantaged relative to those in the majority group. Programs that are based on this alleged assumption purportedly lead to the favorable treatment of minority groups at the expense of the majority group.[8]
Reverse discrimination may seem to flip questions traditionally confronted in employment discrimination and fair lending cases on their head; fundamentally, however, the questions being asked are still about disparities between groups after conditioning on the relevant factors that explain between-group differences. Consequently, the concept of equal treatment and the associated statistical techniques applied in traditional discrimination cases are also applicable to reverse discrimination cases. Moreover, these techniques can be applied in the design of special programs that focus on economically disadvantaged populations instead of race, ethnicity, and gender, which is seen as a likely direction of future DEI and affirmative action programs.
Recent Developments Related to Reverse Discrimination
Federal
From the start of the current presidential administration, DEI programs and related diversity initiatives have received a substantial amount of negative federal attention. First, on January 20, 2025, the newly sworn-in president signed the executive order titled “Ending Radical and Wasteful Government DEI Programs and Preferencing,” which called for the end of “all discriminatory programs, including illegal DEI and ‘diversity, equity, inclusion, and accessibility’ (DEIA) mandates, policies, programs, preferences, and activities in the Federal Government.”[9] Then, on January 21, 2025, the president signed another executive order, titled “Ending Illegal Discrimination and Restoring Merit-Based Opportunity,” with a stated policy to “combat illegal private-sector DEI preferences, mandates, policies, programs, and activities” at the individual institution level within the private sector.[10] The second executive order potentially sets up a possible tsunami of federal investigations and litigation into allegedly discriminatory DEI programs and initiatives in the private sector by requiring the attorney general to submit a report within 120 days of the signing of the order that proposes a “strategic enforcement plan” and individual targets developed with the goal of eliminating allegedly illegal discrimination practices in the private sector.[11]
Subsequently, both the Equal Employment Opportunity Commission (“EEOC”) and the Federal Trade Commission (“FTC”) set out guidance on their respective agency’s anti-DEI enforcement focus. In its advisory document, “What You Should Know About DEI-Related Discrimination at Work,” the EEOC states its position that reverse discrimination against a majority group is no different from discrimination against a minority group, asserting that “there is no such thing as ‘reverse’ discrimination; there is only discrimination.”[12] Accordingly, the EEOC says that it “applies the same standard of proof to all race discrimination claims, regardless of the victim’s race.”[13] The Supreme Court’s decision in Ames applies a similar argument, as we discuss further below. The FTC’s February 26, 2025, “Directive Regarding Labor Markets Task Force” presents a novel theory that connects DEI to antitrust injury: “[c]ollusion or unlawful coordination on DEI metrics, which may have the effect of diminishing labor competition by excluding certain workers from markets, or students from professional training schools, on the basis of race, sex, or sexual orientation.”[14] It remains to be seen how the FTC will argue this theory of harm. One potential argument would be that exclusion of majority group workers resulting from the use of “DEI metrics” is a mechanism through which competition is harmed.
The DOJ also issued a memorandum on February 5, 2025, establishing that its “Civil Rights Division will investigate, eliminate, and penalize illegal DEI and DEIA preferences, mandates, policies, programs and activities in the private sector and in educational institutions that receive federal funds.”[15] The DOJ took further action in May by (1) opening an investigation into whether the City of Chicago “made hiring decisions solely on the basis of race” in favor of Black applicants[16] and (2) issuing the Civil Rights Fraud Initiative Memorandum, which states that the False Claims Act “is implicated when a federal contractor or recipient of federal funds knowingly violates civil rights laws—including but not limited to Title IV, Title VI, and Title IX, of the Civil Rights Act of 1964—and falsely certifies compliance with such laws.”[17] Such investigation and litigation are pursued under the Civil Rights Fraud Initiative, which is co-led by the Civil Division’s Fraud Section and the Civil Rights Division.[18] Given the administration’s directive to eliminate reverse discrimination, it is likely that investigations into violations of the False Claims Act and resulting litigation will focus on federal contractors’ use of DEI initiatives. The DOJ also encouraged private parties to file lawsuits and litigate claims under the False Claims Act.[19] Purported evidence of discrimination presented in government and private-plaintiff suits related to the Civil Rights Fraud Initiative will almost surely include economic or econometric analysis.
State
At the state level, the Missouri attorney general filed a lawsuit against Starbucks on February 11, 2025, alleging that Starbucks “ties compensation to racial and sex-based quotas, discriminates on the basis of race and sex in training and advancement opportunities, and discriminates on the basis of race and sex with respect to its board membership,” violating federal and state laws prohibiting discrimination.[20] Among other demands, the State of Missouri seeks compensatory damages,[21] which, based on the allegations in the complaint, appear to require assessments of the extent to which White and/or male Missourians were differentially affected by the policies at issue compared to other groups.
Private Plaintiffs
There has also been private litigation related to reverse discrimination. A bellwether case is Ames v. Ohio Department of Youth Services, which was decided by the Supreme Court on June 5, 2025, and centered on the heightened standard of evidence that plaintiffs who are members of a majority group must put forth in order for their cases to proceed.[22] Through this case, brought by a heterosexual woman claiming that she “faced bias in the workplace after she was passed over for positions that went to gay colleagues,”[23] the Supreme Court decided that the burden of proof to demonstrate discrimination for majority groups is the same as the burden of proof for minority groups.[24] The unanimous decision states, “[T]he standard for proving disparate treatment under Title VII does not vary based on whether or not the plaintiff is a member of a majority group.”[25] Because it lowers the bar for claims by majority plaintiffs, this decision will likely increase the number of private-plaintiff reverse discrimination cases. As we discuss further below, this decision also has implications for the statistical methods used to prove reverse discrimination in court.
In private-plaintiff cases, theories of reverse discrimination have been filed in settings involving fair lending,[26] employment,[27] and in other domains like college admissions.[28] The Students for Fair Admissions, Inc. v. President & Fellows of Harvard College decision, in which the U.S. Supreme Court “struck down affirmative action in college admissions,”[29] was cited in the second DEI-related executive order[30] and the Civil Rights Fraud Initiative Memorandum,[31] with the latter noting that the Supreme Court stated that “[e]liminating racial discrimination means eliminating all of it.”[32] In addition, this case has been followed by a number of lawsuits brought by legal strategist Edward Blum, who initiated the Students for Fair Admissions case, including cases related to college admissions, supplier diversity programs, private-sector hiring, and Southwest Airlines’ free ticket program for Hispanic students.[33]
Econometric Techniques for Assessing Discrimination and Reverse Discrimination
From a legal perspective, discrimination arises when individuals who are “similarly situated” based on relevant characteristics, such as their job skills and experience in an employment matter or their credit score and debt-to-income ratio in a fair lending matter, have different experiences or outcomes based only on their protected group status (e.g., race, ethnicity, gender, age, religion, and/or national origin).[34] Statistical models are used by experts to identify and hold these characteristics constant so that differences between one group relative to another can be measured. Because the standard statistical model compares the average difference between a protected group and another group of similarly situated people, the tools that we apply to measure disparities in one direction can also be used to assess disparities in the opposite direction.
To make this more concrete, suppose we run a regression to assess the disparities in loan pricing between Black and White borrowers.[35] If we were to consider White borrowers the control group,[36] the regression would take the form:
interest ratei= β0 + β1Blacki+ γ Xi+ εi
where Blackiis an indicator for whether the borrower is Black, Xiis a set of factors that could plausibly explain between-group differences in interest rates (e.g., credit score or loan-to-value ratio), and εi is an error term. If one were to assume that controlling for the Xifactors captures all variation in loan pricing except for disparities attributable to whether an applicant is Black, then β1would measure the average difference in interest rates between similarly situated Black and White applicants. A positive and statistically significant value of β1would indicate a disparity; more specifically, it would indicate that Black borrowers face higher interest rates, on average, than similarly situated White borrowers.
On the other side of the coin, a negative and statistically significant value of β1would indicate that Black borrowers face lower interest rates, on average, than similarly situated White borrowers—or, put another way, that White borrowers face higher interest rates than similarly situated Black borrowers. As White borrowers comprise the majority of borrowers, this would support a claim of reverse discrimination against the lender. In our example, the same model may be used to assess the question of disparity when inquiring about both discrimination and reverse discrimination, and it is generally true that one may use the same statistical framework to test for disparities consistent with discrimination and reverse discrimination, with the sign of the β1coefficient indicating the direction of any disparity.[37]
A corollary is that statistical significance in either direction could be cause for concern, as one direction would indicate discrimination against the White group and the other would indicate discrimination against the Black group. Thus, an employer or a lender must walk a proverbial knife’s edge when auditing its practices for disparities across groups. Indeed, in our experience, employers are mindful of reverse discrimination. For example, if a thorough audit reveals that male nurses earn less than similarly situated female nurses, the employer will typically adjust pay practices to eliminate statistically significant differences. When there are multiple groups to consider, the knife has more than two edges but balancing across all groups is possible when similarly situated people are consistently treated the same by employers and lenders.
Application 2: Assessing Discriminatory Quotas with the 4/5th Rule
The same duality of testing for disparities using statistics exists for claims of (reverse) discriminatory quotas, like that alleged by the Missouri attorney general against Starbucks. Discriminatory quota claims typically allege that selections by a lender or employer are based on reaching a goal of a certain number or percentage of people in a protected group, rather than based on merit.[38] Experts use a variety of statistical techniques to identify discrimination in “yes-or-no” decisions, such as for hiring, termination, promotion, or denying a loan, by employers and lenders. A simple approach is to apply the EEOC’s four-fifths, or 80 percent, rule.[39]
The rule states that the selection rate of a protected group (e.g., the percentage of the group members selected for a promotion) should be at least 80 percent of the nonprotected group’s selection rate. In other words, the impact ratio (i.e., the ratio of one group’s selection rate over the other group’s selection rate) should be 80 percent or more. In reverse discrimination, the protected group would be defined as White and/or male and placed in the numerator of the equation. Applying the four-fifths rule in both directions implies a group’s selection rate should be 80 percent to 125 percent of the selection rate of the group to which it is being compared.[40]
For instance, assume that a bank decides to investigate its acceptance of mortgage applications by race. An analyst puts the counts of Black and White applications accepted and rejected into the following table (table 1) and calculates the impact ratio with Black applicants in the numerator and then with White applicants in the numerator. The analyst finds that mortgage selection by the bank fails the four-fifths rule because the Black selection rate is 62.5 percent of the White selection rate, or, put in terms of reverse discrimination, the White selection rate is 160 percent of the Black selection rate, which is over 125 percent.
Table 1: Example Impact Ratio Analysis
Black
White
Total
Accepted
10
64
74
Rejected
10
16
26
Total
20
80
100
Selection Rate
0.5
0.8
0.74
Impact Ratio
0.625
1.6
The four-fifths, or 80 percent, rule is a rule of thumb rather than a formal test. It does not assess the statistical significance of the difference between the groups’ selection rates or even the difference between the impact ratio and the 80 percent target. To determine the statistical significance of a difference in selection rates, a simple approach used by experts is to test the hypothesis of independence between the selection rate and membership in a group. In essence, this statistical technique compares the number of selections/rejections expected based on the overall selection rate to the actual number of selections/rejections by group to identify differences that are more extreme than expected under equal treatment.[41] Because the test asks whether group membership matters for selection, it will identify disparities that favor or disfavor White and/or male group members.
A limitation of the four-fifths rule and tests of independence is that they do not control for characteristics of the individuals being analyzed other than group membership. When there are characteristics that are expected to explain differences in selection rates for all applicants or employees, it is necessary to use a regression approach. The regression approach used to test for disparities in outcomes that are binary (yes-or-no decisions) is similar to the model presented above. Experts can use linear probability models, which are the same as the model above, or they can use logit or probit regression models to better fit the binary outcome data. With logit or probit models, the coefficient of interest can be interpreted as the change in the odds of being selected that can be attributed to group membership (i.e., the difference in the probability of being selected, divided by the probability of not being selected across groups). Estimates from these models are often reported as log odds or odds ratios.[42] Thus, when estimating whether Black borrowers are less likely to be selected for a loan offer, the regression coefficient Biestimates how the odds of being selected for a Black borrower differ from those of a White borrower, all else being equal. As in the case of nonbinary outcomes discussed above, the estimated difference between the two groups can reveal either discrimination or reverse discrimination, should either exist.
However, even when relying on a regression model to provide evidence for or against a claim of a discriminatory quota, litigation parties disagree about what makes individuals perform better or worse at a loan or job. Membership in a protected group must be explicitly proven to be relevant to doing a job or the profitability of a loan before it can be used to justify a difference in treatment relative to individuals in a majority group. Likewise, this concept may be similarly used in allegations of reverse discrimination to justify the alleged preferential treatment of a protected group relative to the majority group.
Takeaways
In conclusion, with the recent focus on reverse discrimination in the federal government and the spate of legal cases involving allegations of reverse discrimination, legal practitioners and regulators, as well as employers, lenders, and other decision-makers, should be aware of the conceptual analyses and statistical tools available to assess disparities. The fact that the same approaches can be used to assess discrimination and reverse discrimination simplifies the job of experts tasked with assessing ex post disparities in this environment. It also streamlines the job of employers, lenders, and other decision-makers seeking to minimize risk and ensure equitable treatment proactively, through an audit of their practices.
Ames v. Ohio Dep’t of Youth Servs., 145 S. Ct. 1540 (2025). ↑
Memorandum from Tom Branch, Deputy Att’y Gen., U.S. Dep’t of Just. (May 19, 2025) (Subject: Civil Rights Fraud Initiative) [hereinafter Civil Rights Fraud Initiative Memorandum]. ↑
Letter from Harmeet K. Dhillon, Assistant Att’y Gen., U.S. Dep’t of Just., to Brandon Johnson, Mayor, Chi., Ill. 1 (May 19, 2025) (Re: Investigation of the Employment Practices of the City of Chicago, Illinois, Pursuant to Section 707 of Title VII of the Civil Rights Act of 1964, as Amended) [hereinafter Chicago Letter]. ↑
See, e.g., Found. Against Intolerance & Racism Inc. v. Walker, No. 2:24-cv-01770, 2025 WL 1756875 (W.D. Wash. June 24, 2025) (granting motion to dismiss). ↑
Complaint, State of Missouri ex rel. Bailey, Att’y Gen. of Mo. v. Starbucks Corp., No. 4:25-cv-00165 (E.D. Mo. Feb. 11, 2025). ↑
The heightened burden of proof challenged in Ames required plaintiffs to prove that they were discriminated against despite being in a majority group. In a July 19, 2023, ruling in Ultima Services Corp. v. Department of Agriculture, the U.S. District Court for the Eastern District of Tennessee decided that the Small Business Administration’s 8(a) Business Development Program could not determine eligibility of applicants through a presumption of social disadvantage based on simply being a member of a minority group. SeeUpdates on the 8(a) Business Development Program, U.S. Small Bus. Admin. (last visited June 27, 2025). ↑
To further inform and advise me so that my Administration may formulate appropriate and effective civil-rights policy, the Attorney General, within 120 days of this order, in consultation with the heads of relevant agencies and in coordination with the Director of OMB, shall submit a report to the Assistant to the President for Domestic Policy containing recommendations for enforcing Federal civil-rights laws and taking other appropriate measures to encourage the private sector to end illegal discrimination and preferences, including DEI. The report shall contain a proposed strategic enforcement plan identifying:
(i) Key sectors of concern within each agency’s jurisdiction;
(ii) The most egregious and discriminatory DEI practitioners in each sector of concern;
(iii) A plan of specific steps or measures to deter DEI programs or principles (whether specifically denominated “DEI” or otherwise) that constitute illegal discrimination or preferences. As a part of this plan, each agency shall identify up to nine potential civil compliance investigations of publicly traded corporations, large non-profit corporations or associations, foundations with assets of 500 million dollars or more, State and local bar and medical associations, and institutions of higher education with endowments over 1 billion dollars;
(iv) Other strategies to encourage the private sector to end illegal DEI discrimination and preferences and comply with all Federal civil-rights laws;
(v) Litigation that would be potentially appropriate for Federal lawsuits, intervention, or statements of interest; and
(vi) Potential regulatory action and sub-regulatory guidance. ↑
Memorandum from Andrew N. Ferguson, Chairman, U.S. Fed. Trade Comm’n, to Daniel Guarnera, Dir., Bureau of Competition, et al. (Feb. 26, 2025) (Subject: Directive Regarding Labor Markets Task Force). ↑
Memorandum from Pamela Bondi, Att’y Gen., U.S. Dep’t of Just. (Feb. 5, 2025) (Subject: Ending Illegal DEI and DEIA Discrimination and Preferences). ↑
Ames v. Ohio Dep’t of Youth Servs., 145 S. Ct. 1540, 1542 (2025). ↑
Plaintiffs claim that the Washington State Housing Finance Commission’s Covenant Homeownership Program’s eligibility criteria violate the Equal Protection Clause of the Fourteenth Amendment by facially discriminating on the basis of race. See Found. Against Intolerance & Racism, Inc. v. Walker, No. 2:24-cv-01770 (W.D. Wash. Oct. 29, 2024) (complaint for declaratory and injunctive relief); 2025 WL 1756875 (W.D. Wash. June 24, 2025) (granting motion to dismiss). ↑
Palmer v. Cognizant Tech. Sols. Corp., No. 2:17-cv-06848 (C.D. Cal. Sept. 18, 2017). On October 4, 2024, a California federal jury found “that Cognizant Technologies engaged in a ‘pattern or practice’ of intentional discrimination against a class of non–South Asian and non-Indian employees who were terminated.” Craig Clough, Jury Finds Cognizant Biased Against Non-Indian Workers, Law360 (Oct. 4, 2024). ↑
Students for Fair Admissions, Inc. v. President & Fellows of Harvard Coll., No. 1:14-cv-14176 (D. Mass. Boston Div. Nov. 17, 2014). ↑
The concept of comparing to those “similarly situated” to a plaintiff in a discrimination case resulted from two decisions by the U.S. Supreme Court. See Lewis v. City of Union City, Georgia, 918 F.3d 1213, 1217 (11th Cir. 2019) (“Faced with a defendant’s motion for summary judgment, a plaintiff asserting an intentional-discrimination claim under Title VII of the Civil Rights Act of 1964, the Equal Protection Clause, or 42 U.S.C. § 1981 must make a sufficient factual showing to permit a reasonable jury to rule in her favor. She can do so in a variety of ways, one of which is by navigating the now-familiar three-part burden-shifting framework established by the Supreme Court in McDonnell Douglas Corp. v. Green, 411 U.S. 792 . . . (1973). Under that framework, the plaintiff bears the initial burden of establishing a prima facie case of discrimination by proving, among other things, that she was treated differently from another ‘similarly situated’ individual―in court-speak, a ‘comparator.’ Texas Dep’t of Cmty. Affairs v. Burdine, 450 U.S. 248, 258–59 . . . (1981) (citing McDonnell Douglas, 411 U.S. at 804 . . .).”). ↑
One can generalize this to include other races, but we are assuming two groups to simplify exposition. To maintain consistency between group labels, we have used uppercase for both Black and White. ↑
In this example, there are only two race groups being analyzed: Black and White borrowers. When there are more than two race categories, multiple regression models must be run to do a complete comparison of loan pricing. For example, comparing the prices offered to White borrowers to the prices received by all other groups could be one framework. However, this type of model compares the average interest rate of White borrowers to the average interest rate received by all non-White borrowers. But, if White borrowers receive a higher interest rate, on average, relative to Black borrowers, this fact will not be observed. Moreover, if the number of Black borrowers is small or very different from other non-White borrowers, the impact of Black borrowers on the overall average for non-White borrowers will be “noisy,” producing a result that may not show a statistically significant difference between the White and non-White applicants’ average interest rate. ↑
Due to this duality, an alternative approach to analyzing disparities between Black borrowers and White borrowers would be to change the omitted race category from White borrowers to Black borrowers. ↑
For an interesting discussion of the legality of racial quotas, see Atinuke O. Adediran, Racial Targets, 118 Nw. U. Legal Rev. 1455 (2024). ↑
Let be the selection rate of group A and be the selection rate of group B. Applying the four-fifths rule in both directions requires that a ≥ ⅘ b and b ≥ ⅘ a. This implies ⁵⁄₄ a ≥ b ≥ ⅘ a. ↑
In independence tests, selections or any general sets of mutually exclusive categories are arranged in a contingency table. For example, a 2 x 2 table might have employees grouped by Black or White race categories and whether or not the employee was hired. A chi-square test statistic (one of many possible statistics) compares the actual number to the expected number in each cell of the table (i.e., Black/hire, Black/rejected, White/hire, and White/rejected) to determine whether a hypothesis of independence across all categories cannot be rejected using the traditional measure of statistical significance. SeeChi-Square Independence Test, Nat’l Inst. Standards & Tech. (last visited July 16, 2025). ↑
See,e.g., Fair Lending Report of the Consumer Financial Protection Bureau, April 2016, 81 Fed. Reg. 29,547 (2016) (“One traditional method involves odds ratios, which measure the ratio of the odds of two different events. In the context of an underwriting analysis, the ratio reflects the odds of a loan application denial between groups of borrowers.”). ↑
Harrington v. Purdue Pharma L.P., 603 U.S. 204 (2024).
In a landmark 5–4 decision, the Supreme Court ruled that non-debtors can no longer use a debtor’s chapter 11 plan to secure for themselves non-consensual third-party releases.
Purdue Pharma is the maker of OxyContin, an opioid pain relief drug. Purdue was owned and controlled by the Sackler family, with members of that family serving as president and chief executive officer, dominating the board, and being heavily involved in the firm’s marketing strategy. In 2007, an affiliate of the company pled guilty to a federal felony for misbranding OxyContin. Thousands of lawsuits ensued. Following the plea agreement, the Sacklers began to take as much as 70% of the company’s revenue per year, with distributions between 2008 and 2016 totaling approximately $11 billion. These distributions left Purdue Pharma in a significantly weakened state.
In 2019, Purdue Pharma sought chapter 11 bankruptcy protection. In connection with this bankruptcy, the Sacklers proposed to return to the estate $4.325 billion of the $11 billion they had withdrawn from the company. This repayment was to be made over the course of a decade. In exchange for this prepayment, the Sacklers sought to end the lawsuits brought against them by opioid victims. This latter relief was termed by the Supreme Court as the “Sackler Discharge.” The Sackler Discharge included both a release and an injunction barring not just current claims, but future ones, whether or not the claimant participated in the bankruptcy proceeding. Purdue, as debtor in possession, agreed to these terms and included them in its proposed plan of reorganization. This plan sought to reorganize the company as a “public benefit” company, dedicated to opioid education and abatement. The plan also proposed payments of between $3,500.00 and $48,000.00 to those harmed by the company’s products.
While most of the creditors who returned ballots supported the plan, fewer than 20% of eligible creditors participated. The United States Trustee, along with eight states, the District of Columbia, the City of Seattle, and various Canadian municipalities and tribes joined with a number of opioid victims in opposing the plan. The bankruptcy court overruled these objections and confirmed the plan, including its provisions relating to the Sackler Discharge. The district court promptly vacated that decision, holding that nothing in the law authorized the bankruptcy court to extinguish claims against the Sacklers without the consent of the victims who brought those claims. The plan proponents and others appealed that decision to the Second Circuit.
While the appeal was pending, the plan proponents advised that the Sacklers were willing to contribute an additional sum if the eight states and the District of Columbia would be willing to withdraw their objections. Even with this additional sum, the Sacklers’ proposed contribution still fell short of the $11 billion amount they received pre-bankruptcy and would still be structured as installment payments. Nonetheless, the states and the District of Columbia agreed to drop their objections. However, a number of individual victims, the Canadian creditors, and the U.S. Trustee persisted with their objection. A divided panel of the Second Circuit reversed and revived the bankruptcy court’s order confirming the plan. The U.S. Trustee then filed an application for certiorari and the Supreme Court granted it to resolve a circuit split.
The Court began its analysis with section 1141 of the Bankruptcy Code. Section 1141(d)(1)(A) provides that a bankruptcy court’s order confirming a plan “discharges the debtor from any debt that arose before the date of [] confirmation.” 11 U.S.C. § 1141(d)(1)(A). In addition, section 524(e) of the Bankruptcy Code provides that a discharge “does not affect the liability of any other entity” beyond the debtor. 11 U.S.C. § 524(e). The Court noted that, “The Sacklers have not filed for bankruptcy and have not placed virtually all their assets on the table for distribution to creditors, yet they seek what essentially amounts to a discharge.” 603 U.S. at 215.
The Court framed the question before it as: “whether a court in bankruptcy may effectively extend to nondebtors the benefits of a [c]hapter 11 discharge usually reserved for debtors.” Id. (emphasis in original). To answer that question, the Court turned to section 1123 of the Bankruptcy Code, which addresses the contents of a plan, both mandatory and optional. No party argued that anything like the Sackler Discharge was required to be included in a plan. Instead, the plan proponents suggested that the Sackler Discharge was a provision that a debtor was allowed to include and that a bankruptcy court was permitted to approve under section 1123(b). The first five items addressed by section 1123(b), which simply addressed the scope of claims and property belonging to a debtor or its estate and the rights of creditors of such claims, were easily disregarded by the Court as potential sources of authority for the Sackler Discharge. Nothing in any of the first five paragraphs authorized the client to extinguish claims against third parties without the consent of the affected claimants.
The only possible source of authority for the Sackler Discharge in section 1123(b) would have to be found in subparagraph 6, which provides that a plan may “include any other appropriate provision not inconsistent with the applicable provisions of this title.” 11 U.S.C. § 1123(b)(6). It was that provision that the Second Circuit cited in support of its decision. Because the Bankruptcy Code does not expressly forbid a non-consensual non-debtor discharge, the plan proponents argued that the bankruptcy court was free to authorize such relief after finding it appropriate. The Court rejected this reasoning. First, subparagraph (6) “is a catchall phrase tacked on the end of a long and detailed list of specific directions. When faced with a catchall phrase like that, courts do not necessarily afford it the broadest possible construction it can bear.” 603 U.S. at 217 (citing Epic Sys. Corp. v. Lewis, 584 U.S. 497, 512 (2018)). Instead, such catchall provisions are generally “interpreted in light of its surrounding context and read to ‘embrace only objects similar in nature’ to the specific examples preceding it.” Id. (quoting Epic Sys. Corp., 584 U.S. at 512). With that principle in mind, the Court held that subparagraph (6) does not afford a bankruptcy court the blanket authority proposed by the plan proponents. In this case, the various plan provisions listed in the first five subparagraphs of section 1123(b) concerned the debtor, its rights, responsibilities, and relationship with creditors. While subparagraph (6) clearly operates to confer additional authority on bankruptcy courts, the Supreme Court held that “the catchall cannot be fairly read to endow a bankruptcy court with the ‘radically different’ power to discharge the debts of a nondebtor without the consent of affected nondebtor claimants.” Id. at 218 (quoting Epic Sys. Corp., 584 U.S. at 513). The majority decision then rejected the dissent’s argument that the purpose of bankruptcy law was to solve collective action problems. While the majority acknowledged that bankruptcy may serve to address some of those problems, it noted that the Bankruptcy Code does not provide a bankruptcy court “with a roving commission to resolve all such problems” that it happens to encounter. Id. at 220.
As further support for its conclusion that the Sackler Discharge was impermissible, the Court went beyond section 1123(b) and looked at other provisions of the Bankruptcy Code. It noted that the Code reserves the benefit of a discharge for the debtor that actually files for bankruptcy. Id. at 221 (citing 11 U.S.C. §§ 1141(d)(1)(A), 524(e), 727(a)-(b)). Moreover, the discharge afforded a debtor is not unlimited. Id. at 221–22 (citing 11 U.S.C. §§ 523(a)(2), (4), (6)). The Court emphasized that the Sacklers had not agreed to place anything approaching the entirety of their assets on the table, but nonetheless sought a judicial order arguably broader than that available in the form of a discharge.
The Court then noted that the Bankruptcy Code contains a significant exception to the foregoing rules. In the asbestos context, bankruptcy courts are expressly authorized to issue an injunction barring any action directed against a third party under certain specified circumstances. The fact that the Code “does authorize courts to enjoin claims against third parties without their consent, but does so in only one context, makes it all the more unlikely that [section] 1123(b)(6) is best read to afford courts that same authority in every context.” Id. at 222 (emphasis in original). The final nail in the coffin of the Sackler Discharge was pre-Code practice, which confirmed the Court’s reasoning. Every bankruptcy statute cited to the Court, ranging from 1800 to 1978, “generally reserved the benefits of discharge to the debtor who offered a ‘fair and full surrender of [its] property.’” Id. at 223–24 (quoting Sturges v. Crowninshield, 4 Wheat. 122, 176 (1819)).
Although both sides of the debate raised policy-based arguments, the Supreme Court held that it was “the wrong audience for them.” Id. at 226. “Congress may choose to add to the [B]ankruptcy [C]ode special rules for opioid-related bankruptcies as it has for asbestos-related cases. Or it may choose not to do so. Either way, if a policy decision like that is to be made, it is for Congress to make.” Id.
Finally, the Court noted the limits of its decision. “Nothing in what we have said should be construed to call into question consensual third-party releases offered in connection with a bankruptcy reorganization plan; those sorts of releases pose different questions and may rest on different legal grounds than the nonconsensual release at issue here.” Id. (citing In re Specialty Equip. Cos., 3 F.3d 1043, 1047 (7th Cir. 1993). Nor did the Court attempt to address what constitutes a consensual release or what is the full satisfaction of a claim against a third-party non-debtor. Chief Justice Kavanaugh dissented, in which the Chief Justice, Justice Sotomayor and Justice Kagan joined.
Truck Ins. Exch. v. Kaiser Gypsum Co., 602 U.S. 268 (2024).
Truck Insurance Exchange (“Truck”) was the primary insurer of companies that manufactured and sold products containing asbestos. Many of those companies sought chapter 11 bankruptcy protection after facing thousands of lawsuits. Truck objected to one such company’s bankruptcy plan. The Fourth Circuit Court of Appeals concluded that Truck was not a “party in interest” in accordance with section 1109(b) because the plan was “insurance neutral.” Truck sought review at the Supreme Court and the Supreme Court granted certiorari. The question before the Court was whether an insurer with financial responsibility for a bankruptcy claim was a “party in interest” within the meaning of section 1109(b).
Under the relevant insurance contracts, the debtors had an obligation to pay a $5,000 deductible per claim and to “assist and cooperate with Truck in defending against the claims.” Id. at 275. In confirming the plan, the bankruptcy court made a finding that the debtors’ conduct in the bankruptcy proceedings neither violated this duty to assist and cooperate nor breached any implied covenant of good faith and fair dealing. Further, the confirmed plan treated insured and uninsured claims differently. Insured claims were left to the tort system, where lawsuits would be filed and Truck would be compelled to defend. If the claimant prevailed, the trust created by the plan would pay the deductible and Truck would be left to pay up to $500,000 per claim. Uninsured claims, on the other hand, were submitted directly to the trust for resolution. As part of this latter process, claimants were required to identify all other related claims and file a release authorizing the trust to obtain documentation for other asbestos trusts that others submitted claims.
Truck was the only party before the bankruptcy court to object to the plan. Its objection was threefold: First, Truck contended that the plan was not proposed in good faith, as required by section 1129(a)(3) of the Bankruptcy Code, both because the plan was the result of a collusive agreement between the debtor and the claimants and because the plan did not require the same disclosures for insured and uninsured claims. Second, the finding required by the plan—that the debtors’ conduct during the bankruptcy did not violate its duty to assist and cooperate—impermissibly altered Truck’s rights under its policies by relieving the debtors of their assistance and cooperation obligations and by barring Truck from raising the debtors’ bankruptcy conduct as a defense to its own payment obligations. Third, Truck contended that the trust did not comply with various provisions of section 524(g) of the Bankruptcy Code. The district court, based on a recommendation by the bankruptcy court, confirmed the plan and held that Truck had limited standing to object solely on the grounds that the plan was not “insurance neutral.” Because the district court found that the plan was insurance neutral, it overruled all of Truck’s objections. The Fourth Circuit affirmed.
The Court began its analysis with the text of section 1109(b), which provides an illustrative, but not exhaustive, listing of parties in interest. The listed parties share a common thread in that each could be directly affected by a confirmed plan of reorganization, either because it had a financial interest in the estate’s assets, or it represented parties that do. In the Court’s view, these illustrations made clear that anyone holding a direct financial stake in the outcome of the case should have an opportunity to participate. This understanding aligned with the Court’s prior observation that the term “party in interest” is used when Congress intends a broad application of the term. Id. at 278 (quoting Hartford Underwriters Ins. Co. v. Union Planters Bank, N.A., 530 U.S. 1, 7 (2000)). The Court then noted that this reading of the statute was also consistent with the ordinary meaning of the term “party in interest,” as well as the historical context and purpose of the statute. “Congress consistently has acted to promote greater participation in reorganization proceedings.” Id. at 279.
Given these broad principles, the Court held that insurers, such as Truck, with financial responsibility for bankruptcy claims are “parties in interest.” Put simply, “an insurer with financial responsibility for bankruptcy claims can be directly and adversely affected by the reorganization proceedings.” Id. at 281. The Supreme Court rejected the Fourth Circuit’s focus on whether the plan altered Truck’s contract rights or its quantum of liability, holding that such approach, known as the insurance neutrality doctrine, “is conceptually wrong and makes little practical sense.” Id. at 283. In essence, the Court said, the doctrine conflated the merits of an objection with the threshold “party in interest” inquiry. Section 1109(b) asks whether reorganization might affect a prospective party, not how a particular plan might affect that party. Section 1109(b), the Court held, could not depend on a plan-specific rule as it would be unusable given that the Bankruptcy Code authorizes a party in interest to request acts unrelated to a specific plan or before a plan is confirmed or even proposed. Accordingly, the judgment of the appellate court was reversed.
§ 3.2. First Circuit
Fin. Oversight & Mgmt. Bd. for P.R. v. U.S. Bank N.A. (In re Fin. Oversight & Mgmt. Bd. for P.R.), 104 F.4th 367 (1st Cir. 2024).
Reversing the court (the “Title III Court”) overseeing the proceedings under Title III of the Puerto Rico Oversight Management and Economic Stability Act (“PROMESA”), the First Circuit delivered a partial win to certain holders of municipal bonds issued by the Puerto Rico Electric Power Authority (“PREPA”). In its June 2024 decision, the First Circuit ruled that PREPA’s obligation to repay the bonds was secured by the bondholders’ perfected, unavoidable security interests in PREPA’s net revenues. However, the court also reversed the Title III Court when it determined that the payment obligations were nonrecourse and that the bondholders were not entitled to recover an unsecured claim against other PREPA assets.
The facts of the case are simple. In 1941, Puerto Rico passed the Puerto Rico Electric Power Authority Act, which not only authorized the creation of PREPA, but also granted PREPA the authority to raise funds by issuing bonds secured by its “entire gross or net revenues and present or future income.” P.R. Laws Ann. tit. 22, § 206(e)(1). In 1974, PREPA entered into a Trust Agreement pursuant to which it exercised its authority under to raise funds by issuing bonds (“Revenue Bonds”) purportedly secured by “the revenues of [PREPA] . . . and other moneys to the extent provided in this [Trust] Agreement.” Id. at 382. Then, in 2017, in the midst of the Puerto Rican government-debt crisis, PREPA defaulted on its Revenue Bond payment obligations. Because of the enactment of PROMESA in 2016, the Financial Oversight and Management Board for Puerto Rico (the “Board”) was empowered to place PREPA into Title III proceedings following this default.
In the course of those proceedings, the Board commenced an adversary proceeding “to define the rights and remedies that bondholders had against PREPA.” Id. at 379. The Board asserted that: (i) the bondholders were secured by revenues only to the extent that such revenues had flowed into certain funds designated by the Trust Agreement; (ii) the bondholders had failed to perfect their security interest in certain of the designated funds, such that their security interests were voidable pursuant to 11 U.S.C. § 544(a); and (iii) the Revenue Bonds were nonrecourse such that the bondholders were not entitled to a deficiency claim to the extent that the value of their security interest was less than the face value of the Revenue Bonds. The Title III Court agreed with the Board that bondholders were secured only to the extent that revenues were actually deposited in the designated funds and that the bondholders’ security interest in certain of the designated funds were avoidable, but determined that the bondholders were entitled to an unsecured claim against PREPA in the amount of approximately $2.4 billion.
On appeal, the First Circuit largely reversed the Title III Court. Turning first to the question of whether the Trust Agreement itself in fact granted the bondholders a security interest, the court considered whether the granting language, which appeared in the Trust Agreement’s preamble, was merely prefatory. Disagreeing with the Title III Court, the First Circuit held that, under Puerto Rico law, there is no “magic language” required to grant a security interest. The language in the preamble evinced a clear intent to grant a security interest. Next, to determine the scope of the bondholders’ security interest, the First Circuit considered whether the bondholders’ lien extended to PREPA’s gross or net revenues. After analyzing the language of the Trust Agreement, the court concluded that the security interest must extend to PREPA’s net revenues only. However, the court noted that, even if the language of the Trust Agreement had not indicated that the bondholders’ interest extended only to net revenues, section 928(b) of the Bankruptcy Code subordinated the bondholders’ lien to PREPA’s reasonable and necessary postpetition operating expenses. Third, the First Circuit rejected the Board’s argument that the bondholders’ lien extended only to net revenues that had flowed into certain designated funds. Finding the language in the Trust Agreement ambiguous, the court instead determined that such a result would have misled a reasonable investor. Finally, the court considered whether the bondholders’ lien extended to future net revenues. Looking to both Puerto Rican law and the Bankruptcy Code, the First Circuit held that the pledge of net revenues made under the Trust Agreement included future net revenues that PREPA acquired.
After determining that the bondholders held a security interest in PREPA’s current and future net revenues, the First Circuit then considered whether the bondholders had perfected their security interest. Concluding that the bondholders’ interest in the net revenues was an interest in an “account” under the Uniform Commercial Code, rather than “money” or “deposit accounts,” the court held that the bondholders were properly perfected by filing of a financing statement. As a result, the Board could not avoid the bondholders’ lien under section 544(a) of the Bankruptcy Code.
Finally, the First Circuit examined the Title III Court’s estimation of the bondholders’ unsecured claim. The Title III Court had found that the bondholders were entitled to an unsecured claim as a result of the bondholders’ rights, under the Trust Agreement, to certain equitable remedies in the event PREPA breached its performance obligations. See 11 U.S.C. § 101(5)(B). The Title III Court then estimated the amount of the bondholders’ unsecured claim arising from such equitable remedies, in accordance with section 502(c)(2) of the Bankruptcy Code, to be approximately $2.4 billion. The First Circuit, however, disagreed that the bondholders’ right to payment arose from the equitable rights afforded to the bondholders under the Trust Agreement. Instead, the First Circuit held that, because the amount of the bondholders’ claim could be easily determined by the terms of the Trust Agreement, the claim was more similar to a liquidated claim, and thus could not be estimated under section 502(c). The First Circuit further held that, under section 927 of the Bankruptcy Code, the bondholders were not entitled any recourse from PREPA’s other assets. See 11 U.S.C. § 927.
Milk Indus. Regul. Off. of Commonwealth of P.R. v. Ruiz (In re Ruiz), 83 F.4th 68 (1st Cir. 2023).
In this case, the First Circuit addressed the applicability of the “capable of repetition” exception and the “collateral consequences” exception to the doctrine of constitutional mootness. Holding per curiam that neither exception applied at the time the case was decided by the Bankruptcy Appellate Panel for the First Circuit (the “BAP”), the First Circuit vacated the BAP’s decision, but left undisturbed the bankruptcy court’s orders underlying the appeal.
This case arises from the decision of the Milk Industry Regulatory Office of the Commonwealth of Puerto Rico (“ORIL”) to suspend the license of a chapter 12 debtor, Luis Manuel Ruiz Ruiz (“Ruiz”), to produce and sell a certain quota of milk. While Ruiz was appealing ORIL’s suspension of his license to the Puerto Rico Court of Appeals, Ruiz sought an order from the bankruptcy court authorizing Ruiz to lease a portion of his milk quota to a willing lessee for six months. Although ORIL received notice of Ruiz’s motion, ORIL failed to object to the relief sought. The bankruptcy court granted Ruiz’s motion and Ruiz executed the lease, which Ruiz then submitted to ORIL for registration. Twelve days after the bankruptcy court’s order approving the lease was granted, ORIL asked the bankruptcy court to reconsider. The bankruptcy court denied the reconsideration request. ORIL then appealed both the bankruptcy court’s order authorizing Ruiz to enter into the lease and the order denying reconsideration to the BAP. Notwithstanding the BAP’s request for supplemental briefing regarding mootness, the BAP affirmed both bankruptcy court orders on the merits.
The First Circuit, by contrast, considered the question of mootness to be a threshold question affecting the court’s jurisdiction over the appeal. But more than its own jurisdiction, the First Circuit examined as well whether the BAP had jurisdiction to issue a judgment on the merits. Because the original six-month term of the lease expired while the appeal was pending before the BAP, the First Circuit held that the bankruptcy court orders became moot prior to the BAP’s decision. The court then considered whether either of two exceptions to constitutional mootness applied. The first exception—the “capable of repetition” exception—permits a court to review an action without controversy where “(1) the challenged action is in its duration too short to be fully litigated prior to its cessation or expiration, and (2) there is a reasonable expectation that the same complaining party will be subjected to the same action again.” Id. at 74 (quoting United States v. Sanchez-Gomez, 584 U.S. 381, 391 (2018)). Because ORIL had not demonstrated that Ruiz, or any other milk producer, would seek approval of a short-term lease of its license, despite pending revocation of said license, the court held that the exception was inapplicable. The second exception—the “collateral consequences” exception—requires a party to demonstrate that it would suffer adverse consequences in another proceeding if a lower court’s decision were permitted to stand on grounds of mootness. Id. at 75–76 (quoting ConnectU LLC v. Zuckerberg, 522 F.3d 82, 88 (1st Cir. 2008)). The First Circuit held that ORIL had waived its argument under this exception by failing to brief it.
Having determined that ORIL’s appeal was moot at the time of the BAP’s decision, the First Circuit then considered the appropriate disposition of the appeal. “When a civil case becomes moot pending appeal, the ‘established practice . . . is to reverse or vacate the judgment below and remand with a direction to dismiss.’” Id. at 77 (quoting United States v. Munsingwear, 340 U.S. 36, 39 (1950)). While the First Circuit easily concluded that the BAP judgement should be vacated and the appeal dismissed, the decision as to whether the bankruptcy court’s orders should be vacated required more consideration. Ultimately, the court held that, because ORIL “‘slept on its rights’ in several respects throughout the course of th[e] litigation,” id. at 78 (quoting Munsingwear, 340 U.S. at 41), the balance of equities weighed against vacatur of the bankruptcy court’s orders.
§ 3.3. Second Circuit
In re Nine W. LBO Sec. Litig., 87 F.4th 130, 139 (2d Cir. 2023), cert. denied sub nom. Stafiniak v. Kirschner, 144 S. Ct. 2551 (2024).
Clarifying its decision in In re Tribune Co. Fraudulent Conv. Litig., 946 F.3d 66 (2d Cir. 2019) regarding the scope of the safe harbor outlined in section 546(e) of the Bankruptcy Code, the Second Circuit held that whether a bank customer may be considered a “financial institution” under section 101(22)(A) must be evaluated on a “transfer-by-transfer” basis rather than a “contract-by-contract” basis. As a result, the mere fact that a qualifying bank acts as agent on behalf of a customer in connection with one segment of a transaction does not imbue an entire consolidated transaction, such as the leveraged buyout at issue here, with the protections afforded under section 546(e).
In 2013, private equity firm Sycamore Partners (“Sycamore”) proposed to acquire Jones Group, Inc. (“Jones Group”), a footwear and apparel company, through a leveraged buyout (the “LBO”). Pursuant to the merger agreement, the former public shareholders of Jones Group would receive $15 per share of Jones Group, which payments would be effectuated by Wells Fargo, as paying agent. The merger agreement also provided for payments to former directors, officers and employees of Jones Group on account of their restricted shares in Jones Group, although Wells Fargo was not involved in such payments. Through the LBO, Jones Group was ultimately merged into a subsidiary of Sycamore, which was then renamed Nine West Holdings, Inc. (“Nine West”). Upon the closing of the LBO, Sycamore caused Nine West to sell three of its allegedly most valuable brands to Sycamore affiliates.
In 2018, Nine West commenced bankruptcy proceedings. Following confirmation of Nine West’s plan of reorganization, certain creditors (the “Trustees”) brought suit against the former directors, officers, and shareholders of Jones Group, seeking to avoid the payments they had received in connection with the LBO as fraudulent conveyances. The cases were then consolidated in multidistrict proceedings before the Southern District of New York. Following the consolidation, the public shareholders, forming one group of defendants known as the “Public Shareholders,” moved to dismiss the fraudulent conveyance claims under section 546(e)’s safe harbor provision. The former directors, officers, and employees of Jones Group, forming a separate group of defendants known as the “Individual Shareholders,” joined the motions. The district court, relying in part on Tribune, granted the defendants’ motion to dismiss the fraudulent conveyance claims. It held that Nine West qualified as a “financial institution” within the meaning of section 101(22)(A) due to its retention of Wells Fargo as a paying agent with respect to the payments made to certain of the public shareholders. As a result, the district court found that all of the transfers in connection with the LBO were safe harbored by section 546(e). In doing so, the district court failed to consider whether Wells Fargo had a role in each of the transfers made to shareholders, including the Individual Shareholders.
On appeal, the Second Circuit determined that the district court erred by using a “contract-by-contract” interpretation of section 101(22)(A)’s definition of “financial institution” with respect to bank customers. Instead, the Second Circuit held that whether a bank customer qualifies as a “financial institution” within the meaning of section 101(22)(A) must be analyzed on a “transfer-by-transfer” basis for three reasons. First, the Second Circuit found that the plain language of section 101(22)(A) required a transfer-by-transfer analysis in order to afford meaning to the phrase “when any such [bank] . . . is acting as agent or custodian for a customer . . . in connection with a securities contract.” By contrast, a contract-by-contract approach would lead to an absurd result wherein every transfer made in connection with an LBO would be safe harbored as long as a bank served as agent for at least one component of the transfers. Second, the court looked to the structure of the Bankruptcy Code itself. Because the Bankruptcy Code grants to trustees the power to avoid certain transfers, it defied logic to conclude that the shield to such avoidance powers under section 546(e) was not similarly limited to a transfer-by-transfer limitation. Finally, the Second Circuit considered the legislative purpose behind section 546(e)’s safe harbor. In enacting the safe harbor, Congress sought to avoid triggering systemic risks in securities markets by precluding the trustee from unwinding certain qualifying transactions. To extend that protection to transfers that did not implicate those same concerns would likely exceed Congress’s intention in enacting the safe harbor.
In his dissent, Judge Richard J. Sullivan rejected the majority’s “transfer-by-transfer” approach. Adopting instead the “contract-by-contract” approach, Sullivan argued that the majority’s interpretation would render the inclusion of bank customers in the definition of “financial institution” superfluous. Accordingly, Sullivan would have affirmed the district court’s judgment in its entirety.
Worms v. Rozhkov (In re Markus), 78 F.4th 554 (2d Cir. 2023).
Adding to the corpus of case law surrounding a bankruptcy court’s inherent authority to impose sanctions, as articulated in Rosellini v. U.S. Bankr. Ct. (In re Sanchez), 941 F.3d 625 (2d Cir. 2019) (per curiam), the Second Circuit explicitly condoned a bankruptcy court’s imposition of non-nominal, civil contempt sanctions. In so doing, the court articulated the requirements for when such sanctions could be imposed.
In April 2016, the Moscow Arbitration Court commenced bankruptcy proceedings against Russian citizen Larisa Ivanovna Markus (“Markus”) and appointed Yuri Vladimirovich Rozhkov (the “Foreign Representative”) to liquidate Markus’ assets. Because Markus was alleged to have significant assets in the United States, in January 2019, the Foreign Representative filed a petition for recognition of the Russian bankruptcy proceedings against Markus pursuant to chapter 15 of the Bankruptcy Code. On April 1, 2019, the U.S. bankruptcy court granted the Foreign Representative’s request for recognition.
In the course of conducting discovery regarding Markus’ U.S.-based assets, the Foreign Representative soon encountered resistance from attorney Victor A. Worms (“Worms”), who appeared on Markus’ behalf. Worms had failed to respond to all efforts of the Foreign Representative to obtain discovery from Markus, arguing that the recognition of the Russian bankruptcy proceedings against Markus was null and void. Notwithstanding Markus’ motion to vacate the recognition order, the bankruptcy court issued multiple orders directing Worms, on Markus’ behalf, to comply with the discovery requests. After repeated failures to comply with the bankruptcy court’s orders, the bankruptcy court warned Worms that he was at risk for being sanctioned. On September 11, 2019, on the bankruptcy court’s advice, the Foreign Representative filed a motion for sanctions against Worms and Markus, seeking both (i) attorneys’ fees and costs and (ii) pursuant to the bankruptcy court’s inherent authority, civil contempt sanctions against Worms in the amount of $1,000 for each day until he produced documents responsive to the discovery requests. After a hearing, on October 8, 2019, the bankruptcy court issued an order, pursuant to its inherent authority, imposing sanctions on Worms for his repeated failure to comply with the discovery orders. The bankruptcy court also awarded the Foreign Representative attorneys’ fees against Worms personally. After multiple appeals to the district court, the amount of the contempt sanctions was fixed in the amount of $55,000 and the attorneys’ fees, in the amount of $36,600.
On appeal, Worms argued that the imposition of civil contempt sanctions was outside of the bankruptcy court’s inherent authority to issue sanctions, relying in part on the Second Circuit’s decision in Sanchez. The Second Circuit flatly rejected this argument.
Nowhere in Sanchez did the Court say, as Worms argues, that a bankruptcy court’s inherent sanctioning authority was limited to non-contempt sanctions. In fact, Sanchez suggests that the opposite is true by recognizing that bankruptcy courts, like Article III courts, possess inherent sanctioning powers, and it is beyond dispute that Article III courts have inherent contempt authority.
Id. at 565 (first citing Sanchez, 941 F.3d at 628; then Chambers v. NASCO, Inc., 501 U.S. 32, 44 (1991); and then Anderson v. Dunn, 19 U.S. 204, 227 (1821)).
Nonetheless, the Second Circuit continued to hold that, although a bankruptcy court’s inherent authority to impose sanctions extends beyond those sanctions at issue in Sanchez, such inherent authority was not unlimited. The court articulated a multi-prong framework for considering when sanctions issued pursuant to a bankruptcy court’s inherent authority are warranted: first, any express authority for imposing sanctions must be insufficient; second, the bankruptcy court cannot override statutory directives and prohibitions in imposing sanctions; third, the court must be explicit about its invocation of its inherent authority and must otherwise adhere to the principles of due process; fourth, a finding of bad faith may be required in certain circumstances, including when an attorney is acting in his or her capacity as an advocate, rather than an officer of the court; and finally, the imposition of civil contempt sanctions must comply with other established legal principals, such as the prohibition against punitive contempt sanctions under Gucci Am., Inc. v. Weixing Li, 768 F.3d 122, 144 (2d Cir. 2014) and the requirement for a movant to provide clear and convincing evidence that contempt sanctions are warranted as provided under King v. Allied Vision, Ltd., 65 F.3d 1051, 1058 (2d Cir. 1995). Because all of these requirements were met, the Second Circuit upheld both the bankruptcy court’s imposition of the contempt sanctions and the award of attorneys’ fees against Worms as proper exercises of the bankruptcy court’s inherent sanctioning authority.
§ 3.4. Third Circuit
In re FTX Trading Ltd., 91 F.4th 148 (3d Cir. 2024).
In a precedential opinion, the Third Circuit reversed the ruling of the Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) and held that the plain text and congressional intent of section 1104(c)(2) of the Bankruptcy Code mandate the appointment of an examiner in cases upon the request of a party where the debtor’s unsecured debts exceed $5 million.
In November 2022, FTX Trading Ltd. and its affiliates (collectively, the “Debtors”), a cryptocurrency exchange, suffered a rapid collapse as reports of numerous corporate failures came to light and customers scrambled to withdraw billions of dollars. Consequently, the Debtors filed voluntary petitions in the bankruptcy court seeking relief under chapter 11 of the Bankruptcy Code. The Debtors’ newly appointed CEO, John J. Ray, III, an experienced restructuring professional, reported that he had never “seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information.” Due to these failures, which included faulty regulatory oversight, cash management failures, and inadequate record keeping, the Debtors were only able to locate a fraction of the Debtors’ digital assets at the time of the filing.
In the wake of this disorganization, the Office of the United States Trustee (the “U.S. Trustee”) moved to appoint an examiner under section 1104(c) of the Bankruptcy Code. The U.S. Trustee asserted that an examiner would be better positioned to examine the implications of the Debtors’ collapse and would allow Mr. Ray to concentrate on stabilizing the Debtors’ business. The U.S. Trustee contended that the language in section 1104(c) is mandatory, requiring the appointment of an examiner if either condition within subsection (1) or (2) is met. The U.S. Trustee argued that because the Debtors’ unsecured debts substantially exceeded the $5 million threshold in section 1104(c)(2), appointment of an examiner was required.
The Debtors and other interested parties objected to the U.S. Trustee’s motion. They argued that the phrase “as is appropriate” within section 1104(c) left the decision of whether to appoint an examiner to the discretion of the Bankruptcy Court. The Bankruptcy Court agreed with the objectors and ruled that appointment of an examiner was discretionary under the Bankruptcy Code.
The U.S. Trustee appealed the Bankruptcy Court’s decision to the District Court and sought certification for direct appeal to the Third Circuit. The District Court granted, and the Third Circuit authorized, the direct appeal.
The Third Circuit acknowledged at the outset that question before it was primarily a question of statutory interpretation; accordingly, the Third Circuit looked to the plain language of section 1104(c). Section 1104(c) provides:
[O]n request of a party in interest or the United States trustee, and after notice and a hearing, the court shall order the appointment of an examiner to conduct such an investigation of the debtor as is appropriate . . . if
(1) such appointment is in the interests of creditors, any equity security holders, and other interests of the estate; or
11 U.S.C. § 1104(c). The Third Circuit noted that Congress’ use of the word “shall” is a word of command and serves as the equivalent of “must.” Regarding the objector-appellees’ argument that “as is appropriate” rendered the decision discretionary, the Third Circuit reasoned that under the last-antecedent rule of statutory interpretation, the qualifying phrase is read to apply to the immediately preceding term; here, the Third Circuit held that it modified the phrase “to conduct such an examination of the debtor.” Likewise, the Third Circuit noted that the language “as is appropriate” is not the same as “if appropriate,” with the latter providing a court discretion while the former only empowers a court to determine the scope of the examination.
The Third Circuit also relied on legislative history wherein Congress discussed the inclusion of an examiner in large cases to protect the interests of debtors, creditors, and the public. However, the Third Circuit noted that Congress had made the mandatory appointment of an examiner subject to some discretion: first, a party-in-interest or the U.S. Trustee must move for an examiner’s appointment; second, courts are left discretion to direct the scope, degree, duration, and cost of the examiner’s investigation. The court briefly explained that an examiner was required to be disinterested and to make its findings public, so an examiner’s investigation differs from one undertaken by a debtor or a creditors’ committee. The court concluded the Bankruptcy Court erred in denying the U.S. Trustee’s motion and remanded the proceeding to the Bankruptcy Court with instructions to enter an appropriate order.
In re LTL Mgmt. LLC, Nos. 23-2971, 23-2972, 2024 WL 3540467 (3d Cir. July 25, 2024).
In this non-precedential opinion, the Third Circuit affirmed the Bankruptcy Court for the District of New Jersey (the “Bankruptcy Court”), dismissing the LTL Management, LLC (“LTL”) bankruptcy case (for a second time) due to an absence of financial distress.
LTL, formed by Johnson & Johnson (“J&J”) through a two-step merger transaction to address its mass tort talc liabilities, filed for chapter 11 with a funding agreement from J&J in the amount of $61.5 billion to pay its talc liabilities and bankruptcy expenses. Its chapter 11 case was dismissed because the Third Circuit found that LTL lacked financial distress—principally, its funding agreement provided more than enough funds to address its liabilities. LTL filed a second chapter 11 hours later with a funding agreement from J&J in a substantially reduced amount of approximately $30 billion. The Third Circuit was called upon again to determine whether LTL’s bankruptcy case was filed in good faith—i.e., whether LTL was in financial distress. Three principal issues were raised on appeal.
First, the Third Circuit affirmed the Bankruptcy Court’s factual finding that LTL was not in financial distress. LTL’s own expert estimated a high-end liability not greater than $21 billion against a funding agreement well in excess of that amount.
Second, the Third Circuit affirmed the Bankruptcy Court’s application of its prior ruling on financial distress. The Third Circuit does not require insolvency before filing for bankruptcy, and can consider other factors that may make financial distress apparent—e.g., credit risk, liquidity issues, difficulties with employees, customers, and vendors, etc. However, LTL did not establish that it was suffering from any apparent financial distress and in its worst-case scenario, LTL’s assets exceeded its liabilities. While a solvent company confronted by mass-tort litigation can encounter financial distress that warrants bankruptcy, LTL did not meet its burden.
Finally, the Third Circuit held that section 1112(b)(2) of the Bankruptcy Code, which allows a court to decline to dismiss a bankruptcy case if unusual circumstances establish that it is not in the best interests of the creditors and the estate, did not provide an avenue to keep the cases in chapter 11. The Third Circuit affirmed the Bankruptcy Court in concluding that “lack of financial distress is not the type of ‘bad faith’ that could be subject to the [section] 1112(b) exception[.]” Id. at *4 (quoting In re LTL Mgmt., LLC, 652 B.R. 433, 451–54 (Bankr. D.N.J. 2023)).
Vertiv, Inc. v. Wayne Burt PTE, Ltd., 92 F.4th 169 (3d Cir. 2024).
In a precedential opinion, the Third Circuit vacated the order of the District Court for the District of New Jersey (the “District Court”) dismissing a complaint filed by plaintiffs Vertiv, Inc., Vertiv Capital, Inc., and Gnaritis, Inc. (collectively, “Vertiv”) against defendant Wayne Burt PTE, Ltd. (“Wayne Burt”) on grounds of international comity and remanded to apply a refreshed test for cases involving adjudicatory comity to a foreign bankruptcy proceeding.
Wayne Burt, a Singaporean corporation, was in liquidation proceedings in Singapore (the “Singaporean Liquidation Proceeding”). Prior to the Singaporean Liquidation Proceeding, Vertiv filed two suits alleging breach of contract against Wayne Burt in the District Court. The lawsuits were resolved by a consent judgment for $29 million. However, Wayne Burt, through the Singaporean liquidator, asserted lack of authority to consent to judgment and later moved to dismiss for failure to state a claim under Rule 12(b)(6) based on international comity grounds.
The District Court applied two tests in determining whether the action should be dismissed: the test articulated by the District Court in Austar International, Ltd. v. Austarpharma, LLC, 425 F. Supp. 3d 336 (D.N.J. 2019) and the test articulated by the Third Circuit in Philadelphia Gear Corp. v. Philadelphia Gear de Mexico, S.A., 44 F.3d 187 (3d Cir. 1994). The Austar test applies generally whenever a federal court seeks to determine whether to extend comity to a court of foreign jurisdiction, while the Philadelphia Gear test is specifically tailored to determine whether to extend comity to a foreign bankruptcy proceeding. Under both tests, the District Court determined that extending comity to the Singaporean Liquidation Proceeding was appropriate. Thus, the District Court granted Wayne Burt’s motion to dismiss. Vertiv timely appealed.
The Third Circuit noted that the category of comity at issue was adjudicatory comity, a discretionary act of deference towards a foreign court, so the Austar test was inapplicable. It further commented that it had been nearly three decades since the court addressed the topic in Philadelphia Gear and a “refreshed test” was warranted.
Under Philadelphia Gear, the first inquiry is whether the foreign bankruptcy proceeding is “parallel” to the civil action in the United States court. The foreign bankruptcy proceeding will be “parallel” when: (i) the foreign bankruptcy proceeding is ongoing in a duly authorized tribunal while the civil action is pending before the United States court; and (ii) the outcome of the United States action may affect the debtor’s estate. The court likened this inquiry to “related to” jurisdiction in a United States bankruptcy proceeding. Here, the court ruled that a $29 million judgment would affect the Singaporean Liquidation Proceeding and therefore, the proceedings were parallel.
The second inquiry from Philadelphia Gear is whether the party seeking the extension of comity makes a prima facie case by showing that “(1) ‘the foreign bankruptcy law shares our policy of equal distribution of assets,’ and (2) ‘the foreign law mandates the issuance or at least authorizes the request for the stay.’” Id. at 180 (quoting Phila. Gear, 44 F.3d at 193). The court then cited to a non-exhaustive list of factors that demonstrate principles of equality:
(1) whether creditors of the same class are treated equally in the distribution of assets; (2) whether the liquidators are considered fiduciaries and are held accountable to the court; (3) whether creditors have the right to submit claims which, if denied, can be submitted to a bankruptcy court for adjudication; (4) whether the liquidators are required to give notice to the debtors’ potential claimants; (5) whether there are provisions for creditors’ meetings; (6) whether a foreign country’s insolvency laws favor its own citizens; (7) whether all assets are marshaled before one body for centralized distribution; and (8) whether there are provisions for an automatic stay and for the lifting of such stays to facilitate the centralization of claims.
Id. at 181 (quoting Finanz AG Zurich v. Banco Economico S.A., 192 F.3d 240, 249 (2d Cir. 1999)). Here, the Third Circuit held that Singapore shares the United States’ policy of equal distribution of assets among similarly situated creditors and Singapore law authorizes a stay.
Finally, the last inquiry is the prejudice to the party opposing the extension of comity to the foreign bankruptcy proceeding. In essence, the United States court must assess whether the pending foreign bankruptcy proceedings provide due process protections for the party opposing the extension of comity, utilizing the non-exhaustive factors above. Because the District Court did not evaluate this last part of the test, the Third Circuit remanded to apply the refreshed test.
Wells Fargo Bank, N.A. v Hertz Corp. (In re Hertz Corp.), 117 F.4th 109 (3d Cir. 2024).
In a precedential opinion, the Third Circuit ruled not only that (i) make-whole fees (the “Applicable Premiums”), payable under Hertz’s unsecured bonds issued by The Hertz Corporation and certain of its affiliates (“Hertz” or the “Debtors”), constituted unmatured interest disallowed by section 502(b)(2) of the Bankruptcy Code, but also that (ii) because Hertz ultimately turned out to be solvent, the bondholders were entitled to postpetition interest at the contract rate, including payment of the Applicable Premiums, but not asserted early redemption fees.
The Debtors filed voluntary chapter 11 cases due to the pandemic, but were able to emerge from bankruptcy as solvent, with a plan of reorganization (the “Plan”) that nominally left all creditors unimpaired and provided a return to stockholders valued at approximately $1.1 billion. However, the Plan’s proposed treatment of unsecured bondholders provided for payment of postpetition interest at the federal judgment rate, while leaving the Applicable Premiums and early redemption fees, which were payable under the terms of the bonds, unpaid. Although the bondholders contested this treatment, the Debtors and the bondholders agreed to reserve such issues to resolution until after the Debtors’ emergence from bankruptcy. As a result, the Plan was confirmed. The bondholders later filed a complaint seeking payment of (i) postpetition interest at the contract rate, (ii) the Applicable Premiums, and (iii) the early redemption fees. The Bankruptcy Court dismissed the complaint, but ultimately certified the decision for direct appeal to the Third Circuit in light of intervening rulings from the Fifth and Ninth Circuits.
While the Third Circuit found that the Applicable Premiums constituted “interest” under both the standard “dictionary definition” and the “economic equivalent” approaches—and thus, must be disallowed under Bankruptcy Code section 502(b)(2) as unmatured interest—the Third Circuit also held that postpetition interest, including the Applicable Premiums, must be paid at the contract rate of interest because the Debtors were solvent. The Third Circuit explained that because the stockholders received value of over $1 billion, refusing to pay postpetition interest at the contract rate and the Applicable Premiums to the Noteholders, who were senior in priority to the stockholders, violated the absolute priority rule. Pointing to the Supreme Court’s decision in Czyzewski v. Jevic Holding Corp., 580 U.S. 451 (2017), the Third Circuit opined that “the Bankruptcy Code entitles every creditor—not just dissenting impaired creditors who can invoke [section] 1129(b) [of the Bankruptcy Code]—to treatment consistent with absolute priority absent a clear statement to the contrary.” 117 F.4th at 128 (citing Jevic, 580 U.S. at 465). Accordingly, the Third Circuit established this solvent debtor exception, relying on a long history of cases and codification in the Bankruptcy Code’s absolute priority rule.
Finally, the Third Circuit affirmed the bankruptcy court’s holding that the bondholders were not entitled to early redemption fees because the fee was never triggered as a matter of contract law and thus, not payable.
§ 3.5. Fourth Circuit
Blair v. Bestwall, LLC (In re Bestwall, LLC), 99 F.4th 679 (4th Cir. 2024).
Over the dissent of Circuit Judge Robert Bruce King, a Fourth Circuit panel declined to review a bankruptcy court’s orders (i) holding certain bankruptcy creditors, and their counsel, in contempt for violating a discovery order and (ii) imposing monetary sanctions, finding that both the order for contempt and the order for sanctions were nonfinal, interlocutory decisions for which neither the district court nor the Fourth Circuit had the jurisdiction to review.
In November 2017, Bestwall, LLC (“Bestwall”) commenced chapter 11 proceedings to address its asbestos-related liabilities. To aid Bestwall in estimating its liabilities, Bestwall sought, and was granted, an order directing all claimants asserting liabilities for mesothelioma against Bestwall to complete and submit a personal injury questionnaire (the “PIQ Order”). The Official Committee of Asbestos Claimants, along with various individual claimants, attempted to appeal the PIQ Order to the district court, but the appeal was dismissed for lack of jurisdiction. The district court concluded that the PIQ Order was not a final, appealable order and did not warrant interlocutory review. Thereafter, certain claimants (the “Illinois Plaintiffs”) sought to enjoin Bestwall from enforcing the PIQ Order by seeking an injunction before an Illinois federal district court. In response, Bestwall approached the bankruptcy court, seeking an order to enforce the PIQ Order. The bankruptcy court granted Bestwall’s enforcement motion and found all of the Illinois Plaintiffs and their counsel (together, “Appellants”) in contempt. Instead of sanctions, however, the bankruptcy court offered to purge Appellants’ contempt if the Illinois Plaintiffs dropped their injunction suit. When most of the Illinois Plaintiffs failed to drop their suit, the bankruptcy court imposed joint and several sanctions on Appellants in the amount of approximately $400,000, representing Bestwall’s fees and expenses incurred in defending the injunction action and enforcing the PIQ Order. Appellants appealed both the contempt and sanctions orders to the district court, which concluded that neither order was final and therefore dismissed the appeal for lack of jurisdiction. This appeal followed.
In a 2–1 decision, the Fourth Circuit affirmed the district court’s dismissal. On appeal, Appellants argued that the contempt and sanctions orders were final decisions in a discrete “proceeding” within the meaning of 28 U.S.C. § 158(a), and were therefore appropriate for appellate review by the district court. The Fourth Circuit majority disagreed. Because the contempt and sanctions orders arose from enforcement of the PIQ Order, which was an order for discovery in aid of the overarching goal of putting together a chapter 11 plan, neither the contempt order nor the sanctions order brought any sort of finality to the matter. Moreover, the majority held that construing the “proceeding” to be limited to the final determinations of whether the Illinois Plaintiffs violated the PIQ Order and whether sanctions were warranted would eviscerate the requirement for finality as a threshold for appellate review. “If we accepted Appellants’ formulation of finality, every ruling to enforce a discover order—and, likely, every discovery order itself—would be an appealable final decision supposedly terminating a bankruptcy ‘proceeding.’” Id. at 686 (citing Ritzen Grp., Inc. v. Jackson Masonry, LLC, 589 U.S. 35, 46–47 (2020)).
Judge King, however, agreed with Appellants. In his view, the discrete dispute regarding Appellants’ contempt had been raised by Bestwall in its motion to enforce the PIQ Order. Because the contempt and sanctions orders fully and finally resolved the issue of Appellants’ contempt, they were subject to appellate review pursuant to 28 U.S.C. § 158(a).
§ 3.6. Fifth Circuit
Briar Cap. Working Fund Cap., L.L.C. v. Remmert (In re S. Coast Supply Co.), 91 F.4th 376 (5th Cir. 2024).
The debtor was a distributor of industrial products. When the debtor encountered financial troubles, it borrowed $800,000 from its chief financial officer pursuant to a loan agreement. The debtor made forty-seven payments on that debt totaling in excess of $320,000. Ultimately, the debtor filed a voluntary chapter 11 petition in the Southern District of Texas. Briar Capital Working Fund Capital, L.L.C. (“Briar Capital”) was the debtor’s sole prepetition, secured lender. The debtor ultimately confirmed its plan, which provided, inter alia, for the transfer to Briar Capital of a pending preference action brought by the debtor against the former CFO. Shortly before trial in the preference action, the CFO filed a motion to dismiss pursuant to Rule 12(b)(1) of the Federal Rules of Civil Procedure, arguing that Briar Capital lacked standing to prosecute the preference action. The district court agreed because a successful recovery would not benefit the debtor’s estate or its creditors.
The appellate court began its analysis by noting that the “appeal turns on whether preference claims—a type of avoidance action—may validly be sold.” Id. at 380. This question was novel for the Fifth Circuit. The court began its analysis with section 363 of the Bankruptcy Code, which provides that a debtor in possession “may use, sell, or lease . . . property of the estate.” 11 U.S.C. § 363(b)(1). “Property of the estate” is defined in section 541 of the Bankruptcy Code to include “all legal or equitable interests of the debtor in property as of the commencement of the case.” 11 U.S.C. 541(a)(1). The Fifth Circuit held that a preference action met this standard. Similarly, the court noted that section 541(a)(7) provides that “property of the estate” includes “any interest in property that the estate acquires after the commencement of the case.” 11 U.S.C. § 541(a)(7). Thus, the Fifth Circuit held that a preference action qualifies as property of the estate under that section as well. Beyond the statutory language, the Fifth Circuit also founds its decision to be in accord with those of other circuit courts. Notably, the Eighth and Ninth Circuits had held that preference claims are property of the estate that can be sold.
The CFO also argued that even if the avoidance actions were property of the estate that could be sold, Briar Capital lacked standing to pursue the claims because it was not a representative of the estate. The Fifth Circuit rejected this argument. Because it found that the preference claims could be sold, the court also held the secured creditor had standing to pursue the claim as a purchaser of the claim regardless of whether it was a representative of the estate.
Charitable DSF Fund, L.P. v. Highland Cap. Mgmt., L.P. (In re Highland Cap. Mgmt., L.P.), 98 F.4th 170 (5th Cir. 2024).
In 2019, litigation pushed the debtor, Highland Capital Management, L.P. (“Highland”), to seek chapter 11 protection. At the time of filing, Highland was controlled by co-founder James Dondero (“Mr. Dondero”). Ultimately, Mr. Dondero and Highland parted ways. Mr. Dondero relinquished control to three independent directors, one of whom was appointed by the bankruptcy court as Highland’s chief executive officer, chief restructuring officer, and foreign representative (the “CRO”). To protect the CRO from vexatious litigation, the bankruptcy court adopted a gatekeeping order, which essentially provided that no claim or cause of action could be brought against the CRO without prior approval of the bankruptcy court. The order specifically noted that the bankruptcy court would have the sole jurisdiction to adjudicate any claim for which approval to proceed had been granted.
Notwithstanding this order, entities controlled by Mr. Dondero, the Charitable DAF Foundation and its affiliate CLO Holdco (collectively “DAF”), brought litigation against Highland in district court, alleging that Highland, through its CRO, had withheld information and engaged in self-dealing. After filing the initial complaint, DAF moved for leave to amend its complaint to add the CRO as a named defendant without seeking bankruptcy court approval, as required by the gatekeeping order. DAF’s theory in so doing was that “the district court sitting over the bankruptcy court would obviate this defect.” Id. at 173. The district court dismissed the motion for leave on procedural grounds. As a result, DAF did not ever actually sue the CRO.
Highland then moved for an order requiring DAF, the persons who authorized the motion for leave, and their attorneys to show cause why they should not be held in civil contempt for violating the bankruptcy court’s gatekeeping order. The bankruptcy court granted that motion, and also required Mr. Dondero, individually, to show cause why he should not be sanctioned. Following extensive discovery and a lengthy evidentiary hearing, the bankruptcy court concluded that the filing of the motion for leave was a violation of the gatekeeping order. It held all of the parties involved in filing the motion, including Mr. Dondero, in contempt and ordered them to pay the debtor nearly $240,000. The bankruptcy court calculated the amount of sanction based on the expenses Highland actually incurred in connection with the contempt motion. The bankruptcy court concluded that Highland’s fee submissions were “conservative,” and added an additional $50,000 “based on mere guesswork.” Id. The bankruptcy court denied Highland’s request for treble damages but imposed, sua sponte, a sanction of $100,000 for failed appeals. On appeal to the district court, the sanctioned parties argued that the sanction was punitive and, therefore, exceeded the bankruptcy court’s civil contempt power. The district court vacated the bankruptcy court’s $100,000 per appeal sanction as excessive, but affirmed the remainder of the award, finding that the bankruptcy court’s award was designed to compensate Highland for costs incurred and was therefore compensatory and civil.
On appeal, the Fifth Circuit began by noting that bankruptcy courts are not Article III courts. As such they lack the inherent power to punish violations of their orders through criminal contempt. Instead, bankruptcy courts only have civil contempt powers. Because civil contempt proceedings are uniquely susceptible to abuse, “civil contempt sanctions may not have the ‘primary purpose’ of ‘punish[ing] the contemnor [or] vindicate[ing] the authority of the court.’” Id. at 174 (alterations in original) (quoting Lamar Fin. Corp. v. Adams, 918 F.2d 564, 566 (5th Cir. 1990)). Instead, civil contempt “must be ‘remedial and for the benefit of the complainant.’” Id. (quoting Int’l Union, United Mine Workers of Am. v. Bagwell, 512 U.S. 821 (1994)). In other words, civil contempt sanctions must be calculated either to (1) coerce compliance with a court order or (2) compensate another party for the violation of that order. Civil contempt sanctions designed to coerce compliance are permissible only if they are conditional on the offending party’s conduct. In contrast, “contempt sanctions imposed for compensatory purposes are civil only if they are ‘based on evidence of the complainant’s actual loss.’” Id. at 175 (quoting United States v. United Mine Workers of Am., 330 U.S. 258, 304 (1947)). In the context of a fee-shifting sanction, there must be “‘a causal link[] between the litigant’s misbehavior and legal fees paid by the opposing party.’” Id. (alteration in original) (quoting Goodyear Tire & Rubber Co. v. Haeger, 581 U.S. 101, 108 (2017)). In other words, the bankruptcy court may only shift those fees incurred because of the misconduct. Without that causal link, the sanction is punitive and falls outside the bankruptcy court’s authority.
The Fifth Circuit noted that Highland “incurred virtually all its contempt-related expenses because the bankruptcy court permitted extensive discovery and conducted a marathon evidentiary hearing to unearth Dondero[’]s role in filing the [motion for leave].” Id. at 176. However, the Fifth Circuit determined that Mr. Dondero’s intentions were only relevant to criminal contempt, for which the bankruptcy court could not impose sanctions. The only question in a civil contempt proceeding would have been whether and to what extent Highland was harmed by the filing of the motion for leave. Attempting to justify the bankruptcy court’s sanction, Highland argued that the bankruptcy court had “every right and reason to vindicate its own authority by finding out who is responsible for violating its orders.” Id. (emphasis original). The Fifth Circuit found that argument to be outcome-determinative: if the purpose of the sanction was to vindicate the authority of the court, it was criminal and therefore beyond the bankruptcy court’s authority. Accordingly, the Fifth Circuit vacated the judgment of the district court and remanded the case to the bankruptcy court with instructions to limit any sanction award to the damages Highland suffered because the motion was filed in the wrong court. In other words, the sanction should be limited to the expenses Highland reasonably incurred in opposing the motion in the district court, less those it would have spent opposing the motion had it been filed in bankruptcy court.
Excluded Lenders v. Serta Simmons Bedding, L.L.C. (In re Serta Simmons Bedding, L.L.C.), Nos. 23-20181, 23-20450, 23-20363, 23-2041, 2024 WL 5250365 (5th Cir. Dec. 31, 2024).
Prior to filing its bankruptcy petition, the debtor, Serta Simmons Bedding, LLC (“Serta”), in 2016 and 2020 executed a variety of financing deals with multiple lenders. The 2016 transaction involved the refinance of Serta’s debt through a series of syndicated loans, including $1.95 billion of first-lien syndicated loans and $450 million of second-lien syndicated loans. The credit agreement governing the first lien loans (the “2016 Agreement”) specifically provided that all lenders would receive their pro rata share of any payment or recovery. In other words, Serta could not choose to pay its obligations to one lender while offering nothing to the others. Under the 2016 Agreement, the favored lender would be required to share the payment with the others. The 2016 Agreement further required unanimous consent to waive this provision. The 2016 Agreement contained one exception to the ratable-sharing provision that was relevant to the appeal. That section provided that any lender could assign all or a portion of its rights to Serta or certain of its affiliates on a non-pro rata basis.
In the years following the 2016 refinance, Serta struggled. To bolster its financial position, Serta chose to engage in an uptier transaction (the “2020 Uptier Transaction”). The Fifth Circuit described an uptier transaction as follows:
The borrower amends the terms of a credit facility to allow the issuance of new super-priority debt. Because a majority of lenders in the existing facility must typically consent to such an amendment, the borrower purchases consent by allowing these lenders to exchange their existing debt for new super-priority debt, often at an above-market price.
2024 WL 5250365, at *2 (citations omitted). If fewer than all lenders participate in the uptier, it is a non-pro rata transaction. That is exactly what Serta chose to do by engaging in an uptier transaction with some—but not all—of the lenders who were party to the 2016 transaction. As the appellate court described the transaction, Serta “gained cash and lowered its overall debt load, while the Prevailing Lenders slashed the nominal value of their holdings (which were trading far below par) to jump the creditor line and get paid before their erstwhile first- and second-lien comrades.” Id. at *4. Because the 2020 Uptier Transaction was controversial, Serta and the lenders involved in the uptier took a number of steps to protect themselves: first, they amended the 2016 Agreement to expressly allow the 2020 Uptier Transaction based on their bare majority of the first-lien debt; second, Serta and the participating lenders labeled the 2020 Uptier Transaction as an open-market purchase; and finally, Serta agreed to indemnify the participating lenders.
In 2023, Serta filed for bankruptcy protection under chapter 11. Serta and some of the participating lenders filed an adversary proceeding seeking declaratory relief blessing the 2020 Uptier Transaction as not violating the 2016 Agreement’s pro rata provisions. The defendants in this adversary proceeding had opposed the 2020 Uptier Transaction as “lender-on-lender violence.” The bankruptcy court held that the term open-market purchase, which was not defined in the 2016 Agreement to be clear and unambiguous. The bankruptcy court further held that the 2020 Uptier Transaction was a valid open-market purchase and, thus, an exception to the pro rata sharing required by the 2016 Agreement.
In the main bankruptcy case, Serta proposed a plan of reorganization that expressly provided for the survival of Serta’s indemnification obligations related to the 2020 Uptier Transaction, but only as to (i) those participating lenders who had not sold their super-priority debt and (ii) those who did not originally participate in the 2020 Uptier Transaction, but who had later purchased super-priority debt on the secondary market. The plan proponents argued that the original indemnity provided in the 2020 Uptier Transaction for all participating lenders, regardless of whether they still held the super-priority debt, should be disallowed, but that the modified indemnity in the final plan could be justified as part of a settlement. The bankruptcy court found the settlement indemnity to be a fair and equitable component of the plan and confirmed the plan with this new indemnity.
The issue was then appealed directly to the Fifth Circuit. The court began by addressing the open-market issues. Applying established rules of contract interpretation, the circuit held that the 2020 Uptier Transaction was not a permissible open-market purchase. First, an open market is one that is generally open to participation by various buyers and sellers. That market needs to be relevant to the purchased product. As such, the open market in this context would be the secondary market for syndicated loans. The court held that “the words ‘open market’ point to a specific ‘market,’ not merely a general context where private parties engage in non-coercive transactions with each other.” Id. at *13. While the latter might be an “open purchase,” it would not be an “open market purchase.” Competition does not suffice to establish an open market. Instead, an open market is one tied to a specific market and not merely the background concept of “free competition.” Because Serta chose to privately engage individual lenders outside of the established secondary market, it did not qualify for the open-market protection of the 2016 Agreement. The Fifth Circuit, thus, reversed the bankruptcy court’s ruling to the contrary.
Having concluded that the 2020 Uptier Transaction was not permitted under the open market exception, the court remarked that the lenders who had been excluded had a strong case that Serta and the participating lenders had breached the 2016 Agreement. Because there was little substantive discussion of the breach of contract issue in the appellate briefing, the Fifth Circuit remanded for reconsideration of the excluded lenders’ breach of contract counterclaims.
The court then turned to the plan indemnity issues. The court held that the plan improperly included indemnities relating to the 2020 Uptier Transaction. First, the court rejected the argument that the appeal of the settlement indemnity was equitably moot. Even though a stay of confirmation had not been obtained and the plan had been substantially consummated, the circuit held that issue was not equitably moot because excising the indemnity from the plan would not affect the rights of parties not before the court or the success of the plan. The court also forcefully rejected the argument made by the participating lenders that it would be unfair to consider an appeal that allowed the plan to remain confirmed, but excised a portion of the relief for which they bargained. The participating lenders contended that, if the court were to eliminate this bargained-for relief, the parties should be permitted to go back to the drawing board to revisit the entire plan. But the court determined that doing so would amount to a “judge-made, atextual doctrine of pseudo-abstention.” Id. at *20. The court wrote that, “to the extent equitable mootness exists at all, we affirm that it cannot be ‘a shield for sharp or unauthorized practices.’” Id. (quoting In re Pac. Lumber Co., 584 F.3d 229, 244 n.19 (5th Cir. 2009)).
The Fifth Circuit then held that the inclusion of the modified indemnity was “an impermissible end-run around the Bankruptcy Code.” Id. at *21. Section 502(e)(1)(B) requires a bankruptcy court to “disallow any contingent claim for reimbursement where the claiming entity is co-liable with the debtor.” Id. The indemnity claims asserted by the participating lenders were clearly contingent claims for reimbursement where the participating lenders were co-liable with Serta. All parties and the bankruptcy court agreed that section 502(e)(1)(B) disallowed the claims and invalidated the related prepetition indemnity (i.e., the first iteration of the indemnity that indemnified all participating lenders). But Serta and certain lenders attempted to obtain the modified indemnity by calling it a “settlement,” authorized by section 1123(b)(3)(A). While the bankruptcy court approved of this strategy, the Fifth Circuit did not. Section 1123 simply did not provide for the back-end resurrection of claims already disallowed and the bankruptcy court was wrong to approve of this strategy. The court further found that, even if section 1123(b)(3)(A) could have justified the settlement indemnity, section 1123(a)(4), which requires equal treatment of similarly situated creditors, would bar it. Accordingly, the Fifth Circuit chose to excise the offending indemnity from the plan and reversed the bankruptcy court’s final order confirming the plan only insofar as it approved the indemnity.
Finally, the court noted that the 2020 Uptier Transaction was the first major uptier, but was likely not the last. The court wrote that “there are doubtless still many contracts with open market purchase exceptions to ratable treatment.” Id. at *24 (citation omitted). While each such contract should be reviewed on its own terms, the court concluded its opinion by suggesting that such open market purchase exceptions would not often justify uptier transactions.
§ 3.7. Sixth Circuit
Cal. Palms Addiction Recovery Campus, Inc. v. Vara (In re Cal. Palms Addiction Recovery Campus, Inc.), 87 F.4th 734 (6th Cir. 2023).
Joining the Third, Seventh, and Ninth Circuits, the Sixth Circuit became the latest Court of Appeals to hold that a bankruptcy court’s order granting a motion to convert from chapter 11 to chapter 7 is a final, appealable order from which an appeal may arise under 28 U.S.C. § 158.
California Palms Addiction Recovery Campus, Inc. (“California Palms”) was a substance abuse treatment center located in Ohio. However, it was beset by legal problems, including (i) revocation of its operating license by the State of Ohio, (ii) seizure of nearly $600,000 by the U.S. Department of Justice (the “DOJ”), and (iii) a pending eviction action by its landlord. To resolve these issues, California Palms (a) sued the State of Ohio to reinstate its license, (b) sued the DOJ to recover the seized assets, and (c) commenced bankruptcy proceedings under subchapter V of chapter 11. The subchapter V trustee sought to convert the case to chapter 7 due to concerns that California Palms’ continued prosecution of its various litigations would “bleed the estate dry.” Id. at 738. Although the bankruptcy court initially put the subchapter V trustee’s motion on hold, later adverse developments in the DOJ suit and missed deadlines in the bankruptcy case caused the bankruptcy court to schedule a show-cause hearing as to why California Palms’ case should not be converted. Despite California Palms’ objection, the bankruptcy court made factual and legal findings to support conversion of California Palms’ case to chapter 7.
As a gating item, the Sixth Circuit first considered whether it had jurisdiction to review the bankruptcy court’s order converting the case based on the “finality” of the order. The Court of Appeals found that the bankruptcy court’s order converting the proceeding to a chapter 7 case was appealable as a final order because the conversion motion both resolved a “proceeding,” meaning a “‘discrete dispute’ with specific procedural steps.” Id. at 739 (quoting In re Jackson Masonry, LLC, 906 F.3d 494, 500 (6th Cir. 2018)). In addition, the granting of a motion to convert “terminates” the proceeding by eliminating the debtor’s right to reorganize pursuant to chapter 11. Id. at 740. Accordingly, the bankruptcy court’s order converting California Palms’ subchapter V case to chapter 7 was final and appealable, and therefore within the Sixth Circuit’s purview for appellate review. The Court of Appeals then easily concluded that the bankruptcy court had not abused its discretion in finding cause to convert based on the low likelihood of success for California Palms to successfully reorganize in the face of substantial, continuing losses.
§ 3.8. Seventh Circuit
In re Int’l Supply Co., 103 F.4th 478 (7th Cir. 2024).
The Seventh Circuit rejected a lender’s argument that the “sole legally permissible approach to defining solvency,” under the Illinois Uniform Fraudulent Transfer Act, is the balance sheet test. Id. at 481.
In August of 2013, Lee Hofmann (“Hofmann”) agreed to have one of his companies, International Supply Company (“International Supply”), pay Citizens Equity First Credit Union (the “Lender”) $1.72 million as part of a settlement. The settlement was related to the Lender’s judgment against Hofmann for failure to honor his personal guarantee of the debt of another one of his companies.
In 2015, International Supply commenced bankruptcy proceedings, and a trustee (the “Trustee”) was appointed to distribute the proceeds of the sale of its assets to creditors. In September of 2017, the Trustee brought a preference action against the Lender, asserting that International Supply was insolvent when it made the August 2013 payment to the Lender and that it had not received reasonably equivalent value for that payment.
At trial, the bankruptcy court heard expert testimony as to International Supply’s 2013 solvency using each of the balance sheet, cash flow, and adequate capital tests. Ultimately, the bankruptcy court concluded, and the district court affirmed, that International Supply was insolvent in August 2013 because it was unable to keep the business afloat and repay its debts. As a result, the settlement payment by International Supply to the Lender was voidable and the Lender was ordered to pay the estate $1.72 million, plus interest.
On appeal to the Seventh Circuit, the Lender argued that the bankruptcy court had erred when it looked beyond International Supply’s balance sheet in evaluating International Supply’s solvency as of August 2013. However, the Seventh Circuit held that the Illinois Uniform Fraudulent Transfer Act contained no express limitation as to the means of assessing a debtor’s solvency. In fact, the court held that the Illinois statute “set up multiple ways in which a business can be insolvent for the purpose of fraudulent-conveyance liability.” Id. at 482. In addition, the Lender failed to cite any caselaw to support its proposition that the balance sheet test alone was the appropriate method of assessing solvency under the Uniform Fraudulent Transfer Act.
Petr v. BMO Harris Bank N.A., 95 F.4th 1090 (7th Cir. 2024).
The Seventh Circuit made two definitive rulings that fortified the protections provided by Bankruptcy Code section 546(e)’s safe harbor: (i) transactions involving private securities that do not implicate the national securities market are protected by the statute, and (ii) section 546(e) preempts state law claims seeking relief that would be otherwise barred under the Bankruptcy Code.
BWGS, LLC (“BWGS” or the “Debtor”) was a privately held company with its outstanding stock in an Employee Stock Ownership Plan Trust (the “ESOP Trust”). To acquire BWGS, Sun Capital Partners VI, L.P. (“Sun Capital”) entered into a stock purchase agreement (the “SPA”) with the ESOP Trust through which a newly formed subsidiary of Sun Capital, BWGS Intermediate Holding, LLC (“Intermediate Holding”), would acquire the stock of BWGS for approximately $37.8 million. To finance the acquisition, Intermediate Holding borrowed $25.8 million (the “Bridge Loan”) from BMO Harris Bank N.A. (“BMO”), with Sun Capital guaranteeing the loan. The acquisition closed on December 30, 2016.
Subsequently, on January 27, 2017, Sun Capital caused BWGS to enter into two borrowing arrangements, along with Intermediate Holding: (i) a $20 million term loan from LBC Credit Agency Services, LLC (the “Term Loan”); and (ii) a revolving line of credit of up to $20 million from JP Morgan Chase Bank, N.A. (the “Revolver”). On the same day, Sun Capital caused BWGS to pay BMO approximately $20 million borrowed under the term loan, approximately $5 million borrowed under the Revolver, and approximately $400,000 of cash on hand (collectively, the “Transfer”). As a result of the Transfer, Intermediate Holding and Sun Capital were relieved of their obligations under the Bridge Loan, while BWGS, which was already struggling financially, received no value.
BWGS’s creditors ultimately filed an involuntary chapter 7 bankruptcy petition against BWGS. In the bankruptcy proceedings, the chapter 7 trustee (the “Trustee”) filed a complaint against BMO, Sun Capital, and others to (i) avoid the Transfer as a constructively fraudulent transfer pursuant to the Indiana Uniform Voidable Transactions Act (the “IUVTA”) and section 544(b)(1) of the Bankruptcy Code and (ii) recover the value of the Transfer from Sun Capital pursuant to section 550(a) of the Bankruptcy Code and its IUVTA analog, section 18(b)(1), by virtue of the Trustee’s “strong arm” power under section 544(a). BMO and Sun Capital (together, the “Defendants”) moved to dismiss the Trustee’s complaint, arguing that the Transfer fell within section 546(e)’s safe harbor. The bankruptcy court denied the Defendants’ motion, finding that only the SPA was a “securities contract” under section 546(e) and that the Transfer was not made “in connection with” the SPA. The bankruptcy court also held, sua sponte, that the Trustee’s claim to recover the value of the Transfer from the Defendants under the IUVTA did not implicate section 546(e)’s safe harbor and was permissible. The district court reversed, finding that (i) the SPA, the Bridge Loan agreement, and Sun Capital’s guaranty of the Bridge Loan all qualified as “securities contracts” within the meaning of section 546(e) and that the Transfer was made “in connection with” such securities contracts, meaning section 546(e) barred the Trustee’s claims, and (ii) section 546(e) preempted claims brought under section 18(b)(1) of the IUVTA, by virtue of section 544(a). The Trustee appealed.
Affirming the district court entirely, the Seventh Circuit first rejected the Trustee’s argument that section 546(e) only applied to “transactions that implicate the national system for the clearance and settlement of publicly held securities” because Congress intended “to insulate the nation’s financial markets from instability generated by the avoidance of public securities transactions.” Id. at 1097. Because both the terms “securities contract” and “in connection with,” as used in section 546(e), were unambiguous, the Court of Appeals determined that there was no need to turn to legislative history or Congressional intent of section 546(e). Rather, it was plain on the face of the statute that section 546(e) could reach transactions involving privately held securities.
The Seventh Circuit then addressed whether the Trustee could evade the implications of section 546(e)’s safe harbor by using section 544(a) to recover the value of a claim that was avoidable under state law. The Court of Appeals rejected this argument, holding that section 546(e) preempted state law claims seeking to recover the value of transfers that would otherwise be shielded from avoidance by the safe harbor. Joining the Second and Eighth Circuits in so holding, the court said, “[T]o allow a bankruptcy trustee to recover the otherwise-unavoidable payments ‘would render the [section] 546(e) exemption meaningless, and would wholly frustrate the purpose behind that section.’” Id. at 1103 (quoting Contemp. Indus. Corp. v. Frost, 564 F.3d 981, 988 (8th Cir. 2009)).
§ 3.9. Eighth Circuit
Kelley v. BMO Harris Bank N.A., 115 F.4th 901 (8th Cir. 2024).
Aligning with the Second Circuit’s analysis of the in pari delicto doctrine under New York law, the Eighth Circuit concluded that, although Minnesota law may permit a receiver to avoid the defense of in pari delicto, a bankruptcy trustee inherits the right of the debtor corporation subject to any equitable or legal defenses that could have been raised against the debtor.
In 2008, Thomas Petter (“Petter”) was arrested for fraud in connection with a multibillion-dollar Ponzi scheme perpetrated through his company, Petters Company, Inc. (“PCI”). A federal district court subsequently placed PCI into a receivership and appointed Douglas Kelley (“Kelley”) as receiver. As receiver, Kelley then commenced bankruptcy proceedings on behalf of PCI. Kelley was then appointed trustee of the bankruptcy estate.
As the trustee, Kelley filed an adversary proceeding in bankruptcy court against BMO Harris Bank (“BMO”), as successor-in-interest to M&I Bank (“M&I”), alleging that M&I aided and abetted the Ponzi scheme by ignoring signs of the fraud. BMO moved for summary judgment, arguing that the doctrine of in pari delicto barred the PCI estate from recovering against BMO for M&I’s alleged wrongdoing because PCI was equally, if not more, culpable. The bankruptcy court ruled that the doctrine did not apply because, under Minnesota law, PCI was no longer bound by its officers’ previous fraudulent acts when it entered receivership. As the case headed to trial, the district court, at several different points, likewise denied BMO relief based on the doctrine of in pari delicto.
On appeal, the parties disputed whether the placement of PCI into receivership “cleansed” Kelley of PCI’s wrongdoing. Kelley argued that, under Minnesota law, a receiver “is not bound by the fraudulent acts of a former officer of the corporation.” Id. at 905 (quoting Magnusson v. Am. Allied Ins., 290 Minn. 465 (1971)). However, a bankruptcy trustee “steps into the shoes of the debtor and is subject to any defenses that could be raised against the debtor, including the defense of in pari delicto.” Id. (citing Grassmueck v. Am. Shorthorn Ass’n, 402 F.3d 833, 836 (8th Cir. 2005)). The Eighth Circuit held that Minnesota law did not “cleanse” PCI of its wrongdoing, but merely liberated the receiver from such wrongdoing while acting in the capacity of receiver. Accordingly, the in pari delicto defense was not “extinguished” under Minnesota law. When Kelley shifted from receiver to bankruptcy trustee, “the custodian of the claims [against BMO] changed, but the claims did not. The claims entered the bankruptcy estate subject to a defense based on PCI’s previous fraudulent acts.” Id. at 906. As such, the Eighth Circuit distinguished between the rights and obligations of the corporation, which pass into bankruptcy subject to the in pari delicto defense, and the rights and obligations of the receiver, to whom Minnesota law offers a shield. In addition, the court notes the consistency of its ruling with that of the Second Circuit in Picard v. JPMorgan Chase & Co. (In re Bernard L. Madoff Inv. Sec. LLC), 721 F.3d 54 (2d Cir. 2013).
§ 3.10. Ninth Circuit
Mont. Dep’t of Revenue v. Blixseth (In re Blixseth), 112 F.4th 837 (9th Cir. 2024).
In this case, the Ninth Circuit reviewed both the application of the “collateral order doctrine” and the parameters of sovereign immunity in the context of an adversary proceeding against the Montana Department of Revenue (“MDOR”) for damages arising under section 303(i) of the Bankruptcy Code for a dismissed involuntary bankruptcy petition.
Following an audit of the debtor, Timothy Blixseth, and his business entities, three state taxing authorities, including MDOR, commenced an involuntary bankruptcy proceeding against Blixseth for unpaid taxes. After the other two state taxing authorities withdrew as petitioning creditors after settling with Blixseth, the bankruptcy court ultimately dismissed the involuntary petition for lack of the requisite number of petitioning creditors. Blixseth then brought an adversary proceeding against MDOR, seeking attorney’s fees and costs, damages, and sanctions against counsel pursuant to section 303(i) of the Bankruptcy Code. MDOR moved to dismiss on grounds of sovereign immunity. The bankruptcy court denied MDOR’s motion, finding that (i) MDOR had “voluntarily invoked the jurisdiction of [the bankruptcy] court by filing the [i]nvoluntary [p]etition,” id. at 842 (alterations in the original); (ii) MDOR’s counsel had “clear[ly] and unequivocal[ly] waive[d] [the State’s] sovereign immunity under the Eleventh Amendment regarding any future Section 303(i) claims,” id.; and (iii) MDOR’s sovereign immunity was explicitly waived under section 106(a)(1) of the Bankruptcy Code because the section 303(i) action was “ancillary to the bankruptcy court’s in rem jurisdiction,” id. When MDOR appealed to the Bankruptcy Appellate Panel (the “BAP”), the BAP dismissed the appeal for want of jurisdiction, finding that the “collateral order doctrine” did not apply.
On appeal, the Ninth Circuit first analyzed whether it had jurisdiction under the “collateral order doctrine.” Pursuant to the collateral order doctrine, an appellate court may review a non-final order addressing claims collateral to the underlying action if “the collateral claims are ‘too important to be denied review and too independent of the cause itself to require that appellate consideration be deferred until the whole case is adjudicated.” Id. at 843 (quoting Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541, 546 (1949)). Because both the Supreme Court and the Ninth Circuit had found that denials of sovereign immunity were immediately appealable under the collateral order doctrine, id. (first citing P.R. Aqueduct & Sewer Auth. v. Metcalf & Eddy, Inc., 506 U.S. 139, 144 (1993); and then Childs v. San Diego Family Hous. LLC, 22 F.4th 1092, 1095–96, 1096 n.2 (9th Cir. 2022)), the Ninth Circuit determined that the BAP had erred in failing to consider the merits of MDOR’s appeal.
Turning to the merits of the appeal, the Ninth Circuit found that the bankruptcy court had likewise erred when it concluded that MDOR was precluded from asserting sovereign immunity. First, the Ninth Circuit determined that MDOR only voluntarily invoked the jurisdiction of the bankruptcy court if it asserted a claim against the res of the debtor’s estate. Here, MDOR had not filed a proof of claim, and so a voluntary waiver of immunity could only be found if Blixseth’s section 303(i) claim arose from the same operative facts as MDOR’s filing of an involuntary petition under section 303(b). Because MDOR’s involuntary petition was based on Blixseth’s unpaid taxes, while Blixseth’s section 303(i) claim arose from the fact of the filing of the involuntary petition, the Ninth Circuit determined that the claims did not arise from the same operative facts, and thus, were insufficient to justify a waiver of sovereign immunity.
Next, the Court of Appeals considered MDOR’s supposed unequivocal waiver, made in a statement by MDOR’s counsel in a hearing before the bankruptcy court. The Ninth Circuit determined that an “unequivocal” consent to suit must be statutory, citing United States v. Nordic Vill., Inc., 503 U.S. 30, 37 (1992). Accordingly, MDOR’s counsel was not capable of waiving MDOR’s sovereign immunity through in-court statements.
Finally, the Ninth Circuit considered whether the section 303(i) claim was “ancillary” to the bankruptcy court’s in rem jurisdiction to justify a waiver of MDOR’s sovereign immunity. In so doing, the Ninth Circuit first noted that the bankruptcy court had erred in relying on section 106(a)(1)’s abrogation of sovereign immunity, based on earlier precedent determining that section 106(a) was “an unconstitutional assertion of Congress’s power.” Id. at 845 (quoting Mitchell v. Cal. Franchise Tax Bd. (In re Mitchell), 209 F.3d 1111, 1120 (9th Cir. 2000)). The Ninth Circuit panel then went on to consider whether the adversary proceeding brought by Blixseth, seeking section 303(i) damages, was “necessary to effectuate the in rem jurisdiction of the bankruptcy courts,” as delineated in Central Virginia. Community College v. Katz, 546 U.S. 356 (2006). 112 F.4th at 847 (quoting State of Fla. Dept. of Revenue v. Diaz (In re Diaz), 647 F.3d 1073, 1086 (11th Cir. 2011)). Because an adversary proceeding under section 303(i) did not concern the res of the bankruptcy estate and did not further the debtor’s “fresh start,” the Ninth Circuit held that waiving MDOR’s right to sovereign immunity solely on the basis of filing an involuntary bankruptcy petition was an impermissible expansion of the limited waiver of sovereign immunity. Accordingly, the Ninth Circuit reversed the bankruptcy court, finding that MDOR had properly invoked sovereign immunity.
In re PG&E Corp. Sec. Litig. (Pub. Emps. Ret. Ass’n of N.M. v. Earley), 100 F.4th 1076 (9th Cir. 2024).
In this interlocutory appeal, the Ninth Circuit determined that the district court had abused its discretion when it extended the automatic stay, sua sponte, to certain individual co-defendants of PG&E Corporation and Pacific Gas & Electric Company (together, “PG&E”) to halt a pending putative securities class action.
In the wake of the 2017 and 2018 Northern California wildfires, certain shareholders of PG&E (the “Plaintiffs”) brought a putative class action (the “Class Action”) in district court against PG&E and certain of its current and former officers, directors, and bond underwriters (collectively, the “Individual Defendants”), alleging false or misleading statements pertaining to PG&E’s wildfire-safety policies and regulatory oversight. When PG&E commenced bankruptcy proceedings in January 2019, the Class Action was automatically stayed as to PG&E pursuant to section 362 of the Bankruptcy Code. However, the Class Action continued as to the Individual Defendants, who filed motions to dismiss in October 2019. Despite briefing being completed by January 2020, the district court did not take any further action until April 2021, when it, sua sponte, issued a Notice of Intent to Stay the Class Action pending completion of the claims process established pursuant to PG&E’s plan of reorganization, which had become effective in July 2020. Although the Plaintiffs objected, the district court issued an order in September 2022 staying the Class Action in the name of judicial efficiency, citing the overlap between the securities claims brought in the PG&E bankruptcy proceedings and the claims at issue in the Class Action. The Plaintiffs timely appealed.
As a preliminary matter, the Ninth Circuit first addressed the issue of appellate jurisdiction over an interlocutory appeal. Although appellate jurisdiction typically depends on entry of a final order—which a stay order is not—the Ninth Circuit considered the precedent established in Moses H. Cone Memorial Hosp. v. Mercury Construction Corp., 460 U.S. 1 (1983), which held that “a stay order is appealable as a final decision under 28 U.S.C. § 1291 if the order places the plaintiff ‘effectively out of court.’” 100 F.4th at 1084 (citing Moses H. Cone, 460 U.S. at 9). Here, because the stay was imposed until the PG&E claims process was fully resolved—a process that expert testimony established would take years—the stay was both sufficiently lengthy and indefinite to afford the Ninth Circuit appellate jurisdiction under the Moses H. Cone doctrine.
Having determined that the Ninth Circuit had jurisdiction to review the merits of the district court’s stay order, the Ninth Circuit then turned to the question of whether the district court had abused its discretion by staying the Class Action pending resolution of the PG&E bankruptcy proceedings. Although the district court cited judicial efficiency in its order, the Plaintiffs and the Individual Defendants disputed whether there were any judicial efficiencies to be gained by staying the Class Action. The Ninth Circuit ultimately concluded that, while there were efficiencies in allowing the bankruptcy process to proceed first, the district court was also obligated to analyze any prejudice caused by the imposition of the stay. Because the district court failed to consider the prejudice to the Plaintiffs in delaying their opportunity to litigate the Class Action until the PG&E bankruptcy had been resolved, the Ninth Circuit vacated the stay and remanded for further consideration of the prejudice to the Plaintiffs from imposition of the stay.
§ 3.11. Tenth Circuit
Montoya v. Goldstein (In re Chuza Oil Co.), 88 F.4th 849 (10th Cir. 2023).
Affirming the bankruptcy court and reversing the Bankruptcy Appellate Panel (the “BAP”), the Tenth Circuit analyzed the doctrine of earmarking as a defense to certain avoidance actions brought by the chapter 7 trustee.
The debtor, Chuza Oil Co. (“Chuza”), was a New Mexico petroleum company that was operated by an individual named Bobby Goldstein. In 2012, Goldstein’s father loaned Chuza $500,000 under a promissory note (the “Note”), guaranteed by Goldstein and another of Goldstein’s companies, Bobby Goldstein Productions, Inc. (“BGPI”). After Goldstein’s father passed away, Goldstein’s mother, Paula, held the Note.
In 2014, Chuza filed for protection under chapter 11 of the Bankruptcy Code. The bankruptcy court confirmed a plan of reorganization in March 2016, which provided for the subordination of insider unsecured creditors, like Paula. However, Chuza’s financial situation did not improve after exiting chapter 11. Between September 2016 and December 2017, Goldstein, Paula, and BGPI loaned nearly $500,000 to Chuza to keep the business in operation. Chuza then transferred approximately $50,000 to Paula as payment on the Note, even though it had not paid all remaining claims with higher priorities under the chapter 11 plan. Goldstein later testified that the $50,000 was only loaned to Chuza on the condition that it was used to repay the Note.
In July 2018, Chuza was pushed into an involuntary chapter 7 bankruptcy. The chapter 7 trustee (the “Trustee”) initiated an adversary proceeding to avoid the transfers to Paula as preferential transfers under Bankruptcy Code section 547(b), intentionally fraudulent transfers under Bankruptcy Code section 548(a)(1)(A), and constructively fraudulent transfers under Bankruptcy Code section 548(a)(1)(B). The bankruptcy court ruled against the Trustee, holding, in the first instance, that Chuza did not have an interest in the funds transferred since they were earmarked to repay Paula; and, in the second instance, that (i) the transfers were not preferences because they were part of an contemporaneous exchange for new value; (ii) there was no intent to commit fraud, as require to assert an intentionally fraudulent transfer claim; and (iii) Chuza had received reasonably equivalent value for the transfers, and thus the transfers could not be constructively fraudulent. The Trustee appealed to the BAP, which reversed the bankruptcy court’s ruling, finding that the transfers diminished Chuza’s estate by replacing debt subordinated under the plan with unsubordinated debt. The BAP also found that there was never an “exchange” of value, as required for both the contemporaneous exchange defense to a preferential transfer claim and the reasonably equivalent defense to a constructively fraudulent transfer claim.
On appeal, the Tenth Circuit first analyzed the earmarking doctrine, through which a court analyzes whether a debtor has an “interest” in property it transferred away from itself. Under Tenth Circuit precedent, a debtor must establish that it did not have an interest in the transferred property under both (i) the “dominion and control” test and (ii) the “diminution of the estate” test to establish that the debtor did not have an interest in the property that might be avoidable. Under the “dominion and control” test, the Tenth Circuit found that the bankruptcy court had not erred when it accepted Goldstein’s testimony that the funds loaned to Chuza were loaned on the condition that some of the money would be used to repay Paula. As a result of this condition, Chuza did not have “control” of the funds.
As to the “diminution of the estate” test, the Court of Appeals noted two plausible interpretations of the transfers at issue: either the payments harmed other unsecured creditors because the transfers had the net effect of exchanging Paula’s subordinated debt for non-subordinated debt owed to Goldstein and BGPI, or the payments net benefitted creditors the estate received approximately $450,000 which was not earmarked. The bankruptcy court accepted the latter explanation, and the Tenth Circuit could not find error in such determination.
Finally, the Tenth Circuit considered whether the bankruptcy court erred in finding that there was both a contemporaneous exchange of value and a reasonably equivalent exchange of value for purposes of the statutory exceptions to the preference and constructive fraudulent transfer claims. Again, the Tenth Circuit found that there were two plausible interpretations—that Goldstein loaned the entirety of the borrowed amount to Chuza on the condition that only a portion was paid to Paula versus that Goldstein loaned only the specific amounts that were ultimately earmarked for Paula to Chuza for that purpose. If the former interpretation prevailed, the statutory exceptions applied to the transfers; but not if the latter interpretation prevailed. Determining that both were plausible, the Tenth Circuit found no error in the bankruptcy court’s conclusion that the first interpretation applied.
§ 3.12. Eleventh Circuit
Bay Point Cap. Partners II LP v. Thomas Switch Holding, LLC (In re Virtual Citadel, Inc.), 113 F.4th 1304 (11th Cir. 2024).
In this case, the Eleventh Circuit was confronted with the issue of how to properly value crypto mining assets. In affirming the bankruptcy court’s findings, the Eleventh Circuit held that a property with certain enhancements designed to facilitate the massive energy consumption required attendant to bitcoin mining can qualify as a “special purpose property.”
The debtors were two related crypto businesses that were located on two adjacent properties. One property housed a bitcoin mining operation and the other housed a data storage center. Following the owner’s death, the businesses commenced chapter 11 proceedings, pursuant to which the businesses, including the properties, were sold together for $4.9 million. A transfer tax of $2,450 on each property supported an equal split between the properties of $2.45 million each. The purchaser who had bought the properties specifically intended to make use of the existing bitcoin mining infrastructure.
Pursuant to the sale order, the bankruptcy court ordered the escrow of $700,000 of the sale proceeds, pending determination of the value of the liens of secured creditor, Thomas Switch Holding (“Switch”). If the bitcoin mining property was valued at $700,000 or higher, then Switch would receive the full escrow amount; otherwise, Switch would receive the valuation amount and another creditor, Bay Point Capital (“Bay Point”), would receive the remaining escrow amount.
After a bench trial, which included expert testimony from both Switch and Bay Point, the bankruptcy court determined that the value of the mining property exceeded $700,000, based on a cost approach. This result largely adopted the testimony from Switch’s expert, which the bankruptcy court found was the most reliable because it accounted for improvements to the property that allowed the property to be used for bitcoin mining. Because the highest and best use for the property was as a bitcoin mining operation, the bankruptcy court also determined that the property was a “special purpose property.” The bankruptcy court likewise found that, although the tax stamp valuation was not deserving of much weight, a $2.45 million estimated value militated in favor of a total valuation for the mining property in excess of $700,000. By contrast, Bay Point’s expert valued the mining property at $48,000, based on comparisons to other properties of comparable size that could be put to “light industrial use.” Bay Point appealed to the district court, which affirmed the bankruptcy court’s decision.
On appeal to the Eleventh Circuit, Bay Point argued: (i) the bankruptcy court erred in determining that property was a special purpose property with the highest and best use of bitcoin mining; (ii) the bankruptcy court erred as a matter of law when it selected the cost approach, instead of the sales comparison approach, to value the mining property; and (iii) the bankruptcy court clearly erred when, as part of its valuation, it considered the tax stamp value of the property. First, the Eleventh Circuit found that the mining property was a special purpose property because, among other things, the improvements to the property allowed it to be used for bitcoin mining. While the property could be used for other purposes, valuing the property for generalized “light industrial use” would be a waste of the infrastructure investments to the property. Next, having determined that the property was a special purpose property, the Eleventh Circuit concluded that the bankruptcy court correctly used the cost approach in arriving at its valuation. A comparison approach was disfavored for unique assets. Finally, the Eleventh Circuit found that the bankruptcy court appropriately weighed the evidence concerning the tax stamp value.
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