This article is Part I in the Many Splendors of Fraud Claims series by Glenn D. West.

I know that many believe that all that could be written about avoiding fraud claims in private company M&A has been written. However, ABRY Partners V, L.P. v. F & W Acquisition LLC^[1] continues to give birth to additional progeny (in the form of new, recent cases) that require attention and possible modification of drafting practices in response. In a series of articles over the next few weeks, I will address some of these recent additions to the ABRY Partners lineage. We will begin with Labyrinth, Inc. v. Urich.^[2]

Background of the Labyrinth Case

Labyrinth involved a stock purchase agreement (“SPA”) that contained the following relevant provisions:

SPA Section 9.3:

The agreement of the parties that is comprised of this Agreement sets forth the entire agreement and understanding among the parties with respect to the subject matter hereof and supersedes any and all prior agreements, understandings, negotiations and communications, whether oral or written, relating to the subject matter of this Agreement. In the event of any inconsistency between the statements in the body of this Agreement and those in the Ancillary Documents, any Exhibit and the Disclosure Schedules (other than an exception expressly set forth in the Disclosure Schedules), the statements in the body of this Agreement will control.^[3]

SPA Section 4.28:

Except for the representations and warranties contained in Section 3 and this Section 4 (including the related portions of the Disclosure Schedules), none of Seller, the Company or any other Person has made or makes any other express or implied representation or warranty, either written or oral, on behalf of Seller or the Company, including any representation or warranty as to the accuracy or completeness of any information regarding the Company furnished or made available to Buyer and its Representatives[,] or any information, documents or material made available to Buyer in expectation of the transactions contemplated hereby[,] or as to the future revenue, profitability or success of the Company, or any representation or warranty arising from statute or otherwise in law.^[4]

SPA Section 5.27:

Buyer has conducted its own independent investigation, review and analysis of the business, results of operations, prospects, condition (financial or otherwise) or assets of the Company, and acknowledges that it has been provided adequate access to the personnel, properties, assets, premises, books and records, and other documents and data of Seller and the Company for such purpose. Buyer acknowledges and agrees that in making its decision to enter into this Agreement and to consummate the transactions contemplated hereby, none of Seller, the Company or any other Person has made any representation or warranty as to Seller, the Company or this Agreement, except as expressly set forth in Sections 3 and 4 of this Agreement (including the related portions of the Disclosure Schedules).^[5]

Sections 3 and 4 of the SPA apparently contained the representations of the company and the seller, respectively, and section 5 apparently contained representations of the buyer.

Following the closing of the transaction in Labyrinth, the buyer sued the seller for both intra-contractual fraud (i.e., fraud in the representations and warranties set forth in the SPA) and extra-contractual fraud (i.e., fraud allegedly committed outside the specific representations and warranties made in the SPA). The extra-contractual fraud allegations were largely based upon oral assurances allegedly made by the seller that the “key financial performance metrics—fourth quarter collections, profits, and accounts receivable—were all unaffected by Seller’s collection practice disclosures.”^[6]

Understanding the Court’s Ruling: A Multiple-Choice Quiz

Which of the following statements are likely true about the action of the Delaware Court of Chancery in ruling on the seller’s motion to dismiss the extra-contractual fraud counts?

1. The court was unpersuaded that section 9.3 was relevant to the motion to dismiss the extra-contractual fraud claims because it was a mere “integration clause” that “does not operate as a bar to fraud claims, but rather simply . . . limit[s] the scope of the parties’ contractual obligations to those set forth in the written agreement.”^[7]
2. The court was unpersuaded that section 4.28 had any effect to disclaim the buyer’s reliance on extra-contractual statements of the seller because section 4.28 was a statement by the seller “of what [the seller] was and was not representing and warranting”; it was not a statement by the buyer of what the buyer was relying upon.^[8]
3. The court was unpersuaded that section 5.27 was effective as a no-reliance clause because the first sentence of section 5.27 “details all the information that formed Buyer’s own independent analysis of the company, including the extracontractual information Seller provided,”^[9] and the second sentence “does not disclaim reliance on any extracontractual information.”^[10]
4. The court dismissed the extra-contractual fraud claims because no “magic words” are required in Delaware to disclaim reliance upon extra-contractual representations,^[11] and sections 4.28 and 5.27 taken together demonstrate “‘that the Buyer only relied on the representations and warranties in the SPA,’ thereby ‘establish[ing] the universe of information on which that party relied,’ and, together with an integration clause [SPA section 9.3], ‘add[ed] up to a clear anti-reliance clause.’”^[12]

Take a moment to test yourself before reading further.

* * *

“A” is clearly correct. Courts across the country say this all the time. Section 9.3 did not even have any anti-reliance language respecting purported extra-contractual representations; it simply excluded oral agreements from constituting part of the parties’ contract.

“B” is also correct. The old practice (which is still followed by some) of having the seller’s representations include a concluding representation (by the seller) that the seller has not made any representations other than those set forth in the agreement simply does not work. It is technically not a statement of no reliance but instead a statement that no extra-contractual representations were made (i.e., it is a “no-representations” clause rather than a “no-reliance” clause). And even if a statement that “no representations” outside the agreement were made by the seller is deemed sufficient as an effective disclaimer of reliance in Delaware, Delaware has long been insistent that the buyer must make that statement. Here, the seller (section 4), not the buyer, made the statement.^[13]

The better practice, of course, is to make sure that the statement both is a statement of no reliance and is made by the buyer. Indeed, an effective anti-reliance clause requires not only correct language but also correct placement in the agreement. I have even likened the creation of an effective disclaimer of extra-contractual representations to the effective means of “neutralizing” a flesh-eating zombie—it requires a specialized weapon to administer a blow to a precise spot.^[14]

“C” is a little tougher. In Texas (and perhaps other states), section 5.27 would clearly not work because there is no express use of the word rely or reliance. Moreover, simply stating (even from the buyer’s perspective) that no representations have been made is ineffective to defeat extra-contractual fraud in Texas.^[15] Instead, what is required in Texas is a clear statement that the buyer did not rely upon any statements that may have been made (even though the parties agreed that no statements were made). According to the Texas Supreme Court, “[t]here is a significant difference between a party disclaiming its reliance on certain representations, and therefore potentially relinquishing the right to pursue any claim for which reliance is an element, and disclaiming the fact that no other representations were made.”^[16] The former (disclaiming reliance) works, but the latter (disclaiming a fact) does not.

However, in Prairie Capital III, L.P. v. Double E Holding Corp.,^[17] the Delaware Court of Chancery rejected this strict approach requiring specific language disclaiming “reliance.” Instead, the Delaware Court of Chancery declared that “Delaware law does not require magic words.”^[18] Rather, “[l]anguage is sufficiently powerful to reach the same end by multiple means, and drafters can use any of them to identify with sufficient clarity the universe of information on which the contracting parties relied.”^[19] While I never was completely sure of what constituted that other “sufficiently powerful” language,^[20] one might be tempted to view the second sentence of section 5.27 (which is a statement coming from the buyer proclaiming that there are no other representations other than those made by the seller and the company in the agreement) as sufficient, under Delaware law, to define the universe of information upon which the buyer was relying despite the failure to use the words disclaim reliance or did not rely.

But in Labyrinth, Vice Chancellor Zurn stated that the first sentence of section 5.27 “can be read to reflect that Buyer was expressly representing it did rely on extra-contractual information” by stating that the buyer “conducted its own independent investigation” from information that was provided by the seller.^[21] In other words, the first sentence suggests that “Buyer formed a judgment or opinion of ‘the business, results of operations, prospects, condition (financial or otherwise), or assets of the Company’ from what Seller provided, namely ‘the personnel, properties, assets, premises, books and records, and other documents and data of Seller and the Company for such purpose.’”^[22] But then, according to Vice Chancellor Zurn, the second sentence merely “identifies Seller’s representations[;] . . . it [does not] preclude[] Buyer’s reasonable reliance on representations that are not identified.”^[23] Stated differently, in the second sentence, “Buyer did not affirmatively acknowledge any disclaimer by Seller, or otherwise specifically establish the universe of information on which Buyer did or did not rely.”^[24]

The safer course is always to think of Delaware as effectively Texas, and to have the Buyer always expressly disclaim reliance on any extra-contractual statements.^[25]

Now, as to “D.” Vice Chancellor Zurn refused to find that the combination of three ineffective clauses (what Vice Chancellor Zurn called “a standard integration clause [9.3], an independent investigation clause [5.27], and a representation and warranty clause [4.28]”)^[26] somehow collectively constituted an effective disclaimer of reliance. As I long ago warned, while Delaware may claim that there no “magic words” required to effectively create an exclusive universe of contract-based representations and warranties upon which any fraud claim must be premised and thereby eliminate the “dog’s breakfast”^[27] of extra-contractual claims, you should assume there actually are required magic words—and use them.

So, the correct answers are A, B, and C.

The Playbook for Disclaiming Extra-Contractual Fraud Claims

To defeat extra-contractual fraud claims, (a) actual disclaimers of reliance should be used, not simple “no representations” statements; (b) disclaimers of reliance should be properly placed in the acquisition agreement so that they are coming from the point of view of the buyer;^[28] and (c) the disclaimer of reliance should be “robust” (i.e., disclaim reliance on an exhaustive list of things that might be provided or discussed in the lead-up to the execution of the agreement).^[29] And, based on Labyrinth, including an independent investigation provision does not necessarily add anything and may in fact do more harm than good, particularly when it suggests that there was a lot of information provided by the seller upon which the buyer relied.

ABRY Partners and its extensive progeny have provided a “playbook” for effectively disclaiming extra-contractual fraud claims in Delaware. While Prairie Capital may have suggested there were some easy outs from actually reading and applying that playbook strictly, do not fall into that trap. You are expected to have fully read the playbook and found the $100 taped to the last page.^[30]

1. 891 A.2d 1032 (Del. Ch. 2006). ↑

2. 2024 WL 295996 (Del. Ch. 2024). ↑

3. Id. at n.188. ↑

4. Id. at n.190. ↑

5. Id. at *16. ↑

6. Id. at *12 (quoting Complaint at ¶ 80, Metro Commc’n Corp. BVI v. Advanced Mobilecomm Techs. Inc., 854 A.2d 121 (Del Ch. 2024)). ↑

7. Id. (quoting Kronenberg v. Katz, 872 A.2d 586, 592 (Del. Ch. 2004)). ↑

8. Id. (quoting FdG Logistics LLC v. A&R Logistics Holdings, 131 A.3d 842, 860 (Del. Ch. 2016)). ↑

9. Id. at *17. ↑

10. Id. at *18. ↑

11. Prairie Cap. III, L.P. v. Double E Holding Corp., 132 A.3d 35, 51 (Del. Ch. 2015) (see infra note 18 and accompanying text). ↑

12. Labyrinth, 2024 WL 295996, at *18 (quoting Prairie Cap., 132 A.3d at 51). ↑

13. See FdG Logistics, 131 A.3d at 860. ↑

14. Glenn D. West, The Surprising Connection Between an Extra-Contractual Fraud Claim and a Flesh-Eating Zombie, Weil’s Glob. Priv. Equity Watch (Mar. 3, 2016). ↑

15. Italian Cowboy Partners, Ltd. v. Prudential Ins. Co. of Am., 341 S.W.3d 323 (Tex. 2011). ↑

16. Id. at 335 (emphasis in original). ↑

17. 132 A.3d 35. ↑

18. Id. at 51. ↑

19. Id. ↑

20. In Prairie Capital, while not expressly disclaiming reliance on extra-contractual representations, the buyer did state that the buyer “agrees that all [extra-contractual representations] are specifically disclaimed by the [seller].” Id. at 50. This language was obviously not present in section 5.27. In addition, Prairie Capital did not contain the unfortunate first sentence of section 5.27; instead, it simply said that “[t]he Buyer acknowledges that it has conducted to its satisfaction an independent investigation of the financial condition, operations, assets, liabilities and properties of the [seller].” Id. ↑

21. Labyrinth, Inc. v. Urich, 2024 WL 295996, at *17 (Del. Ch. 2024) (quoting Anschutz Corp. v. Brown Robin Cap., 2020 WL 3096744, at *14 (Del. Ch. 2020)) (emphasis in original). ↑

22. Id. (quoting SPA section 5.27). ↑

23. Id. at *18. ↑

24. Id. ↑

25. See Glenn D. West, Avoiding the Other F-Word: An Anti-Reliance Clause Should Actually Disclaim Reliance on Extra-Contractual Representations Even When the Parties Agree that None Were Made, Weil’s Glob. Priv. Equity Watch (Mar. 25, 2019). An example of an “anti-reliance” provision is available in Glenn D. West, Reps and Warranties Redux—A New English Case, An Old Debate Regarding a Distinction with or Without a Difference, Weil’s Glob. Priv. Equity Watch (Aug. 2, 2016). ↑

26. Labyrinth, 2024 WL 295996, at *18. ↑

27. See Glenn D. West, Avoiding a Dog’s Breakfast—Some Timely Reminders of How to Effectively Limit the Universe of Purported Representations upon Which Fraud Claims Can Be Made, Weil’s Glob. Priv. Equity Watch (Aug. 13, 2018). ↑

28. Of course, sellers should insist that the anti-reliance clauses be reciprocal (i.e., sellers should also disclaim reliance upon any extra-contractual representations purportedly made by the buyer), particularly in cases involving earnouts. ↑

29. See West, supra note 27. ↑

30. See Draft Day (Summit Entertainment & Oddlot Entertainment 2014) (Ralph Mowry speaking to Sonny Weaver about Bo Callahan and how Washington checks if their potential players have read the entire playbook). ↑

Artificial intelligence (“AI”) can be defined in several ways. The Oxford English Dictionary definition refers to “software used to perform tasks or produce output previously thought to require human intelligence, esp. by using machine learning to extrapolate from large collections of data.” One broad definition, courtesy of IBM—comprehensive enough to include things as diverse as facial recognition software, smart cars, GPS, legal research tools, and chess programs—is “technology that enables computers and machines to simulate human intelligence and problem-solving capabilities.” From the same source comes a definition of generative AI (“GAI”): “deep-learning models” that compile data “to generate statistically probable outputs when prompted.”^[1]

Amidst the continuous flurry of media coverage, publicity generated by tech companies, notoriety based on so-called “hallucinations,” and sundry other extravagances, practicing lawyers must surely, by now, be aware that use by the legal profession of GAI is evolving rapidly and, as with much other technological innovation in the professions, fraught with peril. Bar regulators in several states—including (in alphabetical order) California, Florida, New Jersey, New York, and Pennsylvania—along with the patent bar have variously issued ethics opinions or guidance on the ethical use of GAI. Webinars, both public and private, proliferate, along with comprehensive courses to educate not only lawyers but the judiciary as well. As recently as August 2024, the ABA Task Force on Law and Artificial Intelligence, created in 2023, issued its first report.

Likewise, the ABA Standing Committee on Ethics & Professional Responsibility has recently (July 29, 2024) weighed in with Formal Opinion 512, Generative Artificial Intelligence Tools (“Formal Op. 512”). This opinion highlights many of the same ethical rules as the other guidance, opinions, and reports, but identifies ethical requirements in a slightly different manner. Even though the approach of Formal Op. 512 is not binding on lawyers, it does offer a useful compilation of ethics guidance keyed to the Model Rules of Professional Conduct.

To be sure, GAI can significantly enhance efficiency in law practice because of the ability of this powerful tool to accomplish in a short timeframe a variety of tasks (e.g., legal research, document review, analysis of contracts and other legal documents) that used to be significantly more time-consuming. This, in turn, can benefit clients by reducing the often astronomical costs of legal services and possibly enhance access to justice by underserved populations.

Yet there are also significant pitfalls. Foremost among these are so-called “hallucinations”—a euphemism for nonexistent or false products of research, exemplified by notorious cases such as Mata v. Avianca, United States v. Michael Cohen, and the even more recent Second Circuit decision in Park v. Kim. Other common ethics hazards include potential breaches of client confidentiality and data privacy and succumbing to having one’s independent professional judgment swayed, if not entirely overborne, by the siren song of GAI work product.

Formal Op. 512 organizes the pertinent legal ethics implications of lawyers using GAI quite well. Here is a synopsis of the topics addressed:

• Competence (Model Rule 1.1): Lawyers must understand the capacity and limitations of GAI and periodically update that understanding.
• Communication (Model Rule 1.4): Formal Op. 512 offers guidance on when, and to what extent, lawyers are required to communicate their use of GAI to clients.
• Fees (Model Rule 1.5): Lawyers may not charge clients for time spent learning a technology to be used for client matters generally, unless a client specifically requests the use of a particular AI tool in a matter, in which case a lawyer may charge for learning how to use that particular tool. A lawyer may consider the cost of GAI to be part of office overhead, or may charge for a portion of an expensive and proprietary GAI tool, or on a per-use basis if appropriate, provided everything is fully explained to the client in advance and informed consent is obtained.
• Confidentiality (Model Rule 1.6): Lawyers are responsible for knowing how GAI uses data and putting in place adequate safeguards to ensure that data processed by GAI is secure and not susceptible to unwitting or unauthorized disclosure to third parties. Formal Op. 512 recommends that lawyers secure clients’ informed consent before using client confidences in GAI tools and opines that boilerplate consent included in engagement letters will not be adequate. The opinion also cautions that use by several lawyers of the same GAI tool may result in inadvertent use and disclosure of client information.
• Meritorious Claims and Contentions (Model Rule 3.1): Lawyers must be on their guard to prevent GAI “hallucinations” from forming the basis of asserting frivolous claims and arguments.
• Candor Toward the Tribunal (Model Rule 3.3 and Model Rule 8.4(c)): Overreliance on or uncritical adoption of GAI can result in making false statements of fact or law to a “tribunal” (which is broadly defined to include not only courts but others acting in an adjudicative capacity, potentially including arbitrators, administrative agencies, and legislative bodies). Duties to the tribunal require lawyers, before submitting materials, to review GAI output, including analysis and citations to authority, and to correct errors, including misstatements of law and fact, any failure to include controlling legal authority, and any misleading arguments.
• Responsibilities of Supervisory Lawyers (Model Rule 5.1): Partners and other lawyers with managerial duties must establish clear policies regarding the permissible use of GAI and supervise lawyer staff to ensure compliance with these policies. In this connection, Formal Op. 512 analogizes to principles in various state ethics opinions relating to cloud computing and outsourcing.^[2]
• Supervising Nonlawyers (Model Rule 5.3): Partners and other lawyers with supervisory responsibilities must make sure that nonlawyers (including those in a law firm as well as third-party contractors or other providers outside the law firm) are adequately trained in the ethical and practical uses of GAI.

Not discussed by Formal Op. 512 but worthy of consideration is another point:

• Bias and Prejudice in Law Practice and in Lateral Hiring (Model Rule 8.4(g)): As more firms routinely grow by lateral hiring, there is the potential for built-in bias or discrimination in any AI used to screen applicants and select from large numbers of résumés those to be interviewed. Lawyers must be careful to monitor the use of AI in hiring and results of such use.

In sum, GenAI, like a word processor or even a proprietary database like LexisNexis or Westlaw, is a tool, not a substitute for the exercise of legal expertise and judgment. Using GAI may streamline or even enhance lawyers in the performance of their tasks, but it does not absolve them of their responsibilities under applicable ethics rules.

1. Forms of AI have been in use by the legal profession, whether lawyers were aware of it or not, for many years now. Examples include Microsoft’s Editor, which checks for spelling and grammar errors; Microsoft Excel; a plug-in for Microsoft Word called Brief Catch, which is designed specifically for lawyers and can identify citation problems and errors that arise exclusively in a legal context; and of course Lexis and Westlaw, which have been using AI to help with searches for federal and state case law, statutes, regulations, and secondary legal sources as well. More recently, Lexis and Westlaw have unveiled GAI services to expedite legal research. ↑

2. See Formal Op. 512 at 11 nn.55–58 (citing, inter alia, Fla. Bar Advisory Op. 12-3 (2013); Iowa State Bar Ass’n Comm. on Ethics & Practice Guidelines Op. 11-01 (2011); Fla. Bar Advisory Op. 24-1). ↑

The Rising Tide of NAV Facilities

Fund finance, the practice of lending to investment funds, is experiencing a significant transformation with the increasing prominence of Net Asset Value (“NAV”) credit facilities. NAV facilities are credit facilities that have availabilities that are based on the net asset value of a fund’s underlying investments. These facilities can have a variety of collateral packages, ranging from a direct lien on the underlying investments, to just being limited to the right to receive distributions and the associated bank accounts, and/or a pledge of the equity interests of the entities that hold the investments.

Secondaries funds (funds that invest in interests in other funds) and especially private credit funds (funds that invest in loans to private companies, which are often backed by private equity funds) have long utilized NAV facilities. However, certain key factors have driven the expansion of NAV facilities into use by private equity and other funds, including the liquidity crunch.

NAVigating a Liquidity Crisis

Today, funds are facing an unprecedented challenge in generating liquidity. This is in contrast to the pre-COVID era, during which the market enjoyed explosive growth of subscription credit facilities as they became a near-universal part of a fund’s capital structure. These facilities—secured by unfunded capital commitments of investors, the general partner’s right to call capital, and the enforcement of those rights—are attractive to lenders due to their extremely low default rates and perceived safety as a product. However, due to the failure of several large participants in the subscription lending market during the banking crisis of 2023, the exit or retreat of other large participants from a significant presence in the market, and tighter capital requirements required by the proposed BASEL III endgame regulatory changes, demand for subscription lines currently outstrips supply.

In addition to the decline in the supply of subscription facilities, today’s challenging market conditions have constrained other traditional sources of liquidity as well. Today, private equity funds are facing the slowest private M&A and IPO market in decades, which has significantly slowed the pace of asset disposition. The lack of exit opportunities is also causing many funds to be cautious in calling capital from limited partners, who have expressed that they are facing their own liquidity crisis due to inflation, geopolitical uncertainty, high interest rates, and the denominator effect (i.e., overweighting of private equity assets as part of an institutional investor’s entire portfolio). The lack of distributions has also contributed to the slowdown in new fundraising opportunities to these same limited partners.

NAV facilities allow the fund to navigate this liquidity challenge by enabling distributions to investors and serve a number of other important purposes, including acquiring new investments, supporting existing investments, and providing working capital. NAV facilities permit the fund managers to continue operating the fund with the view of maximizing the investor return, and avoid the premature and possibly discounted dispositions of assets that may otherwise be required.

Structured Finance Meets NAV Facilities

Today, a private equity fund seeking a NAV facility can access a market of providers familiar with the product and willing to compete for their business. In recent years, as the discourse on these NAV facilities to private equity and other funds has continued, the pool of providers has significantly expanded,^[1] in particular to include insurance companies that are seeking highly rated debt products with an attractive yield. The resulting competition has led to a significant compression of pricing on these NAV facilities, which has further driven up demand and has made the product more accessible to a broader set of managers and funds. At the same time, the addition of insurance companies as new entrants has meant that structures and techniques that facilitate the obtaining of a rating, which were long used in the structured finance market, are gaining ground in fund finance. NAV facilities across various asset classes are increasingly structured using independent credit ratings, tranching, bankruptcy-remote special purpose vehicles, true sale, and non-consolidation techniques.

This mirrors the development that has already undertaken in regular-way NAV facilities in the private credit space, which has already seen a widespread adoption of these techniques to assist in decoupling the creditworthiness of the fund’s assets from that of the fund or sponsor, leading to lower pricing and access to a wider range of financing sources. A similar dynamic is found in the rise of collateralized fund obligations (“CFOs”), a form of securitization of underlying investment fund assets. Typically, the fund interests are transferred to a holding company held by the CFO issuer, which issues both debt (notes) and equity interests, backed by the payments and distributions received by the underlying fund interests.

It remains to be seen whether the high interest from insurance companies in NAV facilities to private funds will be sustained. In particular, the National Association of Insurance Commissioners (“NAIC”) has been actively reviewing the regulatory oversight of private equity and complex assets within the insurance industry. In particular, the NAIC has adopted amendments to statutory accounting reporting requirements to state that CFOs and similar private funds–associated products may no longer automatically be given the regulatory treatment that they were typically given (as “bonds”).

Practical Considerations

Both lenders and fund managers entering the NAV facility space should ensure they have competent advice from counsel familiar with these complicated transactions and the internal infrastructure to implement and maintain these facilities. The initial structuring of these facilities requires a deep understanding of the tax and regulatory considerations for all parties. Asset transfers and pledges require significant diligence and coordinated execution. Maintaining the facilities and associated vehicles as separate from the original owner requires discipline and investor education. Lastly, NAV facilities may require compliance with additional regulatory regimes, including the securitization regulations adopted in the EU and the UK and the asset-backed security and associated risk retention requirements in the US.

In addition, fund managers should be aware of recent discourse on NAV facilities generally. In particular, the Institutional Limited Partners Association (“ILPA”) has recently provided guidance regarding the use of NAV facilities, in particular when the proceeds are used to make distributions to limited partners because such distributions can potentially impact fund performance calculations and the limited partner’s ability to allocate capital. ILPA recommends greater communication between GPs and LPs regarding the use of NAV facilities, and many major NAV lenders note that the vast majority of their NAV facilities are not used for distributions, but rather add-on investments or refinancings of pre-existing debt to the portfolio at a lower cost of capital than might otherwise be available.

The Future of Fund Finance

NAV facilities represent a significant evolution in fund finance, offering new opportunities for both funds and lenders. As the market evolves, it is crucial for participants to gain a thorough understanding of these facilities, including their structures, applications, and potential risks. For fund managers and lenders aiming to navigate economic challenges and seize opportunities, a deep knowledge of these tools—such as fund manager constraints and the motivations of various investor groups—will be essential for creating flexible capital structures and optimizing outcomes in a rapidly changing market. Even though the rise of NAV facilities has been in part driven by the current liquidity crisis and the challenges of the subscription facility market, we expect this market to continue to grow even after these broader market conditions pass, as lenders recognize the attractiveness of the product and fund managers understand NAV facilities to be an additional tool in managing their portfolios and find a broader spectrum of lenders willing to offer the product.

This evolving trend is a key focus of the Fund Finance/Asset Based Lending Subcommittee of the ABA Business Law Section, and this article is based on presentations and discussions by that subcommittee, including those by the Authors and other members of the Subcommittee, including Elizabeth Tabas (Chair of the Subcommittee) of Sidley Austin LLP, Leah Edelboim of Cadwalader, Wickersham and Taft LLP, and Linda Filardi of Flagstar Bank.

1. For example, HSBC Asset Management has recently publicly announced that it is launching a NAV financing strategy. ↑

Stablecoins are cryptocurrencies designed to maintain a steady value by pegging themselves to a reserve asset, typically a fiat currency like the U.S. dollar. However, because many stablecoins have experienced market price fluctuation from their pegged value,^[1] a number of foreign and domestic jurisdictions have passed laws regulating them.^[2] While laws have been passed in the EU and elsewhere, the U.S. does not yet have a comprehensive federal law providing a clear legal framework specific to stablecoins. At the same time, some states have passed applicable laws and issued regulations.^[3] Since stablecoins may be transacted across borders and overseas,^[4] there is a strong interest in considering the interplay of regulation in foreign jurisdictions when formulating a domestic framework. Doing so may reduce regulatory arbitrage and help facilitate cross-border interoperability. This article will examine the existing state of global regulations and distill some common principles that may inform U.S. policymaking on the national level.

Overview of Stablecoins

Stablecoins are cryptocurrencies engineered to maintain a consistent value, typically by pegging themselves to a reserve asset. While many stablecoins are pegged to fiat currency like the U.S. dollar, they can also be linked to commodities or even other cryptocurrencies. The specific mechanism backing each stablecoin is stipulated by its smart contract—the computer code that created it.

Despite aiming to offer the benefits of digital assets without extreme volatility, many stablecoins have experienced market price fluctuations. Nevertheless, the stablecoin market has grown considerably, with fiat-backed stablecoin supply reaching approximately $159 billion in 2024.^[5]

There are four main types of mechanisms aimed at maintaining stablecoin price stability:

1. Fiat-backed stablecoins: Each stablecoin issued has a corresponding unit of currency or cash equivalent held in reserve, often U.S. T-bills, typically held in custody at a depository institution. This method ensures that the stablecoin can be redeemed for its fiat counterpart at a fixed rate. Measured in total market capitalization, fiat-backed stablecoins are by far the largest category of stablecoins.^[6]
2. Commodity-backed stablecoins: The value of each stablecoin is pegged to a specific value of a commodity (i.e., gold or silver), which is held in custody in secure vaults. The stablecoin issuer must hold enough of the commodity to fully back all circulating stablecoins.
3. Crypto-backed stablecoins: Crypto-backed stablecoins are backed by other cryptocurrencies. They may be pegged to the price of the other cryptocurrencies or the price of a fiat currency. These stablecoins are often overcollateralized to account for the volatility of the reserve assets. This means that in order to provide a buffer against market fluctuations, the value of the cryptocurrencies held in reserve exceeds the value of the stablecoins issued.
4. Algorithmic stablecoins: This type of stablecoin does not hold assets in reserve. Instead, an algorithm dynamically adjusts the supply by creating more stablecoins to reduce the price when demand falls or by destroying stablecoins to increase the price when demand rises. In theory, this “stabilizes” the value of the stablecoin relative to the target peg. In practice, these mechanisms have notoriously failed to maintain a stable peg.^[7]

Stablecoins are used for several purposes, including trading and effectuating transactions. Because stablecoins aim to offer price stability, they may be used to facilitate payments, both in the U.S. and across borders. Stablecoins are also an actively traded component of the cryptocurrency markets because they can be readily exchanged for other cryptocurrencies. Since January 2020, the supply of fiat-backed stablecoins has grown from $5 billion to approximately $159 billion.^[8]

European Union (EU)

The EU Markets in Crypto-Assets Regulation (MiCA) was enacted in June 2023 and is slated for full implementation by December 2024 (see timeline below).^[9]

The EU Markets in Crypto-Assets Regulation (MiCA) was enacted in June 2023 and is slated for full implementation by December 2024. Source: Markets in Crypto-Assets Regulation (MiCA), Eur. Sec. & Mkts. Auth. (last visited Sep. 18, 2024).

MiCA establishes a comprehensive regulatory framework to increase the safety and transparency of European digital asset markets.^[10] The provisions of MiCA that are specific to stablecoins went into effect on June 30, 2024. The regulation encompasses several critical components such as licensing requirements for custodians and other crypto-asset service providers, enhanced consumer protections, specific stipulations for stablecoins, and provisions to prevent market abuse.^[11]

MiCA categorizes stablecoins into two distinct types: electronic money tokens (EMTs) and asset-referenced tokens (ARTs).^[12] EMTs are fiat-backed and intended to maintain a stable value relative to a single currency. They are treated similarly to electronic money under existing regulations. Conversely, ARTs are backed by several assets, potentially including multiple currencies, commodities, or financial instruments. This structure theoretically distributes risk but requires stringent oversight due to the varied underlying assets.

Specifically, MiCA designates fiat-backed EMTs as electronic money, requiring that issuers either have or obtain authorization as electronic money institutions (EMIs) or credit institutions (i.e., banks). To become authorized, an issuer must apply with the competent supervisory authority of its home member state. As EMIs, these issuers must adhere to the European Electronic Money Directive and MiCA-specific mandates.^[13] These include the obligation to establish a legal entity within the EU, obtain authorization to operate, and publish a detailed crypto-asset white paper approved by a competent authority.^[14] EMT issuers must maintain liquid reserves equal to the tokens in circulation, ensuring redemption at par value at any moment, even under market stress.^[15] MiCA mandates that a minimum of 30 percent of these funds (or 60 percent in the case of “significant” EMTs)^[16] be held in separate accounts at credit institutions, with the remainder invested in secure, low-risk, highly liquid financial instruments denominated in the same currency as the currency referenced by the EMT. Those liquid financial instruments must have minimal market, credit, and concentration risks.^[17] Additionally, EMT issuers are not permitted to offer interest on these tokens and must implement robust measures for safeguarding reserves, handling customer complaints, and segregating reserve assets.

Issuers of ARTs face similar regulatory requirements, including obtaining authorization from their national competent authority unless the issuer is an authorized credit institution, issues tokens below a €5 million threshold over a twelve-month period, or restricts token sales to qualified investors. ARTs must give holders a perpetual redemption right, meaning that issuers must redeem tokens upon request.^[18] MiCA also imposes strict rules concerning reserve composition, risk management, custody arrangements, governance, disclosure practices, complaints handling, and conflict of interest mitigation.

There are limits on how many ARTs and EMTs denominated in a non-EU currency can be used for exchange within the EU. These limits are expressed as trading volume caps.^[19] This is part of MiCA’s broader aim “to address risks that the wide use of crypto-assets which aim to stabilise their price in relation to a specific asset or a basket of assets (such as ARTs) could pose to financial stability, the smooth operation of payment systems, monetary policy transmission or monetary sovereignty.”^[20]

The European Banking Authority (EBA) is tasked with developing more detailed regulations for both EMTs and ARTs, further refining the governance framework established by MiCA.^[21]

United Kingdom (UK)

In November 2023, the UK’s financial regulatory authorities—the Bank of England, the Financial Conduct Authority (FCA), and the Prudential Regulation Authorit—unveiled proposals for the first phase of a comprehensive regulatory framework for digital assets. This initial phase of the framework addresses fiat-backed stablecoins, defined as those intended to hold a stable value by reference to one or more specific fiat currencies.^[22]

Under this proposed framework, any entity issuing or providing custodial services for fiat-backed stablecoins within the UK must obtain authorization from the FCA and adhere to stringent regulatory standards. These standards include segregating client assets, maintaining robust governance controls, and maintaining meticulous records. Additionally, issuers would be required to back the issued stablecoins with stable and liquid reserves to enable swift customer redemptions, and they would be prohibited from offering interest on these stablecoins.

The framework also categorizes stablecoin-based payments into two types: hybrid and pure. Hybrid transactions involve using a regulated stablecoin to enter or exit a transaction, while pure transactions are conducted entirely on-chain with a single stablecoin. Both types of transactions are subject to at least some aspects of the existing Payment Service Regulations, which will be expanded to encompass features unique to stablecoin transactions. This inclusion ensures that stablecoin users enjoy protections similar to those afforded to traditional payment service users, such as specific disclosures, execution time limits, and a structured process for resolving complaints.^[23]

Phase 1 of the framework does not cover commodity-backed or algorithmic stablecoins, which are slated for consideration under Phase 2 regulations. Additionally, the UK is assessing how to appropriately regulate foreign stablecoins that participate in UK payment systems. The current proposals require that a UK-authorized firm approve such stablecoins as meeting standards equivalent to regulated (i.e., UK-issued) stablecoins. This can be contrasted with the EU approach of requiring stablecoins offered to the EU public to be issued by EU-incorporated entities and subject to local reserve requirements.

United States

While the U.S. lacks comprehensive stablecoin legislation, certain existing regulations apply. At the federal level, stablecoins would be considered convertible virtual currency (CVC) by the Financial Crimes Enforcement Network (FinCEN),^[24] and thus obligations under the Bank Secrecy Act apply. Notably, the issue of whether stablecoins are securities or not is being actively litigated, such as in Securities & Exchange Commission v. Binance Holdings Ltd.^[25]

Significant variation exists in state-level regulation of stablecoins. Across the country, money transmission laws apply to stablecoin-related activities. However, some states, such as New York, offer specific guidance or entire regulatory regimes tailored for stablecoins. New York pioneered the BitLicense in 2015, which operates as a license and charter-based system for digital assets.^[26] Such a license is required to conduct a digital asset business in New York. In June 2022, New York’s Department of Financial Services (NYDFS) released guidance on issuing U.S. dollar–backed stablecoins.^[27] The guidance applies to U.S. dollar–backed stablecoin issuers licensed under a BitLicense or chartered as limited-purpose trust companies under New York banking law. The guidance creates “recommendations or principles” related to redeemability, reserves, and attestation (confirmation of accounting statements). Stablecoin issuers must hold at least a 1:1 ratio of reserves segregated from other assets, and the reserves must be highly liquid.^[28]

Common Principles

Although there are many differences in jurisdictional approaches to stablecoin regulation, some common regulatory principles emerge:

1. Stablecoin issuances require explicit regulatory approval by the appropriate regulator.
2. Reserves must be liquid and stable, ensuring that they can cover all issued stablecoins on a 1:1 basis.
3. Stablecoin payment services must align with existing financial regulations, offering protections akin to traditional currency-based payment systems.^[29]

As interest in stablecoins grows, consideration of regulations in foreign jurisdictions is becoming increasingly crucial to prevent regulatory arbitrage and facilitate cross-border transactions. This will require careful analysis as well as collaboration between foreign jurisdictions and their regulators.

1. USDC and USDT, the two largest U.S. dollar–denominated stablecoins by market cap, have experienced temporary price deviation from their target price of US$1. On March 11, 2023, one day after Silicon Valley Bank failed, the market price of USDC dropped to $0.9715. Historical Snapshot—11 March 2023, CoinMarketCap (Mar. 11, 2023). In March 2020, during the initial COVID-19 pandemic wave, the market price of USDT dropped to $0.9742. Historical Snapshot—18 March 2020, CoinMarketCap (Mar. 18, 2020). ↑

2. Markets in Crypto-Assets Regulation (MiCA), Eur. Sec. & Mkts. Auth. (last visited Aug. 29, 2024). ↑

3. Joseph Jasperse, 50-State Review of Cryptocurrency and Blockchain Regulation, Stevens Ctr. for Innovation in Fin. (2024). ↑

4. Comm. on Payments & Mkt. Infrastructures, Bank for Int’l Settlements, Considerations for the Use of Stablecoin Arrangements in Cross-Border Payments (Oct. 2023). ↑

5. Global Live Cryptocurrency Charts & Market Data, CoinMarketCap (last visited Sep. 19, 2024). ↑

6. Top Stablecoin Tokens by Market Capitalization, CoinMarketCap (last visited Aug. 29, 2024). ↑

7. TerraUSD (UST) was an algorithmic stablecoin designed to maintain a stable price of US$1. It aimed to do so by dynamically adjusting supply in reference to its sister token, a cryptocurrency named LUNA. In May 2022, the price of UST and LUNA collapsed, wiping out $45 billion in value. The founder of UST, Do Kwon, has been found liable for securities fraud, see Sec. & Exch. Comm’n v. Terraform Labs PTE Ltd., and charged with multiple criminal fraud counts, see United States v. Do Hyeong Kwon. ↑

8. Global Live Cryptocurrency Charts & Market Data, supra note 5. ↑

9. Markets in Crypto-Assets Regulation (MiCA), supra note 2. This image may be obtained free of charge through the ESMA website. ESMA does not endorse this publication and in no way is liable for copyright or other intellectual property rights infringements nor for any damages caused to third parties through this publication. ↑

10. Regulation (EU) 2023/1114 of the European Parliament and of the Council of 31 May 2023 on Markets in Crypto-Assets, and Amending Regulations (EU) No 1093/2010 and (EU) No 1095/2010 and Directives 2013/36/EU and (EU) 2019/1937 (Document 32023R1114) [hereinafter MiCA]. ↑

11. Markets in Crypto-Assets Regulation (MiCA), supra note 2. ↑

12. “Tokens” are fungible digital assets that represent value or utility. ↑

13. Eur. Banking Auth., Draft Guidelines on Recovery Plans Under Articles 46 and 55 of the Regulation (EU) 2023/1114 (Nov. 8, 2023) (Consultation Paper EBA/CP/2023/30). ↑

14. Issam Hallak & Rasmus Salén, Eur. Parliamentary Rsch. Serv., Non-EU Countries’ Regulations on Crypto-Assets and Their Potential Implications for the EU (Sept. 2023). ↑

15. Eur. Banking Auth., Draft Regulatory Technical Standards to Specify the Minimum Contents of the Liquidity Management Policy and Procedures under Article 45(7)(b) of Regulation (EU) 2023/1114 (Nov. 8, 2023) (Consultation Paper EBA/CP/2023/26). ↑

16. Article 56(1) refers to the “significance” criteria for ARTs set out in Article 43(1):

    The criteria for classifying asset-referenced tokens as significant asset-referenced tokens shall be the following, as further specified by the delegated acts adopted pursuant to paragraph 11:

    1. the number of holders of the asset-referenced token is larger than 10 million;
    2. the value of the asset-referenced token issued, its market capitalisation or the size of the reserve of assets of the issuer of the asset-referenced token is higher than EUR 5 000 000 000;
    3. the average number and average aggregate value of transactions in that asset-referenced token per day during the relevant period, is higher than 2,5 million transactions and EUR 500 000 000 respectively;
    4. the issuer of the asset-referenced token is a provider of core platform services designated as a gatekeeper in accordance with Regulation (EU) 2022/1925 of the European Parliament and of the Council;
    5. the significance of the activities of the issuer of the asset-referenced token on an international scale, including the use of the asset-referenced token for payments and remittances;
    6. the interconnectedness of the asset-referenced token or its issuers with the financial system;
    7. the fact that the same issuer issues at least one additional asset-referenced token or e-money token, and provides at least one crypto-asset service.

    The 60 percent deposit requirement with credit institutions for significant EMTs is set out in Article 3(2) of the final draft of regulatory technical standards from the European Banking Authority. Eur. Banking Auth., Draft Regulatory Technical Standards to Further Specify the Liquidity Requirements of the Reserve of Assets Under Article 36(4) of Regulation (EU) 2023/1114 (June 13, 2024) (Final Report EBA/RTS/2024/10). ↑

17. Eur. Banking Auth., Draft Regulatory Technical Standards to Specify the Minimum Contents of the Liquidity Management Policy and Procedures, supra note 15. ↑

18. MiCA, supra note 10, art. 16(2). ↑

19. The European Banking Authority published the final draft of its regulatory technical standards in relation to this concept on June 19, 2024. Eur. Banking Auth., Draft Regulatory Technical Standards on the Methodology to Estimate the Number and Value of Transactions Associated to Uses of Asset-Referenced Tokens as a Means of Exchange Under Article 22(6) of Regulation (EU) No 2023/1114 (MiCAR) and of E-Money Tokens (Final Report EBA/RTS/2024/13). ↑

20. Id. at 5 (citing recital 5 of MiCA). ↑

21. Eur. Banking Auth., Markets in Crypto-Assets (last visited Aug. 31, 2024). ↑

22. Fin. Conduct Auth., Regulating Cryptoassets Phase 1: Stablecoins (Nov. 2023) (Discussion Paper DP23/4). ↑

23. Id. ↑

24. FinCEN issued guidance in 2019 and 2014 on how FinCEN’s regulations apply to certain business models involving convertible virtual currencies. See, e.g., FinCEN, Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies (May 9, 2019) (FIN-2019-G001). ↑

25. Sec. & Exch. Comm’n v. Binance Holdings Ltd., No. 1:23-cv-01599 (D.D.C. June 28, 2024), ECF No. 248. ↑

26. N.Y. Comp. Codes R. & Regs. tit. 23, § 200.1 (2015). ↑

27. Industry Guidance, Adrienne A. Harris, Superintendent of Fin. Servs., N.Y. Dep’t of Fin. Servs., Guidance on the Issuance of U.S. Dollar–Backed Stablecoins (June 8, 2022). ↑

28. The reserves are subject to NYDFS approval and may only be comprised of “U.S. Treasury bills acquired by the Issuer three months or less from their respective maturities”; “Reverse repurchase agreements fully collateralized by U.S. Treasury bills, U.S. Treasury notes, and/or U.S. Treasury bonds on an overnight basis”; “Government money-market funds”; or “Deposit accounts at U.S. state or federally chartered depository institutions.” Id. Issuers must adopt clear redemption policies that allow for timely redemption (not more than two full business days) at par value. Moreover, stablecoin issuers must release public attestations monthly that a third-party accountant verifies. NYDFS issued these requirements as guidance, not rules. However, the guidance states that “[i]ssuers that currently issue U.S. dollar–backed stablecoins under DFS supervision are expected to come into compliance with this Guidance within three months of the date hereof.” Id. ↑

29. Cryptocurrency companies in the U.S. are already subject to all state-based money-service business laws and must register as a money services business (MSB) in any state in which they operate. ↑

I. The Bill of Obligations

A. Introduction

We are challenged today to consider what it means to be a true citizen of our country: to consider our Rights as American citizens in the context of the Bill of Rights and Constitution and our Obligations and Responsibilities to the country and each other as American citizens in the context of what it takes to make our Constitution work.

We hear, read, and say a great deal about our rights as citizens and say, read, and hear much less about our obligations as citizens.

B. The Ten Habits of Good Citizens

In his book The Bill of Obligations: The Ten Habits of Good Citizens, author Richard Haass starts the reader with a discussion of rights and their limits, as well as the importance of addressing citizens’ duties and responsibilities, the performance of which is necessary to support and assure the maintenance, preservation, and enforcement of those rights. Haass then articulates his thoughts on restoring the essentials of good citizenship if we are to avert threats to the future of our country. Those ten habits are:

1. Be Informed. Haass notes that an effective, functional democracy necessitates an informed citizenry, and goes on to ask what is an informed citizenry, and what does it take to be an informed citizen? He highlights an awareness of civics, understanding the fundamentals of how the country functions from a governance and governing perspective, and notes the importance of understanding the world in which the country operates, including both domestic and international challenges. He comments that being informed is essential to casting one’s vote in favor of particular candidates and understanding what those candidates bring to the table from the perspective of experience, judgment, ethics, and trustworthiness, as well as their function in both governing and representing the country. He notes the importance of exercising judgment as to peoples’ opinions and how the uninformed may be subject to being manipulated by misinformation and the intentions of the various people seeking to be part of the governance of the country. Haass notes the plethora of information and newspapers, magazines, television, podcasts, websites, social media, and the other tools used to transmit information and opinions, and he points out that an informed person must be able to choose sources that are significant to being informed and avoiding those aimed at misleading or misinforming an aware citizen. He notes that being informed is essential to one’s ability to hold people accountable for their actions, pronouncements, etc., and that accountability is essential to a functioning democratic country given that the people vote on who is best to lead that country. It is also true that being informed is significant to influencing the views of others who are less informed and still essential to voting practices within a democracy.
2. Get Involved. Haass immediately asserts, with respect to getting involved, that a democracy will depend on the participation of its citizens, and that again, it is essential that these citizens are well informed and capable of exercising their responsibility to act, as well as their responsibility to hold others (particularly elected officials) accountable for their actions. He notes the importance of individual actions to making a difference in the way society performs and how particular individuals, by simple acts, have created changes in policy.
3. Stay Open to Compromise. Haass notes that while on the one hand, compromise can be viewed as a sign of weakness, on the other hand, compromise is essential to the functioning of a democracy so that multiple interests can be addressed and recognized. In many ways, compromise was at the heart of drafting the Constitution and many other achievements of our society from civil rights to other matters of American government interests, as well as our societal interests. Haass comments that while compromise is a value, it’s also important to be able to describe and understand the give-and-take in the process, as well as the ultimate choices made and matters considered in effecting a resolution. Through compromise, he says, one can help the country move beyond stalemate to arrive at action.
4. Remain Civil. Haass notes the importance of civility as a means of overcoming cynicism and bridging disagreements that come in a democracy by exercising respect for various sides. Haass notes that in discussions where there are multiple sides and issues to be resolved, civility is sometimes an essential quality in reaching resolution.
5. Reject Violence. Haass highlights the differences between democracy and democratic governments and authoritarian systems. He notes that in particular, rejecting violence in almost any situation is preferable to using it to achieve any kind of political end, as in a democracy, violence is the antithesis of achieving results that reflect the best interests of the groups involved, etc.
6. Value Norms. Haass notes the importance of observing and respecting norms, mores, and social conventions that form the fabric of a society, as one can’t make laws to cover all situations, nor is a society purely based on laws and their observance, to the exclusion of these other elements that are essential to a society’s viability.
7. Promote the Common Good. Haass notes that the “common good” is critical to the functioning and existence of a democracy. Looking past our own self-interests, it is critical to look at the best collective interests of the country itself for civil and political service.
8. Respect Government Service. While Haass notes that it is very American to be suspicious of government and governmental authority, it is also critical to respect those who provide government service as a social good, who often take less and have a sense of public service that motivates them to do the work they do, which should be respected, and not denigrated.
9. Support the Teaching of Civics. Haass and others have noted the current critical failure of the teaching and knowledge of civics, resulting in a lack of understanding of and commitment to the structure and critical elements of our democracy. Interestingly, in order to become a citizen of the United States, those seeking to immigrate are required to review materials including civics information pertaining to U.S. history and government as part of the naturalization process. (See Section II.) Recently, the American Bar Association’s Task Force for American Democracy and deans of American law schools have stressed the critical importance to our society and its founding principles of improved education with respect to civics and the primacy of the Rule of Law.
10. Put the Country First. Interestingly, Haass notes that governing one’s self, personal character, integrity, and tolerance towards others is essential to the functioning of our democracy. He comments in particular on several situations in which the interests of the country were not put first, but were sacrificed to political objectives, and the damage to the interests of the country and its principles as a whole resulting from that kind of action.

II. The Citizenship Pledge for Newly Naturalized Citizens

A. Introduction

When persons seek to become U.S. citizens, they must obtain an application from U.S. Citizenship and Immigration Services (USCIS), and they must review materials containing civics information pertaining to U.S. history and government in preparation for an interview with a USCIS officer, who may ask ten or more questions from a list of one hundred questions in the materials. Applicants who answer at least six questions correctly and are approved for citizenship are invited to participate in a naturalization ceremony, where the applicants must raise their right hands and swear an Oath of Allegiance. As a new citizen, each person taking the Oath of Allegiance agrees to take on and perform those duties and responsibilities sworn to in the Oath.

B. The Seven Undertakings of Newly Admitted American Citizens

1. In order to become a citizen, each person renounces all allegiance, loyalty and fidelity to any foreign ruler, state, or sovereignty of whom or which such person had once been a subject or citizen. In other words, the applicant renounces all loyalty, citizenship, duties, or obligations to any non-U.S. leader, state, or country.
2. In order to become a citizen, each person promises to bear true faith and allegiance to the Constitution and the laws of the United States, essentially a commitment to the rule of law as an essential element of U.S. citizenship.
3. In order to become a citizen, each person commits to support and defend the U.S. Constitution and the laws of the United States of America against all enemies, foreign and domestic.
4. In order to become a citizen, each person promises to bear arms on behalf of the United States when required by law.
5. In order to become a citizen, each person agrees to perform noncombative services in the Armed Forces of the United States when required by U.S. law.
6. In order to become a citizen, each person agrees to perform work of national importance under civilian direction when required by law.
7. Further, each person taking the Oath swears “under God” that they have agreed to perform the duties and responsibilities in the Oath “freely, without any mental reservation or purpose of evasion.”

“Reflections on Citizenship’s Obligations” by John H. Stout, co-chair of the American Bar Association Business Law Section’s Rule of Law Working Group, is part of a series on the rule of law and its importance for business lawyers created by the Rule of Law Working Group. Read more articles in the series.

Every year, the American Arbitration Association-International Centre for Dispute Resolution (AAA-ICDR) administers thousands of consumer arbitration matters, and, over time, those have grown in variety and sophistication. Disputes involving solar power, sales of electric vehicles, data privacy, emerging technologies like cryptocurrency, and the gig economy now make up a significant portion of filings.

Each area raises new issues, different legal principles may apply, and new types of parties are involved. Arguments over the specific technical aspects of the products have become more common; these disputes can delve into topics ranging from battery performance to SIM swap fraud to the inner workings of web-based advertising. Warranty and terms of use agreements are longer and more sophisticated than ever, and they include arbitration provisions that have been crafted with great care. Historically, consumer cases were considered “simple” matters, but these are not your parents’ consumer cases.

The AAA-ICDR has adapted to these changes by:

• embracing virtual hearings,
• addressing emerging technology disputes, and
• upholding procedural safeguards to help ensure fair and enforceable outcomes.

As the quantity of cases and the stakes in individual cases grow, a fair process has become even more critical.

Consumer claims may arise out of an agreement that applies to thousands or millions of consumers. Although some consumer arbitration clauses contain opt-out provisions, consumers generally do not have much choice about how their dispute will be resolved. When a consumer contract calls for arbitration to be administered by the AAA-ICDR, we require a baseline level of due process protections as set out in the Consumer Due Process Protocol and the Consumer Arbitration Rules. For example, the Protocol and Rules call for:

• a fundamentally fair process,
• at a reasonable cost (not more than $225 to the consumer),
• in a reasonably convenient location,
• before a neutral arbitrator who can allow for discovery necessary for a fundamentally fair process and all remedies that could be available in court.

These procedural safeguards cannot be replaced with a simpler process; otherwise, the AAA-ICDR will not administer the case and any decision of the arbitrator could potentially be subject to vacatur. This is possibly the worst outcome for an arbitration process, because the parties who have spent the time, money, and energy going through the process usually must go through it again to resolve their case. Balancing the considerations of fairness and speed helps ensure that the outcome will withstand further challenges and that parties can move on from the dispute. In 2023, the median time from filing to award for consumer cases administered by the AAA-ICDR was 9.6 months, while it was 35.6 months for cases in US district courts.^[1]

Filing to Award: Consumer arbitration cases filed with the AAA that proceeded to hearing and award in 2023 did so much more quickly compared to US district courts. Source: “2023 Consumer Arbitration Statistics,” AAA-ICDR.

Expert, diverse arbitrators are needed to decide consumer disputes.

It is more important than ever to have arbitrators experienced in consumer law deciding consumer arbitrations. The nuances of consumer claims require arbitrators who are familiar with modern technologies and how people interact with them, as well as the law governing those interactions. Arbitrators who educate themselves and interact with these technologies are more likely to serve the parties and the process better than those arbitrators who rely on an assistant to “work the computer.” A roster of arbitrators should also reflect the diversity of the population served to help ensure fair outcomes. Thirty-nine percent of those on the AAA-ICDR’s consumer roster are women and/or people of color, with 39 percent of appointments going to panelists from that group.^[2]

Transparency about consumer arbitration cases and outcomes is important.

The AAA-ICDR provides information about our cases in several forms. Each quarter, we update our Consumer and Employment Arbitration Statistics Report,^[3] which shows case data for all consumer matters closed within the last five years. This report does not show the consumer party’s name but contains information about the opposing party, arbitrator, and case outcome, as well as other important data. We also maintain a quarterly report on arbitrator demographic data.^[4] Both of these reports are free and available to the public.

In addition to these reports, the AAA-ICDR anonymizes and provides for publication of consumer awards. These awards are available via legal research sites and contain the identity of the arbitrator as well as the text of the award.

Virtual hearings are here to stay and have clear benefits for consumer disputes.

The COVID pandemic shifted much of our lives online, and consumer arbitration was not exempt. Virtual hearings have become the norm in our cases, even as the world has returned to in-person activities.

The popularity of virtual hearings seems to indicate that most parties have grown comfortable presenting their cases via those platforms and that arbitrators are comfortable hearing cases in that manner. Virtual hearings also improve access to justice, allowing parties to attend from a comfortable and familiar location without paying for travel costs, with electronic management of evidence, and with less disruption to their work and family obligations.

Technology will continue to enhance the dispute resolution process for consumers.

Online Dispute Resolution (ODR) could be the future of resolving consumer disputes. Online Dispute Resolution can be used as a step in a dispute resolution program and incorporates both binding and nonbinding processes. Various successful ODR tools already resolve over sixty million cases per year and could serve as the model for new platforms to be implemented on a broader scale.^[5]

Artificial intelligence is already impacting dispute resolution, with new tools and services appearing frequently. Parties can build a clause with the AAA-ICDR’s ClauseBuilderAI, edit drafts and analyze documents with GenAI tools like ChatGPT or Claude, and make use of AI transcription services for their hearings. While some AI tools are priced for mid-sized or large law firms, the capabilities of more widely available platforms continue to increase while the cost remains relatively low for an individual subscription. Free platforms also continue to advance, potentially increasing access to justice.

Consumer arbitration has evolved significantly, reflecting the complexities and technological advancements of modern disputes. The AAA-ICDR’s adaptation to these changes, through the embrace of virtual hearings, addressing of emerging technology disputes, and upholding of procedural safeguards, helps to ensure a fair and efficient process. With the growing importance of an expert and diverse group of arbitrators, transparency in case outcomes, and the integration of technology such as ODR and AI tools, the future of consumer arbitration is poised to offer even greater accessibility and effectiveness. These advancements not only uphold the fundamental principles of fairness and due process but also enhance the efficiency and adaptability of the arbitration system, ultimately benefiting all parties involved.

1. “2023 Consumer Arbitration Statistics,” AAA-ICDR, accessed September 18, 2024. ↑

2. Id. ↑

3. “2024 Q1 Consumer and Employment Arbitration Statistics Report,” AAA-ICDR, accessed September 18, 2024. Note: The link to this source begins a spreadsheet download. ↑

4. “2024 Q1 Arbitrator Demographic Data,” AAA-ICDR, accessed September 18, 2024. ↑

5. “About Us,” ODR.com, accessed September 18, 2024. ↑

Introduction

There has been a growing interest in the acquisition and sale of telehealth providers. While the COVID-19 pandemic may have laid the foundation, a recent wave of success for online compounding pharmacies producing weight loss drugs has enhanced the interest in telehealth companies. Such telehealth companies are focusing on “diseases du jour,” some of which have drawn negative attention from lawmakers over their potentially misleading advertising and prescribing practices. Given the recent interest by the Criminal Division of the Department of Justice in compliance-related due diligence, private equity and venture capital companies interested in telehealth companies must ensure that they perform adequate due diligence prior to the purchase of the company, have an adequate and appropriate compliance plan and, if appropriate, voluntarily self-disclose any misconduct they become aware of to avoid criminal charges.

The potential sale of a telehealth company involves the review of a variety of legal and regulatory considerations relating to privacy, practice of medicine, and marketing. This article briefly discusses each of the above in the context of state and Drug Enforcement Agency requirements, Federal Trade Commission expectations, and Food and Drug Administration recommendations. Finally, we review recent telemedicine-related enforcement actions by the Department of Justice.

State Requirements

Telehealth laws can vary from state to state. States may differ on licensing requirements, supervision requirements, distance limitations, the type of technology that must be used, the types of services that are allowed, minimum staffing requirements, recordkeeping requirements, inspections, and more.

It is also important to note that telehealth is a broad category that can involve different types of providers. For example, some companies that provide medications might be using telehealth not only for prescribers to evaluate and prescribe medicines but also for pharmacists to actually dispense the drugs from a variety of locations (telepharmacy). Therefore, review of state licenses for each type of provider and telehealth service provided is key.

Privacy Laws

As one would expect, the storage and sharing of data raises important privacy and security considerations that must be considered while developing a compliant telehealth program. At the federal level, telehealth companies must comply with the Health Insurance Portability and Accountability Act (HIPAA) and its implementing regulations. There are also a variety of relevant state-level privacy requirements, including some specific to health privacy such as California’s Confidentiality of Medical Information Act or the Washington My Health My Data Act. It is important to note that while some state privacy laws may generally apply to medical information privacy, others target specific disease states such as Pennsylvania’s Confidentiality of HIV-Related Information Act (also known as Act 148). Act 148 generally prohibits the sharing of an individual’s HIV-related information without written permission.

Practice of Medicine

The practice of medicine is also regulated on a state-by-state basis. Telehealth companies must ensure that they comply with the varying requirements of states. One particular concern is that telehealth companies that operate in multiple states must consider whether their physicians need to be licensed in different states. For example, Florida requires out-of-state telehealth providers to register.

Disease-Specific Considerations

While telehealth providers must follow general rules related to telemedicine, certain states have disease-specific considerations, such as additional requirements imposed on providers treating obesity. For example, the Florida Commercial Weight-Loss Practices Act has specific body mass index requirements, additional informed consent rules and specific follow up care concerns. Alternatively, Virginia requires a physical examination to prescribe controlled substances for weight reduction or control, which limits the extent and scope of telehealth services.

Federal Requirements

Telehealth has recently been in the news because of companies making unvalidated claims and inappropriate sale of controlled substances. For example, as discussed below, the Drug Enforcement Administration (DEA), along with the Department of Justice, has targeted certain telehealth companies due to their noncompliant sale of controlled substances. To avoid future noncompliance, in 2023 the DEA and the Department of Health and Human Services proposed rules for prescribing controlled medications using telehealth options.

Additional telemedicine flexibilities regarding prescription of controlled medications were put in place during the COVID-19 pandemic but are currently set to expire at the end of 2024. There has been significant discussion about extending many of these flexibilities, and the DEA has been intently listening. For example, it arranged a public listening session on September 12 and 13, 2023, in addition to receiving over 38,000 comments. Despite the uncertainty, telehealth companies have continued with the prescription of controlled substances, which has brought on additional scrutiny from the Department of Justice.

Advertising Requirements

Federal Trade Commission (FTC)

The FTC works to ensure that all marketing materials are truthful and not misleading. This is generally broadly interpreted and enforced. In the context of telehealth, this could include the regulation of advertising and marketing; the use of endorsements, influencers, and reviews; online advertising and marketing; and making health claims. Companies should also pay attention to guidance specific to particular health claims. In fact, given the number of companies now focusing on weight loss, the FTC even put out a reference guide on making weight loss claims. It is worth noting that the Commission can penalize a noncompliant company as much as $50,120 per violation.

Food and Drug Administration (FDA)

While the FTC does have jurisdiction over the promotion of pharmaceutical products, the FDA primarily regulates drug manufacturers to ensure that their products are neither adulterated nor misbranded and are safe and efficacious. Accordingly, if done appropriately, the FDA should not be involved in claims being made by telepharmacy companies. However, there is a growing interest in having the FDA, primarily through the Office of Prescription Drug Promotion, regulate unsupported claims related to prescription drugs.

Telepharmacy and telemedicine companies selling compounded drugs and making drug-like claims for compounded products generally believe that they are safe from FDA scrutiny since the FDA primarily targets manufacturers of pharmaceuticals. However, it is important to note that the FDA has exerted jurisdiction over healthcare providers who are making claims about products for unapproved uses.

Enforcement

Companies and individuals using deceptive marketing in connection with telehealth are subject not only to regulatory oversight, but also civil and criminal penalties.

In July 2022 the Department of Justice (DOJ) announced criminal charges against thirty-six defendants, including a telemedicine company executive and clinical laboratory executives, for more than $1.2 billion in alleged fraudulent schemes involving telemedicine. In one of the cases, an operator of several clinical laboratories “was charged in connection with a scheme to pay over $16 million in kickbacks to marketers who, in turn, paid kickbacks to telemedicine companies and call centers in exchange for doctors’ orders.”

In 2023, Joelson Viveros faced criminal charges related to his allegedly investing in and assisted with a kickback scheme regarding a network of pharmacies that operated a call center. At this call center, telemarketers persuaded Medicare beneficiaries to accept prescriptions for expensive medications that they neither needed nor wanted. Viveros allegedly obtained signed prescriptions by paying kickbacks to two telemedicine companies.

In 2023 executives and owners of DMERx, an internet-based platform for doctors’ orders, were also indicted. The indictments included the CEO prior to a corporate acquisition and the CEO and vice president of the company that operated it after the acquisition. Defendants were allegedly paid for connecting pharmacies, durable medical equipment suppliers, and marketers to telemedicine companies that “would accept illegal kickbacks and bribes in exchange for orders that were transmitted using the DMERx platform.” Allegedly, the prescriptions were not medically necessary and were based on a brief telephone call with the alleged patient or no interaction at all. 

In another case, David Antonio Becerril, a medical doctor, was indicted in connection with a scheme in which he allegedly signed more than 2,800 fraudulent orders for genetic tests and medical for patients he was not treating and had never spoken to. The indictment alleged that telemarketers obtained beneficiary information and prepared fraudulent orders that Becerril signed with an average of less than forty seconds of review, and few or no orders were denied. In some cases, braces were approved for patients whose relevant limbs had already been amputated. 

In May 2024, the DOJ charged a Long Island woman in connection with allegedly selling misbranded and adulterated weight loss drugs, including Ozempic. The defendant allegedly obtained the weight loss drugs from Central and South America and then posted dozens of videos advertising and selling the drugs.

Conclusion

As described above, investors in telehealth companies are exposed to significant risks ranging from lack of appropriate registration of providers, to privacy concerns, to inappropriate promotion. As previously discussed, the DOJ continues to target healthcare fraud and requires compliance oversight prior to and after an M&A transaction. Failure to have adequate compliance programs exposes acquirers to significant liability not only from the FDA, but also the DOJ, FTC, DEA, state regulators, and more.

There has been a notable uptick in clinical research sites being bought out by private equity and venture capital companies. This trend signifies the growing recognition of the value these sites hold, not just in terms of their operational capabilities, but also through the critical data they generate. However, for both buyers and sellers, there are significant considerations to keep in mind to navigate these transactions successfully and ethically.

Before purchasing clinical trial sites, a private equity or venture capital company (collectively, “Buyer”) must have a clear thesis as to why such acquisitions make sense. Various reasons have included wanting to:

1. acquire the data associated with clinical trial participants;
2. dominate a clinical research market for a specific disease state;
3. dominate a specific clinical research geographical area; or
4. vertically integrate into the clinical research space.

Small clinical trial sites are typically structured to ensure that a physician is providing services to the clinical trial site—i.e., the physician serves as a contractor to the clinical trial site and is providing medical services as part of that contract. This, however, can raise significant issues during an acquisition. This article discusses several crucial considerations for Buyers and one option for addressing them.

Privacy Considerations

The Health Insurance Portability and Accountability Act (HIPAA) Privacy Rule requires compliance with “national standards to protect individuals’ medical records and other individually identifiable health information” (“protected health information” or PHI). HIPAA applies to a variety of stakeholders who conduct certain healthcare transactions electronically. State laws also have a meaningful impact on data collection and privacy in this space. California investors alone may need to deal with the California Consumer Privacy Act of 2018, the California Privacy Rights Act of 2020 amending it, and the state’s Confidentiality of Medical Information Act. Without a federal law unifying and simplifying requirements, this hodgepodge of privacy requirements has been, and continues to be, a challenge for Buyers and must be appropriately reviewed to minimize susceptibility to seemingly unlimited fines and penalties.

Compliance with privacy requirements can be pivotal for a deal. Buyers hoping to acquire data associated with clinical trial participants have approached sites to acquire access to subject data in the context of licensing or a sale and thereby enable data brokers to maximize their data chests. However, the lack of appropriate and preexisting consent has often stymied such goals due to the inability to contact past clinical trial subjects at scale.

Regulatory Due Diligence

The quality of clinical research and the integrity of the data produced hinge on robust quality programs and oversight mechanisms. For Buyers, assessing the effectiveness of these programs at the target site is crucial. This assessment includes evaluating the site’s adherence to Good Clinical Practice guidelines and whether a competent quality assurance team is present. An effective quality assurance program may often include having in place defined goals, a clear list of standard operating procedures that are routinely updated and that staff are routinely trained on, and audits.

These audits should be conducted by both internal stakeholders and external consultants to minimize bias. Externally, clinical trial sponsors and clinical research organizations will routinely conduct such audits, since they are intended to improve the functioning at an individual site and also to ensure that if the US Food and Drug Administration (FDA) ever audits the site, the records are appropriately maintained. However, the FDA may nevertheless find problems at the clinical trial site. Such findings, even if addressed, have been deemed devastating by multiple clinical trial sites. It is therefore important for a potential investor to identify potential audit findings and evaluate the implications of such findings on valuation.

Preventing the Corporate Practice of Medicine

One of the foremost considerations in the context of clinical trial site acquisition is the consideration and prevention of the corporate practice of medicine. This doctrine, which varies by state, generally prohibits corporations or non-physicians from practicing medicine or employing physicians to provide professional medical services. It is intended to ensure that medical decisions are made by qualified medical professionals rather than corporate entities driven by profit motives, or individuals who may not adequately appreciate the medical decision-making process.

Some argue that research is exempt from corporate practice of medicine rules. Nevertheless, this conclusion is generally deemed to be premature and may need to be evaluated on a case-by-case basis. By way of example, while the definition of the practice of medicine varies from state to state, the implementing regulations of the Texas Medical Practice Act specifically define “Actively engaged in the practice of medicine” as including “clinical medical research” and “the practice of clinical investigative medicine.”

Some states, such as Michigan, will not allow physicians to be employed by non-physicians and only allow physicians to form professional corporations, professional associations, or professional limited liability companies so that they are owned exclusively by physicians. Accordingly, in such states, a clinical trial site engaged in the practice of medicine cannot be owned by a Buyer who is not a physician. On the other hand, several states, including Arizona, allow non-physicians to own a portion of a professional corporation that practices medicine, but they limit this to a 49 percent interest or other noncontrolling interest. In certain states, this also means that only the physician’s office can bill for medical services. In other states, however, no such requirements are imposed on clinical trial sites. This variability can have a dramatic impact on the value of a clinical trial site, and the appropriate structure of the relationship between a physician and a clinical trial site. It is therefore important to conduct a state-by-state analysis to evaluate the definition of the practice of medicine, its application, and its implication for the corporate practice of medicine to evaluate how it applies to your target research site.

Ownership Considerations

When a Buyer purchases a clinical trial site, they hope to not only own the site, but also prevent the physician performing the research from starting a competing clinical trial site next door.

As discussed above, depending on the state, Buyers may not be able to actually own the doctor’s office or the research site that performs medical services—since that could violate state law.

The Federal Trade Commission (FTC) has proposed banning noncompetes. A Texas district court recently struck down the FTC’s new final rule banning noncompetes. However, this created a circuit split with a Pennsylvania district court, which determined that the plaintiff failed to show it would be irreparably harmed by the noncompete rule and that the FTC had the authority to issue the noncompete rule. Nevertheless some states like Pennsylvania have independently banned noncompetes for healthcare practitioners. Buyers therefore have limited ways to prevent physician flight or prevent physicians from starting a competitor next door.

When the Buyer can neither purchase the physician’s office due to state law, nor prevent the physician from starting a competitor next door, it can be unclear what the Buyer is actually buying.

A Structural Solution

There is, however, a simple, time-tested way to address many of the privacy, regulatory, and corporate practice of medicine problems described above: creating a management service organization (MSO) to handle the nonmedical aspects of the clinical research site. Such a structure enables physicians to maintain control over medical decisions at their medical office, while the MSO can be owned by the Buyer and will provide the physician’s office with services related to clinical research. Such services may include regulatory assistance, sales and marketing, training, and more.

In such a situation, PHI provided to a doctor’s office is subject to HIPAA. However, a HIPAA waiver would be obtained from the patient to enable sharing information with the MSO. This would have the further advantage of sharing the same PHI with pharmaceutical companies or medical device companies (collectively, “Sponsors”), which are also not “covered entities” as defined by HIPAA and are therefore not subject to HIPAA regulations in the context of research. This is especially important since most Sponsors refuse to sign a HIPAA “Business Associate Agreement.” The signing of the HIPAA waiver reduces the risk of privacy-related liability.

In the event a Buyer has a holding company holding multiple MSOs, working with this MSO structure minimizes impact to the holding company and related companies. For example, if a single MSO is affected by a regulatory concern related to the FDA, or privacy, a Buyer may choose to disband or disavow that individual MSO and continue to operate its remaining MSOs without all of them being tainted by the regulatory finding.

Conclusion

For clinical research sites, partnering with Buyers can provide much-needed resources and support, but it also requires careful planning and due diligence to ensure that the partnership is aligned with the mission and values of both sides. Investors and sites preparing for sale and purchase must understand the nuances of complying with corporate practice of medicine doctrines, ensuring proper patient consent for data use, and evaluating the strength and quality of programs to ensure a smooth acquisition process.

In response to the misuse of generative artificial intelligence (“GAI”) in court filings, courts nationwide have promulgated standing orders and local rules on how parties should use GAI in the courtroom. This article will summarize those local rules and standing orders and identify common issues in cases where attorneys’ misuse of GAI resulted in potential sanctions. Of the approaches courts have taken thus far, the local rule set forth by the United States District Court for the Eastern District of Texas presents one notable model for courts considering promulgating a rule on the use of GAI, because it provides guidance on the use of GAI in court filings while remaining able to adapt to GAI’s rapid advancements.

An Overview of GAI

In a nutshell, GAI refers to machine learning algorithms that are “trained on data to recognize patterns and generate new content based on the ‘rules and patterns’ they have learned.”^[1] There are many different GAI programs that serve many different purposes. For example, ChatGPT is a GAI that can generate pages of material and has infamously been responsible for generating court filings that included fake cases. However, Grammarly and Microsoft Copilot are GAI that serve to help with clarity of writing. Moreover, Westlaw and LexisNexis have developed GAI to help with case research, which could streamline attorney work products and save money for law firms and clients.

Legal Standard

Current case law surrounding GAI has invoked Rule 11 and Rule 8 of the Federal Rules of Civil Procedure. Rule 11 provides that any document filed with the court must be signed by at least one attorney of record who certifies that “after an inquiry reasonable under the circumstances . . . the claims, defenses, and other legal contentions are warranted by existing law or by a nonfrivolous argument for extending, modifying, or reversing existing law or for establishing new law.”^[2] Rule 11 also requires certification that any document filed with the court does not “needlessly increase the cost of litigation . . . [and] the factual contentions have evidentiary support or . . . will likely have evidentiary support after a reasonable opportunity for further investigation or discovery.”^[3] Rule 8 provides that “a pleading that states a claim for relief must contain . . . a short and plain statement of the claim showing that the pleader is entitled to relief.”^[4] Although Rule 26 has not been implicated yet, discovery requests, responses, and objections could be drafted using GAI. Similar to Rule 11, Rule 26(g) requires that at least one attorney of record sign discovery requests and responses and certify that after a reasonable inquiry all filings are warranted by existing law, are nonfrivolous, and do not needlessly increase the cost of litigation.

A violation of Rule 8 can lead to a dismissal of the complaint, while violations of Rule 11 and Rule 26 can result in a range of sanctions. If a court decides to issue sanctions sua sponte, it should only do so “upon a finding of subjective bad faith.”^[5] When parties sign and file their affirmations and make no inquiries as to the accuracy of their assertions, it supports a finding of subjective bad faith.^[6] When parties use GAI to file documents that include fake cases, it inherently supports a finding of subjective bad faith because it demonstrates a lack of inquiry sufficient to impose sanctions sua sponte. Therefore, courts possess the power to sanction parties that misuse GAI and do not need to promulgate additional filing requirements.

Local Rules and Standing Orders Relating to the Use of GAI

Courts across the country have varied on how to address the use of GAI in court filings. Court rules on the topic have ranged from guidance implementing no additional requirements to a complete prohibition on GAI. However, most courts have promulgated a rule on GAI that requires some form of disclosure and certification when a party uses GAI.

A. Disclosure and Certification When GAI Is Used to Draft Filings

Courts that require disclosure when GAI is used to draft portions of a filing have variations on their requirements. Some courts only require a verification that the contents of the filing are accurate, while others require a separate certification in addition to the filing. For example, in 2023 the United States Bankruptcy Court for the Western District of Oklahoma promulgated a general order that requires that any document drafted by GAI be accompanied by a certification that

(1) identif[ies] the program used and the specific portions of text for which [GAI] was utilized; (2) certif[ies] the document was checked for accuracy using print reporters, traditional legal databases, or other reliable means; and (3) certif[ies] the use of such program has not resulted in the disclosure of any confidential information to any unauthorized party.^[7]

B. Disclosure and Certification When GAI Is Used to Prepare a Filing

Some courts require disclosure and certification when parties use GAI in any capacity to prepare filings with the court. However, these courts do not distinguish between GAI that can generate work products and other forms of GAI that can help clarify writing or facilitate legal research. For example, Judge Palk of the United States District Court for the Western District of Oklahoma created a standing order that is representative of this issue and requires parties that used GAI to draft or prepare a court filing to disclose “that [G]AI was used and the specific [G]AI tool that was used. The unrepresented party or attorney must further certify in the document that the person has checked the accuracy of any portion of the document drafted by [G]AI, including all citations and legal authority.”^[8] This suggests that to comply with the standing order, parties must disclose and certify every filing where they used legal search engines that incorporate GAI to help streamline search results or proofreading software such as Grammarly or Microsoft Word.

Some courts, mainly in Texas, take this a step further to require a certification regarding GAI regardless of whether it was used; they require that parties certify either that they did not use GAI to draft or prepare a filing or, if they did, that the parties will check “any language drafted by [GAI] . . . for accuracy, using print reporters or traditional legal databases, by a human being.”^[9] Overly broad disclosure and certification requirements can be cumbersome and difficult to enforce, and they may create confusion among individuals trying to file.

C. Prohibitions on the Use of GAI

A minority of courts prohibit parties from using GAI to draft documents that are filed with the court.^[10] Some judges prohibit the use of GAI in any capacity. Although these rules typically create a carve out to allow parties to use search engines that incorporate GAI, these orders do not create the same carve out for proofreading software that utilizes GAI for clarity of writing.^[11] For example, Judge Newman of the United States District Court of the Southern District of Ohio stipulates that “[n]o attorney for a party, or a pro se party, may use Artificial Intelligence (‘AI’) in the preparation of any filing submitted to the Court.” This magnifies the problem with not distinguishing between different forms of GAI discussed above because as more proofreading software incorporate GAI to assist with clarity of writing, this standing order will become increasingly arduous to comply with. Further, it would be impossible to consistently determine whether a party has used GAI to assist with clarity of writing or not, which would make such a standing order too far-reaching to the point that it is moot. As a result, these courts will likely have to change their local rules and standing orders in the near future.

D. Rules That Provide Guidance and Do Not Impose Additional Requirements

A handful of courts have addressed the use of GAI as guidance rather than imposing an additional filing requirement. For example, the United States District Court for the Eastern District of Texas promulgated a local rule that stated if a party used GAI to prepare or draft a court filing, Federal Rule of Civil Procedure 11 still applies. The local rule also reminds parties to review the generated content for accuracy if they use GAI, in order to avoid sanctions.^[12] This approach can achieve a court’s goal of addressing the use of GAI while also being able to adapt to the inevitable widespread adoption of GAI.

Common Issues That Arise in GAI Sanctions Jurisprudence

The main issue that the courts that have sanctioned litigants for misuse of GAI have encountered is the “hallucination” of cases when parties use GAI to generate work products. The United States District Court for the Southern District of New York addressed this issue in the infamous case Mata v. Avianca, where an attorney used ChatGPT to draft an Affirmation in Opposition that cited mostly fake cases.^[13] Since then, citing fake cases has been the main reason parties have been sanctioned for using GAI.^[14] In Kruse v. Karlen, in addition to hallucinating cases, the GAI also provided erroneous information about state statutes.^[15]

Courts have also dismissed pleadings generated with GAI because they violated Federal Rule of Civil Procedure 8(a). In Whaley v. Experian Information Solutions, Inc., a pro se litigant filed a 144-page complaint alleging a violation of the Fair Credit Reporting Act and used GAI to generate a portion of it.^[16] The complaint was verbose and confusing, and it lacked accurate citations. Therefore, the court dismissed the complaint without prejudice because it violated Rule 8(a).^[17]

The United States Bankruptcy Court for the Southern District of New York has also addressed the use of GAI in an expert witness report. In In re Celsius Network LLC, an expert witness generated a 172-page report using GAI in seventy-two hours. He admitted that a “comprehensive human-authored report would have taken over 1,000 hours to complete.”^[18] The report “contained numerous errors, ranging from duplicated paragraphs to mistakes in its description of the trading window selected for evaluation . . . [and] contain[ed] almost no citations to facts or data underlying the majority of the methods, facts, and opinions set forth therein.”^[19] As a result, Judge Glenn excluded the report from the record.^[20]

Although Rule 26 has not been at issue in cases noted thus far, GAI could easily be used in discovery requests, responses, and objections. Some courts have anticipated this possibility in their standing orders and stated that Rule 26 sanctions apply in addition to Rule 11 sanctions.

Conclusion

Although courts should rightfully be concerned about the widespread use of GAI, they already have the tools to address any issue that may arise without promulgating an additional rule. If parties use fictitious sources, they inherently violate the certification requirement under Rule 11 and Rule 26. The Fifth Circuit acknowledged this on June 11, 2024, and decided not to promulgate a rule on GAI because, as Law360 summarized it, “court rules already require attorneys to check filings for accuracy, and using AI doesn’t excuse lawyers from ‘sanctionable offenses.’”^[21] Imposing additional certification requirements or prohibitions is likely unnecessary and could burden parties and courts. Nevertheless, considering the changing landscape of GAI, a local rule similar to the one promulgated by the United States District Court for the Eastern District of Texas may be useful to inform litigants that the use of GAI is permitted and to serve as a reminder to check all sources for accuracy or else be subject to Rule 11 and Rule 26 sanctions.

1. Bernard Mar, What Is Generative AI: A Super-Simple Explanation Anyone Can Understand, Forbes (Sept. 26, 2023, 6:01 p.m.). ↑

2. Fed. R. Civ. P. 11(a), (b). ↑

3. Fed. R. Civ. P. 11(b)(1), (3). ↑

4. Fed. R. Civ. P. 8(b). ↑

5. Mata v. Avianca, 678 F. Supp.3d 443, 462 (S.D.N.Y. 2023) (quoting Muhammad v. Walmart Stores E., L.P., 732 F.3d 104, 108 (2d Cir. 2013)). ↑

6. Avianca, 678 F. Supp.3d at 464. ↑

7. Order re: Pleadings Using Generative A.I., General Order 23-01, Bankr. W.D. Okla. (2023). See also General Order on the Use of Unverified Sources, General Order 23-1, D. Haw. (2023) (requiring parties that used GAI to generate any filing with the court to disclose that they relied on an unverified source and confirm the language generated was not fictitious); Pleadings Using Generative Artificial Intelligence, General Order 2023-03, Bankr. N.D. Tex. (2023) (requiring parties to check for accuracy any portion of a document drafted by GAI through “print reporters, traditional legal databases, or other reliable means”); Blumenfeld Jr., J., Standing Order for Civil Cases, C.D. Cal. (last updated Mar. 1, 2024) (requiring a party that uses GAI to generate a portion of a filing to attach a separate document disclosing the use and certifying the accuracy of its content; Magistrate Judge Oliver of the same district also adopted this standing order); Vaden, J., [Standing] Order on Artificial Intelligence, Ct. Int’l Trade (2023) (requires that any submission that contains text drafted with GAI assistance be accompanied by (1) disclosure of what program was used and portions of the text that were so drafted and (2) a certification that the use of the program did not result in a breach of confidentiality to a third party). ↑

8. Palk, J., Disclosure and Certification Requirements – Generative Artificial Intelligence [Standing Order], D. Okla. (last visited Aug. 8, 2024). Judge Robertson of the United States District Court for the Eastern District of Oklahoma has also adopted this standing order. See also Cole, Mag. J., The Use of “Artificial Intelligence” in the Preparation of Documents Filed before This Court [Standing Order], N.D. Ill. (last visited Aug. 8, 2024) (requiring parties to disclose if GAI was used in any way, including legal research, during the preparation of the filing); Baylson, J., Standing Order re: Artificial Intelligence (“AI”) in Cases Assigned to Judge Baylson, E.D. Pa. (2023) (requiring parties to disclose if GAI was used in the preparation of the filing as well as a certification that each citation is accurate; Judge Pratter of the same district also adopted this standing order). ↑

9. Starr, J., Mandatory Certification Regarding Generative Artificial Intelligence [Standing Order], N.D. Tex. (last visited Aug. 8, 2024). Judge Kacsmaryk of the same district, Judge Olvera of the United States District Court for the Southern District of Texas, and Judge Crews of the United States District Court for the District of Colorado have also adopted versions of this standing order. ↑

10. Coleman, J., Memorandum of Law Requirements [Standing Order], N.D. Ill. (last visited Aug. 8, 2024). ↑

11. See Boyko, J., Court’s Standing Order on the Use of Generative AI, N.D. Ohio (last visited Aug. 8, 2024). See also Newman, J., Artificial Intelligence (“AI”) Provision, Standing Order Governing Civil Cases and Standing Order Governing Criminal Cases, S.D. Ohio (2023). ↑

12. E.D. Tex. Local Rules CV-11(g), AT-3(m) (2023). See also Subramanian, J., Individual Practices in Civil Cases [Standing Order], S.D.N.Y. (2023); Johnston, J., Artificial Intelligence (AI) [Standing Order], N.D. Ill. (last visited Aug. 8, 2024). ↑

13. Avianca, 678 F.Supp.3d at 450. ↑

14. See Park v. Kim, 91 F.4th 610, 612 (2d Cir. 2024) (an attorney cited nonexistent cases, and the judge referred her to the court’s Grievance Panel). See also United States v. Cohen, No. 18-CR-602 (JMF), 2024 WL 1193604, at *2 (S.D.N.Y. Mar. 20, 2024) (Michael Cohen’s lawyer cited three nonexistent cases generated by Google Bard); Ex parte Lee, 673 S.W.3d 755, 756 (Tex. App. 2023) (an attorney cited five sources in an appeal from an order of judgment; three were nonexistent, and the two published cases did not correspond to the reporter the cases were cited with); Will of Samuel, 206 N.Y.S.3d 888, 891, 896 (N.Y. Sur. 2024) (although counsel did not admit to using GAI, the court suspected use of GAI because five out of the six cases he cited were fake and ordered a hearing to determine the issue). ↑

15. Kruse v. Karlen, ED 111172, 2024 WL 559497, at *3 (Mo. Ct. App. Feb. 13, 2024). ↑

16. Whaley v. Experian Info. Sols., Inc., No. 3:22-cv-356, 2023 WL 7926455, at *2 (S.D. Ohio Nov. 16, 2023). ↑

17. Id. ↑

18. In re Celsius Network LLC, 655 B.R. 301, 308 (Bankr. S.D.N.Y. 2023). ↑

19. Id. at 308. ↑

20. Id. at 309. ↑

21. Sarah Martinson, 5th Circ. Won’t Adopt Rule on AI-Drafted Docs, Law360 (Jun. 11, 2024). ↑

Financial institutions have utilized service providers such as third-party vendors and nonbank entities that partner with banks for a multitude of purposes over many years. The use of service providers has not historically been a controversial issue, and financial institutions have always had an obligation to manage relationships in a manner that is consistent with safety and soundness standards. Given this background, what should we do differently when evaluating so-called bank partnership programs that have received more scrutiny, particularly in the FinTech context? The answer: closely monitor state legislation, given how rapidly evolving state law has created a patchwork of legal and regulatory issues for these programs, similar to but more complicated than prior waves of legislation regulating mortgage brokers, loan servicers, and debt collectors.

In June 2023, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) issued guidance on managing risks associated with third-party relationships (Guidance). This Guidance replaces and rescinds prior guidance and frequently asked questions that date back to 2008. The Guidance acknowledges the long-standing use of service providers—“[b]anking organizations routinely rely on third parties for a range of products, services, and other activities”—and the benefit of such relationships: “The use of third parties can offer banking organizations significant benefits, such as quicker and more efficient access to technologies, human capital, delivery channels, products, services, and markets.” However, it notes the use of a third party does not diminish or negate the financial institution’s responsibility to ensure its activities are run in a safe and sound manner and comply with applicable laws and regulations. In other words, a financial institution cannot avoid liability by delegating certain responsibilities to their service provider.

The Guidance emphasizes the need for an appropriate risk assessment of service provider relationships, as well as tailoring the compliance management system and oversight to be commensurate with the risk presented by the service provider. For financial institutions that wish to partner with a nonfinancial institution in a “bank partner” model, this Guidance provides a good framework on how to develop policies and procedures to ensure safe and sound banking practices.

At a glance, this should be the end of the story—create solid risk management practices and appropriately manage your relationships. However, state licensing regimes and the interplay of federal and state law create complex issues, particularly when analyzing a consumer lending bank partner program. Both financial institutions and their partners that are not financial institutions must be cognizant of the rapidly changing landscape on the state level. States have threatened, and currently are attempting, to opt out of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA). The purpose of DIDMCA was to place national and state banks on a level playing field. Other state legislation has created “predominant economic interest” and other so-called “true lender” tests to determine whether the financial institution is in fact the lender of record, or whether the loans should be treated as if the nondepository partner were the lender.

As a result, while the general premise of a bank partnership is old news, the current wave of legislation brings both an old concept (state licensing and supervision) and a new concept (substantively regulating the terms of credit extended by financial institutions through legislation purportedly applicable only to the nondepository entity) to regulating such partnerships. The complexity and sheer volume of state laws aimed at exercising authority over financial services products being provided by financial institutions means that both financial institutions and their partners must be diligent when crafting their relationship and monitoring ongoing legislative changes. Up-front consideration should be taken in developing the program, assigning responsibilities, developing comprehensive compliance management systems, and ensuring ongoing diligence.