In the corporate context, Delaware has long recognized a public policy in favor of both indemnification and advancement. “Indemnification encourages corporate service by capable individuals by protecting their personal financial resources from depletion by the expenses they incur during an investigation or litigation that results by reason of that service.” Homestore, Inc. v. Tafeen, 888 A.2d 204, 211 (Del. 2005). Similarly, in an effort to induce able corporate managers to serve in Delaware corporations, “[a]dvancement provides corporate officials with immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings.”
Despite the policy reasons favoring indemnification and advancement, the Delaware Limited Liability Company Act (the LLC Act) does not mandate either. This is unsurprising given the LLC Act’s policy “to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” 6 Del. C. § 18-1101(b). However, recognizing the importance of the dual incentives of indemnification and advancement, the LLC Act provides that “a limited liability company may, and shall have the power to, indemnify and hold harmless any member or manager or other person from and against any and all claims and demands whatsoever.” 6 Del. C. § 18-108 (emphases added). The Court of Chancery has repeatedly interpreted this language as granting LLC agreement drafters complete discretion on the issues of whether to grant members or managers indemnification or advancement. See, e.g., Fillip v. Centerstone Linen Servs., LLC, 2014 WL 793123, at *3 (Del. Ch. Feb. 27, 2014).
This freedom of contract on the issue of advancement raises the question: are typical contractual defenses, such as fraudulent inducement, available in a summary proceeding seeking to enforce a party’s advancement rights? In the recent decision of Trascent Management Consulting, LLC v. Bouri, __A.3d __, 2016 WL 6947014 (Del. Nov. 28, 2016), the Delaware Supreme Court found that a defendant may not avoid advancing fees by arguing that the underlying LLC agreement was fraudulently induced. According to the court, to allow such a defense “would permit Trascent to escape its clear promise to make advancement until a court found indemnification inappropriate.”
Background Facts
When George Bouri was hired as an executive of Trascent, he also became a manager. After approximately 16 months in these positions, Trascent terminated Bouri and sued him for, among other things, breach of his employment agreement. Bouri’s employment agreement provided:
Unless a determination has been made by final, nonappealable order of a court of competent jurisdiction that indemnification is not required, [Trascent] shall, upon the request of Executive, advance or promptly reimburse Executive’s reasonable costs of investigation, litigation or appeal, including reasonable attorneys’ fees; provided, however, that Executive shall, as a condition of Executive’s right to receive such advances or reimbursements, undertake in writing to repay promptly the Company for all such advancements and reimbursements if a court of competent jurisdiction determines that Executive is not entitled to indemnification. . . .
The Trascent LLC agreement contained almost identical language, except “Executive” was replaced with “Covered Person.” Trascent admitted that Bouri was an “Executive” under the terms of the employment contract and a “Covered Person” under the terms of the Trascent LLC agreement.
Based on the language in the Trascent LLC agreement and his employment agreement, Bouri sought advancement from Trascent to defend the underlying litigation. When Trascent refused to advance legal fees, Bouri filed an action in the Court of Chancery seeking to enforce his right to advancement under both agreements.
Background on Delaware’s Summary Advancement Proceedings
Under the Delaware General Corporation Law (DGCL), certain types of court proceedings are “fast-tracked” based on the inherent need to decide the matter in dispute quickly. For example, when there is a challenge to the election of directors, an action filed pursuant to Section 225 of the DGCL to decide the outcome is summary in nature so as to provide “a quick method for review of the corporate election process to prevent a Delaware corporation from being immobilized by controversies about whether a given officer or director is properly holding office.” Box v. Box, 697 A.2d 395, 398 (Del. 1997). Similarly, advancement proceedings are summary in nature and are, accordingly, “limited to determining the issue of entitlement” to advancement. Homestore, 888 A.2d at 213.
Section 145(k) of the DGCL specifically provides that advancement proceedings should be summary in nature. This reflects a policy of “providing prompt reimbursement to present and former directors and officers who have had to incur attorneys’ fees and related expenses.” Mooney v. Echo Therapeutics, Inc., 2015 WL 3413272, at *8 (Del. Ch. May 28, 2015). Although the LLC Act does not contain a provision with language tracking Section 145(k), the Court of Chancery also treats actions seeking to enforce advancement rights in the LLC context as summary proceedings because “policy objectives surrounding 8 Del. C. § 145 … extend to similar provisions found in operating agreements in the LLC context.” Tulum Mgmt. USA LLC v. Casten, 2015 WL 7269811, at *3 (Del. Ch. Nov. 9, 2015).
Contract May Not Be Challenged in Summary Advancement Proceeding on Fraudulent Inducement Grounds
In Trascent, the defendant attempted to avoid advancing attorneys’ fees by arguing that both the employment agreement and LLC Agreement had been fraudulently induced by Bouri. The Court of Chancery found that the plain language of the contracts at issue mandated advancement unless and until “a determination has been made by final, nonappealable order of a court of competent jurisdiction that indemnification is not required….” Trascent, 2016 WL 6947014, at *2-3 (emphasis added). Advancement and indemnification are two separate issues. Although advanced fees usually have to be clawed-back if a court ultimately finds indemnification is not warranted, that does not mean that fees must not be promptly advanced before that determination is made. Indeed, one of the primary benefits of advancement is that fees are advanced to defend the underlying litigation before the entitlement to indemnification is litigated. According to the Court of Chancery, if it permitted the fraudulent inducement defense in this case, advanced fees would be effectively denied until the underlying plenary action over the contracts was decided. Accordingly, the court rejected the defense and awarded advancement.
On appeal, the Delaware Supreme Court affirmed the Court of Chancery’s decision. Relying on the plain language of the LLC agreement in rejecting the injection of a fraudulent inducement defense into an advancement proceeding, the Delaware Supreme Court explained:
Trascent knew when it entered the contract that Bouri would be entitled to advancement “[u]nless a determination has been made by final, nonappealable order of a court of competent jurisdiction that indemnification is not required.” Thus, Trascent knew it agreed to provide a right, subject to expedited specific enforcement, and it could not reasonably believe that it could deny that right simply by alleging that the contract was invalid. Trascent may later show that Bouri is not entitled to indemnification by proving that the entire employment agreement or the advancement provision was invalid and fraudulently induced. But, Trascent cannot refuse to provide advancement by arguing that Bouri has the duty in an advancement proceeding to disprove Trascent’s belated allegations. That is especially so in this case when Trascent sued Bouri to enforce its rights under the same contract in which Bouri’s right to advancement is set forth, when it was Trascent’s own decision to sue that triggered Bouri’s right to advancement, and when there is a great deal of overlap with Trascent’s substantive claims which seek to deprive Bouri of the benefits of his previous employment and lose any further rights under the employment agreement and LLC agreement, including advancement, on the grounds that he induced his hire by fraud.
The Delaware Supreme Court also found that permitting a party to argue fraudulent inducement in an advancement proceeding would undermine policies for providing efficient, summary proceedings in the advancement context.
Conclusions
A number of conclusions can be drawn from the Trascent decision. First, Delaware courts will continue to treat advancement cases arising out of LLC agreements as summary proceedings, which are meant to be efficient and quick. Second, because of the summary nature of advancement proceedings, defenses such as fraudulent inducement that would derail the proceeding and effectively transform into a litigation over the validity of the underlying contract are unlikely to be permitted. Finally, LLCs are creatures of contract. Section 18-108 of the LLC Act leaves to the drafters’ sole discretion whether to include advancement provisions in the LLC agreement. LLCs remain free to operate without such provisions. However, if the drafters use their discretion to include advancement provisions in the LLC agreement and the member, manager, or officer qualifies for advancement under the terms of the contract, Delaware courts will hold the parties to the terms of that agreement.
On December 15, 2016, the U.S. Court of Appeals for the Eleventh Circuit affirmed the dismissal of a securities class action against Galectin Therapeutics Inc., a Georgia-based biotechnology company. See In re Galectin Therapeutics, Inc. Sec. Litig., __ F.3d __, No. 16-10324, 2016 WL 7240146 (11th Cir. Dec. 15, 2016). The suit alleged that Galectin violated the federal securities laws by failing to disclose that it had retained third-party firms to publish promotional articles about the company. Although a number of district courts have opined on whether an issuer must disclose the hiring of such outside promotional firms, the Eleventh Circuit is the first appellate court to publish an opinion on the question. See, e.g., Stephens v. Uranium Energy Corp., No. H-15-1862, 2016 WL 3855860 (S.D. Tex. July 15, 2016); In re CytRx Corp. Sec. Litig., No. CV 14-1956-GHK (PJWx), 2015 WL 5031232 (C.D. Cal. July 13, 2015); In re Galena Biopharma, Inc. Sec. Litig., 117 F. Supp. 3d 1145 (D. Or. 2015).
The Galectin decision confirms that the duty to disclose payments to outside firms who publish promotional material regarding a company and its stock rests with the third-party firms, not the issuer.
Background
In May 2015, lead plaintiff Glynn Hotz filed suit on behalf of a putative class of Galectin shareholders alleging violations of Section 10(b) of the Exchange Act and Rule 10b-5(b) promulgated thereunder, as well as Section 20(a). The complaint alleged that Galectin and certain of its current and former officers and directors defrauded the company’s investors by secretly hiring third-party firms to publish positive articles about the company and to “tout” its stock. The complaint did not allege that any of the third-party articles were actually false or misleading under the federal securities laws, but rather were “exceedingly boastful.” The complaint did allege, however, that it was false for Galectin to state—in two private contracts between Galectin and its sales agent for two “at-the-market” offerings—that Galectin had not “directly or indirectly” taken any actions that caused or resulted in the “manipulation” of its stock price. The contracts were private agreements between Galectin and its sales agent MLV & Co. concerning the company’s at-the-market offerings. Each was attached as an exhibit to a Form 8-K filed with the Securities and Exchange Commission pursuant to Item 1.01 of SEC Form 8-K, requiring issuers to disclose entry into material definitive agreements. According to Hotz, hiring third-party firms to promote the company was “manipulating” its stock price. Therefore, because the company had stated that it had not engaged in any such “manipulation,” its statements to that effect from the two “at-the-market” offering sales agent agreements were allegedly false.
The U.S. District Court for the Northern District of Georgia granted Galectin’s motion to dismiss the complaint for failure to state a claim. In re Galectin Therapeutics, Inc. Sec. Litig., 157 F. Supp. 3d 1230 (N.D. Ga. 2015). The district court concluded that Galectin did not impermissibly “manipulate” the price of its stock because paying outside promotional firms to publish admittedly truthful information does not constitute stock price “manipulation.” As a result, the challenged “no manipulation” statements were not false or misleading, and there was no duty for Galectin to disclose its retention of the promotional firms. The district court also considered whether Galectin could be considered the “makers” of the statements in the third-party articles, and thus could be liable for statements in the articles under Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135, 131 S. Ct. 2296 (2011). Relying on Janus,the district court held that Galectin’s mere payment of the stock promoters was insufficient to suggest that it “made” the stock promoters’ statements. Hotz appealed the district court’s decision to the Eleventh Circuit.
The Eleventh Circuit’s Opinion
In a unanimous published opinion written by Judge Frank M. Hull, the Eleventh Circuit affirmed the district court’s dismissal of the complaint for failure to allege actionable claims under Section 10(b) or Section 20(a) of the Exchange Act. In re Galectin Therapeutics, Inc. Sec. Litig., __ F.3d __, No. 16-10324, 2016 WL 7240146 (11th Cir. Dec. 15, 2016).
The court considered whether the challenged statements from Galectin’s underwriting agreements that it had not engaged in any “manipulation” of its stock price were false in light of Hotz’s allegations that Galectin had “secretly” paid outside firms to “tout” its stock. In affirming the lower court’s dismissal, the Eleventh Circuit recognized that “nothing in the securities laws prohibits Galectin as a company . . . from hiring analysts to promote Galectin, circulating positive articles about its drug development, or recommending the purchase of Galectin’s stock.” The court confirmed that “manipulation” is “‘virtually a term of art when used in connection with securities markets,’ generally referring ‘to practices, such as wash sales, matched orders or rigged prices, that are intended to mislead investors by artificially affecting market activity.’” (quoting Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 476, 97 S. Ct. 1292, 1302 (1977)). Hotz’s complaint was devoid of allegations that Galectin had engaged in such practices. “The defendants’ lawfully engaging third parties to ‘promote’[] Galectin stock through publications of boastful but truthful articles is not stock price ‘manipulation’ as a matter of law.” The court thus held that, because the complaint failed to allege conduct by Galectin that amounted to “manipulation,” it failed to allege that Galectin’s “no manipulation” statements were false in violation of Section 10(b).
In addition, the court recognized that, under Section 17(b) of the Securities Act, “the duty to disclose promotional payments lies with the parties that receive the payments for promotional activities,” not the issuer that paid for the promotional activities. Consequently, there was no statutory duty imposed on Galectin to disclose payments to outside promotional firms, and Galectin did not violate the securities laws by failing to do so.
Finally, the court concluded that, under Janus, Defendants did not “make” the statements in the articles published by the outside promotional firms, and therefore could not face liability for statements or omissions in those articles, even if they had been alleged to be false. The court acknowledged Hotz’s allegations that Galectin had paid certain firms to write the articles and coordinated with the firms to maximize the effect of the articles, including timing the publications of the third-party articles with the company’s press releases. But the court found that those allegations were insufficient to support a finding that Galectin had “ultimate authority” or “control” over the third-party statements, as required by Janus. In reaching its conclusion, the court confirmed that an issuer’s mere retention of and payment to a promotional firm to publish positive articles about the company does not render the issuer the “maker” of the statements in the articles.
In light of its holding that the complaint failed to state a claim for relief under Section 10(b), the court held that Hotz could have no secondary liability under Section 20(a), and therefore affirmed the district court’s dismissal of Hotz’s control person claim.
Implications of the Decision
The Eleventh Circuit’s Galectin decision is the first published circuit court opinion to address whether an issuer must disclose the hiring and utilization of third-party promotional firms to recommend investment in a publicly traded company. Although a few lower courts had previously concluded that disclosure was required under the circumstances presented there, the Eleventh Circuit in Galectin concluded that disclosure was not required, and distinguished the prior cases. The court’s ruling could prove important to “small cap” companies seeking to bring new technologies or products to market, particularly those in the healthcare, biotechnology, or pharmaceutical sectors, as those companies often rely on third-party firms to promote awareness of the company, its product, and/or its stock. More often than not, such emerging companies lack the revenues and resources to support an internal investor relations department, yet may be heavily dependent upon new investment capital to fund ongoing operations during the developmental phases of their new product or drug. Such companies must often hire outside firms to assist in raising their profile with potential investors and/or consumers. After the Galectin ruling, these emerging companies, or at least those located within the Eleventh Circuit, need not worry about facing expansive securities fraud liability for failing to disclose their retention of such outside firms. Rather, as the Eleventh Circuit made clear, the duty of disclosure under the federal securities laws rests on the third-party firms, not the company.
In January, the Business Law Section published The Bank Examination Privilege: When Litigants Demand Confidential Regulatory Reports by Eric B. Epstein, David A. Scheffel, and Nicholas A.J. Vliestra, a practical, user-friendly resource to understand the intricacies of the bank examination privilege. The book is available to order at the Section member price of $69.95 here.
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Bank examinations are integral to the government’s supervision of the banking industry. A bank examination is an inspection of a bank or other financial institution by a federal or state regulator. The purpose of a bank examination is to assess the institution’s financial health and/or its compliance with applicable laws and regulations.
Bank examinations generally are non-public. Typically, an examination report is not shared beyond the regulator and the bank. However, when a bank is involved in a lawsuit, keeping such records confidential can be difficult. In a lawsuit, a party may seek copies of such records in the hope of using them as evidence as trial.
That’s where the bank examination privilege comes into the picture. The privilege is a federal rule that shields examination records, to an extent, in federal litigation.
The bank examination privilege is an evidentiary privilege. Evidentiary privileges exempt specific types of evidence from disclosure during a lawsuit. The bank examination privilege evolved from federal judicial decisions, and thus can be classified as a federal common-law evidentiary privilege. In many states, state law also shields examination records. The term “bank examination privilege” usually is understood to refer to the overarching federal rule, rather than the rule that exists in any particular state.
The privilege has a number of nuances that counsel should keep in mind when representing a financial institution in a federal lawsuit. We review ten of them below. A more comprehensive overview of the privilege can be found in our new treatise, The Bank Examination Privilege (American Bar Association 2017).
1. The Privilege Belongs to Regulators
The privilege belongs to regulators, not banks. Therefore, in a lawsuit, when a party asks a bank to turn over confidential examination records, the bank should promptly reach out to the regulator that conducted the examination. If the regulator asserts the privilege, one of two things may happen next. First, the bank’s adversary may back down. Second, the bank’s adversary may ask the court to override the regulator’s decision.
If the bank’s adversary asks the court to override the regulator’s decision, the bank can remain neutral and let the dispute play itself out between the regulator and the bank’s adversary. Often, however, the bank will actively work with the regulator to defend the privilege, and will submit arguments in support of the regulator’s position.
2. Courts Follow a Specific Procedure When Applying the Privilege
To resolve disputes related to the privilege, courts follow a specific procedure. First, the court considers whether the examination records fall within the scope of the privilege. Different judicial decisions use different wording to describe the exact boundaries of the privilege. In essence, the privilege protects an examiner’s confidential opinions and recommendations, and other deliberative aspects of the examination process.
The regulator bears the burden of showing that the records fall within the scope of the privilege. To determine whether the regulator has met this burden, a court may directly review the records, or a sampling of the records, in camera.
Next, if the records are privileged, the court will consider whether there is good cause to require disclosure of the records. The party seeking disclosure bears the burden of showing good cause. The good cause analysis usually focuses on five main factors: (1) the relevance of the records to the case; (2) whether the party can obtain the same information from other sources; (3) the seriousness of the case; (4) the government’s role in the lawsuit, and (5) whether disclosure will have a chilling effect on future bank examinations.
In some cases, after conducting this analysis, the court makes an across-the-board determination that the privilege shields all, or none, of the sought-after examination records. In other cases, the court finds that the privilege protects some documents but not others, or covers particular portions of documents.
3. The Privilege Is Not Limited to ROEs
Often, at the conclusion of a bank examination, the examiner will prepare a formal report known as a Report of Examination, or ROE. Much of the case law regarding the privilege concerns the applicability of the privilege to ROEs.
However, the privilege is not limited to ROEs. The privilege can extend to any type of communication. When applying the privilege, the relevant question is not what form the communication takes. The relevant question is whether the substance of the communication reveals privileged information.
For example, the privilege can encompass:
Regulator-to-bank communications other than ROEs, such as letters, e-mails, or oral communications;
Internal agency communications that are not shared with banks;
Bank-to-regulator communications, such as a response to an ROE; and/or,
Internal bank communications that are not shared with regulators, such as internal bank e-mails discussing communications with an examiner.
4. The Privilege Is Not Only about Documents
The majority of judicial decisions regarding the privilege concern the applicability of the privilege to documents. But the privilege is equally applicable to oral testimony. When giving oral testimony at a deposition or at trial, a bank employee may be entitled to withhold privileged information about the bank’s interactions with examiners.
5. Various Regulators May Assert the Privilege
Many of the legal precedents regarding the bank examination privilege involve three specific federal regulators: the Office of the Comptroller of the Currency (OCC), the Federal Reserve, and/or the FDIC. But that does not mean that the privilege is necessarily limited to these three regulators. Other federal regulators, such as the Consumer Financial Protection Bureau, also have taken the position that the privilege encompasses their communications with supervised institutions. Financial institutions should not assume that the privilege is confined to examinations by the OCC, Federal Reserve and/or FDIC.
6. The Privilege Is Distinct from FOIA Exemption 8
Outside of the litigation context, members of the public may ask administrative agencies to release records under the Federal Freedom of Information Act (FOIA). FOIA contains various exemptions that permit agencies to withhold specific types of records. Exemption 8 allows agencies to withhold records related to bank examinations.
At times, FOIA Exemption 8 is mistakenly conflated with the bank examination privilege. Clearly, FOIA Exemption 8 and the privilege stem from the same underlying concern: the need to preserve the confidentiality of bank examinations.
However, the exemption and the privilege focus on two different procedural situations. FOIA Exemption 8 applies to FOIA requests. The privilege governs the exchange of information in a lawsuit under the Federal Rules of Civil Procedure.
The exemption and the privilege also differ substantively. For example, as noted earlier, parties potentially can show good cause to override the privilege. By contrast, FOIA Exemption 8 does not contain a good cause exception.
7. The Privilege Is Not an Administrative Regulation
A variety of federal administrative regulations restrict the disclosure of bank examination records. For example, the OCC’s policy is that such records are “non-public OCC information,” and therefore are “confidential and privileged.” See 12 C.F.R. § 4.36(b). As a result, the OCC “will not normally disclose this information to third parties.”
The bank examination privilege is not a direct application of such regulations. The privilege recognizes that such regulations are grounded in reasonable concerns. However, the privilege is a common-law doctrine, not an administrative regulation.
8. The Privilege Is Related to the Deliberative Process Privilege
The deliberative process privilege shields the internal deliberations of administrative agencies. Some courts have described the bank examination privilege as an extension of the deliberative process privilege. In effect, the bank examination privilege extends the deliberative process privilege to cover a specific type of external agency communication: communications between agencies and financial institutions.
9. State Statutes Sometimes Displace the Privilege
In federal litigation, when the parties’ claims and defenses are based solely in federal law, courts generally resolve privilege disputes by applying federal privilege law. By contrast, when the parties’ claims and defenses are based solely on state law, federal courts usually decide privilege disputes by applying state privilege law.
Based on this rule, when a case involves federal-law claims and defenses, federal courts routinely apply the federal bank examination privilege. But in some state-law cases, federal courts instead have looked to state privilege law to determine whether bank examination records are privileged. Depending on the state, state privilege law may offer more, less, or the same degree of protection for examination records.
10. There Often Are Other grounds for Withholding Examination Records
The bank examination privilege is an important tool for keeping bank examination records confidential during a federal lawsuit. However, in many cases, there also are other valid reasons to withhold such records. For example, a bank may be able to show that such records are entirely irrelevant to the lawsuit. Such records also may come within the scope of other evidentiary privileges. For instance, if such records reflect communications between a bank and the bank’s counsel, they may be subject to the attorney-client privilege. Because the bank examination privilege is not an absolute privilege, it is important for financial institutions to assert all applicable bases for withholding examination records.
Lawyers know a lot about a wide range of subjects—the result of constantly dealing with a broad variety of factual situations. Nevertheless, most lawyers might not know much about machine learning and how it impacts lawyers in particular. In this article, I provide a short and simple guide to machine learning at a level understandable to the typical attorney.
The phrase “artificial intelligence” usually refers to machine learning in one form or another. It might appear as the stuff of science fiction, or perhaps academia, but in reality machine learning techniques are in broad use today. Such techniques recommend books for you on Amazon, help sort your mail, find information for you on Google, and allow Siri to answer your questions.
In the legal field, Westlaw and Lexis use machine learning tools in their natural-language search and other features. ROSS Intelligence is an “AI” research tool that finds relevant “phrases” from within cases and other sources in response to a plain-language search. Kira Systems uses machine learning to quickly analyze large numbers of contracts. These are just two of dozens of new, machine-learning-based products. On the surface, these tools might seem similar to current legal products, but you will see by the end of this article that they do something fundamentally different, making them not only potentially far more efficient and powerful, but disruptive as well. For example, machine learning is the “secret sauce” that enables ride-sharing services like Uber, allowing it to efficiently adjust pricing to maximize both the demand for rides and the availability of drivers, predict how long it will take a driver to pick you up, and calculate how long your ride will take. With machine learning, Uber and similar companies are rapidly displacing the traditional taxicab service. Understanding what machine learning is and what it can do is key to understanding its future effects on the legal industry.
What Is Machine Learning?
Humans are good at deductive reasoning. For example, if I told you that a bankruptcy claim for rent was limited to one year’s rent, you would easily figure out the amount of the allowed claim. If the total rent claim were $100,000, but one year’s rent was $70,000, you would apply the rule and deduce that the allowable claim is $70,000. Now reverse the process. Assume I told you that your client was owed $100,000 and that the annual rent was $70,000, and then told you that the allowable claim was $70,000. Could you figure out how I got that answer? You might guess that the rule is that the claim is limited to one year’s rent, but could you be sure? Perhaps the rule was something entirely different. This is inductive reasoning, and it is much more difficult to do.
Machine learning techniques are computational methods for figuring out “the rules,” or at least approximations of the rules, given the factual inputs and the results. Those rules can then be applied to new sets of factual inputs to deduce results in new cases.
Here is an example that is easy to understand. You all know the old number series games. For example:
246810_?_
The next number is 12, right? Here, the inputs are the series of numbers 2 through 10, and from this we induce the rule for getting the next number—add 2 to the last number in the series. Here is another one:
1 1 2 3 5_?_
The next number is 8. This is a Fibonacci sequence, and the rule is that you add together the last two numbers in the series.
These games illustrate the use of inductive reasoning to figure out the rule. You then apply that rule to get the next number. Broken down a little, the prior game looks like this:
Input Result
1 1 2
1 1 2 3
1 1 2 3 5
1 1 2 3 5 _?_
We look at the group of inputs and induce a rule that gives us the shown results. Once we have derived a workable rule, we can apply it to the last row to get the result “8,” but more importantly we can apply it to any group of numbers in the Fibonacci sequence. This is a simple (very simple) example of what machine learning does.
Naturally, real-world problems are more complex. Instead of a short series of numbers as inputs, a real-world problem might use dozens, perhaps thousands, of possible inputs that might be applied to an undiscovered rule to obtain a known answer. We also do not necessarily know which of the inputs are the ones our unknown rule uses!
To solve a more complex problem, we might begin by building a database with the relevant points of information about a large number of cases, in each instance collecting the data points that we think might affect the answer. To build our prediction model, we would select cases at random to use as a “training set,” putting the remainder aside to use as a “test set.” Then we would begin to analyze the various relationships among the data points in our training set using statistical methods. Statistical analytics can help us identify the factors that seem to correlate with the known results and the factors that clearly do not matter.
Advanced statistical methods might help us sort through the various relationships and find an equation that takes some of the inputs and provides an estimated result that is pretty close to the actual results. Assuming we find such an equation, we then try it out on the test set to see if it does a good job there as well—predicting results that are close to the real results. If our predictive model works on our test set, then we consider ourselves lucky.
For real-world problems, this kind of analysis is difficult. The job of collecting the data, cleaning it, and analyzing it for relationships takes a lot of time. Given the large number of potential variables that affect real-world relationships, identifying those that matter is somewhat a process of trial and error. We might get lucky and generate results quickly, we might invest substantial resources without finding an answer at all, or the relationships might simply prove to be too complex for the methods I described to work adequately. Inductive reasoning is difficult to do manually. This brings us to machine learning. Machine learning can efficiently find relationships using inductive reasoning.
As an example of what machine learning can do, consider these images:
Assume we want to set up a computer system to identify these handwritten images and tell us what letter each image represents. Defining a rule set is too difficult for us to do by hand and come up with anything that is remotely usable, but we know there is a rule set. The letter A is clearly different from the letter P, and C is different from G, but how do you describe those differences in a way a computer can use to consistently determine which image represents which letter?
The answer is that you don’t. Instead, you reduce each image to a set of data points, tell the computer what the image is of, and let the computer induce the rule set that reliably matches all the sets of data points to the correct answers. For the image recognition problem, you might begin by defining each letter as a 20 pixel by 20 pixel image, with each pixel having a different grey-scale score. That gives you 400 data points, each with a different value depending on how dark that pixel is. Each of these sets of 400 data points is associated with the answer—the letter they represent. These sets become the “training set,” and another database of data points and answers is the “test set.” We then feed that training set into our machine-learning algorithm—called a “learner”—and let it go to work.
What does the “learner” actually do? This is a little more difficult to explain, partially because there are a lot of different types of learners using a variety of methods. Computer scientists have developed a number of different kinds of techniques that allow a computer program to infer rule sets from defined sets of inputs and known answers. Some are conceptually easier to understand than others. In this article, I describe how one type works. Machine learning programs will use a variation of one or more of these techniques. The most advanced systems include several techniques, using the one that fits the specific problem best or seems to generate the most accurate answers.
In general, think of a learner as including four components. First, you have the input information from the training set. This might be data from a structured, or highly defined, database, or unstructured data like you might find in a set of discovery documents. Second, you have the answers. With a structured database, a particular answer will be closely identified with the input information. With unstructured information, the answer might be a category, such as which letter an image represents or whether a particular e-mail is spam, or the answer might be part of a relationship, such as text in a court decision that relates to a legal question asked by a researcher. Third, you have the learning algorithm itself—the software code that explores the relationships between the input information and the answers. Finally, you have weighting mechanisms—basically parts of the algorithm that help define the relationships between the input information and the answers, within the confines of the algorithm. Once you have these four components, the learner simply adjusts the weighting mechanisms in a controlled manner until it finds values for the weighting mechanisms that allow the algorithm to accurately match the input information with the known correct answers.
The techniques take a lot of computational power. Machine learning programs, however, can figure out the relationships when there are millions of data points and billions of relationships—when modeling the systems is impossible to do by hand because of the complexity. Machine learning systems are limited only by the quality of the data and the power of the computers running them.
An Example of a Machine Learning System
One example of a type of machine learning system is a neural network. The term “neural network” conveys the impression of something obscure and mysterious, but it is probably the easiest form of a machine learning system to explain to the uninitiated. This is because it is made up of layers of a relatively simple construct called a “perceptron.”
This perceptron contains four components, the first being one or more inputs represented by the circles on the left. The input is simply a number, perhaps between 0 and 1. It might represent part of our input information, or it might be the output from another perceptron.
Second, each input number is given a weight—a percentage by which the input is multiplied. For example, if the perceptron has four inputs of equal importance, each input is multiplied by 25 percent. Alternatively, one input might be multiplied by 70 percent while the other three are each multiplied by 10 percent, reflecting that one input is far more important than the others.
Third, these weighted input numbers are added to generate a weighted sum—a single number that reflects the weights given the various inputs.
Fourth, the weighted sum is fed into a step function. This is a function that outputs a single number based on the weighted sum. A simple step function might output a “0” if the weighted sum is between 0 and .5, and a “1” if the weighted sum is between .5 and 1. Usually a perceptron will use a logarithmic step function designed to generate a number between, say, 0 and 1 along a logarithmic scale so that most weighted values will generate a result at or near 0, or at or near 1, but some will generate a result in the middle.
Some systems will include a fifth element: a “bias.” The bias is a variable that is added or subtracted from the weighted sum to bias the perceptron toward outputting a higher or lower result.
In summary, the perceptron is a simple mathematical construct that takes in a bunch of numbers and outputs a single number. That output number might be fed to another perceptron, or it might relate to a particular “answer.” For example, if your learner is doing handwriting recognition, you might have a perceptron that tells you the image is the letter “A” based on whether the output number is closer to a 1 than a 0.
In a neural network, the perceptrons typically are stacked in layers. The first layers receive the input information for the learner, and the last layer outputs the results.
In between are what are called “hidden layers” of perceptrons, each taking in one or more input numbers from a prior layer and outputting a single number to one or more perceptrons in the next layer.
The computer scientist building the neural network determines its design—how many perceptrons the system uses, where the input data comes from, how the perceptrons connect, what step function gets used, and how the system interprets the output numbers. However, the learner itself decides what weights are given to each input as the numbers move through the network, and what biases are applied to each perceptron. As the weights and biases change, the outputs will change. The learner’s goal is to keep adjusting the weights and biases used by the system until the system produces answers using the input information that most closely approximates the actual, known answers.
Returning to the handwriting recognition example, remember that we broke down each letter image into 400 pixels, each with a greyscale value. Each of those 400 data points would become a input number into our system and be fed into one or more of the perceptrons in the first input layer. We add some hidden layers in the middle. Finally, we would have an output layer of 26 perceptrons, one for each letter. The output perceptron with the highest output value will tell us what letter the system thinks the image represents.
Then, we pick some initial values for the weights and biases, run all the samples in our training set through the system, and see what happens. Do the output answers match the real answers? Probably not even close the first time through. So, the system begins adjusting weights and biases, with small, incremental changes, testing against the training set and continuously looking for improvements in the results until it becomes as accurate as it is going to get. Then, the test set is fed into the system to see if the determined set of ideal weights and biases produces accurate results. If it does, we now have an algorithm that we can use to interpret handwriting.
It might seem a little like magic, but even a relatively simple neural network, properly constructed, can be used to read handwriting with a high degree of accuracy. Neural networks are particularly good at sorting things into categories, especially when using a discrete set of input data points. What letter is it? Is it a picture of a face or something else? Is a proof of claim possibly objectionable or not?
Other machine learning algorithms play an important role in interpreting unstructured data and tasks like natural-language processing. They can identify relationships among words or concepts. The computer does not understand the words, what the concepts are, or what they mean, but it can identify the relationships as relationships and, like a parrot that repeats what it hears, convey the impression of understanding.
Machine Learning in Action
My examples are basic, designed to provide some understanding of what are fairly abstract systems. Machine learners come in many flavors—some suitable for performing basic sorting mechanisms, and others capable of identifying and indexing complex relationships among information in unstructured databases. Some systems work using fairly simple programs and can run on a typical office computer, and others are highly complex and require supercomputers or large server farms to accomplish their tasks.
To understand the power of machine learning systems compared with nonlearning analytic tools, let’s revisit the first example in the article: ROSS Intelligence. ROSS is built on the IBM Watson system, although it also includes its own machine learning systems to perform many of its tasks. Watson’s search tools employ a number of machine learning algorithms working together to categorize semantic relationships in unstructured textual databases. In other words, if you give Watson a large database of textual material dealing with a particular subject, Watson begins by indexing the material, noting the vocabulary and which words tend to associate with other words. Even though Watson does not actually understand the text’s meaning, it develops, through this analysis, the ability to mimic understanding by finding the patterns in the text.
For example, when you conduct a Boolean search in a traditional service for “definition /s ‘adequate protection,’” the service searches its database for an exact match for those terms applying the Boolean search logic provided. ROSS does something different. It looks within the search query for word groups it recognizes and then finds the results it has learned to associate with those word groups. You should not even have to use the term “adequate protection” to get an answer back discussing the concept when that is the appropriate answer to your question. So long as your question triggers the right associations, the system will, over time, learn to return the correct responses.
The key is that a machine learning system learns. In a way, we do the same thing ROSS does. The first time we research a topic, we might look at a lot of cases and go down a lot of dead ends. The next time, we are more efficient. After dealing with a concept several times, we no longer need to do the research. We remember what the key case is, and at most we check to see if there is anything new. We know how the cases link together, so the new materials are easy to find.
A machine-learning-based research tool can do this on a much broader scale. It learns not just from our particular research efforts, but from those of everyone who uses the system. As the system receives more use, it continues to use user feedback to assess how its model performs and allow for periodic retraining. As a result, it will become extremely adept at providing immediate responses to the most common user queries. Even though the system does not have an understanding of the material in the same manner as a human, its ability to track relationship building over a large scope of content and a large number of interactions allow it to behave as you might, if you had researched a particular point or issue thoroughly many times previously. This provides a research tool far more powerful than existing methodologies.
Legal tools based on machine learning have enormous application. Learners already in use by lawyers help with legal research, categorize document sets for discovery purposes, evaluate pleadings and transactional documents for structural errors or ambiguity, perform large-scale document review in M&A, or identify contracts affected by systemic change—like the Brexit. General Motors’ legal department, and likely other large companies, are exploring using machine learning techniques to evaluate and predict litigation outcomes and even help choose which law firms they employ. Machine learning is not the solution for every question, but it can help answer a large number of questions that simply were not answerable in the past, and that is why the advent of machine learning in the legal profession will prove truly transformational.
Interested in learning more about AI and data? Join the Section’s new Legal Analytics Working Group
The Legal Analytics Working Group’s mission is to explore, and educate business lawyers about, the use of math and economics in the substantive practice of business law. Specifically, we are focused on the use and application of:
Data analytics, statistics and probability theory
Economic theories of choice under uncertainty
Game theory
Behavioral economics
Machine learning, and
Computational law aka “QuantumLaw”
The legal community has already started adopting these complex mathematical and economic techniques. This trend is accelerating.
By all accounts, litigation under the Telephone Consumer Protection Act (TCPA) is out of control, having “blossomed into a national cash cow for plaintiff’s attorneys specializing in [such] disputes.” Bridgeview Health Care Ctr., Ltd. v. Clark, 816 F.3d 935, 941 (7th Cir. 2016). In 2007, 14 TCPA cases were filed. As of October 31, 2016, more than 4,000TCPA cases had been filed. WebRecon LLC, TCPA Cracks 4K, Smashes Record with 2 Months Still to Go, 5K in Sight? With TCPA litigation so far out of control, businesses had high hopes that the Supreme Court’s decision in Spokeo v. Robins, 136 S. Ct. 1540 (2016), might rein in this “national cash cow.” Recent federal court decisions applying Spokeo in the context of TCPA litigation have produced mixed results, with some cases offering defendants glimmers of hope, and others not so much.
TCPA litigation has impacted nearly every industry, from payment systems to ride sharing, and from pharmaceuticals to social networking. See, e.g., Roberts v. Paypal, Inc., 621 F. App’x 478 (9th Cir. 2015); Lathrop v. Uber Techs., Inc., No. 14-CV-05678-JST, 2016 WL 97511 (N.D. Cal. Jan. 8, 2016); Kolinek v. Walgreen Co., No. 13 C 4806, 2015 WL 7450759 (N.D. Ill. Nov. 23, 2015); Sherman v. Yahoo! Inc., 997 F. Supp. 2d 1129 (S.D. Cal. 2014). Even the Los Angeles Lakers have faced a TCPA lawsuit. Emanuel v. Los Angeles Lakers, Inc., No. CV 12-9936-GW SHX, 2013 WL 1719035 (C.D. Cal. Apr. 18, 2013).
Given that TCPA cases generally are brought as class actions, with statutory damages ranging from $500 to $1,500 for each call or text message, companies face tremendous exposure. In one such lawsuit, Chase Bank faced the specter of a $48 billion judgment—and bankruptcy—if a jury had found it willfully violated the TCPA. This exposure creates pressure to settle, and settle companies have, sometimes for enormous sums. Capital One settled a TCPA case for $75 million; AT&T, for $45 million; Bank of America, for $32 million; MetLife, for $23 million; Papa John’s Pizza, for $16 million; and Walgreen’s Pharmacy, for $11 million. Adonis Hoffman, Sorry, Wrong Number, Now Pay Up, Wall Street J. (June 15, 2015).
This was never the intent of the TCPA. Passed in 1991, the TCPA was intended to help consumers recover from abusive telemarketers without hiring an attorney. SeeU.S. Chamber of Commerce Institute for Legal Reform, The Juggernaut of TCPA Litigation: The Problems with Uncapped Statutory Damages. Instead of capturing aggressive telemarketers (with small pockets), however, the law has ensnared business calls and text messages from legitimate businesses (with big pockets) simply because the calls or texts may be automated. The automated fraud alerts, prescription reminders, and coupons that come to our cell phones—the hallmarks of our modern technology-based society—have become the basis for TCPA litigation. These automated messages and alerts are a far cry from abusive robo-calls from marketers. For anyone hoping the United States Supreme Court would rein in this “national cash cow” in Spokeo, that day largely came and went.
Spokeo Fails to Address the Crisis Directly…
In Spokeo, the Supreme Court was asked to decide whether a plaintiff had standing to sue when the plaintiff suffered no concrete injury and could point solely to a violation of federal statute. Thomas Robins filed suit against Spokeo, alleging that information available through the company’s people search engine was false. According to Robins, Spokeo’s website indicated he was married with children, employed, held a graduate degree, and was relatively affluent. Robins asserted that none of this information was accurate and was therefore a violation of the Fair Credit Reporting Act (FCRA). Whether these inaccuracies alone were enough to sustain a class-action lawsuit was the question for the Supreme Court. If they were not—if a bare violation a federal statute without more was not enough to invoke the jurisdiction of the federal courts—then litigation under the TCPA and other similar statutes might have been dealt a major blow.
Although noting that a plaintiff “cannot satisfy the demands of Article III by alleging a bare procedural violation” such as an “incorrect zip code,” and that “Article III standing requires a concrete injury even in the context of a statutory violation,” the Supreme Court also determined that “the violation of a procedural right granted by statute can be sufficient in some circumstances to constitute injury in fact.” A concrete injury is a real injury that actually exists, but it does not necessarily mean a tangible injury. “‘Concrete’ is not, however, necessarily synonymous with ‘tangible.’” Ultimately, the Supreme Court ducked ruling on the sufficiency of the injury before it, holding that the U.S. Court of Appeals for the Ninth Circuit had not properly analyzed the standing issue, “having failed to fully appreciate the distinction between concreteness and particularization . . . .” The Supreme Court vacated the Ninth Circuit’s decision and remanded the case for additional analysis.
. . . But Still Leaves Some Hope
Spokeo failed to tackle the statutory violation issue directly, but district court cases have given defendants some helpful precedent for attacking TCPA plaintiffs’ standing. In Kostmayer Constr., LLC v. Port Pipe & Tube, Inc., No. 2:16-CV-01012, 2016 WL 6143075, at *1–2 (W.D. La. Oct. 19, 2016), the plaintiff alleged that it “personally received at least six unsolicited faxes that violated the TCPA” and that the receipt of these faxes caused the plaintiff and the purported class those statutory damages “contemplated by Congress and the [FCC].” Looking to Spokeo, the court found such allegations insufficient to establish standing at the dismissal stage: “Kostmayer must allege facts to establish a concrete injury, and his general references to damages contemplated by congress is insufficient.” See also Sartin v. EKF Diagnostics, Inc., No. CV 16-1816, 2016 WL 3598297, at *3 (E.D. La. July 5, 2016) (“[The complaint’s] vague reference to Congress and the FCC provides no factual material from which the Court can reasonably infer what specific injury, if any, Dr. Sartin sustained through defendants’ alleged statutory violations.”).
Kostmayer Construction’s allegations were vague and unspecific. In Smith v. Aitima Med. Equip., Inc., No. ED 16 CV 339 ABD-TBX, 2016 WL 4618780, at *4 (C.D. Cal. July 29, 2016), the plaintiff’s allegations were more specific, alleging that an unsolicited call (albeit a single call) from the defendant had caused her aggravation, drained her phone’s battery, and served as a nuisance. These allegations, although perhaps specific, were too de minimus to confer standing. More to the point, because the plaintiff had received “only one call,” any amendment would be futile, warranting dismissal with prejudice. See also Supply Pro Sorbents, LLC v. Ringcentral, Inc., No. C 16-02113 JSW, 2016 WL 5870111, at *3 (N.D. Cal. Oct. 7, 2016) (dismissing junk fax case where it was unclear how the plaintiff had “specifically suffered these particular harms”—loss of the use of the fax machine, paper, and ink toner, waste of recipient’s valuable time, and interruption of privacy—from “the single line identifier on the optional cover sheet of a solicited four-page fax it received.”).
In Stoops v. Wells Fargo Bank, N.A., No. CV 3:15-83, 2016 WL 3566266, at *11 (W.D. Pa. June 24, 2016), the district court applied Spokeo to attack the constitutional standing of a professional TCPA plaintiff who had filed nine TCPA lawsuits and had at least 35 cell phone numbers. Finding that a plaintiff who has “admitted that her only purpose in using her cell phones [was] to file TCPA lawsuits” could not have suffered the “nuisance, invasion of privacy, cost, and inconvenience” that the TCPA was intended to guard against. Stoops also found that the plaintiff could not establish that she had prudential standing because her interests were “not within the zone of interests intended to be protected by the TCPA.” “[I]t is unfathomable that Congress considered a consumer who files TCPA actions as a business when it enacted the TCPA as a result of its outrage over the proliferation of prerecorded telemarketing calls to private residences . . . .”
Romero v. Dep’t Stores Nat’l Bank, No. 15-CV-193-CAB-MDD, 2016 WL 4184099, at *1 (S.D. Cal. Aug. 5, 2016), takes these holdings even farther. Elisa Romero claimed to have received 290 unwanted calls from the defendant, causing her emotional distress and other harms. Because each alleged violation of the TCPA is a separate claim, a plaintiff must establish standing—an injury in fact—for each such violation. Each alleged violation by the defendant often comes with different factual underpinnings: a recipient’s phone may be turned off when dialed, may ring but go unheard or unanswered, or is answered.
As a matter of law, a plaintiff lacks standing to assert a TCPA violation for calls that she does not hear. “For Plaintiff to have suffered ‘lost time, aggravation, and distress,’ she must, at the very least, have been aware of the call when it occurred.” The same is true of calls that are heard but that go unanswered, for there is nothing to distinguish, from the plaintiff’s perspective, a call made by a family member or employer from a call made by a manually or ATDS-dialed marketer. “No reasonable juror could find that one unanswered telephone call could cause lost time, aggravation, distress, or any injury sufficient to establish standing.” See also Juarez v. Citibank, N.A., No. 16-CV-01984-WHO, 2016 WL 4547914, at *3 (N.D. Cal. Sept. 1, 2016) (distinguishing aspects of Romero, but noting that calls “made to a neglected phone that go unnoticed or calls that are dropped before they connect may violate the TCPA but not cause any concrete injury.”).
Even among the answered calls, there was no evidence tying the alleged injuries to the fact of a marketer calling from an automated dialing system (a TCPA violation) as opposed to having manually dialed the number (not a TCPA violation). “Although these calls seeking to collect debts may have been stressful, aggravating, and occupied Plaintiff’s time, that injury is completely unrelated to Defendants’ use of an ATDS to dial her number. Plaintiff would have been no better off had Defendants dialed her telephone number manually.” Despite allegations of 290 calls, the Romero court found that the plaintiff had not suffered “an injury in fact traceable to Defendants’ violation of the TCPA” and therefore lacked standing.
Defendants Should Not Get Too Excited; Each of the Cases Cited Above Has Its Foil or Its Detractors
District courts have dismissed TCPA cases for lack of standing following Spokeo, but have also found that the logic of Spokeo is not easily adapted to the TCPA. Spokeo concerned the FCRA, where a violation of the statute—the failure to ensure the accuracy of a consumer report—has the potential to cause serious harm, such as the loss of employment opportunities or a decrease in the consumer’s creditworthiness. A.D. v. Credit One Bank, N.A., No. 14 C 10106, 2016 WL 4417077, at *6 (N.D. Ill. Aug. 19, 2016). A violation of the FCRA could just as easily fail to cause any kind of harm or material risk of harm (such as having an incorrect zip code). Violating the FCRA does not necessarily cause the harm that Congress sought to guard against by passing the statute. The “same cannot be said of the TCPA” because the TCPA does not “require the adoption of procedures to decrease congressionally-identified risks.” By its very nature, a violation of the TCPA causes the privacy-related harm or intrusion that Congress sought to protect by enacting the TCPA. “There is no gap—there are not some kinds of violations of section 227 that do not result in the harm Congress intended to curb, namely, the receipt of unsolicited telemarketing calls that by their nature invade the privacy and disturb the solitude of their recipients.”
Rejecting the logic of Sartin, the Credit One Bank decision held that a TCPA plaintiff’s standing does not turn on whether the plaintiff had suffered “additional tangible harms like wasted time, actual annoyance, and financial losses” because Congress identified that unsolicited telephone contact constitutes an intangible, concrete harm. Seealso Griffith v. ContextMedia, Inc., No. 16 C 2900, 2016 WL 6092634, at *1 (N.D. Ill. Oct. 19, 2016) (“Courts in this district have held, both before and after the Court’s decision in Spokeo . . . that loss of time and privacy are concrete injuries for the purpose of conferring Article III standing.”).
Sartin is not the only case to have its logic questioned. Aitima Medical Equipment, 2016 WL 4618780, at *4,held that a single phone call was too de minimus to confer standing. Other courts have reached the opposition conclusion. In Etzel v. Hooters of America, LLC, No. 1:15-cv-1055 LMM (N.D. Ga. Nov. 15, 2016) (Doc. 39 at 9), the court found that a single call was sufficient to confer Article III standing (“[I]n light of the plain language of the TCPA and Congress’s role in elevating injuries to legally cognizable status, sending a single text message in violation of the TCPA constitutes an injury-in-fact to the recipient so as to provide Article III standing.”) (emphasis added). See also Aranda v. Caribbean Cruise Line, Inc., No. 12 C 4069, 2016 WL 4439935, at *6 (N.D. Ill. Aug. 23, 2016) (disagreeing with “the reasoning of the judge in Aitima Medical Equipment” and noting that it “does not matter whether plaintiffs lack additional tangible harms like loss of cell phone battery life, actual annoyance, and financial losses.”). The Juarez court reached the same conclusion. Juarez, 2016 WL 4547914, at *3 (“Even a single phone call can cause lost time, annoyance, and frustration.”).
Romero also has its detractors. According to LaVigne v. First Cmty. Bancshares, Inc., No. 1:15-CV-00934-WJ-LF, 2016 WL 6305992, at *3 (D.N.M. Oct. 19, 2016), accepting the reasoning of Romero would make it all but “impossible for a plaintiff to allege a private right of action under the TCPA for automated solicitation calls.” Instead, LaVigne believed that the history and judgment of Congress suggested that a violation of the TCPA, on its own, constituted a concrete, de facto injury. “The list [of cases] goes on, with each finding that the bare statutory violation of the TCPA constitutes sufficient ‘concrete’ injury for Article III standing.” LaVigne also noted that Article III’s standing requirements do “not contain a minimum cost or harm threshold.” A harm, no matter how small, is actual and real.
More to the point, Romero has likely been overruled by the Ninth Circuit’s recent decision in Van Patten v. Vertical Fitness Group, No. 14-55980 (9th Cir. Jan. 30, 2017), which held that “[u]nsolicited telemarketing phone calls or text messages, by their nature, invade the privacy and disturb the solitude of their recipients.” (emphasis added). As a result, a plaintiff alleging a violation of the TCPA “need not allege any additional harm beyond the one Congress has identified” to satisfy Spokeo and Article III’s standing requirements.
Spokeo Is Still Not the Last Word
In July 2015, the FCC issued a Declaratory Ruling and Order that clarified the TCPA’s definition of “automatic telephone dialing system” and created a “very limited safe harbor” for calls made to reassigned numbers. Lathrop v. Uber Techs., Inc., No. 14-CV-05678-JST, 2016 WL 97511, at *2 (N.D. Cal. Jan. 8, 2016). Nine entities filed petitions with the U.S. Court of Appeals for the District of Columbia Circuit seeking to have the FCC’s ruling vacated, and these nine appeals were consolidated into a single case: ACA International v. Federal Communications Commission, No. 15-1211 (D.C. Cir. 2015).
Two of the five FCC commissioners issued sharp dissents in the July 2015 ruling. If the D.C. Circuit adopts the reasoning of these dissents and determines that the FCC reached the wrong conclusions in its July 2015 Order, such a decision “could potentially be dispositive” of current TCPA issues before the district courts. Fontes v. Time Warner Cable Inc., No. CV14-2060-CAS(CWX), 2015 WL 9272790, at *4 (C.D. Cal. Dec. 17, 2015). One court has already sided with the dissenting Commissioners and stated its belief that portions of the “FCC’s majority interpretation . . . contradict[] the plain language of the statute” and are “not entitled to deference on appeal.” Gensel v. Performant Techs., Inc., No. 13-C-1196, 2015 WL 6158072, at *2 (E.D. Wis. Oct. 20, 2015).
Even after Spokeo, some courts have decided to wait on a decision from the D.C. Circuit in ACA International, believing that a decision in that case has the potential to clarify and streamline important legal issues. See Rajput v. Synchrony Bank, No. 3:15-CV-1595, 2016 WL 6433150, at *1, *8 (M.D. Pa. Oct. 31, 2016) (lifting a stay following the Spokeo decision but then granting another stay pending the D.C. Circuit’s disposition of ACA International); Frable v. Synchrony Bank, No. 16-CV-0559 (DWF/HB), 2016 WL 6123248, at *4 (D. Minn. Oct. 17, 2016) (staying TCPA case until the D.C. Circuit Court of Appeals issues a decision in ACA International); butsee Konopca v. Ctr. for Excellence in Higher Educ., Inc., No. CV155340FLWDEA, 2016 WL 4644461, at *3 (D.N.J. Sept. 6, 2016) (refusing to stay the case while the ACA International case remains pending). Spokeo is not the last word in TCPA litigation, and ACA International may also find its way to the Supreme Court.
When negotiating a credit agreement, several factors, including the borrower’s risk profile or credit ratings, impact the breadth of the affirmative, negative, and financial covenants imposed on the borrower. Some of the most burdensome credit agreements are asset based-lending (ABL) credit agreements. The heart and soul of ABL lending is the collateral; thus, ABL credit agreements often provide for intense lender monitoring and supervision because the borrowing base is tied to “eligible” assets. Under such a strict regime and without good advice from counsel, it is not uncommon for borrowers to trip an unintended default. The purpose of this article is to provide an overview of ABL credit agreements and lay out several best practices when negotiating ABL credit facilities on behalf of borrowers to help avoid unintended “foot fault” defaults.
What Is an ABL Credit Facility?
ABL literally means asset-based loan; thus, it is no surprise that the foundation of any ABL facility is the assets supporting the borrowing base. Unlike a cash-flow facility, where the lenders look to the borrower’s future cash flow, availability of the loan in an ABL facility is driven by the quality and value of the “borrowing base assets,” typically eligible inventory and eligible receivables (and sometimes eligible equipment). In these type of facilities, lenders tend to be keenly interested in ensuring that the assets against which it is lending are, in the case of inventory, of good quality and easily accessible and, in the case of receivables, likely to be collected. This focus can lead to detailed reporting requirements, both as to scope and frequency. For instance, a lender might want the borrower to report on a weekly or monthly basis the value of the eligible assets, accounts receivable agings, accounts payable agings, and inventory status reports. These requirements are burdensome for borrowers, many of whom have treasury staff stretched too thin. There are certain ways, however, for lawyers to help their clients build a culture of compliance to help avoid defaults. These techniques can be employed at the term sheet phase, during credit agreement negotiations, and throughout the life of the loan.
Term Sheet Considerations
Counsel to borrowers should advise their clients on potential compliance issues from the earliest stages of the financing—ideally when the company is negotiating a term sheet for a proposed credit facility. Term sheets typically list in summary fashion eligibility requirements, representations, notices, financial covenants, negative covenants, and events of default that a borrower can expect to see included in its ABL credit agreement. It is critical, therefore, that counsel focus a client’s attention on key operational issues when negotiating a term sheet, especially when those restrictions likely are to be in place for the next four or five years. Counsel should suggest clients clearly define terms to be used in the calculation of availability, eligible receivables, eligible inventory, reserves, and other key provisions. Further, as may be expected, ABL facilities typically provide little flexibility for disposing of assets other than in the ordinary course of business. If the borrower has any asset sales reflected in its business plan, counsel should advise that these dispositions be expressly permitted in the term sheet. By discussing material business issues up front when negotiating the term sheet instead of after lender’s counsel has drafted the credit agreement, the lender will have a clearer understanding of the borrower’s key business drivers affecting the transaction terms, thereby making the processes of marketing the transaction and agreeing to the definitive documents much smoother. Because participating lenders in multi-lender facilities may not even see the full credit agreement until a few days before closing, it is critical to ensure linchpin business issues are vetted at the initial phase of negotiations to avoid credit approval issues popping up at the eleventh hour.
Avoid Defaults Going Forward
Although we often hear business people try to distinguish between “technical” and “real” defaults, as lawyers we know that any event of default—from a late notice to a breach of a financial covenant—gives rise to a lender’s rights and remedies under the contract. Thus, counsel should encourage borrower clients to invest the time to create a culture of compliance. Defaults give lenders leverage, enabling them to renegotiate pricing and terms more favorable to them, and waivers and amendments are distracting, time consuming, and often costly.
Given that ABL facilities often contain detailed reporting requirements, a borrower should tie any notice requirements to a monthly or quarterly financial report. For instance, instead of requiring ten days prior written notice of a new collateral location, counsel could revise the covenant to require that the borrower provide notice of all new collateral locations with the monthly or quarterly financials/compliance certificate. Even better, add a materiality threshold to the notice requirement so that only locations with collateral over a material amount need to be disclosed. That way, the officer responsible for completing the monthly reporting package will be prompted to disclose all new material collateral locations. If counsel structures the ABL credit agreement this way, the borrower is less likely to forget to provide the required notice. This same approach can be used with other notices too (i.e., notices of new bank accounts, commercial tort claims, and intellectual property).
ABL credit agreements also tend to have events of default that a borrower might not see in other types of credit facilities. Keeping with the theme of collateral is key; a lender may include events of default tied to an important customer contract or a material amount of orders cancelled or receivables not collected. As counsel to the borrower, try to remove these provisions because these types of events would inevitably affect the borrowing base. If not, then counsel should try to negotiate the highest thresholds it can to avoid tripping a default. It is one thing for a lost customer to cause a decline in borrowing base availability, but another to have that loss cause an event of default under the ABL credit agreement.
This may seem obvious, but do not overlook the security agreement. Even though business people typically do not focus on the security agreement, there may be a myriad of issues hidden in an ABL security agreement. Oftentimes, lenders bury notice requirements and different, more burdensome covenants in the security agreement, especially related to receivables. For instance, a security agreement may prohibit the borrower from adjusting, forgiving, or amending any receivables. For many borrowers, that standard is too strict to work for their business. To increase compliance success, move all of the reporting requirements to the notice section in the credit agreement and ensure that the documents work together.
After the deal closes, create a compliance checklist for the borrower that summarizes in layman’s terms what the borrower can and cannot do to remain in compliance with its ABL credit agreement. Include regular and occurrence-based reporting requirements as well as operating negative covenants. Including these requirements can be a valuable tool for borrowers as they navigate the sometimes overwhelming number of obligations contained in ABL credit documents. Further, counsel should consider maintaining a running list of compliance issues raised by clients. This list would be helpful to have before any amendment or refinancing to address any common or recurring compliance concerns.
On a final note, it can be helpful for counsel to emphasize to clients the value of building and maintaining strong relationships with their lenders. If the borrower forecasts a potential compliance issue under its credit facility, the borrower should consider alerting its primary banking relationship, such as the administrative agent on its facility. Doing so builds trust and, in the face of a default or other adverse developments, lenders are more likely to work with a company if they are not caught off guard.
Other Areas of Focus
Although we have provided an overview of best practices for counsel in negotiating ABL credit facilities, there are several other unique features of ABL credit facilities that merit additional scrutiny by counsel.
Reserves. Lenders can institute reserves against availability to fence credit risk in many situations. For instance, a lender might institute a rent reserve equal to three months’ rent if inventory is located at a location where the lender does not have a collateral access agreement with the landlord. In other words, the value of the inventory located at that location is reduced by the amount of the rent reserve, thereby reducing the available borrowing amount. As counsel to the borrower, it is critical to expressly state the amount of, or methodology for calculating, the reserves and the situations in which they can be used.
Reasonable Credit Judgment. This can be a helpful standard to incorporate into a company’s ABL credit agreement. As mentioned above, lenders oftentimes include the right to institute reserves on borrowing availability or make other decisions that affect borrowing availability. By holding the lender to an objective, “reasonable credit judgment” standard, you are helping ensure that your client will be treated by the lender in a similar manner as that lender treats other similarly situated borrowers. An example definition might read as follows: “Reasonable Credit Judgment” means, with respect to any Person, a determination or judgment made by such Person in the exercise of reasonable (in the business of secured asset-based lending) credit or business judgment and in good faith.
Eligible Inventory and Eligible Receivables. Many ABL credit agreements define these terms in the negative, listing everything that is not eligible. When dealing with eligible receivables, lenders typically limit the amount of receivables due from one customer (i.e., “concentration” limits) and exclude receivables due from affiliates of the borrower. If the borrower has any international customers, the lender may cap the receivables from those customers unless additional security (for instance, a letter of credit) or steps to perfect in collateral located abroad is provided. Counsel should study these definitions carefully to ensure they do not exclude assets that the borrower does not intend to be excluded. To that end, it can be very helpful for the borrower to submit to the lender a sample borrowing base calculation before closing to ensure that the business teams are using the same calculations in determining eligibility and the borrowing base.
Cash Management. It is typical in an ABL credit facility for the lender to require the borrower to maintain its cash management functions with the lender. Certain institutions further insist on “full dominion and control” over the borrower’s bank accounts, giving lenders the ability to sweep the cash in the borrower’s operating account on a daily basis to pay down borrowings on the line of credit. The borrower then funds disbursements using proceeds of the revolving loans, and the cycle starts over again. Further, to the extent that the borrower maintains bank accounts with other banks, it will be required to enter into a tri-party deposit account control agreement with the depository bank and the lender. As counsel to the borrower, it is important to understand what types of bank accounts a borrower has, at which institutions those accounts are maintained, over which accounts a lender is seeking liens, and whether the lender’s proposed control agreement is a full dominion agreement (i.e., the borrower cannot access the account) or a “springing” agreement (i.e., the lender cannot block access until after an event of default). Note that it is common to exempt from control agreements petty cash, payroll accounts, health care reimbursement, and other employee benefit accounts.
Sidebar: Key ABL Credit Agreement Compliance Takeaways for Counsel
1. Ensure that the credit agreement and security documents work together.
2. Move all notice obligations to one place in the credit agreement.
3. Tie reporting requirements to monthly/quarterly financial reporting.
4. Create a checklist of key compliance terms.
5. Encourage clients to maintain an open dialogue with their relationship bankers—it builds trust.
For every general counsel or public company audit committee member, much of the response to allegations of corporate wrongdoing is familiar: preserve evidence, consider whether to retain outside counsel, inform necessary constituencies inside the company, and scope out the investigation. One disclosure that might be required is to the company’s outside auditor, and this disclosure may lead to a frequently overlooked consideration of the internal investigation: What does the outside auditor need to accept the results of the investigation? In many cases, the inquiries of the outside auditor may appear to constitute unnecessary second-guessing and a revisiting of issues and work, including expensive and time-consuming electronic discovery, that already were deemed resolved.
From the perspective of the outside auditor, however, the depth of some of its inquiries is essential, and, unless satisfied, the auditor will not sign off on the company’s financials. Consequently, the company—ordinarily through its outside counsel—must anticipate and address the auditor’s concerns from the outset and understand how to successfully push back on the auditor’s requests.
Understanding the Auditor’s Obligation: GAAS and Section 10A
Auditors’ obligations with respect to possible illegal acts are dictated by both Generally Accepted Auditing Standards (GAAS) and Section 10A of the Securities Exchange Act of 1934 (Section 10A), 15 U.S.C. § 78j–1, which was enacted in 1995 as part of the Private Securities Litigation Reform Act. Where an auditor becomes aware that an illegal act has or may have occurred at a client, Section 10A requires the auditor to determine the likelihood that an illegal act has in fact occurred, and assess the potential impact of the act on the client’s financial statements. Section 10A’s application is expansive. It defines “illegal act” broadly as “an act or omission that violates any law, or any rule or regulation having the force of law.” Section 10A’s requirements also are triggered regardless of the materiality of the possible illegal act. Section 10A imposes reporting requirements on the auditor—specifically, to inform management of the possible illegal act and to ensure that the audit committee and/or board of directors are “adequately informed” of it. These reporting requirements are triggered unless the act is “clearly inconsequential.”
To assess the impact of a possible illegal act, the auditor must consider both the quantitative and qualitative materiality of the act under the Auditing Standard 2405 Illegal Acts by Clients ¶¶ 12–16, 19–20 (AS 2405) and the SEC Staff Accounting Bulletin No. 99—Materiality. The auditor must evaluate the impact of the illegal act on certain amounts presented in the financial statements, such as loss contingencies, and consider the adequacy of disclosures related to the illegal act. Apart from financial statement impact, the auditor must determine whether the illegal act impacts the audit itself by impairing the reliability of representations made by management. This requirement is critical in investigations where the members of management making representations to the auditor are in any way implicated in the possible illegal act. For this reason, auditors usually expect that outside counsel, and not members of the company’s office of the general counsel, will conduct the investigation because in-house counsel may have pre-existing relationships with members of management under investigation, or knowledge of the facts at issue, that could call their objectivity into question. Similarly, auditors routinely inquire of outside counsel the extent and nature of prior engagements to assess whether outside counsel is sufficiently independent.
The auditor’s ability to fulfill these obligations ultimately impacts its ability to issue an unqualified opinion. If the auditor concludes that it has not received sufficient evidence to evaluate the materiality of an illegal act’s impact on the financial statements, the auditor can disclaim an opinion on the financial statements. In certain circumstances, such a disclaimer could result in the auditor’s withdrawal from the engagement.
In addition to assessing the impact of an illegal act on the financial statements and audit under AS 2405, Section 10A also requires the auditor to assess management’s response to the illegal act. If the auditor concludes that appropriate remedial action has not been taken to address an illegal act materially impacting the financial statements, and the auditor issues a nonstandard opinion or withdraws as a result thereof, the auditor must report those conclusions to the client’s board of directors. The client’s board of directors then has one business day to report the auditor’s findings to the SEC.
In sum, the auditor ultimately has four obligations with respect to possible illegal acts:
determine whether an illegal act occurred;
understand the quantitative and qualitative impact of the illegal act on the client’s financial statements and on the audit itself;
determine whether management has taken sufficient remedial action to address the illegal act; and
make required reporting to the client’s management, board of directors, and audit committee.
The procedures performed by the auditor in response to the detection of a possible illegal act should be geared toward fulfilling these obligations.
Understanding the Lawyer’s Obligation: Privilege in Internal Investigations
Given the auditor’s obligations under GAAS and Section 10A, it is unquestionably in the auditor’s best interest to seek as much information as possible when conducting procedures in response to a potential illegal act. It is axiomatic that the more information and evidence the auditor has, the more informed the auditor believes its ultimate conclusions will be. However, the auditor’s interest in information is at odds with counsel’s obligations to protect the client from overreaching inquiries and to preserve the attorney-client privilege.
Both the attorney-client privilege and work-product doctrine apply in the context of internal investigations. The attorney-client privilege, which protects confidential communications between attorney and client for the purpose of securing legal advice, undoubtedly applies to internal investigations. Upjohn Co. v. United States, 449 U.S. 383, 389, 396–97 (1981). Under Upjohn, this privilege protects disclosure of communications, not disclosure of the facts underlying them. It is also subject to waiver, and external auditors are not privileged parties under federal law. See, e.g., Couch v. United States, 409 U.S. 322, 335–36 (1973). Disclosure of attorney-client privileged communications to auditors constitutes a subject matter privilege waiver. See e.g., Chevron Corp. v. Pennzoil Co., 974 F.2d 1156, 1162 (9th Cir. 1992); In re John Doe Corp., 675 F.2d 482, 488–89 (2d Cir. 1982). Essential to this analysis is whom the attorney represents. In virtually all cases, counsel should inform witnesses that the client is the company, board of directors, or the board committee, not the witness, and that no privilege attaches to the information the witness provides. Accordingly, the focus of counsel’s concerns relating to privilege will be on communications with the client—the company, board, or board committee—and counsel’s mental impressions, as opposed to the factual information witnesses provide.
The work-product doctrine protects materials prepared by an attorney in anticipation of litigation under Fed. R. Civ. P. 26(b)(3). The work-product privilege generally is understood to apply in the internal investigation context, although case law addressing this question is not uniform. See e.g., In re Grand Jury Investigation, 599 F.2d 1224, 1229 (3d Cir. 1979). Unlike the attorney-client privilege, most courts have held that work-product privilege is not waived by disclosure to auditors. See e.g., United States v. Deloitte, 610 F.3d 129, 139 (D.C. Cir. 2010); Merrill Lynch & Co, Inc. v. Allegheny Energy, Inc., 229 F.R.D. 441, 445–49 (S.D.N.Y. 2004). However, disclosure should be avoided whenever possible because some courts have held that disclosure of work product to an auditor waives work-product privilege. See e.g., United States v. Hatfield, No. 06-CR-0550 (JS), 2010 WL 183522, at *3 (E.D.N.Y. Jan. 8, 2010).
Mutual Understanding and Informed Communication
On their face, the obligations of attorneys and auditors appear incompatible. Auditors require sufficient information to satisfy their obligations under GAAS and Section 10A, whereas counsel must satisfy their own obligation to preserve privilege. The key to striking the appropriate balance between these competing interests is informed communication. To achieve informed communication, each party must consider the legal obligations driving the other, and the parties must communicate early and often. This section provides some practical tips for maintaining informed communication throughout the various stages of an investigation.
Planning and Scope
Counsel should involve the client’s auditor from the beginning of the investigation. Consulting with the auditor at the outset sets the tone for the relationship between the parties throughout the investigation. The initial meeting should cover the scope of the investigation, including all planned procedures. When designing those procedures, counsel should consider the auditor’s obligations—namely, to understand the nature and potential impact of the illegal act. This is particularly the case with electronic data review and evidence preservation. Counsel should anticipate that the company’s outside auditors will apply rigorous review to whether and how electronic data is captured and processed, and which search terms are applied against that data. Audit firms, particularly large ones, often have their own forensic groups that are well versed in document preservation, collection, and review. It is not uncommon for the outside auditors to suggest additional procedures or search terms. On the other hand, mindful of the limited nature of the auditor’s review, counsel reasonably can resist expanding the scope of data and document review where the auditor’s suggestions are overbroad.
Engaging with the auditor at the planning stage also has the practical benefit of achieving consensus among the parties before any real work begins. This consensus diminishes the possibility that the attorney will have to perform additional, unplanned procedures later in the investigation.
Executing Planned Procedures
Virtually every investigation will involve document review and witness interviews. To be comfortable with counsel’s document review, the auditor must understand the completeness of the data reviewed and the effectiveness of the review procedures performed. Counsel should be prepared to discuss the technical details of the review with the auditor; auditors frequently test the rates at which search terms generate “hits.” Auditors also occasionally sample documents deemed to be nonresponsive to test the thoroughness of the review. Accordingly, counsel should anticipate these procedures by installing robust quality control over the document review both in order to improve the accuracy of the review and to add to its defensibility when dealing with the auditors.
Counsel should also bear the auditor’s obligations in mind when planning witness interviews. Specifically, counsel should consider the auditor’s need to assess the continued reliability of management assertions when determining which witnesses to interview and what questions to ask during an interview. After the interviews occur, auditors routinely request summaries of key interviews (not including counsel’s mental impressions or other privileged aspects of the interviews) and inquire about the questions asked and responses provided. Depending upon the nature of the investigation, counsel might consider whether to consult with the auditor prior to a witness interview to review whether the auditor (or more likely the auditor’s national office or office of the general counsel) is looking for responses to specific questions. Doing so may avoid duplicative work, such as reinterviewing witnesses to cover additional topics.
Communicating Results
The conclusion of the investigation presents the greatest risk to counsel in terms of waiver of privilege. Auditors frequently request complete access to written reports prepared by counsel, but regularly will accept less than the complete report presented to the client. As a result, counsel should take care in drafting the report (if one is drafted at all), particularly with respect to whether to state conclusions or recommendations in the text of any report, and should consider alternative methods to communicate the substance of the report, including through tailored presentations. Regardless of how the facts learned through the investigation are presented, counsel should expect to engage with the auditor with follow-up to that presentation. Here, in particular, the scope of the auditor’s review is critical. Although the auditor’s curiosity may, at times, seem limitless, the scope of information it actually needs to satisfy its obligations is narrow. This, therefore, is an area where the company readily can explore what information the auditor truly needs to satisfy its inquiry.
In sum, the tension between an investigating attorney and auditor can be alleviated through regular, informed communication throughout an investigation. Understanding the legal obligations of the other party is essential to achieve this result. Accordingly, attorneys conducting internal investigations should consider the obligations of the auditor when planning and executing investigation procedures. At the same time, attorneys should remember that the auditor’s obligations are not boundless, and should use their understanding of the limits of the auditor’s obligations to push back on auditor requests where necessary. Attorneys also should ensure that the auditor understands and considers counsel’s obligation to preserve privilege when requesting information or communications from counsel. Although the interests of auditors and attorneys in an internal investigation may never perfectly align, informed communication can help point them in a similar direction.
At the ABA Business Law Section Council Meeting held in West Palm Beach, Florida, on January 7, 2017, Justice (Ret.) Henry duPont Ridgely delivered the following remarks.
Good morning,
I am very honored to be asked to speak with you this morning as a Business Law Advisor. Often this becomes a time to recount some of the professional history that the Advisor may have. But in view of my recent interview in the December issue of Business Law Today I am not going to go over that again. What I want to talk to you about is, what I am worried about as a member of our profession, as a Judge in Delaware for more than 30 years and as a member of the Bar for 43 years. I am worried about young lawyers. And I want to talk to you about mentoring and the critical importance to our profession of our service as mentors.
It is our shared responsibility as senior members of the Bar to provide and improve guidance to young lawyers and law students as their mentors. Over my career, I have come to recognize that there are limits to what law schools can do. There just isn’t the time to do what a mentor traditionally does. I am worried about young lawyers who can be adrift in a large law firm, or even worse, young lawyers who cannot find jobs and who open a practice on their own without professional guidance.
Since my own admission to the Delaware Bar in 1974, I have seen many Delaware lawyers serve as mentors. We have institutionalized that role in Delaware. Every applicant for Bar Admission must have a preceptor and complete five months of clerkship requirements under the preceptor’s direct supervision and guidance. It’s a long list of things you have to do that essentially is an introduction to the practice of law under the oversight of an experienced Delaware lawyer. You have to have been a lawyer for at least 10 years to be a preceptor. Preceptors set the example of leadership, public service, and professionalism for the new lawyer. The best preceptors convey as mentors that the practice of law is a higher calling. They explain that professionalism means more than mere competence in legal skills and civility. We’ve heard before, and it’s worth saying again, Roscoe Pound’s classic definition of a profession:
The term profession refers to a group . . . pursing a learned art as a common calling in the spirit of public service—no less a public service—because it may incidentally be a means of livelihood. Pursuit of the learned art in the spirit of public service is the primary purpose.
U.S. Supreme Court Justice Robert H. Jackson provided a timeless description of the professional lawyer. That is a person
[who] loves [the] profession, [who] has a real sense of dedication to the administration of justice, [who] holds his [or her] head high as a lawyer, [who] renders and exacts courtesy, honor and straight forwardness at the Bar. [This lawyer] respects the judicial office deeply, demands the highest standards of competence and disinterestedness and dignity, despises all political use of or trifling with judicial power, and has an affectionate regard for every [person] who fills [the] exacting description of a just judge. The law [to this lawyer] is like a religion, and its practice is more than a means of support; it is a mission. [This lawyer] is not always popular in [the] community, but is respected. Unpopular minorities and individuals often found in [this lawyer] their only mediator and advocate. [This lawyer] is too independent to court the populace— [this lawyer] thinks of himself [or herself] as a leader and a lawgiver, not as a mouthpiece.
I recognize that our common calling to lead and to promote justice and public good has inspired members of the American Bar Association to give back by being involved in their communities, by working to improve the profession, and by volunteering for pro bono representation. We must teach young lawyers this responsibility as well. The need for pro bono service has never been greater than it is today.
I ask each of you to counsel young lawyers about their responsibilities. Discuss public service with your mentees. Explain to them, like my father explained to me, that professionalism is expected and that civility can actually help you win for your client. Give them examples of why the golden rule of lawyering—treat others as you would want to be treated—can benefit them and their clients. Explain to them the importance of their integrity and reputation and that word travels fast through the lawyer and judicial grapevine. And explain to them the personal rewards of pro bono service by helping others in need, that pro bono service will sharpen their legal skills and provide them experience they may not otherwise find. Tell them it will enhance the firm’s reputation and visibility with the courts, and draw attention of current and prospective paying clients to your firm’s commitment to the community.
This is not rocket science. Instead it is a matter of commitment and finding the time to do it. There are even books on it. Guidance to your mentees on how to practice law as a higher calling may be found in Judge Carl Horn’s excellent book called Lawyer Life Finding a Life and a Higher Calling in the Practice of Law (2003). Judge Horn provides practical advice in today’s context where economic and competitive pressures are strong. In summing up the message of his book on finding a life and a higher calling in the practice of law today he writes:
First, that law can and should be understood and practiced as something higher and nobler than just a way to make a good living—although it is certainly that, too, and there is undeniably (and properly) a business side to the practice of law. Second, that we should reconnect with the tradition Elihu Root and others represented: the counselor at law. About half the practice of a decent lawyer, Root once observed, consists in telling would be clients they are damned fools and should stop. True then, true now. Third, that as officers of the Court, lawyers should embrace ethics, principles, and values far exceeding the de minimis requirements of the various Codes of Professional Responsibility. Fourth, that lawyers should look for creative ways to make peace between potential disputants and provide more proactive counsel, regarding litigation as a last resort. And fifth, that the legal profession, from law school through retirement, should embrace balance and wholeness for the professional life of every lawyer.
This is advice consistent with the lessons taught to me by my own mentors. If our mentees follow this advice, they will find a life and a higher calling in the practice of law that will be both satisfying and make our communities even better places to live.
So I ask you, what will you do to be a better mentor? The future of our profession depends on our collective answers and commitment to teach young lawyers how to practice law with the integrity, professionalism and civility we expect, how to lead, and how to serve.
Finally, I want to commend our Chair Bill Johnston and this Council for its leadership on Diversity and Inclusion. I have been an eye-witness to the benefits of diversity and inclusion within our Delaware Judiciary. When I joined Superior Court—it was all white males. When the first female judge was appointed my colleagues wondered—some even worried—about how our Court and our collegiality would change. The facts are that with new ideas and new perspectives our Court became progressively stronger as it became more diverse. In 2000, while I was President Judge—our Court was ranked number one among the 50 states by the U.S. Chamber of Commerce. There is no doubt in my mind that the great strength of this Section and the ABA will grow with its diversity and inclusion initiative.
Aetna Inc.’s $37 billion deal to buy rival insurer Humana Inc. was blocked recently by a federal judge, thwarting one of two large mergers that would reshape the U.S. health-care landscape.
Judge John D. Bates of the U.S. District Court for the District of Columbia held January 23 that the Department of Justice can likely prove its case that Aetna and Humana’s merger would harm competition in Medicare Advantage markets in 364 counties in 21 states. Judge Bates also said that the merger will likely harm competition in at least three public exchange markets under the Affordable Care Act (ACA), even though Aetna pulled out of those markets during the merger challenge in a bid to undermine the government’s case.
About two weeks later, on February 8, Judge Amy Berman Jackson also blocked Anthem Inc.’s proposed $48 billion takeover of Cigna Corp., but her opinion explaining the decision is currently sealed. Even without benefit of Judge Jackson’s take on these megamergers, Judge Bates’s reasoning provides several lessons that other merging parties, particularly in health care, should consider.
What Efficiencies?
Efficiencies arguments based on cost weren’t successful in Aetna’s case. The proffered efficiencies are not cognizable under the law, and even if they are, the parties aren’t likely to pass any savings on to consumers, Judge Bates said.
Judge Bates’s opinion fits into a longer chain of decisions that support federal antitrust enforcers’ skeptical view of procompetitive merger efficiencies. The lessons of those decisions—and Judge Bates’s in particular—may resonate with Judge Jackson.
Parties face an uphill battle in proving any efficiencies defense in health-care mergers since the Federal Trade Commission successfully challenged a merger between the Saltzer Medical Group and St. Luke’s Health System, St. Alphonsus Med. Ctr.–Nampa Inc. v. St. Luke’s Health Sys., Ltd., 778 F.3d 775 (9th Cir. 2015).
In St. Alphonsus, the district court ordered St. Luke’s to divest Saltzer because the combined entity could raise prices for insurers. Although the parties argued that the combined entity would significantly improve patient outcomes, the court concluded that the proposed efficiencies were not “merger specific,” because they could be achieved by less restrictive means.
The U.S. Court of Appeals for the Ninth Circuit affirmed the order unraveling the deal, saying it remained “skeptical about the efficiencies defense in general and about its scope in particular.”
Though there have been glimmers of success for efficiencies defenses at the district court level since St. Alphonsus, appellate courts have rejected proffered efficiencies in challenged health-care mergers.
Based on the Ninth Circuit’s precedent, any efficiencies defense faces a high bar. The parties have to “clearly demonstrate” that the challenged deal produces “extraordinary efficiencies” in order to rebut the government’s prima facie case under Clayton Act §7. Particularly, merger efficiencies based on improvements in quality of care, as opposed to cost of services, are difficult to quantify and prove in court.
As more cases pile up rejecting different efficiencies defenses in health-care mergers, the mountain a successful defense must climb grows steeper. If merging parties believe they have substantial efficiencies or consumer benefits from a merger, proving them to the agency during negotiation is key. If the parties fail to convince the agency, convincing a court after a challenge is filed is onerous.
Something’s Gotta Give
The Aetna opinion also may signal that rapid consolidation in health care is reaching a competitive limit.
The relationship between providers and insurers has been described as an “arms race” to improve bargaining position. Regulators have challenged hospital deals by arguing that, when providers gain negotiating leverage, the result will be higher prices for consumers. Regulators alleged confidently that any increase in price will be passed through to consumers by health insurers on the losing side of the bargaining table.
In the Aetna decision, however, the court agreed with the DOJ that the opposite isn’t necessarily true. It is not evident that when insurers win in negotiating with providers, any price reductions they secure will wind up in consumers’ pockets, the court said.
In their approach to health-care mergers, the agencies seem to be signaling that each side of the health-care “arms race” has consolidated enough and neither should be allowed to gain a sizable advantage that way.
The Aetna opinion seems to embrace a view that consumers are not benefiting from this contest. Even if leviathan hospital groups and insurance companies extract better prices from one another, reduced competition on each side of the table means each side has less incentive to pass any savings on to consumers. Regardless of which side wins, consumers lose if both sides do not face robust competition.
Given that consumers are the most visible constituency protected by the antitrust laws, merging parties should expect to provide explicit proof of likely consumer benefit behind arguments about efficiencies based on scale and bargaining power.
Efficiencies arguments based on cost were not successful in Aetna’s case. Parties should watch how the court views the alleged cost advantages of the Anthem/Cigna deal, as well. In that case, the parties argued the merger would reduce costs because they can extract lower prices from providers.
Transparency
Another takeaway from Judge Bates’s decision: strong-arm tactics and gamesmanship are a dangerous route when dealing with the government.
The court found that Aetna threatened to leave ACA exchanges if the government challenged the Humana merger. Aetna then, as a litigation tactic, pulled out of those exchanges the government identified as competitively impacted. Aetna argued that doing so was a business decision, and that the merger wouldn’t reduce competition in those markets because Aetna would no longer compete in those exchanges anyway.
That argument failed. The court agreed with the DOJ that litigation posturing is not business as usual and found that Aetna was likely to return to the most profitable ACA markets when the threat of litigation passed.
Many companies divest assets or leave markets to ease a settlement with the merger authorities—that is standard procedure in contested mergers. Aetna’s tactic was treated differently because Judge Bates found that Aetna tried to hide its motivations for leaving the ACA markets and undermine the government’s case against the merger, rather than making actual business decisions or divesting in good faith.
If a company is large enough to threaten damage to specific markets, merger authorities are less likely to approve a merger that enhances that company’s market power. Throwing weight around is not ultimately a good strategy for merger review.
Layers of Review
There is substantial uncertainty about the priorities for a Trump administration in antitrust enforcement. But the Aetna case highlights another consideration for lawyers involved in health care mergers regardless of what happens at the top of the agencies for the next few years.
Eight states and the District of Columbia joined the court challenge to the Aetna-Humana merger; 11 states and the District of Columbia sued with the federal government to halt the Anthem-Cigna deal. Health-care entities, highly regulated at both the state and federal level, are accustomed to balancing their regulatory approach to take both into account. It is important to remember that the complementary regulatory role of federal and state authorities extends to merger review.
Every state in which a company operates might be concerned about consumer and competitive impacts of a proposed merger. States also work together through the National Association of Attorneys General (NAAG) to investigate and challenge anticompetitive conduct. Even with federal approval, merging parties might have to accommodate state concerns or battle resistance to their tie-up in court.
Furthermore, although Republican administrations are generally viewed as more “business friendly” and less likely to block mergers that fall on the margin of anticompetitive impact, the staff who evaluate mergers within the DOJ and FTC stays from administration to administration. Expect a level of continuity in how mergers are reviewed and what actions are recommended to any new personnel at the top of the agencies.
What’s Next?
Judge Bates’s opinion is well-reasoned and relies on copious record citations. His result rests on two independent grounds in two separate markets. It therefore has the markings of an opinion that will hold up on appeal. Aetna has said it is still weighing its options on whether to seek review in the D.C. Circuit.
The bottom line: according to data from Bloomberg Law Litigation Analytics, both judges are upheld on appeal more than 70 percent of the time, though neither has had many antitrust cases go to trial.
Constructive receipt is a fundamental tax concept that can have a broad and frightening impact. According to the IRS, you have income for tax purposes when you have an unqualified, vested right to receive it. Asking for payment later does not change that. Childs v. Comm’r, 103 T.C. 634, 654 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996). The idea is to prevent taxpayers from deliberately manipulating their income. The classic example is a bonus check available in December that an employee asks to be withheld until January 1. Normal cash accounting suggests that the bonus is not income until paid; however, the employer tried to pay the bonus in December and made the check available, making it income in December even though it is not collected until January.
Cash v. Accrual Accounting
Constructive receipt is an issue only for cash method taxpayers like individuals. Constructive receipt is built into the accrual method (used by most large corporations), under which you have income when all events occur that fix your right, if the amount can be determined with reasonable accuracy. Treas. Reg. §§ 1.446-1(c)(1)(ii), 1.451-1(a). Thus, you book income in accrual accounting when you send out an invoice, not when you collect it. Rev. Rul. 84-31, 1984-1 C.B. 127. For cash method taxpayers, however, the IRS worries about “pay me later” shenanigans. The tax regulations provide that a taxpayer has constructive receipt when income is credited to the taxpayer’s account, set apart, or otherwise made available to be drawn upon. See Treas. Reg. § 1.451-2.
Effect of Restrictions
On the other hand, there is no constructive receipt if your control is subject to substantial limitations or restrictions. There is considerable debate over what substantial limitations or restrictions prevent constructive receipt. For example, what if an employer cuts a check on December 31 but tells its employee to either drive 60 miles to pick it up or wait for its arrival in the mail? The employer may book this as a December payment (and issue a Form W-2 or 1099 that way), but the employee may have a legitimate position that it is not income until received. Such mismatches occur frequently, and there is little to suggest that there is manipulation going on.
Legal Rights
Whether they know it or not, lawyers deal with constructive receipt issues frequently. Suppose a client agrees orally to settle a case in December, but specifies that the settlement be paid in January. When is the amount taxable? In January. The mere fact that the client could have agreed to take the settlement in Year 1 does not mean the client has constructive receipt.
The client holds legal rights and is free to condition his or her agreement (and the execution of a settlement agreement) on the payment in Year 2. The key is what the settlement provided before it was signed. If you sign the settlement agreement and condition the settlement on payment next year, there is no constructive receipt. On the other hand, if you sign first and then ask for a delayed payment, you have constructive receipt. In much the same way, you are free to sell your house and to insist on receiving installment payments, even though the buyer is willing to pay cash. However, if your purchase agreement specifies you are to receive cash, then it is too late to change the deal and say you want payments over time. The legal rights in the documents are important.
Lawyer Trust Accounts
If a case settles and funds are paid to the plaintiff’s lawyer trust account, it usually is too late to structure the plaintiff’s payments. Even though the plaintiff may not have actually received the money, the lawyer has. For tax purposes, a lawyer is the agent of his or her client, so there is constructive (if not actual) receipt.
Consider the impact of disputes between lawyer and client. Suppose that Larry Lawyer and Claudia Client have a contingent-fee agreement calling for Larry to represent Claudia in a contract dispute. If Larry succeeds and collects, the fee agreement provides that Claudia receives two-thirds, and Larry retains one-third as his fee. Before effecting the one-third/two-thirds split, however, costs are to be deducted from the gross recovery.
Suppose that Larry and Claudia succeed in recovering $1 million in September of 2016. Before receiving that money, however, Larry and Claudia become embroiled in a dispute over the costs ($50,000) and the appropriate fee. Larry and Claudia agree that $25,000 in costs should first be deducted, but Claudia claims that the other $25,000 in costs is unreasonable and should be borne solely by Larry. Furthermore, Claudia asserts that a one-third fee is unreasonable, and that the most she is willing to pay is 20 percent. Larry and Claudia try to resolve their differences but cannot do so by the end of 2016. In January 2017, the $1 million remains in Larry’s law firm trust account. What income must Larry and Claudia report in 2016?
Undisputed Amounts
Arguably, there is a great deal that is not disputed. Larry and Claudia have agreed that $25,000 in costs can be recouped and that Larry is entitled to at least a 20-percent fee, although it is not yet clear if that 20-percent fee should be computed on $950,000 or on $975,000. Nevertheless, Larry is entitled to at least $25,000 in costs and to at least a $190,000 fee, for a total income of $215,000. Although it is not yet clear how much Claudia will net from the case, the minimum she will get is specified in the provisions in the fee agreement. Thus, taking the $50,000 as costs, Claudia should receive two-thirds of $950,000, or $633,270. Even under Larry’s reading of the fee agreement, this is the amount to which Claudia is entitled, although she might receive more if her arguments prevail.
How much should Larry and Claudia report as income? You might think that you do not have enough information to make that decision, and you would probably be right. After all, you do not really know whether Larry and Claudia have agreed that partial distributions can be made, or if they are taking the position that they will not agree to anything unless the entire matter is resolved. However, that does not appear to be so. Indeed, the positions of the parties seem clear that each is already entitled to some money. That gives rise to income, regardless of whether they actually receive the cash. If they have a legal right to the money and could withdraw it, then that is constructive receipt, if not actual receipt.
Any talk of withdrawal should invite discussion of restrictions and partial agreements. For example, what if you add to the fact pattern that, although these are the negotiating positions of Larry and Claudia, neither of them will agree to any distributions, treating the entire amount as disputed. Does that mean neither has any income in 2016? Does it matter what documents are prepared? The answer to the latter question is surely “yes.” Good documentation always goes a long way to helping to achieve tax goals.
For example, an escrow agreement acknowledging that all of the money is in dispute and prohibiting any withdrawal until the parties agree might contraindicate income. A document each party signs agreeing that they disagree and that no party can withdraw any amount until they both agree in writing should be pretty convincing. Even so, I am not sure it is dispositive to the IRS. It may be hard to argue with the fact that the parties’ positions speak for themselves, and that some portions of the funds are undisputed. Besides, there is a strong sentiment that a lawyer is merely the client’s agent. Presumptively, settlement monies in the hands of the lawyer are already received by the client for tax purposes.
Consider the defendant in this example. The defendant paid the $1 million in 2016. Depending on the nature of the payment, it seems reasonable to assume that the defendant will deduct it in 2016. It will likely issue one or more IRS Forms 1099, too, probably to both Larry and Claudia in the full amount of $1 million each. How will Larry and Claudia treat those Forms 1099? There may be a variety of possibilities. Assuming both Larry and Claudia argue the entire amount is in dispute, one approach is to footnote Form 1040, line 21 (the “other income” line), showing the $1 million payment. Then, they might subtract the $1 million payment as disputed and in escrow and therefore not income, netting zero on line 21. There is probably no perfect way to do this.
Escrows and Qualified Settlement Funds
Apart from mere escrows, qualified settlement funds (sometimes called QSFs or a 468B trusts) are also increasingly common. A QSF typically is established by a court order and remains subject to the court’s continuing jurisdiction. Treas. Reg. § 1.468B-1(c)(1). If the fund is a QSF, the defendant would be entitled to its tax deduction, yet neither Larry nor Claudia would be taxed on the fund’s earnings. The fund itself would be taxed, but only on the earnings on the $1 million, not the $1 million itself.
In our example, there is no court supervision, so it seems unlikely that the escrow could be a QSF. If the fund is merely an escrow, either Larry or Claudia should be taxed on the earnings in the fund, but not on the principal until the dispute is resolved and the disputed amount is distributed. Unlike a QSF, escrow accounts typically are not separately taxable, so one of the parties must be taxed on the earnings. See Treas. Reg. §§ 1.468B-6, 1.468B-7.
Normally, the escrow’s earnings would be taxable to the beneficial owner of the funds held in escrow. Rev. Rul. 77-85, 1977-1 C.B. 12 (IRB 1977), modified on other grounds, IRS Announcement 77-102 (1977). Either Larry or Claudia (or both) could be viewed as beneficial owners. Therefore, an agreement specifying who will be taxed on the disputed funds while held in escrow would be wise.
Structured Settlements and Structured Legal Fees
Some clients prefer structured settlements that pay them (through the use of annuities) over time rather than in a lump sum. In a similar way, contingent-fee lawyers who expect to receive a contingent fee are allowed to “structure” their fees over time, but if they receive the funds in their trust account, it is too late to structure. In fact, it is too late to structure fees if the settlement agreement is signed and the fees are payable. A lawyer who wants to structure legal fees must put the documents in place before the settlement agreement is signed. Just as in the case of the plaintiff, legal rights are at stake. In general, a contingent-fee lawyer is entitled to condition his or her agreement on a payment over time.
In reality, of course, it is the client of the plaintiff’s lawyer that has the legal rights and is signing the settlement agreement. That is why a lawyer who wants to structure fees must build that concept into the settlement agreement. Like structured settlements for plaintiffs, legal fee structures usually are not installment payments by the defendant. Rather, the settlement agreement will specify the stream of payments and call for the contingent fee to be paid to a third party that makes those arrangements. As you might expect, it is important for each element of the legal fee structure to be done carefully to avoid the lawyer being taxed before he or she receives installments, but the entire concept of structured legal fees must be mindful of the constructive receipt doctrine.
Understandably, cash method taxpayers do not want to be taxed on monies before they actually receive them; however, the constructive receipt doctrine can upset this expectation. Constructive receipt often can be avoided through careful planning and proper documentation.
More About Qualified Settlement Funds
The rules pertaining to constructive receipt seem to be thrown out the window when using this important and innovative settlement device. A QSF typically is set up as a case is resolved. The IRS provides that a fund is a “qualified settlement fund” if it satisfies each of the following:
It is established pursuant to an order of, or is approved by, specified governmental entities (including courts) and is subject to the continuing jurisdiction of that entity;
It is established to resolve or satisfy one or more claims that have resulted or may result from an event that has occurred and that has given rise to at least one claim asserting certain liabilities; and
The fund, account, or trust must be a trust under applicable state law, or its assets must otherwise be segregated from other assets of the transferor. Treas. Reg. § 1.468B-1(c).
Section 468B trusts allow defendants to pay money into the trust and be entirely released from liability in a case, yet the plaintiffs and their counsel do not have income until the money comes out. The 468B trust is a kind of holding pattern where no one is (yet) taxed on the principal or corpus of the trust. Even so, the defendant can deduct the payment for tax purposes. Any interest earned on the monies in the QSF is taxed to the trust itself. There are many nuances to observe about the use of QSFs.
However, QSFs can be a kind of safety valve from the constructive receipt doctrine. In appropriate cases, QSFs can provide lawyers and clients with additional time to sort out who is entitled to what, to resolve liens, and to arrange for structured settlements and structured legal fees. A QSF allows plaintiffs and their lawyers to resolve such issues after the defendant(s) have paid the settlement or judgment but before the plaintiffs and their lawyers have receipt.
Conclusion
Constructive receipt is a fundamental, yet widely confused, tax doctrine. It applies when you have an unrestricted right to income but you do not accept it. Consequently, lawyers and their clients may encounter constructive receipt concerns if they sign legal releases or are otherwise entitled to payments that they then try to delay. Be careful. A good rule of thumb is not to sign a settlement agreement unless: (1) you are clear on what the timing of the payments will be; and (2) this timing is acceptable to you. Once you (or your client) signs and is entitled to payment, it may be too late to change it. In some litigation, one way to build in payment flexibility can be by using a QSF that holds the funds. A QSF can be especially appropriate in complex cases with multiple parties involving disputes over payment amounts and timing. However you address these issues, no one wants to be taxed on money they have not even received!
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