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Considerations for Contractual Provisions Extending Statutes of Limitations

Posted on May 1, 2014 by Louis G. Hering - Uncategorized

Overview

Like the law in many other states, subject to the exception noted below for contracts under seal, Delaware law does not permit the extension of a statute of limitations by contract.¹ While many practitioners may be familiar with this prohibition, some may not have considered the types of provisions that could be construed to run afoul of the prohibition and the implications for certain legal opinions. Practitioners who are drafting, or providing enforceability opinions on, provisions that could be construed as contractual extensions of the statute of limitations should be aware of the prohibition and, more importantly, the ways in which the issue can arise. For example, many private company acquisition agreements require the seller to indemnify the buyer post-closing for losses arising from a breach of the seller’s representations and warranties. The parties may approach this through a combination of survival clauses, notice provisions, and contractual indemnification obligations. Such indemnification obligations may, by their terms, extend for a number of years post-closing and, in the case of indemnification for breach of certain representations, such as authority and capitalization, may extend indefinitely.

Extension of the Statute of Limitations by Contract

If an acquisition agreement specifically provided that the right to file suit for breach of representations and warranties was extended for specified periods, for example, three years for business representations, ten years for environmental representations, and indefinitely for “fundamental” representations, the statute of limitations issue may be readily apparent to practitioners familiar with the public policy limitation. However, the provision purporting to extend the statute of limitations contractually may do so in a more subtle fashion. For example, many agreements provide that the representations and warranties will “survive” for a specified period of time, much like the time periods noted above.

In GRT, the Delaware Court of Chancery interpreted a survival clause in a securities purchase agreement as a contractual statute of limitations.² There, the survival clause had the effect of shortening the statute of limitations rather than extending it.³ The survival clause provided that certain representations survived for a one-year period and would thereafter “terminate,” together with associated indemnification rights and contractual remedies.⁴ Under Delaware law, parties may shorten the statute of limitations by contract because a shortening of the statute of limitations is consistent with the policy behind statutes of limitation.⁵ Although the GRT court was only required to address the effect of the one-year survival clause, the court addressed, in dicta, the interpretation of a provision purporting to cause the representations and warranties to survive “indefinitely,” and explained that such a provision would constitute an impermissible attempt to extend the statute of limitations under Delaware law.⁶ The GRT court instructed that, under Delaware law, such a provision would be read “as establishing that the ordinarily applicable statute of limitations governs the time period in which actions for breach can be brought.”⁷ Thus, a Delaware court would give effect to such a provision by reading it in a manner consistent with Delaware public policy.

The “survival” provisions discussed above are often coupled with notice requirements and covenants to indemnify for breaches of the representations and warranties occurring during the survival periods.⁸ The covenants to indemnify can relate to third-party claims as well as claims between the parties. It is important to note, however, that, under Delaware law, the analysis of a claim for indemnification for breach of representations or warranties and for damages suffered as a result of that breach caused by the diminution in value of the transferred assets is analyzed differently from a claim for indemnification for third-party claims.⁹ With regard to the former, a claim for contractual indemnification for breach of representation or warranty will generally accrue at closing, such that the Delaware statute of limitations for breach of contract will begin to run at closing, absent a basis for tolling.¹⁰ With regard to the latter, however, the claim may not accrue until the extent of the liability to the third party is established and thus the statute of limitations for that claim would not begin at closing but rather when losses to the third party are ascertained.¹¹

For example, if a seller agrees to indemnify a purchaser for losses arising from a breach of a representation that there is no environmental contamination on a property and also for any losses arising from any environmental contamination on the property prior to closing and it turns out that there is, in fact, environmental contamination and, moreover, that contamination has already affected neighboring properties owned by third parties, then the seller could have indemnification obligations based both on the breach of the environmental representation giving rise to a claim for diminution of the value of the property and on the payments made to any third party for the environmental contamination. The indemnification claim for damages for the loss of value to the property as a result of the contamination would accrue at closing while the indemnification claim for damages for the amounts payable to third parties as a result of the contamination would accrue upon determination of liability to the third party. Thus, under Delaware law, an agreement that obligates a seller to “indemnify” a buyer for losses arising from a breach of representation or warranty for more than three years may, with respect to certain claims, constitute an impermissible attempt to extend the statute of limitations by contract, while a similar agreement, with respect to other third-party indemnification claims, may constitute an enforceable obligation that does not attempt to extend the statute of limitations.

Enforceability Issues

To the extent that a contractual provision purports to modify the statute of limitations, either expressly or through the use of a survival clause, under Delaware law, practitioners should carefully consider the enforceability of such a provision and, as discussed below, the possibility of alternative drafting to achieve the desired result. A complete assessment of enforceability would require practitioners to determine the applicable statute of limitations—a determination that would involve resolution of a number of different variables. And, given the way many contracts are drafted, it may not be possible at the outset to determine, with any degree of certainty, which jurisdiction’s statute of limitations will apply.

As a starting point, practitioners should note that, in Delaware, the statute of limitations is considered procedural rather than substantive, such that the statute of limitations of the forum governs.¹² Except for a cause of action that arises outside of Delaware, a Delaware court will generally apply the relevant Delaware statute of limitations, rather than the statute of limitations under the chosen law of the contract or under the law applicable in the absence of a choice of law provision.¹³ With respect to a cause of action that arises outside of Delaware, Delaware has adopted a “borrowing statute,” which provides that when a cause of action arises outside of Delaware, an action cannot be brought in a Delaware court after the expiration of the shorter of the Delaware statutory period or the statutory period of the state or country where the cause of action arose.¹⁴ The borrowing statute essentially requires the Delaware court to determine the applicable statute of limitations in Delaware as well as the applicable statute of limitations in the jurisdiction where the cause of action arose—an exercise that may be difficult in the context of a breach of contract claim, and apply the shorter one.¹⁵ The policy behind the borrowing statute is “to protect Delaware’s courts from having to adjudicate stale out-of-state claims.”¹⁶ By requiring the Delaware courts to apply the shorter statutory limitations period, “the General Assembly sought to prevent forum shopping to take advantage of a longer limitations period.”¹⁷ However, this rule, as described below, is subject to modification by contract.¹⁸

In addition to the analysis required to determine the possible effect under the borrowing statute, the determination of the applicable statute of limitations may be complicated by the nature of the alleged injury. Certain types of claims may not fall clearly within a particular statute of limitations in Delaware.¹⁹ For example, in Juran v. Bron, the Court of Chancery struggled with the appropriate statutory period and considered the applicability of the statutory limitations period for breach of contract (three years) and statutory period for a wage claim (one year) in the context of resolving a dispute under an employment agreement.²⁰

Finally, the enforceability of a contractual modification of the statute of limitations may be impacted by the type of court in which the dispute is brought. The Delaware Court of Chancery, as a court of equity, does not apply a statute of limitations except by analogy through the doctrine of laches.²¹ A court applying laches may shorten or lengthen the statutory period based on equitable considerations, but the plaintiff ’s failure to file in the analogous statutory period will be given “great weight” in determining whether the claim is barred.²² The general rule is that “a statute of limitations for an action at law that is analogous to the action in equity will guide an Equity Court in applying the equitable doctrine of laches.”²³ However, the statute of limitations is not binding on a court in equity and will not be applied where there are “special circumstances.”²⁴

The framework described above assumes that the action is brought in a Delaware court. If the contract does not choose Delaware as the exclusive forum or the exclusive forum provision is not enforced, the Delaware prohibition on lengthening the statute of limitations by contract and the overlay of the borrowing statute may not be relevant to the enforceability analysis. The bottom line is that it may be difficult to determine at the time an opinion is rendered which statute of limitations will control.

Drafting Considerations

From a drafting standpoint, there are a number of ways to resolve some of the uncertainty regarding enforceability. First, practitioners could consider including a specific provision choosing the statute of limitations of a particular jurisdiction within its choice of law provision. In Delaware, a choice of law provision that includes the statute of limitations of the relevant jurisdiction will be respected so long as inclusion of the statute of limitations is “specifically noted.”²⁵ Thus, if a contract provided for the exclusive jurisdiction of the Delaware courts and contained a Delaware choice of law provision that expressly included a choice of the Delaware statutes of limitations, a breach of contract claim should be governed by Delaware’s three-year statute of limitations (or the twenty-year statute of limitations applicable to contracts under seal, as discussed below).

Second, to the extent that parties want to permit recovery beyond the three-year statutory period, practitioners could consider drafting the obligation as a covenant requiring future performance as losses are incurred rather than as a provision requiring reimbursement for breach of representations and warranties. In CertainTeed v. Celotex Corp., the seller had agreed to “indemnify” the buyer for claims arising from seller’s breach of representations and warranties and for the buyer’s losses for third-party claims relating to defective products.²⁶ The CertainTeed court instructed that the contractual “indemnification” for breach of contract was not common law indemnification, but rather a contractual remedy for breach.²⁷ By contrast, common law indemnification provides “a general right of reimbursement for debts owed to third parties.”²⁸ While the claims for breach of representations and warranties accrued at closing, the common law indemnification claims would not accrue until the payment was made to the third party.²⁹ Accordingly, if the contractual obligation can be drafted as a future covenant rather than as a contractual remedy for an existing breach, the parties may be able to avoid the prohibition on extension of the statute of limitations by contract and still accomplish the desired allocation of risk between the contracting parties.

Finally, practitioners could consider following certain formalities to create a contact under seal because, under Delaware law, a contract under seal is subject to a twenty-year limitations period.³⁰ Historically, the requirements for creating a contract under seal (outside of the debt context) had received conflicting treatment under Delaware law.³¹ In 2009, the Delaware Supreme Court resolved a portion of the conflict by adopting a bright-line rule for individuals (rather than entities) attempting to create a sealed contract.³² The rule adopted for individuals is that “the presence of the word ‘seal’ next to an individual’s signature is all that is necessary to create a sealed instrument, irrespective of whether there is any indication in the body of the obligation itself that it was intended to be a sealed document.”³³

For entities (rather than individuals) to create a contract under seal, a greater degree of formality is required.³⁴ The contract must contain language referencing a sealed contract in the body of the document and a recital affixing the seal and there must be extrinsic evidence of the parties’ intent to create a contract under seal.³⁵

With respect to contracts under seal, practitioners should be mindful of at least two issues: First, it may be necessary to couple the provisions relating to a contract under seal with a forum selection clause agreeing to litigate exclusively in Delaware (which itself could be subject to challenge),³⁶ since the statute of limitations will be governed by the law of the forum. Second, the choice of law provision should include a choice of the Delaware statute of limitations, i.e., the choice of Delaware law for the statute of limitations should be “specifically noted,” so that the borrowing statute does not cause the Delaware court to apply the statute of limitations of the jurisdiction in which the cause of action arose to the extent that statute is shorter than the twenty-year statute of limitations applicable to contracts under seal in Delaware.

Opinion Considerations.

For purposes of Delaware law, if practitioners are asked to provide enforceability opinions with respect to such agreements, they should be aware that provisions purporting to allow recovery for breaches of representations and warranties beyond the three-year statute of limitations applicable to contract claims may not be enforceable as a matter of public policy. From an opinion standpoint, if the potential infirmity is not addressed in the agreement, practitioners should consider specifically qualifying the opinion as to such provisions or noting that they will be subject to the applicable statutes of limitations. One possible form of opinion qualification would be to include the following statement: “We express no opinion as to the enforceability of any provision in the [Transaction Documents] to the extent it violates any applicable statute of limitations.” Similarly, the qualification could provide that “we express no opinion as to any waiver of any statute of limitations.” Alternatively, the opinion could identify the specific sections of the documents that raise the concern and note that the enforcement of those sections “would be subject to any applicable statute of limitations.”

Although prudence may dictate inclusion of an exception along the lines described, given the uncertainty discussed above as to which statutes of limitations may apply to various claims arising under any given contract, one could reasonably take the position that an opinion recipient should not assume that the opinion giver is addressing whether or not the terms of the subject agreement could be construed as an impermissible extension of any possible applicable statute of limitations, especially when the agreement does not contain an explicit provision purporting to extend the statutory period, but rather a survival clause that could, under certain circumstances, be construed to have that effect. Moreover, an opinion recipient should recognize the application of a doctrine as basic as the statute of limitations without the requirement that an opinion giver specifically reference it. As such, one could reasonably take the position that an unstated exception with respect to the application of the statute of limitations would be deemed to be a customary practice limitation implicitly included in an opinion.

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* Louis G. Hering and Melissa DiVincenzo are partners at the law firm of Morris, Nichols, Arsht & Tunnell LLP in Wilmington, Delaware.

1. See GRT, Inc. v. Marathon GTF Tech., Ltd., No. 5571-CS, 2011 WL 2682898, at *15 n.80 (Del. Ch. July 11, 2011) (stating that “[a] freely made contractual decision among private parties to shorten, rather than lengthen, the permitted time to file a lawsuit does not violate the unambiguous negative command of 10 Del. C. § 8106 [the statute of limitations for breach of contract], but a decision to lengthen it does and allows access to the state’s courts for suits the legislature has declared moribund”); see also Wesselman v. Travelers Indem. Co., 345 A.2d 423, 424 (Del. 1975); Bonanza Rest. Co. v. Wink, No. S10C-10-018 RFS, 2012 WL 1415512, at *1 (Del. Super. Ct. Apr. 17, 2012), aff’d, 65 A.3d 616 (Del. 2013); Shaw v. Aetna Life Ins. Co., 395 A.2d 384, 386–87 (Del. Super. Ct. 1978).

2. GRT, 2011 WL 2682898, at *3–4, *14–16; see also ENI Holdings, LLC v. KBR Grp. Holdings, LLC, No. 8075-VCG, 2013 WL 6186326 (Del. Ch. Nov. 27, 2013) (construing a survival clause as a contractual statute of limitations).

3. GRT, 2011 WL 2682898, at *2–3, *6.

4. Id. at *1.

5. See id. at *12 n.59 (“[T]he shortening of statutes of limitations by contract is viewed by Delaware courts as an acceptable and easily understood contractual choice because it does not contradict any statutory requirement, and is consistent with the premise of statutory limitations periods, namely, to encourage parties to bring claims with promptness, and to guard against the injustices that can result when parties change position before an adversary brings suit or where causes of action become stale, evidence is lost, or memories are dimmed by the passage of time.”).

6. Id. at *15.

7. Id.

8. One variation on the “survival” clause that was not directly addressed by the GRT court is a provision requiring that notice be given during the survival period as a prerequisite to indemnification under the contract. The survival period in such a provision could be consistent with or shorter than the statutory period. GRT could be read to suggest that a survival period during which notice must be given will be construed as the same period during which claims must be filed. But see Sterling Network Exch., LLC v. Digital Phoenix Van Buren, LLC, No. 07C-08-050WLW, 2008 WL 2582920, at *5 (Del. Super. Ct. Mar. 28, 2008) (describing a survival period as a contractual statute of limitations but ultimately holding that the disputed claim had to be noticed during the survival period rather than filed). Even if the survival period is construed as the time period during which claims have to be noticed rather than filed, if the notice period is close to or the same as the statutory limitations period, there may be a very limited window between the giving of notice and the end of the statutory period for filing suit.

9. See Certainteed Corp. v. Celotex Corp., No. 471, 2005 WL 217032, at *5 (Del. Ch. Jan. 24, 2005) (“[I]n the case of counts for breach of contract and misrepresentation, where claims involve direct injury to CertainTeed—e.g., claims resting on the assertion that CertainTeed was injured because a Facility’s environmental condition was not as represented in the Agreement—timeliness is to be measured by the statute of limitations for breach of contract and torts, respectively, with accrual occurring at the date of breach or injury, absent tolling. Only if the underlying claim for contractual indemnification is actually a claim for losses resulting from liability to a third party (i.e., like a common law indemnity claim) will CertainTeed’s claim accrue at the time when the last dollar of loss is ascertainable.”).

10. See id.

11. See id.

12. See Cent. Mortg. Co. v. Morgan Stanley Mortg. Capital Holdings LLC, No. 5140-CS, 2012 WL 3201139, at *16 (Del. Ch. Aug. 7, 2012); Norman v. Elkin, No. 06-005-JJF, 2007 WL 2822798, at *3 (D. Del. Sept. 26, 2007); David B. Lilly Co. v. Fisher, 799 F. Supp. 1562, 1568 (D. Del. 1992), aff’d, 18 F.3d 1112 (3d Cir. 1994); Cheswold Volunteer Fire Co. v. Lambertson Constr. Co., 489 A.2d 413, 421 (Del. 1984).

13. See, e.g., Norman, 2007 WL 2822798, at *3; Cheswold, 489 A.2d at 421.

14. DEL. CODE ANN. tit. 10, § 8121 (West, Westlaw through 79 Del. Laws chs. 1–185).

15. See Juran v. Bron, No. 16464, 2000 WL 1521478, at *11 (Del. Ch. Oct. 6, 2000).

16. Id. at *12.

17. Id.; see also Huffington v. T.C. Grp., LLC, No. N11C-01-030 JRJ CCLD, 2012 WL 1415930, at *6–9 (Del. Super. Ct. Apr. 18, 2012).

18. See Central Mortgage, 2012 WL 3201139, at *16 n.138 (“A contractual choice of law provision does not change the result [that the forum statute of limitations applies], unless the provision explicitly calls for the application of that law’s statute of limitations.”); Juran, 2000 WL 1521478, at *11 (stating that “there is some authority . . . that while generally choice of law provisions will be given effect, those provisions will only include the statute of limitations of the chosen jurisdiction if their inclusion is specifically noted”).

19. See, e.g., cases cited at supra note 18.

20. 2000 WL 1521478, at *11.

21. See Whittington v. Dragon Grp., L.L.C., 991 A.2d 1, 9 (Del. 2009); Weiss v. Swanson, 948 A.2d 433, 451 (Del. Ch. 2008); see also Carsanaro v. Bloodhound Techs., Inc., 65 A.3d 618, 645 (Del. Ch. 2013).

22. Whittington, 991 A.2d at 9.

23. Juran, 2000 WL 1521478, at *11.

24. Id.

25. Id.

26. See No. 471, 2005 WL 217032, at *1 (Del. Ch. Jan. 24, 2005).

27. Id. at *3–5.

28. Id. at *3.

29. Id. at *3, *5.

30. See Whittington, 991 A.2d at 10; see also Sunrise Ventures, LLC v. Rehoboth Canal Ventures, LLC, No. 4119-VCS, 2010 WL 975581, at *1–2 (Del. Ch. Mar. 4, 2010), aff’d, 7 A.3d 485 (Del. 2010).

31. See Whittington, 991 A.2d at 11–12.

32. Id. at 14.

33. Id. (internal quotation marks and citation omitted); see Sunrise, 2010 WL 975581, at *1.

34. See Whittington, 991 A.2d at 10–11.

35. See Aronow Roofing Co. v. Gilbane Bldg. Co., 902 F.2d 1127, 1129 (3d Cir. 1990).

36. See TriBar Opinion Comm., The Remedies Opinion — Deciding When to Include Exceptions and Assumptions, 59 BUS. LAW. 1483, 1498–1502 (2004) (forum selection clauses).

Collecting Time-Barred Debt: Is it Worth the Risk?

Posted on April 24, 2014 by Thomas Dominczyk - Uncategorized

Collecting time-barred debts has never been an easy task. Tracking down debtors and convincing them to pay is difficult enough. Now with the latest activity from plaintiffs’ attorneys, the Federal Trade Commission (FTC), and the Consumer Financial Protection Bureau (CFPB), collectors may want to think twice before engaging in this already arduous task.

What is a “debt”? According to the Merriam-Webster.com dictionary, a debt is “an amount of money that you owe to a person, bank, company, etc.” According to the Fair Debt Collection Practices Act (FDCPA), a debt is “any obligation or alleged obligation arising out of a transaction in which the money, property insurance or services which are the subject of the transaction are primarily for personal, family or household purposes, whether or not such obligation has been reduced to judgment.” (15 U.S.C. 1692a(6).) While the FDCPA definition is verbose, at its core it is no different than the dictionary definition: an obligation to pay money. And neither definition includes the qualifier that the debt is still enforceable in court.

In the real world if you owe me money, I will ask you for the money and hopefully you will pay your debt to me. If you do not pay me and I do not have the time to keep asking you for the money you owe me, I may hire a collector to try to collect the money from you. That collector may call you on the telephone. That collector may call you on the telephone many times. That collector may send you a letter or many letters. All of these communications are designed to recover the money that you owe me. Once we have exhausted all other efforts to collect from you, we may have to resort to filing a lawsuit against you (to recover the money that you owe me). It does not matter whether we ask you for the money today, tomorrow, or 40 years from now. The fact remains that you still owe the debt.

This all sounds very simple, as it should. At its core, debt collection is not complicated. However, over the years, debt collectors, plaintiffs’ attorneys, and the government have turned the simple act of collection into an extremely complicated and financially dangerous profession.

Frustrated with “abundant evidence of the use of abusive, deceptive and unfair debt collection practices by many debt collectors,” Congress passed the FDCPA in 1977 with the stated purpose of “eliminate[ing] abusive debt collection practices by debt collectors.” Congress did not say that it wanted to prohibit debt collection, and in fact, acknowledged that it wanted to “insure that those debt collectors who refrain from using abusive debt collection practices are not competitively disadvantaged.”

Congress has never said that you should not pay me, nor has it said that I cannot collect from you. Rather, Congress wants to make sure that my collection efforts are not abusive, deceptive, or unfair. Should it matter that your debt to me is from money that I loaned you 25 years ago? You still owe me the money today, the same way you did when you had big hair and a jean jacket.

In most states, the statute of limitations does not extinguish a debt. Mississippi and Wisconsin are the only states that currently have statutes that extinguish the debt upon the running of the statute of limitations. (See Miss. Code Ann. § 15-1-3; Wis. Stat. Ann. § 893.05.) North Carolina limits a debt buyer’s ability to collect time-barred debts, but does not prohibit it in its entirety. (See N.C. Gen. Stat. § 58-70-115.) Elsewhere, the statute of limitations is an affirmative defense that must be asserted or it will be waived. (See e.g., Notte v. Merchants Mut. Ins. Co., 185 N.J. 490, 500 (2006).) Bankruptcy courts have also held that creditors may file proofs of claim on time-barred debts and that it is the responsibility of the debtor to object to the claim under the Bankruptcy Code. (See e.g., In re Keeler, 440 B.R. 354 (E.D. Pa. 2009); In re Varona, 388 B.R. 705 (Bankr. E.D. Va. 2008).) In fact, even a discharge in bankruptcy does not extinguish the debt, but only the debtor’s personal obligation to pay the debt. (See e.g., 11 U.S.C. 524(f).)

The FDCPA does not extinguish debts either. However, many least sophisticated plaintiffs over the years have used it as a tool to practically extinguish their debts and to increase their income as well as the income of their attorneys participating in this cottage industry. (See Jacobson v. Healthcare Fin. Servs., 434 F. Supp. 2d 133, 138 (E.D.N.Y. 2006) (lamenting the growth of the cottage industry and abundance of professional plaintiffs).) Even though time-barred debts are valid and enforceable (but subject to the statute of limitations defense), courts began to hold that filing suit or threatening to file suit on time-barred debts violated the FDCPA. One of the earliest reported decisions was Kimber v. Fed. Fin. Corp., 668 F. Supp. 1480, 1488 (M.D. Ala. 1987), where the court found that the defendant violated the FDCPA by filing a collection lawsuit after the statute of limitations had expired. The court reasoned that “time-barred lawsuits are, absent tolling, unjust and unfair as a matter of public policy, and this is no less true in the consumer context.” Kimber rejected the defendant’s argument that the statute of limitations was an affirmative defense that had to be raised and found the conduct both deceptive under Section 1692e and unfair/unconscionable under Section 1692f.

After Kimber, courts expanded on the statute of limitations problem, finding violations where a collector threatened suit on time-barred debts, but did not actually file them. For example, in Larsen v. JBC Legal Group, P.C., 533 F. Supp. 2d 290 (E.D.N.Y. 2008), a collector demanded payment and warned that “you may be sued 30 days after the date of this notice if you do not make payment.” The court held that the letter threatened legal action that could not be taken and violated Sections 1692e(5) and 1692e(10).

At this point, filing suit and explicitly threatening to file suit on valid debts were considered violations of the FDCPA. For quite some time, this was the limit of extra protections afforded to debtors who owed old debts. The Eighth Circuit specifically drew the line at this point in Freyermuth v. Credit Bureau Servs., 248 F.3d 767, 771 (8th Cir. 2001), holding that “in the absence of a threat of litigation or actual litigation, no violation of the FDCPA has occurred when a debt collector attempts to collect on a potentially time-barred debt that is otherwise valid.” Many courts have agreed with this line, including the Third Circuit in Huertas v. Galaxy Asset Mgmt., 641 F.3d 28 (3d Cir. 2011), and most recently, the Fourth Circuit in Mavilla v. Wake-Med Faculty Physicians, 2013 U.S. App. LEXIS 18803 (4th Cir. Sept. 10, 2013). So as long as I do not sue you or threaten to sue you, I can still ask you to repay me the money that you owe me.

Well, not so fast. What exactly does “threaten to sue you” mean? The language in the Larsen letter is pretty overt: “Warning: You may be sued 30 days after the date of this notice if you do not make payment.” Clearly, the letter makes no mistake that the only way to avoid the lawsuit is by making payment on the debt. But what if the threat is a little more subtle? In Baptist v. Global Holding & Inv. Co., L.L.C., 2007 U.S. Dist. LEXIS 49476, *3 (E.D.N.Y. Jul. 9, 2007), an attorney sent a letter on a time-barred debt that stated, “If you do not contact this office and make arrangements for payment of this debt, my office will proceed in accordance with the instructions of [the creditor]. Legal action against you may be authorized. . . . You can avoid this action by contacting this office immediately.” This letter does not threaten suit, but instead advises that the collector will proceed based on the instructions of its client. Nevertheless, the court held that this was enough to lead the least sophisticated consumer to believe that litigation was likely unless the debtor contacted the collector as instructed in the letter. The court noted that the fact that the letter came from an attorney as opposed to a collection agency was a factor to consider in the implied threat. Indeed, in Knowles v. Credit Bureau of Rochester, 1992 U.S. Dist. LEXIS 8349, *4 (W.D.N.Y. May 28, 1992), the statement “failure to pay the creditor will leave our client no choice but to consider legal action” did not threaten legal action as it did not come from an attorney. Nevertheless, most courts have held that attorney letterhead alone is insufficient to imply a threat of litigation. (See e.g. Nichols v. Frederick J. Hanna & Assocs., PC, 760 F. Supp. 2d 275, 279 (N.D.N.Y. 2011).)

The clear line in the sand drawn by Freyermuth is definitely getting messier, but it seems as though as long as I do not sue you, threaten to sue you, or imply that I may sue you, I am in the clear. Well . . . not exactly. Like many other areas of the FDCPA, implied threats of suit are open to interpretation by the courts. Thanks in part to the FTC, courts are really stretching to find an implied threat of suit.

Back in July 2010, the FTC issued a report titled Repairing A Broken System, Protecting Consumers in Debt Collection Litigation and Arbitration. In the report, the FTC acknowledged that collecting time-barred debt is not prohibited (except in Wisconsin and Mississippi), and stated that it took no position as to whether the FDCPA should be amended to preclude collectors from collecting debts that are time-barred. But the FTC did take the position that in certain situations, the act of collecting time-barred debt could “create a misleading impression that the collector can sue the consumer in court to collect the debt.” The report continues: “To avoid creating this misleading impression, collectors would need to disclose clearly and prominently to consumers before seeking payment on such time-barred debt that, because of the passage of time, they can no longer sue in court to collect the debt or otherwise compel payment.” Wow! So how does that work in our example? “Hey buddy, remember that money you owe me for the Whitesnake album? Well, I really need you to pay me back, but just so you know, I am not able to sue you or in any way compel you to pay the debt. Please pay me.”

That sounds pretty crazy, but that is exactly what the City of New York requires you to do if you want to collect time-barred debt. Pursuant to Local Law No. 15, a debt collector is prohibited from contacting a consumer to collect a time-barred debt unless the following disclosure is included in every written communication to the consumer: “WE ARE REQUIRED BY LAW TO GIVE YOU THE FOLLOWING INFORMATION ABOUT THIS DEBT. The legal time limit (statute of limitations) for suing you to collect this debt has expired. However, if somebody sues you anyway to try and make you pay this debt, court rules REQUIRE YOU to tell the court that the statute of limitations has expired to prevent the creditor from obtaining a judgment. Even though the statute of limitations has expired, you may CHOOSE to make payments. However, BE AWARE: If you make a payment, the creditor’s right to sue you to make you pay the entire debt may START AGAIN.” (Emphasis in original.)

Do not even think about burying this disclaimer on the back of your letter with a bunch of other disclaimers, as the local law requires the notice to be “provided in at least 12 point type and set off in a sharply contrasting color from all other type on the permitted communication. The language must also be placed adjacent to the identifying information about the amount claimed to be due or owed on the debt.”

The FTC continued to push the disclosure requirement in its complaint against Asset Acceptance, LLC. As part of a Consent Decree, Asset was required to include the following notice when attempting to collect time-barred debts: “The law limits how long you can be sued on a debt. Because of the age of your debt, we will not sue you for it.” (United States of America v. Asset Acceptance, LLC, No. 8:12-cv-00182-T-27EAG (M.D. Fla. Jan. 31, 2012).) While previously acknowledging that collecting time-barred debt is permitted by most states, the FTC has now required a debt collector to inform consumers that nothing will happen to them if they do not pay the debt that they are trying to collect.

Picking up on the FTC’s position, plaintiff’s attorneys are now asking courts to adopt this reasoning in their FDCPA lawsuits. In McMahon v. LVNV Funding, LLC, 2012 U.S. Dist. LEXIS 92655 (N.D. Ill. Jul. 5, 2012), the plaintiff asked the court to give deference to the Asset Consent Decree and certify a class of individuals who merely received letters to collect time barred debts. In declining to do so, the court noted that the FTC’s position was that “in many circumstances, [attempting to collect on a time-barred debt] may create a misleading impression that a collector can sue the consumer . . .” but did not specify those many circumstances. Nevertheless, on a motion for reconsideration, the court did allow the plaintiff leave to amend his complaint to pursue a class action on the basis that offering a “settlement” on a time-barred debt implied that there was some legal obligation to pay the debt in violation of the FDCPA. (McMahon v. LVNV Funding, LLC, 2012 U.S. Dist. LEXIS 113576 (N.D. Ill. Aug. 13, 2012).)

From here, things are only getting worse for debt collectors trying to collect time-barred debts. In Magee v. Portfolio Recovery Assocs., LLC, 2013 U.S. Dist. LEXIS 8500 (N.D. Ill. Jan. 13, 2013), the collector sent a letter offering to settle a time-barred debt. In addition to the settlement offer, the letter also stated the date that the debt collector purchased the debt, but not the date that the debt was incurred. The court found that it was plausible that the least sophisticated consumer could believe the debt was recent, thus rendering the letter false under the FDCPA. In Harris v. Total Card, Inc., 2013 U.S. Dist. LEXIS 131747 (N.D. Ill. Sep. 16, 2013), a debt collector tacitly acknowledged that it was attempting to collect an older debt in a letter which stated, “We believe most people want to do the right thing and satisfy their past financial obligations.” But the letter went on to state that the collector had negotiated a fantastic settlement offer which the court found could be construed as implying that there was some legal obligation to pay the debt.

Things were bad enough for debt collectors when it was just the FTC inspiring plaintiffs, but now the CFPB has entered the fray and has been much more active in investigating debt collectors and filing amicus briefs. (For a current list of amicus briefs filed by the CFPB, see www.consumerfinance.gov/amicus.) In addition, the CFPB has identified the collection of time-barred debt as one of the areas it will explore in its Supervision and Examination Manual (see http://files.consumerfinance.gov/f/201210_cfpb_debt-collection-examination-procedures.pdf), and devoted an entire section to time-barred debts in its Advanced Notice of Proposed Rule Making for debt collection (see http://files.consumerfinance.gov/f/201311_cfpb_anpr_debtcollection.pdf). Recently, the CFPB joined the FTC in amicus briefs filed with the Seventh Circuit in Delgado v. Capital Management Services, LP, and the Sixth Circuit in Buchanan v. Northland Group, Inc.

At the trial level in Delgado, the court sided with the plaintiff and decided to give deference to the FTC’s position as stated in the Asset Consent Decree and its prior reports and held that “absent disclosures to consumers as to the age of their debt, the legal enforceability of it, and the consequences of making a payment on it, it is plausible that dunning letters seeking collection on time-barred debts may mislead and deceive unsophisticated consumers.” (Delgado v. Capital Management Services, LP, 2013 U.S. Dist. LEXIS 40796, *19 (C.D. Ill. Mar. 22, 2013).) The letter at issue contained an offer to settle for 30 percent of the amount owed. In the amicus brief, the FTC and CFPB argued that “the debt collector need not make an overt threat or a false or misleading representation about the debt to violate the FDCPA. Rather, the court must consider a practice’s effect on unsophisticated consumers from their perspective – for example, in light of circumstances such as their prior collections experience and any preexisting misconceptions.” The FTC and CFPB argued that “in some circumstances, a debt collector may be required to make affirmative disclosures in order to avoid misleading consumers.” They do not specify the “circumstances,” but taking the argument to the extreme, a completely benign letter containing little more than the Section 1692g(a) disclosures could violate the FDCPA given an unsophisticated debtor’s “preexisting misconceptions.”

The Seventh Circuit agreed with the FTC and CFPB, noting that they have found that “most consumers do not understand their legal rights with respect to time-barred debts.” (McMahon v. LVNV Funding, LLC, 2014 U.S. App. LEXIS 4592, *29 (7th Cir. Mar. 11, 2014) (the McMahon and Delgado appeals were consolidated).) In affirming the district court’s denial of the motion to dismiss, the Seventh Circuit Googled the term “settlement” and cited to the Wikipedia entry for “settlement offer” as support for its conclusion that a consumer could be misled into believing that a time-barred debt is legally enforceable. (Interestingly, that same Wikipedia entry later notes that “this article does not cite any reference or sources.”) The Seventh Circuit acknowledged that its reasoning conflicts with the Eighth and Third Circuits, which both require an overt threat of litigation. The Seventh Circuit reasoned that “whether a debt is legally enforceable is a central fact about the character and legal status of that debt,” and any misrepresentation about that fact is a violation of the FDCPA.

An optimistic takeaway from the Seventh Circuit opinion is that the focus of the opinion was on the use of the term “settlement.” However, the conclusion is a little more grim for debt collectors: “we conclude that an unsophisticated consumer could be misled by a dunning letter for a time-barred debt, especially a letter that uses the term ‘settle’ or ‘settlement.’” (Emphasis added.) It seems extremely unlikely that any suits based on collection of time-barred debts will be dismissed at the pleading stage under this standard.

The appellate arguments in Buchanan v. Northland Group, Inc., Case No. 13-2523 (6th Cir. 2013), are nearly identical to those made in Delgado except that at the trial level, the court in Buchanan was not persuaded by the FTC reports or consent decree and dismissed the complaint for failure to state a claim. However, in Buchanan, the amicus brief asks the Sixth Circuit to import a Seventh Circuit standard for interpreting letters, specifically, to consider extrinsic evidence when determining a letter’s effect on an unsophisticated consumer. They argue for a fact-bound interpretation of the letter from the perspective of the unsophisticated consumer which will essentially preclude ruling on the letters as a matter of law. Adopting this standard will make dismissal at the pleading stage extremely difficult, if not impossible, in time-barred debt cases in the Sixth Circuit, as they are now in the Seventh Circuit.

So what do you do with time-barred debts? Unfortunately, Wikipedia has no answers. Sure you can put a disclaimer on the letter, but you might as well tell the debtor that it does not have to pay the debt. Otherwise it appears that the less enticing your letters sound, the less likely they are to confuse the least sophisticated debtor into believing he or she is legally obligated to pay the debt. The trend appears to be that collecting time-barred debt is almost certainly going to be an invitation to litigation, and perhaps at some point collectors will have to decide if it is even worth the effort to try and collect, time-barred debt at all. Of course if older debt becomes harder and harder to collect it will become harder and harder for original creditors to sell these accounts in the first place. As a result, the original creditors and their collectors will have more incentive to pursue litigation before the statute of limitations runs. This will lead to more consumers being sued and having to deal with their debts sooner rather than later. Consider whether the original creditors will offer consumers as great a discount on their debts as debt buyers currently do. If that is the case, is this big push to eradicate the collection of time-barred debts really going to help consumers in the end? I doubt it.

Is Foreclosing on a Security Interest Collection of a Debt? Perspectives on the Application of the FDCPA

Posted on April 21, 2014 by Sulejman Dizdarevic - Uncategorized

Congress passed the Fair Debt Collection Practices Act (FDCPA) in 1977 following a wave of reports of perceived abuse in the consumer debt collection industry. The purpose, of course, was not only to punish the unscrupulous, but also to level the playing field for those debt collectors operating fairly, thus eliminating whatever competitive advantage the unscrupulous might otherwise have enjoyed.

Thirty-seven years later, courts (and litigators) continue to explore the limits of the kinds of activities the FDCPA precludes, oftentimes with inconsistent results. These inconsistencies have resulted in varying interpretations of the FDCPA’s coverage, creating a kind of patch-work across jurisdictions. For those businesses involved with consumer financial services nationally, or at least regionally across states and federal circuits, this can result in the daunting challenge of figuring out whether the FDCPA applies to your activity.

One area that has seen a surge in recent court decisions is the potential FDCPA liability of mortgage servicers when foreclosing on a mortgage or other security interest. That is, does the FDCPA apply generally to the enforcement of security interests in addition to traditional debt collection practices? Some courts regard foreclosing on a secured property interest as outside the ambit of the FDCPA, while others look to the ultimate purpose of the foreclosure – repayment of a loan – as implicating the very concerns underpinning the act. Behind these inconsistent court decisions is not only the fact that certain of the FDCPA’s key provisions are rather vague, but, more fundamentally, a patent tension between the broad ameliorative goals of the FDCPA and a statutory text that is quite limited in scope.

This article looks at a few of the key recent decisions in this burgeoning area of FDCPA claims in the context of foreclosures, as well as the Consumer Financial Protection Bureau’s (CFPB) position on this issue.

The FDCPA

As with most statutes, the key to determining whether the FDCPA applies to a given party or conduct lies in the definitions, which courts scrutinize closely in analyzing its application to foreclosures. The FDCPA only applies to “debt collectors,” and the proscribed action or communication must be made as part of an attempt to collect a debt. The act defines “debt collector” as “any person who uses any instrumentality of interstate commerce or the mails in any business the principal purpose of which is the collection of any debts, or who regularly collects or attempts to collect, directly or indirectly, debts owed or due or asserted to be owed or due another.” (15 U.S.C. § 1692a(6).) The act thus excludes creditors, and generally only applies to third-party debt collectors.

Further, to be a “debt collector,” one’s principal purpose of business must be debt collection, or one must simply “regularly” engage in debt collection. Needless to say, a lot of litigation has revolved around whether a particular entity is “regularly” engaged in debt collection.

The FDCPA is not silent with respect to the enforcement of security interests, as it provides that for purposes of a specific sub-section of the FDCPA (Section 1692f(6)), the term “debt collector” also includes “any person who uses any instrumentality of interstate commerce or the mails in any business the principal purpose of which is the enforcement of security interests.” Therefore, the FDCPA clearly regulates enforcers of security interests for purposes of compliance with Section 1692f(6); the question that has divided courts is whether the other provisions of the FDCPA that proscribe certain activity “in connection with the collection of any debt” apply to enforcers of security interests to the same degree as traditional debt collection activity.

Also important in the context of foreclosures is the definition of “debt,” which the act defines broadly as “any obligation” a consumer incurs to pay for personal, family, or household expenses. (15 U.S.C. § 1692a(5).) Again, despite the seeming simplicity of these definitions, courts have struggled applying them to the myriad of entities and relationships at play in the consumer financial services industry.

The fact that the FDCPA includes a fee-shifting provision, allowing successful plaintiffs to recover their fees and costs incurred in prosecuting the action, means that FDCPA actions have enjoyed a kind of renaissance with the downturn in the economy in 2008, despite the rather modest statutory damages that are available (capped at $1,000 per violation).

A Thicket of Litigation

Perhaps not surprisingly, the recent wave of FDCPA litigation has resulted in an array of interpretations as to whether the FDCPA applies generally to entities that are pursuing foreclosure actions.

The FDCPA Covers Foreclosure of Security Interests

Most recently, the Sixth Circuit stepped into the fray in a widely-anticipated decision, in which it held mortgage foreclosure is debt collection within the meaning of the FDCPA. (Glazer v. Chase Home Finance LLC, 704 F.3d 453 (6th Cir. 2013).)

In Glazer, the plaintiff brought a FDCPA claim against Chase Home Finance and the law firm hired by Chase to foreclose on his property. Mr. Glazer asserted that Chase (and its attorneys) had violated the FDCPA by, among other things, falsely stating in a foreclosure complaint that Chase owned the note and mortgage, when he claimed it did not. The district court granted the defendants’ motions to dismiss for failure to state a claim under the FDCPA. However, Mr. Glazer appealed and found a more receptive audience in the Sixth Circuit.

While the Sixth Circuit affirmed the district court’s dismissal of Mr. Glazer’s claims against Chase, finding that Chase was not a “debt collector” because Chase obtained the mortgage loan prior to the loan going into default, it reversed the district court’s dismissal of Mr. Glazer’s FDCPA claim against Chase’s foreclosure counsel. The key question for the Sixth Circuit was whether mortgage foreclosure constitutes debt collection under the FDCPA.

The court first expressed some obvious frustration with the statutory definitions of “debt” and “debt collector,” lamenting that while the concepts “may seem straightforward enough,” considerable confusion has arisen, despite the fact that these concepts are “pivotal” to the operation of the act. Starting with the text of the act, the court explained that whether an obligation is a “debt” within the meaning of the act depends not on whether it is secured, but rather on the purpose for which it was incurred (i.e., primarily for personal, family, or household purposes). As such, a home loan, even if secured, is a “debt” within the meaning of the FDCPA. Moreover, the court construed the act as defining broadly what it considers debt collection, including conduct or communications in the course of a legal proceeding (i.e., foreclosure).

The court bolstered its conclusion by explaining that “every foreclosure, judicial or otherwise, is undertaken for the very purpose of obtaining payment on the underlying debt, either by persuasion (i.e., forcing a settlement) or compulsion (i.e., obtaining a judgment of foreclosure, selling the home at auction, and applying the proceeds from the sale to pay down the outstanding debt). Clearly, the court concluded, the purpose of foreclosing on property is to obtain payment on an outstanding debt, and therefore plainly must fall within the purview of the FDCPA.

The Sixth Circuit was not the first court to so rule, as the Fourth Circuit, in 2006, had ruled on similar grounds, rejecting a foreclosure law firm’s argument that foreclosure under a deed of trust is not the enforcement of an obligation to pay money, and finding that the FDCPA encompasses such activity. (See Wilson v. Draper & Goldberg, P.L.L.C., 443 F.3d 373, 376 (4th Cir. 2006).)

The FDCPA Does Not Cover Foreclosure of Security Interests

A very recent decision from the U.S. District Court for the Eastern District of New York came to the opposite conclusion. In Boyd v. J.E. Robert Co., 2013 WL 5436969 (E.D.N.Y. Sept. 27, 2013), a group of plaintiffs filed a putative class action alleging violations of various provisions of the FDCPA. The court granted the defendants’ motions for summary judgment, finding that (1) tax liens are not “debts” within the meaning of the FDCPA, and (2) the foreclosure of such liens does not constitute “debt collection” within the meaning of the FDCPA. Because the foreclosure related to the tax liens was solely an action against the property, and did not request a deficiency judgment, there was no “debt collection” activity as the conduct was only the enforcement of security interests. Plaintiffs filed a motion for reconsideration, which the court denied, ruling firmly that foreclosure activities are not debt collection. The court characterized an amicus brief filed by the CFPB, along with the Sixth Circuit’s decision in Glazer and other authority, as replete with “misguided reasoning,” which it refused to adopt. Instead, the court adopted the statutory interpretation set forth by the District of Minnesota, which had reached the same result. See Gray v. Four Oak Court Association, 580 F. Supp. 2d 883 (D. Minn. 2008). In Gray, the court explained,

The FDCPA does not define ‘the collection of any debt.’ However, the statute’s definition of a ‘debt collector’ clearly reflects Congress’s intent to distinguish between ‘the collection of any debts’ and ‘the enforcement of security interests.’ 15 U.S.C. § 1692a(6). The first sentence of that definition defines a debt collector as “any person who uses any instrumentality of interstate commerce or the mails in any business the principal purpose of which is the collection of any debts, or who regularly collects or attempts to collect, directly or indirectly, debts owed or due or asserted to be owed or due another.” Id. § 1692a(6). The third sentence of § 1692a(6) provides that for purposes of § 1692f(6), a debt collector is also ‘any person who uses any instrumentality of interstate commerce or the mails in any business the principal purpose of which is the enforcement of security interests.’ If a party satisfies the first sentence, it is a debt collector for purposes of the entire FDCPA. See Kaltenbach, 464 F.3d at 529. If a party satisfies only the third sentence, its debt collector status is limited to § 1692f(6). However, if the enforcement of a security interest was synonymous with debt collection, the third sentence would be surplusage because any business with a principal purpose of enforcing security interests would also have the principal purpose of collecting debts. Therefore, to avoid this result, the court determines that the enforcement of a security interest, including a lien foreclosure, does not constitute the ‘collection of any debt.’

Similarly, the Tenth Circuit addressed this very issue in ruling on a mortgage servicer’s motion to dismiss in Burnett v. Mortgage Electronic Registration Systems, Inc., 706 F.3d 1231 (10th Cir. 2013). Burnett had argued that she had stated claims under the FDCPA for conduct related to the foreclosure of her property. The Tenth Circuit appeared to disagree, acknowledging that while the “initiation of foreclosure proceedings may be intended to pressure the debtor to pay her debt,” “when a debt has yet to be reduced to a personal judgment against a mortgagor, a non-judicial foreclosure does not result in a mortgagor’s obligation to pay money – it merely results in the sale of the property subject to a deed of trust.” While the court did not ultimately decide the issue, as it granted the motion to dismiss solely on the grounds that Burnett had not pleaded sufficient facts, it appeared to show its cards by highlighting the competing tensions in determining whether mortgage foreclosure conduct can subject parties to FDCPA liability.

The CFPB Enters the Ring

Predictably, in its court filings, commentaries to its final “larger participant” rule, and other publications, the CFPB promotes an expansive interpretation of the FDCPA advocating that the enforcement of security interest should qualify as conduct relating to debt collection. The CFPB acknowledges that under the FDCPA’s general definition of “debt collector” (see 15 U.S.C. § 1692a(6)), a person who only enforces a security interest and does not seek payment of money, does not necessarily qualify as a debt collector. At the same time, however, the CFPB’s position is that when a person seeks payment of money and enforces a security interest, that person can qualify as a debt collector.

For example, in one of its first amici briefs ever filed, the CFPB argued that a mortgage servicer that engages in debt collection during foreclosure should be considered a “debt collector” and that such conduct should be construed as relating to debt collection as defined under the FDCPA. (See Amicus Brief filed in Birster v. American Home Mortgage Servicing, Inc., 481 Fed. Appx. 579 (11th Cir. July 18, 2012).) Specifically, the CFPB argued that the district court erred when it dismissed the action on the basis that the mortgage servicer did not qualify as a debt collector and that its conduct did not relate to collection.

In Birster, two consumers brought FDCPA claims against a mortgage servicer claiming that the mortgage servicer made repeated harassing and threatening phone calls to induce them to pay their mortgage debt in order to avoid foreclosure. The district court rejected the consumers’ claims, holding that they failed as a matter of law because the alleged conduct related to the enforcement of a security interest and, as a result, was not debt collection activity covered by the FDCPA. The district court also seemed to conclude that the mortgage servicer qualified as a “debt collector” only for the limited purpose under Section 1692f(6), not the entire FDCPA. The CFPB filed its amicus brief in which it advocated for a more expansive interpretation of the FDCPA; namely, that a party attempting to collect money during foreclosure qualifies as a “debt collector” under the general definition of the FDCPA, (see 15 U.S.C. § 1692a(6)), and that such conduct relates to debt collection.

The CFPB acknowledged that Section 1692a(6) “suggests that the enforcement of a security interest, standing alone does not qualify as debt collection.” However, the CFPB argued that “[n]othing in the FDCPA’s text suggests that attempting to obtain payment of a debt ceases to qualify as debt collection if it occurs in the context of foreclosure.” Further, the CFPB disagreed with some courts’ rulings which suggested that enforcers of security interests qualify as “debt collector” only for the limiting purpose of Section 1692f(6), which bars collectors from “taking or threatening to take nonjudicial action to effect dispossession or disablement of property” if they are not legally entitled to do so. The CFPB maintained that an entity that enforces a security interest might also regularly collect debts and, therefore, meet the general definition of “debt collector.” As a result, such an entity meets the definition of “debt collector” under Section 1692a(6) and qualifies as “debt collector” for purposes of the entire FDCPA, even if its principal purpose is enforcing security interests and even if it is enforcing a security interest in that particular case.

The CFPB also maintained that an attempt by the enforcer of a security interest to obtain payment of debt during foreclosure constitutes a debt collection conduct as defined under the FDCPA. The CFPB reasoned that debt collectors “regularly initiate foreclosure proceedings and then advise debtors to pay a specified amount to avoid foreclosure. “Such communications,” the CFPB argued, “both move toward foreclosure and seek to obtain payment of a debt, they relate both to enforcement of a security interest and to collection of a debt.” Therefore, based on the CFPB’s reading of the statute, seeking payment of money from a debtor qualifies as debt collection conduct even if the debt collector seeks to enforce a security interest in a foreclosure proceeding at the same time.

The Eleventh Circuit agreed with the CFPB’s position. In Birster, the court concluded that the mortgage servicer’s conduct supported the conclusion that it engaged in debt collection activity. Similarly, in Reese v. Ellis, Painter, Ratterree & Adams, LLP, 678 F.3d 1211 (11th Cir. 2012), the court adopted the CFPB’s position almost wholesale by holding that an entity involved in the enforcement of a security interest can constitute a “debt collector” subject to the entire FDCPA if it regularly collects or attempts to collect debts. The court also found that demanding a payment of money qualifies as debt collection subject to the FDCPA even if the demand relates to foreclosure proceeding.

Following Birster and Reese, the CFPB reiterated its expansive interpretation of the FDCPA as part of its final “larger participant” rule on consumer debt collection. (See 12 C.F.R. 1090 et seq.) In its commentary to the rule, the CFPB declared that the FDCPA could apply to foreclosure proceedings. While it recognized that the enforcement of the security interest alone is insufficient to constitute debt collection, the CFPB stated that “when a person both seeks payment of money and enforces a security interest, that person can qualify as a debt collector for purposes of the Final Consumer Debt Collection Rule.” Likewise, in its 2013 Annual Report on the FDCPA, the CFPB repeated this interpretation of the statute and its discontent with some courts’ refusal to apply the statute in the foreclosure context According to the CFPB, a narrow interpretation of the statute leaves “consumers vulnerable to harmful collection tactics as they fight to save their homes from foreclosure.”

Practical Considerations

While it is obviously important for those engaged in the enforcement of security interests to be aware of whether their specific conduct is subject to the FDCPA, even in those jurisdictions where the FDCPA does not apply to foreclosure activity alone, this general rule is of course modified to the extent enforcers of security interests seek deficiency judgments personally against defendants or otherwise make demands for payment in the course of the foreclosure proceedings, which often go hand-in-hand with foreclosure. That is, operating in a jurisdiction in which the FDCPA does not apply to security enforcement actions does not mean that one is insulated from the FDCPA for other actions taken in the course of enforcement that clearly are within the reach of the FDCPA. There is, therefore, no safe harbor, and thus all communications, demands, and other actions taken in the course of enforcing a security interest should be undertaken with the assumption that the FDCPA applies.

The U.S. District Court for the Southern District of Indiana summarized the distinction succinctly in Overton v. Foutty & Foutty, LLP, 2007 WL 2413026, *6 (S.D. Ind. Aug. 21, 2007), explaining that: “If a person invokes judicial remedies only to enforce the security interest in property, then the effort is not subject to the FDCPA [other than the specific provision subject to security enforcement]. But if the person is also seeking additional relief, such as a personal judgment against the borrower, then the FDCPA applies.” See also Birster v. Am. Home Mortg. Servicing, Inc., 481 Fed. Appx. 579 (11th Cir. 2012) (explaining that simply because one seeks to enforce a security interest does not make one immune from the FDCPA, as entities often seek to enforce security interest and collects debts in the same action).

Conclusion

Part of the apparent inconsistency in the results courts have reached is no doubt due to the fact that courts have answered these questions in the context of specific and oftentimes unique factual contexts, leading them to ask (and answer) different questions. Of course, any party engaged in the enforcement of security interests should be aware of the potential for the FDCPA to cover their conduct and should proactively implement policies and procedures to ensure that their actions do not lead to burdensome and costly FDCPA compliance issues down the road.

Considerations in Drafting Board Advisor Arrangements

Posted on April 21, 2014 by Erik Kantz - Uncategorized

This article and the companion article on board advisors both address a corporate governance arrangement under which the skill set of the formal board of directors is supplemented by individuals who are appointed to serve in an observational or advisory capacity. These individuals do not have the fiduciary duties of elected board members. Board observers are typically a phenomenon of venture capital backed companies and represent the interests of such investors. In contrast, the use of board advisors is increasingly becoming a feature of board of directors meetings across the spectrum, including closely-held family-controlled businesses, venture capital or private equity-backed companies, and public companies.

* * *

Companies increasingly are including board advisors or corporate advisory boards in their corporate governance arrangements. This trend is not limited to any particular segment, but spans across companies large and small, public and private, and corporations and alternative entities (such as limited liability companies).

Board advisors are individuals with business experience or other relevant expertise who advise a company’s directors and management, most frequently on management and strategy issues. Board advisors are voluntarily appointed and serve at the pleasure of the board or company management. Board advisors attend board meetings and may advise the company’s directors and management, but have no actual authority to make business decisions.

Since advisors are not elected and have no authority to make business decisions, they do not owe fiduciary duties to the shareholders of the company by virtue of their advisory role. This is a key difference from the company’s directors, who do owe fiduciary duties, and are subject to liability arising from any breach of those duties. This distinction may be a contributing factor to the increasing use of advisory boards, which allows advisors to contribute to the company’s management and strategic planning without the duties (and liability exposure) accompanying service as a director of the company.

There is little case law or other legal authority addressing the rights, duties and potential liabilities of board advisors. Reference to basic principles of corporate law and corporate authority, however, should provide corporations sufficient guidance in structuring advisory board arrangements. This article is intended to provide insights and tools that practitioners can use to advise their clients who may currently use advisors or may be considering using them.

While much of the discussion applies to businesses using other entity forms, this article assumes that the company is organized as a corporation.

Role of the Advisory Board

Unlike the members of a company’s board of directors, shareholders do not elect board advisors. The advisors instead are appointed by, and generally serve at the pleasure of, the board or company management. Before a company begins a relationship with a board advisor or establishes an advisory board, the company and its counsel should have a clear idea of the benefits the company expects from the relationship and how the relationship will function in practice. A company and its counsel should also be prepared to address common board advisor concerns and protect key company interests throughout the relationship.

A board advisor’s precise duties and responsibilities depend on the company’s particular needs and objectives. Board advisors generally provide the company with knowledge, expertise, and connections that expand those of the company’s management and directors. For example, an entrepreneurial company may engage board advisors who have started their own businesses to help identify common pitfalls or be a sounding board for product or business plan ideas. A mature, public company may organize an advisory board because, unburdened by regulatory and oversight responsibilities, the advisors will be free to focus exclusively on strategic issues, such as technology improvements, product marketing and development, and the like.

Advisors Distinguished from Board Observers

In many cases, investors in companies financed by venture capital or private equity firms have a contractual right to appoint board observers to attend meetings and receive information available to the directors. A board observer represents the interests of the investor that appointed the observer, and therefore, from the company’s perspective, the board observer is a mandatory requirement driven by the investors’ rights and needs. For this reason, while observers may provide valuable advice and perspective to the board and company management similar to advisors, they may face greater skepticism or hostility from directors or management because they primarily protect the investor group they represent.

Like board advisors, board observers attend and participate in meetings of a company’s board of directors and are typically entitled to receive all information provided to board members. Also like board advisors, board observers have no voting rights.

Fiduciary Duties

Similar to a board observer, a board advisor should not be considered a fiduciary of the corporation solely by virtue of his or her role as an advisor. The imposition of fiduciary duties on board advisors would be largely inconsistent with the corporate law underpinnings of fiduciary duties. Corporate law fiduciary duties arise from trust law concepts – a party who manages an asset for the benefit of another party is held to standards of care and loyalty in managing the asset for the beneficiary. Thus in a corporation, as its business and affairs are managed by or under the direction of the board of directors, the directors owe fiduciary duties to the stockholders.

Members of a company’s board of directors have fiduciary duties to shareholders and can be liable for breach of those duties. Board advisors, on the other hand, are not elected by shareholders and have no authority to make business decisions for the company. Accordingly, under corporate law, they do not owe fiduciary duties to company shareholders solely because of the advisor role.

Nonetheless, board advisors may be concerned about potential liability to the company’s shareholders and other parties arising out of their role. Therefore, the company should reduce the risk of liability by (1) creating documents that clearly identify advisors and distinguish their duties from those of the members of the board of directors; (2) ensuring that board advisors do not, in practice, perform duties traditionally reserved to a director (such as participating in board or committee voting); and (3) ensuring that advisors do not exert (or appear to exert) control over members of the board of directors when they meet in their capacity as directors.

Advisory Board Agreements

For practical and legal reasons, a company should define its relationship with its advisory board members in a written agreement or policy. While there is no legal requirement to have any particular documents, clearly drafted agreements and other documents can help avoid misunderstandings and confusion about the advisors’ roles, limit their liability exposure, and protect the company’s interests, including confidentiality and intellectual property rights.

Board advisor relationships are typically documented by using an advisory board or consulting agreement. Some companies also adopt by-law provisions and separate advisory board charters. To the extent an advisor’s role is not detailed in the agreement, it may be helpful to prepare an onboarding memo outlining the role of the advisory board and the particular advisor. In any case, the company’s board should formally approve the creation of the advisor relationship or advisory board with resolutions or a written consent, including adoption of the advisory board agreement.

Advisory Board Agreements – Key Provisions

Duties

The agreement should specify that the advisor’s role is to provide consulting services, either to the board of directors or to management, as an independent contractor. It should make clear that the advisor has no power to act for, represent, or bind the company and cannot take action that implies it has this type of authority. The agreement also should specify the duties the company expects the advisor to perform, which may include: (1) the number of meetings, conference calls, or other events the advisor must attend; (2) any preparation the advisor should complete in advance of these meetings or events, including reviewing materials such as business plans or budgets; and (3) any other duties the company and advisor have agreed upon, such as identifying business opportunities or assisting the board with management communications.

Term of Service

Advisors generally serve at the will of the board or company management. However, providing for a term encourages advanced planning and helps ensure the company and advisor are on the same page about the minimum commitment expected. It also provides the company a graceful way to exit the relationship if the advisor does not add value. Even if the agreement specifies a term, it should also clearly state that the advisor serves at the will of the board or management and that the agreement may be terminated at any time by either party, with or without reason.

Compensation

Companies take different approaches to compensating their board advisors. Whether or not the advisor is compensated, the agreement should address which party is responsible for expenses and how expenses must be reported. If the advisor will be compensated, the amounts and timing of payments should be specified. If the compensation involves an equity component, then there will be many more issues for consideration and much more documentation involved, all of which is beyond the scope of this article.

Information and Participation Rights

Unlike directors, board advisors have no statutory or common law right to receive notice of meetings of the board, to receive any materials or other information provided to directors, or to inspect the corporation’s books and records. Any rights extended to the advisors, therefore, are provided voluntarily by the directors or company management. Also, unlike board observer arrangements, the right to access company information is, in most cases, expressly reserved to the company in its sole discretion.

In order to ensure that the advisors can assist the board or management effectively, however, the company should provide copies of all notices, minutes, reports, and other materials that the corporation provides to members of the board (or committee) at such time as those documents and materials are provided to members or the board or committee. That said, the agreement should be clear that the company, in its sole discretion, may or may not provide information as it deems necessary or appropriate.

Confidentiality and Privilege

Given that board advisors will have access to board meetings and sensitive corporate materials, all confidential and proprietary materials and information furnished to the advisor must remain the property of the corporation, and the use and disclosure of such materials and information should be restricted. The agreement should contain a detailed definition of what constitutes “confidential information” and should require the advisor to keep those materials confidential, subject to customary exceptions (e.g., where the disclosure is required by law).

The advisor will want to ensure, however, that the confidentiality restrictions are not drafted so broadly as to encroach upon his or her other business activities. For this reason, the company should carefully consider any conflicts of interest that might develop in light of its business and an advisor’s other activities and commitments.

If the agreement permits the advisor to share confidential information and materials with his or her representatives, it should obligate the advisor to inform such representatives of the restrictions on the disclosure and use of such information and materials and instruct them to comply with those provisions. The agreement also should provide that the advisor is responsible for any breach of the agreement by his or her representatives.

A corollary to confidentiality is attorney-client privilege. A recent Illinois decision confirms that, generally speaking, the privilege does not extend to advisors. (See BSP Software, LLC v. Motio, Inc. (N.D. Ill., June 12, 2013).) This includes discussions during board of directors’ meetings with counsel regarding privileged matters. As a practical matter, this means that advisors should be asked to step out of any meeting when privileged matters are being discussed, and privileged documents should not be shared with advisors.

Protecting Intellectual Property, Disclosing Conflicts of Interest

The company also should take steps to protect any intellectual property its advisors may create while performing their roles. Developments or other works created by advisors generally would not be deemed work-for-hire owned by the company. As a result, any intellectual property rights would generally be retained by the advisor. Therefore, the agreement should contain an express assignment to the company of any developments or works created by the advisor within the scope of his or her engagement, or that otherwise arise from the use of the company’s confidential or proprietary information.

More broadly, the company again should consider potential conflicts of interest of its advisors or prospective advisors. Generally speaking, a company may not want to engage an advisor that is also serving on the board of, or consulting with, a competitor or company in a related industry. Those circumstances create conditions for potential cross-over discussions of proprietary information or trade secrets, which may lead to disputes over IP rights. For this reason, the agreement should clarify whether the advisor’s role with the company is exclusive, and the advisor should represent and warrant that his or her duties under the advisory board agreement do not conflict with any arrangement with another company or venture.

Indemnification and Advancement

Due to his or her participation in board meetings and access to materials, a board advisor runs the risk of being named as a defendant in shareholder lawsuits or other actions involving the corporation. This is particularly true for start-up companies, when an advisor often has a net worth greater than the corporation itself (and therefore may be viewed as a “deep pocket” by potential litigants).

The company typically will indemnify the advisor and advance expenses in connection with any suits or proceedings brought against the advisor, or to which the advisor is otherwise made a party or witness, by reason of his or her role with the company. Assuming such rights are extended, the agreement should specify that the corporation is providing third-party indemnification rights, and is not providing rights to indemnification or advancement of expenses to the advisor in his or her capacity as a director or officer of the corporation.

Governing Law and Consent to Jurisdiction or Arbitration

The agreement should specify the law by which it is governed. In general, the parties should provide that the agreement will be governed by the law of the jurisdiction in which the corporation is incorporated or in which its principal place of business is located. The agreement should also require that disputes be resolved in a specified jurisdiction and venue. Given that any disputes are likely to be business disputes among sophisticated parties, the parties should waive the right to a jury trial.

Alternatively, the parties may wish to provide that disputes arising under the agreement be submitted to binding arbitration. In that case, the agreement should set forth with specificity the provisions that would govern the arbitration proceedings. Any such provisions should have a carve-out for the enforcement of any restrictive covenants (such as confidentiality restrictions).

Conclusion

Board advisors can provide tremendous value to a company’s board and management. Like board observers, however, this arrangement is defined almost entirely by contract, with few statutory or common law rights or obligations granted to or imposed upon the corporation or the advisor. For that reason, directors and management should ensure that the agreement governing the arrangement covers the key issues that are important to the parties and is drafted with precision.

Considerations in Drafting Board Observer Arrangements

Posted on April 21, 2014 by John Mark Zeberkiewicz - Uncategorized

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Although board observer arrangements are not uncommon, there is little case law squarely addressing the rights, duties, and potential liabilities of board observers. Reference to basic principles of corporate law, however, should provide corporations and investors sufficient guidance in structuring board observer arrangements. These arrangements may offer several advantages over a traditional designated board seat. From the investor’s standpoint, the arrangement may provide insight into a corporation that operates in a business line in which the investor is currently active or in which it is seeking to expand. At the same time, the arrangement helps to avoid subjecting the investor’s designee to traditional fiduciary duties. From the corporation’s standpoint, the arrangement may give the corporation access to an investor designee who has knowledge of the corporation’s business, and it may serve to promote a relationship with a potential strategic partner. The arrangement might also represent a compromise by which the corporation grants greater access and information to the investor in exchange for assurances that the investor will not be able to exert undue influence over corporate decisions or, in the event of intra-corporate disputes, gain access to privileged information. To function as all parties intend, a board observer arrangement should be carefully documented. This article sets forth some of the key issues that parties documenting board observer arrangements should consider.

General – Fiduciary Duties

A board observer should not be considered a fiduciary of the corporation whose board he or she observes solely by virtue of his or her role as observer. The imposition of fiduciary duties on board observers would be largely inconsistent with the corporate law underpinnings of fiduciary duties. Corporate law fiduciary duties arise from trust law concepts – a party who manages an asset for the benefit of another party is held to standards of care and loyalty in managing the asset for the beneficiary. In the corporate law setting, the business and affairs of the corporation are managed by or under the direction of the board of directors, and the directors, in discharging their duties, owe fiduciary duties to the stockholders, as the residual beneficiaries of the corporation. Board observer arrangements generally do not confer upon the observer managerial discretion or control over the corporation’s assets, nor do they give rise to such discretion or control. Since board observers, as such, have no control over the corporation’s assets and business, they should not be bound by traditional fiduciary duties.

The board observer agreement should nevertheless specify the limitations on the observer’s role and functions. Such limitations will help to constrain the observer, and thereby protect against claims that the observer is serving in a fiduciary capacity. Specifically, the board observer agreement should expressly provide that the observer has no right to vote on matters brought before the board (or any committee), and that the observer’s presence will not be necessary to establish a quorum at any meeting. In addition, the board observer agreement should not grant the observer any veto rights over corporate matters, including with respect to the establishment of budgets, financing arrangements, investment decisions, or any other matter brought before the board. Any such rights, if granted, should be given to the investor in the form of charter-based protective provisions or negative covenants in a separate agreement between the corporation and the investor. Even if the board observer agreement precludes the observer from voting on corporate matters, the observer may offer his or her views for consideration by the board of directors. In fact, the directors may from time to time seek the observer’s input. The observer should not, however, participate in any formal vote of the board or in any “straw poll” on a matter brought before the board.

Board Observer Agreements

Parties

The corporation and the investor are the principal parties to the board observer agreement. Since the agreement will impose obligations upon the observer, however, the observer should be named as a party. The agreement should also provide that if the investor removes any board observer, no person may be designated as a replacement observer unless and until he or she shall have executed a counterpart to the agreement.

Information and Participation Rights

Unlike directors, board observers have no statutory or common law right to receive notice of meetings of the board, to receive any materials or other information provided to directors, or to inspect the corporation’s books and records. Any rights extended to the observer, therefore, must be provided contractually. The board observer agreement should specify, among other things, the meetings the observer will be entitled to attend and of which he or she will be given notice. For example, the agreement may provide that the board observer will be given notice of and may attend all meetings of the board, whether regular or special, or only a subset of such meetings (e.g., the regularly scheduled quarterly meetings of the board).

The agreement may also specify the observer’s rights with respect to meetings of committees of the board of directors. If the investor wants to secure rights for the observer to receive notice of and to attend committee meetings, it should ensure those rights are expressly granted in the agreement; in the absence of such rights, the corporation may be entitled to exclude the observer from committee meetings. The corporation, however, may resist any such request, or it may seek to limit the observer’s rights to specified committees. In all cases, the corporation should ensure that it retains the power to exclude the observer from meetings of committees established for the purpose of negotiating with the investor or negotiating transactions that could implicate or affect the investor’s rights.

The agreement should also provide that the observer is entitled to receive copies of all notices, minutes, reports, and other materials that the corporation provides to members of the board (or committee) when such documents and materials are provided to members or the board or committee. The investor should include within the list of materials the observer is entitled to receive every form of action by unanimous consent in lieu of a meeting of the board and of each committee that the observer is entitled to observe, together with the exhibits and annexes to any such consent.

The agreement should specify the manner and form in which notice of meetings will be provided to the observer. In many cases, the agreement will provide that the observer will be entitled to the same notice as is provided for regular or special meetings of the board or committee, as applicable, under the corporation’s bylaws.

Limitations on the Observer’s Rights

In addition to specifying the observer’s rights to participate in meetings and receive information and materials, the board observer agreement should set forth the express limitations on those rights. Typical limitations relate to the observer’s right to receive information and materials or to participate in meetings if the board determines in good faith that the provision of such information or materials to the observer or the observer’s participation in such meetings would result in a waiver or compromise of the attorney-client privilege. The investor may seek to require that the board, in making such determination, do so after consultation with outside counsel, or that the board’s determination be based on the advice of counsel.

The corporation may wish to seek limitations that extend beyond the attorney-client privilege, limitations that restrict the observer’s access to specified classes or categories of confidential or sensitive information or materials. In addition, the corporation may wish to specify that it will not be required to furnish to the observer information relating to transactions or potential transactions between the corporation and the investor, or information that implicates or would affect the investor’s rights and obligations vis-à-vis the corporation.

In all cases, the corporation should bear the burden of determining the information and materials from which the observer should be shielded and which meetings (or portions of meetings) from which the observer should be excluded. The board or a committee, acting in good faith, should make the determination on behalf of the corporation. Although the corporation would be responsible for making those determinations, the observer may nevertheless wish to disclaim the right to receive information or participate in a meeting (or portion thereof), even if not specifically requested to do so. For example, in a situation in which the investor is considering a bid to acquire the corporation or some or all of its assets, or is considering a recapitalization or similar proposal, the investor may wish to remain unburdened by confidential information. This will help to allay, for example, complications that may arise if the investor is imputed with constructive knowledge of material information regarding the corporation.

Confidentiality

Given that the observer will have access to board meetings and sensitive corporate materials, the corporation will want to ensure that the board observer agreement makes clear that all materials and information furnished to the board observer remain the property of the corporation and imposes restrictions on the use and disclosure of such materials and information. The agreement should contain a detailed definition of what constitutes “confidential information” and should require the observer to keep those materials confidential, subject to customary exceptions (e.g., where the disclosure is required by law). The investor will want to ensure, however, that the confidentiality restrictions are not drafted so broadly as to prevent the observer from sharing information and materials with the investor. Where the observer is permitted to share information and materials with the investor, the agreement should impose on the investor restrictions on disclosure and use.

If the agreement permits the observer or investor to share confidential information and materials with their representatives, it should obligate the investor or observer to inform such representatives of the restrictions on the disclosure and use of such information and materials under the board observer agreement to instruct such representatives to comply with such provisions. The board observer agreement should also provide that the investor is responsible for any breach of the agreement by its or the observer’s representatives.

Indemnification and Advancement

Due to his or her participation in board meetings, and his or her access to materials furnished to the board, a board observer runs the risk of being named as a defendant in stockholder lawsuits and in other actions involving the corporation. The observer or investor may seek provisions obligating the corporation to indemnify and advance expenses to the observer in connection with actions, suits, or proceedings brought against the observer, or to which the observer is otherwise made a party or witness, by reason of the observer’s position. If such rights are extended, the board observer agreement should specify that the corporation is providing third-party indemnification rights, and is not providing rights to indemnification or advancement of expenses to the observer in his or her capacity as a director or officer of the corporation.

Governing Law and Consent to Jurisdiction or Arbitration

The board observer agreement should specify the law by which it is governed. In general, the parties should provide that the agreement will be governed by the law of the jurisdiction in which the corporation is incorporated or in which its principal place of business is located. The board observer agreement should also require all parties to agree that all disputes will be resolved in a specified jurisdiction and venue. The parties likely would want to select the courts of the jurisdiction in which the corporation is incorporated or in which its principal place of business is located. Given that any disputes are likely to be business disputes among sophisticated parties, the parties should waive the right to a jury trial. The parties may wish to provide instead that disputes arising under the agreement shall be submitted to binding arbitration. In that case, the board observer agreement should set forth with specificity the provisions that would govern the arbitration proceedings.

Specific Enforcement

In light of the nature of the parties’ obligations under the board observer agreement, it is likely that any disputes between the parties would involve a request for equitable relief. Accordingly, the board observer agreement should include a standard specific performance clause in which each of the corporation, the investor, and the observer acknowledges and agrees that it, he, or she would be irreparably harmed in the event of a breach by any other party, that monetary damages would not be a sufficient remedy, and that each will be entitled to specific performance or injunctive relief. The parties may also consider including a fee shifting clause.

Conclusion

Board observer arrangements may be advantageous to both investors and corporations. The arrangement, however, is defined almost entirely by contract, with few statutory or common law rights or obligations granted to or imposed upon the corporation or the observer. For that reason, corporations and investors should ensure that the agreement governing the arrangement covers the key issues that are important to the parties and is drafted with precision.

Collecting Interest on Charged Off Debts and How Debt Collectors Must Disclose the Accrual of Interest to the Debtor

Posted on April 7, 2014 by Rachel Marin - Uncategorized

The debt collection community has been concerned with whether a debt collector can charge interest under the Fair Debt Collection Practices Act (FDCPA), 15 U.S.C. § 1692 et seq. A creditor will usually “charge off” a debt when a consumer fails to make monthly payments for six consecutive months, at which point the account is closed to future charges, although the consumer still owes the debt. Many creditors will not collect interest on a charged off debt even if they have the right to do so. One pressing issue is whether a debt collector may collect interest on a debt in a situation where the creditor had stopped charging interest. The second issue is interpreting a debt collector’s responsibilities under the FDCPA regarding providing the debtor with information as to the accrual of interest.

Waiver of Interest by Creditor

The Consumer Financial Protection Bureau has offered the following guidance as to whether debt collectors are permitted to collect interest on charged off debts:

A debt collector may not collect any interest or fee not authorized by the agreement or by law. The interest rate or fees charged on your debt may be raised if your original loan or credit agreement permits it. Some state laws and some contracts allow interest to be charged and costs to be added. If you still have the contract, it may say what interest rate can be charged or how much it can increase. State law may also limit the amount of interest charged.

Creditors often stop charging interest after they charge off a defaulted account because of certain business reasons and because they are otherwise obligated under the Truth in Lending Act to send monthly statements to cardholders. Many debt collectors have attempted to collect interest both retroactively and monthly moving forward in their collection attempts. Some attorneys for debtor plaintiffs have successfully argued that in this situation, the creditor may have legally waived the right to collect interest and that the waiver may apply to the debt buyer who purchases the debt.

For example, in Simkus v. Cavalry Portfolio Servs., LLC, et al., 2014 U.S. Dist. LEXIS 9470 (N.D. Ill. Jan. 27, 2014), Cavalry attempted to collect interest retroactively from the time that the creditor charged off the debt to the point that it sold the debt to the debt buyer. The court denied Cavalry’s motion for summary judgment on the Section 1692e and 1692f claims and held that under Arizona law, a fact finder would need to determine whether the creditor waived its right to collect interest. The Simkus court stated that if a trier of fact determined that the creditor waived its right to collect interest, then Cavalry violated Section 1692e. However, the court dismissed Simkus’ Section 1692f(1) claim and held that Cavalry did not attempt to collect an unauthorized debt, reasoning that there was no dispute that the original contract permitted the collection of interest. The court noted that “§ 1692f(1) is ‘directed at debt collectors who charge fees not contemplated by the original agreement, not debt collectors who seek to charge fees contemplated by the agreement but arguably waived thereafter.’”

While the Simkus court held that only a jury could decide the waiver issue and that there was no Section 1692f(1) violation, in McDonald et al. v. Asset Acceptance, LLC, 2013 U.S. Dist. LEXIS 110829 (E.D. Mich. Aug. 7, 2013), the court decided those same issues on summary judgment and did not leave them to be heard by a jury. The court granted summary judgment to McDonald and held that Asset violated Sections 1692e(2)(A) and 1692f(1) when it attempted to collect interest, including retroactive interest. The judge reasoned that “because Chase and WFNB waived the interest, Asset could not retroactively impose interest for the period in which it did not own the accounts. . . . To hold otherwise would create a monetary interest out of thin air and provide a potential windfall to Asset.”

Finally, it is important for debt collectors to research state laws in the state in which they are collecting to determine whether debt collectors are permitted to charge interest, and if so, the rate at which they are permitted to collect. Even in cases where the creditor waived its contractual right to collect interest, some states permit debt collector to charge statutory interest at a rate approved by state law.

Disclosure of Interest Accrual

The second hot topic issue is how debt collectors must disclose to the debtor the accrual of interest, if at all. Section 1692g(a)(1) of the FDCPA only requires the debt collector to state the “amount due” when communicating with debtors. Courts have been left to interpret how exactly the debt collector must disclose the accrual of interest. Various judges have reached opposite conclusions in interpreting this section.

A Pennsylvania judge in Jones v. Midland Funding, LLC, 755 F. Supp. 2d 393 (D. Conn. 2010), granted summary judgment to Jones, holding that Midland violated Section 1692g(a)(1) where Midland stated the “balance due” in its initial letter, the subsequent letter stated a “balance due” for a greater amount, and neither letter mentioned interest accrual. The court determined that only the initial letter violated the FDCPA because it failed to state that interest was accruing and the rate at which it was accruing. Another Pennsylvania judge in Lukawski v. Client Servs., Inc., 2013 U.S. Dist. LEXIS 124075 (M.D. Pa. Aug. 29, 2013), considered a case with slightly different facts and ruled that where the first letter discloses that interest will accrue, subsequent letters must also disclose the accrual of interest.

Certain federal judges in New York have not required debt collectors to disclose the interest accrual so long as the initial letter and subsequent letters state the correct balance due. However, some debt collectors have been exposed to liability when they attempt to explain the interest accrual. In Weiss v. Zwicker & Associates, P.C., 664 F. Supp. 2d 214 (E.D.N.Y. 2009), Zwicker & Associates sent an initial letter to Weiss stating:

[A]s of the date of this letter, the balance on your account is $30,982.09. Your balance may include additional charges including delinquency charges, as applied at the direction of American Express, if said charges are permissible in accordance with the terms of your agreement.

Zwicker & Associates sent another letter stating that the balance was $32,596.04, which is higher than the balance listed in the first letter. The court held that the initial letter violated Section 1692g(a)(1) of the FDCPA because it could be read by the least sophisticated consumer in two ways; one being that the amount included interest, the other that the amount did not include interest. Interestingly, the court found that the second letter was permissible under the FDCPA because a debt collector “has [no] obligation to explain why a consumer’s debt has increased.

The Weiss court did not consider the issue of whether a debt collector is obligated to inform the consumer in the initial letter that interest is accruing. However, the year after the Weiss decision, the judge in Pifko v. CCB Credit Servs., 2010 U.S. Dist. LEXIS 69872, at *10 (E.D.N.Y. July 7, 2010), addressed that exact issue. In Pifko, the debt collection letters simply stated the balance owed and the letters reflected a higher balance with each letter sent. The letters did not mention interest accrual. The court held that none of the letters violated Sections 1692g or 1692e(10), because the letters contained no confusing language. Certain federal judges in Arizona and Massachusetts have reached the same conclusion based on similar reasoning in cases with nearly identical facts and claims. (See Goodrick v. Cavalry Portfolio Servs., 2013 U.S. Dist. LEXIS 117171 (D. Ariz. Aug. 19, 2013); Schaefer v. ARM Receivable Mgmt, Inc., 2011 U.S. Dist. LEXIS 77828 (D. Mass. July 19, 2011.)

Taking a look back at Simkus v. Cavalry Portfolio Servs., LLC et al., 2014 U.S. Dist. LEXIS 9470 (N.D. Ill. Jan. 27, 2014), the same case as was discussed in the first section of this article pertaining to the waiver issue, the court also addressed how debt collectors must communicate interest accrual to debtors. The Simkus facts are the same as Pifko, Goodrick, and Schaefer, where the letters made no mention of whether interest had been added to the amount owed and simply stated the balance owed. In contrast to those cases, where the courts held that the collectors had no obligation to inform the debtors that interest was accruing, the Simkus court held that while the letters on their face did not violate Sections 1692e or 1692f because Cavalry was not required to itemize interest and principal, the parties had to brief the related issue of whether Simkus had extrinsic evidence to prove that the least sophisticated consumer would be confused by the letters.

Some courts have suggested particular safe harbor language that collectors may use in letters to debtors. For example, in Miller v. McCalla, Raymer, Padrick, Cobb, Nichols and Clark, LLC, 214 F.3d 872 (7th Cir. 2000), the Seventh Circuit approved the following language:

As of the date of this letter, you owe $___ [the exact amount due]. Because of interest, late charges, and other charges that may vary from day to day, the amount due on the day you pay may be greater. Hence, if you pay the amount shown above, an adjustment may be necessary after we receive your check, in which event we will inform you before depositing the check for collection. For further information, write the undersigned or call 1-800-[phone number].

A Connecticut judge, in Jones v. Midland Funding, LLC, 755 F. Supp. 2d 393, 398 (D. Conn. 2010), suggested the following language:

As of today, [date], you owe $___. This amount consists of a principal of $___, accrued interest of $___, and fees of $___. This balance will continue to accrue interest after [date] at a rate of $___ per [day/week/month/year].

Debt collectors must carefully draft their letters based on the state and federal law in the jurisdiction where the debtor resides in order to lessen the chances of being held liable for an FDCPA violation regarding disclosure of interest. If the debt collector chooses to inform the debtor that interest is accruing, then using the safe harbor language suggested by courts within the jurisdiction may reduce the debt collectors’ exposure to FDCPA liability.

Conclusion

Certain judges have held that only a jury can decide the issue of whether a debt collector may charge interest in situations where the creditor stopped collecting interest after charging off the debt. Debt collectors must understand whether state laws restrict collectors from charging contractual or prejudgment interest. Additionally, courts have interpreted the FDCPA differently regarding whether a debt collector must disclose that interest is accruing on the account. Some judges require the debt collector to inform the debtor in the initial letter that interest may be accruing and the rate at which it is accruing. Other judges have determined that debt collectors have no obligation to disclose that interest is accruing, and that the debt collectors must only correctly state the total amount due. Many collectors are finding that attempting to collect post-charge off interest is too much of a risk and have been foregoing the practice in its entirety.

Who Decides: The Court or the Arbitrator?

Posted on March 20, 2014 by Carolyn G. Nussbaum - Uncategorized

As anyone who practices in the field of arbitration knows, the mere existence of an arbitration clause does not answer all the questions of what will happen in the arbitration. Indeed, often it will not even answer clearly the question of who will decide what with respect to the arbitration. Courts have concluded that, unless the parties have agreed otherwise, “procedural arbitrability” will be decided by the arbitrator and “substantive arbitrability” will be decided by the court.

As the recent decisions discussed in this article illustrate, how courts have applied this distinction continues to depend on the specific facts and circumstances of each dispute and the particular contract language.

Who Decides the Timeliness of an Arbitration Demand?

In United Steel, Paper & Forestry, Rubber, Mfg., Energy, Allied Indus. & Serv. Workers Int’l Union, Local 13-423 v. Valero Servs., Inc., No. 1:12-cv-113, 2013 U.S. Dist. LEXIS 19175, at *14-15 (E.D. Tex. 2013), the plaintiff union filed a grievance on behalf of a terminated employee of defendant Valero. After the grievance was denied, the union filed a demand for arbitration under a collective bargaining agreement (CBA). The CBA required the union to file any demand for arbitration within a prescribed time. Neither party disputed the existence of a valid agreement to arbitrate or that an arbitrator should decide the merits of the dispute. The defendant conceded that arbitrators generally decide issues of procedural arbitrability, including timeliness of an arbitration demand, but argued that under the terms of the CBA, the parties had agreed to submit all questions of arbitrability to the court. In particular, the CBA provided that “[a]ny dispute as to the arbitrability of a given matter shall be resolved by a court of competent jurisdiction and not by an arbitrator, unless the parties specifically agree otherwise in writing.” It also provided that “[a]ny question on any matter outside of this Agreement shall not be the subject of arbitration.”

To decide whether the issues of timing was one of “arbitrability,” or was otherwise “outside” the agreement and thus for a court, the district court looked at the entire language of the arbitration clause, which expressly excluded certain issues from arbitration, such as the use of contractors or the exercise of the company’s right to lay off after notice, both of which are issues of substantive arbitrability. Applying principles of contract interpretation, it held that the CBA language applied only to substantive arbitrability and did not displace the general rule that procedural arbitrability is for the arbitrator to decide. Moreover, because the underlying dispute about the employee’s discharge was subject to arbitration, the related question of the timeliness of the arbitration demand was more appropriately before the arbitrator. The court acknowledged that a court may deny arbitration when the procedural provision in question operates to bar arbitration altogether, but there was nothing in the arbitration clause indicating that the timing provisions would completely preclude arbitration.

Who Decides Whether an Arbitration May Proceed on a Class or Consolidated Basis?

In Planet Beach Franchising Corp. v. Zaroff, C.A., No. 13-438 Section: J:1, 2013 U.S. Dist. LEXIS 121908 (E.D. La. Aug. 27, 2013), the plaintiff franchisee filed a unitary demand for arbitration with the AAA for damages based on a franchisor’s alleged misrepresentations and omissions in sales materials used to induce the franchisee to enter into four separate franchise agreements. Each of the four relevant franchise agreements stated that “[n]either party shall pursue class claims and/or consolidate the arbitration with any other proceeding to which the franchisor is a party . . . .” The franchisor then sued to compel the franchisee to maintain separate arbitration proceedings under each of its four separate agreements. The franchisee replied that it had filed a single arbitration, not a “consolidated” demand, and that an arbitrator must decide if the arbitration could proceed on a unitary basis.

The Eastern District of Louisiana first sought to decide “who should make the determination as to whether the [franchisee] can pursue one arbitration proceeding against [franchisor] consisting of all of [its] claims that arise or relate to the four franchise agreements. . . .” (Emphasis in original.) It held that, contrary to the franchisor’s arguments, Stolt-Nielsen S.A. v. Animal Feeds Int’l Cor., 130 S. Ct. 1758 (2010), did not instruct courts to make the decision of whether an agreement prohibits class arbitration. Instead, the court held, based on the general presumption in favor of arbitration and the broad nature of the arbitration clause, that an arbitrator must interpret whether the parties’ agreement permits consolidated arbitration. It therefore denied the franchisor’s motion to compel four separate arbitrations.

In Parvataneni v. E*Trade Fin. Corp., No. C 13-02428 JSW, 2013 U.S. Dist. LEXIS 136950 (N.D. Cal. July 2, 2013), the plaintiff sued defendant E*Trade for violations of California state law related to unpaid overtime. E*Trade removed to federal court and moved to dismiss or compel arbitration pursuant to an arbitration provision in the plaintiff’s employment agreement. The arbitration clause, which was concededly broad, stated that “[i]n the event of any dispute or claim arising out of or relating to your employment . . . such Disputes shall be fully, finally, and exclusively resolved by binding arbitration . . . ” conducted by the AAA.

The plaintiff argued that this clause should be read to allow him to pursue collective arbitration, or, if not, that the arbitration provision was void under state law. The district court held that the issue of class arbitration was a question for the court in the absence of “clear and unmistakable evidence” that the parties intended to arbitrate arbitrability. The court noted, for example, that the parties did not choose to incorporate the rules of the AAA which would have constituted such “clear and unmistakable evidence” to permit an arbitrator to decide arbitrability. The court then proceeded to hold, however, that because the arbitration agreement was silent as to class arbitration, under Stolt-Nielsen, it could not construe the agreement to include class arbitration.

Who Decides the Validity of an Arbitration Agreement and Arbitrability?

In Rent-A-Center, West, Inc. v. Jackson, 130 S. Ct. 2772 (2010), the Supreme Court held that parties may agree to arbitrate “threshold issues” regarding the arbitrability of their disputes. Since Jackson, courts have struggled to define the exact limits of this rule.

In Holzer v. Mondadori, No. 13-civ-5234(NRB), 2013 U.S. Dist. LEXIS 37168 (S.D.N.Y. Mar. 14, 2013), on remand and dismissed by Holzer v. Mondadori, 40 Misc. 3d 1233(A) (N.Y. Sup. Ct. 2013), for example, the defendants had marketed investments in a Dubai real estate venture to the plaintiffs. When the venture failed, the plaintiffs sued for damages in New York state court. One of the defendants petitioned for removal on the basis of Section 205 of the Federal Arbitration Act, 9 U.S.C. § 205 (implementing the New York Convention on Recognition and Enforcement of Foreign Arbitral Awards), which permits removal of an action “relating to” a foreign arbitration or arbitral award under the New York Convention, and sought to compel arbitration of the plaintiffs’ claims. This defendant was not a signatory to the underlying purchase agreements containing the arbitration clause. Furthermore, these agreements contained a Dubai choice of law provision. The court concluded, however, based on precedent in other circuits, that United States law must govern the arbitrability question because determinations of agreements governed by the New York Convention implicate the allocation of power between courts and arbitrators. It therefore held that, under federal common law, a party must provide “clear and unmistakable evidence” of intent for an arbitrator to arbitrate arbitrability.

The purchase agreements expressly incorporated by reference the Arbitration Rules of the Dubai International Arbitration Centre (DIAC Rules). The district court found that this incorporation by reference could serve as “clear and unmistakable evidence” that the signatories intended to submit questions of arbitrability to the DIAC arbitration tribunal. But the language of the arbitration clauses in the purchase agreements also provided that arbitration of “all disputes between the parties in relation to or arising from” the contract would be submitted to arbitration. Because the moving defendant was not a signatory to the agreements, nor had a sufficiently close relationship to signatory defendants, the district court concluded that it could not compel arbitration and remanded to state court.

In contrast, in Oracle Am., Inc. v. Myriad Group A.G., 724 F.3d 1069 (9th Cir. 2013), the district court concluded that UNCITRAL rules did not provide such evidence that an arbitrator should decide arbitrability; a decision, however, that the Ninth Circuit promptly reversed. The defendant Myriad, a Swiss mobile software company, licensed Java, a computer programing language, from the plaintiff Oracle. Based on that license, Oracle sued Myriad in the Northern District of California, asserting claims for breach of contract, violation of the Lanham Act, copyright infringement, and unfair competition under California law. Myriad moved in response to compel arbitration based on an arbitration clause in the parties’ license agreement that called for arbitration in accordance with the UNCITRAL rules.

The district court granted Myriad’s motion to compel arbitration with respect to Oracle’s breach of contract claim, but denied Myriad’s motion with respect to all other claims. The court concluded that it had the authority to decide whether the other claims were arbitrable because UNCITRAL arbitration rules “did not constitute clear and unmistakable evidence that the parties intended to delegate questions of arbitrability to the arbitrator.”

On appeal, the Ninth Circuit reversed the district court’s decision. It held instead that “as long as an arbitration agreement is between sophisticated parties to commercial contracts, those parties shall be expected to understand that incorporation of the UNCITRAL rules delegates questions of arbitrability to the arbitrator.”

Whether a Contract as a Whole is Void Remains an Issue for the Arbitrator

Almost half a century ago, the Supreme Court held that while challenges to an agreement to arbitrate contained in a contract may be decided by a court, challenges to the contract as a whole must be decided by an arbitrator. See, e.g., Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967). While litigants sometimes try to avoid the rule, it remains firmly planted in the judicial language.

In Damato v. Time Warner Cable, Inc., No. 13-cv-944(ARR)(RML), 2013 U.S. Dist. LEXIS 107117 (E.D.N.Y. July 30, 2013), the plaintiff subscribers filed a putative class action against defendant Time Warner Cable for violations of multiple states’ consumer protection laws. Time Warner Cable replied with a motion to stay or dismiss the action pending arbitration pursuant to an arbitration clause in the plaintiffs’ subscriber agreements. The arbitration clause provided for binding arbitration unless the subscribers elected to opt out. The plaintiffs nonetheless argued that the arbitration clause was invalid as illusory because the subscriber agreement gave Time Warner Cable the power to change its terms unilaterally and therefore the agreement to arbitrate was not supported by any mutual obligation. The court found that these arguments challenged the validity of the contract as a whole, rather than just the arbitration clause, because Time Warner Cable retained power to change the terms of the entire agreement. It rejected the plaintiffs’ claims that the agreement to arbitrate was unconscionable, because the plaintiffs relied on terms that affected the entirety of the subscriber agreement rather than solely the arbitration clause. The court therefore concluded that plaintiffs’ arguments “chiefly attack the validity of the contract as a whole,” and must be determined by the arbitrator.

Who Decides Procedural Issues Related to Arbitration?

In AFSCME, Council 4, Local 1303-325 v. Town of Westbrook, 75 A.3d 1 (Conn. 2013), the plaintiff union filed an action to vacate an arbitration award deciding that the defendant town’s decision not to reappoint its assessor was outside the terms of a collective bargaining agreement. The trial court, limiting the scope of its review to only the arbitrators’ determination that the plaintiff’s claim was not arbitrable, affirmed the arbitrators’ award. On appeal, the union claimed that the trial court improperly limited its scope of review and had incorrectly concluded that the defendant’s reappointment decision was not arbitrable.

The union argued that the arbitrators had exceeded their authority by considering state and city laws and thus that the trial court should have applied a broad scope of review to the arbitration decision. The Connecticut Supreme Court disagreed. It affirmed, holding that the arbitration agreement gave the arbitrators “broad authority” to decide the question of arbitrability, and noting that the award clearly revealed that the arbitrators had decided only that question. The parties had committed the question of arbitrability to the authority of the arbitrators and fully expected to be bound by the arbitrators’ decision on that issue. As the court held, “[w]hen a party that has agreed to arbitrate the question of arbitrability wishes to challenge the arbitrators’ determination regarding that issue, the court’s review of that determination, like its review of any other issue that parties empowered the arbitrators to decide, is limited.”

In Duran v. The J. Hass Group, L.L.C., 531 Fed. Appx. 546 (2d Cir. 2013), plaintiff Duran sued the defendants, various debt settlement companies located in Arizona, under the Credit Repair Organizations Act and state law. The district court granted the defendants’ motion to dismiss the action and compel arbitration. On appeal to the Second Circuit, the plaintiff conceded that her claims were subject to arbitration, but contended that the forum selection clause contained in the arbitration agreement, which mandated arbitration in Arizona, was unconscionable. Because the plaintiff conceded that her claims were subject to arbitration, the Second Circuit agreed with the district court that it was for the arbitrator, rather than the court, to decide in the first instance whether the forum selection clause was unconscionable. As the court of appeals held, “[w]hile ‘a gateway dispute about whether the parties are bound by a given arbitration clause raises a question of arbitrability for a court to decide,’ [. . .] an arbitrator presumptively resolves issues of ‘contract interpretation and arbitration procedures.’” The Second Circuit noted that, had the plaintiff argued only that the arbitration agreement was itself unconscionable due to the forum selection clause, the court would have had to decide the matter. But because the plaintiff conceded that her claims were arbitrable, the unconscionability of the forum selection clause was for the arbitrator to decide.

Who Decides Res Judicata in Arbitration?

The decisions in Carlisle Power Transmission Prods., Inc. v. United Steel, Paper & Forestry, Rubber, Mfg., Energy, Allied Indus. & Workers Int’l Union, 725 F.3d 864 (8th Cir. 2013), arose from a dispute between a union and an employer (Carlisle) over long-term disability benefits for a Carlisle employee injured on the job. The union brought a grievance against Carlisle per the procedures listed in a 2001 collective bargaining agreement (CBA). A few days later, that CBA expired and was replaced by a 2006 CBA. The parties agreed to submit to an arbitrator the procedural issue of whether the union’s claim on behalf of the employee was arbitrable under the 2006 CBA. This arbitrator found that the grievance was arbitrable under the 2006 CBA even though the dispute arose while the 2001 CBA was in effect. Carlisle and the union then picked a different arbitrator to hear the substantive claims and scheduled a hearing date. But Carlisle also sought a declaratory judgment in court that the union’s claims were not arbitrable under the 2006 CBA (chiefly because the union was seeking disability benefits governed by a separate agreement).

The union moved for summary judgment in the disability benefit action. It argued that Carlisle’s claim was barred by res judicata. The district court found that the requirements of res judicata were met, but that the union had waived its right to raise that defense by agreeing to limit the scope of the initial arbitrator’s decision to arbitrability of procedural issues. Proceeding to the merits, the district court then held that the 2006 CBA excluded disputes concerning long-term disability benefits and thus the union’s claims were not subject to arbitration.

On appeal, the Eighth Circuit reconsidered the res judicata issue. It viewed the initial arbitrator’s decision as a decision on the merits, and concluded that Carlisle’s declaratory judgment claim arose out of the same facts, even though it advanced different legal theories. The Eighth Circuit agreed with the union that res judicata does not foreclose an action if the parties agree to allow a plaintiff to split its claim and proceed in two different actions. But it found that the union did not agree to allow claim-splitting because it did not agree to defer the merits determination until after the arbitrator decided the issue of arbitrability under the 2006 CBA. Moreover, while Carlisle had not raised the argument that the long-term disability benefits claims were not arbitrable in its initial arbitration proceeding, it could have done so. The court of appeals therefore vacated the district court’s order, holding that the initial arbitrator’s award was final and precluded Carlisle’s argument as to nonarbitrability of long-term disability benefits.

In the case of In re: Yin-Ching Houng, 499 B.R. 751 (C.D. Cal. 2013), appellee Tatung initiated an arbitration proceeding against appellants Westinghouse Digital Electronics, LLC (WDE) and Houng for breach of contract. The arbitrator found Houng to be liable as an alter ego of WDE and assessed damages, plus interest. Houng then filed for bankruptcy. Tatung sought relief from the automatic stay in bankruptcy to complete the arbitration proceedings and confirm the award, as well as an order from the bankruptcy court that Houng’s debt was nondischargeable.

The bankruptcy court held that the debt from the arbitration was nondischargeable, finding that the arbitration award had preclusive effect. Houng responded by appealing this decision to the district court. The district court held that the bankruptcy court had erred in giving the arbitration award preclusive effect under California law before it was confirmed. However, because the arbitration award was later confirmed, the district court found that the error was harmless. It therefore affirmed the bankruptcy court’s decision that the debt was nondischargeable.

Who Decides Claims of Fraud in the Inducement?

In Tower Ins. Co. of N.Y. v. Davis/Gilford, A JV, No. 13-0781 (RBW),2013 U.S. Dist. LEXIS 127121 (D.D.C. Sept. 6, 2013), plaintiff Tower, an insurance company, issued a performance bond to the defendant, a joint venture, guaranteeing work performed under a subcontract executed between the defendant and a third party. The bond incorporated the subcontract by reference. When the third party defaulted, Tower elected to continue performance and drafted a takeover agreement with the defendant that also referenced the subcontract.

When a dispute arose, the defendant moved to compel arbitration pursuant to the arbitration provision in the subcontract. Tower separately instituted suit in district court seeking a declaration that it was not required to arbitrate because it had been fraudulently induced to issue the performance bond. Tower conceded that its allegations of fraud concerned the issuance of the performance bond in its entirety, and not the arbitration provision itself, but argued that submission of its fraudulent inducement claim to an arbitrator was “illogical” because “if a bond is void ab initio, then it never existed, and never incorporated the subcontract or the arbitration clause by reference in the first place.” The district court rejected the argument, basically relying on the Supreme Court’s decision in Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440 (2006), which acknowledged that a party may be forced to arbitrate even pursuant to a contract that an arbitrator later finds to be void. The court concluded that Tower was therefore required to arbitrate its fraudulent inducement claims.

As the discussion of the recent cases above reveals, questions of who decides certain threshold issues of arbitrability, including issues of timeliness, unconscionability, and whether an arbitration may proceed on a collective basis, continue to provide fodder for numerous opinions. Modern Supreme Court cases provide some guidance, but the many different mixes of the parties’ circumstances, arbitration clauses, and arbitration rules, continue to present unanswered issues, particularly where the clauses and rules chosen by the parties do not exactly match their particular circumstances. Parties who make an agreement to arbitrate simply by inserting what they think is a short and simple clause for a streamlined alternative dispute resolution mechanism, may, in the end, find that they have instead acquired a protracted and expensive dispute over threshold issues. This is why (despite the availability of boilerplate provisions from many sources) arbitration clauses should be carefully crafted by experienced counsel, using language tailored to the specific forum selected and any anticipated issues.

The Importance of Bilateral Investment Treaties (BITs) When Investing in Emerging Markets

Posted on March 19, 2014 by Helena Sprenger - Uncategorized

Tax planning forms a natural part of any decision-making process regarding the optimal structure of foreign investments. Strangely enough, until recently, BIT-planning (i.e., planning to protect the investor’s interests against unfair treatment by the host country’s government via bilateral investment treaties), rarely received a seat at the table. Venezuela’s actions in the oil and gas industry have emphasized, however, that the value of bilateral investment treaties cannot be overestimated. The decision by Mobil Corporation and ConocoPhilips to structure (or restructure) their investments in the Orinoco Oil Belt projects in Venezuela through a company incorporated under Netherlands law will probably save them billions of dollars. These investors invoked the protection of the Bilateral Investment Treaty entered into between the Kingdom of the Netherlands and Venezuela after the expropriation of their investments, and are currently involved in multibillion dollar arbitrations with Venezuela.

Foreign investors, especially those investing in emerging markets, are well advised to analyze not only the tax efficiency of a particular investment vehicle, but also the existence and substance of BITs to which the host country is a signatory. Sometimes the tax and BIT analyses point to the same optimal investment vehicle. If not, the solution may be to use two investment vehicle layers so that optimal tax planning is combined with the best protection under BITs.

This article discusses what BITs are, how investors can enforce claims under BITs, and why using a Dutch or Curaçao entity and the associated extensive BIT treaty network of the Netherlands and Curaçao may prove useful when investing in countries that are perceived to be politically unstable. Finally, this article will also briefly address BIT developments in the EU.

What are BITS?

BITs are agreements between two countries protecting investments made by investors from one contracting state in the territory of the other contracting state. The purpose of BITs is to stimulate foreign investments by reducing political risk. The number of BITs entered into has increased exponentially over the last two decades. The first BIT was entered into between Germany and Pakistan in 1959. At the end of the 1980s, there were approximately 385 BITs, whereas currently the number approaches 3,000. Most BITs include the following substantive obligations that each country undertakes toward investors from the other country, with only narrow exceptions:

Treating foreign investors’ investments fairly and equitably, i.e., not taking unreasonable or discriminatory measures and treating investments of foreign investors at least as favorably as investments from its own nationals and nationals of third states;
Not nationalizing or expropriating investments from foreign investors, unless the measures taken are non-discriminatory, taken in the public interest, and while observing due process, are taken against payment of prompt, adequate, and fair compensation. Importantly, regulations substantially negatively affecting the value of an investment can qualify as an expropriation for these purposes; and
Allowing funds relating to investments to be freely transferred by foreign investors without delay, which includes protection against foreign exchange restrictions. This protection was invoked several times under BITs entered into by Argentina.

In this article we only address bilateral investment treaties. Please note that there are a few multinational treaties that also offer investment protection, the most important ones of which are NAFTA and the Energy Charter.

Enforcement of BITs

BITs are quite unique in that they provide a basis for claims by an individual person or company against a state. In an effort to avoid the need to turn to the national courts for a judicial remedy, BITs usually contain an arbitration clause submitting disputes to a neutral arbitration tribunal, normally the International Centre for Settlement of Investment Disputes (ICSID), the most frequently used alternative being arbitration under the rules of the United Nations Commission on International Trade Law (UNCITRAL). Awards rendered by the ICSID are binding on parties and not subject to any court or other appeal, provided that an award can be annulled by a second ICSID panel, but only on grounds that are significantly narrower than the grounds that can be found in the New York Arbitration Convention. The ICSID was established under the Convention on the Settlement of Investment Disputes between States and Nationals of other States on March 18, 1965 (the “Washington Convention”), as an initiative of the World Bank. The Washington Convention entered into force on October 14, 1966, after having been ratified by 20 countries. Under Article 54 of the Washington Convention, each of the current 150 states that have ratified it must recognize an award rendered pursuant to the Washington Convention as binding and must enforce the monetary obligations imposed by that award as if it were a final judgment of a court of that state. However, it should be noted that local law of the country in which enforcement is sought will ultimately determine whether particular sovereign assets can be seized.

There are currently 183 cases pending before the ICSID, including the $7 billion case Mobil Corporation, Venezuela Holdings B.V. and others v. Venezuela and the $30 billion case ConocoPhillips Petrozuata B.V. and others v. Venezuela, both based on the BIT entered into between the Kingdom of the Netherlands and Venezuela. In the Mobil case, the arbitration panel confirmed, in accordance with existing case law from ICSID panels, that the fact that a Dutch intermediary holding company was added to the structure years after the original investment and probably with a view to the political environment in Venezuela, did not negatively affect the rights of Mobil to seek protection under the Dutch BIT. In the ConocoPhillips case, the arbitral tribunal ruled on September 3, 2013, that Venezuela has unlawfully expropriated the investments of ConocoPhillips in three oil projects in Venezuela by failing to offer just compensation for the taking of ConocoPhillips assets in the oil projects. The arbitration will continue to determine the level of compensation. Venezuela (27) and Argentina (24) head the list of countries against which the most ICSID cases are pending.

BIT Due Diligence

Not all BITs are created equal. If a host country has entered into multiple BITs, it is worthwhile to review the contents of those BITs in order to determine which BIT provides the best protection for a specific investment. Some BITs are worded more investor-friendly than others. We’ll explore below some of the issues to look for when doing due diligence on BITs:

Which investments are protected? Each BIT will have a definition of “Investments.” Some of these definitions are worded broadly, but it may also be the case that BIT protection is only awarded to a narrow category of investments, or that certain investments are expressly excluded. It may, for example, be limited to protection of equity interests.
When does the BIT apply? It will be important to see whether BIT protection is only granted to citizens of, and companies incorporated under the laws of, or having their head quarters in, the contracting state, or whether for example, companies in third countries owned and/or controlled by such citizens or corporations also qualify for protection.
Term of BIT protection. BITs are entered into for a specific term and may, or may not, be extended for a certain period after a termination notice has been given. In addition, it may be important to check whether the protection is also afforded to investments made before the BIT becomes effective.

Use of Dutch or Curaçao Investment Vehicles

Dutch or Curaçao investment vehicles are already often used for tax reasons. Dutch policy aims at removing international double taxation, and the Netherlands has therefore entered into nearly 100 international tax treaties. In addition, Dutch tax law does not provide for withholding tax on outbound interest and royalties. Lastly, profits received by a Dutch parent company from a foreign subsidiary or made through a permanent establishment situated abroad are exempt from taxation in the Netherlands (often referred to as the “participation exemption”). The extensive BIT treaty network of the Netherlands and Curaçao provides another strong argument for using a Dutch or Curaçao investment vehicle when making foreign investments in countries which are perceived to be politically risky.

The Kingdom of the Netherlands entered into 97 BITs of which 89 are currently in effect. These BITs generally apply to The Netherlands, Curaçao, St. Maarten, and Aruba. Curaçao is probably the only well-known off-shore jurisdiction that provides the benefit of such an extensive BIT treaty network. The model treaty on which most are based is considered to be very investor-friendly. The issues referred to above are dealt with as follows:

Which investments are protected? In virtually all BITs entered into by the Kingdom of the Netherlands, the definition of “investments” is worded broadly and is open-ended. The definition generally covers any kind of asset, including, but not limited to: (1) movable and immovable property and security rights in relation thereto; (2) rights derived from shares, bonds, and other interests in corporations and joint ventures; (3) monetary claims; (4) intellectual property rights; and (5) rights to explore, extract, and win natural resources and other rights granted under public law.

To which investors does the BIT apply? The Dutch Kingdom’s BITs typically not only apply to citizens and corporations of the Netherlands, Aruba, Curaçao, and St. Maarten, but also to foreign corporations that are directly or indirectly controlled by such citizens or corporations. A significant number of BITs of other countries require qualifying investors to be both established in the contracting country and to have their head office there. These other BITs would therefore not provide protection on the basis of intermediary holding companies located in the state that entered into the BIT with the host country. The Dutch Kingdom’s approach gives a lot of flexibility to structure investments in a tax efficient manner, while allowing the investor at the same time to benefit from the rights granted to investors under the relevant BIT, since it is possible to use multiple layers of investment vehicles. Almost all Dutch Kingdom BITs provide protection as long as there is a Dutch or Dutch Caribbean vehicle in the corporate structure.

Term of BIT protection. The BITs of the Dutch Kingdom are in most cases valid for an initial period of 15 years. They usually also apply to investments that have been made before the date of entry into force. Unless a six-month advance termination notice has been given by one of the contracting states before its expiry date, they will automatically be extended for 10 years. Importantly, in the case of a termination, the provisions of the BIT generally survive for a further period of 15 years for investments that were made before its termination. Consequently, the Dutch Kingdom-Venezuela BIT that has been terminated upon Venezuela’s request as of November 1, 2008, will for example, remain in force until November 1, 2023, for investments made before November 1, 2008.

BITS in Effect

Netherlands 89

Curaçao 89

Brazil 0

China 100 (not including U.S.)

India 65 (not including U.S.)

U.S. 40

Cayman Islands 0

Bermuda 5

Canada 27

BITs and BRICs

Below, we will briefly describe the BIT situation in the BRIC (Brazil, Russia, India and China) countries and provide, if applicable, some details of the BITs entered into by the BRICs with the Kingdom of the Netherlands, which are among the most investor-friendly BITs entered into by the relevant countries.

Brazil

Brazil executed 14 BITs, including one with the Kingdom of the Netherlands, but apparently had a change of heart and has not ratified any of them. It is not a party to the Washington Convention.

Russian Federation

The Russian Federation is a signatory to 44 BITs. The Russian Federation, or rather its predecessor, the Soviet Union, entered into a BIT with the United States in 1992, but never ratified it, so it is not effective. The BIT with the Kingdom of the Netherlands became effective in 1991. Russia has executed the Washington Convention, but has not ratified it.

The Dutch-Russian BIT has the following features:

The definition of investments is very broad and includes, for example, intellectual property rights and concessions to explore natural resources.
It offers protection for the benefit of intermediary holding companies.
It offers direct access to ad hoc arbitration with arbiters to be appointed by the president of the chamber of commerce in Stockholm.

India

India has 65 BITs in effect, with a few pending. There is no BIT with the United States. The BIT between India and the Kingdom of the Netherlands has the following main features:

The definition of investments is very broad and includes for example intellectual property rights and concessions.
It offers protection for the benefit of intermediary holding companies.
It offers access to ICSID or UNCITRAL arbitration.

China

China entered into about 100 BITs. The list does not include the United States. When investing in China, U.S. investors could therefore benefit from interposing an intermediary holding company from a jurisdiction with an investor-friendly China BIT. Obviously, interposing the intermediary holding company should not result in the payment of additional taxes, so the choice of jurisdiction will also depend on a thorough tax analysis. Interposing a Dutch intermediary holding company may fit the bill.

The Dutch-China BIT has the following features:

The definition of investments is very broad and includes, for example, intellectual property rights.
It also offers protection for the benefit of intermediary holding companies.
It offers direct access to ICSID or UNCITRAL arbitration (contrary to many other China BITs).

In the case of China, it is especially interesting that the BIT offers protection for the benefit of intermediary holding companies. Given that the Dutch-China Tax Treaty provides for a 10 percent dividend withholding tax, whereas, for example, an investment by a Hong Kong entity would only trigger a 5 percent withholding tax burden, the investment should not be directly made through a Dutch subsidiary. To add BIT protection, the Dutch subsidiary should be interposed above, for example, such Hong Kong entity. Interposing the Dutch entity will not lead to additional taxes, given the Dutch participation exemption for subsidiaries (income derived though qualifying subsidiaries are not subject to corporate income tax) and the fact that dividends paid by the Dutch entity to a U.S. parent can be made without dividend withholding tax, either by using the U.S.-Dutch Tax Treaty, or by structuring the Dutch entity as a “cooperative.”

Developments in the EU

As of December 1, 2009, the EU became exclusively authorized to enter into new BITs on behalf of its member states. However, existing BITs entered into by an EU member state remain effective, unless and until the EU enters into a new BIT with the relevant other state.

Conclusion

When contemplating foreign direct investments, especially in emerging markets, BIT due diligence should be part of the work undertaken. Basing the decision on which investment vehicle to use solely on tax considerations may prove costly if a host government takes hostile action.

Using a Dutch or Curaçao entity may not only make sense from a tax perspective, but also because of the extensive BIT network of the Netherlands and Curaçao.

Unauthorized Practice of Law and the Transplanted In-House Counsel

Posted on March 19, 2014 by Michael Sweeney - Uncategorized

George, an in-house lawyer employed by Acme Corporation, is licensed to practice law in New York. Fifteen years ago, George moved to Acme’s headquarters in Chicago, where he has worked ever since. He is not a member of the Illinois bar. Is George engaged in the unauthorized practice of law (UPL), and if so, what might be the consequences?

In-House Lawyers and Unauthorized Practice

Lawyers move – including, frequently, both across state lines and from private law firm practice to in-house legal departments. For decades prior to the adoption of Rule 5.5(d) of the American Bar Association’s Model Rules of Professional Conduct, an in-house lawyer licensed only in a state other than where he or she worked rarely attracted scrutiny with respect to UPL, from bar authorities or otherwise. To the extent that issues arose, it was often when the lawyer left the in-house position to return to private firm practice and applied for local bar admission; at that point some state bar regulators might pose pointed questions about what the lawyer did during his or her in-house tenure.

The Model Rule 5.5(d)-(e) Safe Harbor for In-House Lawyers

Model Rule 5.5(d)-(e), adopted by the ABA House of Delegates in 2002, was meant to create a safe harbor for in-house lawyers admitted in a U.S. jurisdiction, but not where they work. This was one of several multijurisdictional practice safe harbors added to Rule 5.5. In general, it is relatively easy for an in-house lawyer to comply with subsections (d) and (e) of Model Rule 5.5, which reflect a policy judgment that such an in-house role “does not create an unreasonable risk to the client and others because the employer is well situated to assess the lawyer’s qualifications and the qualities of the lawyer’s work.” Model Rule 5.5, Comment 16.

New In-House Registration and Limited Admission Rules

Illinois adopted a modified version of Model Rule 5.5(d). If that had been the only step taken on this topic in Illinois and elsewhere, George and other in-house lawyers licensed only in other states would have little to worry about with respect to UPL (as long as they kept their licenses current and confined their practices to representation of their employers). In tandem with the adoption of versions of Model Rule 5.5(d)-(e), however, many states (including Illinois, where George works) also adopted rules requiring in-house lawyers who are only admitted elsewhere in the United States to register with or obtain limited admission from the state bar regulatory authority. While the safe harbor in Illinois Rule of Professional Conduct 5.5(d) covers George, Comment 17 to the Illinois rule (based on Comment 17 to Model Rule 5.5) also contains a cross-reference to another Illinois rule on limited admission of in-house counsel in George’s position. The 2014 edition of the Comprehensive Guide to Bar Admission Requirements, compiled by the National Conference of Bar Examiners and the American Bar Association Section of Legal Education and Admission to the Bar, states that 33 states now have license, registration, or certification requirements for corporate counsel not otherwise admitted in-state, with application fees ranging from zero to $1,300.

The ABA has adopted a Model Rule for Registration of In-House Counsel, but state rules on this topic vary on a number of subjects, including whether:

The rule is framed in terms of “registration” or “limited admission” of in-house lawyers;
Representation is also permitted of organization personnel on matters relating to their organizational roles;
Court appearances on behalf of the organization are allowed;
Pro bono work for clients other than the organizational employer is authorized;
Time worked under the rule can later be used to “waive in” for general bar admission purposes;
The in-house lawyer must satisfy continuing legal education requirements; and
A one-time fee, annual payments, or both are required.

Some states have no such in-house counsel rules. For that matter, not all states have yet even adopted a version of Model Rule 5.5(d)-(e); a number of states simply retain a vague prohibition on engaging in or assisting the unauthorized practice of law.

A New Risk Spectrum

Whereas UPL by in-house lawyers was once a relatively low-risk subject nationwide, if only because of a relative lack of scrutiny, the UPL risk spectrum for in-house lawyers has broadened considerably. At one end of the spectrum, jurisdictions in which versions of Model Rule 5.5(d)-(e) have been adopted without any supplemental rules relating to registration of out-of-state in-house lawyers are even lower-risk from a UPL perspective than they once were. On the other hand, lawyers like George working in jurisdictions that have adopted registration or limited admission rules for in-house lawyers who are only licensed elsewhere now face greater risks than they did before Model Rule 5.5(d)-(e) – at least if they fail to comply. An initiative that was intended to help house counsel like George who are not locally admitted seems to have focused added local bar attention on in-house lawyers.

Privilege Loss?

Another possible issue, on which there does not yet seem to be any case law, is whether George’s failure to comply with the Illinois house counsel rule could be used as a basis for claiming that Acme’s communications with George are not covered by the attorney-client privilege. A similar argument in analogous circumstances was rejected in Gucci America, Inc. v. Guess?, Inc., 2011 U.S. Dist. LEXIS 15 (S.D.N.Y. January 3, 2011). In that case, the in-house lawyer had been admitted in a state other than where he worked in-house, but had then gone on inactive status. The court concluded that a lawyer on inactive status was nonetheless a lawyer for purposes of the attorney-client privilege, and that the corporate employer was not under any obligation to check on the active bar status of its in-house lawyer. The case, however, did not address any in-house lawyer admission or registration rules, and it is unclear whether courts would take the Gucci approach in cases involving such rules.

Illinois Amnesty

Responding to a perception that a significant number of in-house lawyers who are subject to the Illinois rule on this subject may not yet have obtained the required limited in-house licenses, the Illinois Supreme Court declared an amnesty for lawyers who apply for such licenses during 2014. In addition to the $1,250 registration fee provided for under the Illinois rules, an in-house lawyer taking advantage of the amnesty must also pay an additional $1,250 penalty, but is not expected to make up back payments or continuing legal education requirements. The court stated that the prior failure of such lawyers to apply under the rule would not be a basis for prosecution for having engaged in the unauthorized practice of law, that it would not be grounds for denying a license or discipline, and that such applicants would not be investigated by the Illinois Attorney Registration and Disciplinary Commission. Presumably implicit in those statements is the possibility that a lawyer such as George who is covered by the house counsel rule (Illinois Supreme Court Rule 716) and who does not take advantage of the amnesty could be subject to those actions thereafter.

Conclusion

If unauthorized practice rules exist primarily to protect clients and others against unqualified lawyers, it is difficult to find many situations in which such problems have been experienced by corporations or other organizations employing in-house lawyers. To some, state rules regarding registration or limited admission of in-house lawyers like George are solutions in search of a problem. As a practical matter, these rules are probably designed, not to solve systemic problems relating to the performance quality of George or other in-house lawyers, but rather to (a) require such in-house lawyers to contribute financially to funding the state bar, and (b) ensure that such in-house lawyers are subject to local state bar jurisdiction. In-house lawyers such as George who have not complied with such rules should consider addressing the situation, and Acme and other employers of such lawyers may want to help or require them to do so.

Rule 5.5(d)-(e) of the Model Rules of Professional Conduct

(d) A lawyer admitted in another United States jurisdiction or in a foreign jurisdiction, and not disbarred or suspended from practice in any jurisdiction or the equivalent thereof, may provide legal services through an office or other systematic and continuous presence in this jurisdiction that:

(1) are provided to the lawyer’s employer or its organizational affiliates; are not services for which the forum requires pro hac vice admission; and, when performed by a foreign lawyer and requires advice on the law of this or another U.S. jurisdiction or of the United States, such advice shall be based upon the advice of a lawyer who is duly licensed and authorized by the jurisdiction to provide such advice; or

(2) are services that the lawyer is authorized by federal or other law or rule to provide in this jurisdiction.

(e) For purposes of paragraph (d), the foreign lawyer must be a member in good standing of a recognized legal profession in a foreign jurisdiction, the members of which are admitted to practice as lawyers or counselors at law or the equivalent, and are subject to effective regulation and discipline by a duly constituted professional body or a public authority.

Observations on Captive Insurance Companies: 10 Worst and 10 Best Things

Posted on February 18, 2014 by Jay D. Adkisson - Uncategorized

A captive insurance company (commonly referred to in short as a “captive”) is an insurance subsidiary that is set up by the parent company to underwrite the insurance needs of the other subsidiaries. For example, British Petroleum wisely set up a captive insurance company (Jupiter Insurance Ltd.) to provide environmental insurance to its operating units, and the moneys from its captive were used to fund in substantial part the Gulf cleanup.

The vast majority of Fortune 500 companies now have captive subsidiaries (and many companies have several captives, including those for employee benefits), and captives are now also routinely used by small companies for the same purpose. Over 30 states now have captive-enabling legislation, most recently North Carolina and Texas, in addition to states such as Delaware, Kentucky, Missouri, Nevada, Utah, and Vermont, which are very active in marketing their states as premier jurisdictions for the formation of captives.

A captive can be a wonderful risk management tool when used correctly; but therein lies the rub, many are not. The difference between a poorly-run captive and a well-run captive is often difficult for novices to discern. So, in reverse order, here are 10 bad practices involving captive insurance companies, followed by 10 good ones.

Dangers of a Bad Captive Arrangement

10. Bogus Risk Pools

A lot of businesses with valid needs for insurance don’t have enough subsidiaries to pass what is known as the “multiple insured” test for risk distribution, and so they instead participate in what is known as a “risk pool” to obtain risk-distribution.

In a nutshell, a “risk pool” is an insurance arrangement involving multiple, usually unrelated captive owners who share certain risks through their individual captives. Risk pools are usually set up by captive managers to facilitate the needs of certain of their captive clients. In various guidance, the IRS has validated the concept of the risk pool when run correctly.

The difficulty is with the “when run correctly” part. The problem with most risk pools is that there is in fact very little sharing of risks, and thus, the large premiums being charged by the pool are neither actuarially sound nor bear anything but a coincidental relationship to reality. The IRS refers to these as “notional risk pools” – there is a notion of a risk, but not much beyond the mere notion.

Many of these pools have been operated for years with few or no claims, which calls into serious question whether the large premiums they charge are realistic (the answer is that they are not). Maybe in the first year when the pool has no loss history, it can be aggressive in how it prices the premiums paid. By the fifth year, however, a run of large premiums with few or no losses probably indicates that the premiums were mispriced.

By like token, if there is true risk-sharing in a pool, that means that the participants are subject to actual risk of loss – including the total loss of their premiums paid by their operating businesses into the pool. This is where the wink-wink, nod-nod of “That will never happen; actually you’ll never lose anything significant” usually shows up, which is another way of saying the risk pool is just a vehicle to facilitate the appearance of risk-shifting, without actual risk-shifting, i.e., tax fraud.

While the saying around my office is “Pools are for fools!,” the truth is that some clients (including some of mine) cannot meet the test for risk distribution in any other way, and therefore make an informed business decision to participate in a risk pool. However, for these clients my advice is usually, “Do whatever reorganization of your business is necessary to get out of the risk pool as quickly as you can.” If a client is still in a risk pool after a few years just because they need the risk-distribution for tax purposes, there has been a serious failure in business planning by someone.

9. Failure to Make Feasibility Study Prior to Formation

Before the decision to form the captive is even made, a feasibility study should be conducted that looks at all aspects of the captive and validates its viability and economics, as well as whether the captive will meet critical tests for risk-shifting and risk-distribution.

If for no other reason, a feasibility study that carefully documents the non-tax purposes of the captive (to distinguish it from a tax shelter masquerading as a captive) should be done, since the IRS on audits of captives routinely asks for such documents as part of its evaluation. A good captive feasibility study will go a long way in showing the IRS that the captive is founded on solid business economics and does not exist merely to try to save some bucks in taxes.

8. Ignoring State Tax Issues

There is a misconception that if the underlying business is doing business in State A, and the captive is formed in State B, then by virtue of that alone, State A cannot tax the captive.

Not true. Actually, whether State A can tax the captive depends on a variety of factors. If business decisions regarding the captive are made in State A, for example (probably the most common way to blow this), then State A can probably tax the captive.

Captive owners must be very careful to not let the captive “touch” State A in any way, unless of course the captive is formed in State A (and then it doesn’t matter, which is often the easiest and most sensible approach). This is usually accomplished by using a captive management firm (“captive manager”) to perform all the functions of the captive in State B; but just having a captive manager in State B isn’t enough – diligence is required not to blow this.

7. Single-Line Myopia

Too often, captives are formed to underwrite one single risk of the organization, without looking at the myriad other risks of the enterprise. This happens the most when the captive is promoted by an insurance broker who is only focusing on helping the client with that one line of business, usually workers compensation, and it misses a lot of benefits for the client.

In a sense, a captive is a lot like a casino – the more games in a casino, the better the risk distribution of the casino. The same is true with a captive having different types of policies; there is more risk distribution. Also, since the costs of a captive are often fixed or not dependent on how much insurance the captive underwrites, the more insurance that it underwrites, the better the economics of the captive. Which is to say that captives are usually the most efficient when they are underwriting all possible lines of coverage for the organization, not just a single line.

Often, when a captive is being evaluated solely for a single line, the conclusion is reached that the captive will not be economical as to that single line only, when it might be very economical if it takes on other risks. It is difficult to understand why those involved with captives would not look to all the possible coverages the captive might underwrite for a particular client, but such myopia occurs very frequently. Frankly, there is a lot of “If I don’t sell it, I’m not going to worry about it” going on with the insurance brokers, but that attitude doesn’t serve their clients well. Good insurance brokers who assist their clients with captives will look at the entirety of the clients’ books of insurance business, as well as where the clients have chosen not to purchase third-party insurance because it is too costly.

Take caution, however, that the IRS now apparently tests for “line-item homogeneity,” meaning it takes the position that each line of coverage must meet the tests for risk distribution separately, i.e., without regard to other lines of coverage being underwritten by the captive. Many captive tax professionals believe the IRS is flat wrong on that point and will lose a challenge on appeal to a U.S. Court of Appeals, but who wants to pay for that fight?

6. Poorly-Drafted Policies

The policies underwritten by a captive should not be substantially different in their form than policies underwritten by any other insurance company. A good captive manager will use modified standard industry forms to draft policies. By contrast, bad captive managers will draft simplistic policies that often omit key insurance contract terms or else unnecessarily expose the captive to lawsuits by third-party claimants.

There is a reason why there is so much boilerplate in typical insurance contracts – it works. But also, one of the biggest benefits to a client is the ability to custom-tailor coverage to more closely fit their needs by modifying the standard industry forms. Too many captive managers just slap out some basic policies and call it a day; what a shame for their clients to lose a wonderful opportunity.

5. Bogus Insurance Contracts

I’ve actually sat in on meetings where some other adviser has told their prospective client something to the effect that, “You’ll pay premiums, but you don’t have to make claims!” (wink-wink, nod-nod). Then, I’ve had to inform the client that, “If you don’t make and pay valid claims under the policies, then you don’t have a captive, but instead, you just have a tax fraud.”

The U.S. Supreme Court has defined “insurance” as including an “insurance contract.” If there is no valid, binding contract, which is fully honored between the captive and the operating subsidiaries, then there is no insurance. What you have then is simply a sham.

4. Inadequate Capital

About once a month, somebody will call me to inquire about a captive, and say that they have already decided to put the captive in X jurisdiction. When I ask why, they say that it is because X jurisdiction only requires $25,000 in capital or some other small number.

The problem here is that while a small amount of capital may be all that is required by local regulatory law, the minimum capital requirements of a captive for tax purposes is usually much higher, and must be set by an actuary. It is very rare that a captive will take in more than five times the amount of its capital in the first year, and more than three times the amount of capital in succeeding years.

The idea is that the captive needs to have some “skin in the game” other than the premiums that it receives from insureds. In fact, the more capital that a captive has, the safer the arrangement will be from a tax standpoint.

Note that this is primarily a first-year problem, since after the first-year’s policies expire, the reserves that back those policies then go into surplus and are available as capital for future underwriting. However, the problem can materialize in later years if there are excessive claims or the captive’s owners distribute too much of profits to themselves, leaving the captive’s capital cupboard bare.

3. Highly Questionable Risks

A big problem with captives that are just disguised tax shelters is that their policies reflect the underwriting of longshot risks. Like, a really big longshot, as in a “10,000,000,000 to 1, an-asteroid-is-likely-to-hit-the-Earth-first” longshot. Think, hurricane insurance for a business whose operations are in Lincoln, Nebraska, or terrorism insurance for a business in Little Rock, Arkansas.

Maybe it is possible that a really huge hurricane could make its way to Lincoln, or Al Qaeda someday decides to take out a firm in Little Rock, but what is the real risk of that happening? And even if one could say with a straight fact that it might happen, what is the correct amount of premiums for such a policy? $1 per $100,000,000 in coverage? It is sure not $500,000 for $2,000,000 in coverage, which is how the promoters of sham captives will often write it.

Where a captive is formed as a tax shelter, sometimes the risks that are underwritten are already covered by insurance; such as where a doctor sets up a captive for tax reasons and tries to underwrite his or her malpractice liability risks, but then keeps an existing malpractice policy in place so that there is in actuality nothing being covered by the policy (since he or she doesn’t want the captive to actually have to pay a claim!).

2. Premiums Not Bearing Any Relationship to Reality

There is an old joke in the captive insurance world, which is that “You don’t go to the bathroom without first getting an actuary to sign off on it.” That is not too far from the truth. Premiums must be set by a qualified actuary, or else they are probably not defensible in tax court. Unfortunately, what happens too often is that a tax attorney and the insurance manager meet with the client and ask, “How much do you want to save in taxes?” They then pull some premium numbers out of the sky to get the client to the desired target.

Sorry, but it doesn’t work that way. The premiums of a captive have to be determined like any other insurance company; setting the premiums as would be done in an arm’s length transaction, which is by, among many other things, assessing the true risks of the operating subsidiaries, their needs for the particular insurance, and the minimum and maximum coverage required.

Going back to the hurricane insurance for the business in Lincoln or the terrorism insurance for the company in Little Rock: what is the correct amount of premiums? It is going to be really low, as in dig-the-loose-change-out-of-your-couch low. It is not going to be $500,000 or even $100,000, yet such goofy premium calculations are common with captives that are merely a facade for a tax shelter.

Note that having an actuary sign off on premium calculations is not always going to save you, as those premiums have to be reasonable too. Just like there are real estate appraisers whose first question is “What number do you want?,” there are corrupt actuaries who will give you either a $1 or $10,000,000 premium number for the exact same policy and risk. But remember: if the premium calculation is not reasonable, it will not survive a challenge no matter how lengthy the actuary’s credentials.

1. Captive Insurance Companies Sold as Tax Shelters

The primary use of a captive must be for bona fide risk management purposes, and not to save taxes. Unfortunately, many of the same promoters of tax shelters who a few years ago were selling Son of Boss, CARDS, BLIPS, and other flavor-of-the-day tax shelters, are now selling captives as a way to save taxes, with only the barest lip-service being paid to the risk management function.

Hale Stewart, an author of a book on captive insurance company taxation, told me recently, “Captives sold as a tax mitigation tool and not as a bona fide risk reduction, are not really captives at all. But I keep running into them.” So do I, mostly (but not all) so-called 831(b) captive insurance companies, i.e., captives that have made an election to be taxed as a small insurance company under IRS Code Section 831(b). While the vast majority of 831(b) captives are quite legitimate, there is still probably much more abuse going on with these companies than with non-831(b) companies.

These “tax shelter captives” usually suffer from significant flaws, including inadequate capital, grossly overpriced premiums, insuring non-existent risks, lack of true risk distribution, or as a scheme to buy life insurance with pre-tax dollars. It is probably only a matter of time before these companies, and their owners, come to grief on any number of theories the IRS could assert.

Avoiding the Hazards of a Bad Captive Arrangement

Like any other complex legal and financial structure, the money that one spends on a second opinion from truly independent counsel will be some of the best money they will ever spend. In this context, “truly independent” means somebody that a client finds themselves and is not related to or recommended by whoever is pitching them the captive.

A lot of people in the captive world have gotten away for years with some really bad practices only because the IRS has not spent much time or effort looking in to the practices of captive insurance companies. But as the captive market has dramatically expanded, it is unrealistic to think that the IRS’s lack of attention will last much longer.

So, either do a captive right, or don’t do it at all. Now, on to the good things about captive insurance, also presented in reverse order:

10. Create a Giant War Chest for the Business

Like any insurance company, captives tend to accumulate a considerable amount of assets in reserves and surplus. While these assets back the policies issued by the insurance company, a portion of those assets may be available to the business owner in a worst-case scenario where the business owner needs the funds to cover a larger catastrophe.

While there may be significant tax ramifications to “cashing out the captive” to meet some emergency not covered by a policy, at least the business owner has the option of so doing, and can then weigh the cost/benefit analysis at the time the money is needed. Certainly, getting money out of a captive is easier and more expedient than obtaining a business loan from a bank at a time when the business is in deep distress.

During the 2008 crash, more than a few business owners did exactly that. And while their captives became empty shells for a while, they were able to use the money to save their businesses. While one who is setting up a captive certainly hopes their business never will have such a need, it is nice to know that safety net is there.

9. Retain Key Employees

Occasionally, business owners will award a key employee or two by giving them equity in the captive as part of an overall strategy to retain those employees for the benefit of the business. Giving key employees stock in the captive is sometimes less messy and troublesome than giving them equity in the business itself, and can avoid the animosity that can sometimes materialize when other employees are not given a stake in the business.

While this situation is rare, it works swimmingly. While ownership in the operating business is difficult to conceal, particularly for businesses with significant accounting staffs, often no one in the business except the owners knows what is going on with the captive, allowing great flexibility in creating key employee arrangements.

8. Enterprise Asset Protection

A collateral benefit to a captive is that each dollar paid by the operating business to the captive reduces the assets of the operating business by that same dollar. Accordingly, if something goes dreadfully wrong for the business, those dollars are no longer available to creditors of the business.

Indeed, captive insurance must rank as one of the best enterprise asset protection strategies ever created. Note that it would be very difficult for creditors of a business to prove that payments to a captive for bona fide insurance coverage would be a fraudulent transfer, since the business received back a substantial economic benefit in the insurance coverage from the captive. Also, the captive may (and usually is) structured to be remote from the underlying business for purposes of bankruptcy, so even if the operating business is forced into bankruptcy, the odds are low that the captive will be swept into the bankruptcy vortex.

7. Cover Risks Otherwise Exposed

Businesses are often forced to effectively self-insure risks (whether they realize it or not) because either the risk is so unusual that insurance cannot be purchased for it at any price, or because the insurance to cover the risk is exorbitantly expensive. These are ideal risks to be covered by a captive, and indeed, this is one of the primary purposes of captive insurance.

Moreover, even where a business has insurance against certain types of risks, the business will still be exposed to deductibles and exclusions. While in the past, general liability insurance (known in the industry as “GL”) covered a very broad range of risks, typical modern exclusions give such a policy more holes than Swiss cheese. These days, the typical GL policy may have exclusions for things like employment practices liability, which exposes the business to claims of sexual harassment, age discrimination, wage and hourly claims, and the like. The insurance provided by captives can fill these gaps.

6. Draft Your Own Policies

Captives can (and should) draft carefully custom-tailored policies to fit the exact needs of the business. This not only means covering areas of exposure and eliminating exclusions, but also drafting the policy in ways that make it nearly impossible for a third-party claimant against the business to assert a claim directly against the policy (unlike most commercial policies).

Because policies can be custom-tailored, they can be much more efficient. With commercial policies, a business might be stuck with $2 million in coverage of some risk, even though as to that particular risk, the business might only need a more precisely-calculated $1.45 million in coverage – so the business need not pay for what it doesn’t need, and instead allot those same premium dollars to other risks for which the business is exposed.

5. Choose Your Own Counsel

When you buy insurance from a commercial carrier, they typically retain the right to hire an attorney for you. Theoretically, the attorney that your insurance company hires will be your attorney and only look out for your interests even to the detriment of the insurance company – but will he or she really do so?

Insurance defense counsel may be assigned 200 cases from a particular insurance company in a year, only one of which is yours. Who do you think they will really owe their loyalty to? Additionally, insurance companies are notoriously cheap when it comes to hiring counsel – you may get someone whose primary qualification to handle your defense is that he or she bid lower than any other insurance defense attorney for the work.

My advice has long been that if you are ever sued and your insurance company appoints counsel for you, get your own counsel to ride herd on your insurance company’s lawyers; i.e., make sure that they competently represent your interests first and foremost, and if possible, settle the claim within policy limits.

With a captive, a business doesn’t have these problems at all. Since the business owners control the captive, they can select the counsel of their choice to handle particular claims. They have the option of not opting for the cheapest insurance defense counsel, but the best. Or, on the flipside, they can retain a good insurance defense attorney to handle most matters at a discount. All this usually has the effect of a better defense at a lower cost to the business.

4. Administer Claims on Your Own Terms

A problem with commercial carriers is that they can allow a small claim to fester, either by not taking care of the claim early or by allowing it to drag on without resolution. Or, the insurance company may settle a frivolous claim just to save defense costs, thus encouraging more such frivolous claims against the business.

With a captive, the business owners can administer their own claims on their own terms, and get on top of claims quickly before they spin into something much larger. The business owners can also choose to not settle frivolous claims, forcing the plaintiff’s attorneys to incur time and expense litigating the claims before dismissal, and by doing so, deter future lawsuits.

A captive’s ability to draft its own policies, choose its own attorneys, and administer its own claims are all important cost-saving benefits of a captive.

3. Save Money on Insurance

The primary purpose of a captive is to save money on insurance, and in this, captives have no equal. There are three main aspects to this:

First, by underwriting the insurance needs of the business, the captive can capture and retain the underwriting profits that would ordinarily be lost to the commercial carrier. Additionally, considering that commercial carriers have enormous costs that must be priced into their policies, such as the expense of compensating agents, marketing and advertising expenses, and high executive compensation, there is a great deal of fluff having nothing to do with true risk in commercial policies that can be saved through the use of a captive.

Second, even where the business decides to keep commercial insurance in place against particular risks, the captive can be used to reduce costs by raising deductibles, lowering coverage limits, or increasing exclusions – the idea being for the business to find the sweet spot where the commercial insurance is most economical, and then use the captive to insure around that area. Since the greatest expense of most insurance policies is the “first dollar” expense, simply increasing deductibles can result in dramatic premium decreases with commercial policies.

Third, the mere existence of the captive and its ability to underwrite risks can save money even if the captive is never used for that purpose at all. This is because the insurance broker knows that if the premium prices offered to the operating business for insurance are not efficient, the operating business may decide to cover them in the captive instead – and once that particular book of business is lost, it may be forever lost to the broker. Thus, the threat of a captive can be used to significantly barter down the commercial carrier into offering insurance to the operating business at rock-bottom prices.

The combination of all three of these factors can result in very substantial savings to the business enterprise, but the benefits of a captive can extend well beyond the immediate savings of insurance dollars.

2. Forces the Business to Focus on Risk Management

When a business is buying insurance from a commercial carrier, the concept of claims is only loosely attached to the economic cost to the business in terms of increased premiums. But when claims are being paid from a captive – effectively, from the business owner’s pocket – the focus on claims can become intense, and consequently, the business becomes focused (often for the first time) on enterprise risk management.

The benefits of enterprise risk management, while sometimes hard to exactly quantify, are enormous. The focus shifts to analyzing the business so as to spot potential risks. Claims are thus prevented instead of administered. In the end, the business owner gains a better understanding of the business and its limitations, and that is priceless.

1. Create a New Business

Many business owners who form captives think of it for what it does, but they don’t realize that they have just created a new business – an insurance company – and thereby cast themselves into the business of insurance. The captive thus acts not just as an enterprise risk management tool, but also as a segue into a whole new business opportunity.

An existing captive with sufficient capital can be converted to a full insurance company that offers insurance to the general public by changing its license and business plan, and meeting certain other state requirements. This usually doesn’t mean that the new insurance company owner will throw open the doors to the general public, but instead often limits business to the same business that the owner is familiar with – offering insurance to similar businesses where the insurance company owner can get a good feel as to their claims exposure, and accordingly, price premiums appropriately.

The business of insurance can be a great business, and more than a few business owners find insurance an even better business than the successful business they are already in. I’ve had more than a dozen clients go from their captive being just another affiliate in their overall business organization, to running an insurance company and conducting the business of insurance as their primary business.

A Final Note

Note that I haven’t mentioned tax savings as one of my favorite benefits of captives. While captives can offer certain tax advantages to business owners, my tendency is to view a proposed captive arrangement as tax-neutral and make sure that it works without any regard to any tax benefits. This is because to the extent that a captive offers tax benefits, those are the icing on the cake – the cake is the numerous other non-tax advantages of captives, and the cake by itself is pretty good.

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