Editors

Chelsea Mikula

Tucker Ellis LLP
950 Main Avenue, Suite 1100
Cleveland, OH 44113
216-696-2476
[email protected]

Giovanna Ferrari

Seyfarth Shaw LLP
560 Mission Street, Suite 3100
San Francisco, CA 94105
415-544-1019
[email protected]

§1.1 Introduction

Trial lawyers eagerly anticipate the day they begin opening statements in the courtroom and get to take their client’s matter to trial. With a trial comes a lot of hard work, preparation, and navigation of the civil rules and local rules of the jurisdiction. This chapter provides a general overview of issues that a lawyer will face in a courtroom, either civil or criminal. The authors have selected cases of note from the present United States Supreme Court docket, the federal Circuit Courts of Appeals, and selected federal District Courts, that provide a general overview, raise unique issues, expand or provide particularly instructive explanations or rationales, or are likely to be of interest to a broad cross section of the bar. It is imperative, however, that prior to starting trial, the rules of the applicable jurisdiction are reviewed.

§1.2 Pretrial Matters

§ 1.2.1 Pretrial Conference and Pretrial Order

Virtually all courts require a pretrial conference at least several weeks before the start of trial. A pretrial conference requires careful preparation because it sets the tone for the trial itself. There are no uniform rules across all courts, so practitioners must be fully familiar with those that affect the particular courtroom they are in and the specific judge before whom they will appear.

According to Federal Rule of Civil Procedure 16, the main purpose of a pretrial conference is for the court to establish control over the proceedings such that neither party can achieve significant delay or engage in wasteful pretrial activities.[1] An additional goal is facilitating settlement before trial commencement.[2] Following the pretrial conference, the judge will issue a scheduling order, which “must limit the time to join other parties, amend the pleadings, complete discovery, and file [pre-trial] motions.”[3]

A proposed pretrial conference order should be submitted to the court for review at the conference. Once the judge accepts the pre-trial conference order, the order will supersede all pleadings in the case.[4] The final pretrial conference order is separate from pretrial disclosures, which include all information and documents required to be disclosed under Federal Rule of Civil Procedure 26.[5]

§ 1.2.2 Motions in Limine

A motion in limine, which means “at the threshold,”[6] is a pre-trial motion for a preliminary decision on an objection or offer of proof. Motions in limine are important because they ensure that the jury is not exposed to unfairly prejudicial, confusing, or irrelevant evidence, even if doing so limits a party’s defenses.[7] Thus, a motion in limine is designed to narrow the evidentiary issues for trial and to eliminate unnecessary trial interruptions by excluding the document before it is entered into evidence.[8]

In ruling on a motion in limine, the trial judge has discretion to either rule on the motion definitively or postpone a ruling until trial.[9] Alternatively, the trial judge may make a tentative or qualified ruling.[10] While definitive rulings do not require a renewed offer of proof at trial,[11] a tentative or qualified ruling might well require an offer of evidence at trial to preserve the issue on appeal.[12] A trial court’s discretion in ruling on a motion in limine extends not only to the substantive evidentiary ruling, but also the threshold question of whether a motion in limine presents an evidentiary issue that is appropriate for ruling in advance of trial.[13]

Motions in limine are not favored and many courts consider it a better practice to deal with questions as to the admissibility of evidence as they arise at trial.[14]

§1.3 Opening Statements

One of the most important components of any trial is the opening statement—it can set the roadmap for the jury of how they can find in favor of your client. The purpose of an opening statement is to:

“acquaint the jury with the nature of the case they have been selected to consider, advise them briefly regarding the testimony which it is expected will be introduced to establish the issues involved, and generally give them an understanding of the case from the viewpoint of counsel making a statement, so that they will be better able to comprehend the case as the trial proceeds.”[15]

It is important that any opening statement has a theme or presents the central theory of your case. As a general rule, a lawyer presents facts and evidence, and not argument, during opening statements. Being argumentative and introducing statements that are not evidence can be grounds for a mistrial.[16] It is also important that counsel keep in mind any rulings on motions in limine prohibiting the use of certain evidence. Failure to raise an objection to matters subject to a motion in limine or other prejudicial arguments can result in the waiver of those rights on appeal.[17] And the “golden rule” for opening statements is that the jurors should not be asked to place themselves in the position of the party to the case.[18]

§1.4 Selection of Jury

§1.4.1 Right to Fair and Impartial Jury

The right to a fair and impartial jury is an important part of the American legal system. The right originates in the Sixth Amendment, which grants all criminal defendants the right to an impartial jury.[19] However, today, this foundational right applies in both criminal and civil cases.[20] This is because the Seventh Amendment preserves “the right of trial by jury” in civil cases, and an inherent part of the right to trial by jury is that the jury must be impartial.[21] Additionally, Congress cemented this right when it passed legislation requiring “that federal juries in both civil and criminal cases be ‘selected at random from a fair cross section of the community in the district or division where the court convenes.’”[22]

Examples of ways that jurors may not be impartial include: predispositions about the proper outcome of a case,[23] financial interests in the outcome of a case,[24] general biases against the race or gender of a party,[25] or general biases for or against certain punishments to be imposed.[26]

Over the years, impartiality has become more and more difficult to achieve. This is due mainly to citizens’ (potential jurors) readily available access to news, and the news media’s increased publicity of defendants and trials.[27] In Harris, the Ninth Circuit analyzed whether pre‑trial publicity of a murder trial biased prospective jurors and prejudiced the defendant’s ability to receive a fair trial.[28] The court recognized that “[p]rejudice is presumed when the record demonstrates that the community where the trial was held was saturated with prejudicial and inflammatory media publicity about the crime.”[29] However, the court found that despite immense publicity prior to trial, because the publicity was not inflammatory but rather factual, there was no evidence of prejudice in the case.[30]

§1.4.2 Right to Trial by Jury

All criminal defendants are entitled to a trial by jury and must waive this right if they elect a bench trial instead.[31] However, a criminal defendant does not have a constitutional right to a bench trial if he or she decides to waive the right to trial by jury.[32] In civil cases, the party must expressly demand a jury trial. Failure to make such a demand constitutes a waiver by that party of a trial by jury.[33] For example, in Hopkins, the Eleventh Circuit explained that a plaintiff waived his right to trial by jury in an employment discrimination case when he made no demand for a jury trial in his Complaint and did not file a separate demand for jury trial within 14 days after filing his complaint.[34]

Additionally, not all civil cases are entitled to a trial by jury. First, the Seventh Amendment expressly requires that the amount in controversy exceed $20.[35] Additionally, only those civil cases involving legal, rather than equitable, issues are entitled to the right of trial by jury.[36] Equitable issues often arise in employment discrimination cases where the plaintiff seeks backpay or another sort of compensation under the ADA, ERISA, or FMLA.[37]

Another issue that arises in civil cases is contractual jury trial waivers. Most circuits permit parties to waive the right to a jury trial through prior contractual agreement.[38] Generally, the party seeking enforcement of the waiver “must show that consent to the waiver was both voluntary and informed.”[39]

§1.4.3 Voir Dire

Voir dire is a process of questioning prospective jurors by the judge and/or attorneys who remove jurors who are biased, prejudiced, or otherwise unfit to serve on the jury.[40] The Supreme Court has explained that “voir dire examination serves the dual purposes of enabling the court to select an impartial jury and assisting counsel in exercising peremptory challenges.”[41]

Generally, an oath should be administered to prospective jurors before they are asked questions during voir dire.[42] “While the administration of an oath is not necessary, it is a formality that tends to impress upon the jurors the gravity with which the court views its admonition and is also reassuring to the litigants.”[43] Moreover, jurors under oath are presumed to have faithfully performed their official duties.[44]

Federal trial judges have great discretion in deciding what questions are asked to prospective jurors during voir dire.[45] District judges may permit the parties’ lawyers to conduct voir dire, or the court may conduct the jurors’ examination itself.[46] Although trial attorneys often prefer to conduct voir dire themselves, many judges believe that counsel’s involvement “results in undue expenditure of time in the jury selection process,” and that “the district court is the most efficient and effective way to assure an impartial jury and evenhanded administration of justice.”[47]

“[I]f the court conducts the examination it must either permit the parties or their attorneys to supplement the examination by such further inquiry as the court deems proper or itself submit to the prospective jurors such additional questions of the parties or their attorneys as the court deems proper.”[48] However, a judge still has much leeway in determining what questions an attorney may ask.[49] For example, in Lawes, a firearm possession case, the Second Circuit found that it was proper for a trial judge to refuse to ask jurors questions about their attitudes towards police.[50] If, on appeal, a party challenges a judge’s ruling from voir dire, the party must demonstrate that trial judge’s decision constituted an abuse of discretion.[51] Thus, it is extremely difficult to win an appeal regarding voir dire questioning.[52]

§1.4.4 Ground for Challenge

A challenge “for cause” is a request to dismiss a prospective juror because the juror is unqualified to serve, or because of demonstrated bias, an inability to follow the law, or if the juror is unable to perform the duties of a juror. 18 U.S.C. § 1865 sets forth juror qualifications and lists five reasons a judge may strike a juror: (1) if the juror is not a citizen of the United States at least 18 years old, who has resided within the judicial district at least one year; (2) is unable to read, write, or understand English enough to fill out the juror qualification form; (3) is unable to speak English; (4) is incapable, by reason of mental or physical infirmity, to render jury service; or (5) has a criminal charge pending against him, or has been convicted of a state or federal crime punishable by imprisonment for more than one year.[53]

In addition to striking a juror for these reasons, an attorney may also request to strike a juror “for cause” under 28 U.S.C. § 1866(c)(2) “on the ground that such person may be unable to render impartial jury service or that his service as a juror would be likely to disrupt the proceedings.”[54]

A challenge “for cause” is proper where the court finds the juror has a bias that is so strong as to interfere with his or her ability to properly consider evidence or follow the law.[55] Bias can be shown either by the juror’s own admission of bias or by proof of specific facts that show the juror has such a close connection to the parties, or the facts at trial, that bias can be presumed. The following cases illustrate examples of challenges for cause:

• S. v. Price: The Fifth Circuit explained that prior jury service during the same term of court is not by itself sufficient to support a challenge for cause. A juror may only be dismissed for cause because of prior service if it can be shown by specific evidence that the juror has been biased by the prior service.[56]
• Chestnut v. Ford Motor Co.: The Fourth Circuit held that the failure to sustain a challenge to a juror owning 100 shares of stock in defendant Ford Motor Company (worth about $5000) was reversible error.[57]
• United States v. Chapdelaine: The First Circuit found that it was permissible for trial court not to exclude for cause jurors who had read a newspaper that indicated co‑defendants had pled guilty before trial.[58]
• Leibstein v. LaFarge N. Am., Inc.: Prospective juror’s alleged failure to disclose during voir dire that he had once been defendant in civil case did not constitute misconduct sufficient to warrant new trial in products liability action.[59]
• Cravens v. Smith: The Eighth Circuit found that the district court did not abuse its discretion in striking a juror for cause based on that juror’s “strong responses regarding his disfavor of insurance companies.”[60]

§1.4.5 Peremptory Challenge

In addition to challenges for cause, each party also has a right to peremptory challenges.[61] A peremptory challenge permits parties to strike a prospective juror without stating a reason or cause.[62] “In civil cases, each party shall be entitled to three peremptory challenges. Several defendants or several plaintiffs may be considered as a single party for the purposes of making challenges, or the court may allow additional peremptory challenges and permit them to be exercised separately or jointly.”[63]

Parties can move for additional peremptory challenges.[64] This is common in cases where there are multiple defendants. For example, in Stephens, two civil codefendants moved for additional peremptory challenges so that each defendant could have three challenges (totaling six peremptory challenges for the defense).[65] In deciding whether to grant the defendants’ motion, the court recognized that trial judges have great discretion in awarding additional peremptory challenges, and that additional challenges may be especially warranted when co-defendants have asserted claims against each other.[66] The court in Stephens ultimately granted the defendants’ motion for additional challenges.[67]

Parties may not use peremptory challenges to exclude jurors on the basis of their race, gender, or national origin.[68] Although “[a]n individual does not have a right to sit on any particular petit jury, . . . he or she does possess the right not to be excluded from one on account of race.”[69] When one party asserts that another’s peremptory challenges seek to exclude jurors on inappropriate grounds under Batson, the party challenged must demonstrate a legitimate explanation for its strikes, after which the challenging party has the burden to show that the legitimate explanation was pre-textual.[70] The ultimate determination of the propriety of a challenge is within the discretion of the trial court, and appellate courts review Batson challenges under harmless error analysis.[71]

Finally, some courts have found that it is reversible error for a trial judge to require an attorney to use peremptory challenges when the juror should have been excused for cause. “The district court is compelled to excuse a potential juror when bias is discovered during voir dire, as the failure to do so may require the litigant to exhaust peremptory challenges on persons who should have been excused for cause. This result, of course, extinguishes the very purpose behind the right to exercise peremptory challenges.”[72] However, courts also acknowledge that an appeal is not the best way to deal with biased jurors. The Eighth Circuit recognized that “challenges for cause and rulings upon them . . . are fast paced, made on the spot and under pressure. Counsel as well as court, in that setting, must be prepared to decide, often between shades of gray, by the minute.”[73]

§1.5 Examination of Witnesses

§1.5.1 Direct Examination

Direct examination is the first questioning of a witness in a case by the party on whose behalf the witness has been called to testify.[74] Pursuant to Fed. R. Evid. 611(c), leading questions, i.e., those suggesting the answer, are not permitted on direct examination unless necessary to develop the witness’ testimony.[75] Leading questions are permitted as “necessary to develop testimony” in the following circumstances:

• To establish undisputed preliminary or inconsequential matters.[76]
• If the witness is hostile or unwilling.[77]
• If the witness is a child, or an adult with communication problems due to a mental or physical disability.[78]
• If the witness’s recollection is exhausted.[79]
• If the witness is being impeached by the party calling him or her.[80]
• If the witness is frightened, nervous, or upset while testifying.[81]
• If the witness is unresponsive or shows a lack of understanding.[82]

Additionally, it is improper for a lawyer to bolster the credibility of a witness during direct examination by evidence of specific instances of conduct or otherwise.[83] Bolstering occurs either when (1) a lawyer suggests that the witness’s testimony is corroborated by evidence known to the lawyer, but not the jury,[84] or (2) when a lawyer asks a witness a question about specific instances of truthfulness or honesty to establish credibility.[85] For instance, in Raysor, the Second Circuit found that it was improper for a witness to bolster herself on direct examination by testifying about her religion or faithful marriage.[86]

When a party calls an adverse party, or someone associated with an adverse party, the attorney has more leeway during direct examination. This is because adverse parties may be predisposed against the party direct-examining him. Because of this, the attorney may ask leading questions, and impeach or contradict the adverse witness.[87] Courts have broadened who they consider to be “associated with” or “identified with” an adverse party. Employees, significant others, and informants have all constituted adverse parties for purposes of direct examination.[88] Further, even if the witness is not adverse, an attorney may also ask leading questions to a witness who is hostile. In order to ask such leading questions, the direct examiner must demonstrate that the witness will be resistant to suggestion. This often involves first asking the witness non-leading questions in order to show that the witness is biased against the direct examiner.[89]

When a witness cannot recall a fact or event, the lawyer is permitted to help refresh that witness’s memory.[90] The lawyer may do so by providing the witness with an item to help the witness recall the fact or event. Proper foundation before such refreshment requires that:

the witness’s recollection to be exhausted, and that the time, place and person to whom the statement was given be identified. When the court is satisfied that the memorandum on its face reflects the witness’s statement or one the witness acknowledges, and in his discretion the court is further satisfied that it may be of help in refreshing the person’s memory, the witness should be allowed to refer to the document.[91]

However, the item/memorandum does not come into evidence.[92] In Rush, the Sixth Circuit found that although the trial judge properly permitted defense counsel to refresh a witness’s memory with the transcript of a previously recorded statement, the trial judge erred in allowing another witness to read that transcript aloud to the jury.[93]

Further, sometimes the party calling a witness wishes to impeach that witness. Generally, courts are hesitant to permit parties to impeach their own witnesses because the party who calls a witness is vouching for the trustworthiness of that witness, and allowing impeachment may confuse the jury or be unfairly prejudicial.[94] Prior to adoption of the Federal Rules of Evidence, a party could impeach its own witness only when the witness’s testimony both surprised and affirmatively damaged the calling party.[95]

However, Federal Rule of Evidence 607 states that “the credibility of a witness may be attacked by any party, including the party calling the witness.”[96] The Advisory Committee Notes of Rule 607 indicate that this rule repudiates the surprise and injury requirement from common law.[97] A party can impeach a witness through prior inconsistent statements, cross-examination, or prior evidence from other sources.[98] However, a party may not use Rule 607 to introduce otherwise inadmissible evidence to the jury.[99] Additionally, a party may not call a witness with the sole purpose of impeaching him.[100] Further, even courts that don’t permit a party to impeach its own witness still permit parties to contradict their own witnesses through another part of that witness’s testimony.[101]

§1.5.2 Cross-Examination

Cross-examination provides the opposing party an opportunity to challenge what a witness said on direct examination, discredit the witness’s truthfulness, and bring out any other testimony that may be favorable to the opposing party’s case.[102] Generally under the federal rules, cross-examination is limited to the “subject matter” of the direct examination and any matters affecting the credibility of the witness.[103] The purpose of limiting the scope of cross-examination is to promote regularity and logic in jury trials, and ensure that each party has the opportunity to present its case in chief. However, courts tend to liberally construe what falls within the “subject matter” of direct examination.[104] For example, in Perez-Solis, the Fifth Circuit found that a witness’s brief reference to collecting money from a friend permitted opposing counsel to cross-examine him on all of his finances.[105] Additionally, the language of Fed. R. Evid. 611(b) states that although cross-examination “should not” go beyond the scope of direct examination, the court may exercise its discretion to “allow inquiry into additional matters as if on direct examination.”[106] However, if the questioning goes beyond the subject matter, it generally should not include leading questions.

One of the main goals of cross-examination is impeachment. The Federal Rules of Evidence explain three different methods of impeachment: (1) impeachment by prior bad acts or character for untruthfulness,[107] (2) impeachment by prior conviction of a qualifying crime,[108] and (3) impeachment by prior inconsistent statement.[109] Additionally, courts still apply common law principles and permit impeachment through three additional methods as well: (1) impeachment by demonstrating the witness’s bias, prejudice, or interest in the litigation or in testifying, (2) impeachment by demonstrating the witness’s incapacity to accurately perceive the facts, and (3) impeachment by showing contradictory evidence to the witness’s testimony in court.[110] The following present case examples of each of the six methods of impeachment:

• Prior bad Act or Dishonesty: In O’Connor v. Venore Transp. Co.,[111] the First Circuit found that trial judge did not abuse discretion when he allowed defense counsel to cross-examine plaintiff with his prior tax returns with the purpose of demonstrating dishonesty.
• Conviction of qualifying crime: In Smith v. Tidewater Marine Towing, Inc.,[112] the Fifth Circuit found that, in Jones Act action arising from injuries plaintiff received while working on a tugboat, defense counsel permissibly crossed the plaintiff about his prior convictions.
• Prior inconsistent statement: In Wilson v. Bradlees of New England, Inc.,[113] a product liability case, the First Circuit found that defense counsel appropriately crossed plaintiff with an inconsistent statement made in a complaint filed in a different case against a different defendant.
• Bias or prejudice: In Udemba v. Nicoli,[114] the First Circuit found that it was permissible for defense counsel to cross-examine the plaintiff’s wife about domestic abuse to show bias in a case involving excessive force claims against the police.
• Incapacity to accurately perceive: In Hargrave v. McKee,[115] the Sixth Circuit found that the trial court should have permitted defense counsel to question a victim about how her ongoing psychiatric problems affected her perception and memory of events.
• Contradictory evidence: In Barrera v. E. R. DuPont De Nemours and Co., Inc.,[116] the Fifth Circuit held, in a personal-injury action, that the trial judge erred in denying the use of evidence showing that plaintiff received over $1000 per month in social security benefits because the evidence was admissible to contradict defendant’s volunteered testimony on cross-examination that he did not have a “penny in his pocket.”

Once the right of cross-examination has been fully and fairly exercised, it is within the trial court’s discretion as to whether further cross-examination should be allowed.[117] In order to recall a witness, the party must show that the new cross-examination will shed additional light on the issues being tried or impeach the witness. Further, it is helpful if the party seeking recall demonstrates that it came into possession of additional evidence or information that it did not have when it previously crossed that witness.[118] Further, it is difficult to succeed on an appeal of a trial court’s failure to permit recall for further cross‑examination. This is because courts review a trial judge’s decision for abuse of discretion, and often find that the lack of recall was a harmless error.[119]

§1.5.3 Expert Witnesses

Experts are witnesses who offer opinion testimony on an aspect of the case that requires specialized knowledge or experience. Experts also include persons who do not testify, but who advise attorneys on a technical or specialized area to better help them prepare their cases. A few key criteria should be considered at the outset when choosing an expert. First is the level of relevant expertise and the ability to have the expert’s research, assumptions, methodologies, and practices stand up to the scrutiny of cross-examination. Many law firms, nonprofits, commercial services, and government agencies maintain lists of experts categorized by the expertise; those lists are a helpful place to begin. Alternatively, counsel may begin by researching persons who have spoken or written about the subject matter that requires expert testimony. An Internet search is, in many cases, the place to start when developing a list. Counsel also might consider using a legal search engine to identify persons who have provided expert testimony on the subject matter in the past. Westlaw and LexisNexis both maintain expert databases.

Any expert who is on counsel’s list of candidates should produce, in addition to his or her curriculum vitae (CV), a list of prior court and deposition appearances, as well as a list of publications over the last 10 years. In federal court, this information must be disclosed in the expert report, per Federal Rule of Civil Procedure 26(a)(2).[120]

Another consideration when retaining an expert is whether he or she will be a testifying expert, or whether the expert will only act in a consulting role in preparing the case for trial (non-testifying expert) because this will determine the discoverability of the expert’s opinions. Testifying experts’ opinion are always discoverable, while consulting experts’ opinions are nearly always protected from discovery.

A testifying expert must be qualified, and the proponent of an expert witness bears the burden of establishing the admissibility of the expert’s testimony by a preponderance of the evidence. Federal Rule of Evidence 702 sets forth a standard for admissibility, wherein a witness may be qualified as an expert by knowledge, skill, experience, training or education and may testify in the form of an opinion if they meet certain criteria. It is for the trial court judge to determine whether or not “an expert’s testimony both rests on a reliable foundation and is relevant to the task at hand,” thereby making it admissible.[121]

§1.6 Evidence at Trial

§1.6.1 Authentication of Evidence

With the exception of exhibits as to which authenticity is acknowledged by stipulation, admission, judicial notice, or exhibits which are self-authenticating, no exhibit will be received in evidence unless it is first authenticated or identified as being what it purports to be. Under the Federal Rules of Evidence, the authentication requirement is satisfied when “the proponent . . . produce[s] evidence sufficient to support a finding that the item is what the proponent claims it is.”[122]

When an item is offered into evidence, the court may permit counsel to conduct a limited cross-examination on the foundation offered. In reaching its determination, the court must view all the evidence introduced as to authentication or identification, including issues of credibility, most favorably to the proponent.[123] Of course, the party who opposed introduction of the evidence may still offer contradictory evidence before the trier of fact or challenge the credibility of the supporting proof in the same way that he can dispute any other testimony.[124] However, upon consideration of the evidence as a whole, if a sufficient foundation has been laid in support of introduction, contradictory evidence goes to the weight to be assigned by the trier of fact and not to admissibility.[125] It is important to note that many courts have held that the mere production of a document in discovery waives any argument as to its authenticity.[126]

While there are many topics to discuss regarding authentication of evidence, this section will focus on electronically stored information. Proper authentication of e-mails and other instant communications, as well as all computerized records, is of critical importance in an ever-increasing number of cases, not only because of the centrality of such data and communications to modern business and society in general, but also due to the ease in which such electronic materials can be created, altered, and manipulated. In the ordinary course of events, a witness who has seen the e-mail in question need only testify that the printout offered as an exhibit is an accurate reproduction.

• Web print out – Printouts of Internet website pages must first be authenticated as accurately reflecting the content of the page and the image of the page on the computer at which the printout was made before they can be introduced into evidence; then, to be relevant and material to the case at hand, the printouts often will need to be further authenticated as having been posted by a particular source.[127]
• Text message – When there has been an objection to admissibility of a text message, the proponent of the evidence must explain the purpose for which the text message is being offered and provide sufficient direct or circumstantial corroborating evidence of authorship in order to authenticate the text message as a condition precedent to its admission; thus, authenticating a text message or e-mail may be done in much the same way as authenticating a telephone call.[128]
• Social networking services – Proper inquiry for determining whether a proponent has properly authenticated evidence derived from social networking services was whether the proponent adduced sufficient evidence to support a finding by a reasonable jury that the proffered evidence was what the proponent claimed it to be.[129]

§1.6.2 Objecting to Evidence

Objections must be specific. The party objecting to evidence must make known to the court and the parties the precise ground on which the objecting party is basing the objection.[130] The objecting party must also be sure to indicate the particular portion of the evidence that is objectionable.[131] However, a general objection may be permitted if the evidence is clearly inadmissible for any purpose or if the only possible grounds for objection is obvious.[132]

The purpose of a specific objection to evidence is to preserve the issue on appeal. On appeal, the objecting party will be limited to the specific objections to evidence made at trial. However, an objection raised by a party in writing is sufficiently preserved for appeal, even if that same party subsequently failed to make an oral, on-the-record objection.[133]

Objections to evidence must be timely so as to not allow a party to wait and see whether an answer is favorable before raising an objection.[134] Failure to timely object results in the evidence being admitted. Once the evidence is admitted and becomes part of the trial record, it may be considered by the jury in deliberations, the trial court in ruling on motions, and a reviewing court determining the sufficiency of the evidence.[135] In some instances, the trial judge may prohibit counsel from giving descriptions of the basis for his or her objections. However, the attorney must still attempt to get in the specific grounds for the objection on the record.[136]

§1.6.3 Offer of Proof

If evidence is excluded by the trial court, the party offering the evidence must make an offer of proof to preserve the issue on appeal.[137] For an offer of proof to be adequate to preserve an issue on appeal, counsel must state both the theory of admissibility and the content of the excluded evidence.[138] Although best practice is to make an offer of proof at the time an objection is made, an offer of proof made later in time, even if it is made at a subsequent conference or hearing, may be acceptable.[139] An offer of proof can take several different forms:

• A testimonial offer of evidence, whereby counsel summarizes what the proposed evidence is supposed to be. Attorneys using this method should be cautious, however, as the testimony may be considered inadequate.[140]
• An examination of a witness, whereby a witness is examined and cross-examined outside of the presence of a jury.[141]
• A written statement by the examining counsel, which describes the answers that the proposed witness would give if allowed to testify.[142]
• An affidavit, taken under oath, which summarizes a witness’s expected testimony and is signed by the witness.[143] However, this use of documentary evidence should be marked as an exhibit and introduced into the record for identification on appeal.[144]

There are exceptions to the offer of proof requirement. First, an offer of proof is unnecessary when the content of the evidence is “apparent from the context.”[145] Second, a cross-examiner who is conducting a proper cross-examination will be given more leeway by a court, since oftentimes the cross-examiner does not know what a witness will say if permitted to answer a question.[146]

§1.7 Closing Argument

Different than an opening statement, closing argument is the time for advocacy and argument on behalf of your client. It is not an unfettered right, however, and there are certain rules to remember about closing argument. First, present only that which was presented in evidence and do not deviate from the record.[147] You also do not want to comment on a witness that was unable to testify or suggest that a defendant’s failure to testify results in a guilty verdict.[148] Further, an attack on the credibility or honesty of opposing counsel is considered unethical.[149] But that does not mean lawyers cannot comment on the credibility of evidence and suggest reasonable inferences based on the evidence.[150] And keep in mind, generally, courts are “reluctant to set aside a jury verdict because of an argument made by counsel during closing arguments.”[151]

§1.8 Judgment as a Matter of Law

Federal Rule of Civil Procedure 50 governs the standard for judgment as a matter oflLaw, sometimes referred to as a directed verdict in state court matters.[152] A motion for  judgment as a matter of law “may be made at any time before the case is submitted to the jury” and the motion “must specify the judgment sought and the law and facts that entitle the movant to the judgment.”[153] But, “[a] motion under this Rule need not be stated with ‘technical precision,’” so long as “it clearly requested relief on the basis of insufficient evidence.”[154] Although it may be “better practice,” there is no requirement that the motion be made in writing.[155] The 6th Circuit Court of Appeals has even held that it is “clearly within the court’s power” to raise the motion “sua sponte.”[156]

Importantly, Rule 50 uses permissive, not mandatory, language, which means “while a district court is permitted to enter judgment as a matter of law when it concludes that the evidence is legally insufficient, it is not required to do so.” The Supreme Court has gone as far as to say “the district courts are, if anything, encouraged to submit the case to the jury, rather than granting such motions.”[157] There is a practical reason for this advice: if the motion is granted, then overturned on appeal, a whole new trial must be conveyed. Conversely, if the case is allowed to go to the jury, a post-verdict motion or appellate court can right any wrong with more ease.

In entertaining a motion for judgment as a matter of law, courts should review all of the evidence in the record, but, in doing so, the court must draw all reasonable inferences in favor of the nonmoving party, and it may not make credibility determinations or weigh the evidence.[158] Credibility determinations, the weighing of the evidence, and the drawing of legitimate inferences from the facts are jury functions, not those of a judge.[159] The question is not whether there is literally no evidence supporting the party against whom the motion is directed but whether there is evidence upon which the jury might reasonably find a verdict for that party. Since granting a judgment as a matter of law deprives the party opposing the motion of a determination of the facts by a jury, it is understandable that it is to be granted cautiously and sparingly by the trial judge.

§1.9 Jury Instructions

§1.9.1 General

The purpose of jury instructions is to advise the jury on the proper legal standards to be applied in determining issues of fact as to the case before them.[160] The court may instruct the jury at any time before the jury is discharged.[161] But the court must first inform the parties of its proposed instructions and give the parties an opportunity to respond.[162] Although each party is entitled to have the jury charged with his theory of the case, the proposed instructions must be supported by the law and the evidence.[163]

§1.9.2 Objections

Federal Rule of Civil Procedure 51 provides counsel the ability to correct errors in jury instructions.[164] The philosophy underlying the provisions of Rule 51 is to prevent unnecessary appeals of matters concerning jury instructions which should have been resolved at the trial level. An objection must be made on the record and state distinctly the matter objected to and the grounds for the objection.[165] Off-the-record objections to jury instructions, regardless of how specific, cannot satisfy requirements of the rule governing preservation of such errors.[166] A party may object to instructions outside of the presence of the jury before the instructions and arguments are delivered or promptly after learning that the instructions or request will be, or has been, given or refused. [167] Even if the initial request for an instruction is made in detail, the requesting party must object again after the instructions are given but before the jury retires for deliberations, in order to preserve the claimed error.[168]

Whether a jury instruction is improper is a question of law reviewed de novo.[169] Instructions are improper if, when viewed as a whole, they are confusing, misleading, and prejudicial.[170] If an instruction is improper, the judgment will be reversed, unless the error is harmless.[171] A motion for new trial is not appropriate where the omitted instructions are superfluous and potentially misleading.[172]

Further, while some courts have been lenient on whether objections are made in accordance with Rule 51, many courts hold that one who does not object in accordance with Rule 51 is deemed to have waived the right to appeal. A patently erroneous instruction can be considered on appeal if the error is “fundamental” and involves a miscarriage of justice, but the movant claiming the error has the burden of demonstrating it is a fundamental error.[173]

§1.10 Conduct of Jury

§1.10.1 Conduct During Deliberations

Jury deliberations must remain private and secret in order to protect the jury’s deliberations from improper, outside influence.[174] Control over the jury during deliberations, including the decision whether to allow the jurors to separate before a verdict is reached, is in the sound discretion of the trial court.[175] During this time, a judge may consider the fatigue of the jurors in determining whether the time of deliberations could preclude effective and impartial deliberation absent a break.[176] Although admonition of the jury is not required, one should be given if the jury is to separate at night and could potentially interact with third parties.[177]

The only individuals permitted in the jury room during deliberations are the jurors. However, in the case of a juror with a hearing or speech impediment, the court will appoint an appropriate professional to assist that individual and the presence of that professional is not grounds for reversal so long as the professional: (1) does not participate in deliberations; and (2) takes an oath to that effect.[178]

Courts have broad discretion in determining what materials will be permitted in the jury room.[179] Materials received into evidence are generally permitted,[180] including real evidence,[181] documents,[182] audio recordings,[183] charts and summaries admitted pursuant to Federal Rule of Evidence 1006,[184] video recordings,[185] written stipulations,[186] depositions,[187] drugs,[188] and weapons.[189] Additionally, jurors are typically permitted to use any notes he or she has taken over the course of trial.[190] Pleadings, however, are ordinarily not allowed.[191]

§1.10.2 Conduct During Trial

Traditionally, the trial judge has discretion to manage the jury during trial.[192] To ensure the jurors are properly informed, the court may, at any time after the commencement of trial, instruct the jury regarding a matter related to the case or a principal of law.[193] If a party wishes to present an exhibit to the jurors for examination over the course of trial, counsel should request that the court admonish the jury not to place undue emphasis on the evidence presented.[194] Additionally, the trial court may, in its informed discretion, permit a jury view of the premises that is the subject of the litigation.[195]

During trial, the court may allow the jury to take notes and dictate the procedure for doing so.[196] The trial court may permit note-taking for all of the trial or restrict the practice to certain parts.[197] A concern of permitting note-taking during trial is that jurors may place too much significance on their notes and too little significance on their recollection of the trial testimony.[198] To mitigate this risk, a judge should give a jury instruction informing each juror that he or she should rely on his memory and only use notes to assist that process.[199]

Allowing a juror to participate in examining a witness is within the discretion of the trial court,[200] although some courts have strongly opposed the practice.[201] If allowed, procedural protections should be encouraged to mitigate the risks of questions.[202] Additionally, the court should permit counsel to re-question the witness after a juror question has been posed.[203]

While trial is ongoing, jurors should not discuss the case among themselves[204] or share notes[205] prior to the case being submitted for deliberations. The same rule applies to communication between jurors and trial counsel[206] or jurors and the parties,[207] although accidental or unintentional contact may be excused.[208]

§1.11 Relief from Judgment

§1.11.1 Renewed Motion for Judgment as a Matter of Law

Pursuant to Federal Rule of Civil Procedure 50(b) a party may file a “renewed” motion for judgment as a matter of law, previously known as a “motion for directed verdict,” asserting that the jury erred in returning a verdict based on insufficient evidence.[209] However, in order to file a renewed motion, a party must have filed a Rule 50(a) pre-verdict motion for judgment as a matter of law before the case was submitted to the jury.[210] The renewed motion is limited to issues that were raised in a “sufficiently substantial way” in the pre-verdict motion[211] and failure to comply with this process often results in waiver.[212] The renewed motion must be filed no later than 28 days after the entry of judgment.[213]

The standard for granting a renewed motion for judgment as a matter of law mirrors the standard for granting the pre-suit motion under Rule 50(a).[214] A party is entitled to judgment only if a reasonable jury lacked a legally sufficient evidentiary basis to return the verdict that it did.[215] In rendering this analysis, a court may not weigh conflicting evidence and inferences or determine the credibility of the witnesses.[216] Upon review, the court must:

“(1) consider the evidence in the light most favorable to the prevailing party, (2) assume that all conflicts in the evidence were resolved in favor of the prevailing party, (3) assume as proved all facts that the prevailing party’s evidence tended to prove, and (4) give the prevailing party the benefit of all favorable inferences that may reasonably be drawn from the facts proved. That done, the court must then deny the motion if reasonable persons could differ as to the conclusions to be drawn from the evidence.”[217]

The analysis reflects courts’ general reluctance to interfere with a jury verdict.[218]

§1.11.2 Motion for New Trial

Federal Rule of Civil Procedure 59 permits a party to file a motion for new trial, either together with or as an alternative to a 50(b) renewed motion for judgment as a matter of law.[219] Like a renewed motion for judgment as a matter of law, a motion for new trial must be filed no later than 28 days after an entry of judgment.[220]

Rule 59 does not specify or limit the grounds on which a new trial may be granted.[221] A party may move for a new trial on the basis that “the verdict is against the weight of the evidence, that the damages are excessive, or that, for other reasons, the trial was not fair . . . and may raise questions of law arising out of alleged substantial errors in admission or rejection of evidence.”[222] Other recognized grounds for new trial include newly discovered evidence,[223] errors involving jury instruction,[224] and conduct of counsel.[225] Courts often grant motions for new trial on the issue of damages alone.[226]

Unlike when reviewing a motion for judgment as a matter of law, courts may independently evaluate and weigh the evidence.[227] Additionally, the Court, on its own initiative with notice to the parties and an opportunity to be heard, may order a new trial on grounds not stated in a party’s motion.[228]

When faced with a renewed judgment as a matter of law or a motion for new trial, courts have three options. They may (1) allow judgment on the verdict, if the jury returned a verdict; (2) order a new trial; or (3) direct the entry of judgment as a matter of law.[229]

§1.11.3 Clerical Mistake, Oversights and Omissions

Federal Rule of Civil Procedure 60(a) provides that “the court may correct a clerical mistake or a mistake arising from oversight or omission whenever one is found in a judgment, order, or other part of the record. The court may do so on motion or on its own, with or without notice.” This rule applies in very specific and limited circumstances, when the record makes apparent that the court intended one thing but by mere clerical mistake or oversight did another; such mistake must not be one of judgment or even of misidentification, but merely of recitation, of the sort that clerk or amanuensis might commit, mechanical in nature.[230] It is important to note that this rule can be applied even after a judgment is affirmed on appeal.[231]

§1.11.4 Other Grounds for Relief

Federal Rule of Civil Procedure 60(b) provides for several additional means for relief from a final judgment:

• mistake, inadvertence, surprise, or excusable neglect;
• newly discovered evidence that, with reasonable diligence, could not have been discovered in time to move for a new trial under Rule 59(b);
• fraud (whether previously called intrinsic or extrinsic), misrepresentation, or misconduct by an opposing party;
• the judgment is void;
• the judgment has been satisfied, released or discharged; it is based on an earlier judgment that has been reversed or vacated; or applying it prospectively is no longer equitable; or
• any other reason that justifies relief.

Courts typically require that the evidence in support of the motion for relief from a final judgement be “highly convincing.”[232]

§1.12 Virtual Hearings and Trials

In the wake of the COVID-19 pandemic and numerous government shut downs, hearings and trials in both criminal and civil matters have been proceeding electronically. It may be necessary, now and in the future, to submit an application for a trial to proceed remotely.[233]

And while trials always present unique and challenging issues, virtual trials present a new set of challenges, especially jury trials. It brings about a whole new set of factors—what makes for a successful trial in person can be very different from a successful trial over a virtual platform. There are new considerations for testimony by witnesses who are no longer in the same room as counsel, presentation of evidence when counsel can no longer bring binders or large boards, jury selection, and a myriad of other issues. What remains the same, however, is that preparation and practice are key. Being familiar with the local court’s practice and working out any technology issues in advance are critical to ensuring a successful virtual trial.

To date, the Courts have not created consistent rules for remote trials; every judge has their preferred procedures and technology.  Accordingly, it is important to review judge and court rules regarding remote proceedings.  For example, many judges have rules that prohibit the coaching of witnesses through off-screen methods, dictate courtroom behavior and appearance, limit public access and recording, and provide guidance on presentation of documents including documents that are filed under seal,[234] These rules not only dictate how the trial proceeds day-to-day, but may provide a basis for motions in limine and should be discussed with your judge in the pre-trial conference.

[1] See Fed. R. Civ. P. 16.

[2] Id.

[3] Id.

[4] See Basista v. Weir, 340 F.2d 74, 85 (3d Cir. 1965)

[5] See Fed. R. Civ. P. 26.

[6] Luce v. United States, 429 U.S. 38, 40 n.2 (1984).

[7] United States v. Romano, 849 F.2d 812, 815 (3d Cir. 1988).

[8] Frintner v. TruPosition, 892 F. Supp. 2d 699 (E.D. Pa. 2012).

[9] United States v. LeMay, 260 F.3d 1018, 1028 (9th Cir. 2001).

[10] Wilson v. Williams, 182 F.3d 562, 565-66 (7th Cir. 1999).

[11] Id. at 566 (“Definitive rulings, however, do not invite reconsideration.”).

[12] Fusco v. General Motors Corp., 11 F.3d 259, 262-63 (1st Cir. 1993).

[13] Flythe v. District of Columbia, 4 F. Supp. 3d 222 (D.D.C. 2014).

[14] U.S. v. Denton, 547 F. Supp. 16 (E.D. Tenn. 1982).

[15] Henwood v. People, 57 Colo 544, 143 P. 373 (1914). An opening statement presents counsel with the opportunity to summarily outline to the trier of fact what counsel expects the evidence presented at trial will show. Lovell v. Sarah Bush Lincoln Health Center, 397 Ill. App. 3d 890, 931 N.E.2d 246 (4th Dist. 2010).

[16] Testa v. Mundelein, 89 F.3d 445 (7th Cir. 1996) (“being argumentative in an opening statement does not necessarily warrant a mistrial, but being argumentative and introducing something that should not be allowed into evidence may be a predicate for a mistrial.”).

[17] Krengiel v. Lissner Copr., Inc., 250 Ill App. 3d 288, 621 N.E.2d 91 (1st Dist. 1993) (“party whose motion in limine has been denied must object when the challenged evidence is presented at trial in order to preserve the issue for review, and the failure to raise such an objection constitutes a waiver of the issue on appeal.”).

[18] Forrestal v. Magendantz, 848 F.2d 303, 308 (1st Cir. 1988) (suggesting to jury to put itself in shoes of plaintiff to determine damages improper because it encourages the jury to depart from neutrality and to decide the case on the basis of personal interest and bias rather than on the evidence.).

[19] U.S. CONST. amend. VI.

[20] See Kiernan v. Van Schaik, 347 F.2d 775, 778 (3d Cir. 1965); McCoy v. Goldston, 652 F.2d 654, 657 (6th Cir. 1981).

[21] U.S. CONST. amend. VII; Kiernan, 347 F.2d at 778.

[22] Fleming v. Chicago Transit Auth., 397 F. App’x 249, 249-50 (7th Cir. 2010) (quoting Jury Selection & Serv. Act of 1968, 28 U.S.C. §§ 1861-74 (2006)).

[23] Irvin v. Dowd, 366 U.S. 717, 727 (1961).

[24] Zia Shadows, L.L.C. v. City of Las Cruces, 829 F.3d 1232 (10th Cir. 2016).

[25] Turner v. Murray, 476 U.S. 28 (1986).

[26] Wainwright v. Witt, 469 U.S. 412, 423 (1985).

[27] Harris v. Pulley, 885 F.2d 1354, 1361 (9th Cir. 1988).

[28] Id. at 1362.

[29] Id. at 1361.

[30] Id.

[31] People v. Jordan, 2019 IL App (1st Dist.) 161848.

[32] Singer v. United States, 380 U.S. 24, 36 (1965) (finding that it is constitutionally permissible to require prosecutor and judge to consent to bench trial, even if the defendant elects one); United States v. Talik, No. CRIM.A. 5:06CR51, 2007 WL 4570704, at *6 (N.D.W. Va. Dec. 26, 2007).

[33] Fed. R. Civ. P. 38; Hopkins v. JPMorgan Chase Bank, NA, 618 F. App’x 959, 962 (11th Cir. 2015).

[34] Hopkins, 618 F. App’x at 962.

[35] U.S. Const. amend. VII.

[36] Lorillard v. Pons, 434 U.S. 575, 583 (1978).

[37] See Lutz v. Glendale Union High Sch., 403 F.3d 1061, 1069 (9th Cir. 2005) (“[W]e hold that there is no right to have a jury determine the appropriate amount of back pay under Title VII, and thus the ADA, even after the Civil Rights Act of 1991.  Instead, back pay remains an equitable remedy to be awarded by the district court in its discretion.”); see also Bledsoe v. Emery Worldwide Airlines, 635 F.3d. 836, 840-41 (6th Cir. 2011) (holding “statutory remedies available to aggrieved employees under the Worker Adjustment and Retraining Notification (WARN) act provide equitable restitutionary relief for which there is no constitutional right to a jury trial.”).

[38] K.M.C. Co. v. Irving Tr. Co., 757 F.2d 752, 758 (6th Cir. 1985); Leasing Serv. Corp. v. Crane, 804 F.2d 828, 832 (4th Cir. 1986); Telum, Inc. v. E.F. Hutton Credit Corp., 859 F.2d 835, 837 (10th Cir. 1988).

[39] Zaklit v. Glob. Linguist Sols., LLC, 53 F. Supp. 3d 835, 854 (E.D. Va. 2014); see also Nat’l Equip. Rental, Ltd. v. Hendrix, 565 F.2d 255, 258 (2d Cir. 1977).

[40] United States v. Steele, 298 F.3d 906, 912 (9th Cir. 2002) (“The fundamental purpose of voir dire is to ‘ferret out prejudices in the venire’ and ‘to remove partial jurors.’”) (quoting United States v. Howell, 231 F.3d 615, 627-28 (9th Cir. 2000)); Bristol Steel & Iron Works v. Bethlehem Steel Corp., 41 F.3d 182, 189 (4th Cir. 1994) (stating that the purpose of voir dire is to ensure a fair and impartial jury, not to operate as a discovery tool by opposing counsel).

[41] Mu’Min v. Virginia, 500 U.S. 415, 431 (1991).

[42] United States v. Piancone, 506 F.2d 748, 751 (3d Cir. 1974).

[43] Id.

[44] United States v. Delgado, 668 F.3d 219, 228 (5th Cir. 2012).

[45] Finks v. Longford Equip. Int’l, 208 F.3d 225, at *2 (10th Cir. February 25, 2000).

[46] Fed. R. Civ. P. 47(a).

[47] Hicks v. Mickelson, 835 F.2d 721, 726 (8th Cir. 1987).

[48] U.S. v. Lewin, 467 F.2d 1132 (7th Cir. 1972) (citing Fed. R. Crim. P. 24(a)).

[49] U.S. v. Lawes, 292 F.3d 123, 128 (2d Cir. 2002); Hicks v. Mickelson, 835 F.2d 721, 723-26 (8th Cir. 1987).

[50] Lawes, 292 F.3d at 128 (noting that “federal trial judges are not required to ask every question that counsel—even all counsel—believes is appropriate”).

[51] Finks v. Longford Equip. Int’l, 208 F.3d 225, at *2 (10th Cir. 2000).

[52] Mayes v. Kollman, 560 Fed. Appx. 389, 395 n.13 (5th Cir. 2014); Richardson v. New York City, 370 Fed. Appx. 227 (2d Cir. 2010); c.f. Kiernan v. Van Schaik, 347 F.2d 775, 779 (3d Cir. 1965) (finding that judge’s refusal to ask prospective jurors questions about connection to insurance companies constituted reversible error).

[53] See 28 U.S.C. § 1865(b).

[54] 28 U.S.C. § 1866.

[55] United States v. Bishop, 264 F.3d 535, 554-55 (5th Cir. 2001).

[56] United States v. Price, 573 F.2d 356, 389 (5th Cir. 1978).

[57] Chestnut v. Ford Motor Co., 445 F.2d 967 (4th Cir. 1971); c.f. United States v. Turner, 389 F.3d 111 (4th Cir. 2004) (finding that district court was within its discretion in failing to disqualify jurors who banked with a different branch of the bank that was robbed).

[58] United States v. Chapdelaine, 989 F.2d 28 (1st Cir. 1993).

[59] Leibstein v. LaFarge N. Am., Inc., 767 F. Supp. 2d 373 (E.D.N.Y. 2011), as amended (Feb. 15, 2011).

[60] Cravens v. Smith, 610 F.3d 1019, 1032 (8th Cir. 2010).

[61] See 28 U.S.C. § 1866 (stating that a juror may be “excluded upon peremptory challenge as provided by law”).

[62] Swain v. Alabama, 380 U.S. 202, 220, (1965) (“The essential nature of the peremptory challenge is that it is one exercised without a reason stated, without inquiry and without being subject to the court’s control.”).

[63] 28 U.S.C. § 1870; see also Fedorchick v. Massey-Ferguson, Inc., 577 F.2d 856 (3d Cir. 1978).

[64] Stephens v. Koch Foods, LLC, No. 2:07-CV-175, 2009 WL 10674890, at *1 (E.D. Tenn. Oct. 20, 2009).

[65] Id.

[66] Id.

[67] Id.

[68] See Batson v. Kentucky, 476 U.S. 79 (1986) (race); J.E.B. v. Alabama ex rel. T.B., 511 U.S. 127 (1994) (gender); Rivera v. Nibco, Inc., 372 F. App’x 757, 760 (9th Cir. 2010) (national origin).

[69] Powers v. Ohio, 499 U.S. 400, 409 (1991).

[70] Robinson v. R.J. Reynolds Tobacco Co., 86 F. App’x 73, 75 (6th Cir. 2004).

[71] Rivera v. Illinois, 556 U.S. 148 (2009); see also King v. Peco Foods, Inc., No. 1:14-CV-00088, 2017 WL 2424574 (N.D. Miss. Jun. 5, 2017).

[72] Kirk v. Raymark Indus., Inc., 61 F.3d 147, 157 (3d Cir. 1995) (holding, in asbestos litigation, that trial court’s refusal to remove two panelists for cause was error, and the party’s subsequent use of peremptory challenges to remedy the judge’s mistake required per se reversal and a new trial) (citations omitted).

[73] Linden v. CNH Am., LLC, 673 F.3d 829, 840 (8th Cir. 2012).

[74] Black’s Law Dictionary 460 (6th ed. 1990).

[75] Fed. R. Evid. 611(c).

[76] McClard v. United States, 386 F.2d 495, 501 (8th Cir. 1967).

[77] Rodriguez v. Banco Cent. Corp., 990 F.2d 7, 12-13 (1st Cir. 1993).

[78] United States v. Rojas, 520 F.3d 876, 881 (8th Cir. 2008) (citing U.S. v. Butler, 56 F.3d 941, 943 (8th Cir. 1995)).

[79] United States v. Carpenter, 819 F.3d 880, 891 (6th Cir. 2016), reversed and remanded on other grounds, 138 S.Ct. 2206, 201 L. Ed. 2d 507 (2018).

[80] U.S. v. Hernandez-Albino, 177 F.3d 33, 42 (1st Cir. 1999).

[81] United States v. Grassrope, 342 F.3d 866, 869 (8th Cir. 2003) (permitting leading questions when examining a sexual assault victim).

[82] U.S. v. Mulinelli-Navas, 111 F.3d 983, 990 (1st Cir. 1997).

[83] See United States v. Lin, 101 F.3d 760, 770 (D.C. Cir. 1996).

[84] United States v. Jacobs, 215 Fed. Appx. 239, 241 (4th Cir. 2007) (citing United States v. Lewis, 10 F.3d 1086, 1089 (4th Cir. 1993)).

[85] Raysor v. Port Authority of New York & New Jersey, 768 F.2d 34, 40 (2d Cir. 1985).

[86] Id.

[87] Elgabri v. Lekas, 964 F.2d 1255, 1260 (1st Cir. 1992).

[88] See Rosa-Rivera v. Dorado Health, Inc., 787 F.3d 614, 617 (1st Cir. 2015) (employees); United States v. Bryant, 461 F.2d 912, 918-19 (6th Cir. 1972) (informants); United States v. Hicks, 748 F.2d 854, 859 (4th Cir. 1984) (girlfriend).

[89] See U.S. v. Cisneros-Gutierrez, 517 F.3d 751, 762 (5th Cir. 2008).

[90] Fed. R. Evid. 612 authorizes a party to refresh a witness’s memory with a writing so long as the “adverse party is entitled to have the writing produced at the hearing, to inspect it, to cross-examine the witness thereon, and to introduce in evidence those portions which relate to the testimony of the witness.”

[91] Rush v. Illinois Cent. R. Co., 399 F.3d 705, 715-22 (6th Cir. 2005).

[92] Rush v. Illinois Cent. R. Co., 399 F.3d 705, 715-22 (6th Cir. 2005).

[93] Id. at 718-19.

[94] United States v. Logan, 121 F.3d 1172, 1175 (8th Cir. 1997).

[95] United States v. Lemon, 497 F.2d 854, 857 (10th Cir. 1974).

[96] See Fed. R. Evid. 607.

[97] Id.

[98] Util. Control Corp. v. Prince William Const. Co., 558 F.2d 716, 720 (4th Cir. 1977).

[99] United States v. Gilbert, 57 F.3d 709, 711 (9th Cir. 1995).

[100] United States v. Finley, 708 F. Supp. 906 (N.D. Ill. 1989).

[101] United States v. Finis P. Ernest, Inc., 509 F.2d 1256, 1263 (7th Cir. 1975); United States v. Prince, 491 F.2d 655, 659 (5th Cir. 1974).

[102] See Davis v. Alaska, 415 U.S. 308, 316, 94 S. Ct. 1105, 1110, 39 L. Ed. 2d 347 (1974) (“Cross-examination is the principal means by which the believability of a witness and the truth of his testimony are tested.”).

[103] See Fed. R. Evid. 611(b) (effective December 1, 2011) (“(b) Scope of Cross-Examination. Cross-examination should not go beyond the subject matter of the direct examination and matters affecting the witness’s credibility. The court may allow inquiry into additional matters as if on direct examination.”).

[104] See United States v. Perez-Solis, 709 F.3d 453, 463-64 (5th Cir. 2013); see also United States v. Arias-Villanueva, 998 F.2d 1491, 1508 (9th Cir. 1993) (cross-examination is within the scope of direct where it is “reasonably related” to the issues put in dispute by direct examination); United States v. Moore, 917 F.2d 215 (6th Cir. 1990) (subject matter of direct examination under Rule 611(b) includes all inferences and implications arising from the direct); United States v. Arnott, 704 F.2d 322, 324 (6th Cir. 1983) (“The ‘subject matter of the direct examination,’ within the meaning of Rule 611(b), has been liberally construed to include all inferences and implications arising from such testimony.”).

[105] Perez-Solis, 709 F.3d at 464.

[106] Id; see also MDU Resources Group v. W.R. Grace and Co., 14 F.3d 1274, 1282 (8th Cir. 1994), cert. denied, 513 U.S. 824, 115 S. Ct. 89, 130 L. Ed. 2d 40 (1994) (“When cross-examination goes beyond the scope of direct, as it did here, and is designed, as here, to establish an affirmative defense (that the statute of limitations had run), the examiner must be required to ask questions of non-hostile witnesses as if on direct.).

[107] Under Fed. R. Evid. 608, if the witness concedes the bad act, impeachment is accomplished. If the witness denies the bad act, Rule 608(b) precludes the introduction of extrinsic evidence to prove the act. In short, the cross-examining lawyer must live with the witness’s denial.

[108] To qualify, “the crime must have been a felony, or a misdemeanor that has some logical nexus with the character trait of truthfulness, such as when the elements of the offense involve dishonesty or false statement. The conviction must have occurred within ten years of the date of the witness’s testimony at trial, or his or her release from serving the sentence imposed under the conviction, whichever is later, unless the court permits an older conviction to be used, because its probative value substantially outweighs any prejudice, and it should, in the interest of justice, be admitted to impeach the witness. If the prior conviction is used to impeach a witness other than an accused in a criminal case, its admission is subject to exclusion under Rule 403 if the probative value of the evidence is substantially outweighed by the danger of unfair prejudice, delay, confusion or the introduction of unnecessarily cumulative evidence. If offered to impeach an accused in a criminal case, the court still may exclude the evidence, if its probative value is outweighed by its prejudicial effect.” Behler v. Hanlon, 199 F.R.D. 553, 559 (D. Md. 2001).

[109] Fed. R. Evid. 608 (bad acts or character of untruthfulness); Fed. R. Evid. 609 (qualifying crime); Fed. R. Evid. 613 (prior inconsistent statement).

[110] Behler, 199 F.R.D. at 556.

[111] 353 F.2d 324, 325-26 (1st Cir. 1965).

[112] 927 F.2d 838, 841 (5th Cir. 1991).

[113] 250 F.3d 10, 16-17 (1st Cir. 2001).

[114] 237 F.3d 8, 16-17 (1st Cir. 2001).

[115] 248 Fed. Appx. 718, 726 (6th Cir. 2007).

[116] 653 F.2d 915, 920-21 (5th Cir. 1981).

[117] United States v. James, 510 F.2d 546, 551 (5th Cir. 1975).

[118] United States v. Blackwood, 456 F.2d 526, 529-30 (2d Cir. 1972).

[119] Id.

[120] FED. R. CIV. P. 26(a)(2).

[121] Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 597 (1993).

[122] Fed. R. Evid. 901.

[123] U.S. v. Goichman, 547 F.2d 778, 784 (3d Cir. 1976) (“[T]here need be only a prima facie showing, to the court, of authenticity, not a full argument on admissibility . . . .  [I]t is the jury who will ultimately determine the authenticity of the evidence, not the court.”).

[124] Id.

[125] Fed. R. Evid. 803(6), 902(11); United States v. Senat, 698 F. App’x 701, 706 (3d. Cir. 2017).

[126] See, e.g., Stumpff v. Harris, 31 N.E.3d 164, 173 (Ohio App. 2 Dist. 2015) (“Numerous courts, both state and federal, have held that items produced in discovery are implicitly authenticated by the act of production by the opposing party); Churches of Christ in Christian Union v. Evangelical Ben. Trust, S.D. Ohio No. C2:07CV1186, 2009 WL 2146095, *5 (July 15, 2009) (“Where a document is produced in discovery, ‘there [is] sufficient circumstantial evidence to support its authenticity’ at trial.”).

[127] In re L.P., 749 S.E.2d 389, 392-392 (Ga. Ct. App. 2013).

[128] Rules of Evid., Rule 901(a). Idaho v. Koch, 334 P.3d 280 (Idaho 2014).

[129] State v. Smith, 2015-1359 La. App. 4 Cir. 4/20/16, 2016 WL 3353892, *10-11 (La. Ct. App. 4th Cir. 2016); see also OraLabs, Inc. v. Kind Group LLC, 2015 WL 4538444, *4, Fn 7  (D. Colo. 2015) (in a patent and trade dress infringement action, the court admitted, over hearsay objections, Twitter posts offered to show actual confusion between the plaintiff’s and defendant’s products.).

[130] Jones v. U.S., 813 A.2d 220, 226-227 (D.C. 2002).

[131] Dente v. Riddell, Inc., 664 F.2d 1, 2 n.1 (1st Cir. 1981).

[132] Mills v. Texas Compensation Ins. Co., 220 F.2d 942, 946 (5th Cir. 1955).

[133] U.S. v. Gomez-Alvarez, 781 F.3d 787, 792 (5th Cir. 2015).

[134] Jerden v. Amstutz, 430 F.3d 1231, 1237 (9th Cir. 2005).

[135] See, e.g., Hastings v. Bonner, 578 F.2d 136, 142-143 (5th Cir. 1978); United States v. Johnson, 577 F.2d 1304, 1312 (5th Cir. 1978); United States v. Jamerson, 549 F.2d 1263, 1266-67 (9th Cir. 1977).

[136] See United States v. Henderson, 409 F.3d 1293, 1298 (11th Cir. 2005).

[137] Inselman v. S & J Operating Co., 44 F.3d 894, 896 (10th Cir. 1995).

[138] See United States v. Adams, 271 F.3d 1236, 1241 (10th Cir. 2001) (“In order to qualify as an adequate offer of proof, the proponent must, first, describe the evidence and what it tends to show and, second, identify the grounds for admitting the evidence.”).

[139] Murphy v. City of Flagler Beach, 761 F.2d 622 (11th Cir. 1985).

[140] See id. at 1241-42 (“On numerous occasions we have held that merely telling the court the content of . . . proposed testimony is not an offer of proof.”).

[141] Fed. R. Evid. 103(c) (The trial court “may direct an offer of proof be made in question-and-answer form.”). See, e.g., United States v. Yee, 134 F.R.D. 161, 168 (N.D. Ohio 1991) (stating that “hearings were held for approximately six  weeks” on whether DNA evidence was admissible).

[142] Adams, 271 F.2d at 1242.

[143] Id.

[144] Palmer v. Hoffman, 318 U.S. 109, 116 (1943).

[145] Fed. R. Evid. 103(a)(2); Beech Aircraft v. Rainy, 488 U.S. 153 (1988).

[146] Alford v. United States, 282 U.S. 687, 692 (1931).

[147] United States v. Harris, 536 F.3d 798, 812 (7th Cir. Ill. Aug. 6, 2008).

[148] See, e.g., United States v. St. Michael’s Credit Union, 880 F.2d 579 (1st Cir. 1989); Griffin v. California, 380 U.S. 609, 615 (Apr. 28, 1965).

[149] Model Rule of Professional Conduct Rule 3.4(e).

[150] Jones v. Lincoln Elec. Co., 188 F.3d 709, 731 (7th Cir. 1999) (“We find nothing improper in this line of argument. Closing arguments are the time in the trial process when counsel is given the opportunity to discuss more freely the weaknesses in his opponent’s case.”).

[151] Vineyard v. County of Murray, Ga., 990 F.2d 1207, 1214 (11th Cir. 1993).

[152] See, Fed. R. Civ. P. 50(a)(1) (“If a party has been fully heard on an issue during a jury trial and the court finds that a reasonable jury would not have a legally sufficient evidentiary basis to find for the party on that issue, the court may: (A) resolve the issue against the party; and (B) grant a motion for judgment as a matter of law against the party on a claim or defense that, under the controlling law, can be maintained or defeated only with a favorable finding on that issue.”).

[153] Fed. R. Civ. P. 50(a)(2).

[154] Arch Ins. Co. v. Broan-NuTone, LLC, 509 F. App’x 453, fn. 5 (6th Cir. 2012) (quoting Ford v. Cnty. of Grand Traverse, 535 F.3d 483, 492 (6th Cir. 2008).

[155] U. S. Indus., Inc. v. Semco Mfg., Inc., 562 F.2d 1061, 1065 (8th Cir. 1977).

[156] Am. & Foreign Ins. Co. v. Gen. Elec. Co., 45 F.3d 135, 139 (6th Cir. 1995).

[157] Unitherm Food Sys., Inc. v. Swift-Eckrich, Inc., 546 U.S. 394, 405 (2006).

[158] Reeves v. Sanderson Plumbing Prod., Inc., 530 U.S. 133, 120 S. Ct. 2097, 147 L. Ed. 2d 105 (2000); citing Lytle v. Household Mfg., Inc., 494 U.S. 545, 554-555, 110 S.Ct. 1331, 108 L.Ed.2d 504 (1990); Liberty Lobby, Inc., supra, at 254, 106 S.Ct. 2505; Continental Ore Co. v. Union Carbide & Carbon Corp., 370 U.S. 690, 696, n.6, 82 S.Ct. 1404, 8 L.Ed.2d 777 (1962).

[159] Id.

[160] Daly v. Moore, 491 F.2d 104 (5th Cir. 1974) (explaining that a court should refuse instructions not applicable to the facts).

[161] Fed. R. Civ. P. 51(b)(3).

[162] Fed. R. Civ. P. 51(b) (1)-(2); see also Vialpando v. Cooper Cameron Corp., 92 F. App’x 612 (10th Cir. 2004) (explaining that “a district court can no longer give mid-trial instructions without first advising the parties of its intent to do so and giving the parties an opportunity to object to the proposed instruction.”).

[163] Apple Inc. v. Samsung Elecs. Co., No. 11-CV-01846-LHK, 2017 WL 3232424 (N.D. Cal. July 28, 2017); see also Daly, 491 F.2d.104 (affirming court’s omission of instructions on the due process requirements of the Fourteenth Amendment since no facts supported a violation).

[164] Fed. R. Civ. P. 51.

[165] Estate of Keatinge v. Biddle, 316 F.3d 7 (1st Cir. 2002).

[166] Positive Black Talk Inc. v. Cash Money Records, Inc., 394 F.3d 357, 65 Fed. R. Evid. Serv. 1366 (5th Cir. 2004).

[167] Fed. R. Civ. P. 51(c)(2); Fed. R. Crim. P. 30(d); see also Abbott v. Babin, No. CV 15-00505-BAJ-EWD, 2017 WL 3138318, at *3 (M.D. La. May 26, 2017) (explaining that upon an untimely objection courts may only consider a plain error in the jury instructions).

[168] Fed. Rules Civ. Proc. Rule 51; Foley v. Commonwealth Elec. Co., 312 F.3d 517, 90 Fair Empl. Prac. Cas. (BNA) 895 (1st Cir. 2002).

[169] Chuman v. Wright, 76 F.3d 292, 294 (9th Cir. 1996).

[170] Benaugh v. Ohio Civil Rights Comm’n, No. 104-CV-306, 2007 WL 1795305 (S.D. Ohio June 19, 2007), aff’d, 278 F. App’x 501 (6th Cir. 2008).

[171] Chuman v. Wright, 76 F.3d 292, 294 (9th Cir. 1996) (reversing judgment since the instructions could allow a jury to find the defendant liable based on premise unsupported by law).

[172] United States v. Grube, No. CRIM C2-98-28-01, 1999 WL 33283321 (D.N.D. Jan. 16, 1999) (denying motion for new trial since the omitted instructions were superfluous and potentially misleading); see also Cupp v. Naughten, 414 U.S. 141, 94 S. Ct. 396, 397, 38 L. Ed. 2d 368 (1973); Lannon v. Hogan, 555 F. Supp. 999 (D. Mass.), aff’d, 719 F.2d 518 (1st Cir. 1983) (generally cannot seek such relief based on a claim of improper jury instructions, unless the error “so infect[ed] the entire trial that the resulting conviction violated the requirements of Due Process Clause and the Fourteenth Amendment.”).

[173] Fashion Boutique of Short Hills, Inc. v. Fendi USA, Inc., 314 F.3d 48 (2d Cir. 2002) (failure to make specific objections to jury instructions before jury retires to deliberate results in waiver, and Court of Appeals may review the instruction for fundamental error only.).

[174] United States v. Olano, 507 U.S. 725, 737 (1993).

[175] Cleary v. Indiana Beach, Inc., 275 F.2d 543, 545-46 (7th Cir. 1960); Sullivan v. United States, 414 F.2d 714, 715-16 (9th Cir. 1969).

[176] Cleary, 275 F.2d at 546; Magnuson v. Fairmont Foods Co., 442 F.2d 95, 98-99 (7th Cir. 1971).

[177] See United States v. Williams, 635 F.2d 744, 745-46 (8th Cir. 1980) (“It is essential to a fair trial, civil or criminal, that a jury be cautioned as to permissible conduct in conversations outside the jury room. Such an admonition is particularly needed before a jury separates at night when they will converse with friends and relatives or perhaps encounter newspaper or television coverage of the trial.”); United States v. Hart, 729 F.2d 662, 667 n.10 (10th Cir. 1984) (“[A]n admonition . . . should be given at some point before jurors disperse for recesses or for the day, with reminders about the admonition sufficient to keep the jurors alert to proper conduct on their part.”).

[178] United States v. Dempsey, 830 F.2d 1084, 1089-90 (10th Cir. 1987).

[179] United States v. Gross, 451 F.2d 1355, 1359 (9th Cir. 1971).

[180] United States v. Williams, 87 F.3d 249, 255 (8th Cir. 1996).

[181] Taylors v. Reo Motors, Inc., 275 F.2d 699, 705-06 (10th Cir. 1960).

[182] United States v. DeCoito, 764 F.2d 690, 695 (9th Cir. 1985).

[183] United States. v. Welch, 945 F.2d 1378, 1383 (7th Cir. 1991).

[184] Pierce v. Ramsey Winch Co., 753 F.2d 416, 431 (5th Cir. 1985).

[185] United States v. Chadwell, 798 F.2d 910, 914-15 (9th Cir. 2015).

[186] United States v. Aragon, 983 F.2d 1306, 1309 (4th Cir. 1993).

[187] Johnson v. Richardson, 701 F.2d 753, 757 (8th Cir. 1983).

[188] United States v. de la Cruz-Paulino, 61 F.3d 986, 997 (1st Cir. 1995).

[189] United States v. Gonzales, 121 F.2d 928, 945 (5th Cir. 1997).

[190] United States v. Anthony, 565 F.2d 533, 536 (8th Cir. 1977); Unites States v. Johnson, 584 F.2d 148, 157-58 (6th Cir. 1978).

[191] McGowan v. Gillenwater, 429 F.2d 586, 587 (4th Cir. 1970).

[192] United States v. Weisner, 789 F.2d 1264, 1268 (7th Cir. 1986).

[193] Fed. R. Civ. P. § 51(b)(3).

[194] United States. v. Venerable, 807 F.2d 745, 747 (8th Cir. 1986).

[195] United States v. Gray, 199 F.3d 547, 550 (1st Cir. 1999).

[196] United States v. Scott, 642 F.2d 791, 797 (9th Cir. 2011); United States v. Bassler, 651 F.2d 600, 602 n.3 (8th Cir. 1981).

[197] See, e.g., United States v. Darden, 70 F.2d 1507, 1537 (8th Cir. 1995) (court permitted note-taking while examining exhibits only); United States v. Porter, 764 F.2d 1, 12 (1st Cir. 1985) (court permitted note-taking only during opening statements, closing statements, and jury charge).

[198] United States v. Scott, 642 F.3d 791, 797 (9th Cir. 2011).

[199] See United States v. Rhodes, 631 F.2d 43, 45-46 (5th Cir. 1980) (“The court should also explain that the notes taken by each juror are to be used only as a convenience in refreshing that juror’s memory and that each juror should rely on his or her independent recollection of the evidence rather than be influenced by another juror’s notes.”).

[200] United States v. Richardson, 233 F.3d 1285, 1288-1289 (11th Cir. 2000).

[201] United States v. Rawlings, 522 F.3d 403, 408 (D.C. Cir. 2008); United States v. Bush, 47 F.3d 511, 514-516 (2nd Cir. 1995); DeBenedetto by DeBenedetto v. Goodyear Tire & Rubber Co., 754 F.2d 512, 516 (4th Cir. 1985).

[202] Perhaps the most important protection is a screening mechanism where questions are submitted to a judge and reviewed by counsel prior to the question being posed. Rawlings, 522 F.3d at 408; United States v. Collins, 226 F.3d 457, 463 (6th Cir. 2000).

[203] Collins, 226 F.3d at 464.

[204] Charlotte Cty. Develop. Co. v. Lieber, 415 F.2d 447, 448 (5th Cir. 1969).

[205] United States v. Balsam, 203 F.3d 72, 86 (1st Cir. 2000).

[206] Budoff v. Holiday Inns, Inc., 732 F.2d 1523, 1527 (6th Cir. 1984).

[207] United States v. Barfield Co., 359 F.2d 120, 123-24 (5th Cir. 1966).

[208] Dennis v. General Elec. Corp., 762 F.2d 365, 367 (4th Cir. 1985).

[209] Fed. R. Civ. P. 50(b).

[210] Exxon Shipping Co. v. Baker, 554 U.S. 471, 486, 128 S. Ct. 2605, 2617 n.5, 171 L. Ed. 2d 570 (2008).

[211] CFE Racing Prod., Inc. v. BMF Wheels, Inc., 793 F.3d 571, 583 (6th Cir. 2015).

[212] Id. (explaining that the waiver rule serves to protect litigants’ right to trial by jury, discourage courts from reweighing evidence simply because they feel the jury could have reached another result, and prevent tactical victories at the expense of substantive interest as the pre-verdict motion enables the defending party to cure defects in proof) (quoting Libbey-Owens-Ford Co. v. Ins. Co. of N. Am., 9 F.3d 422, 426 (6th Cir. 1993)).

[213] Bowen v. Roberson, 688 F. App’x 168, 169 (3d Cir. 2017).

[214] McGinnis v. Am. Home Mortg. Servicing, Inc., 817 F.3d 1241, 1254 (11th Cir. 2016).

[215] Bavlsik v. Gen. Motors, LLC, 870 F.3d 800, 805 (8th Cir. 2017).

[216] McGinnis, 817 F.3d at 1254.

[217] Id.

[218] See, e.g., Stragapede v. City of Evanston, Illinois, 865 F.3d 861, 866 (7th Cir. 2017), as amended (Aug. 8, 2017) (upholding jury verdict in favor of plaintiff for ADA violation when challenged in renewed 50(b) motion on grounds that the jury properly discounted employer’s evidence).

[219] Fed. R. Civ. P. 59.

[220] Fed. R. Civ. P. 59(b).

[221] Molski v. M.J. Cable, Inc., 481 F.3d 724, 729 (9th Cir. 2007) (noting that federal courts are guided by the common law’s established grounds for permitting new trials).

[222] Montgomery Ward & Co. v. Duncan, 311 U.S. 243, 251, 61 S.Ct. 189, 85 L.Ed. 147 (1940).

[223] Kleinschmidt v. United States, 146 F. Supp. 253, 257 (D. Mass. 1956) (explaining that a party seeking new trial on ground of newly discovered evidence has substantial burden to explain why the evidence could not have been found by due diligence before trial).

[224] Gross v. FBL Fin. Servs., Inc., 588 F.3d 614, 617 (8th Cir. 2009) (granting new trial in age discrimination case where jury instruction improperly shifted the burden of persuasion on a central issue).

[225] Warner v. Rossignol, 538 F.2d 910, 911 (1st Cir. 1976) (counsel’s conduct in going beyond the pleadings and evidence to speculate and exaggerate the plaintiff’s injuries, despite repeated warnings from the trial judge, warranted new trial).

[226] See, e.g., Bavlsik v. Gen. Motors LLC, No. 4:13 CV 509 DDN, 2015 WL 4920300, at *1 (E.D. Mo. Aug. 18, 2015) (granting new trial on issue of damages and rejecting defendants’ argument that the record demonstrated a compromised verdict).

[227] McGinnis, 817 F.3d at 1254.

[228] Fed. R. Civ. P. 59(d).

[229] Fed. R. Civ. P. 50(b).

[230] In re Transtexas Gas Corp., C.A.5 (Tex.) 2002, 303 F.3d 571.

[231] U.S. v. Mansion House Center North Redevelopment Co., C.A.8 (Mo.) 1988, 855 F.2d 524, certiorari denied 109 S.Ct. 557, 488 U.S. 993, 102 L.Ed.2d 583 (district court had jurisdiction to modify judgment, even after it was affirmed on appeal, in order to clarify its intentions and conform judgment to parties’ pretrial stipulation).

[232] See United States v. Cirami, 563 F.2d 26, 33 (2d Cir. 1977).

[233] Flores v. Town of Islip, No. 18-CV-3549 (GRB)(ST), 2020 WL 5211052, at *1 (E.D.N.Y. Sept. 1, 2020) (the court granted a motion to proceed with a virtual trial but required counsel and the court staff to have a pre-trial conference to discuss the logistics of a virtual trial).

[234] See, e.g., New Jersey Federal Bankruptcy Court Zoom Trial Guidelines.

In November 2017, the ABA’S Business Law Section unveiled its new format for Business Law Today: a dynamic website that would cover every practice area in the business law arena and provide monthly updates and analytical articles on critical issues and substantive topics in business law. The unveiling of www.businesslawtoday.org witnessed the culmination of two years of intense planning and development that was spearheaded by Chris Rockers, former BLS chair and current delegate to the ABA House of Delegates, and Jonathan Rubens, the BLT website’s first Editor-in-Chief.

But one ingredient was the key to the BLT website’s success: the staff editor who would guide, nurture, and grow the content. The Business Law Section was fortunate in finding for its first editor, Sarah Claypoole.    

A recent graduate of the University of Chicago, Sarah joined the staff in January 2018 and quickly began to familiarize herself with the various topic areas of business law and demonstrated the valuable traits of an editor who must adhere to quality standards of writing while also balancing deadlines and schedules.

“The new Business Law Today is one of the content offerings of which I’m most proud,” said Norm Powell, Business Law Section Content Officer. “Designed based on significant polling from Section members, it has steadily increased in popularity since the launch. Sarah’s been a huge part of that success. She has shared and delivered on the vision that we were creating a virtual hub (a coffee shop, if you will), where folks regularly pop in to see what’s happening in their worlds.”

During Sarah’s tenure, hundreds of articles and month-in-briefs have published, as well as videos, podcasts, and, most recently, an ambitious content offering of recent developments in business and commercial litigation. The shear amount and quality of content is a reflection on Sarah and her eclectic, analytical approach to subject matter and her appreciation of fine writing.

Her interest in business law was the catalyst for Sarah to consider a career as a lawyer, and, in May 2021, she committed to attend the Duke University School of Law, and will leave as editor of www.businesslawtoday.org in July to make her new home in Durham, North Carolina.

“Sarah has been an integral part of every decision made at BLT since BLT was re-launched as an online platform in 2018,” said Lisa Stark, current Editor-in-Chief. “Sarah’s contributions to BLT have been crucial to BLT’s success.  Sarah also is an amazing person and will be sorely missed.”

A new BLT editor will improve on Sarah’s accomplishments and continue the tradition of quality content that has been a hallmark of the Business Law Section’s content offerings.  Yet, Sarah Claypoole has left her mark on the BLT website and the BLS content members and leadership wish her continued success in law school and in her future career as a lawyer.

Editor

Kathleen Cahill Slaught (Chair)

Seyfarth Shaw LLP
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Contributors

To Disclose Or Not During ERISA Administrative Review —

Jon Karelitz
Mark Casciari

Seyfarth Shaw LLP
233 South Wacker Drive
Suite 8000
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Stunning Development – The Ninth Circuit Enforces an ERISA Plan Arbitration and Class Action Waiver Provision

Michael W. Stevens
Jonathan A. Braunstein

Seyfarth Shaw LLP
560 Mission Street
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Mark Casciari

Seyfarth Shaw LLP
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ERISA Preemption – The Courts of Appeal Continue to Rule as They Await Further Supreme Court Attempts to Define, Once and For All, Its Limiting Principles

Mark Casciari
Ian Morrison

Seyfarth Shaw LLP
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The Trump Administration Wants You to Know, Guidance is NOT Law!

Mark Casciari

Seyfarth Shaw LLP
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No Partnership, No Common Control, No Withdrawal Liability: Private Equity Funds Not Liable for Portfolio Company’s Multiemployer Plan Withdrawal Liability

Jessica Stricklin

Seyfarth Shaw LLP
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Alan Cabral
Ryan Tzeng

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Beware of the “Overshare”: Construe Requests for ERISA Plan Documents Narrowly!

Mark Casciari
Sarah Touzalin

Seyfarth Shaw LLP
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Supreme Court Remands Case Back Seeking Clarification of the Dudenhoeffer Pleading Standard

Jim Goodfellow

Seyfarth Shaw LLP
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Kathleen Cahill Slaught

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Supreme Court’s Sulyma Ruling Toughens ERISA’s “Actual Knowledge” Standard & Makes Dismissal of Fiduciary Breach Actions More Unlikely

Ian Morrison

Seyfarth Shaw LLP
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Will the ACA Case Now Before the Supreme Court Make it Harder for ERISA Fiduciary Breach Plaintiffs to Establish Standing?

Mark Casciari

Seyfarth Shaw LLP
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(312) 460-5000
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ERISA Fee Motions After COVID-19 — A Substantive and Procedural Review

Rebecca Bryant
Mark Casciari

Seyfarth Shaw LLP
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[email protected]
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Whose Law? Where? When? — Risk Management for ERISA Plans in Uncertain Times

Richard Loebl

Seyfarth Shaw LLP
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New York, New York 10018-1405
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Mark Casciari

Seyfarth Shaw LLP
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The Supreme Court Further Narrows Federal Court Jurisdiction Over an ERISA Complaint, Relying on Article III of the Constitution

Michael W. Stevens

Seyfarth Shaw LLP
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Mark Casciari

Seyfarth Shaw LLP
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Limits To ERISA’s Equitable Remedies — What The Supreme Court’s Latest Securities Act Decision Tells Us

Michael W. Stevens

Seyfarth Shaw LLP
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Mark Casciari

Seyfarth Shaw LLP
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The 10th Circuit’s New Interpretation of What is Mandated under ERISA’s Notice Requirements May have Far Reaching Effects On Plan Administrator’s Duties

Rebecca K. Bryant
Ian H. Morrison
Sam M. Schwartz-Fenwick

Seyfarth Shaw LLP
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Transgender Patients Remain Protected: District Court Blocks HHS Rule From Taking Effect

Emily Miller

Seyfarth Shaw LLP
Seaport East
Two Seaport Lane, Suite 300
Boston, MA 02210-2028
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Ben Conley
Sam Schwartz-Fenwick

Seyfarth Shaw LLP
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[email protected]
[email protected]

Countdown to the Supreme Court’s ERISA Preemption Oral Argument in Rutledge — Two Noteworthy Case Developments

Jules Levenson
Mark Casciari

Seyfarth Shaw LLP
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How to Minimize Judicial Review of ERISA Fiduciary Decisions

Ronald Kramer
Mark Casciari

Seyfarth Shaw LLP
233 South Wacker Drive
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(312) 460-5000
[email protected]
[email protected]
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First Circuit Rules That Private Equity Funds Are Not Responsible For Portfolio Company Withdrawal Liability

Bryan M. O’Keefe

Seyfarth Shaw LLP
975 F Street, N.W.
Washington, DC 20004-1454
(202) 463-2400
[email protected]
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Ronald Kramer

Seyfarth Shaw LLP
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Samuel Rubinstein

Seyfarth Shaw LLP
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New York, New York 10018-1405
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§1.1 To Disclose Or Not During ERISA Administrative Review — The Fourth Circuit Weighs In With An Affirmative Answer

In Odle vs. UMWA 1974 Pension Plan, the Court of Appeals for the Fourth Circuit reversed a district court’s decision on summary judgment in favor of a pension plan’s fiduciaries (in this case, the board of trustees for a coal industry multiemployer fund).  The case involved a dispute over service credit towards a deceased participant’s pension.  The plan fiduciaries had denied a claim by the participant’s surviving spouse, concluding that 13.5 years of the participant’s service was actually performed in a position that was not classified as eligible under an industry-wide union agreement.  The administrative record indicated that the fiduciaries based their denial, in part, on an audit of employer timesheet records that was not disclosed to the claimant.  The claimant alleged as well that she requested the audit records, and the plan refused to provide them.  The Fourth Circuit held that “by failing to disclose that audit during the administrative process, the Plan denied [the claimant] the ‘full and fair review’ of her claim that she was entitled to under ERISA.”

The regulations under ERISA Section 503 require that a claimant “be given reasonable access to documents relevant to her claim,” The regulations provide that documents, records and other information are “relevant” if they are “submitted, considered, or generated in the course of making the benefit determination.”

Under the Odle holding, a fiduciary should disclose all documents upon which a claim or appeal decision was based, unless there is a good reason not to.  Such disclosure should provide the claimant with an opportunity to consider all relevant information, and use that information in making arguments in support of the claim.  Of course, there may be compelling reasons not to disclose, under certain circumstances, and Odle does not address all possible arguments that cut against disclosure.

Jon Karelitz and Mark Casciari

§1.2 Stunning Development — The Ninth Circuit Enforces an ERISA Plan Arbitration and Class Action Waiver Provision

In Dorman v. Charles Schwab Corp., No. 18-15281, 934 F.3d 1107 and 2019 WL 3939644 (Aug. 20, 2019), the Ninth Circuit reversed course, overruled precedent, and enforced an arbitration provision in an ERISA 401(k) plan that mandated individual, and not class, arbitration of ERISA § 502(a)(2) and (3) claims.

In Dorman, a 401(k) participant brought suit on behalf of a putative class of plan participants and beneficiaries, alleging that the fiduciaries had breached their fiduciary duties by investing assets in the funds affiliated with the defendant.  However, nine months prior to the named plaintiff’s termination of employment and nearly a year before his account withdrawal, the plan was amended to expressly include an arbitration provision binding the plan to arbitration, and forbidding class actions.

The defendant moved to compel arbitration.  The district court denied the motion on multiple grounds, ruling that ERISA claims cannot be subject to mandatory arbitration; the arbitration provision was added after the named plaintiff’s participation in the plan began; and the plaintiff’s claims were brought on “behalf of the plan,” rather than as an individual, and thus could not be subject to the plan’s arbitration clause.

Thirty-five years ago, in Amaro v. Continental Can Co., 724 F.2d 747 (9th Cir. 1984), the Ninth Circuit had held that ERISA claims were not subject to arbitration.  Amaro reasoned that an arbitral forum may “lack the competence of courts to interpret and apply statutes as Congress intended.” In Dorman, however, the Ninth Circuit recognized that later Supreme Court cases, including American Express Co. v. Italian Colors Restaurant, 570 U.S. 228 (2013), had held that arbitrators were competent to interpret and apply federal statutes.  Thus, Dorman expressly overruled Amaro.

In an unpublished companion opinion, the Ninth Circuit addressed and reversed other holdings by the Dorman district court.  Although the Ninth Circuit had recently held, in Munro v. Univ. of S. Cal., 896 F.3d 1088 (9th Cir. 2018), that Section 502(a)(2) claims belong to the plan, rather than the individual, the critical difference in Dorman was that the plan had been amended to include an arbitration provision binding the plan.  Thus, the Ninth Circuit found, the plan “expressly agreed” that all ERISA claims should be arbitrated.  The Ninth Circuit also held, citing LaRue v. DeWolff Boberg & Assocs., Inc., 552 U.S. 48 (2008), that although a § 502(a)(2) claim may belong to the plan, losses are inherently individualized in the context of a defined contribution plan such as the one at issue.  The Ninth Circuit reversed and remanded with instructions to the district court to compel arbitration.

The Dorman plaintiff filed a petition for en banc review, so it remains to be seen whether the latest Dorman decisions will stand.  On October 2, 2019, the Ninth Circuit ordered the defendants to respond to Dorman’s Petition.  This indicates that the Ninth Circuit may agree to rehear its prior decision that sent Dorman’s claims to arbitration, on an individual basis.

The Ninth Circuit has been the most hostile to arbitration, so Dorman (unless vacated) is a monumental change that could be the start of trend favoring ERISA plan arbitration.  Arbitration in lieu of court litigation has pros and cons that need to be considered carefully before mandating arbitration and a class action waiver in ERISA plans, even though the court most hostile to forced arbitration now seems to allow it.

Michael W. Stevens, Jonathan A. Braunstein and Mark Casciari

§1.3 ERISA Preemption — The Courts of Appeal Continue to Rule As They Await Further Supreme Court Attempts To Define, Once and for All, Its Limiting Principles

The federal Employee Retirement Income Security Act (ERISA) has been effective, as a general matter, since 1974.  Its section 514 preempts state laws that “relate to” ERISA plans.  The United States Supreme Court has wrestled, in 18 cases, with how to define, and thus limit, “relate to,” as everything can be said to be related to everything else.  Compounding matters is that section 514 lists specific exceptions to “relate to” preemption.  It is our expectation that the Supreme Court will agree to hear more ERISA preemption cases in the future.

In the meantime, the Courts of Appeal continue to rule on the limits to ERISA preemption, often with opposite results.

In Rudel v. Hawai’i Management Alliance Ass’n, 2019 U.S. App. LEXIS 27371 (9th Cir. Sept. 11, 2019), an ERISA plan participant received ERISA medical plan benefits after a motorcycle accident.  Plan terms allowed it to seek reimbursement from a third party tortfeasor, to the extent the tortfeasor paid general damages, up to the amount of the plan payout.  The participant sued to clarify the plan’s reimbursement right, or lack thereof to be more precise, relying on a Hawai’i statute that invalidated general damage insurance reimbursement rights.  The Ninth Circuit said that the state law “related to” an ERISA plan, but found no preemption, relying on the statutory exemption to ERISA preemption in favor of state laws that regulate insurance.

The Ninth Circuit found that the Hawai’i statute regulated insurance because it was directed at insurance reimbursement rights.  The Court added that the state statute affected the risk pooling arrangement between the insurer and the insured by impacting the terms by which insurance providers must pay plan members.

In Dialysis Newco, Inc. v. Cmty. Health Sys. Grp. Health Plan, 2019 U.S. App. LEXIS 27418 (5th Cir. Sept. 11, 2019), however, the Court of Appeals for the Fifth Circuit found ERISA preemption.  The ERISA medical plan at issue contained a valid anti-claim assignment provision.  A third party health care provider sued to recover on what it claimed was a valid assignment of plan benefits, by relying on a state statute requiring plan administrators to honor assignments made to healthcare providers.

The Fifth Circuit found that the state statute “related to” the ERISA plan because it impacted a “central matter of plan administration” and interfered with “nationally uniform plan administration.” The Court said, because states could—and seemingly already do—impose different requirements on when such assignments would be honored, permitting one state law to govern the plan would interfere with nationally uniform plan administration.

These two cases show how the courts continue to grapple with the nearly infinite nuances of ERISA’s remarkably broad preemption provision.  Given the historic interest of the Supreme Court on ERISA preemption, it is likely only a matter of time until this or a related ERISA preemption question is again before that Court.  ERISA preemption is bound to get more interesting before it gets boring.

Mark Casciari and Ian Morrison

§1.4 The Trump Administration Wants You to Know, Guidance is NOT Law!

Employee benefit lawyers, including employee benefit litigators, have historically been inclined to rely on federal agency guidance that does not technically have the force of law.  Lawyers have followed this practice to appease the agency—the first line of potential opposition—and thus allow a client to re-focus quickly on business goals.  Another reason is that the federal courts have for years given deference to federal agencies.  So why not reflexively back away from a fight when the agency is likely to win in court anyway?

The difficulty with a “guidance-as-gospel” approach is that federal agency officials and regulators are not elected and thus cannot enact legislation.  Deference may operate as a shield for guidance that is outside what Congress has legislated, and is based on an executive-branch political agenda.

This is the view of the Trump administration.

One of the new executive orders attempts to stop reliance on guidance that goes beyond a statute, or notice and comment regulations (which have the force of law, if consistent with the governing statute).  The other order requires agencies to establish a single, searchable toolbar that links to all of the already issued guidance.  Additionally, the website must note that the guidance does not have the force and effect of law, unless as authorized by law or incorporated into a contract.  The new executive orders direct that enforcement action cannot be based only on guidance.  Enforcement must be based on the governing statute.

The force of the new executive orders may extend beyond the life of the Trump administration.

Federal courts increasingly question the wisdom of the historic deference given to guidance.  Noteworthy is Kisor v. Wilkie, 139 S. Ct. 2400 (2019), wherein a veteran sought PTSD disability benefits from the Department of Veterans Affairs.  The agency partially denied his claim and the Court of Appeals for the Federal Circuit affirmed by deferring to the agency’s interpretation of what it said was an ambiguous regulation.  The Supreme Court reversed and remanded the case back to the Court of Appeals.  Justice Elana Kagan wrote the majority opinion, and stated that a court should defer to the agency only after satisfying itself that the regulation is “genuinely” ambiguous, and if so, “reasonable.” The Court added that the agency’s interpretation must be an official position, as opposed to an ad hoc statement, must implicate its substantive expertise, and be otherwise “fair and considered.”

To be sure, Kisor does not involve guidance, but its holding—federal courts must not reflexively defer to agency action—applies with the same (or greater) force to guidance.  So, employers and fiduciaries should rely only on guidance they believe is fully consistent with a careful analysis of the governing statutory law.

Mark Casciari

§1.5 No Partnership, No Common Control, No Withdrawal Liability: Private Equity Funds Not Liable for Portfolio Company’s Multiemployer Plan Withdrawal Liability

In a 2013 decision, the District Court of Massachusetts found that the two Sun Capital PE funds were not only engaged in “trade or business,” but also were a partnership acting under “common control” with a bankrupt portfolio company, and therefore, liable for the portfolio company’s $4.5 million withdrawal liability to a multiemployer pension plan incurred upon its bankruptcy.  Under ERISA, the common control standard is met if there is an 80% ownership interest.  The district court found that even though the two PE funds had individual investment stakes in the portfolio company of only 70% and 30% respectively, they were acting as a partnership and so their ownership interests should be aggregated, thereby exceeding the 80% threshold.

The PE funds appealed the decision and the First Circuit reached its decision: no partnership, no common control, no withdrawal liability.  Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, No. 16-1376, 2019 WL 6243370 (1st Cir. Nov. 22, 20190.  The First Circuit applied factors derived from an old tax court case, Luna v. Commissioner, and concluded that the PE funds’ activities did not rise to the level of a partnership.  Among the factors considered, the PE funds were not acting in concert when making investments, conducted business under separate names, filed separate tax returns, kept separate books, and disclaimed any sort of partnership.  The court also noted the fact that the PE Funds were formed as LLCs further demonstrated an intent not to form a partnership.

Importantly, the court stated that it was reluctant to impose withdrawal liability on the PE funds when there was no clear congressional intent to do so, and no guidance from the PBGC.

But beware: While this is a significant victory for PE funds in general, the court’s decision was very fact specific, and it did not “reach other arguments that might have been available.” It will be interesting to see if other circuit courts follow this precedent.

Ryan Tzeng, Jessica Stricklin, and Alan Cabral

§1.6 Beware of the “Overshare”: Construe Requests for ERISA Plan Documents Narrowly!

Section 104(b)(4) of ERISA requires that plan administrators provide certain plan documents to a participant or beneficiary (or their authorized personal representative) upon written request, including copies of the summary plan description, plan document, annual report, trust agreement, contract and bargaining agreement, as well as documents that fall within a catch-all of “other instruments under which the plan is established or operated.” When document requests are received, it’s not at all uncommon for the request to include a long list of documents, often times repetitive, leaving the plan administrator to weed through the request and identify the documents that must be provided under ERISA.

In Theriot v. Building Trades United Pension Trust Fund, et al. (E.D. La. Nov. 4, 2019), plaintiff alleged that the defendants, a multi-employer pension fund and its trustees, failed to timely produce plan documents in violation of Section 104(b)(4), entitling the plaintiff to statutory penalties of up to $110 per day.

In 2017, the plaintiff requested “a complete copy of the plan agreement, including [her deceased mother’s] application and all other correspondence from her to the Fund.” The defendants provided a copy of the plan document, current through 2017.  The plaintiff alleged that the defendants should have known that she was also requesting other plan documents, including an outdated version of the plan document and summary plan description, even though she did not specifically request them.

In 2018, the plaintiff made a second request, also including a long list of additional plan documents.  The defendants provided only copies of the 2017 plan document, trust agreement and summary plan description in effect as of the dates specifically requested, as well as copies of Forms 5500 and attachments.  Plaintiff, however, alleged that the defendants failed to produce any of the other documents from the 2018 request.  The court determined that certain of the document requests were not sufficiently clear, some of the requested documents did not exist and some were not relevant to the plaintiff understanding her rights under the plan.  The court also determined that a reasonable plan administrator would not have known that the plaintiff was requesting other documents beyond the 2017 plan document.  And notably, the court agreed with the majority of other circuits that Section 104(b)(4) did not encompass the fidelity bonding policy, any errors and omissions insurance policy or any fiduciary insurance policy.

Takeaway: The Theriot case shows that narrowly construing Section 104(b)(4) can be defensible.  It also can be advisable.  Any lawsuit challenging fiduciary conduct must allege plausible facts to survive a motion to dismiss and enter into expensive discovery.  There is no sound reason to make the plaintiff’s task in this regard easier by over-producing documents under Section 104(b)(4).

Sarah Touzalin and Mark Casciari

§1.7 Supreme Court Remands Case Back Seeking Clarification of the Dudenhoeffer Pleading Standard

In Retirement Plans Committee of IBM v. Jander, the Supreme Court, in a unanimous opinion, clarified the its opinion in Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409 (2014), which set forth the duties that administrators of Employee Stock Ownership Plans (“ESOP”) owe to participants, and when they are required to act on inside information.

In this case, plaintiffs alleged that the IBM’s ESOP fiduciaries violated their duty of prudence under ERISA by continuing to invest the plan’s funds in IBM’s stock even though they knew the stock’s market price was artificially inflated.  Under Dudenhoeffer, a plaintiff bringing such a claim must allege that a fiduciary in the same position could not have concluded that taking a different action “would do more harm than good to the fund.” The question presented to the Court in Jander was whether the plaintiffs’ complaint can survive a motion to dismiss when they make only general allegations that the costs of undisclosed fraud grow over time.

Though the Court agreed to take the case, it ultimately declined to opine on the issue presented.  Rather, it remanded the matter to the Second Circuit for further consideration of the SEC’s position on whether an ERISA based duty to disclose inside information, that is not otherwise required to be disclosed by the securities laws, would otherwise conflict with the objectives of the insider trading and corporate disclosure requirements contained in the securities laws.  IBM argued that ERISA imposed no duty to act on inside information.

Thus, the Supreme Court left unresolved the question presented regarding the pleading standard.  It did, however, provide some helpful guidance to fiduciaries of ESOP plans in that it emphasized that ERISA’s duty of prudence does not require a fiduciary to break the law.  Thus, if taking an action on inside information would violate the securities law, there is no violation of ERISA for not taking that action.  But we will also wait to see how the SEC views ERISA’s duty of prudence in this context.

Jim Goodfellow and Kathleen Cahill Slaught

§1.8 Supreme Court’s Sulyma Ruling Toughens ERISA’s “Actual Knowledge” Standard & Makes Dismissal of Fiduciary Breach Actions More Unlikely

Plaintiff Christopher Sulyma filed a putative class action in October 2015, alleging that Intel’s investment committee and other plan administrators breached their fiduciary duties by utilizing “alternative investments” that lagged behind high-performing index funds.  The Northern District of California granted summary judgment to the committee based on plan disclosures that clearly revealed the disputed investments and were published more than three years before the plaintiff filed suit.  The Ninth Circuit reversed the ruling, finding that Sulyma’s deposition testimony that he did not recall reviewing plan disclosures created a dispute of fact as to his “actual knowledge” and precluded summary judgment.

Affirming the Ninth Circuit, the Supreme Court unanimously found in an opinion authored by Justice Alito that although ERISA does not define “actual knowledge,” it plainly requires awareness of the “relevant facts” provided in the plan’s disclosures.  In addition, Congress’s language in ERISA clearly identifies whether a particular statute of limitations is triggered by what a plaintiff actually knows or what he reasonably should know.  The language in § 1113(2), however, clearly notes that only a plaintiff’s “actual knowledge” triggers the 3-year limitations period for a fiduciary breach action, rather than what he should have known from disclosures provided to him.

Justice Alito, however, stressed that that a participant’s assertion that he did not know about the disclosed information related to the alleged breach might not be the end of the story.  “Actual knowledge” may be proved through inference from circumstantial evidence.  For instance, electronic records may show that a plaintiff reviewed plan disclosures and acted in response.  If a plaintiff’s denial of knowledge is “blatantly contradicted” by the factual record, the Supreme Court instructed trial courts to act accordingly.

The case provides succor to the plaintiffs’ bar because the Court could have found that mere delivery of plan disclosures triggers the three-year limitations period.  While disclosures are not an automatic shield, they form an important part of the defense in most cases.  To rebut claims of lack of knowledge, plans may wish to consider adopting electronic procedures to confirm that participants have reviewed disclosures, such as requiring participant acknowledgments.

Ian H. Morrison

§1.9 Will The ACA Case Now Before The Supreme Court Make It Harder For ERISA Fiduciary Breach Plaintiffs To Establish Standing?

On March 2, 2020, the United States Supreme Court granted certiorari in California v. Texas, No. 19-840, which appeals the decision of the Court of Appeals for the Fifth Circuit that struck down the individual mandate to the Affordable Care Act (ACA).

In Texas v. United States (as the case was styled previously), the Fifth Circuit held that the two individual plaintiffs who were self-employed residents of Texas had standing to challenge the ACA, despite not being subject to a financial penalty.  There was no penalty because the 2017 Tax Cuts and Jobs Act (TCJA) set the penalty for not maintaining individual health insurance at zero dollars.  According to the Fifth Circuit, the individual plaintiffs had standing because they demonstrated the “increased regulatory burden” that the individual mandate imposes.

The Supreme Court is keenly interested whether a federal court plaintiff has a sufficient injury to sue in a federal forum when she can show no other harm besides a technical statutory violation.  In Spokeo v. Robbins, the Supreme Court held that, although Congress can create federal claims, those claims can only be litigated in federal court as long as the plaintiff alleges a “concrete” injury (i) that affects the plaintiff in a personal and individual way, (ii) that is traceable to the defendant, and (iii) that is repressible by the federal judge.

It is possible that the Supreme Court may dismiss the individual plaintiffs in Texas v. United States for lack of standing, finding that they have not been harmed by a mere obligation to maintain individual health insurance without a corresponding penalty.  Such a ruling would seemingly comport with Spokeo, which suggests that private plaintiffs may not sue to enforce statutory obligations when they have not yet been harmed by violations of those obligations.  ERISA fiduciaries thus might expect a drop in class action filings, especially as all private claims for breaches of fiduciary duty under Section 502(a)(2) and (a)(3) may be brought only in federal court, and not in a state court.  A technical ERISA statutory violation may not be found “concrete and particularized,” or “actual or imminent,” and may instead be considered “conjectural” or “hypothetical,” buzz words used to determine the outcome of Spokeo arguments to dismiss.

Mark Casciari

§1.10 ERISA Fee Motions After COVID-19 — A Substantive and Procedural Review

Two interesting lower court decisions on attorney fee motions were recently issued from Judge Susan Brnovich of the federal District of Arizona and Judge Beau Miller in the District Court of Harris County, Texas of the 190th Judicial District.  One decision presents a refresher course on the merits of ERISA fee motions and the other used the novel procedural approach of conducting a Zoom video hearing in lieu of live appearances.

The first decision, United Air Ambulance LLC, v. Cerner Corporation, et al., Case No. CV-17-04016 (U.S. Dist. Ct. D. Ariz., Apr. 14, 2020), addressed when prevailing ERISA plaintiffs may recover fees as instructed by the Court of Appeals for the Ninth Circuit.  Judge Brnovich denied ERISA Section 502(g)(1) fees after carefully considering the following factors: (1) degree of the opposing party’s culpability or bad faith, (2) the ability of the opposing party to satisfy an award of fees, (3) whether an award of fees against the opposing party would deter others from acting under similar circumstances, (4) whether the party seeking fees sought to benefit all participants and beneficiaries under an ERISA plan or to resolve a significant ERISA legal question, and (5) the relative merits of the parties’ positions.  The Court found that these factors split evenly, save for two, which tipped the scales against an award of fees to the plaintiff.  The deterrence factor weighed against plaintiff because the case involved a unique set of facts, so no one else was likely to encounter the scenario at issue.  The resolution of the case was not a benefit to all participants under the plan and resolved no significant legal question about ERISA, as it focused on procedural shortcomings.  This decision is a reminder that, unlike the case with other federal statutes such as Title VII of the Civil Rights Act of 1964, ERISA fee motions by prevailing a plaintiff (or defendant) should not always be given a presumption of success.

In Ahmed v. Texas Fair Plan Assoc., Case No. 2016-09336, Judge Miller considered whether to grant a fee motion in an insurance case.  Following the Texas Supreme Court’s order mandating that all hearings be conducted remotely, the Court held a one-day bench trial via Zoom.

The post–COVID-19 world will present many new ways of doing business, and we can foresee federal judges experimenting with Zoom hearings in lieu of expensive and now unwelcome travel.  A good place to start may be with fee motions, as they are ancillary to the merits of the case.  Video hearings will present new challenges for lawyers and clients, not the least of which are video quality and reliability, and maintaining eye contact in a virtual world.  Savvy ERISA attorneys are likely to improve their command of video appearances and confront the unique challenges of video persuasion, as we enter the brave, new world of the e-trial attorney.

Rebecca Bryant & Mark Casciari

§1.11 Whose Law? Where? When? — Risk Management for ERISA Plans in Uncertain Times

The COVID-19 pandemic seems likely to spawn many claims for ERISA benefits, whether under health, retirement or disability plans, and now is the time to consider anew proactive risk management steps.  A recent decision from the Court of Appeals for the Tenth Circuit, Ellis v. Liberty Life, No. 19-1074 (10th Cir. May 13, 2020), illustrates the particular importance of the risk management tool of including a favorable choice of law provision in an ERISA long-term disability plan that provides benefits through an insurance policy.

The issue in Ellis was whether the federal district court’s review of the plan administrator’s denial of long-term disability benefits was subject to an abuse of discretion standard or subject to de novo review.  The lawsuit was filed in Colorado.  Colorado’s insurance regulations, like those in many states, forbid insurance policies from giving insurers, plan administrators or claims administrators discretion to interpret the policy’s terms in making benefits decisions.  Such laws have been challenged by relying on ERISA’s general preemption of state law that relates to an ERISA plan, but that preemption provision contains an exception for state laws regulating insurance.

However, the plan here contained a choice of law provision stating that if there was an issue of state law, then Pennsylvania law governed.  The employer was both incorporated and headquartered in Pennsylvania.  Unlike Colorado, Pennsylvania does not have an insurance law that prohibits discretionary clauses in insurance policies.  The question was whether the choice of law provision should be honored.

The Court held that such a clause should be enforced so long as the chosen state has a valid connection to the plan.  As the employer was both incorporated and headquartered in Pennsylvania, the Court found the choice of law provision applied and thus reviewed the claim for abuse of discretion.  Applying this standard, the Court affirmed the decision of the insurer.

Employers should take the opportunity now to review their ERISA plans to consider adding risk management provisions.  And such provisions may go beyond a choice of law.  For example, we cannot but wonder if the Ellis case would have proceeded more smoothly to its ultimate conclusion if there had been a forum selection clause mandating that the litigation be held in Pennsylvania.  In addition, the defendant likely could have avoided this entire inquiry if the plan sponsor had drafted a plan document, separate from the insurance certificate, that vested the insurer with discretion.  There are other plan-based risk management tools, such as plan limitations or arbitration provisions, which might be applied in other situations.

Richard Loebl and Mark Casciari

§1.12 The Supreme Court Further Narrows Federal Court Jurisdiction Over an ERISA Complaint, Relying on Article III of the Constitution

In Thole v. U.S. Bank et al., No. 17-1712 (June 1, 2020), the U.S. Supreme Court affirmed dismissal of ERISA claims brought on behalf of participants in a defined benefit pension plan.  The participants alleged financial mismanagement, but suffered no financial loss.  The question was the following: may the participants sue in federal court for monetary relief because of the alleged mismanagement?  The relief demanded by the participants in their complaint was substantial — $750 million and $31 million in lawyer’s fees.

In a 5-4 decision, the majority reasoned that the plaintiffs “would still receive the exact same monthly benefit” even if they won in court, and thus had no concrete injury under the Constitution’s Article III that would allow for the lawsuit (and consequent expensive discovery and possible settlement).  It thus is important to note these controlling preconditions to any lawsuit in federal court that were reiterated in Thole:  (1) a concrete injury, (2) caused by the defendant, that is (3) redressable by the requested judicial relief.

The Article III stakes are high, because the tougher the preconditions for establishing standing to sue in federal court, the harder it will be for class actions to proceed there.  ERISA makes the Thole holding even more consequential because state courts have no jurisdiction to resolve claims of fiduciary breach under ERISA.  That means that plaintiffs cannot resort to state court to avoid Thole when alleging claims to recover excessive 401(k) fees and claims of mere statutory violations.

The majority did say plan participants, in another case, might be able to establish Article III standing if they plausibly allege “that the alleged mismanagement of the plan substantially increased the risk” that benefits would not be paid.  The precise meaning of this proviso will need to be developed in later litigation.  The Court also emphasized that the plan at issue provided a defined benefit, and that a defined contribution plan participant alleging the same wrongdoing might attain Article III standing.

Of note as well is that Justice Thomas, joined by Justice Gorsuch, said that ERISA case law is too tightly bound to the common law of trusts.  This may portend a new line of analysis by the Court in future ERISA cases.  The Court may focus more on the plain reading of the statute, as opposed to traditional notions of trust law not grounded in that statutory language.  Also of note is that Thole represents another effort by the Court, and especially Chief Justice Roberts, to limit federal jurisdiction generally.

The decision is good news for ERISA plans and their sponsors, as it will be more difficult for participants to bring individual or class actions for mere statutory violations that have not impacted benefits.

Michael W. Stevens and Mark Casciari

§1.13 Limits To ERISA’s Equitable Remedies — What The Supreme Court’s Latest Securities Act Decision Tells Us

ERISA’s civil enforcement provisions generally allow the federal courts to award appropriate “equitable” relief.  A permissible equitable remedy is disgorgement, which, in the ERISA context, is restoration to the affected plan of fiduciary profits that were illegally earned with plan assets.

Not much has been written about disgorgement, but Liu v. SEC, 591 U.S. ___, No. 18-1501 (June 22, 2020), a Supreme Court decision interpreting the federal Securities and Exchange Act, offers some insight on its meaning.  (The Court has already ruled that ERISA equitable relief does not permit extra-contractual or punitive damages.  See Mass. Mut. Life Ins. Co. v. Russell, 473 U.S. 134 (1985).  So, a disgorgement remedy cannot include extra-contractual or punitive damages.)

In Liu, an 8-1 majority held that “disgorgement” is a permissible equitable remedy in securities’ cases.  The Court observed that disgorgement can be seen as imposing a constructive trust or an accounting, and is equitable in nature even if not specifically mentioned in a statute.  The Court added that disgorgement is not joint and several, and is not limited to cases involving fiduciary breaches.  The Court held that district courts thus may enter disgorgement awards as part of equitable relief, as long as they target net profits, after deducting legitimate expenses.

Justice Thomas dissented, writing that disgorgement is not a traditional form of equitable relief.  He added that a disgorgement remedy, if ordered, must go to the plan participants victimized by the breach, and not to the government.

Notably, Justice Thomas cited ERISA for the proposition that the Supreme Court has never considered general statutory grants of equitable authority as giving federal courts a freewheeling power to fashion new forms of equitable remedies.  He said that the contours of equitable relief were transplanted to our country from the English Court of Chancery in 1789, in contradistinction to remedies at law, which turn on the words used in statutes.

It thus is worth noting that the parameters of ERISA’s equitable relief provisions will continue to be defined by the federal courts.  But it is now clear that disgorgement is an equitable remedy, even if not specifically mentioned in the statute, as long as it is net of legitimate expenses.  Look for more litigation in an appropriate case on the meaning of “profits” and “legitimate expenses.”  And attorneys for plans and plan sponsors should expect the ERISA plaintiff bar to seek disgorgement whenever possible.  Finally, ERISA practitioners should continue to pay close attention to securities’ decisions from the Supreme Court, as the Court continues to address the overlap between the two statutes.  See Retirement Plans Committee of IBM v. Jander, 573 U.S. __, No. 18-1165 (Jan. 14, 2020) (ERISA stock drop decision).

Mark Casciari and Michael W. Stevens

§1.14 The 10th Circuit’s New Interpretation of What is Mandated under ERISA’s Notice Requirements May have Far Reaching Effects On Plan Administrator’s Duties

In ERISA benefit claim litigation, where there is a sufficient delegation of discretionary authority to an administrator in the governing plan document, a court reviewing an administrator’s decision will generally employ the highly deferential abuse of discretion standard of judicial review rather than the de novo standard of review.

In a recent mental health treatment case, the Tenth Circuit added additional requirements before a court will apply the abuse of discretion standard to analyze a benefit claim determination.  Lyn M.; David M., as Legal Guardians of L.M., a minor v. Premera Blue Cross, No. 18-4098, __ F.3d __.  The court ruled that despite a grant of discretion to the administrator in the governing plan document, the deferential standard of review could not apply in litigation as there was no evidence demonstrating plan participants knew that the employer’s plan document containing the discretionary authority clause existed.  Rather, the participants had received only an SPD, which was silent as to discretionary authority.  The Court determined that proper notice requires the plan administrator to either (1) actually disclose its discretionary authority or (2) explicitly disclose the existence of the plan document containing information about the discretionary authority.  The court found that the fact that the governing plan document was available to participants on request was insufficient this new disclosure requirement.

In a biting dissent, Judge Allison H. Eid reasoned that the SPD sufficiently alerted participants that other plan documents existed and were available.  Judge Eid criticized the majority for imposing a duty on plan administrators, found nowhere in ERISA or case law, “to specifically inform members that documents exist that could affect judicial review.”  The dissent correctly noted that while SPDs must be provided and include certain mandatory information regarding benefit eligibility and claim procedures, there is no duty under ERISA to specifically notify participants of documents that may affect the judicial standard of review should their claims be decided in court.

This decision is a significant departure from the standard principle that the standard of review employed by a reviewing court does not turn on whether the document containing that standard was provided to participants during the claim review process.  Only time will tell if other courts will adopt the Tenth Circuit’s position.  For now, benefit plans operating in the Tenth Circuit should evaluate their claim procedures in light of this decision.

Rebecca K. Bryant, Sam M. Schwartz-Fenwick, and Ian H. Morrison

§1.15 Transgender Patients Remain Protected: District Court Blocks HHS Rule From Taking Effect

A Federal Court has temporarily enjoined the Trump administration from putting into effect its recent rule that strips the Affordable Care Act of its gender identity protections.

The section of the final rule on Section 1557 of the Affordable Care Act that stripped the regulations of their gender identity protections was slated to take effect yesterday.  But it did not.

Rather, on August 17, 2020, a federal judge in the Eastern District of New York issued a stay that blocked that portion of the U.S. Department of Health and Human Services’ final rule from taking effect.  (Tanya Asapansa-Johnson Walker and Cecilia Gentili v. Azar M. Azar II, and the U.S. Dept. of Health and Human Services, Case No. 20-CV-2834, United States District Court, E.D. of NY, August 17, 2020).  The Court only addressed the final rule’s interpretation of “discrimination on the basis of sex” in its stay and did not address the other changes ushered in under the Department’s final rule.  Those other changes took effect on August 18, 2020.

Section 1557 of the ACA prohibits health programs and activities that receive federal financial assistance from discriminating on the basis of race, color, national origin, disability, age, or sex.  Section 1557 takes its prohibition against discrimination on the basis of sex from its reference to Title IX of the Education Amendments of 1972 (Title IX).  Since its inception, Section 1557 has prohibited discrimination on the basis of gender identity in healthcare through its prohibition against discrimination on the basis of sex.

On June 12, 2020, the Department issued its final rule on Section 1557 – explicitly removing protection from discrimination on the basis of gender identity from its prohibition against discrimination on the basis of sex.  This meant that, once the final rule took effect, covered entities could discriminate against transgender patients without violating Section 1557.

On June 15, 2020, in Bostock v. Clayton County, the Supreme Court held that Title VII’s prohibition against discrimination on the basis of sex captures within it a prohibition against discrimination on the bases of sexual orientation and gender identity.  Specifically, the Court held that “it is impossible to discriminate against a person for being homosexual or transgender without discriminating against that individual based on sex.”

And so, we found ourselves in an accordion-like quagmire where “on the basis of sex” included gender identity under Title VII and but was still interpreted by at least one executive branch agency to exclude gender identity under Section 1557 vis-à-vis Title IX.

The injunction signals that a resolution to this quagmire may be on the horizon.

In his ruling, Judge Frederic Block found the Department knew that the then-forthcoming decision in Bostock could have “ramifications” for its final rule given that both Title VII and Title IX prohibit discrimination “on the basis of sex” but “was apparently confident that the Supreme Court would endorse the Administration’s interpretation of sex discrimination…” The Court wryly noted that the Department’s “confidence was misplaced” and held that once the Supreme Court issued Bostock, the Department had to consider its implications for its final rule.  As Judge Block stated: “Instead it did nothing….  Since [the Department] has been unwilling to take that path voluntarily, the Court now imposes it.” The final rule cannot take effect until a court decides what the decision in Bostock means for Section 1557.

And so, the portion of the final rule that would have allowed for discrimination on the basis of gender identity in health programs and activities did not take effect yesterday, and transgender patients remain protected while the litigation challenging the final rule continues.  We will continue to follow this case with interest.

Emily Miller, Ben Conley, and Sam Schwartz-Fenwick

§1.16 Countdown to the Supreme Court’s ERISA Preemption Oral Argument in Rutledge — Two Noteworthy Case Developments

The Supreme Court has agreed to hear Arkansas’s challenge to a decision by the Court of Appeals for the Eighth Circuit holding that ERISA preempts an Arkansas law regulating prescription drug reimbursement.  Merits briefing is now complete and oral argument is set for October 6, 2020 in Rutledge v. Pharmaceutical Care Management Association, (No. 18-540).

The Supreme Court’s decision in Rutledge will have resounding implications on ERISA plans.  fiduciaries and administrators.  Not only are state laws regulating pharmaceutical benefits (the subject matter of Rutledge) widespread, states have also taken to regulating a host of other benefit matters, presenting high hurdles for multi-state employers, fiduciaries and administrators seeking to establish uniform nationwide procedures.

So the precise location of where the Supreme Court draws the line on preemption will likely cause ripple effects well beyond pharmaceutical benefits.  And the Court’s line-drawing reasoning is important given that the statute preempts all state laws “relating” to employee benefit plans regulated by ERISA.

Two recent case developments underscore Rutledge’s importance, both in the pharmaceutical benefits realm and beyond.

First, the Eighth Circuit held that a North Dakota law regulating pharmaceutical benefits is preempted by ERISA because the law’s “provisions apply to plans subject to ERISA regulation and therefore the law cannot function irrespective of any ERISA plan.” Pharm. Care Mgmt. Ass’n v. Tufte, No. 18-2926, 2020 WL 4554980, at *1 (8th Cir. Aug. 7, 2020) (internal quotation marks omitted).  The Court relied on its prior decisions (including Rutledge) striking down similar laws.

Additionally, in another case (filed in the U.S. District Court for the District of New Jersey), an employer trade association is alleging that New Jersey’s WARN Act expansion requiring mandatory severance payments for certain employees is preempted by ERISA.  The ERISA Industry Comm. v. Angelo, No. 20-cv-10094 (D.N.J. Aug. 6, 2020).  The plaintiff contends that the severance obligation requires the creation of a benefit plan that has ongoing administrative obligations and requires the use of discretion in determining benefit eligibility.  The plaintiff alleges that this sort of plan would be governed by ERISA and therefore that the New Jersey law impermissibly “relates” to an ERISA plan.  The plaintiff also alleges that the New Jersey law creates the sort of state-by-state regulatory patchwork that ERISA was designed to avoid.

Jules Levenson and Mark Casciari

§1.17 How to Minimize Judicial Review of ERISA Fiduciary Decisions

One of the enduring paradoxes of ERISA litigation is the judicial standard of review of fiduciary decisions.  The standard of review is important because an easier standard will uphold more fiduciary decisions in court and encourage more individuals to serve as fiduciaries.  No one who acts in good faith—as the vast majority of ERISA fiduciaries do—likes to make tough decisions and be sued or reversed.

On the one hand, the courts frame their review of fiduciary decisions in exacting terms.  For example, in Donovan v. Bierwirth, 680 F.2d 263 (2d Cir. 1982), the Court of Appeals for the Second Circuit said that the ERISA fiduciary’s duty of loyalty to plan participants and beneficiaries is “the highest known to the law.”

But, in Bator v. District Council 4, Graphic Communications Conf., No. 18-cv-1770 (7th Cir. Aug. 27, 2020), the court proffered another viewpoint.  It considered whether ERISA fiduciaries violated their duties by undercutting the financial health of the pension plan they managed.  The plaintiffs alleged that the fiduciaries breached their duties by not enforcing the contribution terms of the Trust Indenture when they allowed one participating local union’s members at one company to contribute to the plan at lower rates than other members form the same local at another company.  Notably, the case did not involve a review of a claim for benefits, and the court’s decision did not turn on claim review.

The Bator court upheld the fiduciary decision by reasoning that the fiduciary interpretation of the governing plan document “falls comfortably within the range of reasonable interpretations” and “is compatible with the language and the structure” of that document.  The Court did so even though it recognized that the plaintiffs’ interpretation of the Trust Indenture was equally reasonable.

So, how can these very different standards of judicial review be reconciled?

Yes, reconciliation is possible.  ERISA’s core focus is the governing plan documents.  If, as in Bator, they provide the fiduciary with broad discretion to interpret their terms, and provide that the fiduciary decision shall be final and binding, the court should give the fiduciary the benefit of the doubt.

One final point is worth noting.  Plaintiffs often argue that equitable principles should govern judicial review of fiduciary decisions.  However, as Justice Thomas said recently in his concurrence in Thole v. U.S. Bank, 140 S.Ct. 1615 (2020), the common law of trusts is not the starting point for interpreting ERISA.  The starting point is the statute itself, and the statute commands that the courts honor ERISA plan terms, including terms that give interpretative discretion to fiduciaries.

Our take away is—there is no substitute for good drafting of ERISA plan terms.

Mark Casciari and Ronald Kramer

§1.18 First Circuit Rules that Private Equity Funds Not Liable for Portfolio Company’s Multiemployer Plan Withdrawal Liability

In a decision published on November 22, 2019, the First Circuit reversed a district court’s prior decision and held two Sun Capital private equity funds were not liable for the withdrawal liability incurred when a jointly owned portfolio company declared bankruptcy and withdrew from a union pension fund.  Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, No. 16-1376, 2019 WL 6243370 (1st Cir. Nov. 22, 2019).

The case arose after a brass manufacturing company, Scott Brass, Inc. (SBI), filed for bankruptcy following the decline of copper prices.  In connection with the bankruptcy, SBI withdrew from a multiemployer pension plan, incurring $4.5 million in withdrawal liability.  At the time of bankruptcy, SBI was a portfolio company owned by a holding company that itself was jointly owned by two private equity funds, Sun Capital Partners III, LP (Sun Fund III) and Sun Capital Partners IV, LP (“Sun Fund IV” and, collectively, the “Sun Funds”).  The Sun Funds were sponsored and managed by a private equity firm, Sun Capital Advisors, Inc.  The multiemployer pension plan assessed withdrawal liability against both SBI and the Sun Funds on the grounds that the Sun Funds were a partnership exercising common control over SBI.

Under ERISA, as amended by the Multiemployer Pension Plan Amendments Act of 1980, when an employer exits a multiemployer pension plan, the plan may assess withdrawal liability on the employer for the employer’s share of unfunded vested benefits.  ERISA provides that, when “trades or businesses” are under “common control,” they are treated as a single employer.  It follows, then, that trades or businesses under common control are jointly and severally responsible for any withdrawal liability incurred by one of the trades or businesses.  With respect to “common control,” for purposes of withdrawal liability, the Pension Benefit Guaranty Corporation (PBGC) adopted regulations that generally mirror IRS controlled group regulations: common control exists if there is individual or aggregated ownership of at least 80%.

In 2013 and 2016, the District Court of Massachusetts found that the Sun Funds were not only “trades or businesses,” but also a partnership-in-fact (i.e., a partnership under common law) acting under “common control” with SBI.  Sun Fund III and Sun Fund IV had individual investment stakes in the portfolio company of only 70% and 30%, respectively, so the strict common control ownership threshold was not met.  However, the critical partnership-in-fact finding meant those individual ownership stakes were nevertheless aggregated for determining common control.  Narrowly, those rulings meant the Sun Funds were jointly and severally liable for SBI’s withdrawal liability.  More broadly, those rulings threatened the fundamental way private equity funds are established, funded, and operated.

Because the First Circuit had previously ruled that Sun Fund III was a trade or business (and, on remand, the lower court found the same for Sun Fund IV), the outstanding issue on appeal was whether the Sun Funds had indeed formed a partnership-in-fact that caused the Sun Funds’ individual ownership stakes in SBI to be aggregated.  In the absence of formal guidance from the PBGC on determining when separate entities are considered to be a partnership-in-fact, the First Circuit turned to the partnership factors articulated in an old tax court case, Luna v. Commissioner¹ for its analysis.  Those factors are:

1. The agreement of the parties and their conduct in executing its terms;
2. The contributions, if any, which each party has made to the venture;
3. The parties’ control over income and capital and the right of each to make withdrawals;
4. Whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income;
5. Whether business was conducted in the joint names of the parties;
6. Whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers;
7. Whether separate books of account were maintained for the venture; and
8. Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.

Applying these Luna factors, the First Circuit noted that some facts supported a partnership-in-fact between the Sun Funds.  For instance, the Sun Funds scouted potential portfolio companies, and essentially the same two individuals ran both the Sun Funds.  However, the First Circuit found facts supporting the opposite finding more compelling.  That is, the Sun Funds expressly disclaimed any sort of partnership with each other in their respective limited partnership agreements and each was created as a separate LLC; they filed separate tax returns and maintained separate books and bank accounts; most of the 230 limited partners in Sun Fund IV were not also limited partners in Sun Fund III; and the Sun Funds did not invest in parallel in the same portfolio companies.

In the end, the First Circuit recognized conflicting policy goals—on the one hand, the need “to ensure the viability of existing pension funds,” and, on the other hand, the need “to encourage the private sector to invest in, or assume control of, struggling companies with pension plans[.]” The court also stated it was reluctant to impose withdrawal liability on the Sun Funds when there was neither clear congressional intent to do so nor formal guidance from the PBGC.

While this is certainly a positive outcome for private equity funds, the First Circuit’s decision was very narrow and fact specific—the court did not reverse the district court’s earlier decision that the Sun Funds were “trades or businesses,” and the court noted that it did not “reach other arguments that might have been available to the parties.” This suggests that had the facts been different, the court could have ruled the other way.

Bryan M. O’Keefe, Ronald Kramer, and Samuel Rubinstein

Editor

Bradford K. Newman

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Chair of North America
Trade Secrets Practice
Baker McKenzie
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Assistant Editor

Adam Aft

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Co-Chair Global Technology Transactions
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Contributor, Legislation Section

Yoon Chae

Senior Associate, IPTech
Baker McKenzie
1900 N. Pearl Street, Suite 1500
Dallas, TX 75201
(214) 965-7204
[email protected]

Introduction

We are pleased to present the inaugural Chapter on Artificial Intelligence.  For years, I have been at the forefront of advocating for rational federal regulation of AI and have published on AI ethics and fairness.I frequently represent clients with legal issues related to both commercial and embedded AI.  Additionally, I am the host of the ABA’s AI.2day Podcast.  In 2018, my proposed legislation, The AI Data Protection Act, was formalized into a House of Representatives Draft Discussion Bill.  In 2021, the ABA will publish my book which is designed to be an AI field guide for business lawyers. 

So I was thrilled when the Section agreed that the Annual Review should include a new Chapter devoted entirely to AI.  Before any substantive federal legislation is enacted, many legal issues related to AI will play out in state and federal courts around the country.  As applications of artificial intelligence, including machine learning, continue to be deployed in a myriad of ways that impact our health, work, education, sleep, security, social interaction, and every other aspect of our lives, many critical questions do not have clear cut answers yet.  Companies, counsel, and the courts will, at times, struggle to grasp technical concepts and apply existing law in a uniform way to resolve business disputes.  Thus, tracking and understanding the emerging body of law is critically important for business lawyers called on to advise clients in this area.  As with other areas of emerging technology, the courts will be faced with applying legal doctrines in new ways in view of the nature of the technology ranging from the use of AI in criminal cases to the impact of AI on patentable subject matter.

The goal of this Chapter is to serve as a useful tool for those business attorneys who seek to be kept up to date on a national basis concerning how the courts are deciding cases involving AI.  Micro and macro trends can only be identified by surveying cases around the country.  We confidently predict the cases we report will increase exponentially year over year.

As this is our first installment of the AI Chapter in a burgeoning field, we made some editorial decisions: (i) we included a few cases older than the past year; (ii) unlike other Chapters, we have included cases of note recently filed in the lower courts which we will track in subsequent editions; and (iii) we included legislation and pending legislation in our summary.

We also made certain judgments as to what should be included.  A notable example is facial recognition.  Due to the nature of the underlying technology and the complexity of facial recognition, the subject matter necessarily involve issues of algorithmic/artificial intelligence.  However, we did not include every case that references facial recognition when the issue at bar pertained to procedural aspects such as class certification (e.g., class action lawsuits filed under the Illinois Biometric Information Privacy Act (BIPA) (740 ILCS 14).

Finally, I want to thank my two colleagues, Adam Aft and Yoon Chae, for their assistance in preparing this inaugural chapter.  Adam and Yoon are both knowledgeable and accomplished AI attorneys with whom I frequently collaborate.  We are excited to add many colleagues from other firms around the country to next year’s Chapter.

We hope this Chapter provides useful guidance to practitioners of varying experience and expertise and look forward to tracking the trends in these cases and presenting the cases arising in the next several years.

Bradford Newman

United States Supreme Court

There were no qualifying decisions by the United Sates Supreme Court.  We note the Court has heard a number of cases foreshadowing the types of issues that will soon arise with respect to artificial intelligence, such as United States v. Am. Library Ass’n (539 U.S. 194 (2003)), in which a plurality of the Court upheld the constitutionality of filtering software that libraries had to implement pursuant to the Children’s Internet Protection Act, and Gill v. Whitford (138 S. Ct. 1916 (2017)), in which, if the plaintiffs had standing, the Justices may have had to evaluate the use of sophisticated software in redistricting (a point noted again in Justice Kagan’s express reference to machine learning in her dissent in Rucho v. Common Cause (139 S. Ct. 2484 (2019))).  The Court had previously concluded that a “people search engine” site presenting incorrect information that prejudiced a plaintiff’s job search was a cognizable injury under the Fair Credit Reporting Act in Spokeo, Inc. v. Robins (136 S. Ct. 1540 (2016)).  These cases are representative of the type of any number of cases that are likely to make their way to the Court in the near future that will require the Justices to contemplate artificial intelligence, machine learning, and the impact of the use of these technologies.

First Circuit

There were no qualifying decisions within the First Circuit.

Second Circuit

Force v. Facebook, Inc., 934 F.3d 53 (2d Cir. 2019). Victims, estates, and family members of victims of terrorist attacks in Israel alleged that Facebook was a provider of terrorist postings where they developed and used algorithms designed to match users’ information with other users and content.  The court held that Facebook was a publisher protected by Section 230 of the Communications Decency Act and that the term “publisher” under the Act was not so limited that Facebook’s use of algorithms to match information with users’ interests changed Facebook’s role as a publisher.

Additional Cases of Note

Calderon v. Clearview AI, Inc., 2020 U.S. Dist. LEXIS 94926 (S.D.N.Y. 2020) (stating the court’s intent to consolidate cases against Clearview based on a January 2020 New York Times article alleging defendants scraped over 3 billion facial images from the internet and scanned biometric identifiers and then used those scans to create a searchable database, which defendants then allegedly sold access to the database to law enforcement, government agencies, and private entities without complying with BIPA); see also Mutnick v. Clearview AI, Inc., 2020 U.S. Dist. LEXIS 109864 (N.D. Ill. 2020).

People v. Wakefield, 175 A.D.3d 158 (N.Y. App. Div. 2019) (concluding no violation of the confrontation clause where the creator of artificial intelligence software was the declarant, not the “sophisticated and highly automated tool powered by electronics and source code”); see also People v. H.K., 2020 NY Slip Op 20232, 130 N.Y.S.3d 890 (Crim. Ct. 2020) (following Wakefield in concluding that, where software was “acting as a highly sophisticated calculator,” the analyst using the software was still a declarant and the right to confrontation was preserved).

Vigil v. Take-Two Interactive Software, Inc., 235 F. Supp. 3d 499 (S.D.N.Y. 2017) (affirmed in relevant part by Santana v. Take-Two Interactive Software, Inc., 717 Fed.Appx. 12 (2d Cir. 2017)) (concluding that BIPA doesn’t create a concrete interest in the form of right-to-information, but instead operates to support the statute’s data protection goal; therefore, defendant’s bare violations of the notice and consent provisions of BIPA were dismissed for lack of standing).

LivePerson, Inc. v. 24/7 Customer, Inc., 83 F. Supp. 3d 501 (S.D.N.Y. 2015) (determining plaintiff adequately pleaded possession and misappropriation of a trade secret where plaintiff alleged its “predictive algorithms” and “proprietary behavioral analysis methods” were based on many years of expensive research and were secured by patents, copyrights, trademarks and contractual provisions).

Third Circuit

Zaletel v. Prisma Labs, Inc., No. 16-1307-SLR, 2017 U.S. Dist. LEXIS 30868 (D. Del. Mar. 6, 2017).  The plaintiff had a “Prizmia” photo editing app.  The plaintiff alleged trademark infringement based on the defendant’s “Prisma” photo transformation app.  In reviewing the Third Circuit’s likelihood of confusion factors, the court considered the competition and overlap factor.  The court concluded that, “while plaintiff broadly describes both apps as distributing photo filtering apps, the record demonstrates that defendant’s app analyzes photos using artificial intelligence technology and then redraws the photos in a chosen artistic style, resulting in machine generated art.  Given these very real differences in functionality, it stands to reason that the two products are directed to different consumers.”

Fourth Circuit

Sevatec, Inc. v. Ayyar, 102 Va. Cir. 148 (Va. Cir. Ct. 2019).  The court noted that matters such as data analytics, artificial intelligence, and machine learning are complex enough that expert testimony is proper and helpful and such testimony does not invade the province of the jury.

Fifth Circuit

Aerotek, Inc. v. Boyd, 598 S.W.3d 373 (Tex. App. 2020).  The court expressly acknowledged that one day courts may have to determine whether machine learning and artificial intelligence resulted in software altering itself and inserting an arbitration clause after the fact.

Additional Cases of Note

Bertuccelli v. Universal City Studios LLC, No. 19-1304, 2020 U.S. Dist. LEXIS 195295 (E.D. La. Oct. 21, 2020) (denying a motion to disqualify an expert the court concluded was component to testify in a copyright infringement case after having performed an “artificial intelligence assisted facial recognition analysis” of the plaintiff’s mask and the alleged infringing mask).

Sixth Circuit

Delphi Auto, PLC v. Absmeier, 167 F. Supp. 3d 868 (E.D. Mich. 2016).  Plaintiff employer alleged defendant former employee breached his contractual obligations by terminating his employment with the plaintiff and accepting a job with Samsung in the same line of business.  Defendant worked for the plaintiff as director of its labs in Silicon Valley, managing engineers and programmers on work related to autonomous driving.  Defendant had signed a confidentiality and noninterference agreement.  The court concluded that the plaintiff had a strong likelihood of success on the merits of its breach of contract claim.  Therefore, the court granted the plaintiff’s motion for preliminary injunction with certain modifications (namely, limiting the applicability of the non-compete provision to the field of autonomous vehicle technology for one year because the Court determined that autonomous vehicle technology is a “small and specialized field that is international in scope” and, therefore, a global restriction was reasonable).

Additional Cases of Note

In re C.W., 2019-Ohio-5262 (Oh. Ct. App. 2019) (noting that “[p]roving that an actual person is behind something like a social-networking account becomes increasingly important in an era when Twitter bots and other artificial intelligence troll the internet pretending to be people”).

Seventh Circuit

Bryant v. Compass Group USA, Inc., 958 F.3d 617 (7th Cir. 2020).  Plaintiff vending machine customer filed class action against vending machine owner/operator, alleging violation of BIPA when it required her to provide a fingerprint scan before allowing her to purchase items.  The district court found defendant’s alleged violations were mere procedural violations that cause no concrete harm to plaintiff and, therefore, remanded the action to state court.  The Court of Appeals held that a violation of § 15(a) (requiring development of a written and public policy establishing a retention schedule and guidelines for destroying biometric identifiers and information) of BIPA did not create a concrete and particularized injury and plaintiff lacked standing under Article III to pursue the claim in federal court.  In contrast, the Court of Appeals held that a violation of § 15(b) (requiring private entities make certain disclosures and receive informed consent from consumers before obtaining biometric identifiers and information) of BIPA did result in a concrete injury (plaintiff’s loss of the power and ability to make informed decisions about the collection, storage and use of her biometric information) and she, therefore, had standing and her claim could proceed in federal court.[1]

Rosenbach v. Six Flags Entertainment Corporation, 129 N.E.3d 1197 (Ill. 2019).  Rosenbach is a key Supreme Court of Illinois case answering whether one qualifies as an “aggrieved” person for purposes of BIPA and may seek damages and injunctive relief if she hasn’t alleged some actual injury or adverse effect beyond a violation of her rights under the statute.  Plaintiff purchased a season pass for her son to defendant’s amusement park.  Plaintiff’s son was asked to scan his thumb into defendant’s biometric data capture system and neither plaintiff nor her son were informed of the specific purpose and length of term for which the son’s fingerprint had been collected.  Plaintiff brought suit alleging violation of BIPA.  The Supreme Court of Illinois held that an individual need not allege some actual injury or adverse effect, beyond violation of his or her rights under BIPA, to qualify as an “aggrieved” person under the statute and be entitled to seek damages and injunctive relief.  The court reasoned that requiring individuals to wait until they’ve sustained some compensable injury beyond violation of their statutory rights before they can seek recourse would be antithetical to BIPA’s purposes.  The court found that BIPA codified individuals’ right to privacy in and control over their biometric identifiers and information.  Therefore, the court found also that a violation of BIPA is not merely “technical,” but rather the “injury is real and significant.”

Additional Cases of Note

Kloss v. Acuant, Inc., 2020 U.S. Dist. LEXIS 89411 (N.D. Ill. 2020) (applying Bryant v. Compass Group (summarized in this chapter) and concluding that the court lacked subject-matter jurisdiction over plaintiff’s BIPA § 15(a) claims because a violation of § 15(a) is procedural and, thus, does not create a concrete and particularized Article III injury).

Acaley v. Vimeo, 2020 U.S. Dist. LEXIS 95208 (N.D. Ill. June 1, 2020) (concluding that parties made an agreement to arbitrate because defendant provided reasonable notice of its terms of service to users by requiring users to give consent to its terms when they first opened the app and when they signed up for a free subscription plan, but the BIPA violation claim alleged by the plaintiff was not within the scope of the parties’ agreement to arbitrate because the “Exceptions to Arbitration” clause excluded claims for invasion of privacy).

Heard v. Becton, Dickinson & Co., 2020 U.S. Dist. LEXIS 31249 (N.D. Ill. 2020) (concluding that, for § 15(b) to apply, an entity must at least take an active step to “collect, capture, purchase, receive through trade, or otherwise obtain” biometric data and the plaintiff did not adequately plead that defendant took any such active step where the complaint omitted specific factual detail and merely parroted BIPA’s statutory language and the plaintiff failed to adequately plead possession because he failed to sufficiently allege that defendant “exercised any dominion or control” over his fingerprint data).

Rogers v. CSX Intermodal Terminals, Inc., 409 F. Supp. 3d 612 (N.D. Ill. 2019) (denying defendant’s motion to dismiss and relying on the Illinois Supreme Court’s holding in Rosenbach (summarized in this chapter) to conclude that plaintiff’s right to privacy in his fingerprint data included “the right to give up his biometric identifiers or information only after receiving written notice of the purpose and duration of collection and providing informed written consent”).

Neals v. PAR Technology Corp., 419 F. Supp. 3d 1088 (N.D. Ill. 2019) (concluding that BIPA does not exempt a third-party non-employer collector of biometric information when an action arises in the employment context, rejecting defendant’s argument that a third-party vendor couldn’t be required to comply with BIPA because only the employer has a preexisting relationship with the employees).

Ocean Tomo, LLC v. PatentRatings, LLC, 375 F. Supp. 3d 915, 957 (N.D. Ill. 2019) (determining that Ocean Tomo training its machine learning algorithm on PatentRatings’ patent database violated a requirement in a license agreement between the parties that prohibited Ocean Tomo from using the database (which was designated as PatentRatings confidential information) from developing a product for anyone except PatentRatings).

Liu v. Four Seasons Hotel, Ltd., 2019 IL App(1st) 182645, 138 N.E.3d 201 (Ill. 2019) (noting that “simply because an employer opts to use biometric data, like fingerprints, for timekeeping purposes does not transform a complaint into a wages or hours claim”).

Eighth Circuit

There were no qualifying decisions within the Eighth Circuit.

Ninth Circuit

Patel v. Facebook, Inc., 932 F.3d 1264 (9th Cir. 2019).  Facebook moved to dismiss plaintiff users’ complaint for lack of standing on the ground that the plaintiffs hadn’t alleged any concrete injury as a result of Facebook’s facial recognition technology.  The court concluded that BIPA protects concrete privacy interests, and violations of BIPA’s procedures actually harm or pose a material risk of harm to those privacy interests.

WeRide Corp. v. Kun Huang, 379 F. Supp. 3d 834 (N.D. Cal. 2019).  Autonomous vehicle companies brought, inter alia, trade secret misappropriation claims against former director and officer and his competing company.  The court determined the plaintiff showed it was likely to succeed on the merits of its trade secret misappropriation claims where it developed source code and algorithms for autonomous vehicles over 18 months with investments of over $45M and restricted access to its code base to on-site employees or employees who use a password-protected VPN.  Plaintiff identified its trade secrets with particularity where it described the functionality of each trade secret and named numerous files in its code base because plaintiff was “not required to identify the specific source code to meet the reasonable particularity standard.”

Additional Cases of Note

Hatteberg v. Capital One Bank, N.A., No. SA CV 19-1425-DOC-KES, 2019 U.S. Dist. LEXIS 231235 (C.D. Cal. Nov. 20, 2019) (relying on advances in technology, including use of artificial intelligence to “deepfake” audio, as a basis for denying defendant’s argument that a plaintiff must plead to a higher standard alleging specific indicia of automatic dialing to survive a motion to dismiss in a Telephone Consumer Protection Act case).

Williams-Sonoma, Inc. v. Amazon.com, Inc., No. 18-cv-07548-EDL, 2019 U.S. Dist. LEXIS 226300, at *36 (N.D. Cal. May 2, 2019) (denying Amazon’s motion to dismiss Williams-Sonoma’s service mark infringement case noting “it would not be plausible to presume that Amazon conducted its marketing of Williams-Sonoma’s products without some careful aforethought (whether consciously in the traditional sense or via algorithm and artificial intelligence)”).

Nevarez v. Forty Niners Football Co., LLC, No. 16-cv-07013-LHK (SVK), 2018 U.S. Dist. LEXIS 182255 (N.D. Cal. Oct. 16, 2018) (determining that protections exist such as protective orders and the Federal Rules of Evidence that prohibit a party from using artificial intelligence to identify non-responsive documents without identifying a “cut-off” point for some manner of reviewing the alleged non-responsive documents).

Tenth Circuit

There were no qualifying decisions within the Tenth Circuit.

Eleventh Circuit

There were no qualifying decisions within the Eleventh Circuit.

D.C. Circuit

Elec. Privacy Info. Ctr. v. Nat’l Sec. Comm’n on Artificial Intelligence, No. 1:19-cv-02906 (TNM), 2020 U.S. Dist. LEXIS 95508 (D.D.C. June 1, 2020).  The court concluded that the National Security Commission on Artificial Intelligence is subject to both the Freedom of Information Act and the Federal Advisory Committee Act.

Court of Appeals for the Federal Circuit[2]

McRO, Inc. v. Bandai Namco Games America, Inc., 837 F.3d 1299 (Fed. Cir. 2016).  Patent litigation over a patent which claimed a method of using a computer to automate the realistic syncing of lip and facial expressions in animated characters.  The plaintiff owners of the patents brought infringement actions, and defendants argued the claims were unpatentable algorithms that merely took a preexisting process and made it faster by automating it on a computer.  The court held that the patent claim was not directed to ineligible subject matter where the claim involved the use of automation algorithms and was specific enough such that the claimed rules would not prevent broad preemption of all rules-based means of automating facial animation.

Filed Cases

• Kraus v. Cegavske, No. 82018, 2020 Nev. Unpub. LEXIS 1043 (Nov. 3, 2020). A lawsuit filed challenging, on behalf of President Trump, use of AI to authenticate ballot signatures.
• Williams-Sonoma Inc. v. Amazon.com, Inc. (N.D. Cal. 3:18-cv-07548). Williams-Sonoma asserted a copyright infringement claim against Amazon related to how Amazon sells Williams-Sonoma’s products.  Amazon argued that Williams-Sonoma didn’t state a claim for direct copyright infringement because it didn’t plead that Amazon engaged in “volitional conduct” where the algorithm chooses the disputed images.  Williams-Sonoma argued that the Copyright Act covers “anyone” who violates it and the term encompasses artificial intelligence and “software agents.”
• Asif Kumandan et al. v. Google LLC (N.D. Cal. 5:19-cv-04286). Plaintiff Google Assistant users filed a wiretapping class action against Google, alleging they were recorded without their consent or knowledge when the artificial intelligence voice recognition program allegedly recorded their conversations when plaintiffs never uttered the trigger words.
• Vance et al v. Amazon.com, Inc. (W.D. Wa. 2:20-cv-01084); Vance et al v. Facefirst, Inc. (C.D. Cal. 2:20-cv-06244); Vance et al v. Google LLC (N.D. Cal. 5:20-cv-04696); and Vance et al v. Microsoft Corporation (W.D. Wa. 2:20-cv-01082). Chicago residents Steven Vance and Tim Janecyk filed four nearly identical proposed class actions against Amazon.com, Inc., Google LLC, Microsoft Corp., and a fourth company called Facefirst Inc., alleging the companies violated Illinois’ Biometric Information Privacy Act by “unlawfully collecting, obtaining, storing, using, possessing and profiting from the biometric identifiers and information” of plaintiffs without their permission.  Plaintiffs allege that the tech companies used the dataset containing their geometric face scans to train computer programs how to better recognize faces.  These companies, in an attempt to win an “arms race,” are working to develop the ability to claim a low identification error rate.  Allegedly, the four tech giants obtained plaintiffs’ face scans by purchasing a dataset created by IBM Corp. (the subject of another suit brought by Janecyk).
• Janecyk v. IBM Corp. (Cook County Cir. Ct. Ill. 2020CH00833). IBM Corp. was accused in an Illinois state court lawsuit of violating the state’s biometrics law when it allegedly collected photographs to develop its facial recognition technology without obtaining consent from the subjects to use biometric information.  Plaintiff Janecyk, a photographer, said that at least seven of his photos appeared in IBM’s “diversity in faces” dataset.  The photos were used to generate unique face templates that recognized the subjects’ gender, age and race, and were given to third parties without consent.  IBM allegedly created, collected and stored millions of face templates—highly detailed geometric maps of the face—from about a million photos that make up the “diversity in faces” database. Janecyk claimed that IBM obtained the photos from Flickr, a website where users upload their photos.  IBM obtained photos depicting people Janecyk has photographed in the Chicago area whom he had assured he was only taking their photos as a hobbyist and that their images wouldn’t be used by other parties or for a commercial purpose.
• Jordan Stein v. Clarifai, Inc. (Cook County Cir. Ct. Ill. 2020CH01810). Clarifai, Inc., an artificial intelligence company, allegedly violated Illinois’ privacy law when it captured and profited from the profile photos of OKCupid Inc. users without their permission or knowledge, according to a lawsuit filed in Illinois state court.  The company allegedly harvested the profile photos of tens of thousands of users, scanned the facial geometry to create face templates, and used the data to develop and train its facial recognition technology.
• K. et al v. Google, LLC (N.D. Cal. 5:20-cv-02257). A proposed class action filed in California federal court alleged that Google violated federal privacy laws by selling and distributing Chromebooks that collect and store students’ facial and voice data.  The complaint alleged that Google violated BIPA and the federal Children’s Online Privacy Protection Act (COPPA).  Chromebooks come with a “G Suite for Education” platform through which Google collects face templates, or scans of a person’s face, as well as voice data, location data and search histories without permission, the complaint says.  Google never informed the parents of the purpose and length of term for which their children’s biometric identifiers and information would be collected, stored and used.  The complaint proposes two classes: (1) a BIPA class and (2) a COPPA class.  The BIPA class seeks an injunction requiring Google to comply with BIPA and destroy data it has collected, plus monetary damages.  The COPPA class seeks an injunction requiring Google to obtain parental consent to collect biometric data and delete data already collected without consent.  The plaintiffs have moved to dismiss the case without prejudice.
• Williams et al. v. PersonalizationMall.com LLC (N.D. Ill. 1:20-cv-00025). An online gift platform, PersonalizationMall.com, owned by Bed Bath & Beyond, moved to dismiss or stay an action against it accusing the online retailer of violating its rights under BIPA.  Plaintiffs allege that they were never informed in writing that PersonalizationMall.com was capturing, collecting, storing or using their biometric information and they never signed a release consenting.  The company moved for dismissal or, in the alternative, moved for the court to stay the case pending Illinois’ Appellate Court decision on whether the Illinois Workers’ Compensation Act (IWCA) preempts claims under BIPA.  The company argues that plaintiffs’ claims clearly arose from their employment because they are challenging PersonalizationMall.com’s requirement that warehouse workers use their fingerprints to track hours and breaks.

Legislation

We organize the enacted and proposed legislation into (i) policy (e.g., executive orders); (ii) algorithmic accountability (e.g., legislation aimed at responding to public concerns regarding algorithmic bias and discrimination); (iii) facial recognition; (iv) transparency (e.g., legislation primarily directed at promoting transparency in use of AI); and (v) other (e.g., other pending bills such as federal bills on governance issues for AI).

Policy

• [Fed] Maintaining Am Leadership in AI (Feb 2019). Executive order 13859 (Feb. 2019) launching “American AI Initiative” intended to help coordinate federal resources to support development of AI in the US.
• [Fed] H R Res 153 (Feb 2019). Legislation to support the development of guidelines for ethical development of artificial intelligence.
• [Fed / NIST] US Leadership in AI (Aug 2019). NIST to establish standards to support reliable, robust and trustworthy AI.
• [CA] Res on 23 Asilomar AI Principles (Sep 2018). Adopted state resolution ACR 215 (Sept. 2018) expressing legislative support for the Asilomar AI Principles as “guiding values” for AI development.

Algorithmic Accountability

• [Fed] Algorithmic Accountability Act (Apr 2019). Bills S 1108, HR 2231 (Apr. 2019) intended to require “companies to regularly evaluate their tools for accuracy, fairness, bias, and discrimination.”
• [NJ] New Jersey Algorithmic Accountability Act (May 2019). Require that certain businesses conduct automated decision system and data protection impact assessments of their automated decision system and information systems.
• [CA] AI Reporting (Feb 2019). Require California business entities with more than 50 employees and associated contractors and vendors to each maintain a written record of the data used relating to any use of artificial intelligence for the delivery of the product or service to the public entity.
• [WA] Guidelines for Gov’t Procurement and Use of Auto Decision Systems (Jan 2019). Establish guidelines for government procurement and use of automated decision systems in order to protect consumers, improve transparency, and create more market predictability.
• [NY] NYC (Jan 2018). —“A local law in relation to automated decision systems used by agencies” (Int. No. 1696-2017) required the creation of a task force for providing recommendations on how information on agency automated decision systems may be shared with the public and how agencies may address situations where people are harmed by such agency automated decision systems.

Facial Recognition Technology

• [Fed] Commercial Facial Recognition Privacy Act (Mar 2019). Bill S 847 (Mar. 2019) intended to provide people information and control over how their data is shared with companies using facial recognition technology.
• [Fed] FACE Protection Act (July 2019). Restrict federal government from using a facial recognition technology without a court order.
• [Fed] No Biometric Barriers to Housing Act (July 2019). Prohibiting owners of certain federally assisted rental units from using facial recognition, physical biometric recognition, or remote biometric recognition technology in any units, buildings or grounds of such project.
• [CA] Body Camera Account Act (Feb 2019). Bill A.B. 1215 was introduced to prohibit law enforcement agencies and officials from using any “biometric surveillance system,” including facial recognition technology, in connection with an officer camera or data collected by the camera.
• [MA] An Act Establishing a Moratorium on Face Recognition (Jan 2019). Senate Bill 1385 was introduced to establish a moratorium on the use of face recognition systems by state and local law enforcement.
• [NY] Prohibits Use of Facial Recog. Sys. (May 2019). Senate Bill 5687 was introduced to propose a temporary stop to the use of facial recognition technology in public schools.
• [SF and Oakland, CA] City ordinances were passed to ban the use of facial recognition software by the police and other government agencies (June, July 2019).
• [Somerville, MA] City ordinance was passed to ban the use of facial recognition technology by government agencies (July 2019).

Transparency

• [CA] B O T Act – SB 1001 (effective July 2019). Enacted bill SB 1001 (eff. July 2019) intended to “shed light on bots by requiring them to identify themselves as automated accounts.”
• [CA] Anti- Eavesdropping Act (Assemb. May 2019). Prohibiting a person or entity from providing the operation of a voice recognition feature within the state without prominently informing the user during the initial setup or installation of a smart speaker device.
• [IL] AI Video Interview Act (effective Jan 2020). Provide notice and explainability requirements for recorded video interviews.

Other

• [Fed] FUTURE of AI Act (Dec 2017). Requiring the Secretary of Commerce to establish the Federal Advisory Committee on the Development and Implementation of Artificial Intelligence.
• [Fed] AI JOBS Act (Jan 2019). Promoting a 21st century artificial intelligence workforce.
• [Fed] GrAITR Act (Apr 2019). Legislation directed to research on cybersecurity and algorithm accountability, explainability and trustworthiness.
• [Fed] AI in Government Act (May 2019). Instructing the General Services Administration’s AI Center of Excellence to advise and promote the efforts of the federal government in developing innovative uses of AI to benefit the public, and improve cohesion and competency in the use of AI.
• [Fed] AI Initiative Act (May 2019). Requiring federal government activities related to AI, including implementing a National Artificial Intelligence Research and Development Initiative.

[1] As noted in our introduction, we made certain judgment calls with respect to which cases to include. For example, we omitted certain BIPA cases that did not add any additional information to those we have presented in this Chapter. See, e.g., Darty v. Columbia Rehabilitation and Nursing Center, LLC, 2020 U.S. Dist. LEXIS 110574 (N.D. Ill. 2020); Figueroa v. Kronos Incorporated, 2020 U.S. Dist. LEXIS 64131 (N.D. Ill. 2020); Namuwonge v. Kronos, Inc., 418 F. Supp. 3d 279 (N.D. Ill. 2019); Treadwell v. Power Solutions International Inc., 427 F. Supp. 3d 984 (N.D. Ill. 2019); Kiefer v. Bob Evans Farm, LLC, 313 F. Supp. 3d 966 (C.D. Ill. 2018); Rivera v. Google Inc., 238 F. Supp. 3d 1088 (N.D. Ill. 2017); In re Facebook Biometric Information Privacy Litigation, 185 F. Supp. 3d 1155 (N.D. Cal. 2016); Norberg v. Shutterfly, Inc., 152 F. Supp. 3d 1103 (N.D. Ill. 2015).

[2] As noted in our introduction, we made certain judgment calls with respect to which cases to include. For example, we omitted several patent cases directed to subject-matter eligibility that we felt did not substantiate additional insight to those we have presented in this Chapter. See, e.g., Kaavo Inc. v. Amazon.com, Inc., 323 F. Supp. 3d 630 (D. Del. 2018); Hyper Search, LLC v. Facebook, Inc., No. 17-1387, 2018 U.S. Dist. LEXIS 212336 (D. Del. Dec. 18, 2018); Purepredictive, Inc. v. H20.AI, Inc., No. 17-cv-03049, 2017 U.S. Dist. LEXIS 139056 (N.D. Cal. Aug. 29, 2017); Power Analytics Corp. v. Operation Tech., Inc., No. SA CV16-01955 JAK, 2017 U.S. Dist. LEXIS 216875 (C.D. Cal. July 13, 2017); Nice Sys. v. Clickfox, Inc., 207 F. Supp. 3d 393 (D. Del. 2016); eResearch Tech., Inc. v. CRF, Inc., 186 F. Supp. 3d 463 (W.D. Pa. 2016); Neochloris, Inc. v. Emerson Process Mgmt. LLP, 140 F. Supp. 3d 763 (N.D. Ill. 2015).

Editor

Tim Farahnik

Partner, Seyfarth Shaw LLP
601 South Figueroa Street Suite 3300
Los Angeles, CA 90017-5793
(213) 270-9656 phone
[email protected]

Introduction

The ongoing coronavirus pandemic has impacted nearly every aspect of Americans’ lives since mid-March, and the virus’s disruption to the world of real estate has been especially large and widespread.  Governmental authorities at all levels and in all areas of the country began taking swift and decisive measures to respond to the emergency at hand, often requiring citizens to shelter at home and ordering non-essential businesses of all types to close their doors or otherwise substantially scale back their operations.  In order to protect the interests of people who had lost their jobs and the businesses who could not operate at full capacity, many jurisdictions also imposed temporary eviction and foreclosure moratoria to stay in effect during the pandemic.  The effects of these actions on the basic functioning of the real estate market has been dramatic.  Many businesses and people could not meet their rent and mortgage obligations.  Landlords could no longer, for the most part, evict their tenants for nonpayment of rent.  Ongoing real estate purchase and financing transactions were put on hold indefinitely.  The ability to hold foreclosure sales was made much more difficult.  Real estate attorneys very quickly needed to become experts on the doctrine of force majeure.

As with any disruptive force, the COVID-19 pandemic soon resulted in a wave of lawsuits by individuals, companies and organizations who were negatively impacted by it.  This article will take an in-depth look at several of the prominent lawsuits that have thus far been fought and decided in the wake of the pandemic, to see how courts from all around the nation have tried to find the right balance between the interests of various parties who have been affected by these unprecedented events.

Part I – State and Local Challenges

As authorities at each of the federal, state, county and local levels enacted a broad range of measures to combat the spread of COVID-19 in their communities and to mitigate the negative effects of lockdowns and business closures on their citizens, many of these governmental regulations specifically targeted the rights and obligations of owners and renters of real property.  Not surprisingly, several parties who were especially harmed by these emergency regulations and who felt that their rights were being violated sought help from the courts to protect their interests, challenging the constitutionality of these laws, ordinances and orders.  Part I of this article will examine several significant decisions handed down in lawsuits challenging state and local COVID-19 regulations.

Elmsford Apartment Associates, LLC v. Cuomo

In Elmsford Apartment Associates, LLC v. Cuomo, three residential landlords brought suit in the United States District Court in New York seeking an injunction against Executive Order No. 202.28 on the grounds that the Executive Order violated their rights under the Takings Clause, Contracts Clause, Due Process Clause and Petition Clause of the United States Constitution.[1]

On March 2, 2020, in response to the first reported cases of COVID-19 in New York state, the legislature passed Senate Bill S7919, giving Governor Andrew Cuomo the power to suspend statues or regulations and issue accompanying directives “necessary to cope with the disaster,” provided that such measures are “in the interest of the health or welfare of the public,” “reasonably necessary to aid the disaster effort,” and “provide for minimum deviation” from existing laws.[2]  On March 20, 2020, Governor Cuomo issued Executive Order 202.8, the first of several orders issued to temporarily prohibit evictions and foreclosures of residential and commercial tenants.  One such subsequent order, Executive Order 202.28 (“EO 202.28”), was issued on May 7, 2020, allowing any tenant to use its security deposit (and any interest accrued on the deposit) as payment for rent under such tenant’s lease, and also suspending landlords’ ability to commence eviction proceedings for nonpayment of rent.[3]  The plaintiffs in Elmsford brought suit to challenge the constitutional validity of EO 202.28.

The Elmsford court first dismissed the plaintiffs’ claim that the eviction moratorium constitutes a physical taking of their property.  Citing various precedent from both the U.S. Supreme Court and the Second Circuit, the court reasoned that “[g]overnment action that does not entail a physical occupation, but merely affects the use and value of private property, does not result in a physical taking of property,” and that “a state does not commit a physical taking when it restricts the circumstances in which tenants may be evicted.”[4]  Importantly, because the eviction moratorium is “temporary on its face, and does not disturb the landlords’ ability to vindicate their property rights”[5]  at a later time (since rent arrearages will continue to accrue during such period and landlords will be able to evict their tenants once the moratorium expires), EO 202.28 does not constitute a physical taking of the plaintiffs’ property.

The court then concluded that EO 202.28 also does not constitute a regulatory taking of the plaintiffs’ property.  Regulatory takings fall into two categories – categorical and non-categorical.  A categorical regulatory taking occurs only when no productive or economic use of a property is permitted.  Since the plaintiffs still enjoyed many economic benefits of ownership, the court easily concluded that EO 202.28 is not a categorical taking.  As for a non-categorical taking, the court employed the three-pronged test established in Penn Central Transportation Co. v. New York City, weighing: (i) the economic impact of the regulation, (ii) the extent to which the regulation interferes with investment-backed expectations, and (iii) the character of the governmental action.[6]

The court’s evaluation of the economic impact of EO 202.28 was somewhat inconclusive, stating that “[i]t is difficult to quantify the precise economic impact that the eviction moratorium and security deposit provisions have had on Plaintiffs’ property,”[7]  while also recognizing that the Order did not prevent the plaintiffs from making any economic use of their property.  With regard to the plaintiff’s investment-backed expectations, the court noted that the plaintiffs understood that residential real estate is a heavily regulated industry with a broad range of pre-existing laws and rules governing all manners of the landlord-tenant relationship.  As such, “[t]he Order’s temporary adjustment of those rules, which does nothing more than defer the ability of the landlord to collect (or obtain a judgment for) the full amount of the rent the tenant freely agreed to pay, does not disrupt the landlords’ investment-backed expectations.”[8]  Finally, with respect to the character of the government action, the court concluded that “state governments may, in times of emergency or otherwise, reallocate hardships between private parties, including landlords and their tenants, without violating the Takings Clause.”[9]  Based on these evaluations, the Elmsford court also dismissed the plaintiffs’ claims that EO 202.28 constitutes a taking of their property.

The court then turned to the plaintiffs’ Contract Clause claims.  While the U.S. Constitution does prohibit states from passing any law “impairing the Obligation of Contracts,”[10] the Contracts Clause’s prohibition “does not trump the police power of a state to protect the general welfare of its citizens, a power which is ‘paramount to any rights under contracts between individuals.’”[11]  Here the court employed another three-pronged test, this one established under Buffalo Teachers Federation v. Tobe, asking whether: (i) the contractual impairment is substantial, (ii) the law serves a legitimate public purpose, and (iii) the means chosen to accomplish this purpose are reasonable and necessary.[12]

The Elmsford court again noted that because residential real estate is a heavily regulated industry, it is foreseeable that the state may impose future regulations on the industry and these potential future regulations are therefore “priced into [any] contracts formed under the prior regulation,”[13] and that “the foreseeability of additional regulation allows states to interfere with both past and future contracts.”[14]  The court went on to reason that EO 202.28 also sufficiently safeguards the plaintiffs’ ability to realize the benefit of their bargain.  With regard to the security deposit provisions of EO 202.28, since “the Order does not displace the civil remedies always available to landlords seeking to recover the costs of repairs or unpaid rents still owed at the end of a lease term,”[15] the security deposit provisions therefore “do not prevent Plaintiffs from ‘safeguarding or reinstating [their rights]’ as soon as the Order expires.”[16]  As it relates to the eviction moratorium portion of EO 202.28, the court concluded that it merely postpones but does not eliminate a landlord’s ability to seek eviction as a remedy, and also does not eliminate a tenant’s obligations under their lease, such that “the landlord may obtain a judgment for unpaid rent if tenants fail to honor their obligations.”  For these reasons, the court also concluded that EO 202.28 does not violate the Contracts Clause.

Finally, the Elmsford court quickly rejected both the plaintiffs’ Due Process and Petition Clause claims.  On the Due Process claim, the court reasoned that the plaintiffs failed to demonstrate substantial impairment of their property rights, as a mere potential decrease in value of such property is not sufficient to prevail on a due process claim.  Further, since the plaintiffs will be able to initiate new legal proceedings with respect to their leases once EO 202.28 is no longer in effect, they have also not been denied due process on this basis.  Similarly, the plaintiff’s Petition Clause claim failed since “mere delay to filing a lawsuit cannot form the basis of a Petition Claus violation when the plaintiff will, at some point, regain access to legal process”[17] and the “Plaintiffs’ right to collect both the monetary remedies and injunctive relief they would seek through an eviction proceeding has not been completely foreclosed.”[18]

Auracle Homes, LLC v. Lamont

In Auracle Homes, LLC v. Lamont, the United States District Court in Connecticut considered a similar challenge to the one decided by the Elmsford court.  In this case, numerous owners of residential property in Connecticut challenged the state’s Executive Order Nos. 7G, 7X and 7DDD on the grounds that they violate the Takings Clause, Contracts Clause and Due Process Clause of the U.S. Constitution.[19]

On March 10, 2020, Connecticut Governor Ned Lamont issued a declaration of public health and civil preparedness emergencies and proclaimed a state of emergency due to the COVID-19 outbreak in Connecticut and the United States, allowing the Governor to modify any statute that the Governor finds to be “in conflict with the efficient and expeditious execution of civil preparedness functions or the protection of public health.”[20]  On March 19, 2020, Governor Lamont issued Executive Order 7G, which suspended non-critical court operations.[21]  On April 10, 2020, Governor Lamont issued Executive Order 7X, which (i) temporarily bars residential landlords from delivering a notice to quit to their tenants or from serving any action for nonpayment of rent in most situations, (ii) provides for an automatic sixty-day grace period for April rents and a sixty-day grace period for May rents upon request, and (iii) allows renters who paid a security deposit of more than one month’s rent to apply such portion in excess of one month’s rent to any rent due for April, May or June.[22]  On June 29, 2020, Governor Lamont issued Executive Order 7DDD, which extends and expands the notice to quit prohibition and the security deposit provision of Executive Order 7X.[23]  In seeking to enjoin application of the Executive Orders, the plaintiffs in Auracle Homes argued that the “complete ban on all residential eviction proceedings imposed by Defendant’s Executive Orders nullifies Connecticut’s established statutory eviction procedures,”[24] having the effect of “leaving the Plaintiffs with no recourse, no process to follow, no venue to have their rights adjudicated, and nowhere to appeal.”[25]  The plaintiffs further argued that the Governor’s actions were “unreasonable and inappropriate” since the State “is fully capable or providing monetary relief to those tenants who are ultimately unable to pay on-going rent, either through direct payments to landlords, or by grants to tenants.”[26]

As in Elmsford, the Auracle Homes court quickly ruled out the possibility of a categorical regulatory taking and moved to an analysis of a non-categorical taking by applying the Penn Central factors described above.  Citing Elmsford, the court concluded that the plaintiffs’ claims did not “support a finding that the Executive Orders have a ‘constitutionally significant economic impact.’”[27]  As for the plaintiffs’ investment-backed expectations, the court reasoned that the Executive Orders merely regulate the terms governing how the plaintiffs may use their property as previously planned during a pandemic, and since the Executive Orders do not permanently relieve tenants from their obligations under their leases, “[t]he Executive Orders are a temporary adjustment of the status quo, and only defer the ability of residential landlords like Plaintiffs to collect, or obtain a judgment for, the full amount of rent the tenants agreed to pay.”[28]  As to the third prong of the Penn Central test, the court concluded that “the character of the governmental action also weighs against a finding that Plaintiffs have suffered a regulatory taking, because the Executive Orders are ‘part of a public program adjusting the benefits and burden of economic life to promote the common good.’”[29]  For all of these reasons, the court rejected the plaintiffs’ Takings Clause claims.

Turning next to the plaintiffs’ Contracts Clause claims, the Auracle Homes court also applied the Buffalo Teachers test to the Connecticut Executive Orders.  In deciding against substantial impairment of the plaintiffs’ rental contracts, the court again concluded that because residential real estate is a heavily regulated industry, some sort of legislative action in this field was foreseeable, and therefore both the eviction moratorium and the security deposit provisions could not be wholly unexpected.[30]  Further, as to the eviction moratorium, “the Executive Orders do not eliminate Plaintiffs’ contractual remedies for evicting nonpaying tenants; Plaintiffs instead have to wait” before taking action.[31]  In determining the second part of the Buffalo Teachers test as to whether the Executive Orders serve a legitimate public purpose, the court evaluated whether the state was “acting like a private party who reneges to get out of a bad deal, or is governing, which justifies its impairing the plaintiff’s contracts in the public interest.”[32]  Since the Executive Orders impair private contracts that do not directly involve the State, the court accorded “substantial deference” to the State’s stated reasoning that it was acting to promote the public interest.[33]  Therefore, even if the Executive Orders did create a substantial impairment of the plaintiffs’ leases, their claims would nevertheless fail because the Executive Orders promote a significant public purpose.  In determining the third and final factor in the Buffalo Teachers test as to whether the State acted reasonably in issuing the Executive Orders, the court argued that when governmental entities undertake actions “in areas fraught with medical and scientific uncertainties, their latitude must be especially broad.”[34]  Since there was “nothing in the record to suggest that Governor Lamont acted unreasonably,” the plaintiffs also failed this part of the analysis.  For all of the reasons summarized above, the Auracle Homes court wholly rejected the plaintiffs’ Contracts Clause claim.

The final analysis came with respect to the plaintiffs’ substantive and procedural Due Process claims, and much like the Elmsford court, the Auracle Homes court quickly rejected these claims.  Because the plaintiffs “failed to demonstrate a substantial impairment of their property rights”[35] or “an independent liberty or property interest”[36] requiring protection, the safeguards afforded by the principles of both substantive and procedural due process did not apply to the plaintiffs’ claims.

HAPCO v. City of Philadelphia

In HAPCO v. City of Philadelphia, an association of Philadelphia residential property owners and managers brought suit to enjoin the City of Philadelphia from implementing several temporary emergency laws enacted in response to the COVID-19 pandemic.[37]  On July 1, 2020, Philadelphia Mayor James Kenney signed into law a series of five separate bills collectively known as the Emergency Housing Protection Act (“EHPA”), which (i) temporarily prohibits landlords from evicting residential tenants and small business commercial tenants that can provide a certificate of hardship due to COVID-19, (ii) allows tenants who prove they have suffered a financial hardship due to COVID-19 to be able to pay past due rent on a set plan through May 31, 2021, (iii) requires landlords to attend mediation before taking steps to evict residential tenants who have suffered a financial hardship due to COVID-19, and (iv) temporarily bars landlords from charging late fees and interest to residential tenants who have suffered a financial hardship due to COVID-19.[38]  The plaintiffs sought to invalidate the EHPA on the grounds that it violates the Takings Clause, Contracts Clause and Due Process Clause of both the U.S. and Pennsylvania Constitutions.

The HAPCO court did not rule on the plaintiffs’ likelihood on the merits of its Takings Clause claims.  It ruled that, even if the plaintiffs were able to successfully argue that the EHPA constituted a governmental taking, the plaintiffs would be able to obtain other relief from the government in the form of just compensation for such taking, making an injunction on this basis inapplicable.

The plaintiffs argued that the EHPA violates the Contracts Clause because it compel[s landlords] to enter into contractual arrangements [the City has] devised, give up rights [landlords] had negotiated in pre-existing leases, and surrender their right to seek redress in a court of law.”[39]  The court applied the two-part Contracts Clause test set forth by the U.S. Supreme Court in Sveen: (i) whether the state law has created a “substantial impairment of a contractual relationship”[40], and (ii) if it has, then “whether the state law is drawn in an appropriate and reasonable way to advance a significant and legitimate public purpose.”[41]  Like Elmsford and Auracle Homes before it, the HAPCO court relied on the fact that real estate is a heavily regulated industry at each of the federal, state and local levels, subject to the real possibility of ongoing legislation, which should be foreseeable to the parties to any contract involving real property.[42]  Further, considering that the provisions of the EHPA are temporary in nature, meaning that “the tenants are still bound to their contracts, the contractual bargain is not undermined and landlord rights are safeguarded.”[43]  Given these factors, the court did not find a substantial impairment of the contractual relationship existed.  The court in HAPCO further concluded that, even if a substantial impairment had existed, the EHPA “is a reasonable way to advance a significant and legitimate purpose” to address the housing and public health emergency caused by the COVID-19 pandemic.[44]  Finally, the court reasoned that the EHPA is “an appropriate and reasonable way to advance the City’s purpose,” especially “[c]onsidering the deference owed to [the] legislative judgment” of the City to address the current emergency.[45]

Turning to the plaintiffs’ Due Process Clause claim, the court in HAPCO reasoned that this clause “generally does not prohibit retrospective civil litigation, unless the consequences are particularly harsh and oppressive,”[46] and that “state laws need only be rational and non-arbitrary in order to satisfy the right to substantive due process.”[47]  Because the EHPA meets all of these requirements, the court denied the plaintiffs’ due process claims as well.

Baptiste v. Kennealy

In Baptiste v. Kennealy, three landlords filed for a preliminary injunction with the United States District Court, District of Massachusetts, against the “Act Providing for a Moratorium on Evictions and Foreclosures during the COVID-19 Emergency,” enacted by the Massachusetts state legislature on April 20, 2020.[48]  The Act (i) prohibits all “non-essential evictions,” including residential evictions for a tenant’s failure to pay rent (without a tenant needing to certify that they are unable to pay rent due to the coronavirus pandemic), (ii) prohibits landlord from sending tenants notices to quit or any notices requesting or demanding that a tenant who has not paid rent leave the premises, and (iii) prohibits Massachusetts courts from accepting for filing any eviction case or taking any action in any pending eviction case.[49]  The plaintiffs brought suit, alleging that the Act violates the Takings Clause, Contracts Clause and Petition Clause of the U.S. Constitution, as well as the First Amendment to the U.S. Constitution because of the limits placed by the Act on the types and subject matter of notices that landlords could send to their tenants (which First Amendment arguments will not be analyzed here, as they are outside the scope of this article).[50]

With regard to the plaintiffs’ Takings Clause claim, the Baptiste court applied the same three-factor Penn Central test as used in Elmsford, Auracle Homes and HAPCO, and largely came to the same conclusions that: (i) no physical taking occurred[51], (ii) the economic impact of the Act does not support the finding of a taking because the effect on the plaintiffs’ property was only temporary and that “mere diminution in the value of property…is insufficient to demonstrate a taking,”[52] and (iii) the character of the government action does not support the finding of a taking because the moratorium is a “public program adjusting the benefits and burdens of economic life to promote the common good.”[53]  The only place in the takings analysis where the Baptiste court differed from the decisions reached in Elmsford, Auracle Homes and HAPCO was that the Baptiste court concluded that the moratorium does significantly interfere with the plaintiff’s investment-backed expectations, since “a reasonable landlord would not have anticipated a virtually unprecedented event like the COVID-19 pandemic and the ensuing six-month ban on evicting and replacing tenants who do not pay rent.”[54]  Despite this difference, however, the court in Baptiste ultimately reached the same conclusion reached in Elmsford, Auracle Homes and HAPCO that the Act did not constitute a regulatory taking of the plaintiffs’ property.[55]

In analyzing the plaintiffs’ Contracts Clause claim, the court applied the same two-factor test as the Elmsford, Auracle Homes and HAPCO cases summarized above, but noted that “[i]t is a close question whether the Moratorium substantially impairs the contracts that plaintiffs’ leases represent,” and also “a close question whether the Moratorium is a reasonable means of addressing the undisputed significant and legitimate need to combat the spread of the COVID-19 virus.”[56]  Regarding the substantial impairment question, the court also noted here that residential real estate is a heavily regulated industry, but also (in departing from the Elmsford, Auracle Homes and HAPCO courts’ analyses) that “a reasonable landlord would not have anticipated a virtually unprecedented event such as the COVID-19 pandemic that would generate a ban on even initiating eviction actions against tenant.”[57]  Regarding the reasonableness question, the Baptiste court recognized that the Act was more burdensome to landlords than the laws enacted in New York (as affirmed by Elmsford), Connecticut (as affirmed by Auracle Homes), and Philadelphia (as affirmed by HAPCO), leading to the conclusion that Massachusetts could have enacted a less restrictive law.[58]  In the final analysis, however, the court in Baptiste dismissed the plaintiffs’ Contracts Clause claim, citing the fact that the moratorium is only temporary, recognizing that the proper standard to judge the reasonableness of the law is whether there was a rational basis for enacting it rather than requiring the law to be drafted in the least restrictive way possible, and further reasoning that, because in the case at hand “the state is not an interested party, courts give deference to elected officials as to what is reasonable and appropriate.”[59]

Other Takings and Contracts Clause Suits

Several other lawsuits in various jurisdictions have also been filed to challenge the constitutionality or authority of state and local orders, law and restrictions enacted to combat the COVID-19 pandemic that do not directly involve regulation of real estate-related matters, but which lawsuits have asserted Takings Clause claims.  For instance, in TJM 64, Inc. v. Harris, filed in the United States District Court in the Western District of Tennessee, Western Division, several owners of bars and limited-service restaurants brought an action against officials in Shelby County, Tennessee challenging an order issued by the County Health Department requiring all such bars and limited service restaurants to close in an effort to combat the COVID-19 pandemic.[60]  In Friends of Danny DeVito v. Wolf, filed with the Supreme Court of Pennsylvania, several business owners and one individual in Pennsylvania filed an emergency ex parte application challenging Governor Tom Wolf’s March 19, 2020 Executive Order requiring the closure of the physical operations of all non-life-sustaining businesses in order to reduce the spread of the coronavirus within the State.[61]  In Lebanon Valley Auto Racing Corp. v. Cuomo, filed with the United States District Court in the Northern District of New York, five operators of outdoor auto racing facilities in the State of New York sought to invalidate Executive Order 202.32, which included a ban on spectators at racetracks in the state, on a Takings Clause claim.[62]  Finally, in Blackburn v. Dare County, filed in the United States District Court in the Eastern District of North Carolina – Northern Division, a couple who lived in Virginia but owned a vacation home in North Carolina brought suit against Dare County and several towns within the County to overturn a County declaration prohibiting nonresident visitors from entering the County in an effort to slow the spread of the coronavirus, by declaring that such prohibition constituted a taking of their private property.[63]

One additional suit of note that did directly implicate real estate was filed in California in San Francisco Apartment Association v. City and County of San Francisco, challenging Ordinance No. 93-20 enacted by the San Francisco Board of Supervisors that, among other things, permanently protects tenants from eviction for nonpayment of rent that was unpaid due to COVID-19 if the rent became due between March 16, 2020 and September 30, 2020.  In a one-page order, the judge in this case dismissed the plaintiffs’ Takings Clause and Contracts Clause claims along similar lines as the cases discussed above, as “a reasonable exercise of police power to promote public welfare.”[64]

All of the lawsuits noted above met the same fate as the Elmsford, Auracle Homes, Baptiste and HAPCO cases summarized above – namely, their Takings Clause claims were rejected, and the validity and authority of all of the laws or orders being challenged were upheld.  The analyses in these additional cases followed a similar track as the cases summarized above, in which the respective courts analyzed the Penn Central factors and reached the overarching conclusion that, since the contested laws or orders were temporary in nature, were an exercise of the governmental authority’s police power, were enacted with the intention of providing a public benefit and protecting citizens, and were drafted to be reasonably related to these goals, that they were all constitutionally valid.

Interestingly, each of the courts reached the same ultimate decision to uphold the laws or orders as written, even though certain courts differed on specific elements of the Penn Central analysis.  For instance, in TJM 64, the court concluded that the closure orders did “interfere in a significant way with Plaintiffs’ investment-backed expectations in their properties, despite their status as highly regulated entities.”[65]  However, even though the court conceded “that Plaintiffs will suffer devastating economic impacts if the Closure Orders remain in effect,”[66] the court nonetheless determined that such impacts did not rise to the level of a taking because of the government’s fundamental interest in promoting the common good, and recognizing that [l]abeling Defendants’ Order a taking would require the state to compensate every individual or property owner whose property use was restricted for the purpose of protecting public health [emphasis in original].”[67]  In Friends of Danny DeVito, the court convincingly distinguished between a government taking and the government’s legitimate use of its police power, stating that “[e]minent domain is the power to take property for public use…The police power, on the other hand, involves the regulation of property to promote the health, safety and general welfare of the people.”[68]  In Lebanon Valley, the court concluded that the economic impact of the regulation on the plaintiffs was substantial enough to weigh in favor of allowing the takings claim to proceed on that factor.[69]  However, because the state has issued the order to promote the common good in order to address an existing public health emergency, “[t]he character of the relevant governmental action therefore strongly favors Defendants.”[70]  Finally, the Blackburn court sided with the plaintiffs on the first two prongs of the Penn Central test, concluding that “plaintiffs do allege some unspecified amount of economic loss, which…would provide some support of plaintiffs’ takings claim,”[71] and that “Defendant County’s regulation did temporarily interfere with plaintiffs’ right to personally travel to their vacation property, diminishing plaintiffs’ right to use the property.”[72]  In the final analysis, however, the County’s interest in reducing the spread of the coronavirus and the reasonable relation of the declaration to this objective superseded the individual property rights that were negatively impacted by such regulation: “Defendant County’s concededly legitimate exercise of its emergency management powers under North Carolina law to protect public health in the ‘unprecedented’ circumstances presented by the COVID-19 pandemic, weighed against loss of use indirectly occasioned by preventing plaintiffs from personally accessing their vacation home for 45 days, does not plausibly amount to a regulatory taking of plaintiffs’ property.”[73]

Part II – Challenging The CDC Moratorium

On September 4, 2020, the Centers for Disease Control and Prevention (“CDC”), a division of the Department of Health and Human Services (“HHS”), issued a temporary eviction moratorium through December 31, 2020 with the intent of helping to prevent the spread of COVID-19 in the United States.  Although the moratorium prohibits evictions of certain renters covered by the order, it also “does not relieve any individual of any obligation to pay rent, make a housing payment, or comply with any other obligation that the individual may have under a tenancy, lease or similar contract.”[74]  Since the CDC order was enacted, “an array of lawyers and lobbyists have inundated federal, state and local courts” with lawsuits challenging the validity of the moratorium as well as HHS’s and the CDC’s authority in issuing it.[75]  While many of these lawsuits remain pending at this time (including a recent case filed by the National Association of Home Builders in the Northern District of Ohio), Part II will discuss the most prominent case that has been brought and adjudicated with respect to the CDC moratorium.

Richard Lee Brown v. Alex Azar

The plaintiffs in Richard Lee Brown v. Alex Azar, made up of the National Apartment Association (representing a membership group of 85,000 landlords nationwide) and four landlords in different states seeking to evict tenants from their respective properties, brought suit in the United States District Court in the Northern District of Georgia, Atlanta Division, to enjoin enforcement of the CDC order.  The plaintiffs’ suit alleged that the CDC order (i) lacks a statutory and regulatory basis, (ii) is arbitrary and capricious, and (iii) violates the plaintiffs’ rights to access the courts.[76]

The plaintiffs first contended that “the CDC acted without statutory and regulatory authority because (1) the Order is not reasonably necessary to prevent the spread of the disease; and (2) the Order does not show that the state and local laws were insufficient to prevent the spread of the disease.”[77]  On the first point above, the court ruled that, since Congress gave the Secretary of HHS (and by extension the CDC) broad power to issue regulations to prevent the spread of diseases, and because the CDC’s order is necessary to help control the COVID-19 pandemic, the CDC was authorized to issue it.[78]  Regarding the second point above, so long as the CDC reasonably determines that the measures taken by any local state or local government are insufficient to prevent the spread of the disease, the court will give deference to the CDC’s determination and confirm its statutory and regulatory authority on these grounds.[79]

The court next analyzed the plaintiffs’ claim that the issuance of the CDC order was arbitrary and capricious.  The plaintiffs argued that “the Order is arbitrary and capricious because it is not supported by substantial evidence or relevant data” to demonstrate that the eviction moratorium would help to prevent the spread of COVID-19 or to demonstrate that existing state and local measures were insufficient to prevent such spread.[80]  The court disagreed with this argument, noting that “the Order explains, in detail, why a temporary eviction moratorium is reasonably necessary.”[81]  Specifically, the CDC order notes that as many as 30 to 40 million people in the U.S. could be at risk of eviction without a moratorium in place, which would result in many more people who would move to shared housing or other congregate settings or who would become homeless, which increases the risk of spread of the virus.[82]  Based on this evidence, the court concluded that “the CDC has shown what it needs to: that an eviction moratorium for individuals likely to be forced into congregate living situations is an effective public health measure that prevents the spread of communicable diseases because it aids the implementation of stay-at-home and social distancing directives.”[83]  The court then disagreed with the plaintiffs’ assertion that the CDC did not show that existing measures taken by state and local government were insufficient.  To the contrary, “the Order plainly states that the measures in state and local jurisdictions that do not provide protections for renters equal to or greater than the protections provided for in the Order are insufficient to prevent the spread of COVID-19.”[84]  In fact, “the CDC did analyze each state’s eviction restrictions, and the evidence suggested that in the absence of eviction moratoria, tens of millions of Americans could be at risk of eviction on a scale that would be unprecedented in modern times.”[85]

Finally, the plaintiffs then argued that the CDC order unlawfully strips them of their constitutional right to access the courts.  The court, however, pointed out that “the Order does not apply to every person renting a property,” “does not apply to every reason a landlord may evict a tenant,” “does not prohibit Plaintiffs from seeking a different remedy to recover their losses,” and “does not apply to all procedural aspects of the eviction proceedings,” since landlords may still serve notices to quit and commence eviction proceedings under the CDC order; rather, “[t]he Order only delays the actual eviction.”[86]  Citing both the Elmsford and Baptiste decisions (which the court also noted involved state orders that were more restrictive against landlords than the CDC order), the court concluded the CDC order does not violate the plaintiffs’ constitutional right to access the courts because (i) a landlord maintains the right to pursue other legal remedies against a non-paying tenant, such as a breach of contract claim, and (ii) the eviction moratorium is only temporary, and mere delay does not amount to a denial of a landlord’s rights when they will “at some point, regain access to legal process.”[87]

Part III – Force Majeure, Impossibility and Frustration of Purpose

With the COVID-19 pandemic forcing most retail and restaurant businesses either to temporarily shut down altogether or otherwise significantly reduce their operations, it has become nearly impossible for many of these businesses remain profitable, in turn making it much more difficult for such businesses to stay current on their lease and mortgage payments.  Many of these struggling companies have taken the position that the pandemic (and the shutdowns ordered in response to it) constitute a force majeure event, excusing their obligations to pay rent under their leases (or other payment obligations under instruments such as mortgages and purchase agreements).  In addition to the force majeure argument, many renters have also invoked the legal concepts of impossibility and frustration of purpose to make the case that their rent payment obligations should be suspended during the pandemic.  For their part, landlords have fought back to enforce the terms of their leases as written.  Part III will discuss several notable cases in which tenants (and in one case, a buyer under a purchase contract) have attempted to assert one or more of the force majeure, impossibility and frustration of purpose defenses for their benefit.

In Re: Hitz Restaurant Group

A creditor under the above-named bankruptcy case petitioned the United States Bankruptcy Court in the Northern District of Illinois – Eastern Division, to enforce the obligation of debtor Hitz Restaurant Group to pay post-petition rent and to modify the automatic stay.  The debtor argued that its obligation to pay any post-petition rent was excused by the force majeure clause contained in the lease between the debtor and such creditor and by the creditor’s failure to make necessary repairs to the leased premises.[88]  The debtor argued that the lease’s force majeure clause was triggered on March 16, 2020, when Illinois Governor J.B. Pritzker issued Executive Order 2020-7 to mitigate the effects of the coronavirus pandemic in the state.[89]  The Executive Order stated, in part, that “all businesses in the State of Illinois that offer food or beverages for on-premises consumption…must suspend service for and may not permit on-premises consumption.  Such businesses are permitted and encouraged to serve food and beverages so that they may be consumed off-premises.”[90]

The Hitz court concluded that the Executive Order did in fact trigger the force majeure clause under the lease, which clause reads as follows: “Landlord and Tenant shall each be excused from performing its obligations or undertakings provided in this Lease, in the event, but only so long as the performance of any of its obligations are prevented or delayed, retarded or hindered by…laws, governmental action or inaction, orders of government….Lack of money shall not be grounds for Force Majeure.”[91]  The court reached its conclusion that “[t]he force majeure clause in this lease was unambiguously triggered by”[92] the Executive Order because the Order “unquestionably constitutes both ‘governmental action’ and issuance of an ‘order’ as contemplated by the language of the force majeure clause,”[93] the Order “unquestionably ‘hindered’ Debtor’s ability to perform,”[94] and the Order “was unquestionably the proximate cause of Debtor’s inability to pay rent.”[95]

In response to the creditor’s position that the lease’s force majeure clause was not triggered because the Executive Order did not shut down the banking system or post offices in Illinois, meaning that the debtor was still physically able to send rental payments to the creditor, the court called this argument “specious” and rejected it “out of hand.”[96]  The court also rejected the creditor’s argument that the debtor’s failure to perform arose merely from a lack of money, which was expressly carved out of the force majeure provision in the lease.  The court instead agreed with the debtor’s position that the proximate cause of the tenant’s failure to pay rent was not mere lack of money, but rather the Executive Order’s shutdown of most of the debtor’s business that was the proximate cause of the debtor’s inability to generate revenue and therefore pay rent.[97]  However, because the Executive Order did not completely stop the debtor from conducting its business, since carry-out, delivery and pickup services were still allowed, the court concluded that the debtor was responsible for partial payment of its rent in proportion to the amount of the leased space that was still usable under the Executive Order for such allowed services (i.e., the kitchen), which amounted to 25% of the space (and therefore 25% of the rent owed).[98]

Martorella v. Rapp

Martorella v. Rapp arises from a case originally filed in the Massachusetts Land Court in 2017 entitled Stark v. Martorella, which was an action for the partition of real property located at 15 Wigwam Road in Nantucket.[99]  Defendant Stuart Rapp was the court-appointed commissioner in Stark, tasked with recommending the best way to partition the Wigwam Road property.[100]  Commissioner Rapp conducted a public auction of the property on February 14, 2020, at which the plaintiff Christopher Martorella was the winning bidder.[101]  The terms of Mr. Martorella’s winning bid, as memorialized in a purchase and sale agreement signed upon the conclusion of the auction, provided for him to pay an initial deposit at the time of the auction and a second deposit four days later, with the remaining balance of the purchase price in the amount of $1,644,300 to be paid “at the time of the delivery of the Deed.”[102]  Pursuant to the terms of the purchase agreement, the delivery of such Deed was to have occurred on March 16, 2020 (which was later extended to March 23, 2020 and then April 6, 2020 upon the mutual agreement of the parties), and the agreement did not provide for any financing or other contingencies to the completion of the sale in Mr. Martorella’s favor, nor did the agreement confer any unilateral right upon Mr. Martorella to extend the time for his performance thereunder.[103]

Due to the effect of the coronavirus pandemic on the economic markets, Mr. Martorella experienced difficulty obtaining financing for the purchase and requested to postpone the closing again to May 5, 2020, which the Land Court in Stark denied.[104]  Mr. Martorella then brought the entitled action against Commissioner Rapp, claiming the doctrine of impossibility due to the COVID-19 pandemic.  The Martorella court reasoned that the core of the question of impossibility is the determination “whether the risk of intervening circumstance was one which the parties may be taken to have assigned between themselves.”[105]  In answering this question, the court referenced Massachusetts case law stating that “[o]nce one party has made itself responsible for the disposition of the subject matter of a contract, it cannot later claim that the occurrence in question was not in the contemplation of the parties at the time of contract.”[106]  Therefore, since the purchase agreement contained no contingencies to Mr. Martorella’s obligation to perform thereunder, which he acknowledged, Mr. Martorella “knowingly assumed the risk of delivering $1,644,300 at closing.”[107]  As such, the court ruled that Mr. Martorella was not excused from performing under the purchase agreement due to impossibility, and deemed him to be in default under the agreement.[108]

Other Notable Cases

Richards Clearview, LLC v. Bed Bath & Beyond, Inc. involved a commercial eviction proceeding by the owner of an indoor shopping mall in Metairie, Louisiana against tenant Bed Bath & Beyond, which paid only partial rent in April, 2020 and no rent in May, 2020 after the Governor of Louisiana issued Emergency Proclamation 33 JBE 2020 ordering all malls to close, “except for stores in a mall that have a direct outdoor entrance and exit that provide essential services and products.”[109]  Even though the tenant believed its rent was partially excused due to the force majeure provision in its lease, the tenant did attempt to pay all of its stated rent in full after it received a notice of default from its landlord; however, the landlord refused to accept such late payments and moved to terminate the lease.[110]  The court here invoked the Louisiana doctrine of “judicial control,” which is “an equitable doctrine by which courts will deny cancellation of a lease when the lessee’s breach is of minor importance, is caused by no fault of his own, or is based on a good faith mistake of fact.”[111]  Because (i) there was a good faith question in the lease as to how much rent was owed (due to certain ambiguous co-tenancy clauses in the lease), (ii) the tenant attempted to remedy the default in a reasonable amount of time given the circumstances caused by the COVID-19 pandemic, (iii) the tenant was continuing to sell certain essential products such as soap, hand sanitizer and first aid equipment to the public during the pandemic, and (iv) the landlord was not materially harmed by the delay in payment, the court elected to exercise judicial control and ruled against cancellation of the lease.[112]

In Palm Springs Mile Associates, Ltd. v. Kirkland’s Stores, Inc., the owner of a shopping center in Hialeah, Florida sued its tenant for past due amounts and accelerated rent under its lease after the tenant stopped paying rent under the lease, with the tenant arguing that the restrictions against non-essential activities and business operations put in place by Miami-Dade County were a force majeure event that suspended its obligation to pay rent.[113]  In ruling in favor of the landlord, the court explained that “force majeure clauses are narrowly construed, and “will generally only excuse a party’s nonperformance if the event that caused the party’s nonperformance is specifically identified.’”[114]  Because the tenant failed to explain how the regulations actually and directly resulted in its inability to pay rent, the court ruled that there was no force majeure event under the lease.[115]

In BKNY1, Inc., d/b/a 132 Lounge v. 132 Capulet Holdings, LLC, a New York landlord sued to terminate its tenant’s lease of for failure to pay rent, which tenant argued that the state’s Executive Order No. 202.3 requiring its restaurant business to close excused it from its obligation to pay rent under the doctrines of frustration of purpose and impossibility.[116]  The court first addressed the tenant’s frustration of purpose defense.  Citing the principle that “financial hardship does not excuse performance of a contract,” the court concluded that the two-month temporary closure of the tenant’s business required by the Executive Order could not have frustrated the overall purpose of the lease with a term of nine years.[117]  In also rejecting the tenant’s impossibility defense, the court quoted the express language of the lease, which stated in part that the tenant’s obligation to pay rent “shall in no wise be affected, impaired or excused because Owner is unable to fulfill any of its obligations under this lease…by reason of…government preemption or restrictions.”

Part IV – Seeking Equitable Remedies

Much like COVID-19’s far-reaching effects on the daily lives of people across the United States, the pandemic has also had far-reaching effects on jurisprudence and the disposition of legal cases in many different areas of law, whether directly or only tangentially involving real estate.  Whether relating to bankruptcy cases, home purchases, or UCC foreclosure sales, no part of the law has been able to avoid the need to account for COVID-19 in determining just outcomes for those individuals and companies utilizing the court system during these times.  Part IV of this article will look at several different courts’ attempts to grapple with this very question of how to deal with the pandemic’s effects to arrive at equitable answers for those affected by it.

In Re: Dudley

The debtor in a Chapter 7 bankruptcy case filed in the United States Bankruptcy Court in the Eastern District of California petitioned the court for an extension of the six-month statutory reinvestment period for debtors to use proceeds from the sale of exempt homestead property in order to acquire another homestead property.  When Clay Dudley, the debtor in the above-referenced bankruptcy case, sold his residence in Chico, California on February 7, 2020, by statute he had six months to reinvest those sale proceeds in another residence to maintain the homestead exemption on the initial sale of his residence.[118]  The debtor claimed that he intended to purchase a replacement property and had been diligent in his efforts to do so, but that his efforts were severely hindered by the COVID-19 pandemic[119] and the State of California’s response to the pandemic, including specifically the statewide “stay at home” order issued by Governor Gavin Newsom under Executive Order N-33-20.[120]

California exercised an option under the Federal Bankruptcy Code to opt out of certain federal bankruptcy exemptions and adopt its own exemptions in their place, which California did in providing for a six-month reinvestment period for the homestead exemption.  Therefore, the bankruptcy court in Dudley applied California state law to determine whether the reinvestment period could be tolled or otherwise extended once it started to run.[121]  Although the court did not find (and the debtor did not cite) any California statutory authority to permit an extension or tolling of the six-month reinvestment period, since the trustee of the bankruptcy estate did not oppose the debtor’s request for such extension, the court looked to equitable remedies to determine whether an extension would be warranted.[122]

The court cited several prior instances under California case law where the six-month reinvestment period was equitably tolled when, through no fault of their own, claimants lacked possession or control over homestead proceeds following an involuntary or voluntary sale of the homestead, or when circumstances beyond the debtor’s control prevented the reinvestment of homestead proceeds within the six-month timeframe.[123]  In referencing these prior decisions, the Dudley court recognized California’s intent to create a liberal construction homestead statute for the benefit of debtors to ensure people’s homes are not lost through a technicality.[124]  Turning to the case at hand, the Dudley court also concluded that the unique circumstances surrounding the current pandemic warranted an equitable extension of the six-month reinvestment period for the homestead exemption, consistent with prior California case law and equitable principles, “reflect[ing] a public policy and legislative effort to protect real property interests, generally, and, specifically, to prevent the loss of residential occupancy and ownership rights due to the COVID-19 pandemic and resulting state of emergency.”[125]

In Re: Pier 1 Imports, Inc.

Pier 1 Imports, Inc. and certain of its related entities, the debtors under a Chapter 11 filing in the United States Bankruptcy Court in the Eastern District of Virginia – Richmond Division, filed their voluntary bankruptcy petition on February 17, 2020, and then saw “their stores shuttered [and their] revenue dr[y] up overnight” during the COVID-19 pandemic.[126]  As a result, the debtors took various actions to preserve their liquidity, but “found that they needed additional relief from the Court to reduce outgoing expenses even further and to preserve the status quo.”[127]  The debtors proposed a temporary period of limited business operations in which only enumerated critical expenses would be paid, meaning that rent payments to certain landlords would be temporarily deferred or reduced during this period, with all accrued rent being paid back over time after the conclusion of the limited business operations period.[128]  Several landlords objected to this proposal.

In considering the debtors’ motion, the court noted that the affected landlords may be entitled to “adequate protection” under the Federal Bankruptcy Code, which is “designed to compensate a non-debtor to the extent any proposed lease ‘results in a decrease in the value of such entity’s interest in such property.’”[129]  However, the court concluded that the “Debtors’ deferred payment of rent while they continue use of the leased premises, does not decrease the value of any Lessor’s interest in the property”[130] since all “insurance payments, security obligations, utility payments, and other similar obligations of the Debtors typically made in the ordinary course of business are continuing to be made by the Debtors.”[131]

In the court’s final conclusion in approving the debtors’ motion, the court recognized the dire situation brought about by the COVID-19 pandemic, stating that “[t]here is no feasible alternative to the relief sought in the Motion.  The Debtors cannot operate as a going concern and produce the revenue necessary to pay rent because they have been ordered to close their business.  The Debtors cannot effectively liquidate the inventory while their stores remain closed….Any liquidation efforts would be ineffective and potentially squander assets that could otherwise be administered for the benefit of all creditors in this case.”[132]

1248 Assoc Mezz II LLC v. 12E48 Mezz II LLC

In 1248 Assoc Mezz II LLC v. 12E48 Mezz II LLC, the New York Supreme Court ruled that Executive Order 202.8 (described above in this article under the discussion of the Elmsford Apartment Associates case), which placed a moratorium on the “foreclosure of any residential or commercial property for a period of ninety days,”[133] did not apply to a proposed foreclosure of an equity interest in a mezzanine borrower entity to be conducted under the Uniform Commercial Code.[134]

The original mezzanine UCC foreclosure sale that was scheduled for May 1, 2020 was temporarily enjoined by the New York Supreme Court on April 30, 2020 on the grounds that the terms of the foreclosure sale were not commercially reasonable in light of the coronavirus pandemic and that Executive Order 202.8’s prohibition on foreclosures extends to UCC foreclosures of mezzanine debt.  The court then issued a final decision in 1248 Assoc Mezz II LLC on May 18, 2020, vacating its prior temporary restraining order and ruling that the scheduled UCC foreclosure could move forward, as it was not prohibited by Executive Order 202.8.[135]  The court reached this conclusion by noting that, “had the Executive Order intended to prohibit sales of collateralized assets…governed by the UCC, such prohibition would have been explicitly provided for within that Executive Order.”[136]  The court then went on to concur with the mezzanine lender’s argument that the foreclosure of a mortgage is “a judicial proceeding, whereas the proposed (and Noticed) sale addresses a disposition of collateral pursuant to Article 9 of the UCC, a non-judicial proceeding,”[137] ultimately concluding that Executive Order 202.8 “addresses enforcement of a judicially ordered foreclosure,”[138]  which does not cover foreclosures conducted under the UCC.

D2 Mark LLC v. Orei VI Investments LLC

In D2 Mark LLC v. Orei VI Investments LLC, the court considered the question of what constitutes a commercially reasonable UCC foreclosure sale in light of the COVID-19 pandemic.  The action involved the Mark Hotel located on the Upper East Side of Manhattan, which was subject to a senior mortgage loan serviced by Wells Fargo Bank, and where 100% of the equity interest in D2 Mark Sub LLC, which was the indirect owner of the hotel, was pledged to the defendant pursuant to a mezzanine loan made by the defendant to the plaintiff.  [139]The hotel “suffered significant financial hardship as a result of the COVID-19 pandemic when it was forced to temporarily close on March 27, 2020,”[140] resulting in the plaintiff missing its April and May loan payments under the senior loan and triggering a default under both the senior loan and the defendant’s mezzanine loan.[141]

On May 18, 2020, the defendant gave notice of a UCC foreclosure sale of the plaintiff’s 100% membership interest in D2 Mark Sub LLC, which sale was to occur on June 24, 2020, which was 36 days from the date of the notice of sale.[142]  On June 8, 2020, New York City entered Phase I of reopening, which allowed the hotel to eventually reopen on June 15, 2020, which in turn allowed potential foreclosure auction bidders to tour and inspect the hotel premises prior to the sale.  New York City then entered Phase II of reopening on June 22, 2020, two days before the scheduled auction, allowing for expanded operations within the hotel and increased ability for potential bidders to perform due diligence on the hotel premises.

The plaintiff filed suit against the defendant mezzanine lender alleging, among other things, that the terms of the proposed UCC foreclosure auction were unreasonable in light of the coronavirus pandemic and seeking to enjoin the sale until September 8, 2020.  In evaluating whether such foreclosure sale terms were reasonable, the court cited the text of the Uniform Commercial Code requiring that “[e]very aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.”[143]

Given the totality of the facts and circumstances involving the proposed foreclosure sale, including the pandemic’s effect on bidding on and buyers performing due diligence on the property, the D2 Mark court concluded that such proposed sale was in fact not commercially reasonable and granted a preliminary injunction to delay the sale.[144]  Specifically, the court agreed with the analysis of plaintiff’s UCC foreclosure sale expert, who opined that UCC foreclosure sales for complex commercial assets such as the hotel would typically provide for 60 to 90 days’ notice (as opposed to the 36 days’ notice provided by the defendant), and that the property would not sell at close to its maximum price without potential buyers being afforded a reasonable opportunity to perform in-person due diligence and inspections on the property, which opportunity was severely affected by the coronavirus pandemic and the business closures that the pandemic necessitated.[145]  The court further agreed with the expert’s assertion that the foreclosure sale was “‘rigged’ so that, as a practical matter, only defendant can obtain the Collateral.”[146]  Examples of such rigging include the fact that the entire purchase price for the hotel was to be due and payable within 24 hours of the completion of the auction, and that plaintiff was barred from participating in the auction, “which is per se unreasonable.”[147]  Additionally, the fact that only two out of 115 potential bidders submitted financial statements to the defendant in connection with the proposed auction sale gave further credence to the conclusion that the terms of the foreclosure sale were unreasonable.[148]

Conclusion

There are presently dozens, if not hundreds, of other lawsuits throughout the United States currently being litigated relating to the coronavirus pandemic, which will provide us with many more answers on how COVID-19 is changing the legal landscape of the country.  However, even with so much being unknown at this time as to the contents of these future decisions, orders and opinions to be written, several discernible patterns have emerged from the cases that have been decided thus far and discussed above in this article.  Courts have clearly given deference to federal, state and local lawmakers to enact laws and regulations to protect the community at large, both from a public health perspective in preventing the spread of the virus, as well as from the perspective of protecting those individuals and businesses who have been hurt financially by the virus and its ripple effects.  Given this well-deserved deference, any current or future litigation challenging the authority or constitutionality of such laws and regulations will face a steep uphill climb to have them overturned.

Similarly, in cases involving contracts between private parties, courts have generally given deference to the terms of those agreements and have avoided reading generous force majeure clauses into them or applying broad interpretations of impossibility or frustration of purpose to them.  While the Hitz case stands out as a clear anomaly of this group, many legal scholars have opined that the result in Hitz was mostly the result of the odd formulation of the force majeure language in that particular lease, which allowed force majeure to be applied more broadly than one would typically see, as opposed to a more common description of force majeure in leases and contracts stating that a force majeure event does not excuse any payments due under such lease or contract.  Therefore, the specific wording of a lease’s or other contract’s force majeure clause will be a key factor in whether a court will provide relief to a tenant or other party to a contract based on such clause.  In furtherance of this point, we note that as of the writing of this article, a partial ruling just issued by a bankruptcy court in Texas (ruling on a lease governed by California law) held that the lease’s force majeure clause which included the term “unusual government restriction, regulation or control” warranted a reduction in rent under the tenant’s lease.[149]

When courts have had more leeway to apply equitable principles in their cases, they have generally given a certain amount of latitude to those parties who have been negatively affected by the pandemic, recognizing the sheer unforeseeability of our current situation.  The bankruptcy cases and the two UCC foreclosure cases discussed above bear this out.  This latitude was also demonstrated in the Richards Clearview case, which, although it was decided in favor of the tenant, was notable in that (a) the court applied the equitable concept of judicial control in its decision, and (b) the court did not conclude that the tenant’s rent was suspended or reduced by a force majeure event, but rather that the lease could stay in place since the tenant attempted to repay all of the prior rent that had not been paid.

As future real estate-related cases involving COVID-19 are litigated and decided, we expect these same three patterns of deference to lawmakers’ regulation, deference to existing written contracts, and application of equitable principles when available, to continue.

[1] Elmsford Apartment Associates, LLC v. Cuomo, 2020 WL 3498456, at *1.

[2] N.Y. Exec. Law Art. 2-B § 29-a.

[3] Elmsford, at *3.

[4] Id. at *7.

[5] Id. at *8.

[6] Penn Central Transportation Co. v. New York City, 438 U.S. 104, 98 S. Ct. 2646, 57 L.Ed.2d 631 (1978).

[7] Elmsford, at *10.

[8] Id. at *11.

[9] Id. at *12.

[10] U.S. Const. Art. I § 10, cl. 1.

[11] Buffalo Teachers Federation v. Tobe, 464 F.3d 362, 367 (2d. Cir. 2006) (quoting Allied Structural Steel Co. v. Spannaus, 438 U.S. 234, 240, 98 S.Ct. 2716, 57 L.Ed.2d 727 (1978)).

[12] Id. at 368.

[13] Elmsford, at *12.

[14] Id. at *13.

[15] Id. at *14.

[16] Id. (quoting Sveen v. Melin, 138 S.Ct. 1815, 1822, 201 L.Ed. 2d 180 (2018)).

[17] Id. at *16.

[18] Id.

[19] Auracle Homes, LLC v. Lamont, 2020 WL 4558682, at *1.

[20] Conn. Gen. Stat. § 28-9(b)(1).

[21] Auracle Homes, at *2.

[22] Id. at* 3.

[23] Id. at *4.

[24] Id. at *6 (quoting Plaintiffs’ Memorandum).

[25] Id. at *7 (quoting Plaintiffs’ Memorandum).

[26] Id. (quoting Plaintiffs’ Memorandum).

[27] Id. at *15 (quoting Elmsford).

[28] Id. at *16.

[29] Id. (quoting Sherman v. Town of Chester, 752 F3d 554, 565 (2d Cir. 2014)).

[30] Id. at *17.

[31] Id.

[32] Id. at *18 (quoting Sullivan v. Nassau County Interim Financial Authority, 959 F.3d 54, 65 (2d. Cir. 2020)).

[33] Id.

[34] Id. (quoting Marshall v. U.S., 414 U.S. 417, 427, 94 S.Ct. 700, 38 L.Ed.2d 618 (1974)).

[35] Id. at *19.

[36] Id. at *20.

[37] HAPCO v. City of Philadelphia, C.A. No. 20-3300, 2020 WL 5095496.

[38] Id. at *2 and *4.

[39] Id. at *5 (quoting Plaintiff’s Reply Memorandum in Further Support of Motion for Preliminary Injunction).

[40] Sveen, at 1821-22.

[41] Id.

[42] HAPCO, at *6.

[43] Id. at *8.

[44] Id.

[45] Id. at *9 and *10.

[46] Id. at *11

[47] Id. (quoting Usery v. Turner Elkhorn Mining Co., 428 U.S. 1, 15, 96 S.Ct. 2882, 49 L.Ed.2d 752 (1976)).

[48] Baptiste v. Kennealy, 2020 WL 5751572.

[49] Id. at *2.

[50] Id. at *3.

[51] Id. at *20.

[52] Id. at *21.

[53] Id. at 22 (quoting Penn Central, at 124).

[54] Id.

[55] Id.

[56] Id. at *14.

[57] Id. at *16.

[58] Id. at *18.

[59] Id. at *14 and *18.

[60] TJM 64, Inc. v. Harris, 2020 WL 4352756.

[61] Friends of Danny DeVito v. Wolf, 227 A.3d 872 (2020).

[62] Lebanon Valley Auto Racing Corp. v. Cuomo, 2020 WL 4596921.

[63] Blackburn v. Dare County, 2020 WL 5535530.

[64] San Francisco Apartment Association v. City and County of San Francisco, Order, San Francisco County Superior Court, Case No. CPF-20-517136.

[65] TJM 64, at *6.

[66] Id. at *7.

[67] Id.

[68] Friends of Danny DeVito, at 894.

[69] Lebanon Valley, at *8.

[70] Id. at *9.

[71] Blackburn, at *5.

[72] Id. at *6.

[73] Id. at *8.

[74] Richard Lee Brown v. Alex Azar, in his official capacity as Secretary, U.S. Department of Health & Human Services, 2020 WL 6364310, at *1.

[75] “Landlords, lobbyists launch legal war against Trump’s eviction moratorium, aiming to unwind renter protections,” by Tony Romm, The Washington Post, October 12, 2020.

[76] Brown, at *6.

[77] Id.

[78] Id. at *7.

[79] Id. at *9.

[80] Id. at *11.

[81] Id. at *12.

[82] Id. (citing Temporary Halt in Residential Evictions to Prevent the Further Spread of COVID-19 (the “CDC Order”), 85 Fed. Reg. at 55,295).

[83] Id. at *13.

[84] Id. (citing the CDC Order at 55,296).

[85] Id. (citing the CDC Order at 55,295-96).

[86] Id. at *14-15.

[87] Id. at *16 (quoting Elmsford at *16).

[88] In re Hitz Restaurant Group, No. 20-B-05012, 2020 WL 2924523, at *2 (Bankr. N.D. Ill. June 2, 2020).

[89] Id.

[90] Ill. Exec. Order 2020-7 § 1.

[91] In re Hitz Restaurant Group, at *2 (quoting Dkt. No. 21, Part 2, pp. 9 & 10).

[92] Id. at *4

[93] Id.

[94] Id.

[95] Id.

[96] Id.

[97] Id. at *5.

[98] Id. at *6.

[99] Martorella v. Rapp, 2020 WL 2844693, at *2.

[100] Id.

[101] Id. at *3.

[102] Id.

[103] Id. at *3 and *5.

[104] Id. at *5.

[105] Id. at *8.

[106] Id. at *9 (quoting Winchester Gables, Inc. v. Host Marriott Corp., 70 Mass. App. Ct. 585, 596 (2007)).

[107] Id.

[108] Id. at *10.

[109] Richards Clearview, LLC v. Bed Bath & Beyond, Inc., 2020 WL 5229494, at *1.

[110] Id. at *5.

[111] Id. (quoting W. Sizzlin Corp. v Greenway, 36,088 (La. App. 2 Cir. 6/12/02), 821 So. 2d 594, 601).

[112] Id. at *4 and *7-8.

[113] Palm Springs Mile Associates, Ltd. v. Kirkland’s Stores, Inc., 2020 WL 5411353., at *1.

[114] Id. at *2 (quoting ARHC NVWELFL01, LLC v. Chatsworth at Wellington Green, LLC, No. 18-80712, 2019 WL 4694146, at *3 (S.D. Fla. Feb. 5, 2019)).

[115] Id.

[116] BKNY1, Inc., d/b/a 132 Lounge v. 132 Capulet Holdings, LLC, 2020 WL 5745631.

[117] Id. at *2.

[118] In re Dudley, 617 B.R. 149, 151 (2020).

[119] Id.

[120] Id.

[121] Id. at 153.

[122] Id. at 154.

[123] Id.

[124] Id.

[125] Id. at 156.

[126] In re Pier 1 Imports, Inc., 615 B.R. 196, 198 (2020).

[127] Id.

[128] Id. at 199.

[129] Id. at 203 (quoting 11 U.S.C. § 361(2)).

[130] Id.

[131] Id.

[132] Id.

[133] New York Executive Order No. 202.8, “Continuing Temporary Suspension and Modification of Laws Relating to the Disaster Emergency.”

[134] 1248 Assoc Mezz II LLC v. 12E48 Mezz II LLC, N.Y.Sup. Index No. 651812/2020.

[135] Id. at 3.

[136] Id. at 2.

[137] Id.

[138] Id.

[139] D2 Mark LLC v. Orei VI Investments LLC, 2020 WL 3432950, at *1.

[140] Id. at *3.

[141] Id.

[142] Id. at *4.

[143] Uniform Commercial Code § 9-610[b].

[144] D2 Mark, at *8.

[145] Id. at *9.

[146] Id. at *10.

[147] Id.

[148] Id.

[149] “How Force Majeure Was Successfully Used by a Tenant in Court,” by Patrick Trostle and Alan Gamza, www.globest.com, November 19, 2020 (discussing In Re: CEC Entertainment, Inc., Ch. 11 Case No. 20-33163 (MI) (Bankr. S.D. Tex.)).

Editor

Jason Twinning

Attorney in Washington, DC and Maryland

§ 1.1 Introduction

“The hand of history lies heavy upon the tort of conversion.”  Prosser, The Nature of Conversion, 42 Cornell LQ 168, 169 (1957).  With roots dating back to the Norman Conquest of England in 1066, the cause of action had its original underpinnings as an alternative to deciding rightful ownership of disputed property by “wager of battle”—a physical altercation or duel between alleged victim and thief.  Ames, The History of Trover, 11 Harv. L. Rev. 277, 278 (1897).

While life-and-death duels aren’t required anymore to ascertain ownership, the stakes of modern litigation over disputed property interests often carry existential consequences for the parties’ business interests.  Despite being an ancient cause of action, conversion claims continue to impact present-day business disputes.  Dozens of purported class action lawsuits pending in multiple jurisdictions seek to use the tort of conversion as a mechanism for adjudicating the proper ownership of billions of dollars the federal government paid for Paycheck Protection Program (PPP) loans pursuant to the Coronavirus Aid, Relief, and Economic Security (CARES) Act.  Some courts have begun to assess how conversion claims may apply to disputes over blockchain cryptocurrencies.  Still other recent decisions assess the cause of action’s applicability to everything from membership interests in limited liability companies, to theft of a manuscript that played a key role in exposing movie producer Harvey Weinstein’s history of committing sexual assault and rape.

§ 1.2 The Development of the Cause of Action

§ 1.2.1 Brief History of Conversion, and Its Gradual Expansion to Include Some Forms of Intangible Property.

Conversion is an intentional act of “dominion or control over a chattel which so seriously interferes with the right of another to control it that the actor may justly be required to pay the other the full value of the chattel.”  Restatement (Second) of Torts § 222A[1] (1965).  Originally, this meant interferences with or misappropriation of only tangible “goods”—personal property capable of being lost or stolen.  See W. Page Keeton et al., Prosser & Keeton on the Law of Torts § 15, at 90 (5th ed. 1984).  Because intangible rights could not be “lost or found” in the eyes of the common law, the general rule was that “an action for conversion [would] not normally lie, when it involves intangible property” because there was no physical item that could be misappropriated.  See Sporn v. MCA Records, 58 N.Y.2d 482, 489, 462 N.Y.S.2d 413, 448 N.E.2d 1324 (1983).

Despite this long-standing reluctance to expand conversion beyond the realm of tangible property, most courts have determined there was “no good reason for keeping up a distinction that arose wholly from that original peculiarity of the action” and allowed conversion claims to reach “things represented by valuable papers, such as certificates of stock, promissory notes, and other papers of value.”  See Ayres v. French, 41 Conn. 142, 150, 151 (1874) (emphasis added).  This, in turn, led to recognition of conversion when an intangible property right can be united—or “merged”—with a tangible object.  New York’s highest court explained:

[F]or practical purposes [the shares] are merged in stock certificates which are instrumentalities of trade and commerce…. Such certificates ‘are treated by business men as property for all practical purposes.’ … Indeed, this court has held that the shares of stock are so completely merged in the certificate that conversion of the certificate may be treated as a conversion of the shares of stock represented by the certificate.

See Agar v. Orda, 264 N.Y. 248, 251, 190 N.E. 479 (1934); see also Sporn, 58 N.Y.2d at 489, 462 N.Y.S.2d 413, 448 N.E.2d 1324 (plaintiff could maintain conversion claim where defendant infringed plaintiff’s “intangible property right to a musical performance by misappropriating a master recording—a tangible item of property capable of being physically taken”).

To some courts, the “lack of a compelling reason to prohibit conversion for redress of a misappropriation of intangible property underscores the need for reevaluating the appropriate application of conversion.”  Thyroff v. Nationwide Mut. Ins. Co., 8 N.Y.3d 283, 291, 864 N.E.2d 1272, 1277 (2007).  This reevaluation has led some courts to hold that conversion claims can embrace purely intangible property.  See, e.g., Kremen v. Cohen, 337 F.3d 1024, 1033–1034 (9th Cir. 2003) (internet domain name; applying California law); Shmueli v. Corcoran Group, 9 Misc.3d 589, 594, 802 N.Y.S.2d 871 (Sup. Ct., N.Y. County 2005) (computerized client/investor list); Town & Country Props., Inc. v. Riggins, 249 Va. 387, 396–397, 457 S.E.2d 356, 363–364 (1995) (person’s name).

The Restatement (Second) of Torts recognizes this development, noting as to “Conversion of Documents and Intangible Rights”:

• Where there is conversion of a document in which intangible rights are merged, the damages include the value of such rights.
• One who effectively prevents the exercise of intangible rights of the kind customarily merged in a document is subject to a liability similar to that for conversion, even though the document is not itself converted.

Restatement (Second) of Torts § 242 (1965).  Yet, the restatement cautions that this “final step” in the law of conversion “does not accord very well with the traditional common law limitations of conversion; and courts which prefer to adhere to the older theory may prefer to regard the liability as one for an intentional inference with the right, which is not identical with conversion, but is similar to it in its nature and legal consequences.”  Id. § 242, comment e.

Prosser and Keeton similarly recognize “[t]here is perhaps no very valid and essential reason why there might not be conversion of” intangible property.  Prosser & Keeton § 15, at 91–92.  Yet they admonish that although “[t]he American economy has experienced an increasing use of intangible ideas. … it would seem preferable to fashion other remedies, such as unfair competition, to protect people from having intangible values used and appropriated in unfair ways.”  Id. at 92.

Accordingly, some courts still insist that conversion claims cannot reach purely intangible rights.  See, e.g., Allied Inv. Corp. v. Jasen, 354 Md. 547, 562, 731 A.2d 957, 965 (1999) (secured interests in corporation stock, collateral assignment of a partnership interest, and proceeds from each); Northeast Coating Tech., Inc. v. Vacuum Metallurgical Co., Ltd., 684 A.2d 1322, 1324 (Me. 1996) (interest in information contained in prospectus); Montecalvo v. Mandarelli, 682 A.2d 918, 929 (R.I. 1996) (partnership interest).  Even courts that adhere to this more traditional view, however, frequently recognize exceptions—for example, “when a plaintiff can allege that the defendant converted specific segregated or identifiable funds, a conversion claim for money may survive.”  See, e.g., Sage Title Grp., LLC v. Roman, 455 Md. 188, 203, 166 A.3d 1026, 1035 (2017) (citation, internal quotation marks omitted).  However, a claim for conversion will fail if the plaintiff cannot establish his right to the funds held in the segregated account.  See, e.g., Cumis Ins. Soc., Inc. v. Citibank, N.A., 921 F. Supp. 1100, 1110 (S.D.N.Y. 1996) (dismissing conversion claim where “there is no allegation of any wrongful or improper act of dominion by [defendant] in contravention of [plaintiff’s] rights.  The alleged acts constituting a conversion are specifically permitted under U.C.C. Article 4–A.”).  Moreover, if a defendant diverts funds from a segregated account, the plaintiff proves his right to those funds, but the defendant satisfies an adverse judgment through use of other funds; there is no liability for conversion, because the plaintiff has suffered no damages.  See Patel v. Strategic Grp., LLC, — N.E.3d —, 2020 WL 6193637, at *8 (8th Dist. Ct. Cuyahoga Cty. Ohio, Oct. 22, 2020) (“Once the trial court returned the full value of the alleged converted property to Patel — as occurred when the trial court awarded Patel $50,000 on his breach of contract claim — Patel suffered no damages pursuant to his conversion action.”).

§ 1.2.2 Elements, Defenses, and Available Remedies

A common thread runs through each jurisdiction’s unique recitation of the elements of conversion—“a wrongful taking, detention, or interference with, or an illegal assumption of ownership or possession, or illegal use or misuse, of the personal property of another.  The gist of the tort is the exercise, or intent to exercise, dominion or control over the property of another in denial of, or inconsistent with, his or her rights in the property.”  7 American Law of Torts § 24:1.  At its most basic, conversion is “any distinct act of dominion wrongfully exerted over the property of another, in denial of the plaintiff’s right, or inconsistent with it.”  Mian v. Sekerci, No. CV N17C-05-585 JRJ, 2019 WL 4580024, at *4 (Del. Super. Ct. Sept. 13, 2019).

The two “key elements” of conversion are (1) the plaintiff’s possessory right or interest in the property and (2) a defendant’s dominion over the property or interference with it, in derogation of plaintiff’s rights.  Palermo v. Taccone, 79 A.D.3d 1616, 913 N.Y.S.2d 859 (4th Dep’t 2010); see also Burlesci v. Petersen (1998) 68 Cal.App.4th 1062, 1066, 80 Cal.Rptr.2d 704 (elements are “(1) the plaintiff’s ownership or right to possession of the property; (2) the defendant’s conversion by a wrongful act or disposition of property rights; and (3) damages”).

Some jurisdictions additionally require that the plaintiff must have demanded return of the property, and the defendant refused.  See Cypress Creek EMS v. Dolcefino, 548 S.W.3d 673 (Tex. App. Houston 1st Dist. 2018), petition for review filed, (July 17, 2018) (listing elements).  Under that analysis, without a demand for possession there’s been no deprivation, and accordingly no harm.  Community Bank, Ellisville, Mississippi v. Courtney, 884 So. 2d 767 (Miss. 2004).

Other courts require demand and refusal only when the defendant’s original possession came about lawfully.  See In re Rausman, 50 A.D.3d 909, 910, 855 N.Y.S.2d 263, 265 (2008) (absent some indication that defendant’s original withdrawal of funds from a Swiss bank account pursuant to the power of attorney was unlawful, conversion claim could not have accrued until a demand was made); Lange-Fitzinger v. Lange, No. A153791, 2019 WL 3424959, at *5 (Cal. Ct. App. July 30, 2019). (“when the defendant’s original possession of the property was not tortious … plaintiff must prove that defendant refused to return the property after a demand for its return”).  But even then, exceptions may apply.  Cuprys v. Volpicelli, 170 A.D.3d 1477, 1478, 97 N.Y.S.3d 325, 327 (2019) (“If possession of the property is originally lawful, a conversion occurs when the defendant refuses to return the property after a demand or sooner disposes of the property.”) (emphasis added); see also CIT Commc’ns Fin. Corp. v. Level 3 Commc’ns, LLC, No. CIV.A.06C-01-236 JRS, 2008 WL 2586694, at *2 (Del. Super. Ct. June 6, 2008) (although “Delaware law does support the notion that if a party was once in lawful possession of the plaintiff’s property, the plaintiff must first make a demand … for return of the property[, t]his requirement is excused when the alleged wrongful act is of such a nature as to amount, in itself, to a denial of the rights of the real owner.”) (internal quotation marks omitted).

Just as in any other tort action, a plaintiff alleging conversion bears the burden of proving the extent of the damages he or she suffered.  Dileo v. Horn, 189 So. 3d 1189 (La. Ct. App. 5th Cir. 2016).  Damages awarded in an action for conversion are determined by the value of the property converted, and if disputed, the plaintiff bears the burden of proof.  Gould v. Ochsner, 2015 WY 101, 354 P.3d 965 (Wyo. 2015).  See Restatement (Second) of Torts § 242, Comment e (in cases involving intangible property there is “very little practical importance whether the tort is called conversion, or a similar tort with another name” because “[i]n either case the recovery is for the full value of the intangible right so appropriated”).

When it comes to defenses, “[c]onversion is a strict liability tort.  The foundation of the action rests neither in the knowledge nor the intent of the defendant.  Instead, the tort consists in the breach of an absolute duty; the act of conversion itself is tortious.  Therefore, questions of the defendant’s good faith, lack of knowledge, and motive are ordinarily immaterial.”  Pegues v. Raytheon Space & Airborne Sys., No. 217CV05420DSFGJSX, 2018 WL 8062690, at *3 (C.D. Cal. Dec. 3, 2018) (quoting Burlesci v. Petersen, 68 Cal. App. 4th 1062, 1066 (1998)).  Nor, generally, can an after-the-fact attempt to return converted property “cure” the conversion.  IBM Corp. v. Comdisco, Inc., 1993 Del. Super. LEXIS 183, *41, 1993 WL 259102.

Actual consent or acquiescence is a complete defense to a claim of conversion.  In re CIL Limited, 582 B.R. 46 (Bankr. S.D.N.Y. 2018), amended on reconsideration, 2018.  Absence of damage to the plaintiff is a good defense, see Baye v. Airlite Plastics Co., 260 Neb. 385, 618 N.W.2d 145 (2000), as is abandonment of the property by the plaintiff.  Toll Processing Services, LLC v. Kastalon, Inc., 880 F.3d 820 (7th Cir. 2018); Boaeuf v. Memphis Station, L.L.C., 107 N.E.3d 817 (Ohio Ct. App. 8th Dist. Cuyahoga County 2018); Lowe v. Rowe, 173 Wash. App. 253, 294 P.3d 6 (Div. 3 2012); Greenpeace, Inc. v. Dow Chemical Co., 97 A.3d 1053 (D.C. 2014).  Similarly, a defendant who possessed the property to accommodate plaintiff has a complete defense to conversion when the property was wrongfully removed by a third person.  Williams v. Edwards, 82 Ga. App. 76, 60 S.E.2d 538 (1950).

Other defenses which may mitigate the damages, but do not constitute a complete defense, include:

• possession originally acquired in a lawful manner,
• bona fide purchase without notice,
• lack of profit or benefit to the defendant,
• benefits conferred by the defendant on the plaintiff by making voluntary payments on the plaintiff’s obligations,
• reasonable care in handling the property by the defendant,
• defendant’s failure to use the property,
• plaintiff’s indebtedness to the defendant,
• plaintiff’s intention prior to the conversion to use the property unlawfully, or
• negligence on the part of the plaintiff.

90 C.J.S. Trover and Conversion § 68.  “Other claims which are not a defense include that the defendant is not in possession of the property sued for, the property is in legal custody, advice of counsel, contributory negligence, the First Amendment, lack of consideration, and commingling of the property with other property before the conversion.”  Id.

§ 1.3 Recent Case Developments

As conversion claims grew to encompass intangible property, the Restatement noted “[t]he law is evidently undergoing a process of expansion, the ultimate limits of which cannot as yet be determined.”  Restatement (Second) of Torts § 242 (1965).  It remains so, as new cases seek to apply the ancient cause of action to pressing modern circumstances.

COVID-19, the CARES Act, and PPP Reimbursement Litigation

As noted above, dozens of purported class action lawsuits pending in multiple jurisdictions seek to use the tort of conversion as a mechanism for adjudicating the proper ownership of billions of dollars the federal government paid for Paycheck Protection Program (PPP) loans pursuant to the Coronavirus Aid, Relief, and Economic Security (CARES) Act.  See, e.g., In re Paycheck Prot. Program Agent Fees Litig., No. MDL 2950, 2020 WL 4673430, at *1 (U.S. Jud. Pan. Mult. Lit. Aug. 5, 2020) (denying consolidation of 62 federal lawsuits pending in 26 districts).

To assist businesses struggling with the effects of the COVID-19 pandemic, Congress sought to incentivize those businesses to keep workers on their payroll by guaranteeing PPP loans made through Small Business Administration (“SBA”)-approved lenders (and offering forgiveness under certain conditions).  “Congress didn’t create the PPP from whole cloth.  Rather, it ‘temporarily add[ed] a new product,’” to the SBA’s “existing [Section] 7(a) Loan Program.”  Lopez v. Bank of Am., N.A., No. 20-CV-04172-JST, 2020 WL 7136254, at *1 (N.D. Cal. Dec. 4, 2020) (citing Business Loan Program Temporary Changes; Paycheck Protection Program Interim Final Rule (the “SBA Rule”), 85 Fed. Reg. 20811 (Apr. 15, 2020)).[1]

However, the CARES Act created an unorthodox system for paying “agents” who assisted the small businesses in obtaining a PPP loan (e.g., attorneys; accountants; consultants; brokers; other persons or entities who prepare an applicant’s application for financial assistance, or who assist a lender with originating, disbursing, servicing, liquidating, or litigating SBA loans).  See, e.g., U.S. Dep’t of Treasury, PPP Information Sheet Lenders, https://home.treasury.gov/system /files/136/PPP%20Lender%20Information%20Fact%20Sheet.pdf (last visited Jan. 12, 2021).

To further assist distressed businesses, the CARES Act prohibited agents from collecting fees directly from any PPP applicant.  But rather than have the SBA compensate those agents directly, the Act required the SBA to pay processing fees to the lenders according to a sliding percentage driven by the loan’s size, and for agents to then pursue payment from those lenders out of the fees the lenders received from the SBA.  According to SBA guidance (id.):

Processing fees will be based on the balance of the financing outstanding at the time of final disbursement.  SBA will pay lenders fees for processing PPP loans in the following amounts:

• Five (5) percent for loans of not more than $350,000;
• Three (3) percent for loans of more than $350,000 and less than $2,000,000; and
• One (1) percent for loans of at least $2,000,000.

Agent fees will be paid out of lender fees.  The lender will pay the agent.  Agents may not collect any fees from the applicant.  The total amount that an agent may collect from the lender for assistance in preparing an application for a PPP loan (including referral to the lender) may not exceed:

• One (1) percent for loans of not more than $350,000;
• 50 percent for loans of more than $350,000 and less than $2 million; and
• 25 percent for loans of at least $2 million.

Unsurprisingly, disputes arose between lenders and agents over how much, if at all, various agents were entitled to be paid out of funds the lenders had received from the SBA.  Those disputes led to a blizzard of litigation, in which the agents advanced conversion claims as one theory of recovery, alleging that the CARES Act and related SBA regulations gave agents “a right to immediate possession of the agent fees,” out of funds that lenders “refused to provide … to Plaintiff and the class….”  See Prinzo & Assoc’s, LLC v. BMO Harris Bank, N.A., Case No. 1:20-cv-3256 (N.D. Ill. 2020) (Complaint, ¶¶ 86–92).  “By withholding these fees,” the lenders were alleged to have “maintained wrongful control over [agents’] property inconsistent with [agents’] entitlements under the SBA regulations,” amounting to “civil conversion by retaining monies owed to Plaintiff and Class members.”  Id.

In Leigh King Norton & Underwood, LLC v. Regions Fin. Corp., No. 2:20-CV-00591-ACA, 2020 WL 6273739, at *12 (N.D. Ala. Oct. 26, 2020), the court dismissed plaintiffs’ conversion claims.  The court noted that “under Alabama law, a conversion claim for money will survive only if “the money itself, not just the amount of it, [is] specific and capable of identification.”  Id. at *11 (quoting Edwards v. Prime, Inc., 602 F.3d 1276, 1303 (11th Cir. 2010) (alteration in original)).  And to be capable of identification, the money must be “traceable to a special account” or come from “segregated sources.”  Id.  Plaintiffs contended that because the funds “emanated” from a specifically identified source—i.e., the processing fees the SBA pays lenders under the PPP—the funds were sufficiently specific and identifiable.  The court disagreed, holding “the fact that money ‘emanates’ from a specific source is not enough; the funds themselves must be identifiable, either because they are physically identifiable or because they have been entirely sequestered from all other funds.”  Id. at *12 (emphasis added).  Accordingly, the court dismissed plaintiffs’ conversion claims.

Similar lawsuits saw the courts dismiss plaintiffs’ conversion claims on the ground that where agents failed to comply with separate SBA rules, neither the CARES Act nor any SBA rule implementing the PPP created an entitlement to the fees—and without an immediate right to possession, conversion claims cannot stand.  For example, in Lopez v. Bank of Am., N.A., supra, a sole proprietor bookkeeper helped his client apply for a PPP loan by compiling the client’s payroll information, reviewing the numbers to determine the appropriate loan amount, and filling out an application with Bank of America on his client’s behalf.  2020 WL 7136254 at *4.  His client received a PPP loan in the amount of $70,243, and he sought to recover his fee ($702.43, or 1%) from Bank of America out of the origination fee it had received from the government.  Id.

Bank of America refused, arguing that plaintiff never entered into a compensation agreement with Bank of America, and neither the CARES Act nor the SBA Rule entitled an agent to fees from a lender in the absence of such a direct agreement between agent and lender.  Id. at *7.  Plaintiff therefore sued on behalf of a purported class, alleging that the defendant lender was “obligated to set aside money to pay, and to pay, agents in accordance with PPP Regulations for work performed on behalf of a client in relation to the preparation and/or submission of a PPP loan application that resulted in a funded PPP loan.”  Id. at *5.

The court disagreed.  Pre-existing SBA rules required an agent “must execute and provide to SBA a compensation agreement,” which “governs the compensation charged for services rendered or to be rendered to the Applicant or lender in any matter involving SBA assistance.”  Id. at *2 (citing 13 C.F.R. § 103.5(a)).  And because nothing in the CARES Act superseded this rule, the court “conclude[d] that the CARES Act and the SBA Rule do not require lenders to pay agent fees for assistance with PPP loan applications, except as required under a written compensation agreement.”  Id. at *8.  Accordingly, because the plaintiff “was not entitled to agent fees under the CARES Act or SBA Rule, he had no ‘right to possession of the property,’” without which the conversion claim necessarily failed.  Id. at *9.

Several other courts have employed a similar analysis.  See Am. Video Duplicating Inc. v. Citigroup Inc., No. 20-cv-03815-ODW (AGRx), 2020 WL 6712232, at *4 (C.D. Cal. Nov. 16, 2020) (citing Sanchez, PC v. Bank of S. Tex., No. CV-20-00139, 2020 WL 6060868 (S.D. Tex. Oct. 14, 2020); Johnson v. JPMorgan Chase Bank, N.A., No. CV-20-4100 (JSRx), ––– F.Supp.3d ––––, 2020 WL 5608683 (S.D.N.Y. Sept. 21, 2020); Sport & Wheat, CPA, PA v. ServisFirst Bank, Inc., No. 20-cv-05425-TKW-HTC, ––– F.Supp.3d ––––, 2020 WL 4882416 (N.D. Fla. Aug. 17, 2020)).

Cryptocurrency Disputes

A Bitcoin is a unit of virtual currency, or “cryptocurrency” that exists only on the internet, without direct ties to any single nation’s monetary systems (though Bitcoins are regularly exchanged for sovereign currencies like the U.S. Dollar and the British Pound).  Bitcoins are stored in virtual “wallets” created by the official Bitcoin software, which can store Bitcoins of a single user, or of multiple users using built-in “Accounts” functionality that tracks each user’s Bitcoin balance independently.

The currency is highly volatile—on March 12, 2020, as the COVID-19 pandemic first began to impact the United States, one Bitcoin traded for $3,858; on January 12, 2021, it traded briefly for more than $36,604 per Bitcoin.  See https://www.coinbase.com/price/bitcoin (last visited Jan. 12, 2021).  The currency is based upon a blockchain[2] that contains a public ledger of all the transactions in the Bitcoin network.  Initial interest in the currency was small, limited initially to those seeking to engage in transactions that could not be easily traced.  Over time, as the currency gained wider exposure, retailers opened up to using bitcoin in 2012 and 2013.  See https://www.investopedia.com/articles/forex/121815/bitcoins-price-history.asp (last visited Jan. 12, 2021).

Bitcoin is now traded on a number of non-centralized independent exchanges, and the currency can also be bought and sold through broker-dealers.  Id.  As Bitcoin has become more prevalent, courts are being asked to resolve whether it’s something that conversion claims can reach, which requires asking (and beginning to answer) questions as foundational as: is Bitcoin tangible, or intangible, property?

Ox Labs, Inc. v. Bitpay, Inc., No. CV 18-5934-MWF (KSX), 2020 WL 1039012, at *5–6 (C.D. Cal. Jan. 24, 2020).[3]  Bitcoin is quasi-tangible property.

Plaintiff provided an advanced trading platform to exchange cryptocurrency, including Bitcoin.  Defendant’s business involved regularly purchasing and selling Bitcoins—including on plaintiff’s platform—to enable other businesses to accept the cryptocurrency for online payments.  At the conclusion of several transactions, plaintiff inadvertently credited Defendant with 200 additional Bitcoins.  The error went unnoticed for over a year, when plaintiff realized approximately 200 Bitcoins were missing from its accounts, but could not locate the source of the missing Bitcoins.  Months later, defendant also identified the error as part of an internal accounting review, and alerted the plaintiff.  Negotiations ensued as to the correct valuation of the 200 Bitcoins, which had appreciated substantially since the initial error—on the date of the error the value was about $260-$300 per Bitcoin on the markets; when the error was identified by defendant, the value was about $1,050 per Bitcoin.  Defendant offered payment based on the lower amount, but plaintiff refused.  By the time plaintiff filed suit, nearly three years after the initial error, the value was more than $6,623 per Bitcoin.

Because California’s statute of limitations for conversion is longer for tangible property (3 years) than intangible property (2 years), the court had to decide a fairly metaphysical question: what sort of thing is Bitcoin, really?  Defendant argued that Bitcoin is intangible property (and thus subject to a shorter limitations period), “because it is a digital currency without a tangible form.”  But according to plaintiff, “Bitcoins do not exist in the detached realm of ideas; rather, they are digital currencies that rely on a shared public ledger … which records all confirmed transactions.”  Plaintiff relied on Fabricon Products v. United California Bank, 264 Cal. App. 2d 113, 70 Cal. Rptr. 50, 53 (1968), where the California Court of Appeal determined that a check for money is tangible property subject to the three-year statute of limitations.

The court agreed with plaintiff, stating: “Bitcoin is not merely an ‘idea’ that is entirely divorced from any physical form.  Rather, it is dependent on blockchain, a public ledger which records all the transactions.”  The Court also found support in another decision that concluded Bitcoins are commodities that can be regulated by the Commodities Futures Trading Commission.  See CFTC v. McDonnell, 287 F. Supp. 3d 213, 228 (E.D.N.Y. 2018) (“Virtual currencies are ‘goods’ exchanged in a market for a uniform quality and value.  They fall well-within the common definition of ‘commodity’ as well as the [Commodity Exchange Act]’s definition of ‘commodities’ as ‘all other goods and articles … in which contracts for future delivery are presently or in the future dealt in.’”).  Accordingly, the longer limitations period applied.

BDI Capital, LLC v. Bulbul Investments LLC, 446 F. Supp. 3d 1127 (N.D. Ga. 2020).  Unlike money, Bitcoin is “specific intangible property” which can be recovered under a conversion theory.

In this case, an owner of Bitcoin sued the operator of a cryptocurrency exchange, alleging that the defendant unlawfully retained plaintiff’s Bitcoin, and asserting a claim for conversion.  Defendant operated a trading platform that allowed its users to buy and sell Bitcoins against U.S. Dollars.  In 2013, plaintiff set up an account on defendant’s trading platform.  In 2017, plaintiff attempted to withdraw all of its Bitcoins stored on defendant’s platform, but was met with error messages.  After various unsuccessful efforts to resolve the issue, plaintiff learned that defendant was in the process of shutting down or had already shuttered its trading platform.  Defendant allegedly decided to close its trading platform because the banks it used had elected to discontinue their business with entities involved with cryptocurrencies.

Plaintiff, through counsel, issued a demand letter to defendant for all balances in plaintiff’s virtual wallet.  When defendant failed to respond to the letter, plaintiff filed suit, arguing defendant should be held liable for conversion because it failed to return plaintiff’s Bitcoin upon demand.  Noting that no Georgia court had addressed “whether bitcoins, as virtual, intangible cryptocurrency, may be the subject of a conversion action at all,” the court noted potential analogues—although generally “specific intangible property may be the subject for an action for conversion, … as fungible intangible personal property, money, generally, is not subject to a civil action for … conversion.” (citations omitted).  The court accordingly inquired whether Bitcoins were “money” (and thus incapable of recovery through a conversion theory) or something different.  The court ultimately was persuaded that Bitcoins could be the subject of a conversion action, because of each Bitcoin’s specificity and identity—the Bitcoin blockchain providing “a giant ledger that tracks the ownership and transfer of every Bitcoin in existence.”  (quoting Kleiman v. Wright, No. 18-CV-80176, 2018 WL 6812914, 2018 U.S. Dist. LEXIS 216417 (S.D. Fla. Dec. 27, 2018)).  According to the court, Bitcoins therefore are sufficiently identifiable to be considered “specific intangible property” subject to an action for conversion.

Other Notable Decisions

McGowan v. Weinstein, No. 219CV09105ODWGJSX, 2020 WL 7210934 (C.D. Cal. Dec. 7, 2020).  In this case the court found a private espionage operation that stole an advance copy of Rose McGowan’s memoir exposing Harvey Weinstein as a rapist—for the purpose of informing a public relations effort to discredit McGowan—did not state a claim for conversion of her intellectual property.

For many years, the defendant used his power in the movie industry to sexually victimize women.  According to the plaintiff, when defendant learned that plaintiff planned to expose him as her rapist in her memoir, Brave, he and his agents mobilized a complex scheme to protect his reputation.  Part of the alleged scheme included using a private intelligence company, known as Black Cube, to obtain the content of Brave before its publication to help inform the smear campaign against its author.

Plaintiff alleged that the defendants were liable for conversion (among other counts) because they “planned to and did implement a scheme to obtain as much of Brave as possible before the book was published, causing interference with [McGowan]’s possession of the confidential manuscript.”  Defendants moved to dismiss on grounds that (1) plaintiff failed to allege a complete dispossession of the manuscript; and (2) her claim was preempted by the Copyright Act.  In opposition, McGowan argued that (1) intangible property can be subject to conversion even if it can be duplicated; and (2) a conversion claim did not require her to have been completely dispossessed of her copy of the manuscript.  According to plaintiff, when Black Cube stole a copy of much of her manuscript—“and was apparently paid handsomely for that theft”—it disturbed and disrupted her right to maintain sole and exclusive possession of the intellectual property until its publication.

The court found plaintiff’s conversion claim preempted by the federal Copyright Act.  “[W]here a plaintiff is only seeking damages from a defendant’s reproduction of a work—and not the actual return of a physical piece of property—the claim is preempted.”  Because “the essence of her claim is that Defendants made an unlawful reproduction of her manuscript of Brave and interfered with her right to be the only person in possession of a copy,” plaintiff’s claim sounded in copyright.  “[W]rongful possession of copies does not typically give rise to a conversion claim if the rightful owner retains possession of the original or retains access to other copies.”  According to the court, “possession of copies of documents—as opposed to the documents themselves—does not amount to an interference with the owner’s property sufficient to constitute conversion.”  And where “the alleged converter has only a copy of the owner’s property and the owner still possesses the property itself, the owner is in no way being deprived of the use of h[er] property.”

Mahon v. Mainsail LLC, No. 20-CV-01523-YGR, 2020 WL 6750150, at *9 (N.D. Cal. Nov. 17, 2020).  An unfulfilled demand for return of unauthorized copies of intellectual property can overcome Copyright Act preemption concerns, regardless of whether the demand came before filing suit.

An independent filmmaker who created the film “Strength and Honor” entered into an agreement with defendant to distribute the film and provided master copies of the film.  However, the Film was released with unauthorized covers and trailers, which plaintiff alleged violated the agreement.  Plaintiff immediately sent “cease and desist” letters instructing defendant to remove the film from distribution.  The Film continued to be distributed around the world, which Mahon claims could only occur based on master copies provided to defendant.  Indeed, plaintiff learned that defendant’s subcontractor had shipped copies of the film to companies around the world, on defendant’s instruction, after plaintiff’s “cease and desist” letter.

Plaintiff filed suit, asserting claims for direct and contributory copyright infringement, illicit trafficking in counterfeit labels, fraud, and conversion against Mainsail.  The Court initially dismissed the conversion claim as preempted by the Copyright Act, because it was based solely on conversion of intangible property (copyrights).  The Court noted, however, that “claims for conversion of intangible property that includes an ‘extra element,’ such as demand for return of tangible property, [are] not preempted.”  Plaintiff amended his complaint reasserting the conversion claim, but added allegations that defendant obtained master copies (i.e., tangible property) of the film and never returned them.  According to the court, this sufficiently stated a claim for an “extra element”—allowing plaintiff to seek recovery of tangible property (the master copies), as opposed to merely asserting unauthorized copying of the intangible property.

Still, defendant argued that plaintiff’s conversion claim should fail because plaintiff purportedly authorized defendant’s use of the master copies.  The court rejected this argument, noting that even if plaintiff initially authorized defendant to use master copies “it strains credulity that [defendant] could have innocently relied on that authorization [through seven years] of litigation and numerous ‘cease and desist’ letters from the [plaintiff].”  Moreover, the court “fail[ed] to see any law … that requires [plaintiff] to have asked [defendant] for return of the property before filing his suit.”  Accordingly, the Court denied defendant’s motion to dismiss the amended conversion claim.

Bamford v. Penfold, L.P., No. CV 2019-0005-JTL, 2020 WL 967942 (Del. Ch. Feb. 28, 2020).  In this case Delaware’s Chancery Court confirmed that conversion claims may encompass membership interests in a limited liability company, no differently than stock in a corporation.

The defendant was plaintiff’s financial advisor and longtime friend—“a relationship that was closer than most brothers,” according to the complaint.  Because of his great trust in the defendant, plaintiff did not inquire further when the defendant (falsely) advised him to waive the conversion feature in debt issued by the entity they co-owned in connection with a reorganization.  Through that reorganization, the defendant obtained complete control of the entity, and, the plaintiff alleged, engaged in misappropriation and self-dealing.

Plaintiff asserted that the defendant’s actions amounted to conversion of plaintiff’s membership interests in the LLC.  Defendant moved to dismiss, arguing that the intangible property at issue should be treated differently than other intangibles, such as shares of stock, of the kind customarily held to have been merged into a tangible document. 

The court disagreed, holding “[t]here is no basis for treating a share of stock in a corporation and a membership interest in an LLC differently for purposes of conversion.  A share of stock represents a bundle of rights defined by the laws of the chartering state and the corporation’s certificate of incorporation and bylaws.  A membership interest in an LLC represents a bundle of rights defined by the laws of the chartering state, any substantive provisions in the certificate of formation (typically none), and the LLC agreement.  Just as a share of stock is subject to conversion, so too is a membership interest in an LLC.”

Voris v. Lampert, 7 Cal. 5th 1141, 1153, 446 P.3d 284, 292 (2019), reh’g denied (Oct. 23, 2019).  Lost wages are not recoverable under a theory of conversion.

For over a year, plaintiff worked alongside defendant to launch three start-up ventures, partly in return for a promise of later payment of wages.  After a falling out, plaintiff was fired and the promised compensation never materialized.  Plaintiff sued the companies and won, successfully invoking both contract-based and statutory remedies for the nonpayment of wages.  He then sought to hold defendant personally responsible for the unpaid wages on a theory of common law conversion.  Plaintiff asserted that by failing to pay the wages, the companies converted his personal property to their own use and that defendant was individually liable for the companies’ misconduct.

The Superior Court for Los Angeles County entered judgment on the pleadings for defendant.  On appeal, California’s Supreme Court further affirmed the trial court, finding that conversion “is not the right fit for the wrong that [plaintiff] alleges, nor is it the right fix for the deficiencies [plaintiff] perceives in the existing system of remedies for wage nonpayment.”  Plaintiff asserted “a right to money that did once exist, but which he believes was squandered.  At least in such cases, [he] argues, the nonpayment of wages should be treated as a conversion of property, not as a failure to satisfy a ‘mere contractual right of payment.’”

The Court refused to endorse this logic, because it “would require us to indulge a similar fiction: namely, that once [plaintiff] provided the promised services, certain identifiable monies in his employers’ accounts became [his] personal property, and by failing to turn them over at the agreed-upon time, his employers converted [his] property to their own use.”  Distinguishing a previous decision that suggested a common law claim such as conversion might lie “under appropriate circumstances” for an employer’s misappropriation of gratuities left for employees, the Court stated “an employer’s misappropriation of gratuities is not the same as an employer’s withholding of promised wages.  When a patron leaves a gratuity for an employee (or employees), it arguably qualifies as a specific sum of money, belonging to the employee, that is capable of identification and separate from the employer’s own funds; indeed, the employee (or employees) for whom it was left has ownership of the gratuity by statute. … Unpaid wages are different in each of these respects.”  A claim for unpaid wages “simply seeks the satisfaction of a monetary claim against the employer, without regard to the provenance of the monies at issue.  In this way, a claim for unpaid wages resembles other actions for a particular amount of money owed in exchange for contractual performance—a type of claim that has long been understood to sound in contract, rather than as the tort of conversion.”

Am. Lecithin Co. v. Rebmann, No. 12-CV-929 (VSB), 2020 WL 4260989 (S.D.N.Y. July 24, 2020).  Although domain names are intangible property, New York allows conversion claims for interference with one’s right to “possession” of the name.

Plaintiffs’ company brought suit in connection with defendant’s registration of certain domain names, and his retention of those domain names after plaintiffs terminated his employment.  Plaintiffs alleged that while defendant was one of plaintiffs’ officers, he “registered under his own name, or transferred to his own name” the eight domain names identical in substance to a trademark that had been previously registered by plaintiffs.  After terminating defendant’s employment, plaintiffs directed him to turn over all company property, but defendant did not transfer the domain names despite multiple demands.

Plaintiffs alleged conversion based on defendant’s transferring the domain names to his own name and continuing to retain them.  Defendant argued that the domain names were intangible property incapable of conversion under New York law.  Recognizing New York’s long-standing hesitancy to allow conversion claims for intangible property, the court nonetheless traced an ongoing trend away from such rigidity, as the law seeks to adapt to an increasingly electronic, computerized information economy.

The court highlighted C.D.S., Inc. v. Zetler, 298 F. Supp. 3d 727, 759 (S.D.N.Y. 2018) (finding, after bench trial, that when defendant changed the registration of various domain names belonging to plaintiff to his own LLC, he “interfered with [plaintiff’s] possessory interest” in the property, and was liable for conversion), and Triboro Quilt Mfg. Corp. v. Luve LLC, No. 10 Civ. 3604, 2014 WL 1508606, at *9 (S.D.N.Y. Mar. 18, 2014) (“New York courts recognize exceptions [to the normal rule that only physical property can be converted] when the rightful owner of intangible property is prevented from creating or enjoying a ‘legally recognizable and protectable property interest in his idea’ such as by being prevented from registering the domain name for a website or being denied access to a database he created.”).  Because “domain names also have inherent value, particularly where they implement an intellectual property right like a trademark,” the court, “motivated by the need for the common law to respond … to the demands of commonsense justice in an evolving society,” the Court concluded that New York law permits a plaintiff to sue for conversion based on interference with a domain name. (quoting Thyroff v. Nationwide Mut. Ins. Co., 8 N.Y.3d 283, 289 (2007).

[1] “Section 7(a) of the Small Business Act … permits extension of financial assistance to small businesses when funds are ‘not otherwise available on reasonable terms from non-Federal sources.’”  United States v. Kimbell Foods, Inc., 440 U.S. 715, 719 n.3, 99 S.Ct. 1448, 59 L.Ed.2d 711 (1979).

[2] Blockchain is a specific type of database that stores data in a particular way—as new data comes in, it is entered into a fresh block; once the block is filled with data, it is chained onto the previous block, which makes the data chained together in chronological order.  Blockchain databases are most commonly used as a ledger for transactions.  In Bitcoin’s case, blockchain is used in a decentralized way so that no single person or group has control—rather, all users collectively retain control.  Decentralized blockchains are immutable, which means that the data entered is irreversible.  For Bitcoin, this means that transactions are permanently recorded and viewable to anyone.  See https://www.investopedia.com/terms/b/blockchain.asp (last visited Jan. 12, 2021).

[3] An earlier order from the same case reviews the facts that gave rise to the dispute.  See Ox Labs, Inc. v. Bitpay, Inc., No. CV 18-5934-MWF (KSX), 2019 WL 6729667, at *4 (C.D. Cal. Sept. 27, 2019).

Editor

Byeongsook Seo

Snell & Wilmer L.L.P., 1200 17th Street, Suite 1900, Denver, CO 80202, 303.635.2085, [email protected]

Byeongsook Seo is a member of the 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 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

Melissa Donimirski

Heyman Enerio Gattuso & Hirzel LLP, 300 Delaware Avenue, Suite 200, Wilmington, DE 19801, 302.472.7314, [email protected]

Melissa N. Donimirski is an attorney with Heyman Enerio Gattuso & Hirzel LLP 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 Co-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, which is published by Bloomberg BNA.

Janel M. Dressen

Anthony Ostlund Baer & Louwagie P.A., 90 South 7th Street, 3600 Wells Fargo Center, Minneapolis, MN 55402, 612.492.8245, [email protected]

Janel Dressen is a lawyer and shareholder with the litigation boutique firm Anthony Ostlund Baer & Louwagie P.A., located in Minneapolis, Minnesota.  Janel has 19 years of experience as a trial lawyer and problem solver.  She assists her clients to avoid and prepare for business and employment-related disputes in and outside of the courtroom.  Janel spends a significant amount of her time resolving family-owned and privately held business disputes for owners that are in need of a business divorce.  In 2019, Janel was selected by her peers to the Top 50 Women Minnesota Super Lawyers list by Super Lawyers.  In 2017, Janel was honored as one of Minnesota’s Attorneys of the Year.

Thomas Kanyock

Schwartz & Kanyock, LLC, 33 North Dearborn Street, Ste. 2330, Chicago, IL 60602, 312.441.1040, [email protected]

Thomas Kanyock is a principal with Schwartz & Kanyock, LLC, in Chicago, where he regularly litigates and resolves commercial disputes involving injunctions, trials and appeals in state and federal courts.  Tom concentrates in representing oppressed equity interest holders frozen into and out of closely held business entities.

John Levitske

Ankura, One North Wacker Dr., Suite 1950, Chicago, IL 60606, 312.252.9533, [email protected]

John Levitske, CPA/ABV/CFF/CGMA, ASA, CFA, CFLC, CIRA, MBA, JD, is a Senior Managing Director in the disputes and economics practice of Ankura, a global business advisory and expert services firm.  He serves as a business valuation, forensic accounting and damages expert witness, arbitrator, and advisor.  John is frequently consulted regarding business disputes, shareholder disputes and post-acquisition transaction disputes.  In addition, he is the current Chair of the Dispute Resolution Committee of the Business Law Section and a Member at Large of the Standing Committee on Audit of the American Bar Association.

John C. Sciaccotta

Aronberg Goldgehn, 330 N. Wabash Ave., Suite 1700, Chicago, IL 60611, 312.755.3180, [email protected]

John C. Sciaccotta is a Member at Aronberg Goldgehn.  He focuses his practice on litigation, arbitration and business counseling matters with a special emphasis on complex civil trial and appellate cases brought in federal and state courts throughout the United States.  John has also been appointed by the American Arbitration Association as an Arbitrator and Lawyer Neutral to adjudicate various claims and disputes in arbitration.  For many years he has advised public and privately held businesses, lenders, employers and individuals in business transactions and disputes.  He is experienced in dealing with numerous industries and business activities and has a specialty focus on representing entities in business divorce and complex ownership dispute resolution.  John is highly active in professional associations and within his community.  Among his activities, he is Co-Founder and current Chair of the Chicago Bar Association’s Business Divorce and Complex Ownership Disputes Committee.  He served on the CBA’s Board of Managers from 2017 to 2019.

Ben T. Welch

Snell & Wilmer L.L.P., 15 West South Temple, Suite 1200, Salt Lake City, UT 84101, 801.257.1814, [email protected]

Ben T. Welch is a commercial litigator and trial attorney at Snell & Wilmer LLP. Ben litigates all types of complex business disputes, including shareholder disputes, contract disputes, and disputes regarding corporate dissolution, non-compete agreements, and trade secrets.

§ 1.1 Introduction

This chapter provides summaries of developments related to business divorce matters that arose from October 1, 2019 to September 30, 2020 from mostly eight states.  Each contributor used his or her best judgment in selecting 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 have rules that prohibit courts and parties from citing or relying on opinions not certified for publication or ordered published.  To the extent unpublished cases are summarized, the reader should always consult local rules and authority to ensure relevant and permissible precedent is found for any particular matter.  We hope this chapter assists the reader in understanding recent developments in business divorces.

§ 1.2 Access to Books and Records

§ 1.2.1 Massachusetts

Bernstein v. MyJoVE Corp., 97 Mass. App. 1127, 150 N.E.3d 1144 (2020), review denied, 486 Mass. 1101 (unpublished).  Plaintiff held dual status as a corporation’s chief technology officer and 30% shareholder.  Plaintiff left the company and his position as CTO, while maintaining his 30% shareholder status.  More than a year later, plaintiff used his knowledge of the company’s computer systems to gain control of its website and to cut off the CEO’s email access for several days.  Plaintiff filed suit claiming statutory rights, per G.L.C. 156D, §16.02, to inspect books and records.  The trial court dismissed the claim.  However, the issue arose again in the defendant company’s counterclaim brought under three federal statutes, each of which provide protections against unauthorized impairments or invasions of computer systems.  The company obtained a preliminary injunction requiring plaintiff to return systems controls.  However, despite the preliminary injunction, plaintiff downloaded and kept select company records and communications.  Plaintiff claimed that his continuing status as a 30% shareholder authorized him to access records and communications.  The trial court entered judgment for counterclaimant and plaintiff appealed.

Plaintiff argued on appeal that he was authorized to take the actions at issue, acting in good faith out of a desire to help the corporation.  Plaintiff asserted his 30%ownership of the close corporation, citing Donahue v. Rodd Electrotype Co., 367 Mass. 578 (1975), claiming a right to participate in management.  As such, reasoned plaintiff, he had an unfettered right to access the computer system to force the controlling member to negotiate.

The Appellate Court, in an unpublished order, rejected plaintiff’s core argument for three main reasons, including:

[T]he trial judge made several factual findings that establish that Bernstein was not “authorized” to take the actions at issue.  The judge found that Bernstein left the company’s employ in September of 2011, that the company termed that a “resignation,” and that Bernstein did not contest that designation at that time.  Thereafter Bernstein may have been involved in some oversight functions, but he was no longer “at the company.”  Bernstein’s successor as CTO changed the company passwords, and did not share them with Bernstein.  The judge found that “within a few months of leaving, [Bernstein] was no longer allowed access to company emails.”  To the extent Bernstein contests these findings, they are not clearly erroneous.  Accordingly, even if we were to accept Bernstein’s contention that his employment with MyJoVE continued past September 30, 2011, the judge was still more than justified in concluding that when Bernstein accessed the company’s computer system over one year later, he knew he was not employed by MyJoVE, and knew he did not have the requisite authorization.

§ 1.2.2 New York

Atlantis Management Group II LLC v. Nabe, 177 A.D.3d 542, 113 N.Y.S.3d 79 (N.Y. App. Div. 2019).  A non-managing member of a limited liability company sought an equitable accounting from the managing members of the LLC.  The trial court granted summary judgment in favor of the equitable accounting and the appellate court affirmed, finding that the managing members owed the non-managing member a fiduciary duty.  The appellate court noted that while an equitable accounting is distinct from a right of accounting, the latter was appropriate here because the managing members had repeatedly refused to respond to demands for access to books and records.

§ 1.3 Business Judgment Rule

§ 1.3.1 California

Coley v. Eskaton, 51 Cal.App.5th 943 (2020).  In an action involving homeowner claims against directors of an HOA, the court addressed whether the business judgment rule was properly ignored to impose liability against the board members for breach of fiduciary duty among other claims for relief.  In doing so, the court analyzed both statutory and common law versions of the business judgment rule.

California recognizes two types of business judgment rules: one based on statute and another on the common law.  Corporations Code section 7231 supplies the relevant statutory rule for nonprofit mutual benefit corporations like the Association.  Under that statute, a director is not liable for “failure to discharge the person’s obligations as a director” if the director acted “in good faith, in a manner such director believes to be in the best interests of the corporation and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.”  The common law business judgment rule is similar but broader in scope.  It is similar in that it immunizes directors for their corporate decisions that are made in good faith to further the purposes of the corporation, are consistent with the corporation’s governing documents, and comply with public policy.  And it is broader in that it also insulates from court intervention those management decisions that meet the rule’s requirements.  A director, however, cannot obtain the benefit of the business judgment rule when acting under a material conflict of interest.

Corporations Code section 7233 provides, among other things, that an interested director who casts a deciding vote on a transaction must show the “transaction was just and reasonable as to the corporation at the time it was authorized, approved or ratified.”  Section 7233, however, only applies to transactions “between a corporation and one or more of its directors, or between a corporation and any domestic or foreign corporation, firm or association in which one or more of its directors has a material financial interest.”  The common law rule, as before, is similar but broader in scope.  It is similar in that it requires interested directors to prove that the arrangement was fair and reasonable—a rigorous standard that requires them not only to prove the good faith of the transaction but also to show its inherent fairness from the viewpoint of the corporation and those interested therein.  And it is broader in that it is not concerned only with transactions between a corporation and either its directors or a business in which its directors have a material financial interest.  Courts have found directors must also satisfy the common law requirements when they approve other transactions in which they have a material financial interest distinct from the corporation’s own interest.

Here the directors were employees of the development company that developed the residential community.  The directors were compensated in a way that encouraged them to pass assessments that benefit the development company and not the owners.  Plaintiff initiated the action in his individual capacity and derivatively on behalf of the HOA.  During litigation, the defendant directors participated in privileged communications between the HOA and its counsel, then shared privileged information with their employer, who was also a defendant in the action.  Given these facts, the court determined the directors had a material conflict of interest, which precluded the application of the business judgment rule.

§ 1.3.2 Massachusetts

Dolan as Tr. of Charles B. Dolan Revocable Tr. v. DiMare, 2020 WL 4347607, at *12-13 (Mass. Super. 2020).  In a case mixing Massachusetts and Delaware oppression issues, plaintiff brought a claim against the company’s controlling shareholder for failure to issue distributions.  Plaintiff alleged that defendant siphoned assets by, among other things, overcompensating himself and family members, thus leaving no funds available for distribution.  Defendant moved to dismiss asserting that the company charter granted him “sole discretion” whether to pay dividends.  The Court denied the motion reasoning that defendant may have frustrated plaintiff’s reasonable expectations:

A minority owner of a closely-held corporation may sue under a freeze-out theory by alleging that a corporate fiduciary kept corporate benefits for themself while denying them to the minority plaintiff.  See Clemmer v. Cullinane, 62 Mass. App. Ct. 904, 905-06 (2004) (rescript) (applying Delaware law).  “Freeze-outs can occur … ‘[w]hen the reasonable expectations of a [minority] shareholder are frustrated.’”  Selmark Assocs., Inc. v. Ehrlich, 467 Mass. 525, 536 (2014).

Where those in control of a closely-held corporation with lots of free cash do not pay any dividends, but use other mechanisms to pay or distribute substantial sums to themselves, they may be liable to the minority shareholders for engaging in shareholder oppression; this is “a classic squeeze out situation.”  Litle, 1992 WL 25758, at *8; accord Crowley v. Communications for Hosp., Inc., 30 Mass. App. Ct. 751, 762-63 (1991) (majority froze out minority stockholder by, among other things, paying themselves excessive compensation while refusing to declare dividends).

§ 1.3.3 New York

Beckerman v. Lattingtown Harbor Property Owners Association, Inc., 183 A.D.3d 821, 124 N.Y.S.3d 651 (N.Y. App. Div. 2020).  A homeowner brought an action against the homeowners’association seeking to annul a license agreement between the board and another member of the association regarding use of the community dock.  In reviewing the action under the business judgment rule, which inquired whether the action was taken in good faith and in furtherance of the legitimate interest of the association, the Court concluded that it should defer to the homeowners’association as long as the board “acts for the purposes of the [homeowners’ association], within the scope of its authority and in good faith.”  Id. at 654.  Here, however, the trial court found that the homeowners’association was acting outside its authority and therefore annulled the license.  The appellate court affirmed.

Witty v. Wallace, 176 A.D.3d 906, 107 N.Y.S.3d 871 (N.Y. App. Div. 2019).  This case involved a dispute between 50% co-owners of a limited liability company that owns a commercial building that leases to a bank under a triple-net lease.  When the lease was renewed in 2010, the tenant was granted a rent reduction, whereupon one of the co-owners brought an action for corporate waste.  In reviewing the application, the Court concluded that pursuant to the business judgment rule, absent evidence of bad faith, fraud, self-dealing, or other misconduct, courts would respect business judgments.  Here, the evidence for overcoming the business judgment rule was not present; rather, the evidence suggested that the lease extension was made in good faith and in furtherance of the corporation’s legitimate business interest.  Thus the trial court’s decision to dismiss the plaintiff’s complaint was proper.

§ 1.4 Dissolution

§ 1.4.1 Delaware

SolarReserve CSP Holdings, LLC v. Tonopah Solar Energy, LLC, 2020 WL 1291638 (Del. Ch. Mar. 18, 2020).  The Court held that equitable dissolution was not available where the petitioning party failed to demonstrate that the Court should “invoke equitable principles to override the plain language” of the Delaware LLC Act and the relevant LLC agreement.  Originally, plaintiff SolarReserve held a direct ownership interest in the subject company, Tonopah Solar Energy, LLC, which would have permitted plaintiff to seek judicial dissolution of that entity.  However, that interest was reduced to an “indirect equity interest” through several intermediary entities, which the Court held were “calculated choices to reshape Tonopah’s complicated ownership structure in order to secure additional funding.”  Because the intended relationship of plaintiff to the subject Company was intended to be remote, the Court held that plaintiff did not meet the standard set forth in In re Carlisle Etcetera LLC, 114 A.3d 592 (Del. Ch. 2015) to warrant finding that plaintiff had equitable standing to seek dissolution.

§ 1.4.2 New York

PFT Technology, LLC, v. Wieser, 181 A.D.3d 836, 122 N.Y.S.3d 313 (N.Y. App. Div. 2020).  A limited liability company and its majority members filed suit against a minority member seeking to dissolve the company and reconstitute without the minority member.  The minority member, in turn, counterclaimed for breach of the operating agreement.  The minority member eventually agreed that the majority could buy out his membership interest, and the court held a valuation proceeding in which the minority member’s interest was valued at $1.250M.  The minority member was also awarded attorney fees and prejudgment interest but not any damages based on his counterclaim.  Both sides appealed.

On appeal the appellate court noted that although limited liability law did not expressly authorize a buyout in a dissolution proceeding, that remedy was appropriate as an equitable remedy.  The appellate court found that the trial court’s decision to allow the buyout was a “provident” exercise of its discretion.  However, the trial court erred in applying certain adjustments to the company’s value, which should have been $1.489M.  The trial court also erred in the amount of attorney fees it awarded.  The trial court did not err in deciding not to award damages on the counterclaim or in the amount of prejudgment interest.

§ 1.4.3 Utah

HITORG, LLC v. TC Veterinary Serv. Inc., 2020 UT App 123, 472 P.3d 1177.  A veterinarian brought suit against other veterinarians for breach of contract, breach of good faith and fair dealing, and dissolution of a limited liability company based on her expulsion.  The other veterinarians moved to compel arbitration pursuant to the operating agreement.  The plaintiff-veterinarian opposed the motion and filed a motion to stay arbitration claiming that she sought dissolution and other causes of action arising from duties and obligations outside the operating agreement (such as statutory dissolution on the basis of oppressive conduct or fraud).  The trial court granted the motion to compel and denied the motion to stay, concluding that the operating agreement contained a provision for judicial dissolution and therefore the issue of dissolution was within the power of the arbitrator to decide along with other claims.  The court of appeals affirmed.

§ 1.5 Jurisdiction, Venue, and Standing

§ 1.5.1 California

Clark v. S&J Advertising, Inc., 611 B.R. 669 (E.D. Cal. 2019).  This case involves the interplay between a bankruptcy court’s jurisdiction and California’s involuntary dissolution/valuation/share buyback statute (Cal. Corp. § 2000) and related proceedings.  A married couple filed a Chapter 13 bankruptcy petition.  The wife later filed a certificate of election to wind up and dissolve a company with the California Secretary of State pursuant to Cal. Corp. Code § 1900.  She owned 50% interest in the company.  The company filed a petition to stay dissolution proceedings and ascertain value of the wife’s shares under § 2000 in state court.  The state court stayed dissolution until appraisers could arrive at a fair valuation.  The bankruptcy court granted the company relief from stay so the valuation could proceed in state court.  The court approved the § 2000 valuation and the transfer of the wife’s shares to the corporation for the valuation price.

The couple appealed the bankruptcy court’s decision to adopt the § 2000 valuation under the Rooker-Feldman doctrine, which precludes a federal court from overturning a state court’s judgment.  Since the bankruptcy court did not overturn the state court’s decision, but effectively affirmed the state court’s decision to proceed with § 2000 proceedings, Rooker-Feldman did not apply.

The couple also argued that the bankruptcy court could not exercise subject matter jurisdiction over the § 2000 proceeding absent removal from state court pursuant to 28 U.S.C. § 1452(a), which sets forth a formal removal process that was not followed in this case.  But the bankruptcy court had not exercised jurisdiction over the § 2000 state proceedings.  It just adopted and applied the § 2000 valuation to the bankruptcy proceedings, so removal was neither necessary nor relevant to the bankruptcy court’s jurisdiction analysis.  The bankruptcy court had proper jurisdiction over the couple and the wife’s shares in the company.

§ 1.5.2 Illinois

Tabirta v. Cummings, 2020 IL 124798.  The Illinois Supreme Court held that an employee’s home office within a county did not qualify as an office of the employer for the purposes of venue.  The court found that there was no evidence that the employer hired the employee because of the location of his residence and home office or that his employment would be affected if he moved to another county and therefore the employer did not purposely select a fixed location as necessary to avail itself to venue in that county.

§ 1.5.3 Massachusetts

In re Bos. Grand Prix, LLC, 2020 WL 6140391, at *16 (Bankr. D. Mass. 2020).  The Court rejected a Chapter 7 trustee’s argument that he had standing to ask the Court to hold an LLC member personally liable for all debtor LLC’s debts as the LLC’s alter ego.  The trustee brought a series of fiduciary breach claims against the sole member, manager, and operating officer of an insolvent LLC purporting to promote auto races in Boston.  The Court had little difficulty entering judgment against the LLC member based on an apparently indefensible series of egregious self-dealings acting as a fraud on creditors, resulting in the Court awarding significant damages and unwinding fraudulent transfers.  However, the Court held that the trustee went too far asking to hold the LLC member personally liable for all LLC debts as its alter ego.  The Court held that, under the Bankruptcy Code, only actual creditors, and not the trustee, have standing to pierce the debtor’s veil.

Dolan as Tr. of Charles B. Dolan Revocable Tr. v. DiMare, 2020 WL 4347607, at *12-13 (Mass. Super. 2020).  In a case mixing Massachusetts and Delaware oppression issues, plaintiff brought direct and derivative claims against the company’s controlling shareholder for failure to issue distributions.  Plaintiff alleged that defendant siphoned assets by, among other things, overcompensating himself and family members, thus leaving no funds available for distribution.  The company had layers of subsidiaries.  The company was a Delaware corporation, but one of its subsidiaries was a Massachusetts corporation.  Plaintiff sued derivatively on behalf of the Massachusetts entity.

Defendant moved to dismiss arguing that plaintiff lacked standing because he never made a pre-suit derivative demand.  Delaware and Massachusetts statutory law differ in that Delaware law still applies the futility exception, while Massachusetts changed its BCA, G.LC. 156D, § 7.42, to always require a prerequisite derivative demand on behalf of a corporation.  The Court denied the motion, noting that plaintiff brought a pass-through “double-derivative” claim and therefore was suing primarily in the interests of the Delaware corporation, thus applying Delaware’s futility exception.

JT IP Holding, LLC v. Florence, 2020 WL 5217118, at *3–4 (D. Mass. 2020).  Unlike corporations, Massachusetts’s LLC Act has no universal pre-suit derivative demand requirement.  Defendant moved to dismiss a derivative claim for failure to make a pre-suit demand, regardless of futility, per § 156 C, § 56, arguing that the LLC operating agreement did not authorize suit without a demand.  The Court denied the motion, holding that a provision in the operating agreement prohibiting action on behalf of the entity without approval of all members was too generic, without more specific language, to require a pre-suit derivative demand.

§ 1.6 Claims and Issues in Business Divorce Cases

§ 1.6.1 Accounting

§ 1.6.1.1 New York

Atlantis Management Group II LLC v. Nabe, 177 A.D.3d 542, 113 N.Y.S.3d 79 (N.Y. App. Div. 2019).  A non-managing member of a limited liability company sought an equitable accounting from the managing members of the LLC.  The trial court granted summary judgment in favor of the equitable accounting and the appellate court affirmed, finding that the managing members owed the non-managing member a fiduciary duty.  The appellate court noted that while an equitable accounting is distinct from a right of accounting, the latter was appropriate here because the managing members had repeatedly refused to respond to demands for access to books and records.

§ 1.6.2 Alternative Entities

§ 1.6.2.1 Delaware

Franco v. Avalon Freight Services, LLC, 2020 WL 7230804 (Del. Ch. Dec. 8, 2020).  Where an LLC Agreement provides that the co-equal members must agree on the identity of a tie-breaking director, but is silent on the topic of how to remove a director, removal is governed by the Delaware LLC Act.  Such provision does not mean that, if one faction becomes dissatisfied with the service of the tie-breaking director, such director must be removed.  Avalon Freight Services, LLC, is a co-equally owned LLC, owned between two members.  The Company is governed by a board of directors, on which sits the two members, two additional directors, one appointed by each member, plus a tie-breaking director, whose appointment must be agreed upon by the two members.  When one member became dissatisfied with the tie-breaking director, that member brought this action seeking a declaration that his dissatisfaction with the tie-breaking director means that “position must be vacated and [the members] must mutually agree on a new person to fill the position.”  The Court held that the provision in question related only to the appointment of the tie-breaking director, and not to such director’s removal.  Because the LLC Agreement did not specify how to remove a director, the terms of the Delaware LLC Act were considered incorporated to fill the gap.

§ 1.6.3 Breach of Fiduciary Duty

§ 1.6.3.1 Delaware

Wright v. Phillips, 2020 WL 2770617 (Del. Ch. May 28, 2020).  In a business divorce between co-equal owners who were formerly husband and wife, the Court found that Phillips failed to demonstrate that Wright’s actions rose to the level of a breach of her duty of care or loyalty.  Phillips claimed that Wright breached her fiduciary duties by (1) using company funds to pay personal credit card bills; (2) “raiding” the offices to take files and equipment; (3) engaging in accounting practices that caused cash crunches; (4) failing to follow the Receiver’s instructions; and (5) removing money to bank accounts that she independently controlled.  The Court held that Wright credibly explained why personal credit card charges appeared on the company accounts and found that there was insufficient evidence to find that this activity was wrongful or that it breached Wright’s fiduciary duties.  The Court additionally held that the allegations of “raiding” the company offices to take files and equipment were without scienter, and were actually “careless actions … directed at the disintegrated personal relationship between the parties.”  With respect to the “cash crunches,” the Court found that both parties were equally at fault in this regard, and, again, that Wright’s actions lacked scienter.  With respect to failing to follow the Receiver’s instructions, which included designating office hours for Wright, the Court held that “a failure to obey guidelines set by a Receiver is not a per se violation of fiduciary duties.”  The Court additionally credited Wright’s trial testimony that she had logical reasons for her choices regarding work hours and location that included her safety and her long history of working from home.  Finally, the Court held that Wright’s actions in removing company money to her personal bank accounts were not actionable because she had “cognizable reasons to move the funds,” and because the Receiver’s instruction to transfer them back was contingent on Phillips reinstating her salary, which he did not do.

§ 1.6.3.2 Illinois

Flynn v. Maschmeyer, 2020 IL App (1st) 190784.  The appellate court held that a member of an Illinois limited liability company who was held to have breached his fiduciary duties to his co-members and the LLC was nonetheless entitled to a judgment on his counterclaim for the fair value of his interest in the LLC.  The court held that the member did not forfeit his right to recover his interest in the LLC by failing to respond to a purported capital call that was sent only to him to recover the amount of funds he had misappropriated from the LLC.

§ 1.6.3.3 Massachusetts

Bernstein v. MyJoVE Corp., 97 Mass. App. 1127, 150 N.E.3d 1144 (2020), review denied, 486 Mass. 1101 (unpublished).  (See description in § 7.1).  The Court rejected plaintiff/counter-defendant’s argument that, after he resigned his position as Chief Technology Officer, he remained a 30% shareholder entitled to access records and communications because defendant/counter-plaintiff breached fiduciary obligations owed to him:

Bernstein did not at any time have an unfettered right to participate in management, and he surely did not once he resigned as CTO.  More importantly, Bernstein’s status as a shareholder of a close corporation did not give him a right to engage in unauthorized acts.  “Allowing a party who has [allegedly] suffered harm within a close corporation to seek retribution by disregarding its own duties has no basis in our laws and would undermine fundamental and long-standing fiduciary principles that are essential to corporate governance ….  ‘Rather, if unable to resolve matters amicably, aggrieved parties should take their claims to court and seek judicial resolution.’”  Selmark Assocs., Inc. v. Ehrlich, 467 Mass. 525, 552-553 (2014), quoting Rexford Rand Corp. v. Ancel, 58 F.3d 1215, 1221 (7th Cir. 1995).  See Donahue, 367 Mass. at 593 n.17 (recognizing that, “[i]n the close corporation, the minority may do equal damage through unscrupulous and improper ‘sharp dealings’”).  To the extent Bernstein felt aggrieved by any mistreatment he may have received by MyJoVE or Pritsker (including Pritsker’s refusal to meet with him), his recourse was not through unauthorized access to the company’s computer system.

Dolan as Tr. of Charles B. Dolan Revocable Tr. v. DiMare, 2020 WL 4347607, at *13 (Mass. Super. 2020).  Plaintiff shareholder brought, among other things, aiding and abetting breach of fiduciary duty claims against the company’s lawyer for failure to inform plaintiff that the company’s controlling shareholder improperly siphoned assets by overcompensating family members, thus leaving no funds available for distribution.  The Court dismissed the claim, holding that allegations that the lawyer had familiarity with the company’s financial condition did not rise to the level of actual knowledge of wrongdoing.

Mahoney v. Bernat, 2019 WL 6497601, at *3 (Mass. Super. 2019).  Plaintiff minority shareholder, Mahoney, brought an aiding and abetting claim against the company’s lawyers, the Sabella Defendants, alleging that they breached a duty owed to him by assisting with preparing a buy-out of another shareholder that plaintiff claimed harmed him.  The Court granted the lawyers’ motion to dismiss:

Massachusetts law imposes a fiduciary obligation on corporate counsel to protect the interests of individual members or shareholders only in rare circumstances.  See Baker v. Wilmer Cutler Pickering Hale & Dorr, LLP, 91 Mass. App. Ct. 835, 837 (2017) (recognizing fiduciary duty on part of corporate counsel to individual members of limited liability company where the LLC was “governed by an operating agreement providing significant minority protections,” and it was alleged that counsel “secretly worked to eliminate those protections …”).  Those rare circumstances are not present here.  The Shareholders’ Agreement does not afford Mr. Mahoney “significant minority protections,” and there is no allegation that the Sabella Defendants engaged in any clandestine effort to undermine Mr. Mahoney’s position vis-a-vis the Company.

§ 1.6.3.4 Minnesota

Blum v. Thompson, No. A19-0938, 2020 WL 1983218 (Minn. Ct. App. Apr. 27, 2020), review denied (July 23, 2020).  Richard Ward and Rosemary Ward raised seven children.  Three of their children, Kathryn, Charles and Thomas (plaintiffs), sued three of their siblings and their father relating to the operations of their family-owned business, Ward Family, Inc. (“WFI”).  The dispute involved a long-term lease that WFI executed that gave one of the defendants’ corporation, El Rancho Manana, Inc., greater authority over a large plot of land known by the parties as “the Ranch.”  Following a jury trial on plaintiffs’ common-law breach-of-fiduciary duty claim against defendants and a court trial on plaintiffs’ statutory shareholder-oppression claim, both the jury and district court found in favor of defendants.  The Minnesota Court of Appeals affirmed, reasoning that the shareholders knew about the plan to formalize the lease arrangement, and that WFI allowed shareholders to propose terms of the lease.  The Court of Appeals, like the district court, rejected a claim that consensus was needed among the shareholders as to the terms of the lease.  While the parties had reached a consensus on some issues in the past, “it was not reasonable for [plaintiffs] to expect that WFI would be governed in a manner inconsistent with its bylaws.”  WFI’s bylaws stated that actions were approved by simple majority. “It is not clear error to conclude that it is unreasonable for minority shareholders to expect that they have veto power over an action permitted by the company’s bylaws just because the majority shareholders had tried to achieve consensus with them in previous disputes.”

40 Ventures LLC v. Minnesquam, L.L.C., No. A19-2082, 2020 WL 5507887 (Minn. Ct. App. Sept. 14, 2020).  Members of Aspire Beverage Company LLC (“Aspire”) entered into a Membership Control Agreement (MCA) that established a six-person board of governors for Aspire.  Plaintiff, a member of Aspire, alleged breach of contract, breach of fiduciary duty, and tortious interference with contract, and sought an order compelling Aspire to disclose company records.  When the Aspire board voted to dissolve Aspire, plaintiff alleged that the board did not have the authority to do so (breaching supermajority requirements set forth in the MCA).  The district court dismissed all of the claims on a Rule 12 motion for failure to state a claim.  The Court of Appeals affirmed, reasoning that the MCA supermajority requirements in the MCA provision applied to the board, not the members.  The Court held that plaintiff could sustain a breach-of-fiduciary-duties claim against the members just because the members appointed governors to the board.  The plaintiff alleged that its allegations in the Complaint related to “actions taken by the members, not the governors, in violation of the member-control agreement”; the only alleged violations of the member-control agreement are the alleged violations of the supermajority requirements in section 3.3 of the member-control agreement, which is an alleged violation by the Aspire board, not by the members themselves.

§ 1.6.3.5 New York

Atlantis Management Group II LLC v. Nabe, 177 A.D.3d 542, 113 N.Y.S.3d 79 (N.Y. App. Div. 2019).  A non-managing member of a limited liability company sought an equitable accounting from the managing members of the LLC.  The trial court granted summary judgment in favor of the equitable accounting and the appellate court affirmed, finding that the managing members owed the non-managing member a fiduciary duty.  The appellate court noted that while an equitable accounting is distinct from a right of accounting, the latter was appropriate here because the managing members had repeatedly refused to respond to demands for access to books and records.

§ 1.6.4 Breach of Contract and Breach of Covenant of Good Faith and Fair Dealing

§ 1.6.4.1 Massachusetts

Bernstein v. MyJoVE Corp., 97 Mass. App. 1127, 150 N.E.3d 1144 (2020), review denied, 486 Mass. 1101 (unpublished).  The Appellate Court rejected plaintiff/counter-defendant’s argument that, after he resigned his position as CTO, he remained a 30% shareholder and therefore entitled to access records and communications because defendant/counter-plaintiff breached the obligation to treat him fairly and in good faith:

[W]e are aware of no authority that would allow Bernstein, as a minority shareholder of a close corporation, to surreptitiously access the company’s computers in retaliation for the alleged breach of such a duty.  Put differently, whether Bernstein was treated with the “utmost good faith and loyalty,” in connection with his resignation or termination in 2011 is simply not before us.  Rather, the issue before us is whether Bernstein was authorized, in November of 2012, to access MyJoVE’s computer system and to interfere with the company’s operations.

Crashfund, LLC v. FaZe Clan, Inc., 2020 WL 4347254 (Mass. Super. 2020).  Plaintiffs invested in Wanderset LLC, which then merged into defendant Wanderset, Inc.  In exchange for plaintiffs’ cash investments, Wanderset granted plaintiffs the conditional right to obtain specified shares of capital stock if Wanderset changed ownership.  Plaintiffs contended that occurred when Wanderset functionally, but not formally, merged Wanderset into FaZe Clan, Inc. Plaintiffs sued both Wanderset and FaZe, asserting two alternative breach of contract theories, tortious interference, and unjust enrichment.

The Court granted defendant FaZe’s motion to dismiss the first alternative breach of contract claim seeking shares of its stock.  Plaintiff’s express contractual right to convert stock was limited to legal mergers, did not extend to de facto successor liability, and thus plaintiff had no right to stock of the succeeding entity.  However, the Court denied the motion as to plaintiff’s second alternative contract claim alleging successor liability for consequential damages equal to the value of the stock if plaintiffs had been permitted to participate if defendants had acted in good faith.  The Court held that plaintiffs may be entitled to recover against all defendants for breach of contract, at least insofar as plaintiff seeks consequential damages, unjust enrichment, and tortious interference.

Ramey v. Beta Bionics, Inc., 2020 WL 4931636, at *5–6 (Mass. Super. 2020).  Plaintiff alleged that a defendant promoter orally promised him a salary and 5% equity stake in a new company to be established developing medical devices.  Plaintiff began working for nothing, and then for his salary, as the defendant established the company.  However, defendant then refused to assign plaintiff his 5% equity, instead engaging in a series of negotiations trying to convince plaintiff to accept a fraction of that stake.  The Court rejected defendant’s argument that the alleged agreement’s terms were too vague to enforce:

While “[i]t is not required that all terms of the agreement be precisely specified, and the presence of undefined or unspecified terms will not necessarily preclude” a contract’s formation, “[t]he parties must, however, have progressed beyond the stage of ‘imperfect negotiation.’”  Id., (citations omitted).…  It may be that, after discovery, Ramey will not be able to prove that his negotiations with Damiano in 2013 progressed beyond the stage of “imperfect negotiations” to an oral agreement on material terms that is sufficiently definite to be enforceable .…  However, given the specificity of Ramey’s allegations that in the fall of 2014, Damiano offered, and he accepted, a 5% interest in the corporation to be formed in exchange for his continued work on the Project, I cannot conclude at this stage that Count I fails to state any claim for breach of contract.

§ 1.6.5 Fraud

§ 1.6.5.1 Massachusetts

In re Blast Fitness Grp., LLC, at *9 (Bk. D. Mass. 2020).  Creditors alleged that a general partner fraudulently induced them to participate in a real estate transaction.  The Bankruptcy Court noted extensive allegations of aiding and abetting the fraud on the part of other entities.  However, the Court stopped short of allowing an aiding and abetting claim against the partnership itself, noting that the complaint contained no such allegations against the partnership – thus drawing a distinction between a general partner acting on behalf of the partnership, which the Court allowed, and whether the partnership itself aided and abetted the fraud, which the Court disallowed.

Sapir v. Dispatch Techs., Inc., 2019 WL 7707794, at *3 (Mass. Super. 2019).  Plaintiff alleged that two director shareholders fraudulently induced him to sell his shares in a closely held corporation by withholding information about the status of software development and fundraising efforts.  Plaintiff also claimed negligent misrepresentation and breach of fiduciary duty.  Defendants moved to dismiss proffering the sale agreement containing the usual integration and waiver clauses.

The Court denied the motion as to the fraudulent inducement claim, holding that, generally, Massachusetts law recognizes that neither integration clauses nor releases bar fraudulent inducement claims, citing Shawmut-Canton, LLC v. Great Spring Waters of America, Inc., 62 Mass. App. 330, 335 (2004).  An exception exists where the alleged inducement contradicts clear statements in the writing – a situation not usually present unless the waiver contains contextual references.

The Court granted the motion as to the negligent misrepresentation claim.  Unlike a claim for fraudulent inducement, a claim for negligent misrepresentation ordinarily can be released or waived; thus, the seller release barred plaintiff’s claim for simple negligence.

The Court also granted the motion as to the fiduciary breach claim.  The Court held that, as a Delaware corporation, Delaware law controlled that issue and that, unlike other jurisdictions, Delaware does not impose a heightened duty of good faith and loyalty on shareholders or directors in a close corporation and does not impose a fiduciary duty on the part of a close corporation for the benefit of individual shareholders.

§ 1.6.6 Interference

§ 1.6.6.1 California

Siry Investment, L.P. v. Farkhondehpour, 45 Cal.App.5th 1098 (2020).  Penal Code section 496 is entitled “Receiving or concealing stolen property.”  Subdivision (a) makes it a crime to (1) “buy[ ] or receive[ ] any property that has been stolen or that has been obtained in any manner constituting theft or extortion, knowing the property to be so stolen or obtained,” or (2) “conceal[ ], sell[ ], [or] withhold[ ] any property from the owner, knowing the property to be so stolen or obtained.”  Subdivision (c) empowers “[a]ny person who has been injured by a violation of subdivision (a)” to “bring an action for three times the amount of actual damages [he has] … sustain[ed]” as well as for “costs of suit[ ] and reasonable attorney’s fees.”  This case presents the question: Does Penal Code section 496, subdivision (c) authorize treble damages and attorney fees where the underlying criminal conduct did not involve trafficking in stolen property, but rather the improper diversion of a limited partnership’s cash distributions through fraud, misrepresentation, and breach of fiduciary duty?  The court ruled that treble damages and attorney fees are not available under Penal Code section 496, subdivision (c) in cases where the plaintiff merely alleges and proves conduct involving fraud, misrepresentation, conversion, or some other type of theft that does not involve “stolen” property for two reasons.  First, treble damages under Penal Code section 496, if held applicable to torts of fraud, misrepresentation, conversion or breach of fiduciary duty, would all but eclipse traditional tort damages remedies.  Second, reading Penal Code section 496 to apply in theft-related tort cases would effectively repeal the punitive damages statutes.  The legislature never declared that it wanted to effect significant changes to tort remedies but only wanted to “dry up the market for stolen goods.”

§ 1.6.6.2 Massachusetts

Viken Detection Corp. v. Videray Techs. Inc., 2020 WL 68244, at *6–7 (D. Mass. 2020).  Defendant allegedly stole confidential information and trade secrets and formed a new entity.  Plaintiff’s claims included one against defendant’s new entity for tortious interference with plaintiff’s customer relationships.  The individual and entity defendants moved to dismiss contending that plaintiff failed to state a claim because the individual defendant, as owner and principal of the entity, was synonymous with his company.  In other words, the individual was so “closely identified” with the entity that he should not be considered a third party for purposes of a claim of tortious contractual interference.  The Court denied the motion, at least at the pleading stage, holding that whether an individual is synonymous with a corporation of which he is owner and principal is a fact-intensive question “ill-suited” for resolution at the motion-to-dismiss stage.

§ 1.6.7 Equitable/Statutory Relief

§ 1.6.7.1 Massachusetts

Automile Holdings, LLC v. McGovern, 483 Mass. 797, 813–14, 136 N.E.3d 1207, 1221–22 (2020).  Defendant was a minority equity owner and executive of plaintiff but left to work for a competitor.  He violated a restrictive covenant in his repurchase agreement by poaching three employees.  Among other claims, plaintiff sued the individual’s new employer for tortious interference and sought a preliminary injunction barring defendant from employing the former officer.

Defendants argued that absent “more expansive interests,” Wells v. Wells, 9 Mass. App. Ct. 321, 326, 400 N.E.2d 1317, 1321 (1980), no legitimate interest exists in stifling competition.  The Court, however, found that more expansive interests indeed existed.  The Court noted the individual’s status as both an owner and officer of plaintiff, reasoning that the contract was more akin to a business interest than an employment restriction.

The Court emphasized that the individual sold his minority interest at a premium because he agreed to the restrictive covenant.  His repurchase agreement, aimed at shoring up the protections in the original operating agreement, thus served plaintiff’s legitimate business interest in ensuring that defendant did not “derogate from the value of the business interest he sold to the other owners” when he left, quoting Boulanger v. Dunkin’ Donuts Inc., 442 Mass. 635, 639, 815 N.E.2d 572 (2004), and Alexander & Alexander, Inc., 21 Mass. App. Ct. at 496, 488 N.E.2d 22 (“Where the sale of the business includes good will, as this sale did, a broad noncompetition agreement may be necessary to assure that the buyer receives that which he purchased”).

§ 1.6.8 Privilege

§ 1.6.8.1 Delaware

Pearl City Elevator, Inc. v. Gieseke, 2020 WL 5640268, at *1 (Del. Ch. Sept. 21, 2020).  The Court ordered the production of documents withheld as privileged on behalf of the subject company regarding matters as to which the subject company and the plaintiff were not adverse.  Plaintiff, Pearl City Elevator, Inc., sought a declaration under 6 Del. C. § 18-110 that it may appoint a seventh and controlling member to the board of directors of nominal defendant, Adkins Energy, LLC.  The Board currently consists of six directors, three designated by Pearl City, as an Adkins member, and three designated by Adkins’ General Members (the “General Directors”).  After plaintiff’s dispute with the General Members emerged, counsel to Adkins Energy began to give legal advice to the General Members and General Directors, to the exclusion of Pearl City and its directors on the question of whether Pearl City’s unit acquisitions were bona fide, and whether Pearl City’s effort to place a seventh member on the Board were effective.  Citing Moore Business Forms, Inc. v. Cordant Holdings Corp., 1996 WL 307444, at *1 (Del. Ch. June 4, 1996), the Court held that Pearl City was just as much the “client” of counsel to Adkins as the General Directors were, and accordingly counsel to Adkins was required to produce to plaintiff privileged documents respecting its analysis of the bona fides of Pearl City’s unit acquisitions and, relatedly, the effectiveness of Pearl City’s effort to place a seventh member on the Board.

§ 1.6.9 Trade Secret

§ 1.6.9.1 Delaware

iBio, Inc. v. Fraunhofer USA, Inc., 2020 WL 5745541, at *14 (Del. Ch. Sept. 25, 2020).  The Court held that the Delaware Uniform Trade Secrets Act (“DUTSA”) preempts common law claims based upon alleged misappropriation of confidential information that does not otherwise qualify as a trade secret under the statute.  iBio, Inc. and Fraunhofer USA, Inc., enjoyed a commercial relationship for several years pursuant to which Fraunhofer developed plant-based biopharmaceutical technology for iBio.  iBio later discovered that Fraunhofer had entered into an agreement to perform the same services for an iBio competitor.  iBio brought suit alleging that, among other things, Fraunhofer misappropriated iBio’s technology in the performance of its duties for the competitor.  iBio brought claims under both DUTSA, as well as for conversion and misappropriation of confidential information that does not qualify as a trade secret under DUTSA.  The Court held that DUTSA preempted the common law claims for conversion and misappropriation, even though the confidential information alleged to have been converted did not qualify as a trade secret under DUTSA.

§ 1.7 Valuation and Damages

§ 1.7.1 Alabama

Porter v. Williamson, 2020 Ala. Lexis 98; 2020 WL 3478540 (Ala. Supr. Ct., Jun. 26, 2020).  In this appeal regarding an action for specific performance of a shareholders agreement, the Court addressed the valuation of the interests in five companies owned by a pair of brothers.  Ultimately, the Court determined that the valuation process at trial was error because it was inconsistent with the evaluation process set forth in the shareholders agreement and beyond the action in the claim and remanded the case to the trial court.

The two brothers owned interests in four corporations and one limited liability company.  The Court stated that the claim before the trial court was only for specific performance of part of the agreement and an injunction, and that the shareholders agreement provided a clear, specific, two-step process to determine values including the parties’ expression that the companies’ accountant would provide the evaluation methods.

Regarding the claim presented, the Court noted that the defendants “argue only that the trial court awarded relief beyond the scope of a request for specific performance of the agreement.”  In addition, the Court stated regarding its review of a trial court’s decision, “The trial court’s findings of fact, insofar as they are based on evidence presented during the hearing, are presumed correct and will not be overturned unless they are shown to be plainly or palpably wrong … However, a presumption of correctness does not attach to the trial court’s legal conclusions, which are reviewed de novo.”  In addition, “Regardless of whether [the] paragraph … of the agreement may allow for legal and equitable remedies beyond specific performance of the agreement and an injunction, [plaintiff] is bound by the claims he actually brought against the … defendants.”

Regarding the process in the agreement, the Court stated, “We cannot agree that the method of determining share value in the agreement was so unclear or indefinite that it could not be specifically enforced … there is no indication that any of the parties believed that the part of the agreement requiring an evaluator to be selected by [the companies’ accountant] … that was acceptable to the shareholders was indefinite or otherwise unenforceable.  Yet, the trial court ignored that clear and specific part of the agreement when it accepted the valuation provided by an evaluator independently selected by [one employee-owner].  As to the second step, we must conclude, as a matter of law, that the agreement clearly expressed the parties’ agreement that [the companies’ accountant] … would provide the evaluation methods that would be used by the independent evaluator acceptable to the shareholders to determine share value… given his knowledge and familiarity with the … companies, we see no reason why the parties could not have agreed to allow [the companies’ accountant] to provide the evaluation methods to be used by an independent evaluator for purposes of determining share value.”

Considering the terms of the agreement in combination with the nature of the claim, the Court concluded that the trial court was not at liberty to depart from and ignore the process in the agreement nor to provide relief in “any other legal or equitable remedy” under the agreement.  Therefore, the Court determined it was an error for the trial court to ignore a clear and specific part of the agreement when it accepted the valuation provided by an evaluator selected by the plaintiff.

§ 1.7.2 Connecticut

R.D. Clark & Sons, Inc. v. Clark, 222 A. 3d 515, 194 Conn. App. 690 (Dec. 10, 2019).  In a buyout dispute involving the value of the departing shareholder’s interest in a family business organized as an “S” Corporation, the Appeals Court considered the trial court’s decision to not tax affect the company’s earnings in determining value even though both sides’ experts had applied tax affects.  The Court affirmed the trial court’s decision to not tax affect.

On appeal, the company asserted that not tax affecting “artificially inflated” the value.  The Court reviewed relevant court decisions in various jurisdictions.  The Court noted that some courts “have chosen to reject an S corporation cash flows based on taxes” such as the US Tax Court in Gross v. Comm’r v. IRS, 272 F.3d 333, 335 (6th Cir. 2001) and called it “the only reported decision on tax affecting by a United States Court of Appeals.”  It also noted that some cases such as one Delaware and one Massachusetts state trial court cases had approved tax affecting.  Furthermore, the Court stated that “the issue of tax affecting continues to be an open debate among experts in the field.”

The Court found it important and influential in this case that before it was a “fair value” proceeding rather than a “fair market value” proceeding.  In this current context of fair value, the Court considered the fact of the company’s policy of covering the shareholders’ tax liabilities.  Ultimately, the Court found that considering that policy, “The present case seems particularly ill-suited to tax affecting earnings … based on the facts of this case … and …  We discern no bright line rule in this area.”

§ 1.7.3 Delaware

Kruse v. Synapse Wireless, Inc., 2020 Del. Ch. Lexis 238 (July 14, 2020).  In a statutory appraisal fair value buyout action, the Court addressed issues of whether there was meaningful market-based evidence of fair value in prior purchases of the company’s stock, and whether there were flaws in the experts’ comparable transactions and discounted cash flow valuation analyses.  Based upon the evidence, the Court found that there was no “wholly reliable indicator of value” in the case and decided to adopt the discounted cash flow valuation analysis by the company’s expert but adjust it.

The Court noted that both experts used the same three valuation methods and “the experts reached monumentally different valuations.”  In its analysis of the evidence regarding prior purchases of the company’s stock, the Court found that the two prior transactions did not take place in a competitive market, and that the earlier of the two transactions was “stale” and at a time when the company faced different prospects.  Regarding the experts’ comparable transactions analyses, the Court found that approach “a dicey valuation method in the best of circumstances,” one in which both experts made “well-considered, convincing objections to the other side’s model,” and, therefore, not reliable in this case.

Regarding the experts’ discounted cash flow analyses, the Court noted that the discounted cash flow method of valuation is “widely considered the best tool for valuing companies when there is no credible market information and no market check.”  Furthermore, the Court considered that both experts looked largely to the company’s management projections for the forecast for the first five years, but the experts differed widely regarding the forecast for years six through ten, long-term growth rate and weighted-average cost of capital discount rate.

The Court determined that none of the valuations by the experts was “wholly reliable,” and that a fact-finder might find that neither party has met their burden of proof, but that the Court “in the unique world of statutory appraisal litigation” was forced to make a fair value decision.  In this regard, the Court viewed the forecasts, long-term growth rate and discount rate used by the company’s expert as more reliable, and the figure for debt of the company as of the transaction date used by the plaintiff’s expert as more reliable.  The Court commented that the company’s expert “credibly made the best of less than perfect data to reach a proportionately reliable conclusion.”  As a result, the Court adopted the company’s expert’s discounted cash analysis but adjusted it by adopting the figure for debt of the company as of the transaction date used by the plaintiff’s expert.

Riker v. Teucrium Trading, LLC, 2020 Del. Ch. Lexis 178; 2020 WL 2393340 (C.A. No. 2019-0314-AGB, May 12, 2020).  In this Demand action to inspect books and records of a limited liability company (“LLC”) for appraisal purposes, the Court concluded that some books and records sought were not necessary, while it deemed others, such as plans and projections, important to valuation.  In its analysis, the Court considered the purpose for seeking the specific books and records, whether the requested information was necessary and essential to valuation, whether the request was reasonably targeted, and whether there was wrongdoing in errors in filed documents.  Consequently, the Court granted in part and denied in part the member’s demand for books and records under the Delaware LLC Act, Section 18-305.

Regarding document requests, the Court considered that “the company [had] produced some documents to [plaintiff] … within weeks of receiving his inspection demand, produced a substantial number of additional documents to him after engaging in a mediation, and produced certain other documents after trial.”  As a result, six document requests from the Demand were still in dispute.

The Court stated that, under the Delaware LLC Act, valuing one’s own interest is a proper purpose to seek books and records.  Furthermore, the Court considered that plaintiff “testified credibly that he was looking to value his interest … to determine whether to sell or hold his shares in light of the Company’s ‘deteriorating financial performance’ and what he perceives to be ‘erratic decision-making at the Company’”; and plaintiff “more specifically identified at trial … types of information … he needs to prepare a DCF analysis.”

In its review of the scope of the requests in dispute, the Court deemed the request for: (1) the Excel workbook detailing the company’s expense allocation model not necessary for the plaintiff’s stated purpose, far exceeds the types of information in the Demand, and that necessary expense information could be found in the company’s audited financial statements which were produced or in the process of being produced; (2) memoranda regarding contingent assets and liabilities not necessary, because they are not significant and information is in the financial statements produced; and (3) documents to investigate potential mismanagement, appointment or removal of officers, not necessary, because no credible evidence of wrongdoing was presented and the errors in the document filings were honest mistakes and corrected.  Nevertheless, the Court deemed the request for cash projections, including the full current year’s budget and business plan, not just portions, important to valuation under the facts in this case and granted this request, because “an investor cannot hope to do is [to] replicate management’s inside view of the company’s prospects.”  In this regard, the Court directed that “to the extent that other parts of the Company’s 2020 budget address expanding the outstanding shares of the Funds, increasing the Company’s assets under management, or restoring the Company to profitability, the Company must produce those parts of the 2020 budget.”

Consequently, the Court concluded that the plaintiff “has failed to establish an entitlement to receive any further documents in response to his broadly worded demand except for a few specific items enumerated herein relevant to valuing his interest in [the company]….”

Zachman v. Real Time Cloud Servs., LLC, 2020 Del. Ch. Lexis 115 (C.A. No. 9729-VCG, Mar. 31, 2020).  At trial regarding a valuation dispute involving a member’s interest in an LLC related to an alleged breach of fiduciary duty, each side offered a valuation expert to opine on the fair value of plaintiff’s fifty-percent economic interest in the company.  In its determination, the Court selected the most representative analysis and then made what it deemed appropriate adjustments to arrive at a valuation.

In evaluating the two sides’ valuation reports, the Court deemed the expert’s report more reliable, which valued the plaintiff’s interest at the date of the subject merger transaction and relied upon financial information from the company’s accounting system, in comparison to the other report which valued the interest as of five months preceding the transaction with financial information from an accounting firm engaged to re-create the company’s financial statements based upon source documents provided by plaintiff.

According to the Court, the plaintiff “had no credible basis for the financial figures supplied to” his valuation expert, “simply guessed” at some of the expenses, and “inflated [the company’s]… income figures.”  Instead, the Court used the figures in the defendants’ expert report as the basis for determining the value of plaintiff’s interest at the time of the merger.

Nevertheless, the Court made adjustments because it found that the defendant’s expert report valuation was based on unduly conservative future growth estimates for the business.  Consequently, the court adjusted the growth estimates upwards “to account for the Company’s early-years hyper-growth” in determining the value of plaintiff’s interest.

§ 1.7.4 Kentucky

§ 1.7.4.1 Henley Mining v. Parton, U.S. Dist. Ct., ED Ky., S. Div., No. 6:17-cv-00092-GFVT-HAI (Aug. 3, 2020)

In a dissenting shareholder action, both sides offered expert testimony and their estimates of fair value varied widely.  The Court found that summary judgment was not the appropriate means to resolve the valuation dispute; because both sides presented thorough expert valuations, the Court’s role is not simply to pick one valuation over the other, and that the Court “may combine or choose among [estimates] as it believes appropriate given the evidence” and “make whatever use of the experts’ appraisals it deems reasonable.”  Consequently, the Court concluded that the fair value standard does not automatically preclude all use of a net asset approach to meet the legal definition of fair value “of the company as a whole and as a going concern.”

The Court noted established precedent that the “value of dissenting shareholders is to be calculated ‘In accord with generally accepted valuation concepts and techniques and without shareholder level discounts for lack of control or lack of marketability.’”  Furthermore, the Court deemed that “one such valuation concept is the net asset value …. [in which] ‘one of the things the appraiser seeks to do is to establish the market value, as opposed to the book value of the company’s assets.’”  It also noted precedent that “the company’s going concern value … is almost certain to be, estimated by reference to market values of one sort or another” but “what is being sought is the company’s going concern value, not the mere liquidation value of its tangible assets,” (p. 5) therefore, “to the extent that the asset approach cannot yield a going concern value … it should be given no weight.”

After reviewing the experts’ reports, the Court determined that the challenged expert valuation is not “inherently, legally flawed because [it] … appraised [the company’s]… equipment as he would equipment for sale.”  Furthermore, the Court considered that the expert “conducted additional analysis” which “also considered the health of the economy, the … industry and a financial analysis of [the company].”  In this context, the Court noted that “business appraisal, of course, is ‘as much an art as it is a science,’” and “should the Court later reject [the challenged] valuation, the Court is not then bound to accept Plaintiff’s valuation whole-cloth.”  Therefore, the Court rejected the motion of summary judgment.

§ 1.7.5 Missouri

Robinson v. Langenbach, 599 S.W.3d 167; 2020 Mo. Lexis 192; 2020 WL 2392488 (Supr. Ct. Mo., No. SC97940, May 12, 2020).  This family business valuation dispute regarding a determination of fair value arises from claims of breach of fiduciary duty and shareholder oppression.  On appeal, the Court evaluated whether the trial court’s use of a valuation which applied discounts for lack of marketability and lack of control was appropriate.  The Court considered the context and particular facts, determined that a separate prior trial on the breach of fiduciary claim had already awarded damages to plaintiff for the increase in the company’s value before plaintiff’s removal, that in this case the shareholder oppression claim does overlap and that the trial court had determined that valuation discounts are needed to avoid double recovery.  As a result, the Court concluded that the trial court’s decision was within the trial court’s broad equitable discretion, and, therefore, upheld the trial court’s decision.

In its analysis, the Court noted that the “parties here agree that fair value is a broader, equitable concept” than fair market value, and that both sides’ experts relied on valuation treatises which indicated that “there is no hard and fast rule regarding the use of discounts to determine fair value… the case law is literally all over the place.”  Although the Court agreed that “the rationale for applying a minority and marketability discount usually would have limited application in the case of a court-ordered sale to a majority stockholder,” it stated that there is “no fixed set of factors a court must review to determine ‘fair value,’” “context is crucial in a ‘fair value’ analysis,” and a trial court has broad discretion “to shape and fashion relief to fit the particular facts and circumstances and equities of the case before it.”  Therefore, considering the particular facts, the Court determined it was not an error for the trial court to agree with the defendant’s expert that a discount was proper in this one case and noted that the trial court “did not purport to determine any broad principle of law as to application of these discounts.”

§ 1.7.6 Nebraska

Anderson v. A&R Spraying & Trucking, Inc., 306 Neb. 484; 946 N.W. 2d 435, 2020 Neb. Lexis 116 (Supr. Ct. Neb., July 17, 2020).  On appeal, in a shareholder buyout dispute regarding fair value, the Court upheld the trial court’s valuation of the shares in which it adjusted the earnings-based valuations of both parties’ experts and averaged the results.  The Court deemed that trial court’s approach not to be an error, because it was reasonable and had an acceptable basis in fact and principle for use of the experts’ income approach valuation analyses but adjusts for inconsistencies.

The Court noted that neither party asserted on appeal that the trial court used an incorrect valuation method, and instead, “the sole issue presented is whether the… court’s valuation ‘is unreasonably high,’ considering expert’s reports and supporting testimony regarding the income approach.”  In addition, the Court commented that “the determination of the weight that should be given expert testimony is uniquely the province of the fact finder.  The trial court is not required to accept any one method of stock valuation as more accurate than another accounting procedure.  A trial court’s valuation of a closely held corporation is reasonable if it has an acceptable basis in fact and principle.”

On appeal, in a shareholder buyout dispute regarding fair value, the Court upheld the trial court’s valuation of the shares in which it adjusted the earnings-based valuations of both parties’ experts and averaged the results.  The Court deemed that trial court’s approach not to be an error, because it was reasonable and had an acceptable basis in fact and principle for use of the experts’ income approach valuation analyses but adjusts for inconsistencies.

In its analysis, the Court found that the trial court carefully reviewed the expert opinions, identified certain variables that were inconsistent with the income approach, adjusted each opinion accordingly, and used the resulting average of the two adjusted valuation conclusions.  Furthermore, a fair value determination assumes that the business is valued as a going concern, which can be achieved through an income approach.  Therefore, it found that the trial court was not speculative when it made an adjustment because it viewed one expert’s “subtracting 100% of the debt from the valuation estimate of the business [because it] does not comport with the overall theory of the Income Approach because a business, as a going concern, is not required to pay back all of its debt on a lump sum basis.”  In this regard, the Court also considered that the business continued to operate, “there have been no effort to liquidate,” both experts agreed that the company generated significant cash flows, and its banker testified that the company paid its loans on time.

§ 1.7.7 New York

Magarik v. Kraus USA, Inc., No. 606128-15, Nassau County, Supreme Court of New York (April 10, 2020).  In a claim alleging shareholder oppression and a petition for judicial dissolution, the Court considered each of the parties’ experts’ valuations, which came to conclusions that “were vastly disparate from each other.”  The Court selected the valuation which item deemed to “reflect a more accurate value,” and rejected the valuation by plaintiff’s expert that it deemed was “based on income projections that were unrealistic and optimistic and not based on comparable businesses.”

In this case, the company prepared projections for purposes of applying for a bank loan, but not in the ordinary course of running the business.  The plaintiff’s expert relied on those projections.  But, based upon the facts in this case, the Court deemed those projections to be “ambitious and, in fact, overstated.”

In evaluating the projections, although the Court noted the early rapid sales growth of the company, it viewed that “not as great as petitioner contended (especially considering … negative cash flow) nor was it accurately predictive of future success.”  Rather, it deemed the projections used “did not sufficiently account for the competitive nature of the … business … lack of cash flow,” and lack of ownership of the brand name.  Furthermore, regarding the statements and forecasts that the company’s owners made to the bank in obtaining the loan, the Court noted “the representations were not accurate.”  Consequently, according to the Court, the plaintiff’s expert’s income approach “was based on unrealistic projections, proven to be unrealized and wrong.”

In addition, the Court considered that both parties’ experts also applied a market valuation approach.  It deemed that the market approach used by the plaintiff’s expert to be “based on incorrect comparables … public companies, not reasonably related to [the subject company] in terms of size, ownership or marketability.”  Nevertheless, the Court viewed the market approach using the “merged and acquired company method” when weighted with the income approach to be “sound” in this case.

In this situation, the plaintiff owned 24 percent of the company’s shares, the other two owners held 25 percent and 51 percent, respectively.  Finally, the Court also accepted “application of a discount for lack of marketability [of 5 percent], recognizing that the shares of [the subject company] cannot be readily sold on a public market.”

PFT Technology, LLC, v. Wieser, 181 A.D.3d 836, 122 N.Y.S.3d 313 (N.Y. App. Div. 2020).  A limited liability company and its majority members filed suit against a minority member seeking to dissolve the company and reconstitute without the minority member.  The minority member, in turn, counterclaimed for breach of the operating agreement.  The minority member eventually agreed that the majority could buy out his membership interest, and the court held a valuation proceeding in which the minority member’s interest was valued at $1.250M.  The minority member was also awarded attorney fees and prejudgment interest but not any damages based on his counterclaim.  Both sides appealed.

On appeal, the appellate court noted that although limited liability law did not expressly authorize a buyout in a dissolution proceeding, that remedy was appropriate as an equitable remedy.  The appellate court found that the trial court’s decision to allow the buyout was a “provident” exercise of its discretion.  However, the trial court erred in applying certain adjustments to the company’s value, which should have been $1.489M.  The trial court also erred in the amount of attorney fees it awarded.  The trial court did not err in deciding not to award damages on the counterclaim or in the amount of prejudgment interest.

§ 1.7.8 Tennessee

Boesch v. Holeman, 2020 Tenn. App. Lexis 410; 2020 U.S.P.Q.2D (BNA) 11062; 2020 WL 5537005 (Ct. App. Tenn., Knox., No. E2019-02288-COA-R3-CV, Sep. 14, 2020).  This case concerns valuation of a disassociated partner’s interest in a business, and the issue of whether a discount should have been applied to the value of the disassociated partner’s one-third minority interest.  On appeal, the Court determined that a discount for lack of marketability as to the entire partnership business and not as to the minority partnership interest may be appropriate, but a discount for lack of control by the minority partnership interest is inappropriate because [Tennessee Code Annotated, Section 61-1-701 (b)] calls for determining value based on the sale of the entire partnership as a going concern.  Consequently, the Court deemed the trial court’s application of a minority discount improper and remanded the case back to the trial court.

In this situation, the plaintiff is one of three partners.  The Court considered that the expert’s report, which the trial court accepted, applied both a discount for lack of control (aka discount for minority position) and a discount for lack of control.  The Court referenced the Uniform Law comment to Tennessee Code Annotated, which states, “The notion of a minority discount in determining the buyout price is negated by valuing the business as a going concern.  Other discounts, such as for a lack of marketability or the loss of a key partner, may be appropriate, however.”  Furthermore, the Court stated that “the statute calls for determining value based on a sale of the entire partnership business as a going concern.”  As a result, the Court concluded that since that expert’s report did not comply with the Tennessee Code, remand to the trial court was necessary.

Raley v. Brinkman, et al., 2020 Tenn. App. Lexis 342 (M2018-02022-COA-R3-CV, Jul. 30, 2020).  In a buyout dispute involving one of the two 50% owners of a limited liability company (“LLC”) organized as an “S” corporation for income tax purposes, the issue on appeal was whether tax affecting is “relevant” to the determination of fair value buyout.  The trial court declined to tax affect.  On appeal, the Court determined that tax affecting assisted “in determining the going concern value of the S corporation to the shareholder or member.”

The Court noted that the defendant’s expert explained “in considerable detail” why tax affecting and applying an income tax rate “was entirely appropriate and comports with generally accepted valuation standards and methods.”  The expert’s rationale included that “all of the components of the Capitalization Rate are based on after-tax values or after-tax income data, the income stream to which the Capitalization Rate is applied in the Income Approach must also be an after-tax amount in order to be comparing apples to apples.”

The Court considered that its role on appeal is not to determine value but only to determine “whether tax-affecting constitutes relevant evidence of fair value.”  Furthermore, the Court stated that relevant evidence under Tennessee law includes “evidence having any tendency to make the existence of any fact that is of consequence to the determination of the action more probable or less probable than it would be without the evidence.”

The Court stated that the trial court erred in rejecting tax affecting because the trial court incorrectly “applied the fair market value standard, as the Gross court[1] [in a tax case, not a buyout case] did” and incorrectly relied on an Internal Revenue Service (“IRS”) job aid.[2]  The Court noted that although there is no Tennessee case law on the precise issue of how to define fair value under the LLC Act, there is a Tennessee decision, Athlon Sports, under the dissenter’s rights statute that is instructive.  In Athlon, the Tennessee Supreme Court said that fair value is the required standard, fair value is not fair market value, and that the selling fair value owner is “not in the same position as a willing seller on the open market – he is an unwilling seller with little or no bargaining power.”

Instead of Gross and the IRS job aid which the trial court referenced, the Court deemed that the better guidance was Delaware Open MRI,[3] in which the Delaware Court of Chancery determined the going concern fair value of interests in an S corporation and deemed tax affecting relevant to determine “what the investor ultimately can keep in his pocket.”  Therefore, the Court concluded that tax affecting is relevant evidence.

§ 1.7.9 Virginia

Biton v. Kreinis and New Tomorrow, Inc., 2020 Va. Cir. Lexis 94 (Cir. Ct. Norf. Va., No. CL19-7991, Jul. 10, 2020).  In this buyout litigation dispute, the fair value of the departing owner’s shares in a corporation was at issue.  Both parties’ experts used an income approach-capitalization of earnings valuation method, but they reached very different conclusions.  Based upon the evidence, the Court resolved disputed issues regarding valuation date and key valuation inputs of: estimating representative annual revenue to calculate annual cash flow to use in the income approach to value, whether a revenue discount is appropriate due to the implied loss of the sales expertise of the departing owner, estimating representative net income margin percentage to calculate annual cash flow, and estimating capitalization rate.

Regarding valuation date, the Court determined that since this is an action for dissolution of corporate stock in lieu of dissolution, “The statutory valuation date is the day before the date on which the dissolution petition was filed unless the court deems another valuation date appropriate under the circumstances. [Plaintiff] … filed her dissolution action on August 2, 2019, so the presumptive valuation date is August 1, 2019.”

In estimating representative annual revenue to calculate annual cash flow to use in the income approach to value, the Court addressed the lack of projections, little revenue history, and problems with the quality of some historical financial information.  In this regard, the Court commented that “although using the twelve months of revenue immediately prior to the valuation date arguably would have yielded a more accurate representative annual revenue for valuation purposes, that would have required using the monthly [internal accounting] figures, which … are not reliable,” and noted several problems, including “the [internal accounting] data are suspect, as evidenced by the fact that the 2018 revenue is more than twelve percent higher than the 2018 tax-reported revenue, a fact that neither expert could explain.  Further, … two [internal accounting] profit-and-loss statements produced in discovery … for the same time period … are markedly different.”

In addition, the Court rejected the defendant’s expert’s use of full calendar year 2019 internal accounting information, because it includes five months of information subsequent to the valuation date of August 1, 2019.  The Court stated, “Using data after the valuation date is discouraged by the Statement on Standards for Valuation Services,[4] which states that ‘[g]enerally, the valuation analyst should consider only circumstances existing at the valuation date and events occurring up to the valuation date,’ and [defendant’s] expert acknowledged as much in his expert report, and he admitted during his testimony that using post-valuation date revenue was highly irregular.”

Based upon the evidence, “For valuation purposes, the Court finds it appropriate to use the 2018 revenue as calculated by [the plaintiff’s] expert … as … representative annual revenue, … subject to discounting to account for [plaintiff’s] unique contributions.”  The Court considered that “[plaintiff’s]… expert chose to use the 2018 tax reported annual revenue because it was the last available year an accountant had filed a corporate tax return, the last full year before the valuation date, and the last year before the events that led to [plaintiff] filing for dissolution.  He also claimed that there was no reason to believe … operations would not continue as in 2018.  He filled in the missing months of … [the additional location’s] operations revenue — January through April 2018 — by calculating an average 2018 monthly income per location and applying a seasonal adjustment.”  The Court also noted that “the … 2018 revenue information that [plaintiff’s] expert used, on the other hand, appears reliable.  The 2018 corporate tax return is available.”

Regarding whether the revenue discount is appropriate, “The Court finds, based on evidence presented at trial, that [plaintiff’s] sales expertise is not easily replaceable and that the corporate revenue for purposes of valuation therefore should be discounted based on her loss,” and “finds it appropriate to discount the representative annual revenue by ten percent to represent [the company’s] future cash flows without the benefit of [plaintiff’s] sales expertise.”

In estimating the representative net income margin percentage to calculate annual cash flow, the Court made adjustments for non-recurring items such as one-time store opening expenses, discretionary charitable contributions, and manager and officer salary costs.

In analyzing the capitalization rate, the Court considered the totality of the evidence and the company’s current circumstances.  According to the court, “The experts agree to a large extent on the discount rate to be used to calculate the capitalization rate applicable to the ongoing cash flows … [however] the experts disagree regarding … longterm sustainable growth rate.”  Regarding growth rate, the Court considered testimony regarding historical and forecast increases in economic gross domestic product, projected inflation rates, and inflation and future prospects for retail sales.

§ 1.7.10 Washington

McClelland v. Patton, 2019 Wash. App. Lexis 2960, 11 Wn. App. 2d 181 (No. 35401-6-III, Nov. 21, 2019).  In this dissolution case regarding interests in a professional limited liability company (PLLC), the Appellate Court addressed a dispute over whether a PLLC can have entity goodwill value separate from the goodwill of the professionals.  The Court considered the evidence, reviewed goodwill principles, and affirmed the trial court’s finding of entity goodwill.

As a basic premise, the Court noted that “goodwill blossoms from a business’ brand name, trade name, customer relationships, locations, memes, logos, patents, and proprietary technology.”  In addition, it noted that previously regarding goodwill, the Washington Court of Appeals said that goodwill is the “expectation of continued public patronage,” and that helpful insight from the Texas Court of Appeals said, “Goodwill is generally understood to mean the advantages that accrue to a business on account of its name, location, reputation, and success.”

The Court considered the proffered testimony by both parties’ valuation experts on the issue, and that the courts in numerous states recognize that a professional business may possess goodwill separate from that of the individual practitioners, but a few states recognize that professional goodwill attaches to the individual professional rather than the entity.  Among various facts, the Court considered that at the time of trial, referrals were still occurring to the PLLC, not to the professionals, professionals continued to practice at all three of the offices, patients received a bill from the PLLC, not the individual professional, and that when the plaintiff bought into the practice several years earlier, he paid a specified amount then for goodwill value.

The Court rejected the assertion by defendant’s expert as a “false alternative” that either the individual practitioner or the entity but not both could have goodwill.  Rather, the Court concluded that “no reason exists to preclude the practitioner and the entity that employs the practitioner from both enjoying goodwill,” and it adopts “the rule that a professional business entity may enjoy goodwill as the rule that best follows the phenomenon that some customers or clients chose to conduct business with the professional organization not only because of the individual skill of one professional inside the entity.”  Furthermore, the Court concluded that dissolution of the PLLC does not mean it is a going concern, and based upon the fact, the value of the entity as a going concern was preserved.  Finally, the Court listed the five goodwill valuation methods, which the Washington Supreme Court has recognized, and stated that the trial court “could have accepted [plaintiff’s expert’s] valuation of goodwill based on a market value on a going concern basis.”

[1] Gross v. Comm’r v. IRS, 272 F.3d 333, 335 (6th Cir. 2001).

[2] “Valuation of Non-Controlling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes,” prepared by representatives of the Large Business and International Division NRC Industry, Engineering Program and the Small Business/Self-Employed Division Estate and Gift Tax Program, dated October 29, 2014.

[3] Delaware Open MRI Radiology Associates, P.A. v. Kessler, 898 A.2d 290 (Del. Ch. 2006).

[4] “Statement on Standards for Valuation Services,” American Institute of Certified Public Accountants.

The following article is an excerpt from 200 Years of American Financial Panics: Crashes, Recessions, Depressions And The Technology That Will Change It All. 

Artificial intelligence has allowed us to enter the age of Big Data, where extremely large collections of digitized data can be analyzed computationally through the application of complex algorithms to reveal patterns, trends, and associations relating to human behavior and interactions. If you believe that history merely repeats itself, Big Data can be enormously profitable to the extent that it allows users to better predict economic outcomes.

The gap in this seamless evolution of technology is the government. If banks are now technology companies, the government should regulate them as such. That means that government regulators must also understand and use technology. But federal and state banking agencies still ground many decisions on the results of manually collected historical data and physical on-site examinations. There is still an important role for an examiner’s ability to look into the eyes of bank executives and discuss and debate the operations and safety and soundness of a bank during an on-site examination. It is also a critical way to identify and evaluate potential fraud and other misdeeds. But it can no longer be the main tool in a real-time environment.

The Panic of 2008 has pointed regulators in the direction of evaluating future risks. For example, regulators now oversee the creation of elaborate bank resolution plans called living wills, sophisticated capital, and stress testing under alternative financial scenarios as a part of its Comprehensive Capital Analysis and Review (CCAR), and measurements of liquidity and risk management plans under similar duress. But the supervisory function should move to the next level and become fully focused on the comprehensive, real-time collection of data that can be analyzed by artificial intelligence algorithms to assess present and predict future economic and financial behavior.

Predicting the next financial crisis is comparable to forecasting the next hurricane. There are endless human, operational, and financial variables that may impact the outcome and timing. Artificial intelligence can be the bridge between the historically based microeconomic analysis that financial regulation supervisors focus on, and predictive macroprudential regulation that can use Big Data to build a safer and sounder financial services network. The risks embedded in the financial statements of a bank are only a part of the challenge that it must confront. The risks inherent in the overall economy and financial networks will often have as much if not more of an impact on the quality of the credit that it has extended and its performance than its own financial predicament.

Our current system of financial regulation is not only seriously challenged when it comes to averting or mitigating financial crises, it can often exacerbate them. Technology provides a solution because the supervision of financial institutions relies on “the evaluation of a vast quantity of objective and factual data against an equally vast body of well-defined rules with explicit objectives.”

Consider how artificial intelligence and Big Data could have impacted the Panic of 2008. Assume that a huge amount of macroeconomic and financial industry data going back to 1965 had been compiled and was being analyzed by sophisticated computer algorithms beginning in 2000. That data input would have covered the inception of interest and usury rate controls, the most volatile interest rate environment the country had ever experienced, the failure of a massive number of S&Ls and banks, the collapse of oil prices, risky lending in Latin America, several real estate development recessions, the junk bond boom and bust, the stock market collapse of 1987, dramatic changes in demography, the rise of mutual and money market funds, the emergence of asset management businesses, and the internet and social media explosion.

An integrated approach to the evaluation of financial data could also have included information related to the financial incentives and behavior, rational and irrational, that were built into the system. Socialized risk and short-term compensation incentives could have been factored into the mix, perhaps leading to a quicker grasp of how, for example, the securitization of assets ranging from home mortgages to credit cards had skewed the risk/reward formula. With better data sets and analysis, the government and industry executives would have had more reliable indications of developing crises years before they arrived.

What would have occurred if years before the Panic of 2008, regulators and executives accessed these new databases and ran simulations that began to show red flags emerging? They would have seen, as early as 2000, disturbing data about the impact of increases in the amounts of outstanding credit, leverage, second and third mortgages, default rates, and the potential impact of several generations of variable-rate mortgages in rising rate and decreasing home value scenarios. Intelligent machines could have analyzed data that the government had in ways that it was not capable of doing. Red flags would have been seen earlier and more clearly about the interrelated impact of reductions in credit quality, increases in credit availability and the proliferation and interaction of shiny new financial products such as MBS, collateralized debt obligations, and credit default swaps. The creation of excessive risk created by parties with no skin in the game and few downside concerns would have been noticed and hopefully financial incentives could have been adjusted. Intelligent computers would have produced alternative economic scenarios that regulators could have evaluated. If regulators could have spent less time micro-supervising less important matters, they would have had the time to war game how these events might have intersected and made appropriate course corrections.

Congress, bank and investment banking executives, the SEC, and the Federal Reserve might have had the chance to realize that under the developing circumstances, the capitalization and leverage ratios of firms like Bear Sterns and Lehman Brothers were dangerously low and were creating a massive systemic threat. Similarly, regulators and executives might have seen much earlier that AIG could not have sustained a credit default swaps exposure that was effectively insuring all of Wall Street. Better data and predictive analysis could have led to more fulsome public securities disclosures by Bear Sterns, Lehman Brothers, AIG, and Merrill Lynch about possible risk factors that the companies were facing. That would have given shareholders the opportunity to speak through their platforms and, perhaps, alter the course of future events.

Technology, and particularly artificial intelligence, bring with it significant challenges. Artificial intelligence is a tool that relies on the integrity of the program, the programmer, and the data being used. It can be wrong, biased, corrupted, hijacked, stale, or simply based on bad data. Trusting artificial intelligence is an exercise in caution and discretion. Whether factual or not, the parable about the US Navy’s testing of artificial intelligence is instructive. As it goes, when the navy’s artificial intelligence applications sensed that a simulated convoy was moving too slowly, it simply sank the slowest two ships in its convoy to speed up the convoy’s overall progress. That is hardly a solution that would work in the field of financial regulation.

The issues of “explainability” and “accountability” are extraordinarily important in the financial world. How does a financial institution explain why the predictive conclusions of a machine were followed or rejected, particularly after the outcome goes wrong? How can a decision made by an intelligent machine be challenged? How is the use of artificial intelligence impacted by privacy laws and the ability or inability to identify an accountable party? Can machines explain what their algorithms did or how they did it to satisfy the kinds of legal obligations that are imposed by the Fair Credit Reporting Act, the Equal Credit Opportunity Act, the Fair Housing Act, and the European General Data Protection Regulation to provide the borrower or customer with an explanation about why credit was denied?  

Big Data, superintelligent and quantum computers, the cloud, complex algorithms, and artificial intelligence will increasingly provide governments with tools that will dramatically increase their ability to predict and avert future economic disasters. While those systems will never be foolproof, they will increase the opportunity for the government and businesses to make course corrections based on a wider and clearer field of vision. They will potentially give regulators better intelligence and more time to improve and adapt financial regulation, monetary and interest rate controls, and economic responses to impending downturns. Imagine being able to avoid the next financial crisis or, more realistically, lessening its impact because of the decisions made based on information produced by algorithms feverishly analyzing sets of Big Data years before. The advantages of having substantially more data that can be analyzed quickly by intelligent machines can alter the course of financial history and create a smarter and more effective system of financial supervision. Every day that passes without this technological tool in the government’s pocket is another day the economy potentially creeps closer to the next financial Armageddon without any clear warning.

200 Years of American Financial Panics:  Crashes, Recessions, Depressions And The Technology That Will Change It All is available from Prometheus Books and all online book outlets. Learn more about the author.

Although the use of ‘blank check’ vehicles dates back to the 1980s, there has been a proliferation of Special Purpose Acquisition Companies (SPACs) as a means of raising capital over the last 18-24 months (mid-2019 to present). The rise of SPACs has – despite a recent slowdown – been unprecedented, both in terms of the number of new SPAC listings taking place and the amount of capital raised.

Of the 248 SPACs which listed in the US in 2020,[1] 94 were incorporated in either the British Virgin Islands (BVI)[2] or, predominantly, the Cayman Islands.[3] This highlights the significance of these international finance centers to the re-emergence of SPACs as a dominant force in the US capital markets.

By June 2021, the number of new SPAC IPOs had begun to fall away from its peak in Q1 2021: whereas the first three months of 2021 saw more capital raised by SPACs than in the whole of 2020,[4] the number of new SPAC listings fell sharply from April 2021.[5] 

This drop-off has been attributed to a combination of possible factors.  The Securities and Exchange Commission’s statement in April 2021 (the SEC’s Statement)[6] concerning the treatment of warrants in a typical SPAC structure as liabilities on a SPAC’s balance sheet rather than as equity undoubtedly led to a pause amongst SPAC sponsors and service providers while the ramifications of the SEC’s Statement were digested and some financials had to be restated.  Further, large numbers of investment opportunities caused institutional investors who typically participate in the Private Investment in Public Equity (PIPE) financing element of SPAC transactions to become more discerning, and merger valuations were impacted by significant competition amongst large numbers of SPACs simultaneously hunting for a target.

As the SPAC IPO market begins to cool slightly in the US, the attention of many M&A practitioners is turning to the substantial levels of capital sitting within SPACs seeking a merger target – recently estimated by Goldman Sachs to be around $129 billion.[7]  Given that SPACs are required to spend money within a certain period or return it to shareholders via redemptions, this seems certain to have a meaningful impact on the domestic and cross-border M&A markets at least through the first half of 2023 as these vehicles begin to effect ‘de-SPAC’, or business combination, transactions.

Since a substantial proportion of SPACs’ dry powder is contained within Cayman Islands or BVI incorporated entities,[8] it is pertinent to analyse the range of options available pursuant to the laws of those jurisdictions to effect a de-SPAC transaction once the SPAC’s management team has identified a merger target.

Initial choice of Cayman Islands or BVI as jurisdiction for SPAC incorporation  

The selection of a jurisdiction for the incorporation of a SPAC (i.e., whether it should be formed in the US or offshore) is typically driven in large part by complex US tax considerations which are both beyond the scope of this article and outside the scope of offshore counsel’s involvement in the structuring process. 

However, generally speaking, where the SPAC’s management team has ascertained that it is more likely than not that the acquisition of a non-US based company – rather than a domestic US company – will be targeted by the SPAC, a non-US jurisdiction is often selected as the jurisdiction of incorporation of the SPAC.

The Cayman Islands or the BVI are commonly selected as the jurisdiction of a non-US SPAC’s incorporation for a number of reasons:

• the entity may be a ‘foreign private issuer’ from an SEC perspective if correctly structured;[9]
• both the Cayman Islands and the BVI are tax neutral, with no withholding taxes, capital gains or stamp duty levied;[10]
• the company law frameworks in each jurisdiction are flexible but sophisticated, with a simple solvency test for distributions, no corporate benefit requirements, and bespoke governance requirements capable of being included in tailored constitutional documents; and
• there is considerable market familiarity (amongst sponsors, institutional investors, bankers and US counsel) with the use of vehicles incorporated in these jurisdictions.    

Just as the corporate flexibility of Cayman Islands and BVI vehicles is attractive at the IPO stage of the SPAC lifecycle, the range of options provided by Cayman Islands and BVI company laws to achieve a desirable structuring outcome in the de-SPAC transaction is notable. 

Availability of de-SPAC structuring alternatives under Cayman Islands and BVI company law

At the business combination stage of the SPAC lifecycle, it is not always the case that a target company which is taken public by an offshore-incorporated SPAC (Offshore SPAC) will continue to be structured as a Cayman Islands or BVI-incorporated holding company after the reverse merger is effected. 

If the Offshore SPAC acquires a non-US target company (Foreign Target), the post-merger listed entity is often incorporated in the same jurisdiction as the Foreign Target, with the transaction commonly accomplished by way of a cross-border merger.  A possible series of transactions in this scenario (assuming that the Offshore SPAC is incorporated in the Cayman Islands) would be:

• Foreign Target forms a wholly-owned Cayman Islands subsidiary (Merger Sub);
• Merger Sub merges with and into the Offshore SPAC with the Offshore SPAC continuing as the surviving company after the merger; and
• the Offshore SPAC becomes a direct, wholly-owned subsidiary of Foreign Target.

This form of transaction structure was used, for example, in the acquisition of Taboola, the Israeli targeted marketing platform, by ION Acquisition Corp. 1 Ltd., a Cayman Islands-incorporated SPAC[11] at an implied valuation of $2.6 billion, per SEC filings in connection with the transaction.[12]     

The statutory merger provisions in Cayman Islands company law allow this form of transaction to be accomplished with ease: typically, a special resolution of the shareholders of the Cayman entity is required to approve the merger, which is generally capable of being passed by 2/3 of voting shareholders at a duly convened and quorate shareholder meeting, along with such other authorization, if any, as may be set out in the Cayman entity’s constitutional documents.  The law also requires the consent of certain security interest holders, although it is rare for a SPAC to have granted security over its assets.[13]

If the Offshore SPAC acquires a domestic US target company, it may be the case that the Offshore SPAC will effect a domestication to a US jurisdiction such as Delaware as part of the business combination transaction, with a domestic US entity as the resulting public company.  For example, per SEC filings,[14] this deal structure was employed in the acquisition of San Francisco-headquartered property technology company Opendoor by the Cayman Islands-incorporated SPAC Social Capital Hedosophia Holdings Corp. II, in a transaction which valued Opendoor at an enterprise value of $4.8 billion.[15]          

As with the Cayman Islands statutory merger provisions, the procedure for effecting a re-domiciliation out of the Cayman Islands (known as a ‘de-registration’) is straightforward.  A number of procedural steps need to be taken in the Cayman Islands, including the filing of a declaration by a director of the Cayman Islands entity confirming that, amongst other things:

• it is solvent and able to pay its debts as they fall due;
• the application for de-registration is not intended to defraud its creditors;
• any contractual consent to the transfer has been obtained, waived or released;
• the transfer is permitted by and has been approved in accordance with the company’s constitutional documents; and
• the laws of the jurisdiction where the Cayman Islands entity is transferring have been or will be complied with.[16]

Alternatively, where the parties to the merger can receive their consideration in the form of shares in another entity formed for that purpose, that entity will then list with both the SPAC and the original target vehicle sitting beneath it.

The corporate flexibility and political stability afforded by both the Cayman Islands and the BVI has ensured that both jurisdictions have been vital in the structuring of cross-border mergers, acquisitions, IPOs and investment fund formations for decades.  Even if the SPAC IPO boom witnessed throughout 2020 and Q1 2021 continues to taper off somewhat, the Cayman Islands and the BVI will continue to remain absolutely central to the domestic and global M&A markets as the billions of dollars of undeployed capital sitting within SPACs incorporated in these jurisdictions continues to seek out suitable merger targets.

[1] https://spacinsider.com/stats/.

[2] Per an analysis of the SEC Form S-1s filed by SPAC issuers in 2020, which disclose the SPAC’s jurisdiction of incorporation.

[3] Ibid.

[4] https://spacinsider.com/stats/.

[5] SPAC Research, reported in CNBC article ‘SPAC transactions come to a halt amid SEC crackdown, cooling retail investor interest’, Yun Li, 21 April 2021.

[6] SEC Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”), 12 April 2021.

[7] Goldman Sachs analyst note (led by David Kostin) dated 21 April 2021, reported by businessinsider.com, ‘SPACs could drive $900 billion of dealmaking over the next 2 years despite the boom slowing, Goldman says’, Harry Robertson, 22 April 2021.

[8] See supra note 2.

[9] SEC Division of Corporation Finance, ‘Accessing the U.S. Capital Markets – A Brief Overview for Foreign Private Issuers’ (Part II: Foreign Private Issuer Status).

[10] See, for example, section 242 of the BVI Business Companies Act 2004 (as amended).

[11] https://www.sec.gov/Archives/edgar/data/1821018/000121390021003870/ea133754-8k_ionacquis1.htm.

[12] Reuters.com, ‘Taboola to go public through $2.6 billion blank-check deal’, 25 January 2021.

[13] Part XVI, Cayman Islands Companies Act.

[14] https://www.sec.gov/Archives/edgar/data/1801169/000110465920112009/tm2030455-1_s41.htm.

[15] Techcrunch.com, ‘Opendoor to go public by way of Chamath Palihapitiya SPAC’, Alex Wilhelm, Natasha Mascarenhas, 15 September 2020.

[16] S. 206 Cayman Islands Companies Act.

Two recent reports suggest that a federal crackdown on cryptocurrency tax avoidance in the United States is in process. In March 2021, Damon Rowe, Director of the IRS Office of Fraud Enforcement, and Carolyn Schenck, National Fraud Counsel & Assistant Division Counsel (International) in the IRS Office of Chief Counsel, announced a partnership between the IRS’s civil office of fraud enforcement and criminal investigation unit targeting cryptocurrency tax evasion.[1] Dubbed “Operation Hidden Treasure,” the effort is “all about finding, tracing, and attributing crypto to U.S. Taxpayers.”[2] Reports indicate that IRS employees are working with European law enforcement agencies as a part of the effort.[3]

Likewise, at an April 13, 2021, hearing of the Senate Finance Committee, Sen. Rob Portman (R-OH) and IRS Commissioner Charles Rettig discussed issues relating to the reporting of cryptocurrency transactions. Commissioner Rettig specifically highlighted new cryptocurrency disclosure obligations on the Form 1040 tax return. Sen. Portman announced a forthcoming bipartisan bill specifically aimed at tax reporting of cryptocurrency-related transactions.[4]

The increased targeting of cryptocurrency transactions means users of cryptocurrency—and their counsel—should be aware of possible tax reporting and fraud issues.

Cryptocurrency Regulatory Confusion

One of the major problems with cryptocurrency regulation in the United States is an inconsistent regulatory conceptualization. Federal banking regulators disagree as to whether cryptocurrency firms are engaged in the business of banking. According to the Securities and Exchange Commission, some, but not all, cryptocurrencies are securities. The Federal Elections Commission considers cryptocurrency as currency, yet cryptocurrency campaign contributions are considered “in-kind” contributions.[5]

The IRS position is also inconsistent, recognizing cryptocurrency as a medium of exchange but refusing to treat it as currency. Instead, the IRS treats of cryptocurrency as a capital asset.[6] Essentially, when a person acquires a cryptocurrency, the cost associated with its acquisition is the asset’s basis. For an owner who holds the cryptocurrency for appreciation in value (as one might with publicly traded securities), the sale or disposition of the cryptocurrency results in either a gain or loss, with appropriate tax treatment.

But cryptocurrency is not acquired just for capital appreciation; it is used as a medium of exchange in ordinary commercial transactions. When normal currency is used in a commercial transaction, typically only the vendor must recognize taxable income. But because the IRS treats cryptocurrency as property with basis, when it is used for the purchase goods or services, the purchaser also must recognize taxable gain or loss on the disposition of the asset.[7]

It is unclear whether cryptocurrency users are aware of these tax consequences. One source estimates that 18 to 21 million taxpayers will need to consider cryptocurrency transactions for 2021 income.[8] And in reporting income, taxpayers need to be careful to properly track the basis of the cryptocurrency to correctly calculate taxable gain or loss.[9]

Form 1040 Disclosures

The 2020 Form 1040 tax return requires taxpayers—as the very first question on the return—to answer, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”[10] According to the Form 1040 Instructions, virtual currency includes digital currency or cryptocurrency, and virtual currency transactions include, but are not limited to:

• The receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or hard fork;
• An exchange of virtual currency for goods or services;
• A sale of virtual currency;
• An exchange of virtual currency for other property, including for another virtual currency; and
• A disposition of a financial interest in virtual currency.[11]

Taxpayers seeking to avoid IRS attention to their cryptocurrency transactions may be tempted to answer “no” to the question, hoping that the supposed anonymity offered by cryptocurrency will protect them. This is the specific type of activity that the IRS seeks to target with Operation Hidden Treasure:

The IRS, through its trained agents working together with specialist vendors, is “analyzing blockchain and de-anonymizing [crypto] transactions” to be “able to track, find, and work to seize crypto in “both a civil and a criminal setting.”

Schenck had a message for crypto traders who are would-be tax evaders: “We see you.”[12]

Civil and Criminal Tax Fraud

Failing to properly disclose cryptocurrency transactions can trigger both civil and criminal tax fraud. If—or perhaps when—the IRS eventually traces cryptocurrency transactions back to the taxpayer, the Internal Revenue Code allows a 75% civil penalty for any underpayment of taxes attributable to fraud.[13] While the IRS bears the burden of proving by clear and convincing evidence that the underpayment is due to fraud, the burden is met by showing that an underpayment of tax exists, and that the taxpayer intended to evade taxes known to be owed intentionally concealing, misleading, or otherwise preventing the collection of taxes.[14]

Criminal tax fraud is also a possibility if the taxpayer fails to truthfully answer the cryptocurrency question on the tax return.[15] However, the federal criminal tax fraud statutes include the heightened mens rea element of willfulness, which is not found in the civil tax fraud statutes. Courts have construed “willfulness” in the context of tax fraud to require the government to show that the law imposed a duty on the taxpayer, that the taxpayer knew of the duty, and that the taxpayer voluntarily and intentionally violated the duty.[16] Given the incongruence between the common use of cryptocurrency in transactions and the tax treatment thereof by the IRS, many taxpayers may be saved by the willfulness element.

Tax Amnesty

Some observers have noted the similarities in the IRS’s early approach to foreign account disclosures and the tactics currently employed with regard to cryptocurrency.[17] Under the Offshore Voluntary Disclosure Program (“OVDP”), first instituted in 2009, taxpayers with undisclosed foreign financial accounts could avoid criminal prosecution and heightened civil penalties by fully disclosing accounts and paying a lesser amount.[18] This “carrot”—contrasted with the “stick” of criminal prosecutions—netted the IRS $11.1 billion of voluntary payments.[19]

Some have called for an IRS voluntary disclosure and amnesty program for cryptocurrency users, similar to the OVDP. At least one observer has described the IRS’s game plan thusly: use Joe Doe summonses directed to cryptocurrency exchanges to obtain user information, push Congress to pass legislation addressing third-party reporting of cryptocurrency transactions, and then offer amnesty for violators that voluntarily disclose.[20] Thus far, the IRS has rebuffed calls for cryptocurrency tax amnesty,[21] but Sen. Portman’s proposed legislation may be a vehicle to advance the outlined strategy.

Foreign Cryptocurrency Accounts

Subsequent to the initial OVDP amnesty, Congress passed the Foreign Account Tax Compliance Act (“FATCA”) in 2010.[22] Like OVDP, FATCA is tool to reduce tax avoidance via foreign financial accounts. Under the statute, foreign financial institutions are obligated to identify and report information about U.S. account holders to the IRS. Institutions that fail to comply with the requirements face a 30% withholding tax on certain types of U.S.-sourced income.[23]

At least one observer has called on regulators to include cryptocurrency within the FATCA regime, noting the similarity between cryptocurrency virtual wallets and financial accounts.[24] Indeed, regulators announced in 2020 that the current foreign reporting regulations would be updated to address cryptocurrency.[25]

But FATCA relies on cooperation between the IRS, foreign governments, and foreign financial institutions in order to complete reporting of foreign accounts. It is unclear whether a FATCA-style reporting system is workable with cryptocurrency—virtual wallet providers beyond the scope of the IRS’s jurisdiction may not voluntarily report their users’ activity, especially when supposed anonymity is one of the selling points of cryptocurrency usage.

Tax Whistleblower Statute

Cryptocurrency users should also be aware of the federal tax whistleblower statute. In a commercial transaction, the vendor and buyer necessarily have identifying information about the other, so that the vendor can ensure that payment is received, and the buyer can ensure that goods or services are delivered according to the contractual specifications. This is true even in commercial transactions with cryptocurrency serving as the medium of exchange—the vendor must be able to match the cryptocurrency to the transaction as a bookkeeping function.

Thus, if a vendor accepting cryptocurrency learns that the buyer is using cryptocurrency to avoid taxes, the vendor may be able to take advantage of the whistleblower program. Under the statute, a whistleblower is eligible to receive up to 30% of the proceeds collected by the IRS in an enforcement action, with lesser amounts available depending on the extent of the whistleblower’s assistance.[26]

The tax whistleblower statute is in contrast with the federal False Claims Act, which permits qui tam actions by individuals to encourage whistleblowing.[27] In a qui tam action, a private person may file a suit under seal on behalf of the government against the defrauding party. The government may take over the case, in which case the relator is entitled to 15% to 25% of the amount recovered; alternatively, the government may decline the case, in which case the relator may continue the action and receive 25% to 30% of the recovery. A successful relator is also entitled to recover attorney fees and other expenses.

Because commercial counterparties will have greater access to information about cryptocurrency usage than the IRS., the qui tam scheme may be especially helpful in eliminating tax fraud. However, the federal False Claims Act specifically excludes tax cases,[28] so qui tam actions are not available to private persons who may know of a tax avoidance scheme. Some have argued for an expansion of the False Claims Act to include federal tax fraud, in an effort to encourage private participation in eliminating tax fraud.[29]

Speculating on Forthcoming Cryptocurrency Taxation and Regulation 

Thus far, Sen. Portman has been coy about the specifics of his forthcoming bill. His comments raise two general areas of concern: defining cryptocurrency for tax purposes, and improving information reporting.[30] With regard to the first concern, a more consistent overall federal regulatory approach treating cryptocurrency as a true medium of exchange would be welcome for commercial parties.

With regard to the second, foreign cryptocurrency account reporting certainly seems to be on the regulatory radar, as discussed above. Vendors accepting cryptocurrency as payment may also see additional information reporting requirements—such as Form 1099s specifically for cryptocurrency transactions. This could potentially open the door for private enforcement mechanisms such as qui tam actions, but there is no indication that policymakers are considering that tactic.

Portman’s comments also specifically highlighted a $1 Trillion “tax gap” between amounts owed by taxpayers and collected by the IRS, with taxes owed on cryptocurrency transactions constituting part of that gap. Treasury Secretary Janet Yellen has also criticized the use of cryptocurrencies in certain commercial transactions as “extremely inefficient.”[31]

One may speculate as to whether enhanced information reporting requirements will be sufficient to close the gap, or whether stronger disincentives towards cryptocurrency use may be on the regulatory horizon. Users of cryptocurrency should consider what a cryptocurrency-specific taxation scheme could look like. A financial transfer tax, such as the “Tobin tax”[32] or “Section 31 Fees”[33] could serve as a model for a federal excise tax on cryptocurrency transactions.

[1] Guinevere Moore, Operation Hidden Treasure Is Here. If You Have Unreported Crypto, Get Legal Advice, Forbes (Mar. 6, 2021), https://www.forbes.com/sites/irswatch/2021/03/06/operation-hidden-treasure-is-here-if-you-have-unreported-crypto-its-time-to-get-legal-advice/?sh=3dcaff4439c9.

[2] Id.

[3] Daniel Kuhn, IRS Initiates ‘Operation Hidden Treasure’ to Root Out Unreported Crypto Income, Coindesk (Mar. 7, 2021) https://www.coindesk.com/irs-operation-hidden-treasure-unreported-crypto.

[4] Press Release, At Senate Finance Hearing, Portman Discusses Concerns Regarding IRS’ Processing Backlog of Tax Filings, Modernization (Apr. 13, 2021), https://www.portman.senate.gov/newsroom/press-releases/senate-finance-hearing-portman-discusses-concerns-regarding-irs-processing.

[5] See, Ralph E. McKinney Jr., Casey W. Baker, Lawrence P. Shao & Jeff Y. L. Forrest, Cryptocurrency: Utility Determines Conceptual Classification Despite Regulatory Uncertainty, 25 Int. Prop. & Tech. L.J. 1, 3-4 (2021).

[6] IRS Notice 2014-21, 2014-1 C.B. 938; 2014-16 I.R.B. 938.

[7] McKinney, et al., supra note 5, at 12-13.

[8] Roger Russell, IRS Sharpens Focus on Crypto Transactions, Accounting Today (Apr. 13, 2021), https://www.accountingtoday.com/news/irs-sharpens-focus-on-crypto-transactions.

[9] Shehan Chandrasekera, What Crypto Taxpayers Need To Know About FIFO, LIFO, HIFO & Specific ID (Sept. 17, 2020), https://www.forbes.com/sites/shehanchandrasekera/2020/09/17/what-crypto-taxpayers-need-to-know-about-fifo-lifo-hifo-specific-id/?sh=b85b47336aa3.

[10] IRS Form 1040 (2020), U.S. Individual Income Tax Return, https://www.irs.gov/pub/irs-pdf/f1040.pdf.

[11] IRS Form 1040 (2020), Instructions, https://www.irs.gov/instructions/i1040gi#idm140260168286256.

[12] Moore, supra note 1.

[13] 26 U.S.C. § 6663.

[14] Parks v. Commissioner, 94 T.C. 654, 660-61 (1990).

[15] See, e.g., 26 U.S.C. §§ 7201 (tax evasion), 7207 (fraudulent return).

[16] Cheek v. United States, 498 U.S. 192, 201; 111 S. Ct. 604, 610 (1990).

[17] See, Caroline T. Parnass, Pay Toll with Coins: Looking Back on FBAR Penalties and Prosecutions to Inform the Future of Cryptocurrency Taxation, 55 Ga. L. Rev. 359 (2020); Nathan J. Hochman, Policing the Wild West of Cryptocurrency: Part Two: The Ability of Federal and State Regulators to Work Together Will Determine Whether the Wild West of Cryptocurrency Enforcement Will Be Won, 41 Los Angeles Lawyer 14 (2018); Arvind Sabu, Reframing Bitcoin and Tax Compliance, 64 St. Louis L.J. 181 (2020).

[18] Jay R. Nanavati & Justin A. Thornton, DOJ and IRS Use “Carrot ‘N Stick” to Enforce Global Tax Laws, 29 Crim. Just. 4 (2014).

[19] IRS, News Release, Offshore Voluntary Compliance Program to End Sept. 28 (Sept. 4, 2018), https://www.irs.gov/newsroom/irs-offshore-voluntary-compliance-program-to-end-sept-28.

[20] Hochman, supra note 17, at 18.

[21] Moore, supra note 1.

[22] Pub. L. No. 111-147, §§ 501, et seq.; 124 Stat. 71, 97-117 (2010).

[23] 26 U.S.C. § 1471.

[24] Elizabeth M. Valeriane, IRS, Will You Spare Some Change?: Defining Virtual Currency for the FATCA, 50 Val. U.L. Rev. 863 (2016).

[25] Financial Crimes Enforcement Network, Notice 2020-2, Report of Foreign Bank and Financial Accounts (FBAR) Filing Requirement for Virtual Currency (Dec. 30, 2020), https://www.fincen.gov/sites/default/files/shared/ Notice-Virtual%20Currency%20Reporting%20on%20the%20FBAR%20123020.pdf.

[26] 26 U.S.C. § 7623.

[27] 31 U.S.C. §§ 3729-3733; see, U.S. Dep’t. of Justice, The False Claims Act: A Primer (2011), https://www.justice.gov/sites/default/files/ civil/legacy/2011/04/22/C-FRAUDS_FCA_Primer.pdf

[28] 31 U.S.C. § 3729(d).

[29] Franziska Hertel, Qui Tam For Tax?: Lessons From The States, 113 Colum. L. Rev. Sidebar 1897 (2013). But see, Sung Woo “Matt” Hu, Fine-Tuning the Tax Whistleblower Statute: Why Qui-tam is not a Solution, 99 Minn. L. Rev. 783 (2014).

[30] See, Press Release, supra note 4.

[31] Jeff Cox, Yellen Sounds Warning About ‘Extremely Inefficient’ Bitcoin, CNBC.com (Feb. 23, 2021), https://www.cnbc.com/2021/02/22/yellen-sounds-warning-about-extremely-inefficient-bitcoin.html.

[32] James Tobin, A Proposal for International Monetary Reform, 4 E. Econ. J. 153 (1978).

[33] Sec. and Exch. Comm’n, Office of Investor Education and Advocacy, Section 31 Transaction Fees (Sept. 25, 2013), https://www.sec.gov/fast-answers/answerssec31htm.html.