On June 21, 2018, the Supreme Court decided Lucia v. SEC, No. 17-130, 138 S. Ct. 2044, holding that the SEC’s Administrative Law Judges (ALJs), appointed under Title 5 of the U.S. Code, were “Officers of the United States,” that the Appointments Clause of the Constitution requires those ALJs to be appointed by the President, a court of law, or the Commission itself, and that an SEC order following a hearing before an improperly appointed ALJ was invalid. The Supreme Court, however, expressly declined to resolve several other constitutional questions raised by the case.

Immediately following the Supreme Court’s decision, the SEC issued a stay of all pending administrative proceedings that were commenced before an ALJ. On August 22, 2018, however, the SEC lifted the stay, remanded all proceedings to the Office of Administrative Law Judges, and provided procedures for proceedings on remand—setting the stage for litigants to begin to make constitutional challenges to the SEC’s adjudicative process based on the questions unanswered by Lucia.

Below we describe the Lucia ruling, track its impact as subsequent litigation works through proceedings at various administrative agencies, review the key questions the decision raises, and identify important considerations for future challenges to regulatory or enforcement actions before various agencies.

The Lucia decision raises more questions than it answers, although what seems clear is that the decision has begun to have far-reaching effects and will likely sponsor waves of litigation concerning the legitimacy of administrative enforcement proceedings that rely on ALJs or similar hearing officials at multiple agencies. For the SEC, key unanswered questions include whether the SEC’s “ratification” of an unconstitutional ALJ appointment cures the constitutional defect. Recognizing this uncertainty, on the same day of the Supreme Court’s order, the SEC stayed all pending administrative proceedings before ALJs and subsequently ordered them reheard by a new ALJ whose appointment was ratified by the SEC in the interim. However, the uncertainty extends beyond the SEC. As explored below, the Federal Trade Commission (FTC), Federal Regulatory Commission (FERC), Occupational Safety and Health Review Commission, Department of the Interior, Environmental Protection Agency (EPA), Federal Mine Safety and Health Review Commission, Department of Health and Human Services, and Consumer Financial Protection Bureau (CFPB), among others, all use ALJs or similar hearing officials in connection with administrative enforcement proceedings. Administrative enforcement proceedings at each agency are subject to similar challenges under Lucia.

Background on ALJ Hiring

Historically, federal agencies have made appointments of ALJs through a competitive-service application and examination process administered by the Office of Personnel Management (OPM). Federal statutes authorized the President to delegate his or her authority over competitive examinations to the director of OPM but barred the director from further delegating that authority, even though the director could delegate other authority to heads of agencies. 5 U.S.C. § 1104(a).

Federal regulations have provided that “[a]n agency may appoint an individual to an administrative law judge position only with prior approval of OPM, except when it makes its selection from the list of eligibles provided by OPM.” 5 C.F.R. § 930.204. OPM generally has required that agencies appoint “one of the top three highest scoring applicants interested in that geographical location.” Even when an agency “is insufficiently staffed with administrative law judges,” federal statutory law provides that the agency can use ALJs appointed by other agencies, but only if selected by OPM and with the consent of the other agencies. 5 U.S.C. § 3344. Moreover, a federal statute provides that, once appointed by an agency, an ALJ may be removed “only for good cause established and determined by the Merit Systems Protection Board on the record after opportunity for hearing before the Board.” Id. § 7521.

Facts and Holding of Lucia

The SEC has five ALJs who preside over almost all administrative proceedings in which the SEC seeks to enforce federal securities laws. Lucia, 138 S. Ct. at 2049. Staff members, rather than the Commission itself, have selected all of the ALJs from the list of eligible candidates identified by OPM. Id. The ALJs have the power to issue subpoenas, hear evidence, and impose sanctions. Id. The ALJs issue “initial decisions” that set out findings of fact and conclusions of law, which can be challenged on appeal to the full Commission, or which the Commission can review sua sponte. Id. In either case, the Commission can choose to review the ALJ’s decision or adopt the ALJ’s decision as final. Id.

In 2012, the SEC initiated an administrative proceeding against investment advisor Raymond Lucia and his investment company, alleging in the order instituting proceedings that Lucia misrepresented back-tested returns of fictional investment portfolios in his presentations, and thereby deceived prospective clients in violation of the Investment Advisers Act of 1940. After a hearing, the ALJ ruled that Lucia and his company had violated the Advisers Act and revoked their investment adviser registrations. See Initial Decision on Remand, In re Raymond J. Lucia Companies Inc., et al. (S.E.C. Dec. 6, 2013). The ALJ imposed a cease-and-desist order, a civil penalty of $50,000 against Lucia, a civil penalty of $250,000 against Lucia’s company, and a permanent industry-wide bar against Lucia. Id. at 58–61. Lucia appealed to the SEC, arguing among other things that the ALJ had not been constitutionally appointed because he was an officer of the United States under the Appointments Clause. See Respondent’s Motion to Stay Appeal and for Leave to Submit Additional Briefing, In re Raymond J. Lucia Companies Inc., et al., at 1–2 (June 12, 2015). The Commission rejected the argument, finding that “ALJs are not ‘inferior officers’ under the Appointments Clause.” Order of the Commission, In re Raymond J. Lucia Companies Inc., et al., at 33.

Lucia then filed a petition for review in the Court of Appeals for the D.C. Circuit. A three-judge panel denied Lucia’s petition, holding that the SEC’s ALJs were not “Officers of the United States” pursuant to the Appointments Clause because, among other things, they “neither have been delegated sovereign authority to act independently of the Commission nor, by other means established by Congress, do they have the power to bind third parties, or the government itself, for the public benefit.” See Raymond J. Lucia Cos., Inc. v. S.E.C., 832 F.3d 277 (D.C. Cir. 2016). After granting rehearing en banc, the full D.C. Circuit denied the petition for review by an equally divided court. Raymond J. Lucia Cos., Inc. v. S.E.C., 868 F.3d 1021 (D.C. Cir. 2017). When Lucia petitioned for certiorari in the Supreme Court, the government switched positions and asked the Supreme Court to grant certiorari and rule in favor of Lucia. The Supreme Court granted certiorari.

The Supreme Court reversed the D.C. Circuit, holding that the SEC ALJs were “Officers of the United States” under the Appointments Clause. The Supreme Court held that the test in determining whether ALJs are officers was twofold: whether the official (1) occupied a “continuing” position established by law, and (2) “exercised significant authority pursuant to the laws of the United States.” Lucia, 138 S. Ct. at 2051–52. The Supreme Court concluded that Freytag v. Commissioner, 501 U.S. 868 (1991), which held that the Tax Court’s special trial judges (STJs) are Officers of the United States, was dispositive. Relying on Freytag, the Supreme Court determined that the SEC’s ALJs hold a continuing position as they “receive[] a career appointment to a position created by statute.” Lucia, 138 S. Ct. at 2053. In addition, the Supreme Court concluded that the ALJs share the same four powers on which the Freytag Court relied in holding that STJs were officers: (1) they “take testimony” by receiving evidence and examining witnesses; (2) they “conduct trials”; (3) they “rule on the admissibility of evidence” and thus “critically shape the administrative record”; and (4) they “have the power to enforce compliance with discovery orders,” including by punishing contemptuous conduct. Id. at 2053–54. If anything, the Supreme Court concluded, ALJs are more clearly officers than STJs because they are more autonomous; whereas the Tax Court must review certain STJ decisions, the SEC need not review any particular ALJ decisions. Id. at 2053–55.

Turning to the issue of remedies, the Supreme Court held Lucia was entitled to relief because he filed a timely challenge to the validity of the ALJ’s appointment “before the Commission, and continued pressing that claim in the Court of Appeals.” Id. at 2055. Noting precedent holding that “the appropriate remedy for an adjudication tainted with an appointments violation is a new hearing before a properly appointed official,” the Court concluded that the new hearing official cannot be the same ALJ who heard the case originally. Id. Even if the ALJ who decided the case below had received a constitutional appointment in the interim, the Supreme Court held that the ALJ during the initial hearing cannot be the hearing official on remand because that same ALJ “cannot be expected to consider the matter as though he had not adjudicated it before.” Id.

Key Constitutional Questions the Court Declined to Resolve in Lucia

In reaching its decision, the Supreme Court declined to address several other constitutional arguments raised by the parties or by amici relating to the work of ALJs or the administrative state more broadly. For instance, the Court declined to resolve:

• Whether ratification of previously-appointed ALJs cures any constitutional deficiency. Although Lucia’s case was pending, the Commission entered an order purportedly “ratifying” the prior ALJ appointments made by SEC staff members. The Supreme Court did not decide whether the SEC’s order purportedly “ratifying” its ALJs cured the Appointments Clause violation. The Court explained that it would not address the issue because the SEC did not identify whether an ALJ or the Commission itself would hear the case on remand. at 2055 n.6.
• Whether statutory restrictions on removal of ALJs are constitutional. The Supreme Court also declined to decide whether the statutory restrictions on removing ALJs were constitutional, noting that no lower courts had addressed the issue. at 2050 n.1. The solicitor general argued before the Supreme Court that if ALJs constitute Officers of the United States, then the statutory restrictions on removing ALJs are unconstitutional restrictions on the President’s executive oversight authority under Article II. The Supreme Court also expressly declined to decide the issue. Given the open question, a presidential administration or private litigants may seek to challenge the removal restrictions on ALJs or similar hearing officers in future litigation, including if it disagrees with the ALJ’s legal reasoning. Elimination of the removal restrictions would allow a presidential administration or executive agency to exert significant control over ALJs and other civil servants who currently operate with certain amounts of independence. As Justice Breyer noted in his opinion concurring in part and dissenting in part, holding that the protections from removal for ALJS, for example, are unconstitutional, “would risk transforming [them] from independent adjudicators into dependent decisionmakers,” contrary to the “substantial independence” that was “a central part” of the scheme of the Administrative Procedures Act. Id. at 2060 (opinion of Breyer, J.).

Additionally, the Supreme Court left open the possibility that a private litigant may contend that it has standing to challenge the constitutionality of the removal restrictions in an attempt to have an enforcement action declared invalid. Although no lower court has yet addressed the removal restriction on ALJs, on July 16, 2018, the Fifth Circuit issued a key ruling in a case styled Collins v. Mnuchin, citing Lucia and holding that the removal restrictions on the Federal Housing Finance Agency’s director were unconstitutional. No. 17-20364, 2018 WL 3430826, at *11–25 (5th Cir. July 16, 2018). Private litigants seeking to challenge decisions by ALJs or officials in similar capacities are likely to rely on Collins as support for the proposition that they have standing to challenge the constitutionality of the removal restrictions because the petitioners in Collins were private parties challenging governmental actions. See id. at *1. The government, however, may rely on Collins to contend that the appropriate remedy for any constitutional infirmity in removal restrictions is to strike the removal limitations and not to invalidate any previous action, as the Fifth Circuit held that the remedy for the unconstitutional structure of the Federal Housing Finance Agency was to invalidate the removal restrictions on the agency’s director while “leav[ing] intact the remainder of [its] past actions.” Id. at *26.

• Whether the ALJs are principal officers who may be appointed only by the President with Senate consent. The Supreme Court assumed, but did not hold, that ALJs were inferior Officers of the United States—and not principal officers who can be appointed only by the President, with Senate consent, under the Appointments Clause.

The Court’s express decision not to resolve these issues signals to current and future litigants that they could raise these arguments in future challenges to administrative actions that were subject to a hearing before an ALJ or a similarly situated hearing officer.

Lucia’s Immediate Aftermath

The SEC and the White House have both taken major actions related to ALJs in the wake of the Lucia decision.

On the day Lucia was decided, the SEC issued an order staying for 30 days all administrative proceedings commenced before ALJs. Order, In re Pending Administrative Proceedings (SEC June 21, 2018).

On July 10, 2018, President Trump issued an executive order exempting all ALJ positions from the rules governing civil service, including the competitive examination process. Executive Order Excepting Administrative Law Judges From The Competitive Service, 2018 WL 3359654, at *1 (July 10, 2018). The order relies on Lucia, stating that, “as recognized by the Supreme Court in Lucia, at least some—and perhaps all—ALJs are ‘Officers of the United States’ and thus subject to the Constitution’s Appointments Clause, which governs who may appoint such officials.” Id. The order further states that “Lucia may . . . raise questions about the method of appointing ALJs, including whether competitive examination and competitive service selection procedures are compatible with the discretion an agency head must possess under the Appointments Clause in selecting ALJs.” Id. Noting that “there are sound policy reasons to take steps to eliminate doubt regarding the constitutionality of the method of appointing” ALJs, the order exempts ALJs from the competitive hiring rules and examinations requirements in an effort to “mitigate concerns about undue limitations on the selection of ALJs, reduce the likelihood of successful Appointments Clause challenges, and forestall litigation in which such concerns have been or might be raised.” Id.

The executive order also provides that “[e]xcept as required by statute, the Civil Service Rules and Regulations shall not apply to removals” of ALJs. Id. at *3. That provision, however, does not appear to alter the statutory restriction that ALJs may be removed only for good cause as determined by the Merit Systems Protection Board (MSPB) following a hearing. In a memorandum to heads of federal agencies and departments, OPM Director Jeff T.H. Pon stated that the statutory removal protections and related procedures prescribed by regulations will remain in effect. Dr. Jeff T.H. Pon, Memorandum for Heads of Executive Departments and Agencies (July 10, 2018), at 2. Further complicating the issue, on July 23, 2018, Reuters reported that a confidential Justice Department memorandum to top lawyers at federal agencies concluded that “the MSPB must be ‘suitably deferential’ to department heads who find an ALJ has failed to perform adequately or has not followed ‘agency policies, procedures or instructions.’” Alison Frankel, In Confidential Memo to Agency GCs, DOJ Signals Aggressive Stand on Firing ALJs, Reuters.com, July 23, 2018.

On July 20, 2018, the SEC extended its stay order an additional 30 days until August 22, 2018. Order, In re Pending Administrative Proceedings (SEC July 20, 2018). On August 22, 2018, the SEC allowed the stay to expire; remanded all proceedings pending before the Commission; vacated all prior opinions in the 126 pending matters; and ordered that, to the extent practicable, the Chief ALJ by September 21, 2018 shall designate an ALJ who did not previously participate in the matter to be the presiding hearing officer. Order, In re Pending Administrative Proceedings (SEC Aug. 22, 2018). “Within 21 days of being assigned to the proceeding, the ALJ shall issue an order directing the parties to submit proposals for the conduct of further proceedings.” Id. at 2. After considering the parties’ proposals, the ALJ “shall hold a new hearing and prepare an initial decision” and “shall not give weight to or otherwise presume the correctness of any prior opinions, orders, or rulings issued in the matter.” Id. If a party fails to submit a proposal, however, the ALJ may enter a default judgment. Id.

Lucia’s Impact and Potential Future Litigation Against the Administrative State

Lucia is likely to have varied impacts across a number of industries and practice areas. Businesses and individuals should consult with attorneys to assess Lucia’s impact on their industry and their regulators. Nonetheless, Lucia raises several salient questions—which may inform potential constitutional challenges—for businesses and individuals facing enforcement actions before ALJs or similar hearing officers in any federal agency. Those questions include:

• What constitutes a “timely challenge” for litigants who have already appeared before invalidly appointed ALJs, and are there grounds for excusing the untimeliness of a challenge?
  • In Jones Brothers, Inc. v. Secretary of Labor, the Sixth Circuit held that a petitioner challenging penalties imposed by an ALJ for the Mine Safety and Health Administration had forfeited its challenge by merely stating that “currently a split among the Circuit Courts of Appeal” exists regarding whether ALJs are inferior officers, but that “extraordinary circumstances” existed under the Mine Act, allowing the court to excuse the forfeiture. No. 17-3483, 2018 WL 3629059, at *6–7 (6th Cir. July 31, 2018).
  • By contrast, the United States District Court for the Central District of California has refused to consider four separate petitioners’ Appointments Clause challenges to the appointment of ALJs employed by the Social Security Administration because the petitioners “fail[ed] to raise it during [their] administrative proceedings.” See, e.g., Trejo v. Berryhill, No. 17-0879-JPR, 2018 WL 3602380, at *3 n.3 (C.D. Cal. July 25, 2018).
• Are the ALJs or hearing officers at other regulatory agencies “Officers of the United States,” like the SEC’s ALJs, or are their roles sufficiently different such that they might not be subject to the Appointments Clause?
• If the ALJs are Officers of the United States, who actually appointed them? Is that person a head of department as required by Article II?
• If the ALJs were invalidly appointed, were their appointments ratified by the head of department? Did the “ratification” of the appointment of the ALJ cure any constitutional infirmity?
  • In Jones Brothers, the chief administrative law judge, rather than the Federal Mine Safety and Health Review Commission (Mine Commission), appointed the ALJ who heard the petitioner’s case. 2018 WL 3629059, at *5. However, on April 3, 2008, while the case was pending before the Sixth Circuit, the Mine Commission issued an order purporting to “[r]atify the prior appointments of, and appoint,” all 13 active ALJs employed by the Mine Safety and Health Administration, including the ALJ who heard the petitioner’s case. Mine Commission, Notice (Apr. 3, 2018). The Sixth Circuit concluded that the ALJ had been improperly appointed and that ratification did not cure the constitutional defect, and held that “Jones Brothers is entitled to a new hearing before a constitutionally appointed administrative law judge.” Jones Bros., 2018 WL 3629059, at *7–8. The Sixth Circuit further held that, even if the previous ALJ “has since received a constitutional appointment,” the new hearing “must be before a new official.” at *8.
• Did OPM limit the head of department’s appointment discretion? If so, does that limitation on the head of department’s authority raise additional constitutional concerns? Do private litigants have standing to challenge any potential constitutional infirmity related to this issue?
• If the ALJs are Officers of the United States, are they inferior officers or are they principal officers who can only be appointed by the President with Senate consent?
• Are the statutory restrictions on the removal of the ALJs constitutional? Do private litigants have standing to challenge the statutory restrictions on the removal of the ALJs?
• If there are no ALJs whose appointment satisfies the constitutional requirements, does the rule of necessity, as discussed in a footnote 5 in Lucia, permit the head of department to conduct the proceedings to remedy the constitutional infirmity?

As demonstrated below, the answers to these questions could impact a variety of industry areas.

Potential Impact on Securities Regulation and Enforcement

Lucia has had a significant impact on pending SEC administrative proceedings, but its impact on future proceedings before SEC ALJs remains to be seen. Even after the SEC ordered re-hearings of pending proceedings before new ALJs, Lucia highlights several potential additional arguments under the Appointments Clause that litigants can raise in an attempt to beat back enforcement actions. Those arguments include that: (1) even if litigants receive a new hearing before an ALJ whose appointment has been “ratified” by the SEC or another agency, the new ALJ was still not properly “appointed” because ratification is different from appointment; (2) the statutory removal restrictions on ALJs are unconstitutional; and (3) the SEC ALJs are principal officers who must be appointed only by the President with Senate consent.

Lucia also may impact regulation and enforcement in the commodities and cryptocurrency markets by the Commodity Futures Trading Commission. Although it eliminated the use of ALJs, the CFTC authorized the use of a “judgment officer” and “presiding officers” for various proceedings, with each type of officer performing many of the same functions as the SEC’s ALJs. See 17 C.F.R. § 10.8 (providing that the presiding officer shall have the same authority and obligations as an ALJ, including the authority to issue subpoenas, receive evidence, examine witnesses, rule on motions, and sanction parties for noncompliance with orders); id. § 12.2 (providing that a judgment officer “is authorized to conduct all reparations proceedings”). Although the presiding officers are appointed for the purpose of “a particular proceeding,” 17 C.F.R. § 10.2(n), the judgment officer “is authorized to conduct all reparations proceedings” in the CFTC, id. § 12.2. Earlier this year, the CFTC issued an order ratifying the prior appointment of its judgment officer, though the CFTC did not specify who appointed the judgment officer. Ratification and Reconsideration Order, In re Pending Administrative Proceedings (CFTC Apr. 9, 2018). Any challenge to the constitutionality of the judgment officer’s appointment relying on Lucia is likely to turn on two questions: (1) who appointed the judgment officer, and (2) whether courts find the ratifications process to be sufficient to cure any constitutional defects. That said, CFTC litigants also might argue that the appointment was unconstitutional because the judgment officer is a principal officer, or that the removal restrictions on the judgment officer are unconstitutional. Similar questions may be raised by litigants appearing before presiding officers, though the limited appointment of such officers appears to reduce the risk of constitutional challenges in future proceedings.

Possible Impact on Data Privacy and Security Regulation and Enforcement

The Federal Trade Commission exercises the most significant data privacy and regulatory and enforcement authority among federal agencies. The FTC generally brings enforcement actions before an ALJ, and parties can appeal to the full Commission, although the FTC may also choose to prosecute claims in federal district courts. See LabMD, Inc. v. F.T.C., No. 16-16270, 2018 WL 3056794, at *8 (11th Cir. June 6, 2018). The FTC has only one ALJ, which, like the SEC’s ALJs, was appointed by staff and not the Commission itself. (For details on ALJs in various departments, click here.) The FTC’s ALJs have powers that appear to be analogous to those held by the SEC ALJs, upon which the Supreme Court relied to conclude that they were Officers of the United States:

• The FTC ALJ has the power to “administer oaths and affirmations,” “take depositions,” and “rule upon offers of proof and receive evidence.” 16 C.F.R. § 3.42(c)(1), (3), (5).
• Like SEC ALJs who have the power to conduct trials, the FTC ALJ has the power and “duty to conduct fair and impartial hearings.” § 3.42(c).
• The FTC ALJ has the power to rule on the admissibility of evidence, § 3.43(d), (g), and to shape the administrative record through both control of the proceedings, id. § 3.43(g), (i), and supervision of the creation of the record, id. § 3.44.

• The FTC ALJ has the power to “regulate the course of the hearings and the conduct of the parties and their counsel therein,” § 3.42(c)(6), and “suspend or bar from participation in a particular proceeding any attorney who shall refuse to comply with his directions, or who shall be guilty of disorderly, dilatory, obstructionist, or contumacious conduct,” id. § 3.42(d).

In 2015, after a party challenged the constitutionality of the appointment of the FTC’s ALJ, the FTC issued an order “ratifying” the appointment of its ALJ. See Order Denying Respondent LabMD, Inc.’s Motion to Dismiss, Exhibit A (Docket No. 9357, Sept. 14, 2015).

FTC litigants with ongoing proceedings may have different responses to Lucia depending upon when they appeared before an ALJ. For those who appeared before an ALJ prior to the ratification order where the proceeding remains ongoing, the party may be able to obtain a new initial hearing based on Lucia. Parties who appeared before the FTC ALJ after the ratification order may argue that the ratification did not cure the Appointments Clause violations discussed in Lucia.

Possible Impact on Financial Services Regulation and Enforcement

The Consumer Financial Protection Bureau utilizes one ALJ in its work, and two ALJs exercise authority under the Office of Financial Institution Adjudication. Like the FTC’s ALJ, the CFPB’s ALJ appears to share the same key characteristics with the SEC’s ALJs:

• The CFPB ALJ has the power to receive evidence. See 12 C.F.R. §§ 1081.103, 1081.303(g).
• The CFPB ALJ has the power to conduct trials. See id.§ 1081.302, 1081.303.
• The CFPB ALJ has the power to rule on the admissibility of evidence, § 1081.303(g), and thus shape the administrative record, see id. §§ 1081.303(h), 1081.304.
• The CFPB ALJ has the power to issue orders for the “exclusion or suspension of counsel from the proceeding” for “[d]ilatory, obstructionist, egregious, contemptuous or contumacious conduct at any phase of any adjudication proceeding.” 12 C.F.R. § 1081.107.

Litigants are likely to challenge the appointment of the CFPB’s ALJ because, although it is unclear who appointed the CFPB’s ALJ, even an appointment by the director of the CFPB might be unconstitutional. The Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which established CFPB, structured CFPB within the Federal Reserve System, such that the CFPB director might not qualify as a “head of a department.”

In addition, one commentator has noted that the Federal Reserve, the Office of Comptroller of the Currency, the Federal Deposit Insurance Corporation (FDIC), and the National Credit Union Administration do not individually appoint ALJs but nonetheless use the same two ALJs who are hired by the Office of Financial Institution Adjudication (OFIA). Barbara S. Mishkin, What Does the Supreme Court’s Lucia Decision Mean for the CFPB and Federal Banking Agencies?, ConsumerFinanceMonitor.com, July 2, 2018. Accordingly, litigants are likely to challenge the validity of OFIA’s appointments.

In 2017, the Fifth Circuit entertained such a challenge in Burgess v. Federal Deposit Insurance Corp., 871 F.3d 297 (5th Cir. 2017). In Burgess, the Fifth Circuit granted a petitioner’s interlocutory motion to stay an FDIC enforcement order finding that the petitioner was likely to succeed on the merits of his claim that an FDIC ALJ’s appointment violated the Appointments Clause because the FDIC ALJs’ position was established by law, and its duties were similarly important to those carried out by the STJs whom the Supreme Court determined to be officers in Freytag. Id. at 201–03. The court then stayed all proceedings pending the Supreme Court’s decision in Lucia. Order, Burgess v. Fed. Deposit Ins. Corp., No. 17-60579 (5th Cir. Jan. 22, 2018). On August 8, 2018, the FDIC filed an unopposed motion to remand the case to the agency for a new hearing. The Fifth Circuit granted the motion and remanded the case to the agency on August 20, 2018. Order, Burgess v. Fed. Deposit Ins. Corp., No. 17-60579 (5th Cir. Aug. 20, 2018).

Possible Impact on Healthcare Regulation and Enforcement

Aside from the Social Security Administration, the Department of Health and Human Services (HHS) employs more ALJs than any other agency. Perhaps most significantly for healthcare providers, HHS utilizes ALJs in the five-level Medicare appeals system. Specifically, ALJs preside over the third level of the Medicare appeals system. There are more than 100 ALJs at the Office of Medicare Hearings and Appeals (OMHA) at HHS. The Medicare program depends heavily on the ALJs to adjudicate appeals. Medicare appeals are often material and may involve multi-million dollar extrapolated overpayments.

As of January 2018, OMHA had approximately 502,000 pending appeals before ALJs. Those ALJs (the OMHA Medicare ALJs) appear to share the two of key characteristics with the SEC’s ALJs: (1) OMHA Medicare ALJs have the power to receive, review, and exclude evidence; and (2) OMHA Medicate ALJs have the power to conduct trials. See 42 C.F.R. § 405.1000(a)–(d); id. § 405.1002; id. § 405.1028(a)–(b); id. § 405.1030. However, the HHS regulations do not expressly authorize OMHA Medicare ALJs to issue sanctions as significant as those issued by certain other ALJs, see id. § 405.1030(b)(3), and the regulations further provide that the administrative record should include “any evidence excluded or not considered by the ALJ” id. § 405.1042(a)(2). Medicare appeal litigants who have received unfavorable ALJ decisions within technical appeal deadlines could potentially challenge those decisions based on the theory that the ALJ was improperly appointed. Providers typically have 60 days to appeal an ALJ’s decision to the Medicare Appeals Council. Id. § 405.1102(a). These litigants may have grounds for applying Lucia to the ALJs working in OMHA, as OMHA ALJs have many similarities to the SEC ALJs—including authorization to conduct hearings at which they receive testimony and evidence, id. § 405.1030(b), and the ability to issue subpoenas, id. § 405.1036(f).

HHS also uses ALJs in a variety of other matters, and each context will present different questions about Lucia’s impact. Id. § 498.5(l). For example, ALJs are used by the HHS Office of Inspector General in “exclusion” proceedings, in which HHS seeks to place an individual or an entity on a list of individuals and entities barred from participating in any federally funded healthcare programs. Here, Lucia could potentially be used to challenge the validity of the ALJ appointment in an attempt to obtain a new ALJ hearing. The precise vehicle and venue for such a challenge, however, is unclear because those ALJ decisions may not be “appealable” by statute or regulation.

Possible Impact on Energy-Related Regulation and Enforcement

Lucia’s most significant possible impacts in the area of energy regulation and enforcement are likely to be in proceedings before the Federal Energy Regulatory Commission (FERC) and the Department of the Interior. FERC currently utilizes 12 ALJs, and nine ALJs exercise authority within the Department of the Interior. The FERC chairperson has been making the ALJ appointments for FERC, and the FERC ALJs exercise many of the same powers as SEC ALJs. A key issue for FERC ALJs is whether the FERC chairperson is a “Head[] of Department[]” under the Appointments Clause. In Free Enterprise Fund v. Public Company Accounting Oversight Board, the Supreme Court held that the entire Securities and Exchange Commission is a “Head[] of Department[]” under the Appointments Clause, suggesting that the SEC chairperson alone is not because the “Commission’s powers . . . [were] generally vested in the Commissioners jointly, not the chairperson alone. 561 U.S. 477, 512–13 (2010). Using this precedent, litigants likely will contend that any ALJ appointments made by a chairperson, rather than by the entire commission, are invalid. The government, however, may argue that, unlike the SEC chairperson, the FERC chairperson is the “head[] of Department[]” because of the special authority given to the person in that role. For example, federal law provides that the FERC “Chairman shall be responsible on behalf of the Commission for the executive and administrative operation of the Commission,” including “the appointment and employment of” ALJs. 42 U.S.C. § 7171(c).

Environmental, Health, and Safety Regulation and Enforcement

Lucia also may have an impact in environmental, health, and safety regulation and enforcement. Specifically, litigants may raise constitutional challenges to proceedings brought before ALJs by the Occupational Safety and Health Review Commission, which currently employs 11 ALJs; the Department of the Interior, which utilizes nine; the Environmental Protection Agency, which utilizes three; the Federal Mine Safety and Health Review Commission, which utilizes 15; and the Departmental Appeals Board of the Department of Health and Human Services, which utilizes five.

As noted above, the Sixth Circuit has ruled that the appointment of ALJs by the chief ALJ of the Mine Safety and Health Administration was unconstitutional, and that those ALJs were required to have been appointed by the Federal Mine Safety and Health Review Commission. Jones Bros., 2018 WL 3629059, at *7–8. In addition, although the issues raised for businesses and individuals subject to environmental, health, and safety regulation and enforcement before other agencies will be varied, the key questions will be those identified above, common to all industry areas.

Possible Impact on Antitrust Regulation and Enforcement

The FTC is the only governmental entity to utilize ALJs in the course of antitrust regulation and enforcement. There is no parallel mechanism at the Department of Justice’s Antitrust Division, and the Antitrust Division must begin any proceedings it initiates in federal court. Accordingly, the impact of Lucia on antitrust regulation and enforcement is likely to be the same impact as on data privacy and security regulation and enforcement, detailed above.

Conclusion

The long-term effects of Lucia remain to be seen. As demonstrated above, however, in the near term, it is reasonable to expect additional challenges to the authority of ALJs or similar hearing officials in multiple administrative contexts.

Consider the following three statements, each of which might be found in a written agreement for a commercial transaction:

• Borrower hereby grants a security interest in all of Borrower’s personal property to secure [the loan].
• Seller [of goods] makes no warranty, express or implied, in connection with this transaction.
• Licensee may not assign its rights under this Agreement.

Each of these statements is clear and unambiguous. Yet none of them is likely to be effective. That is because each would run afoul of a legal rule that requires a heightened degree of explicitness for a particular term to be effective. This article refers to such rules as “rules of explicitness.”¹

There are many rules of explicitness. Some are judicial in origin; others are statutory. Some are specific to one state; some are incorporated in the common law or in uniform legislation, and thus apply widely; and some are federal, and so apply nationally.

If rules of explicitness merely required transacting parties or their lawyers to add a few words to the written agreements they draft, the rules would perhaps be of little consequence. However, some of the rules impose substantial impediments to perfectly legitimate transactions. Others are not widely known, particularly by transacting parties that draft their own documents, and therefore function as traps for the less informed. They surprise lawyers and frustrate parties’ expectations, much like secret liens. This article identifies and critiques several of these rules.

Benign Rules

Not all rules of explicitness are bad. Some are consumer protection rules that, in effect, require disclosure or the use of clear language so as to inform consumers of the consequence of entering into a transaction. Although many of these rules are premised on the highly dubious assumption that consumers actually read the agreements they sign,² such rules are beyond the scope of this article.

Some other rules of explicitness appear to be premised on the belief that contracting parties normally do not intend a particular statement to have its literal meaning. For example, U.C.C. § 2-312(2) states that the warranty of title in a sale of goods can be disclaimed or modified “only by specific language or by circumstances which give the buyer reason to know that the person selling does not claim title in himself or that he is purporting to sell only such right or title that he or a third person may have.” Consequently, the language “Seller makes no warranty, express or implied, in connection with this transaction” would be ineffective to disclaim the warranty of title.³ This probably makes sense. It is likely that most buyers of goods think of warranties as relating to the quality of the goods, not to ownership or the right to sell them. Moreover, few buyers would be willing to pay the purchase price for goods that the seller does not or might not own. So requiring more explicit language or circumstances simply reflects the reasonable observation that contracting parties ordinarily do not understand or intend “no warranty” to exclude the warranty of title.

Similarly, the phrase “time is of the essence” is often included in written agreements to indicate that a delay in performance is material. In other words, it is a somewhat cryptic way of saying “any delay in performing any duty under this agreement is a material breach,” and thereby authorizes the non-breaching party to suspend its own performance. But it is doubtful that the parties to an agreement containing such a phrase really intend that a brief delay in performing a minor duty is a material breach. Consequently, some courts will not give literal effect to the phrase,⁴ although they would likely enforce a more specific statement (e.g., “any delay in delivery is a material breach”).

A rule of explicitness, such as those described in the previous two paragraphs, designed to give effect to the parties’ likely intent is benign and perhaps even beneficial. Most rules of explicitness are, however, either silly or downright dangerous in the sense that they are traps for the unwary.

Silly Rules             

Disclaiming the Warranty of Merchantability

Section 2-316 of the U.C.C. states that, to disclaim the warranty of merchantability in a contract for the sale of goods, the seller must mention “merchantability” or use language—such as “as is” or “with all faults” —that in common understanding makes plain that there is no warranty.⁵ Applying this rule, a statement such as “seller makes no implied warranty with respect to the goods” or the shorter and arguably clearer “seller makes no warranty” is probably ineffective to disclaim the implied warranty of merchantability.⁶

To a limited extent, this rule makes sense. The warranty of merchantability is implied in contracts for the sale of goods when the seller is a merchant with respect to goods of that kind.⁷ The warranty requires, among other things, that the goods be fit for the ordinary purposes for which such goods are used.⁸ In short, the goods must work. However, many buyers probably think of warranties as dealing with the future performance of the goods—that is, how long the goods will last—not with whether the goods work at the time of sale. Consequently, a phrase such as “seller makes no implied warranty with respect to the goods” probably does not signify to many buyers that the goods might not work now. In contrast, a phrase such as “as is” does convey that possibility.

However, the policy underlying the rule seems to have been forgotten when the rule shifts from the language it renders ineffective to the language it regards as effective.  The statement “seller makes no implied warranty with respect to the goods” is ineffective to disclaim the warranty of merchantability but the statement, “seller makes no implied warranty of merchantability with respect to the goods” can be effective.⁹ In short, adding the words “of merchantability” can change an ineffective disclaimer into an effective disclaimer.  If buyers truly understood those two statements differently, the rule might be justifiable.  But there is no reason to think that buyers do that.

Describing Collateral in a Security Agreement

Unless an exception applies, for a security interest to attach to personal property, the debtor must authenticate a security agreement that contains a description of the collateral.¹⁰ The description need not be specific as long as it reasonably identifies what is described.¹¹ Moreover, a description by type of collateral defined in the U.C.C. is effective.¹² However, U.C.C. § 9-108(c) provides that a description such as “all the debtor’s assets” or “all the debtor’s personal property” is ineffective. This rule adds a bit of unnecessary length to a security agreement intended to encumber all of the debtor’s existing personal property. Thus, consider the following two ways of describing the collateral for such a transaction:

The description on the left is, with two exceptions,¹³ effective to cover all personal property to which Article 9 of the U.C.C. applies. The description on the right is ineffective. So, the law effectively mandates that transactional attorneys use an additional 17 words¹⁴ that neither the debtor nor the secured party might understand. There is absolutely nothing unclear or ambiguous about “all personal property.” In fact, that phrase is probably far more likely to be understood by the parties than the more detailed list that is effective. Yet that simpler and shorter phrase is ineffective. It is telling that the official comments do not attempt to justify this rule; they merely state that it “follows prevailing case law,”¹⁵ as if that were an explanation.

Gotcha! Rules

Describing Commercial Tort Claims  

While on the subject of security agreements, let us consider the language needed for a security interest to attach to a commercial tort claim. For this purpose, a commercial tort claim includes any claim arising in tort if the debtor (the claimant) is a business entity.¹⁶ U.C.C. § 9-108(e)(1) provides that describing collateral by its statutorily defined type is ineffective for a commercial tort claim. Thus, describing the collateral to include “all commercial tort claims” in fact covers none.

This rule is far more problematic than the rule of § 9-108(c) which renders “all personal property” ineffective as a description of collateral in a security agreement. Consider a transaction in which a lender will be making a sizeable loan to a business entity and expects in return to get a security interest in all the entity’s assets. To cover existing commercial tort claims, the security agreement must describe each such claim with some particularity.¹⁷ Yet it is possible that a tort might have already occurred of which the debtor is unaware even though such a tort claim might be one that, in time, will seriously undermine the value of the business. In such a case, it would effectively be impossible for the security agreement to properly describe the claim.¹⁸ An explicitness rule is not supposed to prevent otherwise permissible transactions.¹⁹

The explicitness rule of § 9-108(e)(1) applies not merely to security agreements, but also to financing statements, where it makes even less sense. Financing statements serve a different purpose than do security agreements. They are designed merely to give interested parties notice of a possible security interest and information about whom to contact for more information. Hence a general description of collateral as “all assets” or “all personal property” is effective in a financing statement.²⁰ As a result, we end up with a truly anomalous set of rules:

(i) a description of “all commercial tort claims” is ineffective in a financing statement, but

(ii) either a more specific description (“all tort claims arising from the explosion of debtor’s factory”) or a more general description (“all assets”) is effective.²¹

It is hard to understand what policy could be served by a rule that validates a very specific description and a very general description, but invalidates one in the middle.

Providing for Attorney’s Fees

In at least one state, a term in an agreement providing that “in any action relating to this Agreement, the prevailing party will be entitled to reasonable attorney’s fees,” does not cover fees incurred in a successful appeal. To cover such fees, the clause must expressly refer to fees incurred in appellate proceedings.²² The rule is apparently premised on the state supreme court’s belief, in the mid-1960s, that the members of the bar generally understood that a contractual stipulation for attorney’s fees would not include attorney’s fees incurred on appeal.²³ Of course, that belief was not based on any empirical data and it completely ignored the fact that contracting parties occasionally draft their own agreements without the assistance of legal counsel.

In several states, the judicial penchant for the so-called “American Rule,” which requires each party to pay its own attorney’s fees, has resulted in a rule that an award of attorney’s fees incurred in litigating the entitlement to or amount of attorney’s fees will not be available unless the agreement provides for it “in a clear and decided fashion.”²⁴ Nothing about this rule is premised on the likely intent or understanding of the people who draft agreements, yet the rule can significantly undermine the benefit and purpose of a contractual clause on attorney’s fees.

Providing for Interest

At least two explicitness rules deal with the right to interest on indebtedness. One relates to the agreement between the creditor and the debtor, the other applies to an intercreditor agreement.

A promissory note, loan agreement or any other contract that provides for an extension of credit will often provide for a specified rate of interest “until payment is made,” although it might also provide for a higher interest rate after default. While such terms are typically enforceable,²⁵ they will not apply to interest that accrues after a judgment is rendered in federal court. Unless the note or agreement expressly refers to interest “post-judgment,” interest will accrue after the judgment is rendered at the federal statutory rate, which is likely to be much lower.²⁶ This rule, which apparently applies even if the judgment is merely one that confirms an arbitration award, is a trap both for those who draft loan agreements and for litigators choosing a forum in which to file a claim.

A subordination agreement between creditors of the same debtor typically will, at least after the debtor defaults if not before, entitle the senior creditor to be paid in full before the junior creditor may receive any payment. If both creditors are undersecured, so that the debtor’s bankruptcy estate will not be paying post-petition interest to either of them, this might mean that the senior creditor is entitled to post-petition interest before the junior creditor is entitled to return of principal. Perceiving this to be unfair, New York courts have adopted and adhered to a rule called “the Rule of Explicitness,” which requires express reference to “post­-petition interest” if the junior creditor’s claim to principal is to be subordinated to the senior creditor’s right to post-petition interest. A reference merely to interest until the debt is paid in full is not sufficient.²⁷

Given that subordination agreements tend to involve sophisticated parties, each of whom is represented by a lawyer, this rule is unlikely to be major problem. Nevertheless, it is trap for anyone who is unaware of the rule.

Contractual Choice of Law

Unless a contrary intent is manifest, states interpret a contractual choice-of-law clause as dealing only with substantive law, not procedural law.³¹ That distinction can be critical because many states regard a statute of limitations as procedural, and therefore when serving as the forum for litigation, apply their own statute of limitations rather than applicable statute of limitations law.³² It seems doubtful that parties who choose one state’s law to govern their contractual rights and obligations want another jurisdiction’s statute of limitations to apply. So, to the extent that contracting parties want and are permitted to select the limitations period for claims between them, their choice-of-law clause should expressly refer to the chosen law’s statutes of limitations.

Consider the following scenario. A merchant in Detroit regularly contracts to buy and sell goods with business entities in other locations. The merchant’s transaction documents—whether they be agreements formally executed by both parties or unilaterally issued purchase orders or sales acknowledgments that form and memorialize the deal—provide that “the law of the State of Michigan governs the agreement and all matters relating to the relationship of the parties thereto.” That language is effective when the counter-party is located in the United States.²⁸ However, if the counter-party is located in Canada or Mexico, each of which has ratified the United Nations Convention on Contracts for the International Sale of Goods (“CISG”), the choice-of-law clause is likely to be ineffective. Even though contracting parties are free to make the CISG inapplicable to their transaction,²⁹ most courts dealing with the issue have concluded that more specific language is needed to do that.³⁰ They have done so not because the intent of the language is unclear, but due to the rather formalistic notion that, due to the Supremacy Clause, the CISG is part of each state’s law. So, to opt out of the CISG, the choice-of-law clause needs to be rephrased to something like: “the law of the State of Michigan, other than the CISG, governs the agreement and all matters relating to the relationship of the parties thereto.”

Unless a contrary intent is manifest, states interpret a contractual choice-of-law clause as dealing only with substantive law, not procedural law.³¹ That distinction can be critical because many states regard a statute of limitations as procedural, and therefore when serving as the forum for litigation, apply their own statute of limitations rather than applicable statute of limitations law.³² It seems doubtful that parties who choose one state’s law to govern their contractual rights and obligations want another jurisdiction’s statute of limitations to apply. So, to the extent that contracting parties want and are permitted to select the limitations period for claims between them, their choice-of-law clause should expressly refer to the chosen law’s statutes of limitations.

Restrictions on Assignment of Rights

Contractual restrictions on the assignment of contract rights often involve a clash between two fundamental policies of American law: (i) freedom of contract, which suggests that contracting parties should be allowed to agree to restrict either or both parties’ right to assign; and (ii) the free alienability of property, which suggests that anyone with contract rights should be able to transfer them, provided doing so has no material impact on the duties or rights of the contractual counter-party.

To some significant extent, the law now sides with the latter principle by overriding contractual restrictions on assignment.³³ But when it does not—that is, when the law permits contracting parties to prohibit or restrict assignment of their contract rights—it nevertheless imposes a rather peculiar rule of explicitness. Under this rule, a contractual term prohibiting the assignment of contract rights merely gives rise to a claim for breach; it does not render assignment ineffective.³⁴ As the U.S. Court of Appeals for the Third Circuit has explained, there is a difference between the right to assign and the power to assign, and contractual language that merely prohibits assignment affects only the former.³⁵ If the parties want to make an attempted assignment ineffective, they need to expressly so state by adding language such as “and any attempted assignment is void.”

At a superficial level, this rule of explicitness makes some sense. The statement “neither party may assign its rights” is phrased as a denial of discretion or permission, not of power. The statement “neither party shall assign its rights” appears to be a covenant: that is, a promise not to assign rights. Neither statement purports to deal with the consequence of an assignment.  However, given that damages for breach of either statement are likely to be very small and difficult to prove, interpreting either statement as merely a basis for breach makes the statement almost a nullity. It is far more likely that parties using either statement intend to prevent assignment.  Thus, requiring additional language to make that clear is somewhat silly and probably frustrates the parties’ intent.

Scope of Arbitration

In general, a presumption exists that any ambiguity concerning the scope of an arbitration clause should be resolved in favor of arbitration.³⁶ This presumption does not apply, however, to issues of arbitrability.  Instead, there is a presumption that the parties intend courts, not arbitrators, to decide disputes about arbitrability,³⁷ including questions such as whether the parties are bound by a given arbitration clause, or whether an arbitration clause in a concededly binding contract applies to a particular type of controversy.³⁸ In short, courts treat the issue of arbitrability as one for judicial resolution absent clear and unmistakable evidence that the parties delegated the issue to the arbitrator.³⁹ Consequently, an arbitration clause covering “all claims or controversies arising out of or relating to this Agreement” is not sufficient to delegate the issue of arbitrability to the arbitrator.⁴⁰

Applying this explicitness rule, the courts have reached some questionable distinctions.⁴¹ More relevant to this article, however, most courts regard an incorporation by reference of the rules of the American Arbitration Association, which give the arbitrator authority to rule on the existence, scope, or validity of the arbitration agreement,⁴² as sufficiently clear to delegate issues of arbitrability to the arbitrator.⁴³ As a result, the two clauses below, which differ only by the language in blue, have very different effects with respect to delegating issues of arbitrability, even though neither speaks directly to the issue:

This is not a rule of explicitness; it is a rule of inexplicitness.⁴⁴

Notes:

1. A contractual term covered by a rule of explicitness will be enforceable if drafted properly. In contrast, a contractual term that offends public policy might not be enforceable no matter how carefully drafted.

2. See Restatement (Third) of Consumer Contracts, Reporter’s Introduction at 3 (Council Draft No. 4, Dec. 2017) (“disclosure of standard terms generally does not render the assent process any more meaningful, because consumers rarely read the disclosed terms”). These rules are also premised on the assumption – perhaps less dubious but nevertheless unproven – that consumers understand the terms even when the mandated language is used and read.

3. See, e.g., Sunseri v. RKO-Stanley Warner Theatres, Inc., 374 A.2d 1342, 1344-45 (Pa. Super. Ct. 1977) (“Seller shall in nowise be deemed or held to be obligated, liable, or accountable upon or under guaranties (sic) or warranties, in any manner or form including, but not limited to, the implied warranties of title” was ineffective to disclaim the warranty of title). See also Rochester Equip. & Maint. v. Roxbury Mountain Serv., Inc., 891 N.Y.S.2d 781, 782 (App. Div. 2009) (sale of vehicle “as is” did not disclaim the warranty of title).

Note also that the warranty of title is not designated as an “implied warranty,” and thus even if the quoted language were effective to disclaim all implied warranties – which it is not, see infra notes 4-5 and accompanying text – it would still not be effective to disclaim the warranty of title.  See U.C.C. § 2-312 cmt. 6.

4. See, e.g., Kodak Graphic Communications Canada Co. v. E.I. du Pont de Nemours and Co., 640 F. App’x 36 (2d Cir. 2016) (despite a “time is of the essence” clause, a jury could conclude that timely delivery was not a material term); Foundation Development Corp. v. Loehmann’s Inc., 788 P.2d 1189 (Ariz. 1990) (a tenant’s two-day delay in paying the common area charge was not a material breach despite a provision in the lease that time is of the essence); Restatement (Second) of Contracts 242 cmt d & ill. 9 (stock phrases such as “time is of the essence” do not necessarily make every delay in performance a material breach).  See also Boston LLC v. Juarez, 199 Cal. Rptr. 3d 452 (Cal. Ct. App. 2016) (parties to a lease cannot contract around the materiality requirement so that every breach results in a forfeiture); Asif Saleem, Think Twice before Using “Time Is of the Essence,” 7 The Transactional Lawyer 1 (Aug. 2017).  But cf. Mining Investment Group, LLC v. Roberts, 177 P.3d 1207 (Ariz. Ct. App. 2008) (refusing to extend Loehmann’s to a real estate purchase agreement that, instead of having a general time-is-of-the-essence clause, expressly stated that the breach at issue – failure to timely pay – was material); Milad v. Marcisak, 762 N.Y.S.2d 282 (N.Y. Sup. Ct. 2003) (When “time of the essence” is expressly stated, the parties to a real property purchase agreement are obligated to strictly comply with the terms of the contract).

5. U.C.C. § 2-213(2), (3).

6. See, e.g., Pay Tel Sys., Inc. v. Seiscor Techs., Inc., 850 F. Supp. 276, 280-81 (S.D.N.Y. 1994) (language purporting to disclaim any unspecified “warranty, express or implied . . . to any dealer, customer, owner, or user” was ineffective to disclaim the implied warranty of merchantability); Richard O’Brien Cos. v. Challenge-Cook Bros., Inc., 672 F. Supp. 466, 469-70 (D. Colo. 1987) (conspicuous clause stating that “[t]here are no warranties, express or implied, made by Seller on the products sold by it to Dealer, or anyone else” was ineffective to disclaim the warranty of merchantability); Tarter v. MonArk Boat Co., 430 F. Supp. 1290, 1294 (E.D. Mo. 1977) (a statement after an express warranty that “[t]he above policy is [the seller’s] entire warranty and no other warranty is intended or implied other than the above stated policy” did not disclaim the warranty of merchantability).

This conclusion is supported not only by cases, but by the last sentence of § 2-­316(2), which indicates that a phrase such as “there are no warranties which extend beyond the description on the face hereof” can disclaim the implied warranty of fitness but, by its silence, suggests the phrase does not disclaim the implied warranty of merchantability.

7. U.C.C. § 2-314(1).

8. U.C.C. § 2-314(2)(c).

9. It must be made either orally or conspicuously in a writing.

10. See U.C.C. § 9-203(b)(3)(A). Exceptions include situations in which the collateral is in the possession of the secured party pursuant to an oral security agreement, see § 9-203(b)(3)(B), and transactions outside the scope of Article 9, see § 9-109(d).

11. U.C.C. § 9-108(a).

12. U.C.C. § 9-108(b)(3).

13. One exception is consumer goods, for which a more specific description is required. See U.C.C. § 9-108(e)(1).  The other exception is commercial tort claims, discussed infra notes 15-20 and accompanying text.

14. Many transactional attorneys representing secured parties insist that the longer phrase begin with “all personal property, including,” which causes the longer phrase to be 20 words more than the shorter phrase. One possible benefit to including a reference to “all personal property” is that those words might be effective to encumber property if a security interest in it would be outside the scope of Article 9.

15. U.C.C. § 9-108 cmt. 2. To the extent that the now-codified rule is intended to prevent overreaching, it is poorly designed.  Overreaching is more properly addressed through a restriction on what contracting parties may do, see, e.g., U.C.C. § 9-­204(b)(1) (preventing an after-acquired property clause in a security agreement from encumbering consumer goods except in narrow circumstances), than through a rule requiring particular language.

16. U.C.C. § 9-102(a)(13)(A). The tort claim of an individual debtor is a commercial tort claim if the claim arises in the course of the individual’s business or profession and does not include damages for personal injury or death.  U.C.C. § 9-102(a)(13)(B).

17. See U.C.C. § 9-108 cmt. 5 (providing some guidance on how specific the description must be).

18. Moreover, it is unclear whether some types of statutory claims – such as antitrust claims – qualify as tort claims and thus it remains uncertain whether such claims are subject to the rule of § 9-108(e)(1).

19. During the revision of Article 9 in the 1990s, which expanded Article 9’s scope to cover security interests in commercial tort claims, concern was expressed that debtors would inadvertently create security interests in tort claims and that the secured party and its lawyers would interfere with the conduct of the tort litigation. To deal with this, it was decided to limit security interests in commercial tort claims to situations in which the secured party was really relying on the claim as collateral, and the explicitness rule of § 9-108(e)(2) was devised as a proxy for that reliance.

20. See U.C.C. § 9-504(2).

21. Moreover, if a commercial tort claim were proceeds of other collateral, a financing statement that described only that other collateral and which neither described the commercial tort claim nor purported to cover “all assets” would nevertheless be effective to perfect a security interest in the commercial tort claim. See U.C.C. § 9-315(c), (d)(1).  As a result, a prospective lender seeking to determine if a commercial tort claim is encumbered by a perfected security interest cannot safely ignore any financing statement filed against the debtor, regardless of how that financing statement describes the collateral.

If all this were not enough, the rule of § 9-108(e)(2) has also confused courts and led to some astoundingly bad decisions.  See, e.g., Carl S. Bjerre & Stephen L. Sepinuck, Spotlight, Commercial Law Newsletter 9, 11-12 (Nov. 2016) (discussing Bayer Cropscience LP v. Stearns Bank, 837 F.3d 911 (8th Cir. 2016)).  The Permanent Editorial Board is reportedly working on a draft commentary to explain why Bayer Cropscience is incorrectly decided.

22. Synectic Ventures I, LLC v. EVI Corp., 261 P.3d 30 (Or. Ct. App. 2011) (discussing Adair v. McAtee, 388 P.2d 748 (Or. 1964)).

23. Id. at 32.

24. See, e.g., 214 Wall Street Associates, LLC v. Medical Arts-Huntington Realty, 953 N.Y.S.2d 124 (N.Y. App. Div. 2012); Allen Benson, Fees on Fees – Drafting to Include Attorney’s Fees Incurred in Seeking Fees, 4 The Transactional Lawyer 1 (Aug. 2014).

25. A higher rate of interest after default can be invalidated as a penalty. See Stephanie J. Richards, The Enforceability of Default Interest, 5 The Transactional Lawyer 1 (Oct. 2015).

26. Stephen L. Sepinuck, Very Interesting . . . or Is It: Limitations on Default Interest, 3. The Transactional Lawyer 2 (Feb. 2013).

27. See In re Southeast Banking Corp., 710 N.E.2d 1083 (N.Y. 1999). See alsoS. Bank v. T.D. Bank, 569 B.R. 12 (Bankr. S.D.N.Y. 2017) (by providing that the lenders were “entitled to receive post-petition interest . . . to the fullest extent permitted by law,” the intercreditor agreement was sufficiently explicit that both the senior and junior lenders were entitled to post-petition interest before the principal of either the senior or junior debt is paid; it did not matter that post-petition interest would not have been available in the bankruptcy proceeding because  this was not a bankruptcy case and, in any event, the agreement defined “Obligations” to include “interest and fees that accrue after the commencement . . . of any Insolvency or Liquidation Proceeding . . . regardless of whether such interest and fees are allowed claims in such proceeding”); Stephen L. Sepinuck The Dangers of Uni-tranche Loans & the Rule of Explicitness, 3 The Transactional Lawyer 3 (Oct. 2013).

28. See U.C.C. § 1-301(a).

29. See CISG Art. 6 (“The parties may exclude the application of this Convention or, subject to article 12, derogate from or vary the effect of any of its provisions”).

30. BP Oil Int’l, Ltd. v. Empresa Estatal Petroleos, 332 F.3d 333 (5th Cir. 2003); Travelers Prop. Cas. Co. of Am. v. Saint-Gobain Technical Fabrics Canada Ltd., 474 F. Supp. 2d 1075 (D. Minn. 2007); American Mint LLC v. GOSoftware, Inc., 2006 WL 42090 (M.D. Pa. 2006); Ajax Tool Works, Inc. v. Can-Eng Mfg. Ltd., 2003 WL 223187 (N.D. Ill. 2003); Asante Techs., Inc. v. PMC-Sierra, Inc., 164 F. Supp. 2d 1142 (N.D. Cal. 2001). But see American Biophysics Corp. v. Dubois Marine Specialties, 411 F. Supp. 2d 61 (D.R.I. 2006).

31. See, e.g., Restatement (Second) of Conflict of Laws § 122; Parker v. K & L Gates, LLP, 76 A.3d 859 (D.C. 2013).

32. See, e.g., Pivotal Payments Direct Corp. v. Planet Payment, Inc., 2015 WL 9595285 (Del. Super. Ct. 2015) (because, under Delaware law, a choice-of-law provision in a contract does not apply to statutes of limitations unless the provision expressly says so, the parties’ general selection of New York law did not make the N.Y. limitations period applicable, and thus the plaintiff’s fraudulent inducement claim was time barred under Delaware law); Citizens Bank v. Merrill, Lynch, Pierce, Fenner and Smith, Inc., 2012 WL 5828623 (E.D. Mich. 2012) (applying Michigan procedural law, including its six-year statute of limitations, instead of the chosen law of New York, with its three-year limitations period, to tort and contract claims brought under New York law). But cf. In re Sterba, 852 F.3d 1175 (9th Cir. 2017) (exceptional circumstances existed warranting application of the statute of limitations from the chosen state’s law); Restatement (Second) of Conflict of Laws 142 & cmt. f (as amended in 1988) (“The view that statutes of limitations should ordinarily be characterized as procedural has been abandoned in many recent decisions”).  The Restatement distinguishes between and treats differently situations in which the forum state has a longer limitations period than does the chosen law and situations in which the forum state has a shorter limitations period.

33. See, e.g., U.C.C. §§ 2-210(2), (3), 9-406(d), 9-408(a).

34. See Restatement (Second) of Contracts322(2)(b).

A different interpretive rule provides that a contractual term prohibiting assignment of “the contract” merely bars delegation of duties, not assignment of rights.  See Restatement (Second) of Contracts § 322(1); U.C.C. § 2-210(4).  This is probably a desirable interpretive principle, premised on the assumption that contracting parties are more likely to be concerned with delegation of duties than with assignment of rights.

35. Bel-Ray Co. v. Chemrite (Pty) Ltd, 181 F.3d 435 (3d Cir. 1999). See also BSC Assocs., LLC v. Leidos, Inc., 2015 WL 667853 (N.D.N.Y. 2015); Gallagher v. Southern Source Packaging, LLC, 564 F. Supp. 2d 503 (E.D.N.C. 2008); United Health Servs. Credit Union v. Open Solutions Inc., 2007 WL 433090 (E.D. Wash. 2007); Marion Blumenthal Trust ex rel. Blumenthal v. Arbor Com. Mtg. LLC, 2013 WL 3814385 (N.Y. Sup. Ct. 2013); Shao v. Li, 2013 WL 3481411 (N.Y. Sup. Ct. 2013). Contra Travertine Corp. v. Lexington-Silverwood, 683 N.W.2d 267 (Minn. 2004) (right to payment under a management contract); Texas Dev. Co. v. Exxon Mobil Corp., 119 S.W.3d 875 (Tex. Ct. App. 2003); but cf.G. Wentworth S.S.C. Ltd. P’ship v. Callahan, 649 N.W.2d 694 (Wis. Ct. App. 2002) (agreement stating that a party had no “power” to assign structured settlement rendered attempted assignment ineffective); Rother-Gallagher v. Montana Power Co., 522 P.2d 1226 (Mont. 1974) (agreement providing that one party “shall not assign this contract, or any portion thereof, . . . without the written consent”  of the other party was effective to prevent assignment).

36. E.g., Mitsubishi Motors Corp. v. Soler Chrysler–Plymouth, Inc., 473 U.S. 614, 626 (1985); Moses H. Cone Mem. Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24–25 (1983).

37. See, e.g., First Options of Chi., Inc. v. Kaplan, 514 U.S. 938, 944-45 (1995).

38. BG Group, PLC v. Republic of Argentina, 134 S. Ct. 1198, 1206 (2014).

In contrast, an issue about whether the entire agreement is void or voidable is presumptively for the arbitrator.  E.g., Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440 (2006).

39. See, e.g., Rent-A-Ctr., W., Inc. v. Jackson, 561 U.S. 63, 69 n.1 (2010); Simply Wireless, Inc. v. T-Mobile US, Inc., 877 F.3d 522, 526 (4th Cir. 2017) State ex rel. Pinkerton v. Fahnestock, 531 S.W.3d 36, 43 (Mo. 2017).

40. Simply Wireless, Inc., 877 F.3d at 526-27. See also Hernandez v. San Gabriel Temp. Staffing Servs., LC, 2018 WL 1582914 at *5-6 (N.D. Cal. 2018) (“Any dispute that arises out of or relates to Employee’s employment” was insufficient to delegate issue or arbitrability).

41. Compare Baker v. Bristol Care, Inc., 450 S.W.3d 770 (Mo. 2014) (an arbitration clause covering “any dispute relating to the applicability or enforceability of the Agreement” did not delegate issues of arbitrability to the arbitrator), with Ford Motor Credit Co., LLC v. Jones, 2018 WL 1384505 (Mo. Ct. App. 2018) (an arbitration clause covering “[c]laims regarding the interpretation, scope, or validity of this provision, or arbitrability of any issue” did delegate the issue of arbitrability). The reference in Baker to the “enforceability of the Agreement” would seem, necessarily, to cover the enforceability of the arbitration clause contained in the Agreement, and thus delegate issues of arbitrability to the arbitrator.

42. AAA Commercial Arbitration Rules and Mediation Procedures, Rule 7(a) (2013).

43. E.g., Brennan v. Opus Bank, 796 F.3d 1125, 1129 (9th Cir. 2015); Petrofac, Inc. v. DynMcDermott Petroleum Operations Co., 687 F.3d 671, 674 (5th Cir. 2012); Fallo v. High-Tech Inst., 559 F.3d 874, 877-78 (8th Cir. 2009); Qualcomm Inc. v. Nokia Corp., 466 F.3d 1366, 1373 (Fed. Cir. 2006); Terminix Int’l Co. v. Palmer Ranch LP, 432 F.3d 1327, 1332 (11th Cir. 2005); Contec Corp. v. Remote Solution Co., 398 F.3d 205, 208 (2d Cir. 2005); State ex rel. Pinkerton, 531 S.W.3d at 45. See also Simply Wireless, Inc. v. T-Mobile US, Inc., 877 F.3d at 525-28 (incorporation of Judicial Arbitration & Mediation Services rules was sufficient to delegate issue of arbitrability); Belnap v. Iasis Healthcare, 844 F.3d 1272, 1281-82 (10th Cir. 2017) (same); Cooper v. WestEnd Capital Mgmt., LLC, 832 F.3d 534, 546 (5th Cir. 2016) (same); Oracle Am., Inc. v. Myriad Group A.G., 724 F.3d 1069 (9th Cir. 2013) (incorporation of UNCITRAL arbitration rules was sufficient to delegate issue of arbitrability).

The result might be different if either or both contracting parties is not a sophisticated business entity, e.g., Meadows v. Dickey’s Barbeque Restaurants Inc., 144 F. Supp. 3d 1069, 1078-79 (N.D. Cal. 2015), but the bulk of authority appears to be to the contrary, e.g., Esquer v. Education Mgmt. Corp., 2017 WL 5194635 (S.D. Cal. 2017); Cubria v. Uber Techs., Inc., 242 F. Supp. 3d 541, 549-50 (W.D. Tex. 2017).

44. Perhaps in part because of this, that is, because the rule is so opaque, courts have also had to resolve thousands of disputes about what language is a clear and unmistakable delegation of authority to an arbitrator. Thus, the rule appears to have generated litigation rather than reduce it.

Steven L. Sepinuck

In 2017, an ABA Business Law Section task force completed a landmark report titled “Defining Key Competencies for Business Lawyers” that was published in The Business Lawyer. The report, directed towards law firms and law schools, drew on the framework of the influential ABA MacCrate Report (“Legal Education and Professional Development—An Educational Continuum”).

Both reports identify negotiation as a key lawyering skill. As the MacCrate report notes, negotiation is a skill that is “essential throughout a wide range of kinds of legal practice….” The reports discuss specific analytical skills that lawyers should employ when participating in negotiations. The MacCrate report specifically advocates four specific skills that lawyers should utilize in negotiations: (1) determine the bottom line; (2) evaluate alternatives; (3) analyze whether the negotiation is zero-sum, non-zero-sum, or a mixture of the two; and (4) identify outcomes from the negotiation.

This article elaborates on these four analytical skills and includes a link to a free exercise that you can use to develop these skills among members of your negotiating teams.

The Analytical Skills that Lawyers Should Possess

 1. Determine the Bottom Line

The MacCrate report correctly emphasizes the importance of determining the bottom line, which in negotiation terminology is also called the reservation price. But other information is also important when analyzing a negotiation.

• Your stretch goal. Negotiators who have the largest stretch goals are most successful over time. Your challenge is to select a stretch goal that is well beyond your reservation price, but that is not so unreasonable that you lose credibility when presenting it to the other side.
• This is your ultimate goal in a negotiation. Targets lie somewhere between your stretch goal and your reservation price.
• Zone of potential agreement. Great negotiators look at negotiations from the perspective of the other side. This enables them to estimate the zone of potential agreement, which is the range between their reservation price and the reservation price of the other side. If successful, the deal will take place within this zone.

2. Evaluate Alternatives

Your most important task when preparing for a negotiation is to evaluate your best alternative if the negotiation is not successful. In negotiating language, this is your BATNA (“Best Alternative to a Negotiated Agreement”). Determining your BATNA is important because it is a key source of power. The better your alternative, the more leverage you have to walk away from a negotiation. 

Your BATNA strategy should include three elements: find, weaken, and improve. First, you should try to find the other side’s BATNA so that you can determine how powerful they are. Second, you should attempt to weaken their BATNA. For example, if you are involved in negotiating the sale of your client’s company to a buyer who is considering an alternative purchase, you should emphasize problems with the alternative. Third, you should try to improve your BATNA. In negotiating the company sale, for instance, try to find other potential buyers so that you can develop a strong alternative for your client. 

3. Analyze Whether the Negotiation is Zero Sum

Determining whether a negotiation is zero sum is important because your negotiation tactics might be more competitive when fighting over a fixed pie. But don’t be trapped by what researchers call the “Mythical Fixed Pie Assumption.” The assumption that every negotiation is zero sum, while prevalent in settlement negotiations, also arises during transactional negotiations. To avoid the assumption, you should ask questions designed to identify the interests of the other side and match those interests with those of your client to develop opportunities that benefit both sides.

4. Identify Outcomes from the Negotiation

The decision tree is an especially useful tool when identifying outcomes from a negotiation. For example, when you are involved in settlement negotiations, you can use a decision tree to calculate the expected value of the litigation, which is often your BATNA if the negotiation is not successful. Decision trees are also useful during transactional negotiations, such as helping your client decide which of two companies to purchase. Creating a decision tree involves a three-step process: (1) depict the decision in a tree form, (2) add probabilities and financial values, and (3) calculate the expected value of the litigation or a business transaction. I discuss decision trees and the other analytical skills in greater detail in Negotiating for Success, Chapter 3, “Conduct a Negotiation Analysis” (Van Rye Publishing, 2014).

A Negotiation Exercise to Teach the Analytical Skills

To help you and the colleagues on your negotiating teams develop a common understanding of these skills, I have prepared a teaching package that you can use without charge (and no permission is necessary). The package includes a negotiation exercise with two roles, a Teaching Note, and PowerPoint slides. There is a twist to the exercise, known to only one of the parties, that will raise ethical concerns and challenge their negotiating skills.

I have used this exercise in training lawyers and judges. Organizations in the public and private sectors (for example, the World Bank and one of the five largest U.S. companies) have used the exercise for negotiation training led by their in-house staff. Thank you to the University of Michigan for support in the development of this package and encouragement to make it available for free distribution outside the university. My only request is that if you decide to use the exercise, I would appreciate your comments and recommendations for improvement. 

During a speech in San Francisco on June 14, 2018, at the Yahoo! Finance All Markets Summit, William Hinman, director of the Division of Corporation Finance of the Securities and Exchange Commission (SEC), provided some welcome clarity regarding the applicability of the federal securities laws to digital assets and tokens projects (Hinman speech). Hinman’s speech, titled “Digital Asset Transactions: When Howey Met Gary (Plastic),” focused on whether a digital asset offered as a security can, over time, become something other than a security. According to Hinman, the answer to this question is a qualified “yes” when a digital asset is sold only to be used to purchase a good or service available through a network. Hinman also expressed his view that Ether—the cryptocurrency of the Ethereum network—is not a security[1] and therefore is not subject to the U.S. federal securities laws. Hinman said that, in his view, Bitcoin is not a security either, reinforcing what SEC Chairman Jay Clayton stated in his remarks recently on CNBC and what many who follow virtual currency developments thought was a foregone conclusion. On June 21, 2018, as discussed below, SEC Chairman Jay Clayton gave congressional testimony that provided further support for the SEC staff’s approach as outlined by Hinman.

Hinman’s speech was even more significant to the universe of those who pay close attention to regulators’ views on digital assets, in particular when a digital asset is deemed to be a security.[2] Hinman suggested that in limited circumstances, the SEC believes that blockchain startups can raise money by selling tokens (or agreements for future tokens) as securities before a network is launched (i.e., before it has functionality or utility), but then further sales of these same tokens can be made as nonsecurities once the circumstances surrounding that sale transaction have changed in a manner that no longer constitutes an investment contract.

Hinman discussed certain factors to be considered in assessing whether a digital asset is offered as an investment contract in a securities transaction. In particular, Hinman focused on the fourth prong of the Howey investment contract test (as explained below) and whether the efforts of an identifiable third party—be it a person, an entity, or a coordinated group of actors—drives the expectation of a return. Also noteworthy was Hinman’s comment that the SEC is “happy to help promoters and their counsel work through . . . issues . . . [and] . . . stand[s] prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.” As in the cases Hinman discussed, this summary focuses on an analysis under the Securities Act of 1933 and the Securities Exchange Act of 1934. Note that based on context, an analysis under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 may have different results, as may analysis under state laws, due to different definitions or interpretations.

Key Components of Hinman’s Speech

Digital Asset: Product vs. Security. Hinman began by describing promoters selling tokens or coins to raise money to develop networks on which the digital assets will operate, rather than selling shares, issuing notes, or obtaining bank financing. In many cases, the economic substance is the same as a conventional securities offering—funds are raised with the expectation that the promoters will build their system, and investors can earn a return on the instrument. In such cases, Hinman said that it would be “easy to apply” the longstanding “investment contract” test from the 1946 U.S. Supreme Court’s decision in SEC v. W.J. Howey Co.[3] (Howey test): (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the entrepreneurial or managerial efforts of others.

Hinman next focused on the specific facts of the Howey case, which involved a hotel operator, Howey, selling interests in a nearby citrus grove coupled with a service contract obligating the hotel operator to harvest and market the oranges on the purchaser’s behalf. Howey unsuccessfully claimed it was selling real estate rather than securities. Hinman highlighted that although the transaction in Howey was recorded as a real estate sale, it also included a service contract to cultivate and harvest the oranges, which meant that the investors were relying on the efforts of Howey for a return. Hinman emphasized that regardless of whether something is called a “token” or a “coin,” the analysis turns on how an asset is sold, which may cause investors to have a reasonable expectation of profits based on the efforts of others.

Just as in Howey, Hinman stressed, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value to be sold later at a profit.[4] In addition, as in Howey—where interests in the grove were sold to hotel guests who were passive investors, not farmers—tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.

Gary Plastic. As the title of his speech signals, Hinman analogized certain sales of tokens to the facts in Gary Plastic Packaging v. Merrill Lynch,[5] in which the court held that a transaction may be subject to the securities laws, even if the underlying instrument would not be a security, based on the manner of their sale and the promises associated with such sale. In Gary Plastic, the court found that despite the fact that conventional certificates of deposit (CD) issued by a bank are not securities, they were securities in that instance because they were sold in a manner that satisfied the Howey test. The CDs were sold through a program organized by Merrill Lynch that promised retail investors it would maintain a secondary market for the CDs. The court found that the CDs represented a joint effort by the issuers of the CDs and Merrill Lynch, and that the CDs were investment contracts because investors expected to receive profits through the extra services provided by Merrill Lynch.

Applying the same reasoning to tokens, Hinman stated that although tokens themselves (which are, after all, “simply code”) may not be securities, “how [tokens are] being sold and the reasonable expectations of purchasers” are central to the securities law determination. Therefore, in the context of a token sale that resembles the sale of a security, the application of the securities laws is appropriate because such laws’ disclosure requirements (among other protections) are necessary to mitigate the information asymmetry between promoters and investors.

Mutability: From Security to Utility Tokens. Hinman explained that a digital asset transaction may no longer represent a security offering, i.e., an investment contract, if, in addition to the token or coin lacking other security-like features, the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts. Moreover, Hinman added, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede, and as a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult and less meaningful.

Ether and Bitcoin. Hinman expressed his view that sales of Ether are not securities transactions, stating: “Based on my understanding of the present state of Ether, the Ethereum network, and its decentralized structure, current offers and sales of Ether are not securities transactions.” Hinman also said that, in his view, Bitcoin also is not a security because network participants are not reliant upon the efforts of a central third party. Hinman stated:

I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.

Hinman cautioned that the analysis of whether something is a security is not static and does not strictly inhere to the instrument, specifically noting that even digital assets with utility that function solely as a medium of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security.[6]

Director Hinman reiterated that although the token or coin by itself is not a security, the packaging and sale of such token or coin could bring it within the purview of the securities laws.

Token Sales. Hinman provided additional context to Chairman Clayton’s prior remarks in which the chairman noted that an overwhelming number of the token sales he has seen likely qualify as securities offerings under the Howey test. Hinman reiterated that merely calling the token a “utility token” does not give it the substance needed to avoid being a security. He focused on the concepts of full decentralization and consumptive intent of the purchasers as two important factors, but noted that a broader facts-and-circumstances analysis is required.

In what appears to be the SEC’s nod to token pre-sale agreements, such as the SAFT (simple agreement for future tokens) or SAFE-T (simple agreement for equity or tokens), where tokens are issued as securities to accredited investors pursuant to the private offering regime of Regulation D, Hinman noted the possibility of structuring a blockchain-based enterprise with funding through token pre-sale agreements without necessarily affecting the ability of the token to be sold later as a nonsecurity.[7]

Facts-and-Circumstances Assessment

Ultimately, the question of whether the offering of a token qualifies as a security will turn on a facts-and-circumstances analysis. Hinman provided the following illustrative (but not exhaustive) list of considerations:

1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, whose efforts play a significant role in the development and maintenance of the asset and its potential increase in value?
2. Has this person or group retained a stake or other interest in the digital asset such that the person or group would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
4. Are purchasers “investing”—that is, seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
5. Does application of the Securities Act protections make sense? Is there a person or entity on which others are relying and that plays a key role in the profit-making of the enterprise such that disclosure of the person’s or entity’s activities and plans would be important to investors? Do informational asymmetries exist among the promoters and potential purchasers/investors in the digital asset?
6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

In addition, the director set forth the following seven nonexhaustive questions that help market participants evaluate whether a digital asset functions more like a consumer item and less like a security:

1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
2. Are independent actors setting the price, or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
3. Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
4. Are the tokens distributed in ways that meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
5. Is the asset marketed and distributed to potential users or the general public?
6. Are the assets dispersed across a diverse user base or concentrated in the hands of a few users who can exert influence over the application?
7. Is the application fully functioning or in early stages of development?

Growing Consensus Among SEC Officials

On the very same day as Hinman’s speech in San Francisco, Valerie Szczepanik, the SEC’s new Senior Advisor for Digital Assets and Innovation,[8] and Gary Goldsholle, Senior Advisor to the Director of Trading and Markets, corroborated Director Hinman’s remarks while speaking at a panel event on Capitol Hill.[9] Specifically, Goldsholle reiterated Hinman’s position that something can transform from a security to a nonsecurity. Goldsholle made sure to also add that the same instrument could transform back into a security if the facts and circumstances changed yet again. Relatedly, Szczepanik acknowledged that there is a spectrum for tokens, stretching from those that are intended purely for fundraising (i.e., securities) to those that are purely consumptive (i.e., not securities). Both Goldsholle’s and Szczepanik’s comments indicate a building consensus among the SEC staff on these issues.

On June 21, 2018, SEC Chairman Clayton provided further confirmation that the framework outlined in Hinman’s speech is the “approach [SEC] staff takes to evaluate whether a digital asset is a security” in testimony to the U.S. House of Representatives Financial Services Committee.[10] Clayton emphasized that the SEC will consider the facts and circumstances of a given token sale and utilize a principles-based framework to reach a conclusion on whether the token sale constitutes a securities offering. Under such a framework, persons “attempting to fund a project—whether it be opening a new manufacturing plant or creating an application on a distributed network—by inviting others to invest in the enterprise based on the expectation that they will profit from other people’s efforts” must register their offerings with the SEC or rely on an appropriate exemption from registration.

Canadian Securities Administrators Weigh In on Tokens

In the same week, the Canadian Securities Administrators (CSA) separately released a staff notice that addressed the question of when an offering of tokens may or may not involve an offering of securities. Although the CSA did not explicitly address the concept of mutability, it did provide an illustrative list of situations where tokens implicate securities law concerns under Canadian law. Although the SEC and the CSA operate in different jurisdictions, Canada and the United States share similar legal tests for determining an “investment contract,” so the Canadian examples may also provide some persuasive instruction.[11]

Conclusion

Hinman’s speech offers support to software developers, technologists, inventors, and supporters of innovation in applying a framework for evaluating token sales under the Howey test. It is a helpful guide for developers of distributed networks and tokenized products, for enterprises looking to raise money by offering a security that will later become a decentralized token, and exchange platforms seeking to determine when compliance with the securities laws and regulations related to token distribution and secondary trading is necessary.

Importantly, it clarifies the legal standard and factual details that the SEC is likely to consider when evaluating a token sale. Given the significant penalties for violations of the federal securities laws and regulations by those who, among other things, publicly offer unregistered securities, operate a securities exchange that should be registered, or act as a broker-dealer or investment adviser without registration or relying on an exemption, this clarification of the SEC staff’s position will be very well received.

[1] Technically speaking, the token by itself is not a security, so what Hinman pointed out is that sales of Ether currently are not occurring under circumstances that would form an investment contract.

[2] The SEC first officially confirmed its view that tokens sold through initial coin offerings may qualify as securities when it issued a 21(a) report outlining its investigation of The DAO. See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207 (July 25, 2017).

[3] 328 U.S. 293 (1946).

[4] See Munchee Inc., Securities Act of 1933 Release No. 10445 (Dec. 11, 2017) (Although Munchee’s token was labeled a “utility token” that would allow purchasers to buy goods and services on the Munchee ecosystem, Munchee and other promoters emphasized that investors could expect that efforts by the company would lead to an increase in value of the tokens. The company also emphasized it would take steps to create and support a secondary market for the tokens. Given these and other company activities, the SEC found that the tokens were securities.); see also Perkins Coie Client Alert, SEC Takes Aim at Initial Coin Offerings Again (Jan. 11, 2018).

[5] 756 F.2d 230 (2d Cir. 1985).

[6] Hinman stated, “if a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. Similarly, investment contracts can be made from virtually any asset (including virtual assets), provided the investor is reasonably expecting profits from the promoter’s efforts.”

[7] See Hinman Speech, at n.15 (noting that a token obtained via a SAFT through a securities offering may later be sold in a nonsecurities offering).

[8] Press Release, SEC Names Valerie A. Szczepanik Senior Advisor for Digital Assets and Innovation (June 4, 2018).

[9] Amir Zaidi (Director of Market Oversight, CFTC), Rep. Sean Duffy (House of Representatives), and Jim Newsome (former Chairman, CFTC) also participated.

[10] Jay Clayton, Chairman of Sec. & Exch. Comm’n, Testimony on “Oversight of the U.S. Securities and Exchange Commission” Before the Committee on Financial Services, U.S. House of Representatives (June 21, 2018).

[11] Canadian Securities Administrators Staff Notice 46-308, Securities Law Implications for Offerings of Tokens (June 11, 2018).

The U.S. Securities and Exchange Commission (SEC) approved an amendment to Rule 701(e) under the Securities Act of 1933 on July 18, 2018, increasing from $5 million to $10 million the threshold in excess of which a private company is required to deliver additional disclosures, such as financial statements, to employees in a compensatory securities offering. The change became effective July 23, 2018.

The SEC also approved the issuance of a concept release soliciting public comment on possible ways to update the requirements of Rule 701 and Securities Act Form S-8, which provides a simplified registration form for compensatory offerings by public companies. In so doing, the SEC has signaled its willingness to consider possible ways to modernize its regulation of compensatory securities offerings and sales.

Rule 701(e) Amendment Mandated by Congress

Subject to certain requirements, Rule 701 provides a federal exemption for a nonreporting company from the registration requirements of the Securities Act for offers and sales of securities under compensatory employee benefit plans or written agreements for the company’s employees, officers, directors, partners, trustees, and, under certain circumstances, its consultants and advisors. Rule 701(e) requires the company to deliver to all such offerees, within a reasonable period of time before the date of sale, financial statements and certain other information if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million ($10 million following the effectiveness of the amendment). In the adopting Release, the SEC clarified that companies that have commenced an offering in the current 12-month period will be able to apply the new $10 million disclosure threshold immediately upon effectiveness of the amendment.

The SEC’s action to amend Rule 701(e) came as no surprise. It was directed to do so by Congress within 60 days after the Economic Growth, Regulatory Relief, and Consumer Protection Act was signed into law on May 24, 2018. The law also requires that every five years the SEC index for inflation the disclosure threshold amount to reflect the change in the Consumer Price Index for All Urban Consumers. In publishing the final Rule 701(e) amendment without engaging in a cost-benefit analysis or seeking public comment, the SEC made clear that Congress itself had undertaken the requisite analysis and that the agency exercised no discretion. By raising the existing $5 million threshold, the SEC explained, Congress intended to address two key concerns: “that additional disclosure makes it more expensive for [private] companies to compensate their employees with . . . stock and that this disclosure puts [these] companies at risk of disclosing confidential financial information.”

Concept Release Signals Future Changes to Rule 701 and Form S-8

Both the Concept Release and remarks made by the commissioners and the staff during the SEC open meeting recognize that since Rule 701 and Form S-8 were last amended, new forms of equity compensation have evolved along with new types of contractual relationships between companies and individuals involving alternative work arrangements. A key question has emerged: what does the term “employee” really mean in the emerging “gig” economy? In light of these developments, as well as the congressionally-mandated change to Rule 701(e), the SEC believes that “this is an appropriate time to revisit the Commission’s regulatory regime for compensatory transactions.”

During the open meeting, several of the commissioners emphasized that compensatory offers and sales of securities to employee-investors present different issues for private companies than capital-raising offerings aimed at other prospective investors. As noted in the Concept Release, “using equity for compensation can align the incentives of employees with the success of the enterprise, facilitate recruitment and retention, and preserve cash for the company’s operations.” It was this important distinction that prompted the SEC many years ago to adopt Rule 701 and a streamlined Form S-8.

The Concept Release poses 56 questions in total (with almost 75 percent of the questions focused on Rule 701) for public comment—many stemming from the new types of contractual relationships arising between companies and individuals due to the Internet, including short-term, part-time, or freelance arrangements. Individuals participating in these arrangements do not enter into traditional employment relationships and therefore may not be “employees” eligible to receive securities under Rule 701(c). Yet, companies may have the same incentive-related motivations to offer equity compensation to these individuals.

Several of the comment requests focus on what activities an individual should need to engage in, in order to be eligible to participate in exempt compensatory offerings, or put another way, who should be considered an “employee” in the current gig economy. The Concept Release also solicits comments on further revising the disclosure content and timing requirements of Rule 701(e), including, among other things, asking whether the rule should continue to require more disclosure for a period that precedes the new $10 million threshold amount being exceeded, clarify what it means to deliver disclosure “a reasonable period of time before the date of sale,” and specify the manner or medium in which disclosure should be delivered.

The SEC is also soliciting comments on Form S-8. For the “continued harmonization” of Form S-8 and Rule 701, the SEC is asking to the extent the scope of eligible individuals, including “consultants and advisors,” is changed under Rule 701, whether the same changes should be reflected in amendments to Form S-8. Among other questions, the SEC asks whether it should adopt a “pay-as-you go” fee structure, where companies pay filing fees on Form S-8 on an as-needed basis rather than when the form is originally filed.

Howard Dicker and Aabha Sharma