Andrew Pery and Michael Simon have been commissioned by the ABA Business Law Section to write a book on Contract Analytics adoption trends. To that end, they have asked the Business Law Section membership to complete a brief survey about your views and use of Contract Analytics technology. You can access the survey by clicking here.
In his seminal work On Legal AI,Joshua Walker, a pioneer in the application of AI to the practice of law, posited the following rhetorical question relating to the benefits of applying AI to contract analysis: How do we use AI to produce “wise contracts”?
Walker’s predicate for posing this question is based on compelling empirical evidence. The legal profession is using outdated and inefficient practices in contract formation and analysis. As lawyers, we tend to be creatures of habit and, as Walker warns, “include certain vestigial clauses whose original purpose has long been absent and . . . do not necessarily reflect evolving business realities.”
In today’s interdependent and high-velocity business climate, contracts should not be viewed only as legal documents that may be used both as a sword and a shield in the event of breach or noncompliance, but rather as documents that set out a mutually enduring business relationship between the contracting parties. This ambition is far from current practices, however. In a recently published HBR article, A New Approach to Contracts, the authors, David Frydlinger, Oliver Hart, and Kate Vitasek, found that:
“[w]hen contract negotiations begin, they default to an adversarial mindset and a transactional contracting approach . . . used to try to gain the upper hand. However, these tactics not only confer a false sense of security but also foster negative behaviors that undermine the relationship and the contract itself.”
A McKinsey study likewise found that a narrowly focused transactional approach to contracting leads to considerable inefficiencies because such contracts “are lacking basic elements that could enable better vendor performance and cost savings.” Contracts are the engine of a business, with 90 percent of spending and investments governed by terms and conditions embodied in them, yet the McKinsey study found that “suboptimal contract terms and conditions combined with a lack of effective contract management can cause an erosion of value in sourcing equal to 9 percent of annual revenues. For Fortune’s 2016 Global 500 companies, this 9 percent would have equaled $2.5 trillion in value.”
Among the recommendations proposed by the McKinsey study is implementation of more rigorous contract review processes that involve cross-functional collaboration between operations and legal teams in order to achieve “greater visibility into existing contracts to enable the organization to write better contracts going forward. A semiautomated, basic screening process involves scanning contracts for keywords and phrases related to performance, value, and selected cost drivers.”
In the case of investigational contract analytics, contract language is important to surface obligations, potential liabilities, choice of law and forum, and representations and warranties in the event of material breach and penalties. Andrew Bartels, a contract life-cycle expert at the industry analyst giant Forrester, refers to this aspect of contract analytics as “who is responsible or liable when things don’t work as planned.”
According to the Institute for Supply Management, a typical Fortune 1000 company manages anywhere between 20,000 to 40,000 active contracts at any given time, at least 10 percent of which are misplaced, difficult to find, still in paper form, or on a file share somewhere, buried in an e-mail attachment, or otherwise unmanaged or forgotten. Unsurprisingly, the general counsel respondents to a Lexis 2018 study demonstrated that more than half of them—53 percent—spent “too much time on repetitive tasks.”
The pressure to adapt to the demands of high-velocity business transactions coupled with an intensely competitive global business environment is transforming how legal services are consumed and delivered. Richard Susskind, in his book Tomorrow’s Lawyers, referenced a confluence of three market drivers that impact the practice of law:
The “more for less challenge.” While legal department’s budgets are cut, the demand for increased output is increasing whereby legal departments are “facing the prospect of an increasing workload and yet diminishing legal resources.”
Liberalization of legal services delivery. Several jurisdictions now endorse Alternative Legal Service Providers (ALSPs), which could pose a significant competitive threat to traditional law firms. The ALSP market is pegged at $11 billion.
Legal expert systems. New AI systems mimic (even if they cannot replicate) human cognitive intelligence and automate tedious and labor-intensive contract review tasks traditionally performed by an army of over-worked lawyers. By way of illustration, JP Morgan developed an automated commercial credit and contracts review AI-based application that can extract 150 attributes from 12,000 commercial credit agreements and contracts in only a few seconds with a high degree of precision—the equivalent to 360,000 billable hours of legal work by its lawyers.
The level of innovation and its transformative impact on the practice of law is unprecedented. As a recent Yale Journal of Legal Technology article warned: “Technological innovation has accelerated at an exponential pace ushering in an era of unprecedented advancements in algorithms and artificial intelligence technologies . . . . [T]o survive the rise of technology in the legal field, lawyers will need to adapt to a new practice of law.”
Looping back to Joshua Walker’s question—“how do we use AI to produce wise contracts?”—the application of AI to contract formation and analysis is not a panacea. Contrary to the dystopian view that AI will replace lawyers, its likely impact will be as a compliment to good and efficient lawyering. One thing is certain, however: as Joshua Walker observes, “AI is fast. AI is cheap and you [as lawyers] are neither.”
Andrew Pery and Michael Simon have been commissioned by the ABA Business Law Section to write a book on contract analytics adoption trends. Please complete a brief survey about your views and use of contract analytics technology. The survey will take less than 20 minutes to complete. Please don’t miss your chance to tell us how you see the future of contracting.
M&A deal terms originating from Europe are increasingly found in the United States, particularly in the context of cross-border deals. Transactions featuring these deal terms are not yet common, but with the current deal environment, including the prevalence of auctions and increased sell-side private equity activity (both primary and secondary exits), some of these deal terms may eventually become commonplace in the United States. This article focuses on two emerging trends in the United States: the use of Vendor Due Diligence Reports (VDD) and the locked-box mechanism.
B. Vendor Due Diligence Reports
A VDD is typically found in a competitive auction process or a dual-track process (which involves preparing a company for an initial public offering while simultaneously pursuing a third-party sale). The VDD is not a marketing document and differs from a confidential information memorandum in that it objectively and comprehensively describes the target company’s financial and legal situation and discloses issues and risks. This is particularly useful in complex transactions because it helps accelerate the process by providing prospective buyers with more information at an earlier stage.
Of course, the VDD is not without its drawbacks. First, the exercise of producing a VDD can potentially be a source of tension between the client and its advisors, not unlike the auditors and their client in the context of audited financial statements. Second, although the VDD provides several benefits to the seller, including accelerating the bid timeline and helping foster detailed and high-quality indicative bids, one of the significant drawbacks is that it identifies issues that may result in lower bids. In this regard, VDD proponents argue that by disclosing the issues up front, the seller reduces the likelihood of a bid being lowered at a later stage of the negotiations (the rationale being that a sophisticated buyer would likely identify these issues as part of its due diligence and could then attempt to lower its initial bid). Third, the time saved during the accelerated bid timeline is simply shifted to the preparation phase, and the costs associated with a VDD can be significant. In Europe, the VDD can be provided to the prospective buyer and its lenders on a reliance basis, with the accounting or law firm preparing the VDD capping its liability vis-à-vis these third parties. VDDs are increasingly offered by accounting firms in the United States, but they are issued on a nonreliance basis. U.S. law firms generally would not provide any due diligence materials on a reliance basis, and it is unclear whether a law firm would be able to limit its liability, which is permitted in several European jurisdictions. However, European law firms and clients sometimes ask American law firms to provide a due diligence report on a reliance basis, and it may be helpful for the parties to clarify early in the process what the expectation is on this particular point. Please refer to the Report of the ABA Business Law Section Task Force on Delivery of Document Review Reports to Third Parties (67 Bus. Law. 99 (2011)) for an in-depth discussion on this particular issue.
C. Locked-Box Mechanism
The locked-box mechanism originated from the United Kingdom and has been used for years in M&A transactions across Europe, but many American sellers and buyers are still unfamiliar with it. In a nutshell, the locked-box approach removes price uncertainty associated with a post-closing working capital or other similar post-closing adjustment in that the seller and buyer negotiate a fixed price when signing the purchase agreement based on the agreed upon locked-box balance sheet. The locked-box mechanism forces the parties to focus on items such as normalized working capital before signing. Given that the economic interest passes to the buyer as at the locked-box date, the seller will often charge a per diem or (alternatively) interest on the equity value from the locked-box date until the closing to reflect the fact that the seller did not receive the proceeds from the buyer when the economic interest was passed to the buyer. Although concepts such as normalized working capital also apply to closing accounts, the parties sometimes do not focus on it as much as they should before signing and procrastinate until it is time to prepare the closing balance sheet, only to realize that they had not focused on (or agreed to) specific adjustments or normalizations. This lack of focus often results in disputes between the parties, and any claims resulting therefrom would not be covered by representations and warranties (R&W) insurance. The paradox is that the parties secure R&W insurance to avoid post-closing claims, but according to escrow claim studies, claims relating to purchase price adjustments are among the most frequent claims under a purchase agreement. As a result, one of the most “common” risk is one that is not covered by R&W insurance. Although the locked-box mechanism virtually eliminates purchase price adjustment disputes, it can introduce other issues. For one thing, the parties must agree on what constitutes permitted leakage between the locked-box date and the date of closing. An example of such permitted leakage would be arm’s-length, intra-group payments in the ordinary course. The locked box may not be appropriate in all circumstances: a carve-out transaction where assets from different divisions are sold and where there are no financial statements for the carved-out business would be problematic. Finally, agreeing on the locked-box balance sheet may prove to be more difficult in the context of a highly cyclical business, such as a toy business.
D. Conclusion
Although the deal terms described above remain uncommon in America, they are increasingly seen particularly in the context of cross-border deals with Europe. Some of these trends have already migrated to other parts of the world. Given the predictability of the locked-box mechanism and the fact that it virtually eliminates purchase price adjustment disputes, it seems to be the logical complement to R&W insurance, and it is surprising that this approach is not more common in the United States, especially in transactions involving a private equity seller.
In her chapter titled “Artificial Intelligence and the Work of Visionary Boards” from the ABA’s new book Law of Artificial Intelligence and Smart Machines, Anastassia Lauterbach reports that her research has shown that “traditional boards are not sufficiently prepared to address and fully benefit from AI.” Here are some of her findings from the chapter.
Editor, Ted Claypoole
“Before starting with any AI implementation, directors have to understand three facts:
It is becoming an increasingly obvious fact that certain mission critical business and compliance problems cannot and will not be properly solved without AI, including notably, cyber-security.
The regulatory environment around AI is in flux. Technology once again is outpacing and out-flanking the legal and regulatory frameworks, creating confusion as well as opportunity.
Companies must find talent that understands technology, but also has a keen ability to work cross-functionally. Business development and HR executives should rise to new prominence in companies that embrace emerging technologies such as AI.
. . .
There are several market-related factors boards need to understand in order to consider AI within their operational risk management frameworks and strategy oversight.
Technology leaders expect that within the next ten years AI as a stand-alone theme might disappear. It will get embedded into whatever product, service or process a company is designing and/or implementing. There are several market- and customer-related questions a board can ask to evaluate if a company should add Machine Learning components into its products and services. Some of these questions can also support decision making around AI vendors.
Cost to deploy. How much will it cost your customer not just to purchase your technology but also to change from their current solution to the new one? What is a minimum payback period in years in capital expenditures for a prospective customer, or for your company, if a vendor pitches a new Machine Learning solution?
Added-value beyond cost: What value does your Machine Learning-based software offer beyond labor substitution? Better quality, enhanced customer satisfaction, fewer errors, higher performance or throughput, something else?
Conflicting goals within potential customers: The scale at which AI or ML will eliminate or reduce human labor is likely to be significantly larger than any prior technology, resulting in potentially greater resistance. Will the human teams you are selling to lose their jobs as a result of your technology?
Regulatory/compliance issues: What are the current regulatory constraints that might complicate the adoption of your/the vendor’s offering? Besides technical challenges, humans tend to be more forgiving about mistakes made by humans as opposed to those made by AI, which might increase the liability hurdle on people overseeing automated systems.
Cybersecurity issues: The U.S. intelligence community reports that AI actually works in cybercriminals’ favor.[1] Neural networks can be trained to create spams resembling a real email and become an agent for phishing attacks. Fake audio and video files can mimic voice. CAPTCHA bypassing seems to be very easy, exposing digital sign in.[2] Most passwords can be breached with the brute force of Machine Learning. In 2017, the first publicly known example of AI for malware creation was proposed at Peking University in Beijing, when the authors created a MalGAN network.[3]
Industry readiness: Sometimes an industry is just not ready to adopt a new solution because it is highly risk-averse. This occurs primarily in industries that are focused and incentivized on time-consuming activities rather than efficiency through new business models and technologies. An example of this can be seen in traditional utilities. Artificial Intelligence is sometimes incorrectly thought of as a “plug and play” or “black box” solution, when in fact it is not.[4]
Vendors’ dynamics: Boards need to understand how top Internet brands, Machine Learning startups and traditional enterprise vendors compete. So far there are five full-stack AI companies, and all of them are among the global Fortune 10 list of the most valuable companies. These are Alphabet, Apple, Microsoft, Facebook and Amazon. I call these players “full-stack AI companies” as they control the whole technology stack—from semiconductors to devices—from their own platforms to ensure Machine Learning is utilized at every part of their organizations to build AI-powered consumer and business applications. Alphabet, Microsoft and Amazon are competing for dominance in cloud while constantly adding AI offerings. On the other hand, successful machine learning startups have deep domain expertise, and have concrete suggestions on how to solve their customers’ problems within a given legacy IT environment. Traditional enterprise vendors are jumping on the AI bandwagon, though they still have to demonstrate they can differentiate with their ML offerings.”
[1] James R. Clapper, “Statement for the Record. Worldwide Threat Assessment of the US Intelligence Community”, Senate Armed Services Committee, February 9th 2016.
[2] Suphannee Sivakorn, Jason Polakis, and Angelos D. Keromytis, “I’m not a Human: Breaking the Googe reCAPTCHA”, Columbia University, NY, 2016.
[3] “Weiwei Hu, Ying Tan, “Generating Adversarial Malware Examples for Black-Box Attacks Based on GAN”, Peking University, Beijing, 2017, arxiv.org.
[4] Daniel Fagella, “AI Adoption – What it Takes for Industries to Change, HuffPost, August 1st 2017.
For the last several years, noncompete agreements have been under attack in the United States by regulators, legislators, and the courts. For example, late last year, Massachusetts joined a number of states by enacting a law regulating noncompete agreements, including making them inapplicable to “nonexempt” employees. Courts do not favor noncompetes and will limit them or invalidate them completely. Regardless, noncompete agreements are here to stay, and businesses continue to rely on them as one way to protect customer goodwill along with confidential and proprietary information, which is why it’s important for counsel (in-house and outside) to take steps to ensure the noncompete agreements used by their clients have the best chance of surviving regulatory and judicial scrutiny. Here are some tips:
What is a noncompete agreement? A noncompete agreement is a contract entered into by an employer and an employee whereby the employee agrees that if their employment terminates (usually for any reason), then the employee will not—for some period of time and within some geographic boundary—compete directly with or go to work for a company that competes directly with the employer. Most U.S. courts will enforce noncompete agreements if they are reasonable as to geography and time and there is a legitimate business interest at stake.
Keep the group small. One controversial area is the extension of noncompete agreements to all the employees of a company, including administrative assistants and minimum wage workers. When reviewing a noncompete dispute, courts will review whether the employee has access to sensitive customer information and/or any other specialized or confidential information that could harm the employer if that employee started a competing business or went to work for a competitor. Tailor your agreement to the applicable employees and their particular circumstances.
Keep the restrictions reasonable and narrow. Courts will review a noncompete to ensure it does not interfere with the public interest (as set out in state law/state court decisions) or impose an undue hardship on the employee. This analysis includes reviewing the noncompete agreement for reasonableness as to geography and time. If either is overly broad, the court will not enforce the agreement. For example, a worldwide, five-year noncompete is unlikely to survive. Your noncompete stands a much better chance if the restrictions are narrowly drawn to the minimum necessary to protect the company. A one-year noncompete, limited to the state/geography where the company is based/competes will likely withstand scrutiny.
Provide consideration for the agreement. A noncompete, like any other contract, requires consideration to create a valid, enforceable agreement. If you require employees to sign your noncompete as part of their initial job offer, that is sufficient consideration. If you attempt to require an existing employee to sign a noncompete or else they lose their job, that is not sufficient consideration. If the agreement is part of a promotion, stock grant, special bonus payment, or similar offering, however, then the consideration element is satisfied.
Get it in writing. Relying on common law rights around noncompetition versus a clear contractual obligation is playing with fire. All noncompetes should be set out in writing and signed by both parties. Include a provision that gives the employee time to consult with an attorney to review the agreement before a signature is required (including a place for the employee to initial that section).This will help with enforcement.
Prepare multiple versions if necessary. Utilizing a single noncompete template is a bad idea unless your employees work only in one state or one country and work under similar circumstances; otherwise, be prepared to customize your noncompete template based on the laws of each jurisdiction where your employees work. Avoid using one template and finding out it’s unenforceable somewhere when you actually need to enforce it.
Concede choice of law/forum. Choice of law and choice of forum should get extra attention. If enforcement of your noncompete requires the employee to travel long distances at their expense (time and money) or if it imposes the law of a state or country that conflicts with rights the employee enjoys where he or she lives, you can run into problems. Balance and reasonableness are key.
Provisions to include. In addition to choice of law and forum, there are three basic clauses that you should include in every noncompete agreement:
Injunctive relief. Include a clause that expressly provides for injunctive relief as a remedy in the event of a breach. This clause should also provide that if there is a breach, there is a presumption of irreparable harm and consent to injunctive relief.
Attorney’s fees. Your noncompete should provide for an award of attorney’s fees and costs to the prevailing party.
Savings clause. This clause provides that if a court should render any clause in the noncompete invalid, the remaining contract clauses survive intact.
Use other types of agreements. Consider utilizing other types of agreements that might be less draconian than a noncompete but provide some of the same protections, e.g., nonsolicitation agreements (customers and employees) and nondisclosure agreements (protecting confidential information of the company).
Be prepared to enforce it. Nothing puts people on notice about the consequences of violating a noncompete like knowing you will file a lawsuit to enforce it. If you are going to use noncompete agreements, be prepared to enforce them in court.
Imagine that you are a plaintiff in a lawsuit, and you just settled your case for $1,000,000.[1] Your lawyer takes 40 percent ($400,000), leaving you the balance. Most plaintiffs assume their worst-case tax exposure would be paying tax on $600,000, but today, you could pay taxes on the full $1,000,000. Welcome to the crazy way legal fees are taxed.
In Commissioner v. Banks,[2] the Supreme Court held that plaintiffs in contingent-fee cases must generally recognize income equal to 100 percent of their recoveries. This is so even if the lawyer is paid directly by the defendant, and even if the plaintiff receives only a net settlement after fees. This harsh tax rule usually means plaintiffs must figure a way to deduct those fees.
Until 2018, there were two ways to deduct: above the line or below the line. Below-the-line (also called miscellaneous itemized) deductions, where plaintiffs historically deducted most legal fees, were disallowed for 2018 through 2025.[3] Thus, beginning in 2018, above the line is the only remaining choice, if you qualify. The above-the-line tax deduction is for employment, civil rights, and whistleblower legal fees, and is more important than ever. Qualifying for it means that in our example, at most you are taxed on $600,000.
Physical Injury Recoveries
You might think there would be no tax issues in physical injury cases, where damages should be tax free, but section 104 (the tax exclusion section for physical injury recoveries) applies only to compensatory damages, not to punitive damages or interest. What if a case has some of each?
Example: You are injured in a car crash and sue the other driver. Your case settles for $2 million—50 percent compensatory for physical injuries and 50 percent punitive damages. There is a 40-percent contingent fee. That means you net $1.2 million. However, the IRS divides the $2 million recovery in two and allocates legal fees pro rata. You claim $600,000 as tax free for physical injuries, but you are taxed on $1 million and cannot deduct any of your $800,000 in legal fees.
“Unlawful Discrimination” Recoveries
The above-the-line deduction applies to attorney’s fees paid in “unlawful discrimination” cases. The tax code defines a claim of unlawful discrimination with a long list of claims brought under:
The Civil Rights Act of 1991
The Congressional Accountability Act of 1995
The National Labor Relations Act
The Fair Labor Standards Act of 1938
The Age Discrimination in Employment Act of 1967
The Rehabilitation Act of 1973
The Employee Retirement Income Security Act of 1974
The Education Amendments of 1972
The Employee Polygraph Protection Act of 1988
The Worker Adjustment and Retraining Notification Act
The above-the-line deduction applies to whistleblowers who were fired or retaliated against at work. However, what about whistleblowers who obtain awards outside this context? The deduction applies to federal False Claims Act cases and was later amended to cover state whistleblower statutes as well. It applies to IRS tax whistleblowers and in 2018 was extended to SEC and Commodities Futures Trading Commission whistleblowers.
Catchall Employment Claims
Arguably the most important item in this list is a catchall provision for claims under:
[a]ny provision of federal, state or local law, or common law claims permitted under federal, state or local law, that provides for the enforcement of civil rights, or regulates any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.[5]
This is broad and should cover employment contract disputes even where no discrimination is alleged.
Civil Rights Claims
The catchall language in section 62(e)(18) also provides for deduction for legal fees to enforce civil rights. This unlawful discrimination deduction is arguably even more important than the deduction for fees relating to employment cases. What exactly are civil rights, anyway? You might think of civil rights cases as those brought under section 1983. However, the above-the-line deduction extends to any claim for the enforcement of civil rights under federal, state, local, or common law.[6] Civil rights is not defined for the purposes of the above-the-line deduction, nor do the legislative history or committee reports help. Some general definitions are broad, indeed, including:
a privilege accorded to an individual, as well as a right due from one individual to another, the trespassing upon which is a civil injury for which redress may be sought in a civil action. . . . Thus, a civil right is a legally enforceable claim of one person against another.[7]
In an admittedly different context (charitable organizations), the IRS itself has generally preferred a broad definition of civil rights. In a General Counsel Memorandum, the IRS stated that it “believe[s] that the scope of the term ‘human and civil rights secured by law’ should be construed quite broadly.” Could invasion of privacy cases, defamation, debt collection, and other such cases be called civil rights cases? Possibly.
What about credit reporting cases? Don’t those laws arguably implicate civil rights as well? Might wrongful death, wrongful birth, or wrongful life cases also be viewed in this way? Of course, if all damages in any of these cases are compensatory damages for personal physical injuries, then the section 104 exclusion should protect them, making attorney’s fee deductions irrelevant.
However, what about punitive damages? In that context, plaintiffs may once again be on the hunt for an avenue to deduct their legal fees. Reconsidering civil rights broadly might be one way to consider fees in the new environment. In any event, the scope of the civil rights category for potential legal fee deductions merits separate treatment in a forthcoming article.
Business Expenses
If sections 62(a)(20) and 62(e) are not fertile grounds for legal fee deductions, is anything else available? Can legal fees be a business expense? Of course they can. Business expense deductions were largely unaffected by the 2017 tax changes, other than the Weinstein provision restricting deductions in confidential sexual harassment cases.[9]
In a corporation, LLC, partnership, or sole proprietorship, business expenses are above-the-line deductions. Of course, one must ask whether one’s activities are sufficient to be considered really in business, and whether the lawsuit really is related to that business. If one can answer both of these questions in the affirmative, all is well.
However, a plaintiff filing his or her first Schedule C as a proprietor for a lawsuit recovery probably may not be convincing. Before the above-the-line deduction was enacted in 2004, some plaintiffs argued their lawsuits were business ventures. Plaintiffs usually lost these tax cases.[10] The repeal of miscellaneous itemized deductions until 2026 may revive such attempts.
Some may push the envelope about what is a trade or business and how their lawsuit is inextricably connected to it. Some plaintiffs may consider filing a Schedule C even if they have never done so before. Schedule C is historically more likely to be audited and draws self-employment taxes.
Capital Gain Recoveries
If your recovery is capital gain, you arguably could capitalize your legal fees and offset them against your recovery. You might regard the legal fees as capitalized or as a selling expense to produce the income. Thus, the new “no deduction” rule for attorney’s fees may encourage some plaintiffs to claim that their recoveries are capital gain, just (or primarily) to deduct or offset their attorney’s fees.
Exceptions to Banks
The remaining ideas in this article address attempting to keep attorney’s fees out of the plaintiff’s income in the first place. Technically, falling within one of the exceptions to the Banks case is not a way of deducting legal fees, but of avoiding the fees as income. In Banks, the Supreme Court laid down the general rule that plaintiffs have gross income on contingent legal fees. General rules have exceptions, however, and the court alluded to situations in which this general 100-percent gross income rule might not apply.
Separately Paying Lawyer Fees
Some defendants agree to pay the lawyer and client separately. Do two checks obviate the income to plaintiff? According to Banks, they do not. Still, separate payments cannot hurt, and perhaps Forms 1099 can be negated in the settlement agreement.
The Form 1099 regulations generally require defendants to issue a Form 1099 to the plaintiff for the full amount of a settlement, even if part of the money is paid to the plaintiff’s lawyer. Even so, a defendant might agree to issue a Form 1099 only to the plaintiff for the net payment. Banks seems to dictate there is gross income anyway, but the plaintiff might feel comfortable reporting only the net.
Fees for Injunctive Relief
The Supreme Court suggested that legal fees for injunctive relief may not be income to the client. If the plaintiff receives only injunctive relief, but plaintiffs’ counsel is awarded large fees, should the plaintiff be taxed on those fees? Arguably not. However, if there is a big damage award with small injunctive relief, will that take all the lawyer’s fees from the client’s tax return? That seems unlikely, although the documents might help finesse it.
Court-Awarded Fees
Court-awarded fees may also provide relief, depending on how the award is made and the nature of the fee agreement. Suppose that a lawyer and client sign a 40-percent contingent-fee agreement providing that the lawyer is also entitled to any court-awarded fees. A verdict for plaintiff yields $500,000, split 60/40. The client has $500,000 in income and cannot deduct the $200,000 paid to his or her lawyer. However, if the court separately awards another $300,000 to the lawyer alone, that should not have to go on the plaintiff’s tax return. What if the court sets aside the fee agreement and separately awards all fees to the lawyer?
Class-Action Fees
There has long been confusion about how legal fees in class actions should be taxed. Historically, there was a difference between the tax treatment of opt-in cases and opt-out cases. In more recent years, however, the trend appears to be away from taxing plaintiffs on legal fees in class actions of both types.
That is fortunate because the legal fees in class actions generally dwarf the amounts plaintiffs take home. It is an over-generalization, but most plaintiffs in most class actions generally assume that they will not be taxed on the gross amount (or even their pro rata amount) of the legal fees paid to class counsel. Optimally, the lawyers will be paid separately under court order.
Statutory Attorney’s Fees
If a statute provides for attorney’s fees, can this be income to the lawyer only, bypassing the client? Perhaps in some cases, although contingent-fee agreements may have to be customized. In Banks, the court reasoned that the attorney’s fees were generally taxable to plaintiffs because the payment of the fees discharged a liability of the plaintiffs to pay their counsel under their fee agreements. In statutory fee cases, a statute (rather than a fee agreement) creates an independent liability on the defendant to pay the attorney’s fees. If the statutory fees were not awarded, the plaintiff may not be obligated to pay any additional amount to his or her attorney.
Accordingly, some attorneys seem to assume that if a statute calls for attorney’s fees, the general rule of Banks can never apply. Arguably, though, more may be needed. If the contingent-fee agreement is plain vanilla, the fact that the fees can be awarded by statute may not be enough to distance the client from the fees. As the Banks decision notes, the relationship between lawyer and client is that of principal and agent. The fee agreement and the settlement agreement may need to address the payment of statutory fees.
Lawyer-Client Partnerships
A partnership of lawyer and client arguably should allow each partner to pay tax only on that partner’s share of the profits. The tax theory of a lawyer-client joint venture was around long before the Supreme Court decided Banks in 2005. Despite numerous amicus briefs, however, the Supreme Court expressly declined to address this long-discussed topic and whether it would sidestep the holding of Banks.
A mere fee agreement is surely not enough to suggest a partnership, but with appropriate documentation, one can argue that the lawyer contributes legal acumen and services, whereas the client contributes the legal claims. Lawyer purists will note the ethical rules that suggest this cannot be a true partnership because lawyers are generally not allowed to be partners with their clients. Yet, tax law is unique and sometimes at odds with other areas of law.
Could a lawyer-client partnership agreement provide that it is a partnership to the maximum extent permitted by law? Partnership nomenclature and formalities matter, and lawyer-client partnerships rarely seem to be attempted with conviction. A partnership tax return with Forms K-1 to lawyer and client might be difficult for the IRS to ignore. So far, however, lawyer-client partnerships do not look terribly promising.[11]
Conclusion
Returning to our $1,000,000 recovery with $400,000 in fees, no plaintiff will think it is fair to pay taxes on $400,000 paid directly to his or her lawyer. Increase these numbers, and emotions may run higher still. In the old days, alternative minimum tax and phased-out deductions often limited the efficacy of legal-fee deductions. There was plenty of grousing about those rules, but it was relatively rare for them to result in truly catastrophic tax positions. Nevertheless, there were a few cases in which plaintiffs lost money after tax.[12] Today, entirely disallowed legal fee deductions are less likely to be easily endured. Some plaintiffs may aggressively plan or report around this unjust landmine. They may try to gerrymander their settlement agreements to avoid receiving gross income on their legal fees. If plaintiffs cannot credibly argue that they avoided the gross income, they may go to new lengths to try to deduct or offset the fees. The bigger the numbers and the higher the contingent-fee percentage, the more creative and assertive the plaintiff may be. Good luck out there!
[9]See Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 13307 (2017); see also Robert W. Wood, Taxing Sexual Harassment Settlements and Legal Fees in a New Era, 158 Tax Notes 4, 545 (Jan. 22, 2018).
[10]See Alexander v. Comm’r, 72 F.3d 938 (1st Cir. 1995).
[11] Allum v. Comm’r, T.C. Memo 2005-117, aff’d, 231 F. App’x 550 (9th Cir. 2007), cert. denied, 128 S. Ct. 303 (2007).
[12]See Spina v. Forest Preserve District of Cook County, 207 F. Supp. 2d 764 (N.D. Ill. 2002), as reported in 2002 National Taxpayer Advocate Report to Congress, at 166; see also Adam Liptak, Tax Bill Exceeds Award to Officer in Sex Bias Case, N.Y. Times, Aug. 11, 2002, at 18.
Most companies and the boards that govern them like to think their operations and supply chains are free of human rights abuses, yet of the 40 million estimated people enslaved worldwide, 16 million are working in forced labor within company operations and supply chains. Millions more work under dangerous and sometimes brutal conditions, toiling for up to 19 hours a day and subject to physical abuse at the hands of their supervisors. The eighth edition of the List of Goods Produced by Child Labor or Forced Labor and the 17th annual edition of the Findings on the Worst Forms of Child Labor published in September 2018 by the U. S. Department of Labor’s Bureau of International Labor Affairs (ILAB) highlight specific industry sectors in which child labor or forced labor persists. Abused workers can be found around the world, including within the United States. According to the human rights group Walk Free Foundation, an estimated 400,000 people are believed to be trapped in trafficking and modern slavery in the United States. If for no reason other than brand protection, there is a need for immediate proactive corporate initiatives in this context. To eradicate modern slavery, the C-suite must be encouraged by business lawyers to actively engage in supporting meaningful upstream and downstream change in identifying and remediating modern slavery.
The federal Trafficking Victims Protection Act of 2000 (TVPRA), 18 U.S.C. §1589(a)(4) (originally enacted as Victims of Trafficking and Violence Protection Act, Pub. L. No. 106-386, §112, 114 Stat. 1464, 1487 (2000)), defines labor trafficking as “the recruitment, harboring, transportation, provision, or obtaining of a person for labor or services, through the use of force, fraud, or coercion for the purpose of subjection to involuntary servitude, peonage, debt bondage, or slavery.” 22 U.S.C. §7101(9).
The reality is that publishing a policy or two on the company website does not accomplish anything to tackle modern slavery or other abuses of labor standards. The growing development of legislative and investor focus on human rights issues is pushing larger companies to report on what, if anything, they are doing to tackle these problems at every tier of their supply chain. The United Kingdom’s Home Office estimates between 9,000 to 11,000 companies are required to report under the UK Modern Slavery Act alone. The reporting requirements recognize that modern slavery cannot be addressed without direct, private-sector participation. The work necessary for coordination of the efforts of the company’s internal legal, compliance, and procurement departments, however, can be daunting. Corporate resistance and real challenges encountered in drafting human rights policies and contract provisions, including greater exposure to the risk of litigation, must be addressed.
Human rights violations in the work force (including exorbitant recruitment fees and room and board fees, little to no pay, dangerous hourly demands, toxic exposure on the job site, and/or dangerous housing conditions, etc.) most often appear to involve the lower or lowest rung of a multi-tier international supply chain. Typically, this is the result of a breakdown in the company’s internal controls and due diligence processes. Red flags slip through the cracks and go unresolved, causing legal, financial, and reputational damage that cannot always be fully repaired. As more and more countries outside of the United States adopt laws to fight human rights violations, properly assessing the risk of human rights violations within the company’s supply chain and implementing an effective vendor risk-management program to assure compliance is essential to ensure that goods are not tainted by modern slavery, child labor, or other human rights violations.
The development of an enterprise-wide culture is essential, along with an understanding of, and commitment to, human rights (health and safety requirements, anti-forced labor, child labor, and indentured labor constraints). Supply chain mapping, integrated human rights due diligence, engagement with suppliers and workers, identification of root causes such as recruitment fees imposed on workers, and clear processes to remediate breaches when found are recognized as essential good practice if a company is trying to take their anti-slavery and worker abuse elimination seriously. Market-specific approaches must be identified and optimized.
The following diagrams attempt to capture the possible spectrum of diverse corporate cultures in this context and the degree of responsibility undertaken to mitigate or remediate human rights abuses caused, directly or indirectly, by their activities.
The role of U.S. Customs and Border Protection (CBP) to mitigate the risk of forced labor-produced goods from entering the United States under the Tariff Act of 1930, as amended by the Trade Facilitation and Trade Enforcement Act of 2015, should be recognized. The CBP has the authority to detain goods by issuing withhold release orders (WROs) at ports of entry if information reasonably, but not conclusively, indicates that merchandise is made with indentured, forced, or child labor. On September 30, 2019, CBP issued five WROs, effective immediately: garments produced by Hetian Taida Apparel Co., Ltd. in Xinjiang, China; disposable rubber gloves produced in Malaysia by WRP Asia Pacific Sdn. Bhd; gold mined in artisanal small mines in eastern Democratic Republic of the Congo; rough diamonds from the Marange Diamond Fields in Zimbabwe; and bone black manufactured in Brazil by Bonechar Carvão Ativado Do Brasil Ltda. The Reasonable Care September 2017 publication from CBP and its extensive series of questions (pages 8–15) should be routinely referenced because those questions can be easily modified for use by any company serious about supply chain due diligence. The publication also provides a good road map of what CPB auditors look for in trying to determine whether imported goods are tainted by convict, forced, or indentured labor and informs of the kind of documentation CPB (or other governmental units) will ask a company to produce in any forced labor inquiry.
A November 2016 publication born out of a collaboration between the Global Compact Network Netherlands, Oxfam, and Shift entitled How to do business with respect for human rights is a guidance tool for companies that is also extremely helpful as a starting point resource. It is an introduction to the core concepts in the UN Guiding Principles on Business and Human Rights, and includes some practical steps to prevent, address, and remedy human rights abuses committed in business operations. Similarly, the Business & Human Rights Resource Centre has a number of reporting guidance resources, including The Modern Slavery Registry, to address and report on modern slavery in the context of a broader human rights due diligence. Verité, a civil society organization that promotes workers’ rights in global supply chains through research, consulting, training, assessments, and policy advocacy, has also published a number of research reports and white papers that can provide the information necessary to identify complex labor problems and design tools to address those problems. Offering assessment and training, Verité and other consultants work with governments and companies to develop policy and launch compliance initiatives.
Many companies, however, are still under the impression that there are not enough concrete tools to implement human rights policies. The Business Law Section’s Uniform Commercial Code Working Group (Working Group) published their “2018 Report and Model Contract Clauses for International Supply Contracts” in both the Fall 2018 issue of The Business Lawyer (Vol. 73, No. 4) and Business Law Today, November 28, 2018. The aim of the Working Group in drafting the Model Contract Clauses (MCCs) was to use the leverage of Western buyers and the legal force of contract documents to help eradicated forced labor and risks to worker health and safety by creating legally effective and operationally likely provisions. Since publication, there has been widespread interest in the MCCs, some movement toward adoption, and significant constructive feedback that the Working Group has embraced.
During the Business Law Section Annual Meeting in Washington, D.C., the Working Group, along with the Corporate Social Responsibility Committee’s Subcommittee to Implement the ABA Model Principles on Labor Trafficking and Child Labor, decided to use the next six months to a year to determine how best to incorporate in the MCCs much of the constructive feedback received since the initial publication in the Fall of 2018. The idea is to publish a version 1.1. One suggestion is to provide a further explanation of what is referred to in the MCCs as “the Schedule P strategy.” The idea of the Working Group was to encourage any company using the MCCs to incorporate into their supply chain contracts by attachment human rights policies the company developed specific to its industry and operations. Schedule P was to be another set of specifications the goods had to satisfy to be conforming. That is still the idea, but many found vague references to a Schedule P confusing and called for specific examples or references to policies like the UN Guiding Principles on Business and Human Rights or the ABA Model Principles on Labor Trafficking and Child Labor. Another recommendation is for the MCCs to address buyers’ role in the creation of human rights violations with unrealistic delivery targets, last-minute changes to orders, and low price point expectations. The addition of buyers’ representations and warranties within the MCCs has been suggested, along with reference to a “responsible buyer” code of conduct. Turning to the MCCs’ current emphasis on buyer’s termination rights upon discovery of defective goods (defined in the MCCs to include goods that were perfect in every way except for the abuse of human rights in their manufacture, distribution, or shipping), commentators since the MCCs’ publication propose an acknowledgment of buyers’ high switching costs in many industries and stress the benefits of remediation and specific performance as opposed to termination. These alternatives to termination, it has been argued, must be acknowledged as better for the workers as well as for the companies that employ and engage them. Each of these points is to be considered in preparing version 1.1 of the MCCs, along with the addition of an optional arbitration clause to address disputes.
Given the ethical, business, social, and moral issues that are implicated along with the ever-growing international legal requirements, commercial lawyers certainly now have an obligation to advise every business client with complex (multitier) operations of the variety of human rights abuses that may be hidden in their supply chains. The potential liability for exploitative labor practices (legal, moral, and social) require increased vigilance as well as thoughtful analysis of traditional confidentiality obligations and historic ownership of the attorney-client privilege. After discovery of a human rights violation in the audit or due diligence process, what reporting obligations does the discovering company, and its counsel, have to the CBP, local authorities, or the DOJ? The crime/fraud exception to the attorney-client privilege must be addressed by counsel with reference to both state specific and ABA Model Rules 1.6(b)(1), 1.13(c), and 1.16(b)(4) and 2. Such an analysis is especially significant in the context of a merger or acquisition when the buying company uncovers wrongdoing in advance of, or subsequent to, an acquisition and wishes to secure DOJ cooperation credit for successor liability after the transaction.
In 2003, TVPRA was expanded to allow civil causes of action for money damages against traffickers in federal courts and, since 2008, against anyone involved in the list of trafficking-related offenses “whomsoever knowingly benefits, financially or be receiving anything of value from participation in a venture which that person knew or should have known has engaged in an action in violation . . .” of Chapter 77 of Title 18. See William Wilberforce Trafficking Victims Protection Reauthorization Act of 2008, Pub. L. No. 110-457,122 Stat. 5067, tit. ll, § 221(2) (2008), as amended by Justice for Victims of Trafficking Act of 2015, Pub. L. No. 114-22, 129 Stat. 247, tit. l, § 120(2015). TVPRA permits both compensatory and punitive damages as well as attorney’s fees. Plaintiffs frequently file other claims alongside TVPRA, including claims under the Fair Labor Standards Act, state wage and hour laws, common law theories of intentional infliction of emotional distress, false imprisonment, conversion, and breach of contract, according to the Human Trafficking Legal Center’s study Federal Human Trafficking Civil Litigation; 15 Years of the Private Right of Action. Although many settlement amounts are undisclosed, known settlement and damage awards since 2003 total in excess of $108,657,000, according to the same study. In the meantime, every state has passed laws targeting trafficking activities to varying degrees. Delaware, New Jersey, and Washington have laws fulfilling all 10 categories of laws that Polaris, a nonprofit organization dedicated to the global fight to eradicate modern slavery, determined are critical to a basic legal framework that combats human trafficking, punishes traffickers, and supports survivors.
The risk of criminal or civil litigation under applicable international, federal, or state law against a company that knowing produces, or allows affiliates to produce, goods that are the product of modern slavery (or other human rights abuses) is very real and mounting. Addressing the possibility of such a taint at any point in supply chains with the highest degree of corporate leadership, persistence, and transparency is both virtuous and strategic.
The American Bar Association’s Business Law Section recently issued a letter in response to a request for comments from the International Organization of Security Commissions (IOSCO) on its May 2019 Consultation Report addressing “Issues, Risks and Regulatory Considerations Relating to Crypto-Assets Trading Platforms” (IOSCO Report or Report).[1] The IOSCO Report, citing “the emergence of crypto-assets [as] an important area of interest for regulatory authorities,” provided guidance concerning oversight of secondary markets and the trading platforms that facilitate secondary trading of crypto-assets (Crypto-Asset Trading Platforms or CTPs). Members of the ABA Derivatives and Futures Committee’s Subcommittee on Innovative Digital Products and Processes (IDPPS) prepared the comment letter to highlight the need to evaluate whether new regulations are necessary to fit crypto-assets and CTPs within current regulatory frameworks, to consider the viability and potential of self-regulatory organizations (SROs), and to encourage an economic cost-benefit analysis of any new regulations.[2]
The IOSCO Report focuses on several major issues and considerations associated with regulating CTPs and provides helpful toolkits to assist regulatory authorities in analyzing these issues, with a goal of balancing regulatory oversight with fostering innovation. The IDPPS, with its comment letter, aims to provide helpful insight regarding striking the right balance.
The Report’s key considerations include: (1) access to CTPs; (2) safeguarding participant assets; (3) conflicts of interest; (4) CTP operations; (5) market integrity; (6) price discovery; (7) technology (systems resiliency, reliability, and integrity, as well as cybersecurity and resilience); and (8) custody, clearing, and settlement. The Report analyzes these issues with an eye toward promoting IOSCO’s core objectives regarding securities regulation, which include protecting investors and ensuring that the markets are fair, efficient, and transparent.
The Report also discusses certain of the currently operational CTP models, describes the risks and issues identified by regulatory authorities, and examines how such risks and issues have been, or could be, addressed. The IDPPS comment letter, in turn, encourages IOSCO and its members to consider what types of regulation are appropriate for CTPs, and poses the following questions:
Would it be appropriate to regulate the CTP market through an SRO model, or would a mix of SRO with some form of regulatory oversight be appropriate? What types of considerations should local jurisdictions consider when structuring such a regulatory framework?
Separately, would regulation by enforcement be sufficient, and what would be the key considerations in order to make such a determination?
As noted in the comment letter, the market is tackling not only the question of whether and what additional regulation is necessary, but also how to adapt existing regulations to cover these new risks in a regulatory framework that is not prohibitively expensive. Accordingly, SROs are an important means to balance these considerations, especially given the unique features of CTPs and the rapidly evolving crypto-asset markets. In particular, IOSCO, in its previously issued Model for Effective Self-Regulation, endorsed the use of SROs as having the potential to harness industry knowledge, respond quickly to marketplace changes, and potentially facilitate cross-border information sharing.
Crypto-assets, distributed ledger technology, and innovations in financial technology more broadly have the potential to significantly reshape the financial markets. The IDPPS agrees with IOSCO that “fostering innovation should be balanced with the appropriate level of regulatory oversight” and encourages IOSCO to continue engaging with industry participants, including technologists, to understand both the risks and the benefits of new technologies. As the Report recognizes, CTPs and crypto-asset trading generally will operate in ways not contemplated by existing financial regulatory frameworks. The comment letter encourages IOSCO to remain open to differing approaches to achieving regulatory objectives concerning crypto-assets and CTPs. With the rapid pace of technological advances, it also urges financial regulatory authorities to continue improving cost-benefit analyses to account for not only the direct impact of the rules being analyzed, but also the indirect burdens associated with a given rule and whether more flexible or less burdensome requirements can achieve the same or similar objectives.
The IDPPS was established in March 2018 and has over 80 members, comprised of attorneys who work extensively in the areas of derivatives and securities law, FinTech, and related areas. It is organized into three working groups: the Jurisdiction Working Group, the Blockchain Modality Working Group, and the SRO Working Group. In March 2019, IDPPS published a paper prepared by members of the Jurisdiction Working Group and their colleagues that provides a comprehensive survey of the regulation of cryptocurrencies and other digital assets at the federal and state levels in the United States, along with summaries of key initiatives outside the United States. IDPPS is undertaking other projects through its working groups as well. The Blockchain Modality Working Group is considering commercial and regulatory issues relating to application of blockchain technology in the financial markets and financial services industry, and the SRO Working Group is considering issues for potential implementation of self-regulation with respect to CTPs and digital assets markets.
[1] Special thanks to Paul Hastings Associate Andrew Sterritt for his assistance with this article.
[2] The IDPPS Subcommittee wishes to thank Yvette Valdes, Gavin Fearey, and Aaron Friedman for their contributions to the comment letter.
The Rooker-Feldman doctrine[1] is a legal precept invoked by defendants to strip federal district and bankruptcy courts of their subject matter jurisdiction over suits that can be characterized as appeals or reconsideration of state court judgments. This article discusses the nature of the Rooker-Feldman doctrine and its limitations under the Bankruptcy Code when asserted as a defense to the prosecution of avoidance actions.
Under the Bankruptcy Code, avoidance actions consist of the prosecution of preference claims and fraudulent transfers claims. Avoidance actions permit a trustee, a debtor in possession, or the representative of a debtor’s estate to recover assets that were transferred out of the debtor’s estate prior to the commencement of a bankruptcy case for the benefit of the debtor’s creditors. The avoidance powers under the Bankruptcy Code promote the “prime bankruptcy policy of equality of distribution among creditors by ensuring that all creditors of the same class will receive the same pro rata share of the debtor’s estate.”[2] The right to avoid such transfers protects the interests of the debtor’s general body of creditors by maximizing the assets available for distribution to such creditors, thus placing creditors in a more favorable position to recover on their claims against the debtor.
The policy underlying the Rooker-Feldman doctrine is based on the concept that a litigant should not be able to challenge state court orders in federal courts as a means of relitigating matters that already have been considered and decided by a court of competent jurisdiction. The Rooker-Feldman doctrine also applies where a lower federal court is asked to conduct a review of a state court judgment for errors in construing federal law or constitutional claims that are inextricably intertwined with, or impacts the validity of, the state court judgment.[3] The litmus test that a federal court must apply is whether the relief requested in the federal action would effectively reverse the state court decision or void its ruling.
In bankruptcy cases, the Rooker-Feldman doctrine has been applied in cases involving, by way of example, the estimation of a judgment creditor’s claim that arose from a pre-petition state court judgment against a debtor;[4] attacking a state court judgment for lack of procedural due process;[5] dismissing an adversary proceeding challenging a foreclosure judgment; [6] a marital dispute concerning exempt property and discharge in the face of a state court judgment;[7] and a state court’s adjudication of the automatic stay.[8] In these cases, the doctrine was invoked to maintain the separation of federal and state courts and to protect and enforce state court judgments.
However, application of the Rooker-Feldman doctrine is subject to limitations. In Exxon Mobil Corp. v. Saudi Basic Indus. Corp.,[9] the Supreme Court recognized that the Rooker-Feldman doctrine is a narrow jurisdictional bar to litigation where the losing party “repairs to federal court to undo the [state court] judgment in its favor.”[10] The Supreme Court cautioned that “Rooker-Feldman does not otherwise override or supplant preclusion doctrine or augment the circumscribed doctrines that allow federal courts to stay or dismiss proceedings in deference to state-court actions.”[11] The Supreme Court noted that, “[i]f a federal plaintiff ‘present[s] some independent claim, albeit one that denies a legal conclusion that a state court has reached in a case to which he was a party . . . , then there is jurisdiction and state law determines whether the defendant prevails under principles of preclusion.”[12] An important factor in Exxon Mobil is that the plaintiff was not seeking to overturn the state court.
A number of courts examining the reach of the Rooker-Feldman doctrine in bankruptcy cases have concluded that it has little or no application in the context of avoidance actions, which are independent claims under the Bankruptcy Code.[13] Recently, the Third Circuit adopted this position in its decision in the Philadelphia Entertainment[14] bankruptcy case in which the court limited the application of the Rooker-Feldman doctrine to an avoidance action under sections 544 and 548 of the Bankruptcy Code.
In Philadelphia Entertainment, the debtor, which owned a gaming business, was awarded a state license to operate slot machines. Prior to the debtor’s commencement of its chapter 11 case, the state gaming authority revoked the gaming license for the debtor’s failure to comply with its past orders and demonstrate financial suitability. The debtor appealed the revocation order to the state court and lost.
After the confirmation of the debtor’s chapter 11 plan, the litigation trustee commenced an adversary proceeding before the bankruptcy court to avoid the revocation of the license as a constructively fraudulent transfer. Specifically, the debtor claimed that the revocation of the license was a transfer for which the debtor received no value from the state. The bankruptcy court invoked the Rooker-Feldman doctrine to dismiss the trustee’s lawsuit, finding that the doctrine divested the court of subject matter to consider the avoidance claim. The district court affirmed, adopting the bankruptcy court’s Rooker-Feldman conclusions.
The Third Circuit reversed the lower courts concluding that the bankruptcy court erred when it held that the Rooker-Feldman doctrine barred its review of the fraudulent transfer claims. The court noted that the doctrine applies when four requirements are met: (1) the federal plaintiff lost in state court, (2) the plaintiff complains of injuries caused by the state court judgment, (3) that judgment issued before the federal suit was filed, and (4) the plaintiff invites the district court to review and reject the state court judgment. The Third Circuit found that the fourth requirement was not met. Relying on Exxon Mobile, the Third Circuit ruled that so long as federal court litigation does not concern “the bona fides of the prior judgment,” the federal court “is not conducting appellate review, regardless of whether compliance with the second judgment would make it impossible to comply with the first judgment.”[15]
The court further noted that the bankruptcy court applied the Rooker–Feldman doctrine too broadly in finding that the fraudulent transfer claims required the federal courts to void the state court order. In particular, the court found that the litigation trustee was not complaining of an injury caused by the state court judgment and thus was not seeking a review and rejection of that judgment. In particular, the trustee’s fraudulent transfer claims did not require the bankruptcy court to conduct an appellate review of the order revoking the gaming license. An important consideration for the Third Circuit was that “a federal court can address the same issue ‘and reach[] a conclusion contrary to a judgment by the first court,’ as long as the federal court does not reconsider the legal conclusion reached by the state court.”[16] In other words, the Rooker-Feldman doctrine should not apply when a federal statute, in this case the avoidance statutes under the Bankruptcy Code, specifically authorizes a lower court to vitiate a state court judgment.
The exception for avoidance actions under the Rooker-Feldman doctrine is important for debtors in possession and trustees in bankruptcy cases because the prosecution of these claims can be highly valuable for creditor recoveries. As noted, one of the key policy objectives of bankruptcy is the maximization of creditor recoveries, which is often achieved through the prosecution of avoidance actions. Although the Rooker-Feldman doctrine operates to protect the integrity of state court judgments attacked in federal courts, the doctrine does not survive this policy objective under the Bankruptcy Code.
[1] The Rooker-Feldman doctrine derives its name from two U.S. Supreme Court cases, Rooker v. Fidelity Trust Co., 263 U.S. 413 (1923), and District of Columbia Court of Appeals v. Feldman, 460 U.S. 462 (1983). The Ninth Circuit decision in In re Gruntz, 202 F.3d 1074 (9th Cir. 2000), contains an extensive discussion of the origins of the doctrine and its intersection with title 28 of the United States Code.
In a recent decision from Minnesota, a limited partnership was ordered to be dissolved in an action brought by the assignees of the limited partners. Storeland v. Nordic Townhomes Limited Partnership, A18-1564, 2019 WL 1983500 (Minn. Ct. App. May 6, 2019).
Nordic Townhomes was originally organized with three limited partners and three general partners. With the passage of time, all of the original limited partners died. No new limited partners were admitted, and the heirs of the various limited partners became transferees of their respective interests in the partnership. The partnership agreement of Nordic Townhomes and the present situation were summarized by the court as:
[O]nce Nordic did not have any limited partners, the partnership was to dissolve, liquidate, and cease doing business. Despite the fact that Nordic does not have any limited partners, it continued to exist as an entity and conduct business.
The plaintiffs, they being some of the transferees of now deceased limited partners, filed a complaint seeking that Nordic Townhomes wind up its business, satisfy its debts and obligations, and distribute the net proceeds to those holding the economic rights in the partnership. The limited partnership responded by claiming that the plaintiffs did not have standing to seek either judicial or nonjudicial dissolution of the partnership on the basis that they were neither limited or general partners. The trial court granted the plaintiffs’ summary judgment, in effect finding that they could enforce the provision of the limited partnership agreement with respect to the partnership’s dissolution. This appeal followed.
Applying an “injury-in-fact” paradigm, the Minnesota Court of Appeals found that the assignees of the limited partners had standing to enforce that provision of the limited partnership agreement directing that the partnership be dissolved upon having no limited partners:
Here, respondents suffered an injury-in-fact sufficient to give them standing to ask the district court to enforce the partnership agreement. The partnership agreement is clear: Nordic was to be dissolved when there were no longer any limited partners. That process involves liquidating assets, and respondents are entitled to their share of any profits remaining once partnership obligations are resolved. See Minn. Stat. § 321.0702(b)(2) (2018) (stating that “upon the dissolution and winding up of the limited partnership’s activities [a transferee is entitled to] the net amount otherwise distributable to the transferor”). Because respondents are entitled to their share of that money, and because Nordic refused to take steps to dissolve the partnership and liquidate assets, respondents suffered an injury-in-fact sufficient to confer standing.
Further rejecting the claim that the court was allowing a nonpartner to move for judicial dissolution, the court observed that, “respondents’ action is more properly characterized as seeking enforcement of the partnership agreement rather than seeking judicial dissolution of the partnership. And because we conclude that respondents have standing because they suffered an injury-in-fact, respondents do not need a statutory basis to have standing.” Still on that same point, the court wrote:
[T]he partnership agreement clearly states that Nordic was to be dissolved when there were no limited partners. Accordingly, as transferees, respondents had standing to ask the district court to enforce the partnership agreement and the district court correctly required Nordic to follow the partnership agreement’s mandate of dissolution and liquidation.
Finally, although our opinion rests on our application of the law, we observe that adopting Nordic’s position could effectively result in no one having standing to seek enforcement of the partnership agreement. We do not discern the Minnesota law leaves transferees like respondents without redress in cases where remaining general partners fail to abide by the partnership agreement.
I find this decision somewhat troubling. Yes, all the court is doing is enforcing the agreement, but it is enforcing the agreement on behalf of persons who are not parties to it. As transferees of economic interests in the limited partnership, the plaintiffs in this action have no right to participate in the limited partnership’s management. Although the original limited partners would have been parties to the limited partnership agreement and in that role had the capacity to bring an action for its enforcement, that right did not devolve to the transferees upon the deaths of the limited partners. They are not parties to the limited partnership agreement, and for that reason an “injury-in-fact” paradigm fails; the failure of strict compliance with the limited partnership agreement gave no rise to an injury in the transferees because they were never parties to that agreement to begin with. In effect, the court is allowing nonparties to an agreement to insist upon its enforcement. What about the requirement of privity before bringing an action for enforcement? What about the provision of the Minnesota Limited Partnership Act (Minn. Code § 321.0702(a)(3)) that provides a transferee has no right to participate in the partnership’s management?
At its April meeting, the Advisory Committee on Civil Rules approved a proposed amendment to Federal Rule of Civil Procedure 7.01 that, if adopted, will require that each party to a lawsuit in federal court where jurisdiction is conditioned upon diversity jurisdiction (28 U.S.C. § 1332) file a statement setting forth the information necessary to determine each parties’ citizenship.
For purposes of federal diversity jurisdiction, no plaintiff may have the same citizenship as any defendant. See, e.g., OnePoint Solutions, LLC v. Borchert, 486 F.3d 342, 346 (8th Cir. 2007) (complete diversity “exists where no defendant holds citizenship in the same state where any plaintiff holds citizenship.”). In the case of a natural person, one is a citizen of the state in which one is domiciled. Although there can be disputes as to a person’s domicile (see, e.g., Art Van Furniture LLC v. Zimmer, 2019 WL 2433245 (E.D. Mich. June 11, 2019)), seldom will that occur. A corporation (private, nonprofit, professional service, etc.) is a citizen of its jurisdiction of incorporation and a citizen of the state in which it maintains its principal place of business (see 28 U.S.C. 1332(c)(1)), the latter determined under the “nerve center” test. See Hertz Corp. v. Friend, 559 U.S. 77, 130 S. Ct. 1181 (2010) (decision adopting and explaining the “nerve center” test). Although there may be more dispute as to the location of a corporation’s principle place of business than the domicile of an individual, the dispute and confusion is, again, unlikely.
Things become more complicated for other business organizations, including partnerships, limited partnerships, LLCs, and business trusts. In each of those instances, the organization itself has no citizenship. Indeed, the state of organization and location of the principal place of business play no role in determining the citizenship of these organizations. See, e.g., Citizens Bank v. Plasticware, LLC, 2011 WL 5598883 (E.D. Ky 2011); Hale v. MasterSoft Int’l Pty. Ltd., 93 F.Supp.3d 1108 (D. Colo. 2000). Rather, the organization’s citizenship is the citizenship of each of its “members.” In the case of a partnership or limited partnership, the members are, for these purposes, every general partner and every limited partner. See Carden v. Arkoma Assoc., 494 U.S. 185 (1990). In the case of a limited liability company, it will be deemed to have the citizenship of every one of its members. See, e.g., Cosgrove v. Bartoletta, 150 F.3d 729 (7th Cir. 1998). A business trust will have the citizenship of every one of its beneficial owners. See Conagra Foods, Inc. v. Americold Logistics, LLC, 136 S. Ct. 1012 (2016). Whether it will as well have the citizenship of any trustee who is not also a beneficial owner is something of an open question. See Thomas E. Rutledge & Christopher E. Schaefer, The Trust as an Entity and Diversity Jurisdiction: Is Navarro Applicable to the Modern Business Trust?, 48 Real Property, Trust & Estate L. J. 83 (Spring 2013). This means that an unincorporated business organization may be a citizen of numerous states, perhaps even every state if its membership is large enough. See, e.g., Reisman v. KPMG Peat Marwick LLP, 965 F.Supp. 165 (D. Mass. 1997 (noting that the then-“Big Six” accounting firms are “effectively immunized” from being subject to diversity jurisdiction).
The proposed amendments to Rule 7.01, if adopted, would require unincorporated business organizations to file with the court information as to the citizenship of each of its partners/members/beneficial owners. Recall that in many instances business organizations are in turn owned by other business organizations. For example, consider an LLC in which one of the members is a limited partnership. It will now be necessary that the LLC, in order to satisfy the proposed rule, list the partners, both general and limited, of that limited partnership. Ultimately, that LLC (or other unincorporated organization) must drill down through all of its layers of ownership until it reaches natural persons (who have their own citizenship), corporations (again, who have a recognized citizenship), and other structures, an example being a decedent’s estate, that, again, have their own citizenship. See, e.g., Delay v. Rosenthal Collins Group, LLC, 585 F.3d 1003, 1005 (6th Cir. 2009) (“When diversity jurisdiction is invoked in a case in which a limited liability company is a party, the court needs to know the citizenship of each member of the company. And because a member of a limited liability company may itself have multiple members—and thus may itself have multiple citizenships—the federal court needs to know the citizenship of each ‘sub-member’ as well.”).
Although this may seem burdensome at first blush, this proposed rule (and at this juncture it is only a proposal) would require nothing more than is already required; the parties to the dispute and the court have an obligation to confirm that diversity jurisdiction exists. Thus, at some juncture (and that juncture should be early) there must be scrutiny of the parties’ citizenship. See, e.g., Four Winds Distrib., LLC v. Cincinnati Ins. Co., 2019 WL 3940936 (D. Colo. Aug. 20, 2019) (“delay in addressing the issue only compounds the problem if, despite much time and expense having been dedicated to the case, a lack of jurisdiction causes it to be dismissed.”). Parties (particularly their attorneys) fail to engage in this analysis at their peril. See, e.g., Belleville Catering Co. v. Champaign Marketplace, LLC, 350 F.3d 691 (7th Cir. 2003) (case then on appeal on the merits to the Seventh Circuit Court of Appeals remanded to state court where diversity jurisdiction was in fact not present, depriving federal courts of jurisdiction; counsel ordered to relitigate dispute in state court pro bono on behalf of clients as sanction for this “doomed foray into federal court”). The proposed amendment to Rule 7.01, if adopted, will streamline the process, requiring each party to make a declaration to the court rather than leaving the determination of citizenship to the discovery process. Moreover, this proposed rule change may eliminate oft-seen gamesmanship as to the availability of diversity jurisdiction, particularly with respect to facial attacks. See, e.g., Lincoln Benefit Life Co. v. AEI Life, LLC, 800 F.3d 99 (3d Cir. Sept. 2, 2015) (court ordered jurisdictional discovery when defendant asserted a facial attack on the plaintiff’s position that diversity jurisdiction existed, trying to defeat the jurisdictional statement while denying information as to its citizenship, which was not publicly available).
This change (again assuming its adoption) will perhaps reduce the initial burden on a plaintiff filing in or a defendant removing to federal court. It is rare that the membership of an unincorporated entity available in the public record. This objective fact has necessitated allegations of diversity based upon “information and belief.” See, e.g., Wright, Federal Practice & Procedure § 1224 (pleading diversity jurisdiction on the basis of “information and belief” is a “practical necessity.”). There are, however, a number courts that have rejected allegations of diversity based on information and belief. See, e.g., Pharmerica Corp. v. Crestwood Care, LLC, 2015 WL 1006683 (N.D. Ill. Mar. 2, 2015); Principal Solutions LLC v. Feed.Ing BV, 2013 WL 2458630 (E.D. Wisc. June 5, 2013). Assuming that the party bringing the action to federal court has a good-faith basis for the assertion that diversity exists, and as that assertion will be quickly tested against the other parties’ citizenship disclosure, perhaps any bar against information and belief pleading should be reduced.
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