As part of the expanding enforcement of the FCPA, the Justice Department and SEC are increasingly using the FCPA’s internal controls and recordkeeping provisions to prosecute improper payments that may otherwise be beyond the reach of the antibribery provisions.
Often overlooked in the dramatic increase in enforcement of the Foreign Corrupt Practices Act (FCPA) is the critical role of the FCPA’s accounting and recordkeeping provisions. One of the lesser-known problems disclosed by the revelations of the Watergate era in the United States was the accounting and recordkeeping practices that made improper payments possible. To address these practices, in addition to prohibiting improper inducements to foreign officials, the FCPA placed new and significant obligations on issuers to make and keep accurate records and to maintain a system of internal accounting controls.
Known as the “accounting and recordkeeping” provisions, these new obligations constituted the second and less-well-known mechanism to deter improper inducements to foreign officials. Compared to the antibribery provisions, which prohibit improper inducements to foreign officials, the accounting and recordkeeping provisions, in many respects, constitute a more potent mechanism in deterring improper inducements to foreign officials. They provide a completely independent basis for prosecuting issuers or those acting on their behalf for making improper inducements.
Unlike the antibribery provisions, which apply only to improper inducements to foreign officials, the accounting and recordkeeping provisions apply to an issuer’s domestic and foreign operations, including domestic reporting and disclosure practices as well as practices involving foreign payments. They create affirmative duties on the part of issuers and officers, directors, employees, agents, and stockholders acting on behalf of an issuer.
As opposed to the antibribery provisions, no proof of intent is required to establish a civil violation under the accounting and recordkeeping provisions. A criminal violation can lead to a 20-year term of imprisonment instead of a five-year term under the antibribery provisions. Moreover, critical evidence of a violation of the accounting and recordkeeping provisions in a foreign setting is more likely to be under the control of an issuer and subject to compulsion by U.S. enforcement authorities.
Broad Reach
Seemingly, the application of the accounting and recordkeeping provisions is more limited than the antibribery provisions. They apply to foreign and domestic issuers of securities as defined by section 3 of the Securities Exchange Act of 1934 (Exchange Act) as entities required to register under section 12 or file reports under section 15(d). Issuers can include foreign entities with American depository receipts (ADRs).
Unlike the antibribery provisions, the accounting and recordkeeping provisions extend to majority-owned foreign subsidiaries of an issuer. In addition, for an issuer to be held civilly liable, it makes no difference whether the controlling entity lacks knowledge of the conduct of the subsidiary that serves as a basis for a violation. Criminal liability may be established where an individual or entity subject to the accounting and recordkeeping provisions knowingly circumvents or fails to implement a system of internal controls or knowingly falsifies any book, record, or account. Even when an issuer holds an interest of 50 percent or less, the FCPA requires it to “proceed in good faith to use its influence to the extent reasonable under the circumstances to cause [the subsidiary] to devise and maintain a system of internal accounting controls” consistent with the accounting and recordkeeping provisions. In such circumstances, an issuer will be “conclusively presumed” to have complied when it can demonstrate its good-faith efforts to influence its subsidiary. An issuer’s duty to influence a subsidiary’s behavior increases directly with the degree to which it can exercise control over the subsidiary.
In terms of individuals, while acting within the scope of their duties on behalf of an issuer, individuals, and, in particular, officers, directors, employees, stockholders, and agents of an issuer, can be subject to the terms of the accounting and recordkeeping provisions. The accounting and recordkeeping provisions also extend to individuals who, while acting within the scope of their duties, are officers, directors, employees, or agents of a foreign subsidiary where the issuer has an interest greater than 50 percent.
Except for violations relating to disclosures to auditors, the recordkeeping provisions apply to “any person” and not just to officers and directors. Though proof of intent may be required to establish civil liability for aiding and abetting a violation of the accounting and recordkeeping provisions, even individuals and entities not otherwise subject to their terms can become subject to liability. For example, a supplier to an issuer who knowingly facilitates the making of a false invoice to conceal the true nature of the underlying transaction could be subject to prosecution for violating the recordkeeping provisions.
Falsification of Books and Records
Under the recordkeeping provisions, an issuer must ensure that the books and records are accurate so that the financial statements can be prepared in conformity with accepted methods of recording economic events. The recordkeeping provisions are not focused solely with the preparation of financial statements. They seek to strengthen the accuracy of the corporate books and records and the reliability of the audit process. Books and records subject to the recordkeeping provisions are not specifically defined by the FCPA. But given the Sarbanes-Oxley Act of 2002’s (Sarbanes-Oxley) emphasis on internal controls and deterring conduct that might impede or affect the audit function, Congress implicitly reaffirmed the broad scope of records subject to the terms of the accounting and recordkeeping provisions.
In general, the greater the degree to which a record may relate to the preparation of financial statements, the adequacy of internal controls, or the performance of audits, the more courts are likely to find the record to be subject to the terms of the recordkeeping provisions. Records such as corporate minutes, transactional documents, and authorizations for expenditures are all incidental to the preparation of financial statements or recording economic events. Records that may relate to internal controls, such as compliance programs, fall within the scope of records subject to the recordkeeping provisions since such records bear on the accuracy of the financial statements. Similarly, records bearing on the audit of financial statements are likely to be extremely broad in scope.
Of critical significance is the absence of a materiality requirement under the recordkeeping provisions. Even if the amount of a transaction does not affect the bottom line of an issuer in quantitative terms, it may still constitute a violation of the recordkeeping provisions if not accurately recorded. A classic situation is presented by expediting payments, which are permitted under the antibribery provisions but could pose a problem if not accurately recorded.
Manipulating records to mask transactions by characterizing them in some oblique manner or actually falsifying a transaction can implicate an issuer and those individuals involved. Placing a transaction into an abnormal category or burying it in some other way may serve as a basis for a violation. The Securities and Exchange Commission’s (SEC) posture has been described as one of zero tolerance for the falsification of records relating to an improper inducement.
One practical consideration in prosecuting violations of the antibribery provisions is the difficulty in securing evidence in a foreign setting. This difficulty is further complicated by the question of whether evidence obtained in a foreign setting will be admissible in a U.S. court. In the context of prosecuting a violation of the recordkeeping provisions, the evidence is more likely to be documentary in nature, to be in the possession or control of an issuer, and to be admissible in court. An issuer is subject to compulsion by U.S. enforcement authorities to produce records, including foreign records, in its custody or control.
Moreover, in a criminal context, proving a violation of the recordkeeping provisions is more straightforward and more likely to succeed than proving a violation of the antibribery provisions. The evidence necessary to establish a criminal violation is much simpler and less apt to confuse a jury. Unlike the antibribery provisions, proving corrupt intent is not required. Nor is there a requirement to prove whether a foreign official was involved or whether a promise, offer, or payment was made to obtain or retain business. In large part, the elements of the offense are limited to whether the record is subject to the recordkeeping provisions, whether the conduct was willful, and whether the record was accurate in reasonable detail. The documentary nature of the evidence makes proving a violation less dependent upon recollections that can be subjective and that can fade over time. Unlike proving a bribe, proving a false statement is likely to be much more clear-cut and less susceptible to differing interpretations. From the standpoint of a prosecutor, a criminal violation of the recordkeeping provisions has an added strategic advantage because it carries a far more severe penalty than a violation of the antibribery provisions. Given the severity of the criminal penalty for a violation of the accounting and recordkeeping provisions, and a greater ability to prove a violation, a prosecutor has an enhanced ability to negotiate a plea. It also enhances a prosecutor’s ability to secure cooperation to provide evidence relative to violations of the accounting and recordkeeping provisions as well as the antibribery provisions. Individuals facing a prison sentence are apt to be receptive to alternatives that may limit the possibility of a lengthy prison term.
Material Misrepresentations or Omissions to Auditors
In implementing the recordkeeping provisions through the adoption by the SEC of Rule 13b2-2, officers or directors of an issuer were prohibited from making materially false or misleading statements or omitting to state any material facts in the preparation of filings required by the Exchange Act. Although this rule applies only to officers and directors, and anyone acting on their behalf, it is very broad in terms of its coverage. Under Rule 13b2-2, officers and directors are prohibited from “taking any action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements of that issuer for the purpose of rendering such financial statements materially misleading.”
Rule 13b2-2 also extends to written and oral statements made to internal auditors as well as to outside auditors by officers or directors. It also extends to “causing another person to make a material misstatement or make or cause to be made a materially false or misleading statement.” Not only are misrepresentations covered, but a material omission or failure to clarify a statement so as to make it materially false or misleading can constitute a violation.
Adequate Internal Controls
Under the accounting provisions, the purpose of internal controls is to ensure that issuers adopt accepted methods of recording economic events, protecting assets, and confirming transactions to management’s authorization. No specific system of internal controls is required. A system of internal controls must be sufficient to provide reasonable assurance that directors, officers, and shareholders are made aware of and thus able to prevent the improper use of assets. Under the accounting provisions, “[r]easonable assurance” means “such level of detail and degree of assurance as would satisfy prudent officials in the conduct of their own affairs.” The standard for compliance is whether a system, taken as a whole, reasonably meets the requirements of the internal control provisions.
An issuer’s antibribery compliance program should not necessarily be separate from its system of internal accounting controls. A natural interplay was intended between the antibribery and the accounting and recordkeeping provisions. An effective system of internal accounting controls includes a range of review and approval guidelines designed to detect and deter questionable payments. Indeed, the planning, implementation, and monitoring of an issuer’s compliance program should be closely linked, if not intertwined, with its system of internal accounting controls.
For issuers engaged in international business, the failure to devise or maintain an effective system to prevent or detect violations of the antibribery provisions can constitute a violation of the internal controls provisions. At the very least, it must include a formal FCPA policy made applicable to the entire entity, an FCPA compliance program, and a practice of conducting due diligence and maintaining due diligence records on the entity’s foreign agents. Those responsible for ensuring compliance with an FCPA policy must have adequate experience and training to address issues that may arise relative to preventing, detecting, and addressing possible violations of the FCPA. Due to their esoteric nature, and the absence of specific standards, the internal accounting control provisions are seldom the focus of criminal enforcement activity. Yet, in a civil enforcement context, where no proof of intent is required, these provisions provide an almost endless series of bases for the SEC to take action against an issuer. In almost any after-the-fact analysis relating to financial irregularities, the SEC will be able to point to a breakdown of some sort associated with the internal accounting controls of an issuer.
Expediting Payments
A related consideration is how expediting payments are recorded. An effort to conceal expediting payments by placing them among other types of payments would be improper. Regulators prefer that such expenditures be set out in a separate line item. This reasoning is premised on the view that payments of a questionable nature are not apt to be disclosed. Thus the greater the transparency or degree to which expediting payments are fully disclosed, the less likely they will be perceived as being suspect.
A separate line item may not be required as long as the line item in which an expediting payment is incorporated is both logical and not calculated to conceal. If the expediting payment is a relatively small amount of money and has no relationship to any particular function of an entity, its inclusion in a category of miscellaneous items may not be inappropriate. Similarly, the degree to which the expediting payments may be rolled up into larger line items and thereby hidden is not necessarily improper as long as the manner in which such payments are incorporated into a larger line item is logical and not for the purpose of concealing questionable transactions. The classification is not necessarily false or inaccurate. It is mere circumstance that leads to the expediting payment being, in effect, buried. But should the expediting payment be incorrectly classified so that it may be rolled up into a larger line item and thereby concealed, a basis may exist for a violation of the recordkeeping provisions to be alleged.
Expediting payments also bear on the adequacy of internal controls. Consistent with maintaining an effective compliance program and the heightened obligations on auditors to plan audits so as to detect fraud, issuers need to be in a position to be responsive to inquiries and, if necessary, to quickly identify expediting payments and to provide substantiating documentation. Greater segregation is more likely to enhance the adequacy of internal controls. If the expediting payments are not properly approved, an issuer may also open itself up to possible allegations of inadequate internal controls.
Regardless of whether they may be permitted by the FCPA, the underlying dynamic associated with expediting payments must always be kept in mind. By their very nature, expediting payments are illegal in the country of the intended recipient. Proper recordkeeping is more likely to expose an entity to liability associated with an investigation in the host country for making payments prohibited by local law.
Conclusion
The increased reliance on the accounting and recordkeeping provisions to deter improper payments is not likely to decline. To the contrary, at the core of the heightened obligations under Sarbanes-Oxley are those relating to the FCPA’s accounting provisions. Subject to criminal sanctions, internal control reports are now required expressing management’s responsibility for establishing and maintaining adequate internal controls for financial reporting and assessing their effectiveness. An attestation by an issuer’s outside auditor is also required as to management’s assessment of the adequacy of the issuer’s internal controls.
In sum, the critical role of the accounting and recordkeeping provisions in deterring improper inducements to foreign officials cannot be overstated. Conduct that may be perceived to be beyond the reach of the antibribery provisions may constitute a violation of the accounting and recordkeeping provisions. Compliance with the FCPA’s prohibitions on improper inducements cannot be limited to complying with the antibribery provisions. To be effective, an FCPA compliance program must ensure that adequate internal controls are in place and that accurate recordkeeping practices are rigorously enforced.
The power and complexity of the single-member limited liability company (SMLLC) comes from a conceptual contradiction: the conflation of owner and organization for federal income tax purposes and the separation of owner and entity for nontax, state law purposes. The contraction has significant practical consequences, which this article explores by first, explaining why federal regulators chose to disregard the existence of a class of valid and existing state law entities (i.e., SMLLCs) and then, providing several illustrations of the practical vagaries that can result.
Why a Disregarded Entity?
In 1996, as the Internal Revenue Service (IRS) prepared to revolutionize tax classification through its “check the box” regulations, the IRS’s lawyers and theoreticians faced a knotty conceptual problem. The essence of check the box was to accord partnership tax classification, and therefore flow-through tax status, to all noncorporate business entities organized under the law of a U.S. jurisdiction. This approach was destined to, and did, open the floodgates for LLCs having at least two members and, eventually, for limited liability partnerships and limited liability limited partnerships as well.
But what was the IRS to do with the “single-member LLC”–an LLC with only one owner? It is axiomatic under both state and tax law that a partnership has at least two owners. The IRS had neither the statutory nor the jurisprudential basis for announcing that an LLC with only one member would be taxed as a partnership.
The IRS’s solution was a tour de force; it cut the Gordian knot by declaring that a single-member LLC simply does not exist for federal income tax purposes. Put simply, under check the box, unless an SMLLC elects to be classified as a corporation, the SMLLC is a disregarded entity. The sole member of an SMLLC might paraphrase Louis XIV and say, “the entity, it’s me.”
Since the promulgation of “check the box,” the single-member LLC has become a centrally important aspect of LLC law and practice. Countless individuals use the SMLLC to provide a liability shield for entrepreneurial activity (activity that for tax purposes disappears into a Schedule C on the individual’s tax returns), and SMLLCs also figure prominently in more complicated contexts (ranging from simply serving as corporate subsidiaries to playing a pivotal role in structuring “bankruptcy remote” entities for securitization purposes).
The disregarded entity construct solved the IRS’s conceptual problems for federal income tax purposes. However, as discussed below, the new approach has occasioned considerable confusion in other contexts.
Illustration No. 1–The SMLLC in Federal Court
A pair of recent circuit court decisions illustrate the confusion, in the context of the right of a litigant to appear pro se in federal court. Lattanzio v. COMTA, 482 F. 3d 137 (2d Cir. 2007), and U.S. v. Hagerman, 545 F.3d 579 (7th Cir. 2008), both involved essentially the same legal question. In each case, an LLC’s sole owner attempted to appear pro se on behalf of the LLC.
In each case, the attempt failed. Although the right to appear pro se in federal court is of venerable origin, the right applies to individuals and not to juridic persons. As Chief Justice Marshall explained almost 200 years ago, “a natural person may appear for himself,” but “[a] corporation . . . can appear only by attorney.” Osborn v. Bank of the United States, 22 U.S. (9 Wheat.) 738, 830 (1824).
In the pro secontext, an LLC is very much like a corporation. Conflation is not the paradigm; the owner and the organization are distinct conceptually and legally. Even when the entity is an LLC with only one member, for pro se purposes the entity may not be disregarded.
The right to appear pro sein federal court has been codified, 28 U.S.C. § 1654, but the codification leaves unchanged the “no conflation” analysis. In Lattanzio, for example, the court stated, “the [pro se representation] statute does not permit unlicensed laymen to represent anyone else other than themselves.” This limitation prevents “a layperson . . . [from] represent[ing] a separate legal entity such as a corporation,” and the limitation extends to “partnerships and single shareholder corporations” and to limited liability companies as well.
For the Lattanzio court, it was immaterial that the LLC had only one member. The court acknowledged that “some courts allow sole proprietorships to proceed pro se” but sharply distinguished that situation from the situation of a single member LLC: “[A] sole proprietorship has no legal existence apart from its owner. Unlike a sole proprietorship, a sole member limited liability company is a distinct legal entity that is separate from its owner,” with, for example, the power to sue and be sued in its own name.
Having in previous decisions “refus[ed] to distinguish between a single shareholder corporation and a multi-shareholder corporation,” the Lattanzio court saw “no reason to distinguish between limited liability companies and sole member or solely-owned limited liability companies.” Like the sole shareholder of a corporation, “a sole member of a limited liability company must bear the burdens that accompany the benefits of the corporate [sic] form and may appear in federal court only through a licensed attorney.”
Lattanzio was a civil case. U.S. v. Hagerman was a criminal matter, but the Seventh Circuit used the same reasoning as the Second Circuit to reach the same conclusion. “[T]he right to conduct business in a form that confers privileges, such as the limited personal liability of the owners for tort or contract claims against the business, carries with it obligations one of which is to hire a lawyer if you want to sue or defend on behalf of the entity. Pro se litigation is a burden on the judiciary, and the burden is not to be borne when the litigant has chosen to do business in entity form. He must take the burdens with the benefits.” In other words, “now you see it, . . . now you see it.”
Illustration No. 2–Liability for an SMLLC’s Employment Taxes
As a matter of state, nontax law, “[a] limited liability company is an entity distinct from its members.” Revised Uniform Limited Liability Company Act (Re-ULLCA), § 104(a). As a result, even when an LLC has only one member, “the debts, obligations, or other liabilities of a limited liability company, whether arising in contract, tort, or otherwise: (1) are solely the debts, obligations, or other liabilities of the company; and (2) do not become the debts, obligations, or other liabilities of a member . . . solely by reason of the member acting as a member.” Re-ULLCA, § 304(a).
It would seem to follow, therefore, that, when an SMLLC fails to pay its federal employment taxes, the IRS, like any other creditor of the LLC, must
content itself with the assets of the LLC to satisfy the entity’s obligations, or
find a way to use the controlling person liability approach applicable to other state law entities, IRC § 6671(b), or
pursue the elaborate and sometimes difficult path of piercing the veil of the LLC to reach the assets of the LLC’s owner.
Federal regulations effective in 2007 do indeed follow this approach, but the IRS’s path to this conclusion has been tortuous. An initial pronouncement, Notice 99-6, 1999-1 CB 321, contended that an SMLLC’s disregarded status meant that conflation was the rule for purposes of employment tax liability just as much as for pass-through tax status. “The Service recognized that, because the federal tax classification regulations essentially ignore the separate existence of a disregarded entity, the owner of the disregarded entity, and not the entity itself, is treated as the employer and that traditionally employment tax responsibilities rest with the employer.” CARTER G. BISHOP & DANIEL KLEINBERGER, LIMITED LIABILITY COMPANIES: TAX AND BUSINESS LAW, ? 2.07[1][a][i] (1994, Supp. 2010-1).
We criticized that approach as “lead[ing] to confusion” because, as a matter of state law, “the employees are actually employed by the [tax] disregarded entity.” Moreover, the approach conflicted with the IRS’s own recognition that it could not directly levy on the assets of an SMLLC to satisfy the separate tax debt of the LLC’s single member.
Nonetheless, in 2007, in Littriello v. U.S., 484 F.3d 372 (6th Cir. 2007), the Sixth Circuit approved the IRS’s approach and held a sole member automatically liable for the enterprise’s employment taxes. To reach this result, the court applied “Chevron deference”–i.e., the court followed the “directive” in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), “to give deference to an agency’s interpretation of statutes that the agency is entrusted to administer and to the rules that govern implementation, as long as they are reasonable.”
Under that approach, the court upheld the entire check the box regime, and that holding is Littriello‘s enduring significance.
Ironically, however, on the employment tax/SMLLC issue, Littriello is moot. The case validated a regulatory approach that the IRS had already prospectively abandoned. In 2005, the IRS had announced its intention to jettison Notice 99-6 and had issued proposed regulations on the subject. The proposed regulations sought to treat an SMLLC as if it were a corporation for employment tax purposes.
The regulations became final on August 17, 2007. In the context of federal employment taxes, therefore, the disregarded entity has ceased to be transparent. In other words, “now you see it, . . . now you don’t; wait . . . now you do.“
Illustration No. 3–SMLLCs and Transfer Taxes
Suppose that a person becomes a member of a limited liability company and in connection with that event contributes land to the LLC (so as to “pay for” the membership). As a matter of state entity and property law, it seems self-evident that the contribution involves the transfer for value of the land from the would-be member to a separate legal person (i.e., the LLC). Under the laws of many states, such a transfer triggers a transfer tax, and certainly under the LLC laws of all states the transfer severs the transferor’s ownership interest in the land.
However, when the LLC has only one member, under the statutes of some states it is possible to reframe the arrangement to avoid the transfer tax. A Connecticut case shows how.
Mandell v. Gavin, 816 A.2d 619 (Conn. 2003), involved a transfer tax applicable only to transfers made for “consideration,” a term that the court stated “has been used in a specific, legal sense for centuries.” In that sense, “[t]o constitute consideration, a performance or a return promise must be . . . sought by the promisor in exchange for his promise and is given by the promisee in exchange for that promise.”
Timing is therefore everything in a consideration analysis. “Past consideration” is no consideration because the subsequent promise cannot have been exchanged for an action already performed. Through good advice or good fortune (or both), Mr. Mandell got the timing just right. “The plaintiff formed his company soon after the effective date of [Connecticut’s LLC] legislation, naming himself the sole member. The plaintiff then transferred the real property to his company by quitclaim deed. In the deed, the plaintiff recited that the transfer was ‘for NO CONSIDERATION . . .'”
Given this sequence, Mr. Mandell’s transfer of land to his LLC could seem gratuitous. After all, his admission into the LLC as its sole member provided him with all the economic and governance rights a person could have as a member. His subsequent contribution of the land did nothing to increase his rights as a member.
Of course, anyone who actually believes that Mr. Mandell’s admission as the LLC’s member occurred without contemplation of the land transfer has (1) never heard of the “step transaction” doctrine and (2) like the White Queen in Through the Looking Glass, can “believe[] as many as six impossible things before breakfast.” Indeed, Mr. Mandell contested the transfer tax on an entirely different basis. He argued that “he and his single-member limited liability company should be considered a single entity for taxation purposes, and that any transfer of property between them would fail to satisfy the requirement . . . that transfers be for ‘consideration’ to be taxable . . . because he, as an ‘individual, owns the real estate both before and after the purported transfer . . .'”
Although the Connecticut Supreme Court chose not to follow Mr. Mandell’s suggested “disregarded entity” approach, the fact that the LLC was an SMLLC was crucial to the court’s decision. If, for example, the LLC had had just one additional member, it would have been impossible to pretend that the members (1) had first agreed to become members, with an understanding as to how to share governance rights and allocate profits, and then (2) had just happened to make contributions of property to the LLC–fortuitously, gratuitously, and not in furtherance of their agreement as to membership. But with an SMLLC, “now you see it, . . . now you see it, but it doesn’t matter.“
Warning: It’s All How You Look at It
All transfer tax cases depend heavily on the language of the applicable statute, so the Mandell analysis might not apply generally. Nonetheless, the case helps illustrate why lawyers must pay careful attention to the shape-shifting nature of the SMLLC.
Other illustrations are easy enough to find. For example, in Olmstead v. FTC, __ So.3d __, 2010 WL 2518106 (Fl. 2010), the Florida Supreme Court spent more than a year considering an SMLLC question certified by the Eleventh Circuit: do membership transfer restrictions, which were built into LLC statutes in order to prevent the separate creditors of any one LLC member from intruding into the business of a multimember LLC,permit a sole member to shelter assets from the claims of the sole member’s legitimate creditors? The issue is a cause célèbre among LLC practitioners and “asset protection” mavens, and in July a sharply divided court reformulated the certified question, opined in favor of the creditor, and left practitioners and scholars wondering whether the decision undermines transfer restrictions for multimember as well as single member LLCs. In another controversial case, the Tax Court recently held that an SMLLC is not a disregarded entity for the purposes of gift tax law. Two vehement dissents argued that the plain language of the check the box regulations makes them applicable “for [all] federal tax purposes.”
In sum, practitioners must take great care when working with an SMLLC because how separate an SMLLC is from its owner depends on how one looks at the situation. Depending on which legal regime applies, the SMLLC may be as visible and substantial as a stone wall or as diaphanous and prone to disappearance as the Cheshire Cat.
This is the Report of the Model First Lien/Second Lien Intercreditor Agreement Task Force (“Task Force”) established by the Commercial Finance Committee of the Business Law Section of the American Bar Association. This Report will first review the reasons for the creation of the Task Force, its goals, and its methodology. It will then introduce and examine each major provision of the Model Agreement, exploring its purpose, perceived market practice, and the perspectives of first and second lien creditors. Where appropriate, the Report will present alternative provisions and views.
CREATION OF THE TASK FORCE
Intercreditor agreements are used in a variety of financing transactions to establish the respective rights and remedies of two or more creditors in credit facilities provided to a common borrower. Intercreditor agreements are not standardized, and their scope varies widely. Intercreditor agreements may include payment subordination provisions, payment standstill terms, and other creditor rights and remedies that do not involve collateral. Such payment subordination arrangements are typically found in unsecured mezzanine financing, for example. In secured financing transactions, however, the intercreditor agreement may also govern the relative rights and priorities of each creditor’s liens in the borrower’s assets, and it is here that the Task Force has concentrated its efforts.
The past five to eight years have witnessed an increase in the use of “second lien” structures in institutional senior secured syndicated financing transactions. These structures involve a “first lien” loan secured by a first priority lien in substantially all of the assets of the borrower, and a separate pari passu “second lien” loan, typically provided by a separate lender group, secured by a second priority lien in the same collateral. Second lien structures have enjoyed increased popularity in recent years because of the increased liquidity provided by second lien lenders that might not have provided financing on an unsecured basis, and because of the relatively narrow interest rate spreads available in the second lien market before the financial crisis in the latter half of 2008.
Until the financial crisis, the second lien market had grown rapidly. According to the Loan Pricing Corporation, the dollar volume of second lien loans grew from approximately $8 billion in 2003 to over $29 billion in 2006.1 In the second quarter of 2007, second lien loans reached $15.21 billion, the highest quarter recorded for second lien issuance.2 Like other forms of leveraged finance, second lien financing fell sharply with the 2008 credit crisis. By the second quarter of 2009, second lien issuance was under $300 million.3
Second lien structures also migrated to the middle market, and to asset-based loans, where second lien structures became common. A typical structure is for a revolving lender to hold a first lien in all accounts, inventory, and other current assets while a term lender holds a first lien in equipment, real estate, and other fixed assets, with each lender also holding a second lien in the other’s primary collateral. Variations of such “wrap” structures have become increasingly creative.
As the second lien market grew, counsel to first lien lenders drafted various forms of substantially similar first lien/second lien intercreditor agreements. In the early years of the second lien market, the second lien lender generally subordinated virtually all of its rights as a secured creditor to the rights of the first lien creditor until the first lien creditor was paid in full—a so-called “silent second.” Surprisingly, there was little published guidance on the issues that counsel should consider in drafting or reviewing an intercreditor agreement, and participants relied heavily on “market practice.” It gradually became apparent, however, that the market had only a limited experience of the effect of these provisions following a default by the borrower or the initiation of a bankruptcy proceeding.
Although second lien transactions are structured in myriad ways, the principal intercreditor issues remain consistent throughout all structures. Similar intercreditor issues arise in most other secured transactions involving lien subordination. Therefore, the Task Force believes that the development of a form of first lien/second lien intercreditor agreement that covers the major recurring issues and fairly protects the interests of first and second lien creditors while reflecting market expectations would be a useful resource for practitioners.
PRINCIPAL GOALS AND USE OF MODEL AGREEMENT
It is important to identify what the Model Agreement is not. The Task Force initially received the criticism that its work would be of limited utility because an intercreditor agreement could not be standardized for all transactions. Although this is a legitimate concern, it is important to note that nearly all intercreditor agreements dealing with priority of liens in common collateral must necessarily address similar lien subordination issues. Likewise, all must address the effect of the intercreditor terms both outside of bankruptcy and during the pendency of a bankruptcy proceeding. While there will be structural differences in the transaction itself, the same issues will be present.
The Model Agreement and accompanying comments, other footnotes, and text are intended, first and foremost, to be a reference tool for the practitioner. The comments are intended to explain the general purpose of each section, highlight the principal issues encountered in practice, and convey the prevailing market expectation. Accordingly, the Model Agreement is not a universal solution to the problem of identifying the “correct form” to use for a transaction. The form will necessarily be determined by the details of the transaction. The Model Agreement introduces the major components of lien intercreditor agreements generally, addresses why such provisions are necessary, and explores the effect of drafting a provision in a manner more favorable to a first or second lien lender. Armed with an understanding of these basic concepts and their implementation in the Model Agreement, the practitioner may construct an intercreditor agreement that fits his or her transaction.
The Model Agreement does not address all types of transactions. For example, an intercreditor agreement for an asset-based transaction would typically include a provision requiring the holder of a first lien in fixed assets in a wrap structure to allow the holder of the first lien in the current assets to remain on the real property for a certain period of time to use the fixed assets to complete manufacture of goods to provide finished product for pending orders. Increasingly, lien intercreditor agreements also deal with payment subordination provisions and rights of additional secured parties such as third and fourth lienholders on common collateral. These variations are beyond the scope of the Model Agreement.
HOW THE TASK FORCE CONDUCTED ITS WORK
The Task Force is sponsored by the Syndications and Lender Relations Subcommittee of the Commercial Finance Committee of the Section of Business Law of the American Bar Association. The Chair of the Task Force is Gary D. Chamblee. The Vice Chairs of the Task Force are Alyson Allen, Christian Brose, Richard K. Brown, Robert L. Cunningham, Jr., Randall Klein, and Jane Summers, and the Editor is Howard Darmstadter. In addition to the Chair and the Vice Chairs, other members of the Task Force have played key roles in drafting the text and commentary of the Model Agreement, including Anthony R. Callobre, John Francis Hilson, and Matthew W. Kavanaugh. Many other members of the Task Force regularly attended meetings of the Task Force, contributed significantly to the ongoing discussion regarding the many difficult issues faced by the Task Force, and otherwise made contributions essential to the goal of providing a balanced, market-driven Model Agreement. The names of the over 200 members of the Task Force and their law firms or other affiliations can be found on the Task Force web site at http://www.abanet.org/dch/committee.cfm?com=CL190029.
The Task Force was formed in the spring of 2006 and met for the first time at the 2006 Annual Meeting in Honolulu, Hawaii. The Task Force is composed of practitioners who represent primarily first lien lenders, practitioners who represent primarily second lien lenders, and practitioners who represent both. As a result, the Task Force reflected a relatively balanced representation among all concerned parties. At the initial meeting, it was determined that the Task Force would meet at each scheduled meeting of the Section, which includes the Spring Meeting in April, the Annual Meeting in August, and the Fall Meeting in November of each year, and would also meet by telephone conference on a regular basis.
The agreement selected by the Task Force as a source document is an institutional first lien/second lien intercreditor agreement commonly used in the market for second lien transactions initially prepared by Latham & Watkins LLP. This form was disassembled by subject matter sections, with each section being the focus of one or more of the Task Force meetings. Where possible, the Task Force utilized experts in certain practice areas among its members to lead the review and revision of the respective sections in the member’s specialty. After each Task Force meeting, the Model Agreement was revised to reflect the concerns raised by Task Force members at the meeting.
Significant discussion was devoted to the presentation of alternative provisions favoring second lien lenders. Task Force members who represented primarily second lien lenders were troubled by the placement of such provisions as footnotes or at the end of the agreement, feeling that such placement implied that the alternative text did not reflect market terms. It was decided that alternative text that involved concepts important to second lien lenders and that was actually used in practice would be placed in the body of the relevant section of the agreement as a second lien favorable alternative. Concepts deemed less important or not widely used in practice, as well as clarifications and explanations of differences and concerns of the various parties, would be placed in the footnotes. In addition, introductory comments are included in notes to most sections of the Model Agreement.
Following the initial revision of each section, the Model Agreement was further edited and revised stylistically by Howard Darmstadter. The Task Force is grateful for Howard’s fine work in making the Model Agreement more concise and user friendly.
The Task Force intends from time to time to publish appendices or revisions to the Model Agreement to deal with special situations or to reflect the experience of practitioners working with the document and to reflect market changes.
____________________________, as collateral agent for the holders of the First Lien Obligations defined below (in such capacity, First Lien Agent)4
____________________________, as collateral agent for the holders of the Second Lien Obligations defined below (in such capacity, Second Lien Agent)
______________________________, as control agent for First Lien Agent and Second Lien Agent (in such capacity, the Control Agent)
______________________________ (Borrower)
______________________________ (Holdings)
The Guarantor Subsidiaries (as defined below).
BACKGROUND
Borrower, Borrower’s parent company, Holdings, certain lenders and agents, and First Lien Agent have entered into a First Lien Credit Agreement dated the date hereof providing for a revolving credit facility and term loan.
Borrower, Holdings, certain lenders and agents, and Second Lien Agent have entered into a Second Lien Credit Agreement dated the date hereof providing for a term loan.
Holdings has guaranteed, and Holdings and Borrower have agreed to cause certain current and future Subsidiaries of Borrower [and Holdings] (the Guarantor Subsidiaries) to guarantee, Borrower’s Obligations under the First Lien Credit Agreement and the Second Lien Credit Agreement.
Each of Borrower, Holdings, each Guarantor Subsidiary, and each other Person that executes and delivers a First Lien Collateral Document or a Second Lien Collateral Document as a “grantor” or “pledgor” (or the equivalent) is a Grantor.
A Grantor may enter into Hedge Agreements and Cash Management Agreements with one or more lenders under the First Lien Credit Agreement or their affiliates as counterparties, which may be included in the First Lien Obligations defined below.5
The First Lien Obligations and the Second Lien Obligations are secured by Liens on substantially all the assets of Borrower, Holdings, and the Guarantor Subsidiaries.
The Parties desire to set forth in this First Lien/Second Lien Intercreditor Agreement (this Agreement) their rights and remedies with respect to the Collateral securing the First Lien Obligations and the Second Lien Obligations.
1.1 SENIORITY OF LIENS SECURING FIRST LIEN OBLIGATIONS
(a) A Lien on Collateral securing any First Lien Obligation that is included in the Capped Obligations up to but not in excess of the First Lien Cap will at all times be senior and prior in all respects to a Lien on such Collateral securing any Second Lien Obligation, and a Lien on Collateral securing any Second Lien Obligation will at all times be junior and subordinate in all respects to a Lien on such Collateral securing any First Lien Obligation that is included in the Capped Obligations up to but not in excess of the First Lien Cap.
(b) A Lien on Collateral securing any First Lien Obligation that is not included in the Capped Obligations will at all times be senior and prior in all respects to a Lien on such Collateral securing any Second Lien Obligation, and a Lien on Collateral securing any Second Lien Obligation will at all times be junior and subordinate in all respects to a Lien on such Collateral securing any First Lien Obligation that is not included in the Capped Obligations.
(c) The Lien on Collateral securing any First Lien Obligation that is included in the Capped Obligations in excess of the First Lien Cap will have the priority set forth in section 1.11, “Subordination of Liens Securing Excess First Lien Obligations.”
(d) Except as otherwise expressly provided herein, the priority of the Liens securing First Lien Obligations and the rights and obligations of the Parties will remain in full force and effect irrespective of
(1) how a Lien was acquired (whether by grant, possession, statute, operation of law, subrogation, or otherwise),
(2) the time, manner, or order of the grant, attachment, or perfection of a Lien,
(3) any conflicting provision of the U.C.C. or other applicable law,
(4) any defect in, or non-perfection, setting aside, or avoidance of, a Lien or a First Lien Loan Document or a Second Lien Loan Document,
(5) the modification of a First Lien Obligation or a Second Lien Obligation,
(6) the modification of a First Lien Loan Document or a Second Lien Loan Document,
(7) the subordination of a Lien on Collateral securing a First Lien Obligation to a Lien securing another obligation of a Grantor or other Person that is permitted under the First Lien Loan Documents as in effect on the date hereof or secures a DIP Financing deemed consented to by the Second Lien Claimholders pursuant to section 6.1, “Use of Collateral and DIP Financing,”
(8) the exchange of a security interest in any Collateral for a security interest in other Collateral,
(9) the commencement of an Insolvency Proceeding, or
(10) any other circumstance whatsoever, including a circumstance that might be a defense available to, or a discharge of, a Grantor in respect of a First Lien Obligation or a Second Lien Obligation or holder of such Obligation.
[ALTERNATIVE SECTION FAVORABLETO SECOND LIEN LENDERS]7
[1.1 SENIORITYOF LIENS SECURING FIRST LIEN OBLIGATIONS
(a) A Lien on Collateral securing any First Lien Obligation that is included in the Capped Obligations up to but not in excess of the First Lien Cap will at all times be senior and prior in all respects to a Lien on such Collateral securing any Second Lien Obligation, and a Lien on Collateral securing any Second Lien Obligation will at all times be junior and subordinate in all respects to a Lien on such Collateral securing any First Lien Obligation that is included in the Capped Obligations up to but not in excess of the First Lien Cap so long as the Lien securing the First Lien Obligations is valid, perfected, [and unavoidable][and is not avoided in an Insolvency Proceeding].
(b) A Lien on Collateral securing any First Lien Obligation that is not included in the Capped Obligations will at all times be senior and prior in all respects to a Lien on such Collateral securing any Second Lien Obligation, and a Lien on Collateral securing any Second Lien Obligation will at all times be junior and subordinate in all respects to a Lien on such Collateral securing any First Lien Obligation that is not included in the Capped Obligations so long as the Lien securing the First Lien Obligations is valid, perfected, [and unavoidable][and is not avoided in an Insolvency Proceeding].
(c) The Lien on Collateral securing any First Lien Obligation that is included in the Capped Obligations in excess of the First Lien Cap will have the priority set forth in section 1.11, “Subordination of Liens Securing Excess First Lien Obligations.”
(d) Except as otherwise expressly provided herein, the priority of the Liens securing First Lien Obligations and the rights and obligations of the Parties will remain in full force and effect irrespective of
(1) how a Lien was acquired (whether by grant, possession, statute, operation of law, subrogation, or otherwise),
(2) the time, manner, or order of the grant, attachment, or perfection of a Lien,
(3) any conflicting provision of the U.C.C. or other applicable law,
(4) the modification of a First Lien Obligation or a Second Lien Obligation,
(5) the modification of a First Lien Loan Document or a Second Lien Loan Document,
(6) the subordination of a Lien on Collateral securing a First Lien Obligation to a Lien securing another obligation of a Grantor or other Person that is permitted under the First Lien Loan Documents as in effect on the date hereof or secures a DIP Financing deemed consented to by the Second Lien Claimholders pursuant to Section 6.1, “Use of Collateral and DIP Financing,”
(7) the exchange of a security interest in any Collateral for a security interest in other Collateral, or
(8) the commencement of an Insolvency Proceeding.]
The subordination of Liens securing Second Lien Obligations to Liens securing First Lien Obligations set forth in the preceding section 1.1 affects only the relative priority of those Liens, and does not subordinate the Second Lien Obligations in right of payment to the First Lien Obligations. Nothing in this Agreement will affect the entitlement of any Second Lien Claimholder to receive and retain required payments of interest, principal, and other amounts in respect of a Second Lien Obligation unless the receipt is expressly prohibited by, or results from the Second Lien Claimholder’s breach of, this Agreement.
1.3 FIRST LIEN OBLIGATIONS AND SECOND LIEN OBLIGATIONS
(a) First Lien Obligations means all Obligations of the Grantors under
(1) the First Lien Credit Agreement and the other First Lien Loan Documents,
(2) the guaranties by Holdings and the Guarantor Subsidiaries of the Borrower’s Obligations under the First Lien Loan Documents,
(3) any Hedge Agreement entered into with an agent or a lender (or an Affiliate thereof) under the First Lien Credit Agreement (even if the counterparty or an Affiliate of the counterparty ceases to be an agent or a lender under the First Lien Credit Agreement),
(4) any Cash Management Agreement, or
(5) any other agreement or instrument granting or providing for the perfection of a Lien securing any of the foregoing.
Notwithstanding any other provision hereof, the term “First Lien Obligations” will include accrued interest, fees, costs, and other charges incurred under the First Lien Credit Agreement and the other First Lien Loan Documents, whether incurred before or after commencement of an Insolvency Proceeding, and whether or not allowable in an Insolvency Proceeding. To the extent that any payment with respect to the First Lien Obligations (whether by or on behalf of any Grantor, as proceeds of security, enforcement of any right of set-off, or otherwise) is declared to be fraudulent or preferential in any respect, set aside, or required to be paid to a debtor in possession, trustee, receiver, or similar Person, then the obligation or part thereof originally intended to be satisfied will be deemed to be reinstated and outstanding as if such payment had not occurred.
[ALTERNATIVE DEFINITION MORE FAVORABLETO SECOND LIEN LENDERS] [(a) First Lien Obligations means all Obligations of the Grantors under
(1) the First Lien Credit Agreement and the First Lien Loan Documents,
(2) the guaranties by Holdings and the Guarantor Subsidiaries of the Borrower’s Obligations under the First Lien Loan Documents,
(3) any Hedge Agreement entered into with an agent or a lender (or an Affiliate thereof) under the First Lien Credit Agreement (even if the counterparty or an Affiliate of the counterparty ceases to be an agent or a lender under the First Lien Credit Agreement),
(4) any Cash Management Agreement, or
(5) any other agreement or instrument granting or providing for the perfection of a Lien securing any of the foregoing, except that such Obligations will only be considered First Lien Obligations to the extent
(i) they are secured by a valid, perfected, and unavoidable Lien on the Collateral in favor of First Lien Agent,9 and
(ii) a claim for such Obligations would be allowed or allowable in an Insolvency Proceeding applicable to the relevant Grantor.]
[ENDOF ALTERNATIVE DEFINITION]
(b) Second Lien Obligations means all Obligations of the Grantors under
(1) the Second Lien Credit Agreement and the other Second Lien Loan Documents,
(2) the guaranties by Holdings and the Guarantor Subsidiaries of Borrower’s Obligations under the Second Lien Loan Documents,
(3) any Hedge Agreement entered into with an agent or a lender (or an Affiliate thereof) under the Second Lien Credit Agreement if such agent or lender is not an agent or lender under the First Lien Credit Agreement (even if the counterparty or an Affiliate of the counter party ceases to be an agent or a lender under the Second Lien Credit Agreement),
(4) any agreement or instrument granting or providing for the perfection of a Lien securing any of the foregoing[, except that the aggregate principal amount of the Second Lien Obligations (other than Obligations under Hedge Agreements or Cash Management Agreements) in excess of the Second Lien Cap (as defined below) will not be Second Lien Obligations].10
Notwithstanding any other provision hereof, the term “Second Lien Obligations” will include accrued interest, fees, costs, and other charges incurred under the Second Lien Credit Agreement and the other Second Lien Loan Documents, whether incurred before or after commencement of an Insolvency Proceeding[, and whether or not allowable in an Insolvency Proceeding].
(c) The inclusion of Obligations under Hedge Agreements in the First Lien Obligations will not create in favor of the applicable counterparty any rights in connection with the management or release of any Collateral or of the Obligations of any Grantor under any First Lien Collateral Document, and the inclusion of Obligations under Hedge Agreements in the Second Lien Obligations will not create in favor of the applicable counterparty any rights in connection with the management or release of any Collateral or of the Obligations of any Grantor under any Second Lien Collateral Document.
(d) First Lien Agent and the holders of First Lien Obligations are, together, the First Lien Claimholders. Second Lien Agent and the holders of Second Lien Obligations are, together, the Second Lien Claimholders.
Capped Obligations means First Lien Obligations for the payment of principal of Loans and reimbursement obligations in respect of Letters of Credit [, Obligations under Interest Rate Protection Agreements,] and interest, premium, if any, and fees accruing or payable in respect thereof or in respect of commitments therefor.
First Lien Cap means the sum of
(a) the excess of
(1) the aggregate principal amount of First Lien Obligations (including the undrawn amount of all letters of credit constituting First Lien Obligations (Letters of Credit) and the aggregate original principal amount of any term loan that is a First Lien Obligation but excluding First Lien Obligations under Hedge Agreements) up to, but not in excess of, $_________,12 over
(2) the sum of (A) principal payments applied to term loans that are First Lien Obligations, (B) permanent reductions of revolving credit loans (and accompanying commitments) under the revolving credit facility provided for in the First Lien Credit Agreement, and (C) reimbursements of drawings under Letters of Credit constituting First Loan Obligations to the extent that any such reimbursement results in a permanent reduction of the Letter of Credit commitment amount under the First Lien Loan Documents, excluding reductions resulting from a Refinancing, plus
(b) amounts in respect of accrued, unpaid interest, fees, and premium (if any), in each case above accruing in respect of or attributable to, but only in respect of or attributable to, the aggregate principal amount of First Lien Obligations (including the undrawn amount of all Letters of Credit constituting First Lien Obligations and the aggregate original principal amount of any term loan that is a First Lien Obligation) at any one time not to exceed the amount referred to in clause (a) above,13provided that the First Lien Cap shall not apply to any First Lien Obligations other than Capped Obligations[, and plus
(c) [Obligations owing by Grantors to First Lien Claimholders under non-speculative Hedge Agreements][Obligations owing by Grantors to First Lien Claimholders under Interest Rate Protection Agreements designed to protect a Grantor against fluctuations in interest rates on an aggregate principal amount of First Lien Obligations (including the undrawn amount of all Letters of Credit constituting First Lien Obligations and the aggregate original principal amount of any term loan that is a First Lien Obligation) at any one time not to exceed the amount referred to in clause (a) above, plus amounts in respect of accrued, unpaid interest on such Obligations,][, plus
(d) the aggregate amount of all Second Lien Adequate Protection Payments to the extent paid from a DIP financing or Proceeds of Collateral14 [, and
(e) if there is an Insolvency Proceeding, $___________].15
[ALTERNATIVE DEFINITIONOF FIRST LIEN CAPFOR FIRST LIEN LOANS INVOLVINGA BORROWING BASE] [First Lien Cap16 means the excess of
(a) the sum of (1) the aggregate principal amount of First Lien Obligations (including the undrawn amount of all letters of credit constituting First Lien Obligations (Letters of Credit) but excluding for purposes of this section (a) only the principal amount of any term loan that is a First Lien Obligation and any First Lien Obligations under Hedge Agreements) up to, but not in excess of, the lesser of (A) $_________, and (B) [110%] of Availability as determined by First Lien Agent at the time each principal amount is made, issued, or otherwise incurred, plus (2) the aggregate original principal amount of any term loan that is a First Lien Obligation, over
(b) the sum of (1) the aggregate amount of all payments of the principal of any term loan included in the First Lien Obligations, and (2) the amount of all payments of revolving loans or reimbursements of drawings under Letters of Credit that permanently reduce the accompanying revolving credit commitment or letter of credit commitment amount under the First Lien Credit Agreement (excluding reductions in sub-facility commitments not accompanied by a corresponding permanent reduction in the revolving facility or letters of credit commitment amount, excluding reductions under (A) and (B) as a result of a Refinancing, and provided that the First Lien Cap shall not apply to any First Lien Obligations other than Capped Obligations)[, plus
(c) [Obligations owing by Grantors to First Lien Claimholders under non-speculative Hedge Agreements][Obligations owing by Grantors to First Lien Claimholders under Interest Rate Protection Agreements designed to protect a Grantor against fluctuations in interest rates on an aggregate principal amount of First Lien Obligations (including the undrawn amount of all Letters of Credit constituting First Lien Obligations and the aggregate original principal amount of any term loan that is a First Lien Obligation) at any one time not to exceed the amount referred to in clause (a) above, plus amounts in respect of accrued, unpaid interest on such Obligations,][, plus
(d) all Second Lien Adequate Protection Payments to the extent paid from any DIP Financing or Proceeds of Collateral]17,] [,plus
(e) if there is an Insolvency Proceeding, $_______________]].]
[ENDOF ALTERNATIVE DEFINITION]
[ALTERNATIVE DEFINITION MORE FAVORABLETO SECOND LIEN LENDERS]18
Capped Obligations means First Lien Obligations for the payment of principal of Loans and reimbursement obligations in respect of Letters of Credit, and interest, premium, if any, and fees accruing or payable in respect thereof or in respect of commitments therefor[, plus obligations under Interest Rate Protection Agreements in respect of interest on First Lien Principal Obligations not in excess of the First Lien Cap]
[First Lien Cap means the sum of
(a) the excess of (1) the outstanding amount of First Lien Principal Obligations not to exceed in the aggregate [the sum of (x)] $_______ of term Indebtedness [plus (y) the lesser of (A) [110]% of [Availability] as determined by First Lien Agent at the time each principal amount is made, issued, or otherwise incurred, and (B) $_______ of revolving credit Indebtedness included in the First Lien Obligations [(including the outstanding undrawn amount of, and reimbursement obligations in respect of, letters of credit constituting First Lien Obligations (Letters of Credit))] [(calculated, in the case of any First Lien Principal Obligations issued at a discount, at the aggregate amount due at maturity thereof)]], over (2) the aggregate amount of all repayments of term Indebtedness, and all repayments or reductions of revolving credit Indebtedness, included in the First Lien Principal Obligations[, and of reimbursement obligations under Letters of Credit,] (to the extent effected with a corresponding permanent commitment reduction under the First Lien Credit Agreement but excluding reductions as a result of a Refinancing) (First Lien Principal Obligations in excess of the First Lien Cap being the Excess First Lien Principal Obligations), plus
(b) accrued but unpaid interest, commitment, facility, utilization, and other analogous fees and, if applicable, prepayment premiums on the First Lien Principal Obligations referred to in clause (a) above [(at [rates] [interest rate margins] not in excess of __ basis points [or __ %] above the [rates] [interest rate margins] provided for under the First Lien Credit Agreement as in effect on the date hereof)], plus
(c) all fees, expenses, premium (if any), reimbursement obligations, and other amounts of a type not referred to in clause (a) or (b) above payable in respect of the amounts referred to in clauses (a) and (b) above, [plus
(d) Obligations under Hedge Agreements in respect of interest on First Lien Principal Obligations referred to in clause (a) above not to exceed $_______ in the aggregate,] in each case payable pursuant to the First Lien Loan Documents provided that the First Lien Cap shall not apply to any First Lien Obligations other than Capped Obligations.
For purposes of this definition, all payments of First Lien Principal Obligations will be deemed to be applied first to reduce the First Lien Principal Obligations referred to in clause (a)(1) above and thereafter to reduce any Excess First Lien Principal Obligations.]
[ENDOF ALTERNATIVE DEFINITION]
Any net increase in the aggregate principal amount of a loan or Letter of Credit (on a U.S. Dollar equivalent basis) after the loan is incurred or the Letter of Credit issued that is caused by a fluctuation in the exchange rate of the currency in which the loan or Letter of Credit is denominated will be ignored in determining whether the First Lien Cap has been exceeded[, except with respect to the principal amount of First Lien Obligations made, issued, or advanced after the calculation of such fluctuation in exchange rate].19
1.5 FIRST AND SECOND LIEN COLLATERAL TO BE IDENTICAL
(a) The Parties intend that the First Lien Collateral and the Second Lien Collateral be identical, except [specify any exceptions]. Accordingly, subject to the other provisions of this Agreement, the Parties will cooperate
(1) to determine the specific items included in the First Lien Collateral and the Second Lien Collateral, the steps taken to perfect the Liens thereon, and the identity of the Persons having First Lien Obligations or Second Lien Obligations, and
(2) to make the forms, documents, and agreements creating or evidencing the First Lien Collateral and Second Lien Collateral and the guaranties of the First Lien Obligations and the Second Lien Obligations materially the same, other than with respect to the first and second lien nature of the Liens.
(b) Until the Discharge of First Lien Obligations, and whether or not an Insolvency Proceeding has commenced, Borrower and Holdings will not grant, and will use their best efforts to prevent any other Person from granting, a Lien on any property
(1) in favor of a First Lien Claimholder to secure the First Lien Obligations unless Borrower, Holdings, or such other Person grants (or offers to grant with a reasonable opportunity for the Lien to be accepted) Second Lien Agent a junior Lien on such property to secure the Second Lien Obligations (however, the refusal of Second Lien Agent to accept such Lien will not prevent the First Lien Claimholder from taking the Lien), and
(2) in favor of a Second Lien Claimholder to secure the Second Lien Obligations unless Borrower, Holdings, or such other Person grants (or offers to grant with a reasonable opportunity for the Lien to be accepted) First Lien Agent a senior Lien on such property to secure the First Lien Obligations (however, the refusal of First Lien Agent to accept such Lien will not prevent the Second Lien Claimholder from taking the Lien).
(c) Subject to section 1.1, “Seniority of Liens Securing First Lien Obligations,” if a Second Lien Claimholder hereafter acquires a Lien on property to secure a Second Lien Obligation where the property is not also subject to a Lien securing the First Lien Obligations, then such Second Lien Claimholder will give First Lien Agent written notice of such Lien no later than five Business Days after acquiring such Lien. If First Lien Agent also obtains a Lien on such property or if such Second Lien Claimholder fails to provide such timely notice to First Lien Agent, then such property will be deemed to be Collateral for all purposes hereunder.
1.6 PLEDGED COLLATERAL
(a) If First Lien Agent has any Collateral in its possession or control (such Collateral being the Pledged Collateral), then, subject to section 1.1, “Seniority of Liens Securing First Lien Obligations,” and this section 1.6, First Lien Agent will possess or control the Pledged Collateral as gratuitous bailee and/or gratuitous agent for perfection for the benefit of Second Lien Agent as secured party, so as to satisfy the requirements of sections 8-106(d)(3), 8-301(a)(2), and 9-313(c) of the U.C.C. In this section 1.6, “control” has the meaning given that term in sections 8-106 and 9-314 of the U.C.C.
(b) First Lien Agent will have no obligation to any First Lien Claimholder or Second Lien Claimholder to ensure that any Pledged Collateral is genuine or owned by any of the Grantors or to preserve rights or benefits of any Person except as expressly set forth in this section 1.6. The duties or responsibilities of First Lien Agent under this section 1.6 will be limited solely to possessing or controlling the Pledged Collateral as bailee and/ or agent for perfection in accordance with this section 1.6 and delivering the Pledged Collateral upon a Discharge of First Lien Obligations as provided in subsection (d) below.
(c) Second Lien Agent hereby waives and releases First Lien Agent from all claims and liabilities arising out of First Lien Agent’s role under this section 1.6 as bailee and/or agent with respect to the Pledged Collateral [except for claims arising by reason of First Lien Agent’s gross negligence or willful misconduct].
(d) Upon the Discharge of First Lien Obligations, First Lien Agent will deliver or transfer control of any Pledged Collateral in its possession or control, together with any necessary endorsements (which endorsements will be without recourse and without any representation or warranty),
(1) first, to Second Lien Agent if any Second Lien Obligations remain outstanding, and
(2) second, to Borrower,
and will take any other action reasonably requested by Second Lien Agent (at the expense of Borrower or, upon default by Borrower in payment or reimbursement thereof, Second Lien Agent) in connection with Second Lien Agent obtaining a first-priority interest in the Pledged Collateral.
(e) If Second Lien Agent has any Pledged Collateral in its possession or control, then, subject to section 1.1, “Seniority of Liens Securing First Lien Obligations,” and this section 1.6, Second Lien Agent will possess or control the Pledged Collateral as gratuitous bailee and/or gratuitous agent for perfection for the benefit of First Lien Agent as secured party, so as to satisfy the requirements of sections 8-106(d)(3), 8-301(a)(2), and 9-313(c) of the U.C.C.
(f) Second Lien Agent will have no obligation to any First Lien Claimholder or Second Lien Claimholder to ensure that any Pledged Collateral is gen-uine or owned by any of the Grantors or to preserve rights or benefits of any Person except as expressly set forth in this section 1.6. The duties or responsibilities of Second Lien Agent under this section 1.6 will be limited solely to possessing or controlling the Pledged Collateral as bailee and/or agent for perfection in accordance with this section 1.6 and delivering the Pledged Collateral upon a Discharge of Second Lien Obligations [up to any Second Lien Cap] as provided in subsection (h) below.
(g) First Lien Agent hereby waives and releases Second Lien Agent from all claims and liabilities arising out of Second Lien Agent’s role under this section 1.6 as bailee and/or agent for perfection with respect to the Pledged Collateral [except for claims arising by reason of Second Lien Agent’s gross negligence or willful misconduct].
(h) Upon the Discharge of Second Lien Obligations up to any Second Lien Cap, Second Lien Agent will deliver or transfer control of any Pledged Collateral in its possession or control, together with any necessary endorsements (which endorsements will be without recourse and without any representation or warranty),
(1) first, to First Lien Agent if any First Lien Obligations remain outstanding, and
(2) second, to Borrower,
and will take any other action reasonably requested by First Lien Agent (at the expense of the Borrower or, upon default by the Borrower in payment or reimbursement thereof, First Lien Agent) in connection with First Lien Agent obtaining a first-priority interest in the Pledged Collateral.
1.7 LIMITATIONS ON DUTIES AND OBLIGATIONS
(a) (1) First Lien Agent will be solely responsible for perfecting and maintaining the perfection of its Liens on the First Lien Collateral, and (2) except for First Lien Agent’s obligations under section 1.6, “Pledged Collateral,” Second Lien Agent will be solely responsible for perfecting and maintaining the perfection of its Liens on the Second Lien Collateral.
(b) This Agreement is intended solely to govern the respective Lien priorities as between First Lien Claimholders and Second Lien Claimholders and does not impose on First Lien Agent or Second Lien Agent any obligations in respect of the disposition of Proceeds of foreclosure on any Collateral that would conflict with a prior perfected claim in favor of another Person, an order or decree of a court or other Governmental Authority, or applicable law.
(c) Notwithstanding any other provision of this Agreement, First Lien Agent will only be required to verify the payment of, or other satisfactory arrangements with respect to, First Lien Obligations arising under Cash Management Agreements or Hedge Agreements if First Lien Agent receives notice of such Obligations, together with any supporting documentation First Lien Agent requests, from the applicable Person.
(d) Except for obligations expressly provided for herein, the Control Agent and First Lien Claimholders will have no liability to any Second Lien Claimholder for any action by a First Lien Claimholder with respect to any First Lien Obligations or Collateral, including
(1) the maintenance, preservation, or collection of First Lien Obligations or any Collateral, and
(2) the foreclosure upon, or the sale, liquidation, maintenance, preservation, or other disposition of, any Collateral.
(e) First Lien Agent will not have by reason of this Agreement or any other document a fiduciary relationship with any First Lien Claimholder or Second Lien Claimholder. The parties recognize that the interests of First Lien Agent and Second Lien Agent may differ, and First Lien Agent may act in its own interest without taking into account the interests of any Second Lien Claimholder.
1.8 PROHIBITION ON CONTESTING LIENS; NO MARSHALING
(a) First Lien Agent will not contest in any proceeding (including an Insolvency Proceeding) the validity, enforceability, perfection, or priority of any Lien securing a Second Lien Obligation, but nothing in this section 1.8 will impair the rights of any First Lien Claimholder to enforce this Agreement, including the priority of the Liens securing the First Lien Obligations or the provisions for exercise of remedies.
(b) Second Lien Agent will not contest in any proceeding (including an Insolvency Proceeding) the validity, enforceability, perfection, or priority of any Lien securing a First Lien Obligation up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations, but nothing in this section 1.8 will impair the rights of any Second Lien Claimholder to enforce this Agreement, including the priority of the Liens securing the Second Lien Obligations or the provisions for exercise of remedies.20
(c) Until the Discharge of First Lien Obligations, Second Lien Agent will not assert any marshaling, appraisal, valuation, or other similar right that may otherwise be available to a junior secured creditor.21
[ADDITIONAL SECTIONS MORE FAVORABLETO SECOND LIEN LENDERS]
[(d) The assertion in any proceeding (including an Insolvency Proceeding) or otherwise by one Party (Party A) of the invalidity or nonperfection of the other Party’s (Party B’s) security interest as a defense to a claim or assertion by Party B against Party A for or alleging breach of this Agreement arising out of Party A’s exercise or assertion of claims or other rights or enforcement of remedies under this Agreement or any First Lien Loan Documents or Second Lien Loan Documents, as applicable, will not be a “contest” for purposes of this section 1.8.
(e) A Second Lien Claimholder who intends to assert a claim or exercise a right or remedy that would violate this Agreement but for the invalidity or nonperfection of the Lien purporting to secure First Lien Obligations will give First Lien Agent at least five Business Days’ prior notice of the contemplated action, stating the basis for the claimant’s belief that the invalidity or nonperfection exists.
(f) No First Lien Claimholder or Second Lien Claimholder will assert a claim that challenges the perfection or validity of a Lien or Indebtedness of another Claimholder that is based on allegations
(1) of fraudulent conveyance, unlawful payment of distributions to equity holders, or other like allegations, or
(2) that could be asserted with comparable merit against Liens, interests, or rights of the Person asserting the claim.]
[ENDOF ADDITIONAL SECTIONS]
1.9 CONFIRMATION OF SUBORDINATION IN SECOND LIEN COLLATERAL DOCUMENTS
Borrower will cause each Second Lien Collateral Document to include the following language (or language to similar effect approved by First Lien Agent) and any other language First Lien Agent reasonably requests to reflect the subordination of the Lien:
Notwithstanding anything herein to the contrary, the Lien and security interest granted to Second Lien Agent pursuant to this Agreement and the exercise of any right or remedy by Second Lien Agent hereunder are subject to the provisions of the Intercreditor Agreement, dated ________ (as amended, restated, supplemented, or otherwise modified from time to time, the “Intercreditor Agreement”), among _______________, as First Lien Agent, ______________, as Second Lien Agent, ______________, as Control Agent, and the Grantors (as defined therein) from time to time party thereto and other persons party or that may become party thereto from time to time. If there is a conflict between the terms of the Intercreditor Agreement and this Agreement, the terms of the Intercreditor Agreement will control.
1.10 RELEASE OF LIENS [OR GUARANTIES]
(a) If First Lien Agent releases a Lien on Collateral[, or releases a Grantor from its Obligations under its guaranty of the First Lien Obligations which guaranty is secured by a Lien on Collateral,22] in connection with:
(1) an Enforcement Action, or
(2) a Disposition of any Collateral under the First Lien Loan Documents other than pursuant to an Enforcement Action (whether or not there is an event of default under the First Lien Loan Documents),
then any Lien of Second Lien Agent on such Collateral[, and the Obligations of the Grantor under such guaranty of the Second Lien Obligations,] will be, except as otherwise provided below, automatically and simultaneously released to the same extent, and Second Lien Agent will promptly execute and deliver to First Lien Agent [or the Grantor] such termination statements, releases, and other documents as First Lien Agent [or the Grantor] requests to effectively confirm the release, provided that such release will not occur without the consent of Second Lien Agent
(x) for an Enforcement Action, as to any Collateral the net Proceeds of the disposition of which will not be applied to repay (and, to the extent applicable, to reduce permanently commitments with respect to) the First Lien Obligations, or
(y) for a Disposition, if the Disposition is prohibited by a provision of the Second Lien Credit Agreement [other than solely as the result of the existence of a default or event of default under the Second Lien Loan Documents].23
(b) Second Lien Agent hereby appoints First Lien Agent and any officer or agent of First Lien Agent, with full power of substitution, as its true and lawful attorney-in-fact with full power and authority in the place and stead of Second Lien Agent or in First Lien Agent’s own name, in First Lien Agent’s discretion to take any action and to execute any and all documents and instruments that may be reasonable and appropriate for the limited purpose of carrying out the terms of this section 1.10, including any endorsements or other instruments of transfer or release. This appointment is coupled with an interest and is irrevocable until the Discharge of First Lien Obligations or such time as this Agreement is terminated in accordance with its terms.
(c) Until the Discharge of First Lien Obligations, to the extent that First Lien Agent
(1) releases a Lien on Collateral or a Grantor from its Obligations under its guaranty, which Lien or guaranty is reinstated, or
(2) obtains a new Lien or additional guaranty from a Grantor, then Second Lien Agent will be granted a Lien on such Collateral and an additional guaranty, as the case may be, subject to section 1.1, “Seniority of Liens Securing First Lien Obligations.”
1.11 SUBORDINATION OF LIENS SECURING EXCESS FIRST LIEN OBLIGATIONS24
(a) If this Agreement provides for a Second Lien Cap, then all Liens securing Second Lien Obligations up to but not exceeding the Second Lien Cap will be senior in all respects and prior to any Lien on the Collateral securing any Excess First Lien Obligations, as defined below (but only with respect to such excess amounts), and all Liens securing any Excess First Lien Obligations will be junior and subordinate in all respects to any Lien securing a Second Lien Obligation up to but not exceeding the Second Lien Cap. All Liens securing Excess First Lien Obligations will be senior in all respects and prior to any Lien on the Collateral securing any Excess Second Lien Obligations and all Liens securing any Excess Second Lien Obligations will be junior and subordinate in all respects and prior to any Lien securing Excess First Lien Obligations. Example25: Suppose First Lien Obligations are $150 million, with a First Lien Cap of $100 million; Second Lien Obligations are $50 million, with a Second Lien Cap of $20 million; and the total Collateral has a fair market value of $175 million. Then First Lien Claimholders will have a first priority Lien on the first $100 million of Collateral (including Proceeds), Second Lien Claimholders will have a second priority Lien in the next $20 million of Collateral, First Lien Claimholders will have a third priority Lien in the remaining $55 million of Collateral up to the $50 million of Excess First Lien Obligations, and Second Lien Claimholders will have a fourth priority Lien in the remaining $5 million of Collateral. If all of the Collateral is sold at its fair market value, then the $175 million in sales proceeds will be sufficient to pay the First Lien Obligations of $150 million in full and $25 million of the Second Lien Obligations. See also section 4.1, “Application of Proceeds.”
(b) If this Agreement provides for a First Lien Cap but does not provide for a maximum limitation of the amount of the Second Lien Obligations (i.e., a Second Lien Cap), then all Liens securing Second Lien Obligations will be senior in all respects and prior to any Lien on the Collateral securing any Excess First Lien Obligations, as defined below (but only with respect to such excess amounts), and all Liens securing any Excess First Lien Obligations will be junior and subordinate in all respects to any Lien securing a Second Lien Obligation. Example: Suppose First Lien Obligations are $150 million, with a First Lien Cap of $100 million; Second Lien Obligations are $50 million with no Second Lien Cap; and the total Collateral has a fair market value of $175 million. Then First Lien Claimholders will have a first priority Lien on the first $100 million of Collateral (including Proceeds), Second Lien Claimholders will have a second priority Lien in the next $50 million of Collateral, and First Lien Claimholders will have a third priority Lien on the remaining $25 million in Collateral. If all of the Collateral is sold at its fair market value, then the $175 million in sales proceeds will be sufficient to pay $125 million of the First Lien Obligations of $150 million and the Second Lien Obligations totaling $50 million in full. See also section 4.1, “Application of Proceeds.”
(c) Excess First Lien Obligations means any First Lien Obligations that are included in the Capped Obligations and that are in excess of the First Lien Cap.
(d) With respect to the Excess First Lien Obligations and Collateral (including Proceeds),
(1) First Lien Claimholders will have rights and obligations (other than the obligations in respect to the Standstill Period) analogous to the rights and obligations Second Lien Claimholders have under this Agreement with respect to the Second Lien Obligations [not in excess of any Second Lien Cap] and the Collateral (including Proceeds), and
(2) Second Lien Claimholders will have rights and obligations analogous to the rights and obligations First Lien Claimholders have under this Agreement with respect to the First Lien Obligations that are included in the Capped Obligations and that are not in excess of the First Lien Cap, and the Collateral (including Proceeds).
(e) Nothing in this section 1.11 will waive any default or event of default under the Second Lien Loan Documents resulting from
(1) the incurrence of Obligations under the First Lien Loan Documents in excess of the First Lien Cap with respect to the Capped Obligations, or
(2) the grant of Liens under the First Lien Collateral Documents securing any such excess amounts,
or the right of Second Lien Claimholders to exercise any rights and remedies under the Second Lien Loan Documents as a result thereof.
Except as otherwise expressly provided in this section 2,
(a) the First Lien Obligations may be modified in accordance with their terms, and their aggregate amount increased or Refinanced, without notice to or consent by any Second Lien Claimholder, provided that the holders of any Refinancing Indebtedness (or their agent) bind themselves in a writing addressed to Second Lien Claimholders to the terms of this Agreement, and
(b) the Second Lien Obligations may be modified in accordance with their terms, and their aggregate amount increased or Refinanced, without notice to or consent by any First Lien Claimholder, provided that the holders of any Refinancing Indebtedness (or their agent) bind themselves in a writing addressed to First Lien Claimholders to the terms of this Agreement.
However, no such modification may alter or otherwise affect sections 1.1, “Seniority of Liens Securing First Lien Obligations,” or 1.8, “Prohibition on Contesting Liens; No Marshaling.”
Notwithstanding the preceding section 2.1, [and except as otherwise permitted as DIP Financing provided by the First Lien Lenders and deemed consented to by the Second Lien Lenders pursuant to section 6.1, “Use of Cash Collateral and DIP Financing,”] Second Lien Agent must consent to any modification to or Refinancing of the First Lien Obligations, and First Lien Agent must consent to any modification to or Refinancing of the Second Lien Obligations, that:
(a) increases the aggregate principal amount of loans, letters of credit, bankers acceptances, bonds, debentures, notes, or similar instruments or other similar extensions of credit [(but excluding obligations under Hedge Agreements or Cash Management Agreements) [and, for Second Lien Obligations, any increase resulting from payment of interest in kind permitted under the Second Lien Credit Agreement as in effect on the date hereof]] or commitments therefor beyond
(1) for the First Lien Obligations, the amount permitted by the First Lien Cap, or29
(2) for the Second Lien Obligations, the [amount theretofore permitted under the First Lien Credit Agreement][the amount permitted by the Second Lien Cap];
(b) increases
(1) the interest rate or yield, including by increasing the “applicable margin” or similar component of the interest rate or by modifying the method of computing interest, or
(2) a letter of credit, commitment, facility, utilization, or similar fee so that the combined interest rate and fees are increased by more than [_____]% per annum30 in the aggregate [at any level of pricing], but excluding increases resulting from (A) increases in an underlying reference rate not caused by a modification or Refinancing of such Obligations,
(B) accrual of interest at the “default rate” defined in the loan documents at the date hereof or, for a Refinancing, a rate that corresponds to the default rate, or
(C) application of a pricing grid set forth in the loan documents at the date hereof;
(c) for the First Lien Obligations, extends a scheduled amortization payment or the scheduled final maturity date of the First Lien Credit Agreement or a Refinancing beyond the scheduled final maturity date of the Second Lien Credit Agreement or Refinancing;
(d) for the First Lien Obligations, modifies a mandatory prepayment provision in a manner [prohibited by the Second Lien Credit Agreement][that allows amounts that would otherwise be required to be used to prepay First Lien Obligations to be retained by the Grantors to an amount greater than permitted under the Second Lien Credit Agreement];
(e) for the First Lien Obligations, increases the amount of Proceeds of dispositions of Collateral that are not required to be used to prepay First Lien Obligations and that may be retained by the Grantors to an amount greater than permitted under the Second Lien Credit Agreement;
(f) for the First Lien Obligations, modifies a covenant or event of default that directly restricts one or more Grantors from making payments under the Second Lien Loan Documents that would otherwise be permitted under the First Lien Loan Documents as in effect on the date hereof;
(g) for the Second Lien Obligations, modifies covenants, defaults, or events of default to make them materially more restrictive as to any Grantor, except for modifications to match changes made to the First Lien Obligations so as to preserve, on substantially similar economic terms, any differential that exists on the date hereof between the covenants, defaults, or events of default in the First Lien Loan Documents and the covenants, defaults, or events of default in the Second Lien Loan Documents;
(h) for the Second Lien Obligations, accelerates any date upon which a scheduled payment of principal or interest is due, or otherwise decreases the weighted average life to maturity;
(i) for the Second Lien Obligations, changes a prepayment, redemption, or defeasance provision so as to require a new payment or accelerate an existing payment Obligation; or
(j) for the Second Lien Obligations,
(1) changes a term that would result in a default under the First Lien Credit Agreement,
(2) increases the Obligations of a Grantor, or
(3) confers additional rights on a Second Lien Claimholder in a manner materially adverse to a First Lien Claimholder.
[(*) for the First Lien Obligations, increases the Advance Rate applicable to the Borrowing Base to a rate higher than the Advance Rate on the date hereof, or modifies the definitions of “Borrowing Base,” “Eligible Account,” “Eligible Inventory,” or “Reserves” in the First Lien Credit Agreement on the date hereof so as to increase the amount of credit available to Borrower, provided that First Lien Agent’s discretion to establish additional reserves, to release reserves, and to determine eligibility will not be affected or limited in any manner.]
[ENDOF ADDITIONAL SECTION]
2.3 PARALLEL MODIFICATIONS TO SECOND LIEN OBLIGATIONS31
Subject to Section 2.2, “Modifications Requiring Consent,” if a First Lien Claimholder and a Grantor modify a First Lien Collateral Document, the modification will apply automatically to any comparable provision of a Second Lien Collateral Document in which the Grantor grants a Lien on the same Collateral, without the consent of any Second Lien Claimholder and without any action by Second Lien Agent or any Grantor, provided that no such modification will
(a) remove or release Second Lien Collateral, except to the extent that (1) the release is permitted or required by section 6.1, “Use of Cash Collateral and DIP Financing ,” and (2) there is a corresponding release of First Lien Collateral,
(b) impose duties on Second Lien Agent without its consent, [or]
(c) permit other Liens on the Collateral not permitted under the terms of the Second Lien Loan Documents or section 6, “Insolvency Proceedings,” of this Agreement[, or (d) be prejudicial to the interest of Second Lien Claimholders to a greater extent than First Lien Claimholders (other than by virtue of their relative priorities and rights and obligations hereunder)].
First Lien Agent will notify Second Lien Agent, and Second Lien Agent will notify First Lien Agent, of each modification to the First Lien Obligations or Second Lien Obligations, respectively, within ten Business Days after the modification’s effective date and, if requested by the notified Agent, promptly provide copies of any documents executed and delivered in connection with the modification.
Notice and copies will not be required to the extent Borrower or a Grantor has provided the same to the Agent to be notified.
(a) Subject to subsections (b) and (c) below, until the Discharge of First Lien Obligations up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations, First Lien Claimholders will have the exclusive right to
(1) commence and maintain an Enforcement Action (including the rights to set off or credit bid their debt),
(2) subject to section 1.10, “Release of Liens or Guaranties,” make determinations regarding the release or disposition of, or restrictions with respect to, the Collateral, and
(3) otherwise enforce the rights and remedies of a secured creditor under the U.C.C. and the Bankruptcy Laws of any applicable jurisdiction, so long as any Proceeds received by First Lien Agent and other First Lien Claimholders in the aggregate in excess of those necessary to achieve Discharge of First Lien Obligations up to the First Lien Cap with respect to First Lien Obligations that are Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations are distributed in accordance with Section 4.1, “Application of Proceeds,” except as otherwise required pursuant to the U.C.C. and applicable law,34 subject to the relative priorities described in section 1.1, “Seniority of Liens Securing First Lien Obligations .”
(b) Notwithstanding the preceding section 3.1(a), Second Lien Claimholders may commence an Enforcement Action or exercise rights with respect to a Lien securing a Second Lien Obligation if
(1) [120–180] days have elapsed since Second Lien Agent notified First Lien Agent that the Second Lien Obligations were due in full as a result of acceleration or otherwise (the Standstill Period),35
(2) First Lien Claimholders are not then diligently pursuing an Enforcement Action with respect to all or a material portion of the Collateral or diligently attempting to vacate any stay or prohibition against such exercise, [and]
(3) any acceleration of the Second Lien Obligations has not been rescinded[, and
(4) [no][the applicable] Grantor is [not] then a debtor in an Insolvency Proceeding].36
(c) Notwithstanding section 3.1(a), [but subject to section 1.5, “First and Second Lien Collateral to Be Identical,”] a Second Lien Claimholder may
(1) file a proof of claim or statement of interest, vote on a plan of reorganization (including a vote to accept or reject a plan of partial or complete liquidation, reorganization, arrangement, composition, or extension), and make other filings, arguments, and motions, with respect to the Second Lien Obligations and the Collateral in any Insolvency Proceeding commenced by or against any Grantor, in each case in accordance with this Agreement,
(2) take action to create, perfect, preserve, or protect its Lien on the Collateral, so long as such actions are not adverse to the priority status in accordance with this Agreement of Liens on the Collateral securing the First Lien Obligations or First Lien Claimholders’ rights to exercise remedies,
(3) file necessary pleadings in opposition to a claim objecting to or otherwise seeking the disallowance of a Second Lien Obligation or a Lien securing the Second Lien Obligation,
(4) join (but not exercise any control over) a judicial foreclosure or Lien enforcement proceeding with respect to the Collateral initiated by First Lien Agent, to the extent that such action could not reasonably be expected to interfere materially with the Enforcement Action, but no Second Lien Claimholder may receive any Proceeds thereof unless expressly permitted herein, and
(5) bid for or purchase Collateral at any public, private, or judicial foreclosure upon such Collateral initiated by any First Lien Claimholder, or any sale of Collateral during an Insolvency Proceeding; provided that such bid may not include a “credit bid” in respect of any Second Lien Obligations unless the proceeds of such bid are otherwise sufficient to cause the Discharge of First Lien Obligations up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations.
[OPTIONAL PROVISIONS]
[(6) take or fail to take any Lien securing First Lien Obligations or any other collateral security therefor, or take or fail to take any action necessary or appropriate to ensure that any Lien is enforceable, perfected, or entitled to priority as against any other Lien or to ensure that any Proceeds of any property subject to a Lien are applied to the payment of any Obligation secured thereby, or
(7) otherwise release, discharge, or permit the lapse of any Lien securing a First Lien Obligation.]
[ENDOF OPTIONAL PROVISIONS]
(d) [Notwithstanding any provision of this Agreement] [Except as otherwise expressly set forth in this section 3.1 [and ________]],37 Second Lien Claimholders may exercise any rights and remedies that could be exercised by an unsecured creditor [other than initiating or joining in an involuntary case or proceeding under the Bankruptcy Code with respect to a Grantor][prior to the end of the Standstill Period] against a Grantor that has guaranteed or granted Liens to secure the Second Lien Obligations in accordance with the terms of the Second Lien Loan Documents and applicable law, provided that any judgment Lien obtained by a Second Lien Claimholder as a result of such exercise of rights will be included in the Second Lien Collateral and be subject to this Agreement for all purposes (including in relation to the First Lien Obligations).
[OPTIONAL PROVISION]
[(e) First Lien Agent will promptly notify Second Lien Agent of the Discharge of First Lien Obligations.]
(a) A First Lien Claimholder may take any Enforcement Action
(1) in any manner in its sole discretion in compliance with applicable law,
(2) without consultation with or the consent of any Second Lien Claimholder,
(3) regardless of whether an Insolvency Proceeding has been commenced,
(4) regardless of any provision of any Second Lien Loan Document (other than this Agreement), and
(5) regardless of whether such exercise is adverse to the interest of any Second Lien Claimholder.
(b) The rights of a First Lien Claimholder or the Control Agent to enforce any provision of this Agreement or any First Lien Loan Document will not be prejudiced or impaired by
(1) any act or failure to act of any Grantor, any other First Lien Claimholder, or the Control Agent, or
(2) noncompliance by any Person other than such First Lien Claimholder with any provision of this Agreement, any First Lien Loan Document, or any Second Lien Loan Document, regardless of any knowledge thereof that any First Lien Claimholder or the Control Agent may have or otherwise be charged with.
(c) No Second Lien Claimholder will contest, protest, object to, or take any action to hinder, and each waives any and all claims with respect to, any Enforcement Action by a First Lien Claimholder in compliance with this Agreement and applicable law.
First Lien Agent and Second Lien Agent may each demand specific performance of this Agreement, and each waives any defense based on the adequacy of a remedy at law and any other defense that might be asserted to bar the remedy of specific performance in any action brought by a Second Lien Claimholder or a First Lien Claimholder, respectively.
Until the Discharge of First Lien Obligations and the Discharge of Second Lien Obligations, and regardless of whether an Insolvency Proceeding has been commenced, Collateral or Proceeds received in connection with an Enforcement Action or subject to section 6.7, “Reorganization Securities,” received in connection with any Insolvency Proceeding involving a Grantor will be applied
(a) first, to the payment in full or cash collateralization of all First Lien Obligations that are not Excess First Lien Obligations,
(b) second, to the payment in full of the Second Lien Obligations [that are not Excess Second Lien Obligations],
(c) third, to the payment in full of any Excess First Lien Obligations[,
(d) fourth, to the payment in full of any Excess Second Lien Obligations],42 and
(e) fifth, to the applicable Grantor or as otherwise required by applicable law.
in each case as specified in the First Lien Documents or the Second Lien Documents, or as otherwise determined by the First Lien Claimholders or the Second Lien Claimholders, as applicable.
[Notwithstanding the foregoing, until the Discharge of First Lien Obligations up to the First Lien Cap with respect to First Lien Obligations that are capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations, any non-cash Collateral or non-cash Proceeds will be held by First Lien Agent as Collateral unless the failure to apply such amounts as set forth above would be commercially unreasonable.43]
First Lien Agent and Second Lien Agent will be named as additional insureds and/or loss payees, as applicable, under any insurance policies maintained by any Grantor. Until the Discharge of First Lien Obligations up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations, and subject to the rights of the Grantors under the First Lien Loan Documents,
(a) First Lien Agent will have the exclusive right to adjust settlement for any losses covered by an insurance policy covering the Collateral, and to approve an award granted in a condemnation or similar proceeding (or a deed in lieu of condemnation) affecting the Collateral, and
(b) all Proceeds of such policy, award, or deed will be applied in the order provided in section 4.1, “Application of Proceeds,” and thereafter, if no Second Lien Obligations are outstanding, to the payment to the owner of the subject property, such other Person as may be entitled thereto, or as a court of competent jurisdiction may otherwise direct.
Until the Discharge of First Lien Obligations up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations, whether or not an Insolvency Proceeding has commenced, Collateral or Proceeds (including insurance proceeds or property or Proceeds subject to Liens referred to in paragraph (d) of section 1.5, “First and Second Lien Collateral to Be Identical”) received by a Second Lien Claimholder in connection with an Enforcement Action or, subject to section 6.7, “Reorganization Securities,” received in connection with any Insolvency Proceeding, will be
(a) segregated and held in trust, and
(b) promptly paid over to First Lien Agent in the form received, with any necessary endorsements or as a court of competent jurisdiction may otherwise direct. First Lien Agent is authorized to make such endorsements as agent for the Second Lien Claimholder. This authorization is coupled with an interest and is irrevocable until the Discharge of First Lien Obligations.
4.4 REFINANCING AFTER DISCHARGE OF FIRST LIEN OBLIGATIONS46
If, after the Discharge of First Lien Obligations, Borrower issues or incurs Refinancing47 of the First Lien Obligations that is permitted to be incurred under the Second Lien Loan Documents, then the First Lien Obligations will automatically be deemed not to have been discharged for all purposes of this Agreement (except for actions taken as a result of the initial Discharge of First Lien Obligations). Upon Second Lien Agent’s receipt of a notice stating that Borrower has entered into a new First Lien Loan Document and identifying the new First Lien Agent (the New Agent),
(a) the Obligations under such Refinancing indebtedness will automatically be treated as First Lien Obligations for all purposes of this Agreement, including for purposes of the Lien priorities and rights in respect of Collateral set forth herein,
(b) the New Agent under such new First Lien Loan Documents will be First Lien Agent for all purposes of this Agreement,
(c) Second Lien Agent will promptly
(1) enter into such documents and agreements (including amendments or supplements to this Agreement) as Borrower or the New Agent reasonably requests to provide to the New Agent the rights contemplated hereby, in each case consistent in all material respects with the terms of this Agreement, and
(2) deliver to the New Agent any Pledged Collateral held by it together with any necessary endorsements (or otherwise allow the New Agent to obtain control of such Pledged Collateral), and
(d) the New Agent will promptly agree in a writing addressed to Second Lien Agent to be bound by the terms of this Agreement.
If any Obligations under the new First Lien Loan Documents are secured by Collateral that does not also secure the Second Lien Obligations, then the Grantors will cause the Second Lien Obligations to be secured at such time by a second priority Lien on such Collateral to the same extent provided in the First Lien Collateral Documents and this Agreement.
(1) an acceleration of the First Lien Obligations in accordance with the First Lien Credit Agreement,
(2) a payment default under the First Lien Credit Agreement that is not cured, or waived by First Lien Claimholders, within sixty days of its occurrence, or
(3) the commencement of an Insolvency Proceeding,49 (each a Purchase Event), then Second Lien Claimholders may purchase all, but not less than all, of the First Lien Obligations that are included in the Capped Obligations up to but not in excess of the First Lien Cap plus all, but not less than all, of the First Lien Obligations that are not included in the Capped Obligations (the Purchase Obligations). Such purchase will
(A) include all principal of, and all accrued and unpaid interest, fees, and expenses in respect of, all First Lien Obligations outstanding at the time of purchase that are included in the Capped Obligations up to but not in excess of the First Lien Cap plus all principal of, and all accrued and unpaid interest, fees, and expenses in respect of, all First Lien Obligations that are not included in the Capped Obligations,
(B) be made pursuant to an Assignment Agreement [(as such term is defined in the First Lien Credit Agreement)][substantially in the form attached hereto as Exhibit A (the bracketed provisions therein to be appropriately modified to reflect the terms of the First Lien Documents and the outstanding First Lien Obligations)][in form and substance reasonably satisfactory to, and prepared by counsel for, First Lien Agent (with the cost of such counsel to be paid by the Purchasing Creditors)], whereby Second Lien Claimholders will assume all funding commitments and Obligations of First Lien Claimholders under the First Lien Loan Documents, and
(C) otherwise be subject to the terms and conditions of this section 5.
Each First Lien Claimholder will retain all rights to indemnification provided in the relevant First Lien Loan Documents for all claims and other amounts relating to periods prior to the purchase of the First Lien Obligations pursuant to this section 5.
(b) First Lien Claimholders will not commence an Enforcement Action while Second Lien Claimholders have a right to purchase the First Lien Obligations under this section 5.50
5.2 PURCHASE NOTICE
(a) Second Lien Claimholders desiring to purchase all of the Purchase Obligations (the Purchasing Creditors) will deliver a Purchase Notice to First Lien Agent that
(1) is signed by the Purchasing Creditors,
(2) states that it is a Purchase Notice under this section 5,
(3) states that each Purchasing Creditor is irrevocably electing to purchase, in accordance with this section 5, the percentage of all of the Purchase Obligations51 stated in the Purchase Notice for that Purchasing Creditor, which percentages must aggregate exactly 100% for all Purchasing Creditors,52
(4) represents and warrants that the Purchase Notice is in conformity with the Second Lien Loan Documents and any other binding agreement among Second Lien Claimholders, and
(5) designates a Purchase Date on which the purchase will occur, that is (x) at least five but not more than [fifteen] Business Days after First Lien Agent’s receipt of the Purchase Notice, and (y) not more than sixty days after the Purchase Event.
A Purchase Notice will be ineffective if it is received by First Lien Agent after the occurrence giving rise to the Purchase Event is waived, cured, or otherwise ceases to exist.
[ALTERNATIVE SUBSECTION FAVORABLETO SECOND LIEN LENDERS]
[(5) designates a Purchase Date on which the purchase will occur that is at least five but not more than [fifteen] Business Days after First Lien Agent’s receipt of the Purchase Notice.
The Purchase Notice must be received by First Lien Agent during the period following the occurrence of, and during the continuance of, a Purchase Event.]
[ENDOF ALTERNATIVE SUBSECTION]
(b) Upon First Lien Agent’s receipt of an effective Purchase Notice conforming to this section 5.2, the Purchasing Creditors will be irrevocably obligated to purchase, and the First Lien Creditors will be irrevocably obligated to sell, the First Lien Obligations in accordance with and subject to this section 5.
5.3 PURCHASE PRICE
The Purchase Price for the Purchase Obligations will equal the sum of
(a) the principal amount of all loans, advances, or similar extensions of credit included in the Purchase Obligations (including unreimbursed amounts drawn on Letters of Credit, but excluding the undrawn amount of outstanding Letters of Credit), and all accrued and unpaid interest thereon through the Purchase Date ([including][excluding] any acceleration prepayment penalties or premiums53),
(b) the net aggregate amount then owing to counterparties under Hedge Agreements that are First Lien Loan Documents, including all amounts owing to the counterparties as a result of the termination (or early termination) thereof to the extent not allocable to Excess First Lien Obligations,
(c) the net aggregate amount then owing to creditors under Cash Management Agreements that are First Lien Loan Documents, including all amounts owing to the creditors as a result of the termination (or early termination) thereof to the extent not allocable to Excess First Lien Obligations, and
(d) all accrued and unpaid fees, expenses, [indemnities,] and other amounts owed to the First Lien Creditors under the First Lien Loan Documents on the Purchase Date to the extent not allocable to Excess First Lien Obligations.
5.4 PURCHASE CLOSING
On the Purchase Date,
(a) the Purchasing Creditors and First Lien Agent will execute and deliver the Assignment Agreement,
(b) the Purchasing Creditors will pay the Purchase Price to First Lien Agent by wire transfer of immediately available funds,
(c) the Purchasing Creditors will deposit with First Lien Agent or its designee by wire transfer of immediately available funds, [105%] of the aggregate undrawn amount of all then outstanding Letters of Credit and the aggregate facing and similar fees that will accrue thereon through the stated maturity of the Letters of Credit (assuming no drawings thereon before stated maturity), and
(d) Second Lien Agent will execute and deliver to First Lien Agent a waiver of all claims arising out of this Agreement and the transactions contemplated hereby as a result of exercising the purchase option contemplated by this section 5.
5.5 EXCESS FIRST LIEN OBLIGATIONS NOT PURCHASED
Any Excess First Lien Obligations will, after the closing of the purchase of the First Lien Obligations in accordance with this section 5, remain Excess First Lien Obligations for all purposes of this Agreement.54
5.6 ACTIONS AFTER PURCHASE CLOSING
(a) Promptly after the closing of the purchase of all Purchase Obligations, First Lien Agent will distribute the Purchase Price to First Lien Claimholders in accordance with the terms of the First Lien Loan Documents.
(b) After the closing of the purchase of all Purchase Obligations, the Purchasing Creditors may request that First Lien Agent immediately resign as administrative agent and, if applicable, collateral agent under the First Lien Loan Documents, and First Lien Agent will immediately resign if so requested. Upon such resignation, a new administrative agent and, if applicable, a new collateral agent will be elected or appointed in accordance with the First Lien Loan Documents.
(c) First Lien Agent will apply cash collateral to reimburse Letter of Credit issuers for drawings under Letters of Credit, any customary fees charged by the issuer in connection with such draws, and facing or similar fees. After giving effect to each such payment, any remaining cash collateral that exceeds [105%] of the sum of the aggregate undrawn amount of all then outstanding Letters of Credit and the aggregate facing and similar fees that will accrue thereon through the stated maturity of such Letters of Credit (assuming no drawings thereon before stated maturity) will be returned to the Purchasing Creditors (as their interests appear). When all Letters of Credit have been cancelled with the consent of the beneficiary thereof, expired, or been fully drawn, and after all payments from the account described above have been made, any remaining cash collateral will be returned to the Purchasing Creditors, as their interests appear.
(d) If for any reason other than the gross negligence or willful misconduct of First Lien Agent, the cash collateral is less than the amount owing with respect to a Letter of Credit described in the preceding subsection (c), then the Purchasing Creditors will, in proportion to their interests, promptly reimburse First Lien Agent (who will then pay the issuing bank) the amount of the deficiency.
5.7 NO RECOURSE OR WARRANTIES; DEFAULTING CREDITORS
(a) First Lien Claimholders will be entitled to rely on the statements, representations, and warranties in the Purchase Notice without investigation, even if First Lien Claimholders are notified that any such statement, representation, or warranty is not or may not be true.
(b) The purchase and sale of the First Lien Obligations under this section 5 will be without recourse and without representation or warranty of any kind by First Lien Claimholders, except that First Lien Claimholders represent and warrant that on the Purchase Date, immediately before giving effect to the purchase,
(1) the principal of and accrued and unpaid interest on the First Lien Obligations, and the fees and expenses thereof, are as stated in the Assignment Agreement,
(2) First Lien Claimholders own the First Lien Obligations free and clear of any Liens (other than participation interests not prohibited by the First Lien Credit Agreement, in which case the Purchase Price will be appropriately adjusted so that the Purchasing Creditors do not pay amounts represented by participation interests), and
(3) each First Lien Claimholder has the full right and power to assign its First Lien Obligations and such assignment has been duly authorized by all necessary corporate action by such First Lien Claimholder.
[ALTERNATIVE SECTION FAVORABLETO FIRST LIEN LENDERS]
[(b) The purchase and sale of the Purchase Obligations under this section 5 will be without recourse and without any representation or warranty whatsoever by First Lien Claimholders, except that First Lien Claimholders represent and warrant that on the Purchase Date, immediately before giving effect to the purchase, First Lien Claimholders
(1) own the Purchase Obligations free and clear of all Liens (other than participation interests not prohibited by the First Lien Credit Agreement, in which case the Purchase Price will be appropriately adjusted so that the Purchasing Creditors do not pay amounts represented by participation interest), and
(2) have the right to convey whatever claims and interests they may have in respect of the Purchase Obligations.]
[ENDOF ALTERNATIVE SECTION]
(c) The obligations of First Lien Claimholders to sell their respective Purchase Obligations under this section 5 are several and not joint and several. If a First Lien Claimholder (a Defaulting Creditor) breaches its obligation to sell its Purchase Obligations under this section 5, no other First Lien Claimholder will be obligated to purchase the Defaulting Creditor’s Purchase Obligations for resale to the holders of Second Lien Obligations. A First Lien Claimholder that complies with this section 5 will not be in default of this Agreement or otherwise be deemed liable for any action or inaction of any Defaulting Creditor, provided that nothing in this subsection (c) will require the Purchasing Creditors to purchase less than all of the Purchase Obligations.
(d) Borrower and Holdings irrevocably consent, and will use their best efforts to obtain any necessary consent of each other Grantor, to any assignment effected to one or more Purchasing Creditors pursuant to this section 5.
(a) Until the Discharge of First Lien Obligations up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations, if an Insolvency Proceeding has commenced, Second Lien Agent, as holder of a Lien on the Collateral, will not contest, protest, or object to, and each Second Lien Claimholder will be deemed to have consented to,
(1) any use, sale, or lease of “cash collateral” (as defined in section 363(a) of the Bankruptcy Code), and
(2) Borrower or any other Grantor obtaining DIP Financing if First Lien Agent consents57 in writing to such use, sale, or lease, or DIP Financing, provided that
(A) Second Lien Agent otherwise retains58 its Lien on the Collateral, [and]
(B) any Second Lien Claimholder may seek adequate protection as permitted by section 6.4, “Adequate Protection,” and, if such adequate protection is not granted, Second Lien Agent may object under this section 6.1 solely on such basis[.][,]
[(C) after taking into account the use of cash collateral and the principal amount of any DIP Financing (after giving effect to any Refinancing of First Lien Obligations) on any date, the sum of the then outstanding principal amount of any First Lien Obligations and any DIP Financing does not exceed the First Lien Cap59 on such date,60
(D) such DIP Financing and the Liens securing such DIP Financing are pari passu with or superior in priority to the then outstanding First Lien Obligations and the Liens securing such First Lien Obligations,61 and
(E) the interest rate, fees, advance rates, lending limits, and sublimits are commercially reasonable under the circumstances.62]
[Upon written request from First Lien Agent, Second Lien Agent, as holder of a Lien on the Collateral, will join any objection by First Lien Agent to the use, sale, or lease of cash collateral for any purpose other than adequate protection payments to Second Lien Claimholders.]63
[(b) Any customary “carve-out” or other similar administrative priority expense or claim consented to in writing by First Lien Agent to be paid prior to the Discharge of First Lien Obligations up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations will be deemed for purposes of section 6.1(a)
(1) to be a use of cash collateral, and
(2) [not to be] a principal amount of DIP Financing at the time of such consent.]64 [No Second Lien Claimholder may provide DIP Financing to a Borrower or other Grantor secured by Liens equal or senior in priority to the Liens securing any First Lien Obligations[, provided that if no First Lien Claimholder offers to provide DIP Financing to the extent permitted under section 6.1(a) on or before the date of the hearing to approve DIP Financing, then a Second Lien Claimholder may seek to provide such DIP Financing secured by Liens equal or senior in priority to the Liens securing any First Lien Obligations, and First Lien Claimholders may object thereto].]65
[(c) Nothing in this section 6.1 limits or impairs the right of Second Lien Agent to object to any motion regarding DIP Financing (including a DIP Financing proposed by one or more First Lien Claimholders) or cash collateral to the extent that
(1) the objection could be asserted in an Insolvency Proceeding by unsecured creditors generally[, is consistent with the other terms of this section 6.1, and is not based on the status of any Second Lien Claimholder as holder of a Lien], or
(2) the DIP Financing does not meet the requirements of section 6.1(a).]66
Second Lien Agent, as holder of a Lien on the Collateral and on behalf of the Second Lien Claimholders, will not contest, protest, or object, and will be deemed to have consented pursuant to section 363(f) of the Bankruptcy Code, to a Disposition of Collateral free and clear of its Liens or other interests under section 363 of the Bankruptcy Code if First Lien Agent consents in writing to the Disposition, provided that
(a) either (i) pursuant to court order, the Liens of Second Lien Claimholders attach to the net Proceeds of the Disposition with the same priority and validity as the Liens held by Second Lien Claimholders on such Collateral, and the Liens remain subject to the terms of this Agreement, or (ii) the Proceeds of a Disposition of Collateral received by First Lien Agent in excess of those necessary to achieve the Discharge of First Lien Obligations, up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations, are distributed in accordance with the U.C.C. and applicable law[,][.]
[(b) the net cash Proceeds of the Disposition that are applied to First Lien Obligations permanently reduce the First Lien Obligations pursuant to section 4.1, “Application of Proceeds,” or if not so applied, are subject to the rights of Second Lien Agent to object to any further use notwithstanding section 6.1(a),68 and
(c) Second Lien Claimholders [may][are not deemed to have waived any rights to]69 credit bid on the Collateral in any such Disposition in accordance with section 363(k) of the Bankruptcy Code.70]
Notwithstanding the preceding sentence, Second Lien Claimholders may object to any Disposition of Collateral that could be raised in an Insolvency Proceeding by unsecured creditors generally [so long as not otherwise inconsistent with the terms of this Agreement].71
[Upon First Lien Agent’s request, Second Lien Agent, solely in its capacity as holder of a Lien on Collateral, will join any objection asserted by First Lien Agent to any Disposition of Collateral during an Insolvency Proceeding.]72
Until the Discharge of First Lien Obligations up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations, no Second Lien Claimholder may[, during any Standstill Period,]74 seek relief from the automatic stay or any other stay in an Insolvency Proceeding in respect of the Collateral without First Lien Agent’s prior written consent [or oppose any request by First Lien Agent for relief from such stay]75 [, except to the extent that
[a First Lien Claimholder (in such capacity)] [First Lien Agent] seeks or obtains relief from or modification of such stay[, or a motion for adequate protection permitted under section 6.4, “Adequate Protection,” is denied by the Bankruptcy Court]].76
(a) No Second Lien Claimholder will contest, protest, or object to
(1) a request by a First Lien Claimholder for “adequate protection” under any Bankruptcy Law, or
(2) an objection by a First Lien Claimholder to a motion, relief, action, or proceeding based on a First Lien Claimholder claiming a lack of adequate protection.
(b) Notwithstanding the preceding section 6.4(a), in an Insolvency Proceeding:
(1) Except as permitted in this section 6.4, no Second Lien Claimholders may seek or request adequate protection or relief from the automatic stay imposed by section 362 of the Bankruptcy Code [or other relief].78
(2) [If a First Lien Claimholder is granted adequate protection in the form of additional or replacement Collateral in connection with a motion described in section 6.1,79 “Use of Cash Collateral and DIP Financing,” then] Second Lien Agent may seek or request adequate protection in the form of a Lien on [such] additional or replacement Collateral, which Lien will be subordinated to the Liens securing the First Lien Obligations and any DIP Financing (and all related Obligations) on the same basis as the other Liens securing the Second Lien Obligations are subordinated to the Liens securing First Lien Obligations under this Agreement.
(3) Any claim by a Second Lien Claimholder under section 507(b) of the Bankruptcy Code will be subordinate in right of payment to any claim of First Lien Claimholders under section 507(b) of the Bankruptcy Code and any payment thereof will be deemed to be Proceeds of Collateral[, provided that, subject to section 6.7, “Reorganization Securities,” Second Lien Claimholders will be deemed to have agreed pursuant to section 1129(a)(9) of the Bankruptcy Code that such section 507(b) claims may be paid under a plan of reorganization in any form having a value on the effective date of such plan equal to the allowed amount of such claims80].
[(4) So long as First Lien Agent is receiving payment in cash of [all] Post-Petition Claims [consisting of all interest at the applicable rate under the First Lien Loan Documents], Second Lien Agent may seek and, subject to the terms hereof, retain payments of Post-Petition Claims [consisting of interest at the [non-default][applicable] rate]81 under the Second Lien Loan Documents (Second Lien Adequate Protection Payments). If a Second Lien Claimholder receives Second Lien Adequate Protection Payments before the Discharge of First Lien Obligations up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations, then upon the effective date of any plan or the conclusion or dismissal of any Insolvency Proceeding, the Second Lien Claimholder will pay over to First Lien Agent pursuant to section 4.1, “Application of Proceeds,” an amount equal to the lesser of (i) the Second Lien Adequate Protection Payments received by the Second Lien Claimholder and (ii) the amount necessary to Discharge the First Lien Obligations. [Notwithstanding anything herein to the contrary, First Lien Claimholders will [not] be deemed to have consented to, and expressly [waive][retain] their rights to object to, the payment of Second Lien Adequate Protection Payments.82]]
6.5 FIRST LIEN OBJECTIONS TO SECOND LIEN ACTIONS83
Subject to section 3.1, “Who May Exercise Remedies,” nothing in this section 6 limits a First Lien Claimholder from objecting in an Insolvency Proceeding or otherwise to any action taken by a Second Lien Claimholder, including the Second Lien Claimholder’s seeking adequate protection [or asserting any of its rights and remedies under the Second Lien Loan Documents or otherwise].
[ALTERNATIVE SECTION FAVORABLETO SECOND LIEN LENDERS]84 [6.5 FIRST LIEN OBJECTIONSTO SECOND LIEN ACTIONS
Subject to section 3.1, “Who May Exercise Remedies,” nothing in this section 6 limits a First Lien Claimholder from objecting in an Insolvency Proceeding or otherwise to any action taken by a Second Lien Claimholder, including the Second Lien Claimholder’s seeking adequate protection (other than adequate protection permitted under section 6.4(b)) or asserting any of its rights and remedies under the Second Lien Loan Documents or otherwise.]
If a First Lien Claimholder or a Second Lien Claimholder receives payment or property on account of a First Lien Obligation or Second Lien Obligation, and the payment is subsequently invalidated, avoided, declared to be fraudulent or preferential, set aside, or otherwise required to be transferred to a trustee, receiver, or the estate of Borrower or other Grantor (a Recovery), then, to the extent of the Recovery, the First Lien Obligations or Second Lien Obligations intended to have been satisfied by the payment will be reinstated as First Lien Obligations or Second Lien Obligations, as applicable, on the date of the Recovery, and no Discharge of First Lien Obligations or Discharge of Second Lien Obligations, as applicable, will be deemed to have occurred for all purposes hereunder. If this Agreement is terminated prior to a Recovery, this Agreement will be reinstated in full force and effect, and such prior termination will not diminish, release, discharge, impair, or otherwise affect the obligations of the Parties from the date of reinstatement. [Upon any such reinstatement of First Lien Obligations, each Second Lien Claimholder will deliver to First Lien Agent any Collateral or Proceeds thereof received between the Discharge of First Lien Obligations and their reinstatement in accordance with section 4.3, “Payment Turnover.”]86 [No Second Lien Claimholder may benefit from a Recovery, and any distribution made to a Second Lien Claimholder as a result of a Recovery will be paid over to First Lien Agent for application to the First Lien Obligations in accordance with section 4.1, “Application of Proceeds.”]87
Nothing in this Agreement prohibits or limits the right of a Second Lien Claimholder to receive and retain any debt or equity securities that are issued by a reorganized debtor pursuant to a plan of reorganization or similar dispositive restructuring plan in connection with an Insolvency Proceeding[, provided that any debt securities received by a Second Lien Claimholder on account of a Second Lien Obligation that constitutes a “secured claim” within the meaning of section 506(b) of the Bankruptcy Code will be paid over or otherwise transferred to First Lien Agent for application in accordance with section 4.1, “Application of Proceeds,” unless such distribution is made under a plan that is consented to by the affirmative vote of all classes composed of the secured claims of First Lien Claimholders].
If, in an Insolvency Proceeding, debt Obligations of the reorganized debtor secured by Liens upon any property of the reorganized debtor are distributed pursuant to a plan of reorganization or similar dispositive restructuring plan, both on account of First Lien Obligations and on account of Second Lien Obligations, then, to the extent the debt Obligations distributed on account of the First Lien Obligations and on account of the Second Lien Obligations are secured by Liens upon the same property, the provisions of this Agreement will survive the distribution of such debt Obligations pursuant to such plan and will apply with like effect to the Liens securing such debt Obligations.89
(a) No Second Lien Claimholder may oppose or seek to challenge any claim by a First Lien Claimholder for allowance or payment in any Insolvency Proceeding of First Lien Obligations consisting of Post-Petition Claims.91
(b) No First Lien Claimholder may oppose or seek to challenge in an Insolvency Proceeding a claim by a Second Lien Claimholder for allowance [and any payment permitted under section 6.4, “Adequate Protection,”] of Second Lien Obligations consisting of Post-Petition Claims.
(a) any claim it may hereafter have against any First Lien Claimholder arising out of any cash collateral or financing arrangement or out of any grant of a security interest in connection with the Collateral in an Insolvency Proceeding, so long as such actions are not in express contravention of the terms of this Agreement; [and]
(b) any right to assert or enforce any claim under section 506(c) or 552 of the Bankruptcy Code as against First Lien Claimholders or any of the Collateral to the extent securing the First Lien Obligations93[; and
(c) solely in its capacity as a holder of a Lien on Collateral, any claim or cause of action that any Grantor may have against any First Lien Claimholder, except to the extent arising from a breach by such First Lien Claimholder of the provisions of this Agreement].
6.10 SEPARATE GRANTS OF SECURITY AND SEPARATE CLASSIFICATION94
The grants of Liens pursuant to the First Lien Collateral Documents and the Second Lien Collateral Documents constitute two separate and distinct grants. Because of, among other things, their differing rights in the Collateral, the Second Lien Obligations, to the extent deemed to be “secured claims” within the meaning of section 506(b) of the Bankruptcy Code, are fundamentally different from the First Lien Obligations and must be separately classified in any plan of reorganization in an Insolvency Proceeding. Second Lien Claimholders will not seek in an Insolvency Proceeding to be treated as part of the same class of creditors as First Lien Claimholders and will not oppose or contest any pleading by First Lien Claimholders seeking separate classification of their respective secured claims.
The Parties acknowledge that this Agreement is a “subordination agreement” under section 510(a) of the Bankruptcy Code, which will be effective before, during, and after the commencement of an Insolvency Proceeding. All references in this Agreement to any Grantor will include such Person as a debtor-in-possession and any receiver or trustee for such Person in an Insolvency Proceeding.
7 MISCELLANEOUS
7.1 CONFLICTS
If this Agreement conflicts with the First Lien Loan Documents or the Second Lien Loan Documents, this Agreement will control.
7.2 NO WAIVERS; REMEDIES CUMULATIVE; INTEGRATION
A Party’s failure or delay in exercising a right under this Agreement will not waive the right, nor will a Party’s single or partial exercise of a right preclude it from any other or further exercise of that or any other right.
The rights and remedies provided in this Agreement will be cumulative and not exclusive of other rights or remedies provided by law.
This Agreement constitutes the entire agreement between the Parties and supersedes all prior agreements, oral or written, relating to its subject matter.
7.3 EFFECTIVENESS; SEVERABILITY; TERMINATION
This Agreement will become effective when executed and delivered by the Parties.
Each First Lien Claimholder and each Second Lien Claimholder waives any right it may have under applicable law to revoke this Agreement or any provision thereunder or consent by it thereto.
This Agreement will survive, and continue in full force and effect, in any Insolvency Proceeding.
If a provision of this Agreement is prohibited or unenforceable in a jurisdiction, the prohibition or unenforceability will not invalidate the remaining provisions hereof, or invalidate or render unenforceable that provision in any other jurisdiction.
Subject to sections 1.6(d) and 1.6(g), “Pledged Collateral,” 4.1, “Application of Proceeds,” 4.4, “Refinancing After Discharge of First Lien Obligations,” 6.5, “First Lien Objections to Second Lien Actions,” and 6.6, “Avoidance; Reinstatement of Obligations,” this Agreement will terminate and be of no further force and effect
(a) for First Lien Claimholders, upon the Discharge of First Lien Obligations, and
(b) for Second Lien Claimholders, upon the Discharge of Second Lien Obligations.
7.4 MODIFICATIONS OF THIS AGREEMENT
A modification or waiver of any provision of this Agreement will only be effective if in writing signed on behalf of each Party or its authorized agent, and a waiver will be a waiver only for the specific instance involved and will not impair the rights of the Parties making the waiver or the obligations of the other Parties to such Party in any other respect or at any other time. Notwithstanding the foregoing, neither Borrower nor Holdings will have a right to consent to or approve a modification of this Agreement except to the extent its rights are directly affected.
7.5 INFORMATION CONCERNING FINANCIAL CONDITION OF BORROWER AND ITS SUBSIDIARIES
The Control Agent, First Lien Claimholders, and Second Lien Claimholders will each be responsible for keeping themselves informed of
(a) the financial condition of the Grantors, and
(b) all other circumstances bearing upon the risk of nonpayment of the First Lien Obligations or the Second Lien Obligations.
Neither the Control Agent nor any First Lien Claimholder will have any duty to advise any Second Lien Claimholder, and no Second Lien Claimholder will have any duty to advise the Control Agent or any first Lien Claimholder, of information known to it regarding any such condition or circumstances or otherwise.
If the Control Agent or a First Lien Claimholder provides any such information to a Second Lien Claimholder, or a Second Lien Claimholder provides any such information to the Control Agent or any First Lien Claimholder, the Control Agent or the First Lien Claimholder, or Second Lien Claimholder, respectively, will have no obligation to:
(a) make, and it does not make, any express or implied representation or warranty, including as to accuracy, completeness, truthfulness, or validity,
(b) provide additional information on that or any subsequent occasion,
(c) undertake any investigation, or
(d) disclose information that, pursuant to applicable law or accepted or reasonable commercial finance practices, it desires or is required to maintain as confidential.
7.6 NO RELIANCE
(a) First Lien Agent acknowledges that it and each other First Lien Claimholder has, independently and without reliance on any Second Lien Claimholder, and based on documents and information the First Lien Claimholder deemed appropriate, made its own credit analysis and decision to enter into the First Lien Loan Documents and this Agreement, and will continue to make its own credit decisions in taking or not taking any action under the First Lien Loan Documents or this Agreement.
(b) Second Lien Agent acknowledges that it and each other Second Lien Claimholder has, independently and without reliance on any First Lien Claimholder, and based on documents and information the Second Lien Claimholder deemed appropriate, made its own credit analysis and decision to enter into the Second Lien Loan Documents and this Agreement, and will continue to make its own credit decisions in taking or not taking any action under the Second Lien Loan Documents or this Agreement.
7.7 NO WARRANTIES; INDEPENDENT ACTION
(a) Except as otherwise expressly provided herein,
(1) no Second Lien Claimholder has made any express or implied representation or warranty to any First Lien Claimholder, including with respect to the execution, validity, legality, completeness, collectability, or enforceability of any Second Lien Loan Document, the ownership of any Collateral, or the perfection or priority of any Liens thereon, and
(2) each Second Lien Claimholder may manage and supervise its loans and extensions of credit under the Second Lien Loan Documents in accordance with applicable law and as it may otherwise, in its sole discretion, deem appropriate.
(b) Except as otherwise expressly provided herein,
(1) no First Lien Claimholder has made any express or implied representation or warranty to any Second Lien Claimholder, including with respect to the execution, validity, legality, completeness, collectability, or enforceability of any First Lien Loan Document, the ownership of any Collateral, or the perfection or priority of any Liens thereon, and
(2) each First Lien Claimholder may manage and supervise its loans and extensions of credit under the First Lien Loan Documents in accordance with law and as it may otherwise, in its sole discretion, deem appropriate.
No Second Lien Claimholder will have any duty to any First Lien Claimholder, and no First Lien Claimholder will have any duty to any Second Lien Claimholder, to act or refrain from acting in a manner that allows, or results in, the occurrence or continuance of an event of default or default under any agreements with Borrower or any other Grantor (including the First Lien Loan Documents and the Second Lien Loan Documents), regardless of any knowledge thereof that it may have or be charged with.
7.8 SUBROGATION
If a Second Lien Claimholder pays or distributes cash, property, or other assets to a First Lien Claimholder under this Agreement, the Second Lien Claimholder will be subrogated to the rights of the First Lien Claimholder with respect to the value of the payment or distribution, provided that the Second Lien Claimholder waives such right of subrogation until the Discharge of First Lien Obligations up to the First Lien Cap with respect to the Capped Obligations and in their entirety with respect to First Lien Obligations that are not Capped Obligations. Such payment or distribution will not reduce the Second Lien Obligations.
7.9 APPLICABLE LAW; JURISDICTION; SERVICE
This Agreement, and any claim or controversy relating to the subject matter hereof, will be governed by the law of the [State of New York].
All judicial proceedings brought against a Party arising out of or relating hereto may be brought in any state or federal court of competent jurisdiction in [the state, county, and city of New York]. Each Party irrevocably
(a) accepts generally and unconditionally the nonexclusive personal jurisdiction and venue of such courts,
(b) waives any defense of forum non conveniens, and (c) agrees that service of process in such proceeding may be made by registered or certified mail, return receipt requested, to the Party at its address provided in accordance with section 7.11, “Notices,” and that such service will confer personal jurisdiction over the Party in such proceeding and otherwise constitutes effective and binding service in every respect.
7.10 WAIVER OF JURY TRIAL
Each Party waives its right to jury trial of any claim or cause of action based upon or arising hereunder. The scope of this waiver is intended to encompass any and all disputes that may be filed in any court and that relate to the subject matter hereof, including contract claims, tort claims, breach of duty claims, and all other common law and statutory claims. Each Party acknowledges that this waiver is a material inducement to enter into a business relationship, that it has already relied on this waiver in entering into this Agreement, and that it will continue to rely on this waiver in its related future dealings. Each Party further represents and warrants that it knowingly and voluntarily waives its jury trial rights following consultation with legalcounsel. This waiver is irrevocable, meaning that it may not be modified either orally or in writing (other than by a mutual written waiver specifically referring to this section 7.10 and executed by each of the Parties), and will apply to any subsequent modification hereof. In the event of litigation, this Agreement may be filed as a written consent to a trial by the court.
7.11 NOTICES
(a) Any notice to a First Lien Claimholder or a Second Lien Claimholder under this Agreement must also be given to First Lien Agent and Second Lien Agent, respectively. Unless otherwise expressly provided herein, notices and consents must be in writing and will be deemed to have been given (i) when delivered in person or by courier service and signed for against receipt thereof, (ii) upon receipt of facsimile, and (iii) three Business Days after deposit in the United States mail with first-class postage prepaid and properly addressed. For the purposes hereof, the address of each Party will be as set forth below the Party’s name on the signature pages hereto, or at such other address as the Party may designate by notice to the other Parties.
(b) Failure to give a notice or copies as required by section 2.4, “Notice of Modifications,” [or] section 3.4, “Notice of Exercise,” [or section 3.1(e) regarding notice of Discharge of First Lien Obligations] will not affect the effectiveness or validity of any modification or of this Agreement, or the effectiveness or validity of the exercise of remedies otherwise permitted hereunder and under applicable law, impose any liability on any First Lien Claimholder or Second Lien Claimholder, or waive any rights of any Party.
7.12 FURTHER ASSURANCES
First Lien Agent, Second Lien Agent, and Borrower will each take such further action and will execute and deliver such additional documents and instruments (in recordable form, if requested) as First Lien Agent or Second Lien Agent may reasonably request to effectuate the terms of and the Lien priorities contemplated by this Agreement.
7.13 SUCCESSORS AND ASSIGNS
This Agreement is binding upon and inures to the benefit of each First Lien Claimholder, each Second Lien Claimholder, the Control Agent, and their respective successors and assigns. However, no provision of this Agreement will inure to the benefit of a trustee, debtor-in-possession, creditor trust or other representative of an estate or creditor of Borrower, or other Grantor, including where such estate or creditor representative is the beneficiary of a Lien securing Collateral by virtue of the avoidance of such Lien in an Insolvency Proceeding.
If either First Lien Agent or Second Lien Agent resigns or is replaced pursuant to the First Lien Credit Agreement or Second Lien Credit Agreement, as applicable, its successor will be a party to this Agreement with all the rights, and subject to all the obligations, of this Agreement. Notwithstanding any other provision of this Agreement, this Agreement may not be assigned to any Person except as expressly contemplated herein.
7.14 AUTHORIZATION
By its signature hereto, each Person signing this Agreement on behalf of a Party represents and warrants to the other Parties that it is duly authorized to execute this Agreement.
7.15 NO THIRD-PARTY BENEFICIARIES
No Person is a third-party beneficiary of this Agreement and no trustee in bankruptcy for, or bankruptcy estate of, or unsecured creditor of, any Grantor will have or acquire or be entitled to exercise any right of a First Lien Claimholder or Second Lien Claimholder under this Agreement, whether upon an avoidance or equitable subordination of a Lien of First Lien Claimholder or Second Lien Claimholder, or otherwise. None of Borrower, any other Grantor, or any other creditor thereof has any rights hereunder, and neither Borrower nor any Grantor may rely on the terms hereof. Nothing in this Agreement impairs the Obligations of Borrower and the other Grantors to pay principal, interest, fees, and other amounts as provided in the First Lien Loan Documents and the Second Lien Loan Documents. Except to the extent expressly provided in this Agreement, no Person will have a right to notice of a modification to, or action taken under, this Agreement or any First Lien Collateral Document (including the release or impairment of any Collateral) other than as a lender under the First Lien Credit Agreement, and then only to the extent expressly provided in the First Lien Loan Documents. Except to the extent expressly provided in this Agreement, no Person will have a right to notice of a modification to or action taken under, this Agreement or any Second Lien Collateral Document (including the release or impairment of any Collateral) other than as a lender under the Second Lien Credit Agreement, and then only to the extent expressly provided in the Second Lien Loan Documents.
7.16 NO INDIRECT ACTIONS
Unless otherwise expressly stated, if a Party may not take an action under this Agreement, then it may not take that action indirectly, or assist or support any other Person in taking that action directly or indirectly. “Taking an action indirectly” means taking an action that is not expressly prohibited for the Party but is intended to have substantially the same effects as the prohibited action.
7.17 COUNTERPARTS
This Agreement may be executed in counterparts (and by different parties hereto in different counterparts), each of which will constitute an original, but all of which when taken together will constitute a single contract. Delivery of an executed counterpart of a signature page of this Agreement or any document or instrument delivered in connection herewith by telecopy or electronic facsimile or other electronic means will be effective as delivery of a manually executed counterpart of this Agreement or such other document or instrument, as applicable, and each Party utilizing telecopy, electronic facsimile, or other electronic means for delivery will deliver a manually executed original counterpart to each other Party on request.
7.18 ORIGINAL GRANTORS; ADDITIONAL GRANTORS
Borrower and each other Grantor on the date of this Agreement will constitute the original Grantors party hereto. The original Grantors will cause each Subsidiary of Borrower and of Holdings that becomes a Grantor after the date hereof to contemporaneously become a party hereto (as a Guarantor Subsidiary) by executing and delivering a joinder agreement (in form and substance satisfactory to First Lien Agent) to First Lien Agent. The Parties further agree that, notwithstanding any failure to take the actions required by the immediately preceding sentence, each Person that becomes a Grantor at any time (and any security granted by any such Person) will be subject to the provisions hereof as fully as if it constituted a Guarantor Subsidiary party hereto and had complied with the requirements of the immediately preceding sentence.
Unless otherwise stated or the context otherwise clearly requires, the following terms have the following meanings:
Affiliate means, for a specified Person, another Person that directly, or indirectly through one or more intermediaries, controls or is controlled by or is under common control with the specified Person. For these purposes, “control” means the possession, directly or indirectly, of the power to direct or cause the direction of the management or policies of a Person, whether through the ownership of voting securities, by contract or otherwise, and “controlled” has a correlative meaning.
Agreement is defined in the Preamble.
Assignment Agreement is defined in section 5.1(a)(B).
Bankruptcy Code means the federal Bankruptcy Code.
Bankruptcy Law means the Bankruptcy Code and any similar federal, state, or foreign bankruptcy, insolvency, receivership, or similar law affecting creditors’ rights generally.
Borrower is defined in the Preamble.
Business Day means a day other than a Saturday, Sunday, or other day on which commercial banks in [New York City] are authorized or required by law to close.
Capped Obligations is defined in section 1.4.
Cash Management Agreement means an agreement to provide cash management services, including treasury, depository, overdraft, credit or debit card, electronic funds transfer, or other cash management arrangements, to which a Grantor is a party and a lender under the First Lien Credit Agreement or an Affiliate of such lender is the applicable counterparty at the date hereof or at the time it enters into such agreement (even if such counterparty later ceases to be such a lender or Affiliate).
Collateral means all of the property of any Grantor, whether real, personal, or mixed, that is (or is required to be) both First Lien Collateral and Second Lien Collateral, including any property subject to Liens granted pursuant to section 6, “Insolvency Proceedings,” to secure both First Lien Obligations and Second Lien Obligations.97
[Collateral means, at any time of determination, the First Lien Collateral and all other property of any Grantor in which each of First Lien Agent and Second Lien Agent has, pursuant to the First Lien Collateral Documents and the Second Lien Collateral Documents, respectively, a valid and perfected Lien (which Lien has not been avoided, disallowed, set aside, invalidated, or subordinated pursuant to Chapter 5 of the Bankruptcy Code or otherwise) securing payment of First Lien Obligations or Second Lien Obligations, respectively, and including any Liens granted pursuant to section 6, “Insolvency Proceedings,” to secure both First Lien Obligations and Second Lien Obligations.]
[ENDOF ALTERNATIVE DEFINITION]
Control Agent is defined in the Preamble.
Defaulting Creditor is defined in section 5.7(c).
DIP Financing means the obtaining of credit or incurring debt secured by Liens on the Collateral pursuant to section 364 of the Bankruptcy Code (or similar Bankruptcy Law).
Discharge of First Lien Obligations99 means, except to the extent otherwise expressly provided in section 5, “Purchase of First Lien Obligations by Second Lien Claimholders ,”
(a) payment in full in cash of the principal of and interest (including interest accruing on or after the commencement of an Insolvency Proceeding, whether or not such interest would be allowed in the proceeding)100 on all outstanding Indebtedness included in the First Lien Obligations, (b) payment in full in cash of all other First Lien Obligations that are due and payable or otherwise accrued and owing at or prior to the time such principal and interest are paid (other than indemnification Obligations for which no claim or demand for payment, whether oral or written, has been made at such time),101
(c) termination or expiration of any commitments to extend credit that would be First Lien Obligations [(other than pursuant to Cash Management Agreements or Hedge Agreements, in each case as to which satisfactory arrangements have been made with the applicable lender or Affiliate)], and
(d) termination or cash collateralization (in an amount and manner reasonably satisfactory to First Lien Agent, but in no event greater than 105% of the aggregate undrawn face amount) of all Letters of Credit.
[ALTERNATIVE CLAUSE]
[(d) [termination or cash collateralization (in an amount reasonably satisfactory to First Lien Agent) of any Hedge Agreement issued or entered into by any First Lien Claimholder] [termination of any Hedge Agreement and the payment in full by wire transfer of immediately available funds of all Obligations thereunder].
[ENDOF ALTERNATIVE CLAUSE]
Discharge of Second Lien Obligations means
(a) payment in full in cash of the principal of and interest (including interest accruing on or after the commencement of an Insolvency Proceeding, whether or not such interest would be allowed in the proceeding) on all outstanding Indebtedness included in the Second Lien Obligations, and
(b) payment in full in cash of all other Second Lien Obligations that are due and payable or otherwise accrued and owing at or prior to the time such principal and interest are paid (other than indemnification Obligations for which no claim or demand for payment, whether oral or written, has been made at such time).
Disposition means an “Asset Sale” (as defined in the First Lien Credit Agreement), or other sale, lease, exchange, transfer, or other disposition.
Enforcement Action102 means an action under applicable law to
(a) foreclose, execute, levy, or collect on, take possession or control of, sell or otherwise realize upon (judicially or non-judicially), or lease, license, or otherwise dispose of (whether publicly or privately), Collateral, or otherwise exercise or enforce remedial rights with respect to Collateral under the First Lien Loan Documents or the Second Lien Loan Documents (including by way of set-off, recoupment notification of a public or private sale or other disposition pursuant to the U.C.C. or other applicable law, notification to account debtors, notification to depositary banks under deposit account control agreements, or exercise of rights under landlord consents, if applicable),
(b) solicit bids from third Persons to conduct the liquidation or disposition of Collateral or to engage or retain sales brokers, marketing agents, investment bankers, accountants, appraisers, auctioneers, or other third Persons for the purposes of valuing, marketing, promoting, and selling Collateral,
(c) to receive a transfer of Collateral in satisfaction of Indebtedness or any other Obligation secured thereby, [or]
(d) to otherwise enforce a security interest or exercise another right or remedy, as a secured creditor or otherwise, pertaining to the Collateral at law, in equity, or pursuant to the First Lien Loan Documents or Second Lien Loan Documents (including the commencement of applicable legal proceedings or other actions with respect to all or any portion of the Collateral to facilitate the actions described in the preceding clauses, and exercising voting rights in respect of equity interests comprising Collateral), [or
(e) effect the Disposition of Collateral by any Grantor after the occurrence and during the continuation of an event of default under the First Lien Loan Documents or the Second Lien Loan Documents with the consent of First Lien Agent or Second Lien Agent, as applicable,]103provided that “Enforcement Action” will [not] be deemed to include the commencement of, or joinder in filing of a petition for commencement of, an Insolvency Proceeding against the owner of Collateral.104
Equity Interest means, for any Person, any and all shares, interests, participations, or other equivalents, including membership interests (however designated, whether voting or non-voting) of equity of the Person, including, if the Person is a partnership, partnership interests (whether general or limited) or any other interest or participation that confers on a holder the right to receive a share of the profits and losses of, or distributions of assets of, the partnership, but not including debt securities convertible or exchangeable into equity unless and until actually converted or exchanged.
Excess First Lien Obligations is defined in section 1.11(c).
Excess First Lien Principal Obligations is defined in section 1.4(a).
First Lien Agent is defined in the Preamble.
First Lien Cap is defined in section 1.4.
First Lien Claimholders is defined in section 1.3(d).
First Lien Collateral means the assets of any Grantor, whether real, personal, or mixed, as to which a Lien is granted as security for a First Lien Obligation.
[First Lien Collateral means the assets of any Grantor, whether real, personal, or mixed, as to which a Lien is granted as security for a First Lien Obligation pursuant to the First Lien Collateral Documents, which Lien is, at any time of determination, a valid and perfected Lien that has not been avoided, disallowed, set aside, invalidated, or subordinated pursuant to Chapter 5 of the Bankruptcy Code or otherwise.]
[ENDOF ALTERNATIVE DEFINITION]
First Lien Collateral Documents means the [security] [Collateral] documents defined in the First Lien Credit Agreement, and any other documents or instruments granting a Lien on real or personal property to secure a First Lien Obligation or granting rights or remedies with respect to such Liens.
First Lien Credit Agreement is defined in the Preamble.
First Lien Lenders means the “Lenders” under and as defined in the First Lien Loan Documents.
First Lien Loan Documents means
(a) the First Lien Credit Agreement and the “Loan Documents” defined in the First Lien Credit Agreement,
(b) each other agreement, document, or instrument providing for, evidencing, guaranteeing, or securing an Obligation under the First Lien Credit Agreement,
(c) any other document or instrument executed or delivered at any time in connection with Borrower’s Obligations under the First Lien Credit Agreement, including any guaranty of or grant of Collateral to secure such Obligations, and any intercreditor or joinder agreement to which holders of First Lien Obligations are parties, and
(d) each other agreement, document, or instrument providing for, evidencing, guaranteeing, or securing any DIP Financing provided by or consented to in writing by the First Lien Lenders and deemed consented to by the Second Lien Lenders pursuant to section 6.1, “Use of Cash Collateral and DIP Financing,” to the extent effective at the relevant time[, provided that any such documents or instruments to which any First Lien Claimholder is a party in connection with a DIP financing (other than a DIP financing deemed consented to by Second Lien Lenders pursuant to section 6.1, “Use of Cash Collateral and DIP Financing”) will not be deemed First Lien Loan Documents unless so designated in writing by First Lien Agent].106
First Lien Obligations is defined in section 1.3(a).
Governmental Authority means any federal, state, municipal, national, or other government, governmental department, commission, board, bureau, court, agency, or instrumentality, or political subdivision thereof, or any entity or officer exercising executive, legislative, judicial, regulatory, or administrative functions of or pertaining to any government or any court, in each case whether associated with a state of the United States, the United States, or a foreign entity or government.
Grantor is defined in the Preamble.
Guarantor Subsidiaries is defined in the Preamble.
Hedge Agreement means
(a) an Interest Rate Protection Agreement, or
(b) a foreign exchange contract, currency swap agreement, futures contract, option contract, synthetic cap, or other similar agreement or arrangement, each of which is for the purpose of hedging the foreign currency risk associated with the operations of any Grantor, in either case, to the extent that the incurrence of the obligations in respect thereof was permitted under the First Lien Loan Documents as in effect on the date hereof.
Holdings is defined in the Preamble.
Indebtedness means and includes all Obligations that constitute “Indebtedness” under the First Lien Credit Agreement or the Second Lien Credit Agreement, as applicable.
Insolvency Proceeding means
(a) a voluntary or involuntary case or proceeding under the Bankruptcy Code with respect to a Grantor,
(b) any other voluntary or involuntary insolvency, reorganization, or bankruptcy case or proceeding, or any receivership, liquidation, reorganization, or other similar case or proceeding with respect to a Grantor or a material portion of its property,
(c) a liquidation, dissolution, reorganization, or winding up of a Grantor, whether voluntary or involuntary and whether or not involving insolvency or bankruptcy, or
(d) an assignment for the benefit of creditors or other marshaling of assets and liabilities of a Grantor.
Interest Rate Protection Agreement means an interest rate swap, cap or collar agreement, or other similar agreement or arrangement designed to protect a Grantor against fluctuations in interest rates.
Letters of Credit is defined in section 1.4.
Lien means any lien (including, without limitation, judgment liens and liens arising by operation of law, subrogation, or otherwise), mortgage or deed of trust, pledge, hypothecation, assignment, security interest, charge, or encumbrance of any kind (including any agreement to give any of the foregoing, any conditional sale or other title retention agreement, and any lease in the nature thereof), and any option, call, trust, U.C.C. financing statement, or other preferential arrangement having the practical effect of any of the foregoing, including any right of set-off or recoupment.
Modify, as applied to any document or obligation, includes
(a) modification by amendment, supplement, termination, or replacement of the document or obligation,
(b) any waiver of a provision (including waivers by course of conduct), and
(c) the settlement or release of any claim,
whether oral or written, and regardless of whether the modification is in conformity with the provisions of the document or obligation governing modifications.
New Agent is defined in section 4.4.
Obligations means all obligations of every nature of a Person owed to any obligee under an agreement, whether for principal, interest, or payments for early termination, fees, expenses, indemnification, or otherwise, and all guaranties of any of the foregoing, whether absolute or contingent, due or to become due, now existing or hereafter arising, and including interest and fees that accrue after the commencement by or against any Person of any proceeding under any Bankruptcy Law naming such Person as the debtor in such proceeding, regardless of whether such interest and fees are allowed claims in such proceeding.
Party means a party to this Agreement.
Person means any natural person, corporation, limited liability company, trust, business trust, joint venture, association, company, partnership, Governmental Authority, or other entity.
Pledged Collateral is defined in section 1.6(a).
Post-Petition Claims means interest, fees, costs, expenses, and other charges that pursuant to the First Lien Credit Agreement or the Second Lien Credit Agreement continue to accrue after the commencement of an Insolvency Proceeding, to the extent such interest, fees, expenses, and other charges are allowed or allowable under Bankruptcy Law or in the Insolvency Proceeding.
Proceeds means
(a) all “proceeds,” as defined in Article 9 of the U.C.C., of the Collateral, and
(b) whatever is recovered when Collateral is sold, exchanged, collected, or disposed of, whether voluntarily or involuntarily, including any additional or replacement Collateral provided during any Insolvency Proceeding and any payment or property received in an Insolvency Proceeding on account of any “secured claim” (within the meaning of section 506(b) of the Bankruptcy Code or similar Bankruptcy Law).107
Purchase Date is defined in section 5.2(a)(5). Purchase Event is defined in section 5.1(a).
Purchase Notice is defined in section 5.2(a).
Purchase Obligations is defined in section 5.1(a).
Purchase Price is defined in section 5.3.
Purchasing Creditors is defined in section 5.2(a).
Recovery is defined in section 6.6.
Refinance means, for any Indebtedness, to refinance, replace, refund, or repay, or to issue other Indebtedness in exchange or replacement for such Indebtedness in whole or in part, whether with the same or different lenders, agents, or arrangers. “Refinanced” and “Refinancing” have correlative meanings.
Second Lien Adequate Protection Payments is defined in section 6.4(b)(4).
Second Lien Agent is defined in the Preamble.
Second Lien Claimholders is defined in section 1.3(d).
Second Lien Collateral means all of the property of any Grantor, whether real, personal, or mixed, as to which a Lien is granted as security for a Second Lien Obligation.
Second Lien Collateral Documents means the [security] [Collateral] documents defined in the Second Lien Credit Agreement, and any other documents or instruments granting a Lien on real or personal property to secure a Second Lien Obligation or granting rights or remedies with respect to such Liens.
Second Lien Credit Agreement is defined in the Preamble.
Second Lien Lenders means the “Lenders” under and as defined in the Second Lien Loan Documents.
Second Lien Loan Documents means
(a) the Second Lien Credit Agreement and the “Loan Documents” defined in the Second Lien Credit Agreement,
(b) each other agreement, document, or instrument providing for, evidencing, guaranteeing, or securing an Obligation under the Second Lien Credit Agreement, and
(c) any other document or instrument executed or delivered at any time in connection with Borrower’s Obligations under the Second Lien Credit Agreement, including any guaranty of or grant of Collateral to secure such Obligations, and any intercreditor or joinder agreement to which holders of Second Lien Obligations are parties, to the extent effective at the relevant time.
Second Lien Obligations is defined in section 1.3(b).
Standstill Period is defined in section 3.1(b)(1).
Subsidiary of a Person means a corporation or other entity a majority of whose voting stock is directly or indirectly owned or controlled by the Person. For these purposes, “voting stock” of a Person means securities or other ownership interests of the Person having general power under ordinary circumstances to vote in the election of the directors, or other persons performing similar functions, of the Person. References to a percentage or proportion of voting stock refer to the relevant percentage or proportion of the votes entitled to be cast by the voting stock.
U.C.C. means the Uniform Commercial Code (or any similar legislation) as in effect in any applicable jurisdiction.
8.2 USAGES
Unless otherwise stated or the context clearly requires otherwise:
Agents. References to First Lien Agent or Second Lien Agent will refer to First Lien Agent or Second Lien Agent acting on behalf of itself and on behalf of all of the other First Lien Claimholders or Second Lien Claimholders, respectively. Actions taken by First Lien Agent or Second Lien Agent pursuant to this Agreement are meant to be taken on behalf of itself and the other First Lien Claimholders or Second Lien Claimholders, respectively.
Singular and plural. Definitions of terms apply equally to the singular and plural forms.
Masculine and feminine. Pronouns will include the corresponding masculine, feminine, and neuter forms.
Will and shall. “Will” and “shall” have the same meaning.
Time periods. In computing periods from a specified date to a later specified date, the words “from” and “commencing on” (and the like) mean “from and including,” and the words “to,” “until,” and “ending on” (and the like) mean “to but excluding.”
When action may be taken. Any action permitted under this Agreement may be taken at any time and from time to time.
Time of day. All indications of time of day mean [New York City] time. Including. “Including” means “including, but not limited to.”
Or. “A or B” means “A or B or both.”
Statutes and regulations. References to a statute refer to the statute and all regulations promulgated under or implementing the statute as in effect at the relevant time. References to a specific provision of a statute or regulation include successor provisions. References to a section of the Bankruptcy Code also refer to any similar provision of Bankruptcy Law.
Agreements. References to an agreement (including this Agreement) refer to the agreement as amended at the relevant time.
Governmental agencies and self-regulatory organizations. References to a governmental or quasi-governmental agency or authority or a self-regulatory organization include any successor agency, authority, or self-regulatory organization.
Section references. Section references refer to sections of this Agreement. References to numbered sections refer to all included sections. For example, a reference to section 6 also refers to sections 6.1, 6.1(a), etc. References to a section or article in an agreement, statute, or regulation include successor and renumbered sections and articles of that or any successor agreement, statute, or regulation.
Successors and assigns. References to a Person include the Person’s permitted successors and assigns.
Herein, etc. “Herein,” “hereof,” “hereunder,” and words of similar import refer to this Agreement in its entirety and not to any particular provision.
Assets and property. “Asset” and “property” have the same meaning and refer to both real and personal, tangible and intangible assets and property, including cash, securities, accounts, and general intangibles.
SIGNATURES
First Lien Agent:
[NAMEOF FIRST LIEN AGENT],
as First Lien Agent By:
Name:
Title:
[NOTICE ADDRESS]
Control Agent:
[NAMEOF CONTROL AGENT],
as Control Agent By:
Name:
Title:
[NOTICE ADDRESS]
Second Lien Agent:
[NAMEOF SECOND LIEN AGENT], as Second Lien Agent By:
4. The first and second lien agents are parties to the intercreditor agreement, but the first and second lien lenders are not. Therefore, the first and second lien credit agreements should each (i) bind each lender to the terms of the intercreditor agreement, (ii) authorize the agent to enter into the intercreditor agreement on behalf of the lenders and to exercise all the agent’s rights and comply with all its obligations under the intercreditor agreement, and (iii) specify what lender direction or authorization is required for the agent to agree to consents, waivers, or amendments, or to take or refrain from other actions under the intercreditor agreement.
5. The parties may wish to provide for hedge agreements provided by a second lien lender or affiliate.
6. The heart of the intercreditor agreement is the lien subordination provision pursuant to which the second lien lenders agree that their lien on the common assets will be junior and second in priority to the lien of the first lien lenders, including typically both liens on personal property and liens on real estate. Even at this preliminary stage of the intercreditor agreement, the first lien lenders and the second lien lenders are likely to have different points of view as to how broadly the lien subordination provision should be worded. The first lien lenders are likely to insist that their lien on the common assets should remain superior (at least up to the amount of the first lien cap) even if the first lien lenders fail to perfect their lien properly or allow their lien to lapse or their lien is avoided in bankruptcy or otherwise. Second lien lenders will often take the position that only collateral in which both first and second lien lenders have a valid and perfected security interest not subject to avoidance as a preferential transfer or otherwise by the debtor or a trustee in bankruptcy should be subject to the lien priority provisions. See alternative section 1.1 and notes to that section and alternative section 1.7. In practice, the view of the first lien lenders has typically prevailed on this issue although there is increasing recognition of the unintended “payment subordination” by the second lien lenders that may result if the first lien lapses or is avoided in bankruptcy, and the second lien lenders are forced by their agreement to an “absolute” priority provision to be subordinate to the now unsecured first lien lenders.
7. First and second lien lenders typically agree not to challenge the priority, perfection, or validity of their respective liens. However, a first lien agent may fail to perfect, or maintain perfection, of its lien, or may be determined by a court to have participated in a fraudulent transfer or other transaction that results in their claims being disallowed or equitably subordinated. This has occurred in several recent high-profile cases. In such situations, second lien lenders will often argue, particularly in negotiated middle-market transactions, that an agreement to continue to treat an unperfected or equitably subordinated first lien lender as being perfected and senior to the second lien lender converts lien subordination into payment subordination to unsecured or equitably subordinated indebtedness that is not reflected in the coupon on or underwriting assumptions for the second lien obligations. This could place the second lien lenders in a far worse position than if they were unsecured creditors. Therefore, second lien lenders often take the position that only collateral in which both first and second lien lenders have a valid and perfected security interest not subject to avoidance as a preferential transfer or otherwise by the debtor or a trustee in bankruptcy should be subject to the lien priority provisions of the intercreditor agreement. Payment subordination as described in this note can occur if (i) the lien securing first lien obligations maintains priority, and a turn-over right, under the intercreditor agreement even if invalid, unperfected, equitably subordinated, or avoidable, or (ii) first lien obligations include amounts “whether or not allowable in an insolvency proceeding” and the amounts are not allowed. This can result in payment subordination of the claims of second lien lenders to the extent of first lien claims not allowed in an insolvency proceeding, which also leaves the second lien lenders with no enforceable subrogation rights in respect of such claims, and in a position that may be worse than that of an unsecured creditor. On the other hand, application of proceeds to second lien claimholders from unperfected first lien collateral may result in a greater recovery than had the first lien collateral been perfected, and some intercreditor agreements attempt to address this issue. As an example, consider a debtor with $100 million of assets, $50 million of first lien debt, $50 million of second lien debt, and $50 million of unsecured obligations. If the first lien lenders’ claims are unsecured for failure to maintain perfection, the second lien lenders will recover in full ($50 million) on their lien, but pay the entire recovery over to the first lien lenders, and have only an unsecured subrogation claim from the first lien lenders, which will result in a recovery of only $25 million, all due to the failure of the first lien lenders to perfect. If the first lien lenders’ claims are equitably subordinated or disallowed because of bad acts of the first lien lenders, the result for the second lien lenders will be catastrophic. In the example above, they would turn over their $50 million recovery to the first lien lenders, who would be paid in full notwithstanding their bad acts, and the innocent second lien lenders would have no recovery at all. For a detailed discussion of this issue, please see, among other articles, Robert L. Cunningham & Yair Y. Galil, Lien Subordination and Intercreditor Agreements, 25 REV. BANKING & FIN. SERVICES 49 (2009).
8. The typical second lien financing intercreditor agreement does not require payment subordination.
9. These changes in the definition of “First Lien Obligations” would typically be used in connection with the alternative definition of “First Lien Cap” and the alternative lien priority provisions in section 1.1 noted as being more favorable to second lien lenders.
10. Second lien caps are less common than first lien caps. If there is a second lien cap, the following definition should be added:
Second Lien Cap means $_______ minus the aggregate amount of principal payments on the term loan under the Second Lien Credit Agreement (other than payments in connection with a Refinancing).
11. The Model Agreement includes a fairly broad definition of “First Lien Obligations” that encompasses principal, interest, fees, indemnity obligations, the cost of unwinding hedging obligations, and cash management obligations. However, it also provides for a “first lien cap” in an agreed-upon maximum principal amount. The standard definition of “first lien cap” is limited to a cap on principal and a related cap on interest, premiums, and fees on the capped principal amount. The alternative definition more favorable to second lien lenders includes optional limits on other first lien obligations, including separate caps on interest payments and on obligations under hedge agreements. Many intercreditor agreements provide for a first lien cap but fail to address the consequences of the first lien lenders exceeding the cap. The Model Agreement specifically provides in section 1.1 (“Seniority of Liens Securing First Lien Obligations”) that the lien on collateral securing first lien obligations will have priority over the second lien obligations up to but not in excess of the first lien cap. The Model Agreement also deals with the question of how the first lien lenders’ lien securing first lien obligations in excess of the cap should be handled. See section 1.11, “Subordination of Liens Securing Excess First Lien Obligations,” which provides, among other things, that the second lien lenders will be subordinate only to the extent that the principal amount of the first lien loan does not exceed the first lien cap. Similarly, the buy-out provisions of the Model Agreement that permit the second lien lenders to purchase the first lien loan at par following the occurrence of an event of default only apply to the portion of the first lien loan that does not exceed the agreed-upon cap and the uncapped portion of the loan. While a first lien cap is designed to protect the second lien lenders from unanticipated increases in the first lien debt, the first lien lenders will want to make sure that they have a sufficient “cushion” under the first lien cap to increase the first lien loan by a reasonable amount to deal with additional cash needs by the borrower as part of a loan workout or otherwise. The first lien lenders also should consider including an additional “cushion” for debtor-in-possession (“DIP”) financing to be provided by the first lien lenders in the event of bankruptcy. The definition of first lien cap in the Model Agreement includes optional provisions for including DIP financing under the first lien cap. The Task Force has intentionally omitted any provision stating that a breach of the agreement occurs if the first lien lenders exceed the cap. Instead, the agreement provides that exceeding the cap will result in a subordination of the excess amount to the lien of the second lien lenders as provided in section 1.11. The parties may wish to consider including an express agreement by the first lien lenders not to exceed the first lien cap but, in most cases, the Task Force believes that the subordination of the excess will provide a sufficient and appropriate remedy for the second lien lenders. Section 1.11(e) expressly provides that the second lien lenders reserve any rights against the borrower under the second lien loan documents for any event of default resulting from the incurrence of obligations exceeding the first lien cap.
12. In the absence of unusual provisions in the first lien credit agreement (e.g., delayed draw term loans or accordion features), a typical first lien cap for a negotiated transaction would be in the range of 110 percent to 115 percent of the aggregate commitment under the first lien loan documents, with 110 percent being the most common percentage. If the modification section restricts extending scheduled amortization, consider whether the borrower should be prohibited from reallocating its term facility to revolving exposure. This form of agreement assumes that the parties have negotiated a reducing cap as opposed to, for instance, a leverage-based incurrence option or a flat, non-reducing cap. If the parties have agreed to a form of non-reducing cap, then appropriate changes will need to be made to the definition of “First Lien Cap.” This definition of first lien cap applies only to principal. Second lien lenders may argue that the cap should be expanded to include other first lien obligations, including interest, costs, expenses, indemnities, and obligations under hedge agreements and cash management agreements. See the alternative definition of first lien cap more favorable to second lien lenders.
13. It is common to see first lien caps that apply only to principal and do not directly address whether or not interest, fees, and premium (if any) on the “excess principal” above the first lien cap should be entitled to the same priority as interest and fees on outstanding principal up to the cap. That approach may leave open the question of how the “excess” fees, interest, and premium (if any) should be treated for priority purposes. The alternative followed in the Model Agreement is to provide in this section that interest, fees, and premium (if any) on principal up to the first lien cap will have the same priority as such principal, while interest, fees, and premium (if any) on principal in excess of the first lien cap will be treated as “excess first lien obligations” under section 1.11(c). Second lien lenders may logically object to the ability of the first lien lenders to capitalize all interest and add that capitalized interest as an additional priority principal obligation in excess of the stated dollar cap amount. First lien lenders may logically object to not having the ability to capitalize interest to help a debtor though difficult periods without eroding any principal cushion they may have available within the capped amount. The parties should attempt to balance these concerns by negotiation, perhaps by specifying when capitalized interest will not utilize the principal cap.
14. Include if section 6.4 permits second lien adequate protection payments.
15. The parties also need to decide whether a separate basket for potential DIP financing and carve-outs should be included. See also section 6.1 and notes to that section.
16. If this alternative definition of “First Lien Cap” is used, then the following definition should be added to section 8.1:
Availability means, at any time, the aggregate amount of the revolving loans, letter of credit accommodations, and other credit accommodations available to Borrower from the First Lien Lenders based on the Borrowing Base (as such term, and the definitions used in such term, are defined in the First Lien Loan Documents as in effect on the date hereof) (determined without regard to any revolving loans, letter of credit accommodations, or other credit accommodations then outstanding).
17. Include if section 6.4 permits second lien adequate protection payments.
18. If this alternative definition of “First Lien Cap” is used, then the following definitions should also be included in section 8.1:
Excess Second Lien Principal Obligations means Second Lien Principal Obligations in excess of the Second Lien Cap.
First Lien Principal Obligations means, at any time of determination, the aggregate unpaid principal of the loans outstanding under the First Lien Loan Documents together with the undrawn amount of all outstanding Letters of Credit under the First Lien Loan Documents.
Second Lien Principal Obligations means, at any time of determination, the aggregate unpaid principal of the loans outstanding under the Second Lien Loan Documents [together with the undrawn amount of all outstanding letters of credit under the Second Lien Loan Documents].
19. In asset-based transactions with foreign currencies, changes in exchange rates are taken into account in calculation of availability from time to time. The language above should not reverse that requirement to the detriment of the second lien lenders.
20. In light of the recent ION Media decision, if the second lien claimholders wish to preserve an express right to challenge priority on the grounds that certain property does not constitute “first lien collateral,” they may wish to consider arguing for adding language to the effect that: “Nothing in this section 1.8(b) shall prevent the Second Lien Agent or any Second Lien Claimholder from asserting that any property does not constitute First Lien Collateral under the First Lien Collateral Documents.” In the memorandum decision by the Bankruptcy Court in In re ION Media Networks, Inc., 419 B.R. 585 (Bankr. S.D.N.Y. 2009), the intercreditor agreement included an express acknowledgment by the parties “to the relative priorities as to the Collateral . . . as provided in the Security Agreement” and an agreement by the parties that such priority would not be affected or impaired by “any nonperfection of any lien purportedly securing any of the Secured Obligations.” Id. at 594 (emphasis omitted). The purchaser of the second lien obligations argued in a motion objecting to confirmation of the debtor’s plan of reorganization that certain FCC licenses owned by a special purpose vehicle within the debtor’s capital structure were immune from being encumbered due to their special character and that the licenses therefore did not constitute “collateral” for purposes of the intercreditor agreement. Id. at 589. While the first lien lender had a security interest in the proceeds of the FCC licenses, there were no proceeds to which the lien could attach. Id. The court found that the use of the term “purportedly securing” in the intercreditor agreement to describe the liens granted in the security agreement “evidenced the intent of the [s]ecured [p]arties to establish their relative legal rights [with respect to the FCC licenses themselves] vis À vis each other,” regardless not only of the ultimate validity of any lien therein granted by the debtors, but also regardless of whether a lien was even intended to be granted in the FCC licenses. Id. at 594. The court’s attempt to determine and enforce the intent of the parties based on the negotiated terms of the agreement is a positive step for the enforcement of intercreditor agreements based on the agreement of the parties rather than bankruptcy policy grounds. However, the court, in attempting to determine the parties’ intent, arguably ignored the clear language of the security agreement, which expressly excluded the FCC licenses from the collateral, and the fact that a lien on the FCC licenses (as opposed to proceeds thereof) would be prohibited by law. Notwithstanding the foregoing, the court concluded that “[a]t bottom, the language of the Intercreditor Agreement demonstrates that the Second Lien Lenders agreed to be ‘silent’ as to any dispute regarding the validity of liens granted by the Debtors in favor of the First Lien Lenders and conclusively accepted their relative priorities regardless of whether a lien ever was properly granted[, or intended to be granted,] in the FCC Licenses.” Id. First lien lenders can accomplish the result implicit in the court’s decision in a manner that does not ignore the law and the express language of the security agreement by (i) contractually prohibiting the second lien lenders from asserting claims such as those asserted by the second lien lender in ION Media, (ii) ensuring that the language of the granting clause in the security agreement picks up all general intangibles relating to the FCC licenses, including all enterprise value relating to the ownership thereof, as well as all proceeds of the disposition thereof, (iii) insulating the FCC licenses in a bankruptcy remote license subsidiary, and prohibiting any debt (other than the debt of the second lien lenders) in that subsidiary, (iv) subordinating the guarantee or other claims of the second lien lenders against the FCC license subsidiary, and (v) taking a first priority lien on the equity in that subsidiary.
21. Note that the marshaling waiver is not limited to collateral upon which both the first lien and second lien lenders have a lien. Many transactions may involve some collateral, such as foreign collateral, where there is no shared lien, and careful consideration should be given to the marshaling waiver in those circumstances.
22. The bracketed language is an alternative favorable to first lien claimholders. Rights to release a grantor should be considered carefully and may be limited to subsidiaries, as this provision has the effect of subordinating the claims of second lien claimholders to unsecured creditors of the grantor.
23. Bracketed language is a first lien favorable alternative.
24. Many intercreditor agreements simply state that amounts in excess of the first lien cap are not first lien obligations. These agreements do not address the matter further. This leaves a lot of room for speculation. What is the result of the first lien creditors exceeding the cap? The second lien lenders may argue that exceeding the cap is a breach of the intercreditor agreement by the first lien creditors and should allow the second lien creditors to assume first lien priority. That would be a result outside of the intent of the parties to the intercreditor agreement. Even though obligations in excess of the first lien cap are not intended by the parties to be treated as “first lien obligations,” the liens securing the first lien obligations (including U.C.C. Financing Statements and mortgages or deeds of trust) are usually filed before the second lien U.C.C. Financing Statements and mortgages or deeds of trust and would therefore remain first priority liens under the “first to file” rule. There is no guidance with respect to treatment of the excess in such a case. A common alternative in intercreditor agreements in which the parties and their counsel have actually considered this issue is to assign third lien priority to all first lien obligations in excess of the first lien cap. This most closely aligns with the parties’ expectations and assigns a specific “waterfall” of priorities. Section 1.11 takes that approach and goes further to deal with other priority issues relating to any second lien cap included in the intercreditor agreement. See also section 4.1, which establishes a “waterfall” for the application of proceeds received in connection with an enforcement action by either the first lien lenders or the second lien lenders. Although much less common than first lien caps, second lien caps do appear in some intercreditor agreements, particularly more negotiated middle-market transactions.
25. This and the following example are part of the agreement itself, rather than being comments to the agreement.
26. The modification provisions are intended to balance the desire of each class of creditor to ad-minister freely its loan documents and refinance the debt thereunder against the interest of the other class of creditor in protecting against any modification or refinancing that alters any fundamental assumption about the borrower’s capital structure relied on in underwriting the transaction. Fundamen-tal issues usually addressed in the modification provisions include prohibitions on:
i) increasing the maximum permitted advances of first lien/second lien obligations above negotiated caps;
ii) extension of the maturity of the first lien obligations beyond the maturity date of the second lien obligations;
iii) accelerating the amortization/maturity of the second lien obligations or increasing any mandatory prepayment obligations; and
Additional restrictions may or may not appear in the intercreditor agreement or in the first lien loan documents or second lien loan documents.
The scope of restrictions on amendments is highly negotiated and varies depending on the market in question. While first lien and second lien claimholders will usually object to the borrower or its counsel becoming deeply involved in negotiating the terms of the intercreditor agreement, the borrower will be highly motivated to scrutinize the modification restrictions and the debt cap definitions. The borrower’s interests will be aligned with those of the first lien claimholders as these provisions greatly impact the future flexibility of the borrower to incur additional debt, refinance existing debt on market terms, and obtain covenant relief.
27. The Model Agreement starts with the baseline concept that the first lien claimholders and second lien claimholders are generally free to amend their respective loan documents and refinance the obligations thereunder subject to meeting a limited set of parameters. This concept respects the status of the second lien obligations as debt that is senior in priority of payment and may be contrasted with the approach generally taken with respect to mezzanine or other payment subordinated obligations. Payment subordinated obligations are most often subject to broad restrictions on amendments and other modifications and will almost always prohibit any prepayment or refinancing of the subordinated obligations until the senior obligations are paid in full. While the Model Agreement focuses primarily on the economic terms of the obligations and does not prohibit the first and second lien claimholders from tightening or adding covenants or events of default, such amendments are usually prohibited by covenants in the first lien credit agreement in order to preserve any negotiated covenant cushion existing at the outset of the transaction. Likewise, cross-default provisions in the second lien loan documents should be reviewed and qualified as necessary to preserve any such negotiated covenant cushion.
28. The “laundry list” approach set forth in the Model Agreement is frequently encountered in middle-market transactions. Larger syndicated loan transaction and bond second lien deals often have fewer restrictions on the modification or refinancing of the first lien obligations. The restrictions in this section may also be largely addressed in the applicable loan documents rather than in the intercreditor agreement. As discussed above, restrictions on any modification or refinancing must be carefully considered relative to the definitions used to formulate any debt caps. See also note 12 above concerning potential restrictions on amendments that reallocate portions of term facility exposure to revolving exposure in cases where the second lien claimholders are seeking to require a minimum amount of amortization. While it is a case involving payment subordinated obligations, a worst-case scenario for a second lien claimholder (or a best-case scenario for a first lien claimholder) concerning flexibility to modify a class of debt with senior lien priority is illustrated by In Re Musicland Holding Corp., 374 B.R. 113 (Bankr. S.D.N.Y. 2007). In that case, a senior revolving credit facility was successfully modified pursuant to the terms of a broadly drafted intercreditor agreement to incorporate an additional term loan facility that “leapfrogged” the subordinated creditors in the priority of distribution of the debtor’s Chapter 11 estate. Id. at 118–19.
The amount of any permitted percentage increase in the interest rate is among the items subject to negotiation between the parties. A maximum 2 percent per annum increase has been a common agreed upon amount; however, this negotiated amount is being revisited by many in the aftermath of the recent market disruption and widespread re-pricing of transaction exposure. The alternative text with respect to asset-based lending transactions is often strongly resisted. To the extent that such alternative text is included, the first lien claimholders should consider whether sufficient flexibility to make protective advances or over-advances generally is included in the first lien loan documents or needs to be expressly addressed in the intercreditor agreement.
29. Consider whether subordination of excess first lien obligations is a sufficient remedy, or whether the agreement should also include an outright prohibition on extensions of credit in excess of the cap.
30. The amount of any permitted percentage increase in the interest rate is subject to negotiation between the parties. A maximum 2 percent per annum increase is a typical agreed-upon amount. would be customary geographic restrictions, maintenance, and insurance requirements applicable in vessel financings. Provisions pertaining to the application of casualty and condemnation proceeds also merit careful consideration.
31. Consistent with the expectation of the first lien claimholders to control issues related to common collateral, the Model Agreement provides that when the first lien claimholders amend the provisions of the first lien collateral documents, such revisions will automatically apply with respect to corresponding provisions of the second lien collateral documents. This “drag-along” concept is intended to cover only provisions that relate to the collateral and, accordingly, applies only to the collateral documents. It does not apply to covenants in the first lien credit agreement or second lien credit agreement that may relate directly or indirectly to the collateral, such as disposition or insurance covenants or tangible net worth requirements. To that end, the counsel to the first lien claimholders will closely review any such restrictions in the second lien credit agreement for appropriate cushion, where applicable, to allow some flexibility in dealing with the borrower on such issues without the need to obtain an amendment or waiver from the second lien claimholders. The drag-along provision obviates the need to negotiate cushion on potentially highly focused covenants and threshold amounts in the second lien collateral documents, which are generally duplicated from the corresponding first lien collateral documents. That said, the automatic amendment provisions will not apply to amendments that require the release of collateral, except to the extent that such releases are required by other sections of the Model Agreement. Releases of collateral in the context of an enforcement action or dispositions are addressed in section 1.10, “Release of Liens or Guaranties,” and releases in the context of an insolvency proceeding are addressed in section 6.2, “Sale of Collateral.” The automatic amendment provisions are, likewise, qualified to protect the second lien agent from being required to assume additional responsibilities, to protect the second lien claimholders from amendments that permit additional liens that could undermine their collateral position, and, in the case of the optional language, to protect from an amendment that could prejudice a second lien claimholder to a larger degree than a first lien claimholder. Such optional language may be objectionable to first lien claimholders based on the language being somewhat vague in nature and open to interpretation. Second lien claimholders may object to this section—especially in financings where specialized covenants are essential to preserve the expected value of the collateral or the validity of the liens. One such area that comes to mind
32. In order to allow the first lien claimholders and second lien claimholders to track compliance of the other party with the provisions in section 2 of the Model Agreement, we have provided a mutual notice provision. This notice requirement applies after the effectiveness of the modification in question and, while a claim for damages is theoretically possible, the failure to give such notice is not intended to impair the effectiveness of the agreement. Often, parties may prefer to put the burden of providing notices on the borrower; however, this provision is consistent with the general theme in the Model Agreement of attempting to foster reasonable cooperation between the creditors on administrative issues. As the notice provision is also acknowledged by the borrower, it also may provide a waiver by the borrower of confidentiality provisions that might otherwise restrict communication between the creditors on issues covered by the intercreditor agreement.
33. In addition to enjoying relative lien priority over second lien claimholders, first lien claimholders are afforded enforcement priority over the second lien claimholders with respect to the collateral. This lien enforcement priority is not unlimited, however. First lien claimholders are permitted a finite period in which to exercise their exclusive right to bring enforcement actions with respect to the collateral. This exclusive enforcement period afforded the first lien claimholders (which is referred to in the Model Agreement and in practice as a “Standstill Period”—i.e., a period during which second lien claimholders agree to refrain from exercising their subordinate security interests) frequently is a matter of intense negotiation. The length of the standstill period typically ranges from 120 to 180 days, depending upon factors such as the relative bargaining strength of the parties, the nature of the borrower’s business and the collateral, and other factors that may reduce or lengthen the amount of time necessary for first lien claimholders to evaluate whether or not to commence an enforcement action. Accordingly, the Model Agreement provides a range of days for the standstill period, rather than suggesting a single, specific period. Along with their exclusive right during the standstill period to commence an enforcement action with respect to the collateral, first lien claimholders have the exclusive right during the standstill period to exercise certain other rights and remedies. First lien claimholders may exercise all the rights and remedies of a secured creditor under the Uniform Commercial Code. Additionally, first lien claimholders may agree to release or dispose of the collateral (or to place or eliminate restrictions with respect to the collateral), so long as the consent of second lien claimholders is obtained if the proceeds received by first lien claimholders in connection with any such events are not applied to reduce the first lien obligations or if any such action is prohibited under the second lien loan documents. Following the expiration of the standstill period, second lien claimholders may commence an enforcement action against the collateral under certain conditions. These conditions include the requirement that first lien claimholders have not commenced an enforcement action with respect to all or a material portion of the collateral prior to the end of the standstill period and are not then continuing the diligent pursuit of such enforcement action (or diligently attempting to vacate any stay or prohibition against such enforcement action) and the requirement that second lien claimholders have not rescinded any acceleration of the second lien obligations. Even during the standstill period, second lien claimholders may take certain actions to preserve their position as provided in the Model Agreement. For example, second lien claimholders are granted the rights to file a proof of claim, to vote on a plan of reorganization, and to make other filings, arguments, and motions with respect to the second lien obligations and the collateral in any insolvency proceeding involving the borrower. A question of much current interest is whether or not the second lien claimholders should be allowed to join in an involuntary bankruptcy petition against the borrower in the exercise of their reserved rights as unsecured creditors or whether any right to join in an involuntary petition should be expressly excluded on the grounds that it effectively undermines the rights of the first lien claimholders to bring an enforcement action under the standstill provisions. See section 3.1(d) below, including optional language prohibiting the second lien claimholder from initiating or joining in an involuntary bankruptcy petition.
34. Under section 9-617(a) of the U.C.C., the lien securing the second lien obligations will not automatically attach to the proceeds of collateral received following a foreclosure of the first lien, as the second lien will be discharged. U.C.C. § 9-617(a) (2008).
35. Second lien lenders may seek to have an earlier trigger for the commencement of a standstill such as certain actions by the first lien lenders, and they may also oppose acceleration as a requirement for the commencement of the standstill.
36. Second lien claimants will likely take the position that the bankruptcy laws should dictate what rights the first and second lien claimholders have if an insolvency proceeding is commenced, and that a blanket prohibition on remedies is not appropriate. However, first lien claimants do not want the second lien claimants to exercise remedies against any loan parties or accompanying collateral that may not be subject to the protection of the bankruptcy court and may prefer to exercise remedies contemporaneously against all the loan parties.
37. Consider specifying provisions precluding objections to claims, liens, and other agreed provisions that might be more favorable to second lien lenders.
38. The right of first lien claimholders to take an enforcement action against the collateral is generally unfettered. The only real limitation on such right is that first lien claimholders must comply with applicable law. First lien claimholders otherwise are free to take an enforcement action without consultation with or the consent of second lien claimholders. This is so irrespective of whether an insolvency proceeding has been commenced, whether any second lien loan document provides to the contrary, or whether the enforcement action is adverse to the interest of second lien claimholders. Additionally, first lien claimholders are not impeded in bringing any enforcement action by any action or failure to act of the borrower, any guarantor, any other first lien claimholder, or any other party. Nor are first lien claimholders impeded in bringing an enforcement action by the non-compliance by any person other than first lien claimholders with any provision of the intercreditor agreement, the first lien loan documents, or the second lien loan documents, even if the first lien claimholders are aware of such non-compliance. Second lien claimholders specifically agree not to contest, protest, or otherwise take any action to interfere with any enforcement action properly conducted by first lien claimholders.
39. The Model Agreement recognizes that the right to bring an enforcement action or prevent an unauthorized enforcement action is an essential right for which the parties have specifically bargained under the Model Agreement. Accordingly, the Model Agreement grants each party the right to demand specific performance under the Agreement, and each party waives the right to assert the adequacy of a remedy at law or any other defense that might be asserted to bar the remedy of specific performance.
40. First lien claimholders and second lien claimholders have a common interest in the collateral and a common desire to ensure that enforcement actions are conducted in a manner that will yield the maximum possible proceeds for application to the first lien obligations and the second lien obligations. Accordingly, both first lien claimholders and second lien claimholders agree to give each other notice of their commencement of an initial material enforcement action.
41. As has been detailed earlier, among the primary benefits to the first lien claimholders of the Model Agreement are the priority of their liens over those of the second lien claimholders and the enforcement priority that they enjoy relative to their liens. See note 33 to section 3. The enforcement priority is effectuated by the standstill period, which provides the first lien claimholders a “head start” relative to enforcement of their liens. The Model Agreement also continues the exclusivity relative to lien enforcement if, prior to the expiration of the standstill period or prior to the permitted commencement of lien enforcement by the second lien claimholders, as applicable, the first lien claimholders have commenced and thereafter are diligently pursuing the exercise of their rights or remedies with respect to all or any material portion of the collateral. As a corollary to the exclusive enforcement remedies, this section provides for the application of proceeds received in connection with an enforcement action. Commonly referred to as a “waterfall” provision, the section expressly provides that it is applicable before or after the commencement of an insolvency proceeding. It should be noted, however, that this section does not apply to payments or other distributions made in an insolvency proceeding unless those payments or other distributions are received in connection with an enforcement action. It should also be noted that the section is applicable to collateral or proceeds received in connection with an enforcement action irrespective of whether the action was taken by the first lien claimholders or the second lien claimholders. In the unlikely event that the first lien claimholders have allowed the standstill period to expire and the second lien claimholders exercise their rights to take enforcement actions, this section still requires that the proceeds of such exercise be run through the waterfall. While, as to collateral that is subject to Article 9, this would appear to conflict with section 9-615(a) of the U.C.C., section 9-615(a) is not one of the sections of the U.C.C. that section 9-602 expressly states cannot be waived or varied by the debtor. Presumably, the execution of the Model Agreement by the various grantors would be deemed to be a waiver of the provisions of section 9-615(a) when the proceeds result from an enforcement action taken by the second lien claimholders. The waterfall provision establishes a priority of application of the proceeds of the collateral, first to the first lien obligations (up to the amount of the first lien cap), second to the second lien obligations (up to the amount of any second lien cap), third to the excess first lien obligations (i.e., the amount of the obligations owing under the first lien loan documents in excess of the first lien cap), and fourth to the excess second lien obligations (i.e., the amount of the obligations owing under the second lien loan documents in excess of a second lien cap). In each case, the application within a particular tier is as specified in the applicable loan documents. Presumably, the loan documents will contain their own order of application of payments, including applying collateral proceeds to the costs and expenses of enforcement, to accrued and unpaid interest, and to the outstanding principal balance of the loans. When combined with the other provisions of the Model Agreement, this section completes a trifecta, i.e., the liens of the first lien claimholders have priority, the enforcement rights of the first lien claimholders have priority, and the first lien claimholders have priority as to the application of the proceeds of any enforcement action. The section does not distinguish between cash proceeds and non-cash proceeds, but should be interpreted to require the application of cash proceeds to the applicable obligations as and when received and to defer the application of the non-cash proceeds to the applicable obligations until such non-cash proceeds have been monetized.
42. Some intercreditor agreements do not address the consequences of the first lien lender exceeding the first lien cap or the second lien lender exceeding a second lien cap. In the absence of an agreement between the parties as to the effect of the first lien lender exceeding the first lien cap, the second lien lender might argue that the breach by the first lien lender of the intercreditor agreement should preclude it from enforcing the agreement. One alternative for addressing this issue is to provide in the intercreditor agreement that excess first lien obligations (i.e., obligations in excess of the first lien cap) will be given a priority immediately after the second lien obligations. This “waterfall’ may be implemented without formally classifying the excess amount as “subordinated debt,” as such classification of a portion of the first lien obligations as “third lien” or “subordinated” may run afoul of the terms of the first lien lender’s credit approval. See section 1.11.
44. This section is an ancillary set of provisions in aid of the other priorities set forth elsewhere in the Model Agreement. First, it provides that the first lien agent and the second lien agent are to be named as additional insureds and loss payees, as applicable, of insurance policies maintained by the grantors. Of course, this includes insurance policies beyond those that cover casualty losses to the collateral. Second, the section provides that the first lien agent will have the exclusive right to adjust settlement of any claims under an insurance policy covering the collateral as well as approve any award in a condemnation or similar proceeding affecting the collateral. Last, continuing the priority theme discussed above, the section provides that the proceeds of any policy covering the collateral or proceeds of any award will be applied in a manner consistent with the waterfall provision relative to proceeds received from enforcement actions.
45. The requirement in this section that a second lien claimholder turn over any amounts it receives in connection with the exercise of enforcement actions (and certain other actions) is essential to the operation of the waterfall provisions of section 4.1. The section requires that all such amounts be segregated and held in trust for the benefit of the first lien agent and promptly paid over to the first lien agent. Once the second lien claimholders have turned over the proceeds of their enforcement activities, the first lien agent should apply those proceeds in accordance with the waterfall.
46. The first lien obligations may be paid off and, subsequently, the borrower may seek to incur new indebtedness on a first lien basis. This section allows for that possibility and provides that the newly incurred indebtedness should be entitled to the benefits of the Model Agreement to the same extent as if the original first lien obligations were not retired. The provisions of the section should not be interpreted to permit the incurrence of indebtedness that is not permitted under the second lien loan documents or to permit indebtedness in excess of the amount of the first lien cap to enjoy a first priority with respect to the collateral. If such refinancing indebtedness is incurred, the second lien agent is required to enter into appropriate documents and agreements to give effect to the substitution, and the new agent is required to agree with the second lien agent that it is bound by the terms of the Model Agreement.
47. Second lien claimholders may resist the application of this section 4.4 to situations other than the incurrence of new first lien obligations that are used to refinance then-existing first lien obligations, as opposed to a permanent subordination of second lien obligations to future first lien obligations not to exceed the first lien cap.
48. If the collateral agent for the first lien lenders arranges a private sale of the collateral to a third party at a price sufficient to satisfy both the first lien obligations and the second lien obligations, then the second lien lenders will be protected as secured parties second only to the first lien lenders and with a claim superior to all unsecured creditors. However, if the first lien lenders pursue a public sale of the collateral under the U.C.C., the first lien lenders can credit bid and purchase the collateral at the sale. Since the first lien lenders will not bid more than the amount of the first lien debt, the second lien lenders’ lien on the collateral will be extinguished unless the second lien lenders elect to outbid the first lien lenders at the public sale. A more orderly alternative to the uncertainties of a private or public sale of the collateral under the U.C.C. is for the second lien lenders to be granted a right in the intercreditor agreement to purchase the first lien debt following an acceleration of the first lien debt, the filing of bankruptcy proceedings, or for a short period of time (e.g., sixty days) following an uncured payment default. The purchase price is at par. Because first lien credit facilities often include hedge arrangements provided by one of the first lien lenders (usually the agent) or an affiliate of one of the first lien lenders, the Model Agreement includes specific provisions for the unwinding of any hedging obligations. Similarly, provisions are included to deal with undrawn letters of credit and with prepayment premiums. During most of the years that first lien/second lien transactions were closed, first lien debt typically traded on the secondary market at par or close to par. The right of the second lien lenders to purchase all of the first lien position at par was therefore a valuable right. During the financial crisis, first lien debt positions have often traded considerably below par, making it impractical and financially unfeasible for second lien lenders to purchase first lien debt under the intercreditor agreement at par. Still, even during distressed times, the option to purchase provisions provide a valuable starting point and framework for negotiations between first and second lien lenders for purchase of the first lien position by the second lien lenders following a default.
49. Second lien claimholders may wish to include additional purchase events such as (i) notice of a disposition or enforcement action that would force a lien release, or (ii) a payment default under the first lien credit agreement not cured or waived by a specified time period.
50. This concept may work only for purchase options that have a limited exercise window. First lien claimholders should have an exception if exigent circumstances exist.
51. First lien claimholders may wish to consider requiring that the purchase notice include all excess first lien obligations.
52. Second lien claimholders may also negotiate the right to receive (or preferably to have the second lien agent receive on their behalf) notice ten to fifteen days in advance of any acceleration or commencement of an enforcement action, or the taking of any action by the first lien claimholders, and of an estimate of the amount of first lien obligations (not in excess of the first lien cap), within which time, pursuant to specified procedures set forth in the intercreditor agreement or in the second lien credit agreement, (i) the second lien agent would notify the second lien claimholders of the event underlying the notice, (ii) each second lien claimholder would have a specified number of business days to notify the second lien agent as to whether it wishes to exercise its purchase right, and whether it is willing to purchase more (or less) than its pro rata share of the first lien obligations (and commitments) and irrevocably commit to purchasing its allocable portion of the first lien obligations not in excess of the first lien cap, (iii) non-committing second lien claimholders would lose their purchase right as to the event that is the subject of the notice, (iv) the second lien agent would allocate the total amount of first lien obligations not in excess of the first lien cap pro rata among the second lien claimholders wishing to exercise the purchase right (with any shortfall being allocated equitably to those willing to purchase more than their pro rata share), and (v) the second lien agent would send a binding notice to the first lien agent committing the purchasing second lien claimholders to consum-mate the purchase by a pre-negotiated deadline. A standstill would exist during the period specified prohibiting the first lien claimholders from taking any of the specified actions with an exception for exigent circumstances. This right allows the second lien claimholders to exercise their purchase right before significant damage (e.g., the loss of trade credit, the triggering of cross-acceleration clauses in other debt, etc.) is done to the enterprise value of the grantors that may result from an acceleration or the commencement of enforcement actions. The Model Agreement sets forth relatively basic purchase option mechanics. For syndicated transactions with a large number of lenders, consideration should be given to setting forth in detail procedures for the allocation and exercise of the purchase right.
53. Another option for the parties to consider regarding prepayment premiums is to provide that the purchasing creditors will pay to the first lien agent as a deferred portion of the purchase price any prepayment premium that is actually paid to the purchasing creditors within a designated period of time but will not pay any prepayment premium at the closing of the purchase unless the premium was then due and payable.
54. Please note section 1.11(e), which provides in part that, with respect to the excess first lien obligations, first lien claimholders will have rights and obligations (other than the obligations in respect to the Standstill Period) analogous to the rights and obligations that second lien claimholders have under the Agreement with respect of the second lien obligations. With respect to any excess first lien obligations remaining after the exercise of the purchase option by the second lien lenders, section 5.5 and section 1.11(e) would result, for example, in the first lien lenders having the same rights and obligations with respect to the excess first lien obligations that the second lien lenders have under the insolvency provisions in section 6.
55. Holders of a secured claim in bankruptcy have a variety of statutory rights to protect the creditor’s interest in the grantor’s property. When lenders hold a collective security interest under one granting clause, they act by majority instruction to the agent or at times by unanimous instruction. When the secured claims are divided into separate granting clauses, two groups (the first lien claimholders and the second lien claimholders) may assert the rights of secured creditors. Absent agreement to the contrary, the second lien claimholders’ assertion of these rights may be made in a manner that is in conflict with the interests of the first lien claimholders. Such actions may include consenting or objecting to financing secured by priming liens on the collateral, consenting or objecting to the use of cash collateral to operate during the bankruptcy, or consenting or objecting to sale of collateral free and clear of liens. On the other hand, if the second lien claimholders waive these rights as secured creditors, the grantors and first lien claimholders could agree to the use and disposition of collateral in a manner that could cause the diminution of the value of the interest of the second lien claimholders in the collateral. As such, one of the key functions of an intercreditor agreement is to set forth the extent to which the rights of second lien claimholders in collateral may be asserted in a manner that does not conflict with the interests of the first lien claimholders during the bankruptcy.
56. In a Chapter 11 bankruptcy where substantially all of the debtors’ assets have been pledged to secure the first and second lien debt, the debtors will have an urgent need to use cash collateral starting with the first days of the case. In addition, in most situations, the debtors will also want to incur DIP financing both to provide the debtors with liquidity and also to inspire confidence in customers, vendors, and employees. DIP lenders generally insist on super priority claims and priming liens that are senior to both the existing first and second liens. The first lien claimholders generally want to facilitate the debtors’ use of cash collateral under a budget that they approve, so as to preserve the value of the first lien claimholders’ collateral. They are also the most frequent source for DIP financing, given the reluctance of secured lenders to permit other lenders to prime their liens. In order for the debtors to have the right to use cash collateral of the first and second lien claimholders, or to have priming liens on collateral pledged to secure the first and second lien loans approved, they must either obtain the consent of both first and second lien claimholders, or secure an order of the bankruptcy court finding that adequate protection has been given to such claimholders to protect them from any loss of value from the use or priming. A finding of adequate protection can be difficult or impossible to obtain, and is not a requirement that debtors or first lien claimholders want to have imposed at the outset of the bankruptcy. As such, most intercreditor agreements include a deemed consent to the use of cash collateral by the second lien claimholders if supported by the first lien claimholders, as well as a deemed consent to permit a priming DIP financing if consented to by the first lien claimholders. The deemed consent typically has certain limitations and conditions. For example, a pre-consent to a DIP financing is typically conditioned on the amount of the DIP financing not exceeding a specified amount. The second lien claimholders will often reserve the right to object to provisions of a proposed DIP financing that would have the effect of dictating the terms of a restructuring, or that would require the company to liquidate its assets on a rapid schedule. While the second lien claimholders’ right to object to use of cash collateral or a priming DIP is limited, second lien claimholders typically do have the right to insist on replacement liens in the debtors’ post-bankruptcy assets to the extent of any loss of value in the collateral so long as any such replacement liens are junior to the approved DIP financing and any replacement liens granted to first lien claimholders.
58. First lien claimholders will want no interference with the use of cash collateral, but second lien claimholders will not want to have their other interests “primed” or have their liens stripped, by reason of the broad concept of “use” of collateral.
59. As noted above in connection with the definition of “First Lien Cap,” it may be desirable to formulate the cap differently in the context of a DIP financing. Common approaches include (i) an incremental cushion for a DIP financing, or (ii) a cap that is the lesser of the first lien cap and some cushion over outstanding first lien obligations at the commencement of the case.
60. This clause is applicable when the first lien cap is tied to a borrowing base. With respect to principal amounts of new loans that increase the first lien obligations and reduce the amount of collateral available for second lien obligations, most agreements limit the amount of diminution that would be suffered. However, most agreements do not limit the amount of diminution that may result from the use of cash collateral or other diminution of the borrowing base. Consideration should be given as to whether cash collateral objections could be asserted by the second lien agent if the amount of collateral diminution, when added to the first lien obligations, would exceed the first lien cap by reason of the erosion of the borrowing base.
61. First lien claimholders should consider deleting this requirement based upon the protection provided to second lien claimholders from the first lien cap and the fact that the first lien claimholders can condition consent to the DIP financing upon an intercreditor agreement with the DIP lender that subordinates the lien securing the DIP financing to the lien securing the first lien obligations. In addition, it may be beneficial to the first lien claimholders to have a DIP financing that is “junior” to the first lien obligations in connection with plan confirmation requirements for the payment in full of all DIP obligations.
62. First lien claimholders may regard this proviso as creating the potential for delay and uncertainty. The second lien claimholders have the right to assert objections that may be asserted by unsecured creditors that the terms of the DIP financing are not appropriate.
63. The market has developed to generally give first lien claimholders the power to compel second lien claimholders to consent to the diminution of collateral, in the form of use of cash collateral or permitting additional secured financing even if the first lien obligations are sufficiently oversecured that first lien claimholders are otherwise not motivated to police the excess use of cash collateral or DIP financing. On the other hand, the market has not similarly developed to give first lien claimholders the ability to use second lien claimholders’ rights of adequate protection in order to more effectively prevent the diminution of collateral. This draft proposes the first set of rights in favor of first lien claimholders and references the second as an alternative favorable to the first lien claimholders. To the extent that the second lien claimholders are required to join in, or prosecute, such an objection, they should consider requiring that their expenses be paid by the first lien claimholders, which could increase the size of the first lien claim, but will assure that the second lien claimholders will not go out of pocket.
64. Some intercreditor agreements attempt to restrict first lien claimholders from consenting to the subordination of the lien securing first lien obligations and, in turn, such agreements often exclude DIP financing from the scope of such restriction. However, the treatment of “carve-outs” is often omitted or not considered the same as if the first lien agent made advances to fund retainers for professionals. This form treats carve-outs as a use of collateral, but not as though they are the same as if being incurred or used as of the date such “carve-out” obligations are incurred. An alternative approach would be to treat administrative carve-outs as extensions of credit that need to be capped. If this approach is taken, additional consideration should be given to the first lien cap and the inclusion of additional, incremental amounts in the event of an insolvency proceeding, and to the need to reflect clear dollar limits on administrative carve-outs in the DIP orders. For a discussion of “carve-outs” generally, see Richard Levin, Almost All You Ever Wanted to Know About Carve Out, 76 AM. BANKR. L.J. 445 (2002).
65. First lien claimholders may want an absolute bar on second lien claimholders attempting to provide “priming” DIP financing, while second lien claimholders will generally resist any limitation against DIP financing due to the ability of third parties to propose the same. A compromise position is bracketed.
66. Second lien claimholders may seek to preserve unsecured creditor objections to a DIP financing, while first lien claimholders may expect second lien claimholders not to object in any capacity so long as a DIP financing satisfies the parameters specified in the intercreditor agreement. The parties may want to consider alternative permitted objections to DIP financing or cash collateral orders such as: (a) provisions that purport to bind parties to a plan, (b) provisions that compel the sale of collateral, and (c) provisions that are otherwise inconsistent with the intercreditor agreement and priorities of the liens.
67. Second lien creditors typically agree not to contest or object to a sale, lease, exchange, or transfer of collateral under section 363 of the Bankruptcy Code if the first lien creditors have consented in writing to such disposition, provided that (i) the liens of the second lien creditors attach to the proceeds of such disposition to the extent so ordered by the court, (ii) the net cash proceeds are applied to reduce the first lien obligations permanently, and (iii) the second lien creditors will not be deemed to have waived any right to bid in connection with such disposition (subject to the lien priorities set forth in the intercreditor agreement). Once again, second lien creditors may attempt to retain the right to assert any objection that may be available to unsecured creditors generally. First lien creditors will most likely object to this inclusion, as it provides the second lien creditors an opportunity to interfere with the first lien creditors’ exercise of remedies. Alternatively, the first lien creditors may require that such second lien objections be otherwise consistent with the other terms of the intercreditor agreement. The first lien creditors may also argue that the second lien creditors have the ability to protect themselves by the exercise of their buyout right. Some intercreditor agreements also require that the second lien creditors, solely in their capacity as holders of a lien on the collateral, join the first lien creditors in any objection to a sale of collateral to the extent asserted by the first lien creditors. The second lien creditors would typically resist this. In transactions where each party has priority in certain types of collateral, the parties should consider agreeing on a methodology to allocate value received in a disposition among the various categories of assets.
68. Second lien claimholders may seek to preserve rights to object to any proposed sale where liabilities of grantors are assumed (given that this permits trade debt to leapfrog the second lien in terms of priority) or where proceeds are not solely applied to repay first lien obligations or second lien obligations. Provisions of this kind may present impediments to sales, present complexities, and require careful negotiation and drafting. For example, cure payments in connection with the assumption and assignment of contracts would need to be carved out, as would payments of DIP financings (if not included in “First Lien Obligations”) and administrative claims entitled to a “carve-out” under any adequate protection arrangements.
69. Second lien claimholders may want assurances that they will be permitted to credit bid their claims in any bankruptcy sale. First lien claimholders will want merely to preserve any rights that second lien claimholders may have, not assure that they have such rights.
70. It may be desirable to include a provision that any credit bid must respect the priorities set forth in the intercreditor agreement, i.e., any credit bid of second lien obligations must contemplate the payment in full in cash of first lien obligations (other than excess first lien obligations) on closing of any resulting disposition.
71. Second lien lenders will generally expect to be permitted to assert any rights they may have to object to dispositions of collateral that would be available to unsecured creditors in a bankruptcy proceeding. First lien lenders may seek to restrict such rights, or to condition the exercise of such rights on there having been a concession or determination that all or a portion of the second lien obligations are unsecured, arguing that second lien claimholders have the ability to protect themselves through exercise of their buyout rights and that a price for the priority second lien claimholders enjoy over other creditors is that they must give up any rights to interfere with collateral dispositions that first lien claimholders support. An alternative approach is to rely solely on a provision like section 3.1(d), which generally preserves unsecured creditor rights. This approach can be favorable to the second lien, depending on how drafted, since it then applies to all aspects of the agreement that are not expressly carved out. The first lien may expect that certain waivers by second lien claimholders will be unqualified, such as waivers of objections to DIP financings supported or provided by the first lien, objections to liens or claims of first lien claimholders, and where commencement of an involuntary bankruptcy is included in the term “Enforcement Action,” the right to initiate or join in an involuntary bankruptcy.
72. First lien lenders may seek to require the second lien agent to actually support objections that the first lien may have to sales of collateral and other matters in an insolvency proceeding. This is not a usual provision, and many second lien lenders would resist it. To the extent that it is insisted upon, second lien claimholders should consider limiting this undertaking to withholding consent to the applicable disposition of collateral or filing a pleading indicating support for the first lien agent’s objections, and also including a requirement that the second lien claimholders be indemnified for any expenses or other losses incurred in complying with this requirement (that any reimbursement by first lien claimholders not add to the amount of priority first lien obligations).
73. The commencement of a bankruptcy case imposes an automatic stay on actions to foreclose on collateral or otherwise to seek collection of pre-bankruptcy claims. Secured creditors may nonetheless seek a bankruptcy court order lifting the stay and permitting the creditors to take enforcement actions against collateral under appropriate circumstances. First lien claimholders want to control the timing of any effort to pursue remedies against collateral following the bankruptcy filing, and it is thus typical for intercreditor agreements to prevent or severely limit second lien claimholders from seeking relief from the stay to take action against shared collateral.
74. Second lien lenders may seek to retain the right to take action following the standstill period (which would then be modified such that it does not extend indefinitely in bankruptcy). First lien lenders and borrowers would generally resist this.
75. Many agreements only require that second lien claimholders not seek relief themselves. More first lien favorable provisions would go on to preclude second lien claimholders from opposing relief sought by the first lien. This clause would operate in conjunction with section 6.4(b)(1) and could be provided for there as well.
76. First lien lenders would prefer the agreement not to seek relief from the stay to be unqualified.
77. As noted above, in order for the debtors to use cash collateral or grant priming liens on collateral, the debtors must either obtain consent of the secured lenders or must provide adequate protection for any diminution in the value of the secured lenders’ interest in the collateral. Adequate protection can take the form of cash payments of fees and/or interest, principal reductions, or liens on replacement collateral. If the second lien claimholders retain their right to seek adequate protection in connection with a proposed priming DIP financing or use of cash collateral, this can add a significant and perhaps prohibitive cost to the debtors.
It has become customary for intercreditor agreements to provide that second lien claimholders may only seek adequate protection in the form of replacement liens on collateral and many agreements restrict replacement liens unless the first lien claimholders also have been granted replacement liens in the same collateral as adequate protection. Note that the first lien claimholders may well have differing interests from the second lien claimholders in terms of whether replacement collateral is needed as adequate protection, because the first lien claimholders can have a significant cushion when the second lien claimholders do not. As such, the first lien claimholders may not insist upon, or be entitled to receive, replacement liens, while the second lien claimholders may suffer loss of value without them.
78. A pro-second lien provision would eliminate a general restriction against seeking adequate protection and limit the waivers to cash collateral, DIP financing, and asset sales.
79. While common in the marketplace, second lien claimholders and their counsel may question why this should be a condition to second lien claimholders obtaining junior replacement liens on collateral.
80. The parties should consider whether the payment of administrative claims arising under section 507(b) should be paid over to the first lien agent as proceeds of collateral and be applied to reduce the first lien obligations permanently. If first lien claimholders seek confirmation of a plan, the right of second lien claimholders to assert a claim under section 507(b) may preclude confirmation of the plan. The bracketed text would permit the confirmation of the plan so long as second lien claimholders’ section 507(b) claim would otherwise be satisfied under a “cram-down”-type test. The parties may wish to consider an alternative treatment for section 507(b) claims that may include being silent (pro-second) or subordinating the right to assert section 507(b) claims in their entirety until the discharge of first lien obligations.
81. Second lien adequate protection payments could include any or all post-petition claims, or other amounts as may be negotiated between the parties.
82. The bracketed language gives the parties the option to negotiate whether adequate protection payments may be contested or not by the first lien claimholders. To the extent the first lien agent asserts a lien on substantially all property of the applicable grantor, the first lien agent likely would assert that any payment constitutes “proceeds” of collateral and would be subject to turnover and application to payment of the first lien obligations. Second lien claimholders would want to provide expressly that any payments turned over to the first lien agent will be applied to reduce the first lien cap permanently.
83. The first lien claimholders prefer to have complete freedom to act in the bankruptcy, even where this means that they may choose to contest the claims and liens of the second lien claimholders or to oppose actions by the second lien claimholders that are not inconsistent with the intercreditor agreement. For example, the first lien claimholders may want to support the position that the second lien is wholly unsecured because this may facilitate the completion of a bankruptcy plan or sale. This provision preserves the right of the first lien claimholders to object generally to actions taken, or relief requested, by the second lien claimholders.
84. The second lien favorable version specifies that the first lien claimholders may not object to the second lien claimholders’ seeking of adequate protection consistent with the agreement.
85. A debtor or bankruptcy trustee may have the ability to “avoid” or set aside pre-bankruptcy payments or transfers of value as fraudulent or preferential transfers. Fraudulent transfers can be transfers with actual intent to hinder, delay, or defraud creditors. More common in large and mid-size cases are allegations of constructive fraud, where a payment or other transfer was made while the debtor was insolvent and for less than reasonably equivalent value. An example is the debtor repaying debt that was incurred as a result of a leveraged buyout, where the value from incurring the debt flowed to shareholders rather than the borrower. Preferential transfers are those made to creditors within the ninety days prior to a bankruptcy (a year in the case of insider creditors) that result in the creditor receiving more than if the payment had not been made and the debt had been liquidated. Preferences are not a concern where a creditor is, at all points since the offending transfer, oversecured. If a payment is avoided, the creditor will have a claim against the debtor for the value disgorged. Where a first lien loan or a second lien loan has been repaid prior to bankruptcy, the possibility exists that the payment could be subject to avoidance on one of the above theories. The purpose of section 6.6 is to specify that if that does occur, the intercreditor agreement continues to govern the relationship between the first and second lien claimholders, with respect to their claims against the debt as a result of the disgorgement. The more controversial language at the end of the section endeavors to compel second lien claimholders to disgorge to the first lien claimholders amounts that they may have received constituting collateral proceeds during the time between the initial payment to the first lien claimholder and the avoidance of that payment. Second lien claimholders often will strenuously resist any contractual undertaking that would require them to disgorge, on the basis that the payment made to them was permitted under the intercreditor agreement when made and they may well have passed the payment along to their own investors, with no power to obtain a return of such payment. When determining whether and to what extent to resist such provisions, note that the second lien claimholders are likely to be subject to a similar risk of avoidance. As such, though undertaking a contractual obligation to disgorge may be unpalatable, it may not greatly increase the actual risk of disgorgement.
86. Second lien claimholders will oppose disgorgement of proceeds of collateral received after the first lien obligations are discharged. The parties may negotiate a middle ground where disgorgement is applicable only if demanded within a set time period after payment is received by second lien claimholders.
87. Second lien claimholders will object to a pro rata disgorgement of avoidance action proceeds on the grounds that general unsecured creditors would have the right to share in such payments, and that the lien subordination should only pertain to the receipt of proceeds of collateral.
88. In a restructuring, it is common for holders of first and second lien debt to receive debt or equity securities in the reorganized company. One purpose of section 6.7 is to confirm that this is permissible and that second lien claimholders can receive distributions prior to payment in full of the first lien claimholders. The first lien favorable variation specifies that distributions to the second lien claimholders on account of their secured claims are only permitted if the first lien claimholder classes support the plan. Another purpose of this section is to specify that, if both first and second lien claimholders do receive new secured debt that shares collateral, the intercreditor provisions will continue to govern the relative priorities and other rights of such secured debt.
89. There is a hypothetical issue with the fact that this provision covers all debt securities issued with respect to the second lien obligations, in that it is possible that the second lien obligations could be bifurcated into a secured and unsecured component, and that secured debt obligations could be issued with respect to the unsecured component. To the extent that other unsecured creditors also receive the same type of security or the same security, the obligations issued to second lien claimholders could be treated differently because of this provision. Consider whether this potential should be addressed by carving out debt obligations to the extent issued to any unsecured claim held by second lien claimholders and, potentially, to the extent such debt obligations are also issued to other creditors holding unsecured claims.
90. In this section, the second lien claimholders agree not to oppose the allowance of post-petition claims held by the first lien claimholders and the first lien claimholders agree not to oppose the allowance of post-petition claims held by the second lien claimholders. This waiver applies to valuation of the collateral as a component of determination of the secured claim held by the first and second lien claimholders. In addition, the waiver prevents either the first lien or second lien claimholders from objecting to the allowance of the amount of first and second lien debt held by the other parties. Finally, if and to the extent the first lien claimholders have allowed secured claims, the second lien claimholders agree not to oppose the payment of the first lien debt. While this latter waiver is less common in the marketplace, it is consistent with the notion that the second lien claimholders have no right to payment from collateral until after the first lien claimholders have been paid and, therefore, the second lien claimholders should benefit, dollar-for-dollar, from the repayment of the first lien debt. The practical effect of these waivers is that third parties with an incentive to challenge the extent, validity, and priority of the first and/or second lien debt will be the ones to challenge the secured claims and there should not be a challenge commenced by either of the first or second lienholders against the other.
91. Many intercreditor agreements qualify the agreement not to object to claims based upon the extent of the value of any collateral securing the first lien obligations without regard to the existence of the lien securing the second lien obligations. This language is regarded as inconsistent with the notion that the parties to the intercreditor agreement should not interfere with each others’ claims against the grantors.
92. In the mezzanine world, where the junior creditor could not receive payment on its unsecured claims until the senior debt was paid in full, an election by the senior lender under section 1111(b) of the Bankruptcy Code could cause the waiver of the unsecured creditor “dividend” and make it more difficult for the junior creditor to ever receive payment under a plan. Hence, the subordination agreements in a mezzanine context often contained a “waiver” of any claims resulting from the senior lender making the section 1111(b) election. The Model Agreement deletes this waiver as the Task Force believes that the section 1111(b) election does not affect the rights of the second lien claimholders. The other waivers that relate to cash collateral, financing, and granting of security interests are general provisions that are consistent with the DIP financing and cash collateral provisions discussed above. Some second lien claimholders may prefer to be governed by those more specific sections and may object to the more general waiver.
93. Any payment received by a second lien claimholder as a result of a surcharge against collateral under section 506(c) of the Bankruptcy Code would result in the receipt of proceeds of collateral that would otherwise be required to be applied to payment of the first lien obligations.
94. Many forms in the marketplace have elaborate provisions dealing with the classification of claims. The Model Agreement attempts a more streamlined provision that should be sufficient under most circumstances. We believe that the more lengthy waiver grew out of structures where the second lien claimholders held claims under the same security documents, thereby creating the risk of classification in the same class. Separate granting clauses, at least with respect to the secured claims held by the first lien claimholders and second lien claimholders, should result in separate classification as a matter of law.
95. Section 510 of the Bankruptcy Code contains a general reference to the enforceability of “subordination” agreements. There is some difference of opinion as to whether the reference to subordination is to “debt subordination,” “lien subordination,” or both. From the perspective of waivers and estoppel, the Model Agreement takes the position that the claimholders should not dispute that the reference in section 510 includes “lien subordination.” Therefore, no claimholder should be permitted to avoid its contractual obligations set forth in the intercreditor agreement by arguing that the bankruptcy court lacks jurisdiction to enforce a contract between two non-debtors. Of course, the parties cannot confer jurisdiction on the court where none would otherwise exist, but at least this acknowledgement should be evidence of the parties’ intent and should dissuade parties from conduct inconsistent with that intent.
96. Much of the detail, and key substantive terms and distinctions, are found in the definitions. A few of the important ones are discussed briefly in footnotes below, but all of them should be scru-tinized as the most mundane could be important in a particular transaction. A quick note as to form: Breaking with tradition, at least for many of us, the Model Agreement does not group all of the defined terms into a separate section but rather sprinkles many of them throughout the agreement, providing a definition when a term is first employed. As editor Howard Darmstadter pointed out to the drafters of the Model Agreement, it is easier to read a document from the start if uninterrupted by searches for definitions. More common and obvious terms are found in the definition section at the end. Note also that section 8.2, “Usages,” sets forth various conventions as to certain terms and points of interpretation, including as to the calculation of time periods and the time of day, and that a reference to an agreement includes its amendments. Comments on the following few key definitions appear in notes to each of the applicable definitions: “Cash Management Agreement,” “First Lien Obligations,” “Hedge Agreement,” and “Obligations.” These terms all relate to the breadth of the Model Agreement—it includes all of the obligations and indebtedness held by the First Lien Lenders, and certain affiliates and potentially others, including obligations relating to bank products and cash management arrangements such as interest rate swaps and automated clearing services. This broad scope is mitigated by the concept of the first lien cap, and care should be taken as to its definition, as more fully discussed in note 11, and as to the definition of first lien obligations, as to which an alternative definition is provided.
97. Note the alternative definition, available for use with the alternative provisions of section 1.1. As a general matter, the first lien claimholders and second lien claimholders typically expect to hold liens on the same pool of assets (very often all assets), but exceptions to this often occur and the definition as well as the substantive provisions in section 1.5 may need to be adjusted.
98. If the parties use alternative section 1.1, then this definition of “Collateral” can be used.
99. This term is employed throughout the Model Agreement to indicate when the second lien claimholders are no longer subject to the restrictions of the intercreditor agreement and therefore is a key definition. See in particular note 45. Also, the parties should consider whether certain restrictions against the second lien claimholders contained in the intercreditor agreement, as well as certain other provisions of the Model Agreement, should apply only until the first lien obligations have been paid to the amount of the first lien cap or whether such restrictions or provisions should continue to apply until all first lien obligations have been paid in full.
100. If the parties agree as provided in section 1.3 that the first lien agent should not continue to have priority if its lien is not properly perfected, lapses, or is avoided in bankruptcy, then the language in parentheses concerning post-petition claims should be deleted.
101. Clause (b) excludes indemnification obligations for which no claim has been made. Consideration should be given to whether “Discharge of First Lien Obligations” should also include cash collateralization for contingent exposure on claims that have been made, threatened, or, in some cases, may reasonably be expected to be asserted.
102. This definition is broad in scope, capturing in clauses (a), (c), and (d) not only the foreclosure against collateral and other standard secured party remedies, but also the initial steps of a consen-sual disposition of collateral as described in clause (b). However, it does not include the filing of an involuntary bankruptcy proceeding or the exercise of other unsecured creditor remedies. The broad scope benefits the first lien claimholders since the first lien claimholders are given the exclusive right to exercise enforcement actions (section 3.1), and certain events such as the automatic release of liens on collateral securing second lien obligations are triggered by the first lien agent’s enforcement action (section 1.10). On the other hand, section 5.1(b) bars the first lien claimholders from commencing any enforcement action so long as the second lien claimholders’ purchase option right under section 5 is outstanding, thereby benefiting the second lien claimholders by the broad definition.
103. See section 1.10, “Release of Liens [or Guaranties].” First lien claimholders may wish to cause a disposition of collateral by an action of the grantor in lieu of a foreclosure sale.
104. Consider whether the enforcement action concept should, or should not, include commencement of an involuntary bankruptcy proceeding. First lien lenders may consider a right to interrupt their efforts to realize on collateral through filing an insolvency proceeding against a grantor as inconsistent with the proposition that the second lien will defer to the first lien in such efforts. A second lienor may argue that it should not be required to forfeit a right that it would have if it were entirely unsecured. In considering how much to value this right (or to fear it), the parties should note that to commence, or join in commencing, an involuntary bankruptcy petition, a second lienor would likely have to concede that its claims are not fully secured, making this a somewhat unattractive option. A common solution to this issue is to permit second lien claimholders to commence an involuntary insolvency proceeding after the expiration of the standstill period, making the remedy similar to that exercisable by unsecured mezzanine creditors.
105. If the parties use the alternative definition of “Collateral,” then this definition of “First Lien Collateral” can be used.
106. Many intercreditor agreements fail to address whether a non-conforming DIP financing (i.e., one that is not consented to by second lien claimholders) would be subject to the remaining terms and provisions of the intercreditor agreement insofar as the new DIP financing would likely be, at least in part, a refinancing of the first lien obligations. Second lien claimants may resist this provision as it gives first lien claimholders the benefit of opting into the pro-senior intercreditor agreement provisions for a non-conforming DIP financing.
107. Consider whether this additional clause is necessary or should be used in lieu of negotiated provisions regarding bankruptcy distributions in section 6.7, “Reorganization Securities.”
When the National Conference of Commissioners on Uniform State Laws (NCCUSL) approved the Uniform Prudent Management of Institutional Funds Act (UPMIFA) in July 2006, they could not have predicted how imprudent the financial world would seem to nonprofit board members three years later. From the 2008 stock market crash and the collapse of mortgage-backed securities, to the discovery of Bernard Madoff’s Ponzi scheme, prudent managers of institutional funds held by nonprofit corporations and charitable trusts now contend with an investment environment that has been warped by optimistic illusions, fraud, and greed. The continued congressional scrutiny of nonprofits, spearheaded by Senator Grassley, as well as the Obama administration’s commitment to public institution transparency, also color the current financial culture in which nonprofit directors find themselves. Adding it all up, prudent nonprofit directors are in a fine pickle these days: shrinking investment assets, increased demand for charitable services and grants, increased scrutiny, and an untested new law.
The NCCUSL drafting committee worked hard to improve the Uniform Management of Institutional Funds Act (UMIFA) by modernizing endowment fund rules for fiduciaries. Indeed, UPMIFA does take into account important facts and circumstances for investment policies, spending policies, expense management, and delegation in ways that UMIFA did not. The business lawyer serving on a board in 2009 should be knowledgeable about the changes in the law at this particularly perilous time for investment management. The rules of the new UPMIFA regarding investment policies do not differ fundamentally from the rules under UMIFA, which was adopted in 35 states and the District of Columbia beginning in 1972. The spending policy rules are very different, though. The bright-line historic dollar-value floor on spending from an endowment fund that applied under UMIFA has been replaced with rules that allow invasion of principal and require the directors to be “prudent” under the facts and circumstances. In addition, many states have adopted a “presumption of imprudence” for spending rates in excess of 7 percent per year. The potential consequences of getting it wrong have many volunteer board members looking nervously for an exit. This article focuses on the new prudent spending rules being adopted as the states replace UMIFA with UPMIFA, in light of the prudent investment rules and today’s economic reality for institutions. After summarizing the relevant aspects of UPMIFA, I offer some observations about how board members can approach the difficult spending decisions that face them today.
Not surprisingly, the uniformity goal of UPMIFA has been a bit thwarted by the states; there are several variations on the theme. Table I shows the states that have adopted UPMIFA, the effective date, and whether the optional presumption of imprudence has been adopted. There are several other interesting aspects of UPMIFA that are not discussed at length in this article, including the new rules on investment expenses and the self-modification procedures for small, old funds. Helpful details about those aspects, as well as a nice history of UMIFA and UPMIFA, can be found at the Uniform Law Commission’s website on UPMIFA (www.upmifa.org).
Background
In addition to corporate law articulating standards of conduct generally, those states that have adopted UPMIFA apply specific rules to the directors’ duties governing the investment and expenditure of a nonprofit corporation’s investment assets. The spending rules apply only to invested assets held by a charitable institution subject to the donor’s instruction that the assets may not be wholly expended in one year. Thus, these rules do not apply to so-called quasi endowments or board-designated endowments, which are rainy-day funds set aside by a board, but not subject to donor restrictions. The UPMIFA spending rules do apply to assets that are intended to be held either for a stated term of years or for perpetual duration.
Investment Policies
UPMIFA requires that in managing and investing an institutional fund, subject to the intent of a donor expressed in a gift instrument, the board must consider
The charitable purposes of the institution and the purposes of the institutional fund.
General economic conditions.
The possible effect of inflation or deflation.
The expected tax consequences, if any, of investment decisions or strategies.
The role that each investment or course of action plays within the overall investment portfolio of the fund.
The expected total return from income and the appreciation of investments.
Other resources of the institution.
The needs of the institution and the fund to make distributions and to preserve capital.
An asset’s special relation or special value, if any, to the charitable purposes of the institution.
In addition, managers of institutional funds must not make fund management and investment decisions in isolation. With each decision, they are to consider the context of the institutional fund’s portfolio of investments as a whole and as a part of an overall investment strategy. The strategy must be based on risk and return objectives suited to the fund and to the institution. The board must diversify the investments unless the board members determine that, because of special circumstances, the purposes of the fund are better served without diversification. Subject to these standards, the directors can invest the endowment in any kind of property or type of investment.
The board may delegate to an external agent the management and investment of the endowment fund, but must act prudently and in good faith in selecting the agent and establishing the scope and terms of the delegation. The board must periodically review the agent’s actions. In the last 20 years, most nonprofits have come to rely substantially upon the recommendations of professional money managers, and the relevant statutes authorize the board to rely upon professional investment counsel’s advice. There are still some nonprofits whose board members feel comfortable working without professional investment advisors, although those are few and far between.
Spending Policies
UPMIFA also sets forth rules governing spending policies for endowment funds. Under UMIFA, the rules were fairly straightforward: as long as the institution did not invade the “historic dollar value,” any spending rate would be fine. UMIFA’s premise was that the sum of all contributions to a fund, which contributions were restricted by the donor to be held as an endowment, would peg the amount that could never be spent: the historic dollar-value floor. UMIFA did not include an inflation factor and did not specifically require the board to consider whether the purchasing power of the original gift would be preserved when making decisions about the spending rate. So long as the original contribution was never invaded, any amount of spending was permitted.
In some ways, UPMIFA provides considerably more flexibility. Within the boundaries of the donor’s intent as expressed in the gift instrument, an institution may spend or accumulate so much as the board determines is prudent for the uses, benefits, purposes, and duration for which the endowment fund is established. Of course, if the gift instrument states a particular spending rate or formula, that rate or formula will apply and the board has no discretion in determining the spending policy with respect to that particular fund, and UPMIFA does not alter the donor’s instructions. Otherwise, in making a determination to appropriate or accumulate assets in an endowment fund, the board members, acting in good faith, are to apply the prudent person standard, and consider, if relevant
The duration and preservation of the endowment fund.
The purposes of the institution and the endowment fund.
General economic conditions.
The possible effect of inflation or deflation.
The expected total return from income and the appreciation of investments.
Other resources of the institution.
The investment policy of the institution.
UPMIFA’s Big Idea on Spending
The big idea behind UPMIFA’s revision of the spending policy rules was to promote a total return approach to spending, akin to the total return approach to investments. Or, stated another way, spending policy decisions are the flip side of investment policy decisions: invest at a rate that over the long term will preserve the purchasing power of the principal and spend at a rate that over the long term will effect the donor’s intent to serve the charitable purpose each year. In the comments to section 4, the Drafting Committee noted that
[i]nstitutions have operated effectively under UMIFA and have operated more conservatively than the historic dollar value rule would have permitted. Institutions have little incentive to maximize allowable spending. Good practice has been to provide for modest expenditures while maintaining the purchasing power of a fund. Institutions have followed this practice even though UMIFA (1) does not require an institution to maintain a fund’s purchasing power and (2) does allow an institution to spend any amounts in a fund above historic dollar value, subject to the prudence standard. The Drafting Committee concluded that eliminating historic dollar value and providing institutions with more discretion would not lead to depletion of endowment funds. Instead, UPMIFA should encourage institutions to establish a spending policy that will be responsive to short-term fluctuations in the value of the fund. Section 4 allows an institution to maintain appropriate levels of expenditures in times of economic downturn or economic strength. In some years, accumulation rather than spending will be prudent, and in other years an institution may appropriately make expenditures even if a fund has not generated investment return that year. [Emphasis added.]
Unfortunately, the Drafting Committee did not articulate what should happen in the case of a catastrophic decline in value, as we have seen in the last year. Of course, the financial services industry has developed abundant quantitative models that will illustrate for a board the spending rate that would preserve the purchasing power using performance models developed over the last several decades. However, they will always footnote the idea that past performance does not indicate the results that will be obtained in the future. On the flip side, there are no models for institutional directors to rely on in determining the spending rate that will preserve the donor’s intent to serve the particular charitable program envisioned at the time of the gift. While it is relatively easy to assist a board in determining defensible investment and spending policies based on the recommendations of investment professionals who will readily advise on risk-adjusted asset allocations, the spending policy factors of UPMIFA require the board to focus also on qualitative decisions about the donor’s and the institution’s evaluation of intergenerational fairness, programmatic disruptions caused by dramatic changes in funding, inefficiencies created by stop-and-go funding approaches, and the fact that the needs may be greatest during the phase of the economic cycle that most dramatically reduces the investment earnings from the fund.
There is little guidance in UPMIFA or the comments about how a prudent board resolves this dilemma, but it is clear that if they get it wrong, the state’s attorney general can enforce the charitable interests of the public. The problem for directors is particularly acute in the states that adopted the “presumption of imprudence.” At the time this article went to press, nine states had adopted the presumption that a particular spending rate, stated as a percentage, is imprudent (see Table I). This rebuttable presumption in section 4(d) of UPMIFA provides that the “appropriation for expenditure in any year of an amount greater than 7 percent of the fair market value of an endowment fund, calculated on the basis of market value determined at least quarterly and averaged over a period of not less than three years immediately preceding the year in which the appropriation for expenditure is made, creates a rebuttable presumption of imprudence.” There is not, however, a “presumption of prudence” for any appropriation less than or equal to 7 percent.
Before delving into some practical discussions of board decision-making criteria, some ambiguity in the drafting of the presumption deserves discussion. The fair market value to which the presumption is to be applied is “calculated on the basis of market value determined at least quarterly and averaged over a period of not less than three years immediately preceding” the year of appropriation. In the comments to UPMIFA, the commissioners stated:
The period that a charity uses to calculate the presumption (three or more years) and the frequency of valuation (at least quarterly) will be binding in any determination of whether the presumptions [sic] applies. For example, if a charity values an endowment fund on a quarterly basis and averages the quarterly values over three years to determine the fair market value of the fund for purposes of calculating 7 percent of the fund. The charity’s choices of three years as a smoothing period and quarterly as a valuation period cannot be challenged. If the charity makes an appropriation that is less than 7 percent of the value, then the presumption of imprudence does not arise even if the appropriation would exceed 7 percent of the value of the fund calculated based on monthly valuations averaged over five years.
Most institutions do look back just three years in determining their spending policy, but given last year’s dismal performance, and in light of the comments to UPMIFA, the institutions may be better served if they amend their spending policy now and adopt a longer smoothing period with more frequent valuation dates. Using quarterly data from the last 10 years may suggest that a higher amount of appropriation is not imprudent. The statute does not articulate how often the board can revisit this decision, but clearly if the spending rate desired is at a rate that exceeds the ceiling in the presumption, the well-advised board may want to change its spending formula. On the other hand, many charities may not have an articulated formula for determining a payout rate, and so presumably the quarterly/three-year periods would apply by default.
In any event, consider the predicament of a charity that has only one permanent endowment fund, and that fund lost 30 percent of its value since December 31, 2007. Assume that for many years it had budgeted and spent each year, under the typical pre-UPMIFA spending policy, an amount equal to 5 percent of its asset value calculated at the close of each of the three immediately preceding fiscal years. Its investment policy had been designed to match the long-term historically achievable investment performance of 5 percent after expenses, but had not accumulated any earnings, so that the fair market value was equal to its historic dollar value. Let’s assume, for argument’s sake, that neither the donor nor her heirs are available to advise the board about intent, that the gift instrument is specific enough to indicate that the fund was intended to be maintained in perpetuity, but that there is no specific stated instruction for this turn of events.
As Scenario A of Table II illustrates, if the institution maintains the same spending rate, there is no further market decline, and the institution is able to generate the historic 5 percent return on its remaining capital, then the institution’s spending policy will be presumptively imprudent under UPMIFA by 2011, and the endowment will be depleted by about 2030.
Scenario B shows that if the institution immediately reduces its spending rate to match 5 percent of the principal after the dramatic market reduction, it can avoid falling into the presumptively imprudent range, particularly if the market returns to normal historic patterns for the same risk-adjusted asset allocation that the institution had in place before the market correction. Assuming that over the long term the board maintains the pre-2008 investment policy that generated, on average, annual returns of 5 percent, this institution will forever maintain a reduced spending rate.
If UMIFA applies, or if the board decides not to spend any amount until the corpus recovers, then the institution would not be able to support any charitable activities until the historic dollar value is recovered. Accordingly, applying the normal growth and investment assumptions, Scenario C shows that this will happen in 2018.
Several aspects of the three simplified scenarios in Table II merit comment. First, a board that wishes to maintain spending at the historic rate now has the option of doing so, in states that have adopted UPMIFA. If the state has adopted the rebuttable presumption of imprudence, the board will need to document why the current programmatic needs are so important (or, perhaps, are legally or contractually required) that the risk of depletion is acceptable. The board also should document a plan for restoring the principal amount, either by fund-raising, by adopting an investment policy that is more aggressive, or by implementing other revenue streams through related or unrelated business activities. Each of those approaches does, of course, entail myriad other business risks.
The board that adopts Scenario B is unlikely to face depletion; however, its charitable impact is permanently reduced. That board in principle accepts the lower funding model in perpetuity, since, absent fund-raising, aggressive investments, or other revenue streams, the programmatic spending is unlikely to ever return to pre-2008 levels. Note, however, that private foundation boards must adopt this model because they are required to distribute at least 5 percent per year, unless there are other revenue sources for meeting the minimum distribution requirement of section 4942 of the Internal Revenue Code.
The board that adopts Scenario C gets to take the next decade off from any grant-making activity while the corpus recovers. Its responsibilities will be limited to documenting how the decision to accumulate comports with donor intent and keeping close tabs on the investment performance. This board is unlikely to face attorney general scrutiny in states that have adopted UPMIFA because there is no corollary presumption of imprudence if there are no expenditures. If this board also believes that the corpus should be increased to keep up with inflation, the accumulation period will be even longer.
Summary
UPMIFA allows directors the freedom to choose whether to spend or accumulate, to adopt an investment policy that meets the intent of the endowment fund, and to apply their business judgment to management of the charity’s endowment assets without arbitrary limits. In those states that have adopted section 4(b) of UPMIFA, the presumption of imprudence challenges that freedom and may effectively induce institutions to dramatically reduce their spending rate. Few volunteer directors are keen to make decisions that are “presumed” to be imprudent. For those hearty souls with the desire to keep programs running despite dramatic losses, the best advice is to document thorough analysis of the human and programmatic costs of reducing spending, as well as any applicable laws or donor requests. At the same time, board members reconsidering the investment policies will need to maintain a growth orientation, which, given the events of the last 12 months, requires enormous fortitude and confidence.
Backdating is a much misunderstood and largely unexplored subject. It involves a wide range of conduct, some of which is an integral part of everyday law practice. To the layperson, backdating connotes wrongdoing. The propriety of backdating, however, depends upon its purpose and effect. Every lawyer should be capable of distinguishing legitimate backdating from improper backdating. Unfortunately, the dividing line is often far from clear.
Little guidance exists on backdating, notwithstanding its pervasiveness, the complexity of determining its propriety, and the serious consequences of a misjudgment. An indepth examination of the day-to-day backdating issues that most business lawyers face cannot be found in the literature. This Article begins to fill that void.
This Article explains the different meanings of backdating, explores the reasons why it is difficult to distinguish legitimate backdating from improper backdating, examines the impact of disclosure on the propriety of backdating, and develops an analytical approach to assist business lawyers in wrestling with the difficult situations most will confront in their daily practices. By illuminating the subject, it is hoped that this Article will begin a much-needed dialogue about backdating.
INTRODUCTION
Backdating describes a broad scope of conduct ranging from blatant fraud to the common practice of executing a document sometime after the event evidenced by the document occurs. Backdating is not right or wrong per se; rather, its propriety depends upon its purpose and effect. Whether a given instance of backdating is legitimate or improper is a complex, multifaceted question that frequently plagues lawyers.
Almost all business lawyers deal with situations where documents might be backdated. Some lawyers address these situations by carefully evaluating the legal, ethical, and moral issues each case presents; others respond to these situations in a more haphazard fashion. The stakes are high—lawyers who participate in improper backdating can be subject to disciplinary proceedings, civil claims, and even criminal prosecution.
Notwithstanding the pervasiveness and gravity of backdating, the literature is devoid of the much-needed dialogue to guide lawyers, judges, and disciplinary boards through this thicket.1 Attention has been focused on high profile backdating cases, like the recent options backdating scandal involving many large, publicly traded corporations.2 But no meaningful guidance exists as to the far more common day-to-day backdating questions stemming from clients of all sizes. Every lawyer should be equipped with the necessary tools to evaluate the propriety of these everyday backdating issues.
The goals of this Article are to illuminate the subject of backdating, alert lawyers to the necessity of evaluating every backdating situation with care, and provide an analytical approach to assist lawyers in resolving backdating questions. Part I defines backdating and explains the difference between backdating that fabricates and backdating that memorializes. Part II explains that the line between fabricating and memorializing is often unclear and that, even when that line can be discerned, it does not always separate improper backdating from legitimate backdating. Part III considers whether impropriety can be averted by disclosing backdating. Part IV delineates a set of problems to which the Article’s analysis is applied. Finally, Part V provides a series of guidelines intended to help lawyers navigate this minefield.
I. IS BACKDATING WRONG PER SE?
To the layperson, backdating connotes wrongdoing. It sounds like a bad thing. Backdating is just plain wrong—right?
In fact, backdating is neither right nor wrong, per se. Rather, its propriety depends upon its purpose and effect. Backdating can be utilized to perpetrate a fraud or it can be employed in legitimate commercial practice. Part I explores the different meanings of backdating and distinguishes backdating that fabricates from backdating that memorializes.
A. BACKDATING DEFINED
The meaning of the term “backdate” is far from clear. As one commentator has remarked:
It is difficult to generalize about exactly what backdating really is, since there have been significant variations in fact patterns. Indeed, much of the debate centers on which practices are legitimate and which are not.3
The dictionary is a logical starting point for establishing what backdating really means. And the dictionary is as far as one must go to realize that it is impossible to generalize about the propriety of backdating. Whether backdating is legitimate or improper depends upon the type of backdating involved and its potential effects.
Two principal definitions of the verb “backdate” emerge from the dictionary.4 One involves the action of assigning an event “to a date prior to that of actual occurrence.”5 The second involves dating a document “as of a time prior to that of execution.”6 The propriety of backdating depends largely on which of the two actions has occurred.7
To the layperson, the term “backdate” typically connotes an act of fabrication— the action described by the first dictionary definition (i.e., assigning an event “to a date prior to that of actual occurrence”). If an event actually occurred on February 11, 2008, and a lawyer drafted a document stating the event occurred on December 3, 2007, the document fabricates the date of the event. The fabrication might be intended to secure a tax benefit for the lawyer’s client at the expense of the government or an economic benefit from a private party not privy to the truth. Under these circumstances, the backdating facilitates wrongdoing and is clearly improper.8
Not all backdating, however, entails a fabrication. As the dictionary reveals, backdating also describes the practice of dating a document prior to the time it is executed.9 In these circumstances, the document might simply memorialize the prior event. As a matter of law, an event often occurs before the document evidencing the event can be executed.10 For example, if the event in question involves reaching an agreement, the intent of the parties may control that determination and such intent can be expressed long before the document evidencing the agreement is drafted and executed.11 When a document memorializes a prior event, the act of dating the document prior to the date of execution is not nefarious. Such dating is truthful because the event in question occurred on the earlier date. Indeed, the document would fabricate the date of the event if it indicated the event occurred on the execution date, rather than the earlier date on which the event actually transpired.12
In contrast to backdating that fabricates, backdating that memorializes is an integral part of daily law practice.13 Business lawyers routinely face situations where a document must be executed after an event has occurred. The remainder of Part I will illustrate the distinction between backdating that fabricates the time of an event and backdating that memorializes a prior event.
B. BACKDATING THAT FABRICATES
A rich body of case law confirms the impropriety of backdating that fabricates at the expense of a third party or in violation of a law. In the most egregious cases, the backdating fabricates an event that never happened.14 The same potential for impropriety exists, however, when the event described by the backdated document actually occurred, but subsequent to the date reflected in the document. These cases normally involve situations where the beneficiary of the backdating can reap an undeserved benefit at the expense of the government or some other third party only if the event occurred on the earlier date.15 The following are but a few examples of the many cases where the time of an event was fabricated to achieve such a benefit:
To protect real estate from the claim of a client’s creditor, an attorney back-dated a deed to make it appear that the property had been conveyed to the client’s controlled corporation before the creditor’s claim arose.16 The backdating attempted to accelerate the transfer of the real estate by the debtor to deprive the creditor of a recovery.17
To accelerate revenue to an earlier period on a company’s financial statements, the company backdated invoices to make it appear that the revenue occurred in the earlier period.18 The backdating made the company look more profitable and could have induced the purchasers of the company’s stock to pay an inflated price.19
To avoid liability under an employee health benefit plan, the president of a corporation amended the company’s selfinsurance plan to exclude coverage for motorcycle accidents and backdated the amendment to a date before an employee’s motorcycle accident had occurred.20 The backdating attempted to exclude from coverage a claim that had arisen prior to the amendment.21
To enjoy taxfree treatment on the sale of real estate contingent on the identification of replacement property within forty-five days of the sale, documents were backdated to treat the replacement property as having been identified within the forty-five day period.22 The backdating attempted to accelerate the identification date to support favorable tax treatment to which the seller was not entitled.23
To maintain the qualification of certain employee benefit plans, an attorney backdated documents making it appear certain plan amendments were completed in a timely manner.24 The backdating attempted to accelerate the amendments to avoid disqualification of the plan with the attendant adverse tax consequences.25
In many cases, attorneys have backdated documents to make it appear that their clients’ investments in property generating tax deductions were made at an earlier time.26 In each of these cases, the backdating attempted to accelerate the investment date to enable the clients to claim tax deductions to which they were not entitled.
All of the foregoing cases illustrate backdating that fabricated the time at which an event occurred to secure benefits to which the parties were not entitled. Such conduct is clearly wrongful. Consequently, attorneys who engage in or accommo-date this conduct may be subject to disciplinary action, civil liability, and criminal prosecution.
C. BACKDATING THAT MEMORIALIZES
When a document is drafted and executed after an event occurs but accurately reflects the earlier date on which the event actually transpired, the backdating is not a fabrication. Rather, the backdated document simply memorializes the earlier event.27 The act of memorializing is sometimes not even regarded as backdating.28
The legitimacy of memorializing emerges from some simple examples. Assume a lender issues a $5,000 check to a borrower on March 1, 2009, at which time the borrower agrees to repay the $5,000 with 5 percent interest in one year. The parties also agree that the borrower will execute a promissory note incorporating their arrangement. Sometime thereafter, the promissory note is drafted and the borrower executes the note. Quite clearly, the loan occurs on March 1 and the promissory note should bear that date even though the note is prepared and executed at a later time.
As another example of backdating that memorializes, consider a corporate action that requires the approval of the corporation’s board of directors.29 Assume the corporation’s directors convene a meeting in the presence of the corporation’s attorney at which time the directors verbally approve certain corporate actions.30 The minutes of the meeting might be drafted and executed weeks after the actual meeting. Nevertheless, the minutes should normally reflect the date of the meeting because that was the day the action was taken.
Courts have recognized the legitimacy of memorializing a prior act. For example, the Seventh Circuit articulated the clear distinction between backdating that fabricates to perpetrate a fraud and backdating that memorializes a prior event in United States v. Micke.31 There, the defendant, who claimed deductions stemming from a tax shelter investment on his 1982 tax return, asserted that documents executed in January 1983 memorialized an investment made in December 1982.32 Although the court affirmed a criminal fraud conviction, it explained that the backdating would have been legitimate had an agreement actually been reached in 1982:
The sole issue at trial was whether the deal had been agreed on in December or subsequently in January. If the former, the backdating was legitimate and the returns were not fraudulent; if the latter, the backdating and the returns were fraudulent.”33
The Tax Court has gone so far as to treat backdating intended to memorialize a prior agreement as evidencing the existence of that agreement. In Baird v. Commissioner,34 a taxpayer entered into a preliminary agreement to purchase property on August 29, 1970, and the deed was also dated August 29, 1970.35 The deed was not executed until October 28, 1970, however, and was not recorded until November 17, 1970.36 The taxpayer claimed ownership was transferred on the August 29 date stated on the deed.37 By contrast, the Internal Revenue Service claimed that ownership was not transferred until the deed was recorded on November 17.38
The Baird court agreed with the taxpayer that ownership was transferred when the preliminary agreement was reached on August 29, stating: “It is understandable that all the details and the formal documents would require some time for preparation.”39 Moreover, the court determined that the backdating served as evidence of the taxpayer’s intent to transfer the property on the earlier date: “The fact that the formal documents were all backdated to August 29, 1970, also supports the conclusion that the parties intended the transaction to be closed as of that date.”40 The Baird court effectively concluded that the backdating merely memorialized a prior event; in other words, the event in question (the transfer of ownership) had occurred on the date reflected by the backdated document.41
The Internal Revenue Service has also acknowledged the legitimacy of memorializing a prior event.42 In fact, the Internal Revenue Service recently affirmatively argued that a backdated document memorialized a prior event in Moore v. Commissioner.43 That case involved a dispute as to whether a majority member of a limited liability company transferred a 10 percent interest to a minority member in 1997 or in 2000. The document conveying the membership interest was dated January 1, 1997, but was not executed until July of 2000.44 Neither member apparently paid tax on the income attributable to the disputed 10 percent interest during the years at issue.45 The Commissioner attempted to tax the minority member claiming that the transfer occurred on the January 1, 1997, date stated on the document:
[The Commissioner] argues that the . . . agreement was the means of “formalizing” [the majority member’s] transfer of 10-percent membership interests in the LLC to [the minority members] effective January 1, 1997. . . . He argues that the . . . agreement was not “backdated”, i.e., it “was not a document . . . [attempting] to change the past or . . . to misrepresent the past”, but, rather, “was . . . created to formalize informal transactions that had occurred in the past”.46
In agreeing with the Commissioner, the court concluded that the purpose of the agreement was “to reduce to writing a prior oral understanding among the parties.”47 Thus, the backdated document merely memorialized the earlier event because the transfer of the membership interest had occurred on the date reflected by the backdated document.
Part I suggests that a clear line exists between backdating that fabricates and backdating that memorializes. If a document is dated prior to the occurrence of an event, the backdating fabricates and the potential for impropriety exists. By contrast, if the document is executed after an event occurred but accurately reflects the date of the event, the backdating merely memorializes and thereby reflects the truth. Sounds simple—but maybe not. Part II will explore why it is not always so easy to distinguish legitimate backdating from improper backdating.
II. WHY IS IT DIFFICULT TO DISTINGUISH LEGITIMATE BACKDATING FROM IMPROPER BACKDATING?
Determining whether a given instance of backdating is legitimate or improper can be complicated for three reasons. First, the line between fabricating and memorializing becomes unclear when ambiguous law governs the timing of an event or uncertain facts surround the event. Second, establishing that a given instance of backdating is a fabrication is not always determinative of its impropriety; such backdating can be innocuous when it does not compromise the rights of a third party or violate any law. Third, establishing that backdating memorializes does not necessarily establish its legitimacy; backdating that memorializes can mislead a tribunal and thereby expose a lawyer to sanctions. Part II explores the complexities associated with distinguishing legitimate backdating from improper backdating.
A. WHETHER BACKDATING FABRICATES OR MEMORIALIZES IS NOT ALWAYS CLEAR
It is easy to determine whether backdating fabricates or memorializes if one knows with certainty when the event in question occurred. If the event occurred on the date stated in the document, the backdating memorializes; if the event occurred subsequent to the date stated in the document, the backdating fabricates.48 The time at which a given event occurs can be uncertain, however, when the law governing the event is ambiguous or the facts are unclear.
1. Ambiguous Law Might Govern the Time of an Event
Although backdating issues can arise in a variety of contexts, two of the most common instances involve commercial agreements and property transfers. Whether backdating fabricates or memorializes in these situations depends upon (1) when an agreement is reached and (2) when a transfer of ownership occurs. The legal standards governing these events are difficult to apply and often yield unpredictable results.
a. When Does an Agreement Occur?
The question of when, as a matter of law, a contract arises is often uncertain. Generally, an agreement will evolve over time through a series of negotiations that may be oral and/or involve the exchange of writings.49 When such negotiations culminate in an agreement, the precise date on which the agreement is reached may not be apparent.
The inability to discern the date on which an agreement is reached does not preclude the existence of a contract.50 Yet, when a document encapsulating the agreement is backdated to the date the parties believe their agreement was achieved, it might be difficult to determine whether the backdating fabricates or memorializes. If the agreement occurred on the earlier date, the backdating memorializes; if an agreement was not reached until a later date, the backdating fabricates.
Identifying the date on which an agreement is reached is further complicated when the parties reach a tangible preliminary agreement before arriving at a final agreement. In these situations, it is often unclear as to whether the preliminary agreement constitutes a step in the negotiation process or instead represents an agreement that is subsequently being formalized.51 If the preliminary agreement is merely part of the negotiation process, backdating the final agreement to the date of the preliminary agreement is a fabrication. By contrast, if the preliminary agreement constitutes a contract, the final agreement merely memorializes that contract. Not surprisingly, courts have reached different conclusions about the significance of preliminary agreements in factually similar cases.52
The presence of a contingency can also cloud the legal issue of when an agreement exists. A contingency might be seen as precluding a contract from arising (historically referred to as a “condition precedent”53) or, alternatively, as allowing a contract to exist but threatening its continuation (historically referred to as a “condition subsequent”54). Accordingly, when a document is backdated to a time before the contingency is resolved, the backdating is a fabrication if the contingency represents a condition precedent. In this situation, no contract would have existed at the earlier time. By contrast, if the contingency represents a condition subsequent, the backdated document simply memorializes a prior event. In these circumstances, the event in question, arriving at a contract, previously occurred. Unfortunately, the distinction between a condition precedent and a condition subsequent is far from clear. As one venerable commentator has remarked, “[E]ven the best of courts sometimes exhibit confusion in determining whether a condition is subsequent or precedent.”55 For all of the foregoing reasons, the law governing a backdated agreement can create confusion as to whether the backdating fabricates or memorializes.
b. When Is Ownership Transferred?
Backdating also commonly occurs in connection with the conveyance of property. Whether such backdating fabricates or memorializes depends upon when the transfer of ownership occurs. The principles of law governing the transfer of property ownership can be difficult to apply and may lead to uncertain results.
At first blush, the legal standard governing the point at which ownership is transferred seems reasonably clear.56 As a matter of property law, ownership of real estate is transferred when the deed is executed and delivered.57 Rather than focusing on property law, however, backdating cases typically involve the question of when ownership is transferred for purposes of the tax law.58 These cases generally involve the efforts of purchasers to claim deductions associated with property ownership from the earliest possible date.59 Although the transfer of legal title is relevant to the transfer of ownership for tax purposes, courts have often found that ownership of real property was transferred before the deed was delivered.60
In determining when ownership of property is transferred for tax purposes, the courts consider a variety of factors. These factors include the transfer of possession, the transfer of the economic benefits and burdens of ownership, the satisfaction of conditions precedent, the existence of uncertainty regarding the property, and the payment of the purchase price.61 Each of these factors presents additional complexity; for example, the transfer of possession does not necessarily occur at a single moment in time; the benefits and burdens analysis utilizes a variety of factors that can be weighed differently by different tribunals;62 and the existence of conditions precedent requires distinguishing meaningful conditions from insubstantial ones.63 The inconsistency with which courts apply these factors further complicates the determination of ownership.64 As one commentator recently remarked, “In sum, the law of tax ownership is vast, remarkably fragmented, and thoroughly confused.”65 Hence, one must pinpoint an event when the law establishing that event “is a patchwork of rules that appear to lack a unifying principle.”66
This section was not intended to offer a comprehensive analysis of the legal standards for determining when a specific event occurs. Its purpose is simply to highlight the ambiguity surrounding certain common legal standards that must be applied to make this determination. Regardless of how carefully a lawyer might analyze the law in these areas, uncertainty will often exist as to when the event in question actually occurred. When the timing of the event is unclear, determining whether the backdating fabricates or memorializes is no longer a simple matter.
2. Relevant Facts May Be Uncertain
Even when the relevant law is clear, the timing of an event will depend upon the particular facts and circumstances. Unfortunately, ambiguous facts frequently make it difficult to discern the precise time an event occurs. Often, traces of evidence will exist suggesting an event occurred prior to the time of formal documentation. If this evidence is sufficient to establish a fact, backdating the document memorializes the event. If the evidence is insufficient, however, the backdating might fabricate the time of the event. Factual uncertainty can result from ambiguous records, limits on one’s ability to recollect past observations, and reliance on the observations of others.
a. Ambiguous Records
Case law reveals that an ambiguous record can create uncertainty as to whether an event actually occurred before it was documented. For example, in In re Jagiela,67 an attorney drafted an agreement in September and October 1990 to share proceeds of a settlement judgment.68 The agreement was executed in October 1990 but backdated to August 18, 1988.69 The backdated agreement was based on an amalgamation of at least five documents drafted prior to August 18, 1988, and the attorney claimed the agreement “merely memorialized a prior oral agreement between the signatories made on or before August 18, 1988.”70
The Jagiela court found as follows: “It appears from the record that the backdated agreement may well have memorialized a prior oral agreement, at least to some extent.”71 The court nevertheless concluded the event did not occur on the earlier date and the attorney’s actions warranted discipline.72 Although Jagiela’s course of conduct appeared egregious,73 the court’s acknowledgment that the agreement “may well have” memorialized a prior oral agreement74 illustrates how conflicting evidence can create uncertainty as to the actual time of a specific event.75
b. Limits on One’s Ability to Recollect
The complexity presented by factual uncertainty is even more problematic than case law suggests. The cases reflect a static picture—the court has sifted through oral testimony and documents and created a snapshot of an event that may or may not be accurate. The accuracy of those findings is far from clear because no “omniscient observer” exists who witnesses all events and can relate the details of each event with perfect accuracy. Thus, it is necessary to rely upon human observation to establish when events occur.
Countless studies reveal that human recollection even by the most forthright individual under the best possible circumstances is far from accurate.76 Distortions in memory range from slight modifications of the actual event to the construction of memories of events that never occurred.77 Both internal sources and external influences at the time of encoding and retrieval of memories affect the accuracy of recollection.78 For instance, providing subsequent suggestions or new information can completely distort someone’s original memory.79 Considering that ideal circumstances rarely exist and that even a person with the best of intentions will likely resolve uncertainties in his or her favor in at least some cases,80 the prospect of discerning an accurate set of “facts” is often dim.
c. Reliance on the Recollections of Others
In many situations, a lawyer must deal with facts that the lawyer does not observe firsthand. Rather, the lawyer must rely on the recollections or statements of others. Such reliance poses a whole host of problems requiring difficult judgments to be made.
A lawyer is likely to have a unique relationship with each client. The lawyer might have a long history with some clients, dealing with them on a continuing basis and observing them in both business and social situations. Other clients will likely be newer, dealt with infrequently, and only in a professional capacity. If a history of interactions exists, the lawyer might be in a better position to judge the integrity of the client; however, an attorney’s ability to ascertain the veracity of any client’s words in a given case is likely to be limited.
Assume that a lawyer meets with a client on January 15, 2009, at which time the client indicates he purchased an interest in a partnership on December 15, 2008. If the purchase actually occurred on December 15, assume the client would be entitled to claim a significant amount of tax deductions on the client’s 2008 tax return. The client asks the lawyer to prepare documents dated December 15, 2008, evidencing the investment. The client and the seller of the investment will then execute the documents. What should the lawyer do?
Quite clearly, the lawyer should not prepare the documents unless the lawyer can confirm that the purchase actually occurred on December 15. By preparing the documents, the lawyer can be regarded as having made the judgment that the client’s statement is true.81 If the lawyer misjudges the client’s veracity, he or she could be subject to severe sanctions, including criminal prosecution, for participating in a fraudulent transaction. In attempting to evaluate the claims of the client, the lawyer should examine the cancelled check evidencing the investment, learn the identity of all parties present at the December 15 meeting, confirm that all such parties can verify the purchase terms that were agreed upon at that meeting, and secure any additional evidence demonstrating that an investment was actually made on December 15.
Depending upon the lawyer, dramatic variations will likely exist regarding how deeply the lawyer will dig for evidence, how closely the lawyer will examine the evidence, and how much uncertainty, if any, the lawyer will tolerate to be willing to draft the documents. Lawyers will likely rely heavily on past history with the client in judging whether the client’s story is true and the extent to which extrinsic evidence should be sought. If the matter involves a new client and no past opportunities to evaluate the client’s forthrightness exist, most lawyers will likely reject the request to draft the documents, unless strong independent evidence exists corroborating the client’s story. It will probably be much more difficult for the lawyer to reject the request of an existing client, particularly when a history of interactions exists that bolsters the lawyer’s confidence that the client is telling the truth.82 Even when such a history exists, however, the lawyer must recognize the limits on his or her ability to assess the client’s veracity in any given case.
There is no clear answer as to what the lawyer should do in this situation.83 If the client’s story is in fact true, the lawyer can draft the necessary documents to memorialize the transaction. In most cases, however, some degree of uncertainty will exist as to whether the story is true and as to how a tribunal would resolve the question.
Regardless of how carefully the lawyer assesses the facts, if the lawyer erroneously concludes that the client is telling the truth, the lawyer must be prepared to pay a heavy price for having participated in a fabrication that defrauded the government. Because these situations are very dangerous, the prudent lawyer will refrain from participating when any doubt exists about the truthfulness of the client’s story. Ambiguous facts frequently make it difficult for the lawyer to know precisely when an event occurred, thereby compromising the attorney’s ability to evaluate whether backdating fabricates or memorializes.
B. BACKDATING THAT FABRICATES CAN BE INNOCUOUS
Even when it can be determined that backdating fabricates rather than memorializes, uncertainty still might exist as to the propriety of the backdating. Whether backdating that fabricates is wrongful depends upon the purpose and effect of the backdating. In most cases, such backdating is improper because it is utilized to deceive a third party to extract an undeserved benefit.84 In other cases, however, such backdating might be utilized to implement an economic arrangement between two consenting parties where no intent exists to harm a third party, no third party’s rights are adversely affected by the backdating, and no law is violated. In the latter cases, the backdating can be innocuous.
As a matter of law, the parties to an agreement can make their agreement effective on whatever date they wish, provided no third party rights are compromised by the action.85 Hence, if a prospective employee who is to commence employment in March persuades her employer to pay her what she would have earned had she been employed since January, the parties may agree to that result by backdating their agreement to January 1 as long as no third party rights are compromised and no law is violated. Similarly, a landlord holding property in high demand might negotiate an agreement with a prospective tenant whereby, pursuant to a lease negotiated in March, the tenant agrees to pay the landlord the rents that would have been due for January and February had the lease begun in January. Here again, the parties might implement their agreement by backdating the lease provided no third party’s rights are compromised and no law is violated.86
Although the recent options backdating scandal clearly involved wrongdoing, litigation related to that scandal illustrates how backdating that fabricates can be innocuous. The scandal stemmed from the backdating of options issued by certain publicly traded corporations to a date when each company’s stock was trading at a lower price.87 By allowing the recipient of the option to purchase shares at the trading price on the earlier date, an economic benefit was conferred on the recipient.88 For example, assume that a company issues an option to purchase 1,000 shares of stock to an employee on December 15 when the market value of the employer’s stock is $100 per share. Further assume that the option permits the employee to purchase the shares at a price of $70 per share and is backdated six months to June 15 when the market value of the stock was actually $70. In effect, the employee enjoys a potential $30,000 benefit by virtue of being allowed to purchase stock with a value of $100,000 at a price of $70,000.89
As a general matter, no prohibition exists on the form of an employee’s compensation and nothing precludes the parties from utilizing a fiction to quantify the desired level of compensation.90 Presenting that fiction as fact to third parties, however, is clearly improper when doing so adversely impacts the rights of a third party or violates a law.91 The backdating of options was improper because the action was reported to regulatory authorities as if the options had actually been issued on the earlier date, thereby violating accounting rules, securities laws, and tax laws.92 But, as a federal district court recently clarified:
The practice of backdating a stock option occurs when persons responsible for the timing, pricing and/or approval of a stock option grant retroactively set the exercise price for the option based on a date other than the date on which the option was actually granted. . . . However, the practice is not improper, in and of itself, provided it is: 1) fully disclosed to necessary parties, including securities and tax authorities, corporate directors and shareholders;[93] 2) properly accounted for under Generally Accepted Accounting Principles (“GAAP”) in the company’s financial disclosures to shareholders, the SEC and other regulatory agencies; 3) correctly taxed at both the company and grantee levels; and 4) permitted under the company’s by-laws and/or shareholder-approved stock option plans.94
In essence, as long as an economic arrangement based on a fiction does not adversely impact the rights of third parties or violate any law, the use of a fiction to implement the economic goals of the parties can be innocuous.
The foregoing analysis reveals that backdating that fabricates can be innocuous only if the backdating has neither a bad purpose nor a bad effect. In most cases, it should be clear whether a bad purpose exists. If the backdating is utilized to deceive a third party in order to extract an undeserved benefit, the purpose is bad and the action is clearly improper.95 Alternatively, if the backdating is utilized to implement the economic interests of the parties to the arrangement with no intent to harm a third party, the purpose is not objectionable. Nevertheless, the backdating would still be improper if it adversely affected the rights of a third party or violated a law.
Determining whether the rights of third parties might be adversely affected by backdating can be extremely difficult for several reasons. First, in some cases, it will be difficult, if not impossible, to identify the universe of private rights that might be adversely impacted by the backdating. At a minimum, the interests of owners, investors, creditors, and employees must be considered. Second, in addition to private rights, the interests of all levels of government must be considered. Finally, even if all relevant private and public third parties can be identified, it can still be difficult to assess whether the backdating has an improper effect. For example, if the federal, state, or local taxation of one or more of the parties to the backdating is impacted by the fabrication, it might be difficult to assess whether the backdating results in illegal tax evasion.96 Consequently, although backdating that fabricates can theoretically be innocuous, it will often be difficult for the attorney to make this judgment.
Backdating that fabricates the date of an event might sometimes be the simplest way for the parties to implement an economic arrangement and minimize the resulting legal fees. In these situations, the client might exert pressure on the lawyer to utilize a fabricated date. It is critical, however, for the lawyer to realize that the absence of any bad intent on the part of the parties does not render the backdating innocuous. Unless the lawyer is confident that the fabricated date violates no law and does not adversely impact the rights of any third party, the lawyer should not succumb to the temptation posed by ease and economy.
When evaluating whether backdating that fabricates might adversely impact the rights of third parties, the lawyer should assume that every backdated document will be discovered by any interested third party. Regardless of how remote that prospect might seem, a future controversy can always arise and cause a back-dated document to surface. Hence, a lawyer should not participate in such back-dating unless the lawyer is prepared to defend the document in a truthful and forthright manner.
In sum, backdating that fabricates can be innocuous if the backdating has neither a bad purpose nor a bad effect. Before concluding the backdating is innocuous, the attorney must be extremely careful to assess whether the rights of any third party might be adversely impacted, or any law is violated, by the backdating. An attorney who fails to anticipate a harm that materializes could suffer severe consequences by participating in the backdating.
C. BACKDATING THAT MEMORIALIZES CAN BE PROBLEMATIC
In contrast to backdating that fabricates, backdating that memorializes is normally regarded as a legitimate practice. Often, it is not feasible to document an event contemporaneously with its occurrence. Rather, the event will be documented at a later time and the document will be backdated to the date the event actually occurred. Though this action may seem appropriate, the act of memorializing can expose a lawyer to sanctions if it supports the inference that the document was executed when the event occurred, rather than at a later time.
A classic example of problematic memorializing emerges from In re Stern.97 In Stern, an Illinois lawyer was censured for backdating a document that accurately reflected the date the event had occurred. Pursuant to a 1981 divorce, Stern was required to maintain health insurance for his ex-wife and children.98 On December 7, 1982, Stern procured a new health insurance policy that the insurance agent indicated would be effective immediately.99 As such, Stern permitted the old policy to lapse.100 When Stern’s ex-wife learned that the old policy had lapsed, she petitioned the court to find Stern in contempt for failing to maintain insurance.101 On January 10, 1983, Stern learned that the agent who sold Stern the new policy had been mistaken about its effective date and that a lapse in coverage had occurred.102
On January 11, 1983, the date on which Stern was to appear before the court, Stern allegedly told the insurance agent to prepare a letter on the agent’s stationery accurately stating that the agent had told Stern the new policy was effective on December 7.103 The January 11 letter was backdated to December 15.104 The agent brought the letter to court and showed it to Stern and Stern’s attorney.105 Stern’s attorney showed the letter to Mrs. Stern’s attorney who examined the insurance agent about the letter.106 The agent initially falsely testified that he had written the letter on December 15 but then admitted that the letter had been backdated.107 The Review Board of the Illinois Attorney Registration and Disciplinary Commission found that Stern’s conduct violated disciplinary rules prohibiting “conduct involving dishonesty, fraud, deceit or misrepresentation,” “knowingly mak[ing] a false statement of law or fact,” and conduct “which tends to defeat the administration of justice or to bring the courts or the legal profession into disrepute.”108
The Stern court agreed with the review board that Stern had violated disciplinary rules even though the letter in question merely memorialized a prior event. The court stated, “While the actual contents of the letter were true, an element of dishonesty and deceitfulness exists because of the false date the letter bore.”109 Moreover, the court rejected Stern’s argument that the evidence failed to establish an improper motive for the backdating. Rather, the court held that intent can be inferred from surrounding circumstances.110 Specifically, the court reasoned that the letter must have been created to strengthen Stern’s case because he directed that it be created and that it be brought to the court.111
The Stern case demonstrates that attorney disciplinary rules prohibiting dishonesty and deceit can potentially be violated even in the absence of any intent to do harm. The attorney disciplinary codes of most jurisdictions have rules similar to the Illinois rule applied in Stern that prohibit conduct involving “dishonesty, fraud, deceit or misrepresentation.”112 These rules do not generally address the lawyer’s mental state.113 The cases where attorneys have violated these rules typically involve blatant misconduct with respect to which the attorneys’ intent and improper motive are evident.114 Nevertheless, a violation of the rule might be established without direct proof of bad motive or intent.115
Although Stern suggests that backdating that merely memorializes a past event can cause a lawyer to be sanctioned for dishonest conduct, this threat should materialize only if the backdated document becomes the subject of legal proceedings.116 In the vast majority of situations, documents that memorialize events will never be seen by anyone other than the parties executing those documents and their advisors. Nevertheless, the possibility of a future controversy always exists and, therefore, any backdated document might someday appear before a court.117 The lawyer therefore must always be prepared to defend every backdated document in a truthful and forthright fashion.
Courts are likely to have little tolerance for any backdated document that can potentially mislead and adversely impact the integrity of the court’s fact-finding function. The lawyer who drafts such a document must therefore ensure that the document does not support the inference that it was executed on the date of the event when it was actually executed on a later date. Thus, whenever a document is intended to memorialize an event, the lawyer should have the foresight to make adequate disclosure of the backdating to deter any inference that the document was executed on the date of the event.118
Part II has demonstrated that it is often difficult to determine the propriety of backdating. In many cases, it will be unclear whether backdating fabricates or memorializes because complex law and ambiguous facts can cloud the time that the event actually occurred. Moreover, when backdating in fact fabricates the date of an event, the backdating might be innocuous if it neither adversely affects the rights of any third party nor violates any law. By contrast, backdating that in fact memorializes an event can be problematic if it supports the inference that the document was executed on the earlier date of the event. Part III will examine whether disclosure can eliminate the uncertainties that impact the propriety of backdating.
III. DOES DISCLOSING BACKDATING PROTECT AGAINST IMPROPRIETY?
As discussed in Part II, backdating, even in its most benign form, can potentially mislead a court or some other third party into believing a document was executed on an earlier date. To mitigate this possibility, backdating should always be disclosed. Part III examines the impact of disclosure and analyzes two disclosure methods; namely, identifying the date the document was executed and utilizing “as of” dating.
A. THE IMPACT OF DISCLOSURE
When a document memorializes an earlier event and, therefore, is backdated to the date of the event, the document might mislead a court or government agency into believing it was executed on the date the event occurred.119 This possibility should generally be foreclosed, however, when the backdated document reveals on its face that it was executed after the stated date of the event. Hence, disclosure should normally solve any potential problem posed by backdating that memorializes a prior event.
When a backdated document fabricates the time of an event but is not intended to harm a third party, the backdating is nevertheless improper if a third party’s rights are in fact compromised or a law is violated.120 If such backdating is disclosed, any third party with access to the document will have notice of the backdating. Such notice should, at least in some cases, mitigate the possibility of harm.121 In addition, the act of disclosing the backdating belies any intent to deceive because parties who intend to deceive would normally be expected to rely on subterfuge.122 Hence, it is also beneficial to disclose this form of backdating. Disclosure will not ensure the propriety of such backdating, however, because a third party could still be harmed by the backdating, or the backdating could violate a law, even when it is disclosed.123
B. HOW DISCLOSURE MIGHT BE MADE
Backdating might be disclosed by identifying the date on which the back-dated document was executed. Alternatively, disclosure might be made by dating the document “as of” an earlier date. This section will discuss these two forms of disclosure.
1. Identifying the Date of Execution
The most straightforward way of disclosing that a document was backdated would be for the document to identify the date on which it was executed. By disclosing the execution date, no one privy to the document could possibly believe the document was executed on an earlier date. The execution date, however, is often irrelevant to the timing of the event in question and disclosing that date can create unnecessary confusion about when the event governed by the document actually occurred.
As previously discussed, events often occur as a matter of law prior to the date on which the document evidencing the event is executed.124 In many cases, the actual date of the event will be unclear or the parties might have different views of that date. Nevertheless, the parties must agree on an effective date so that they have the same expectations about all terms of the arrangement that are dependent upon that effective date. Regardless of whether the actual date of the event is known or the parties establish an agreed upon effective date, it is unlikely that these dates will coincide with the date of execution. When the dates do not coincide, the execution date is irrelevant to the event governed by the document.
Identifying an irrelevant execution date can create needless confusion as to when the event in question actually occurred. For example, in Sweetman v. Strescon Industries, Inc.,125 a contract stated it was “made this 22nd day of April 1976.”126 The contract was not executed, however, until June 22, 1976, and that date apparently appeared after the signature.127 The issue before the court was whether an indemnification clause in the contract applied to an accident that occurred between those two dates (on May 25, 1976).128 The court stated:
The presence of two different dates creates an ambiguity which opens the matter to evidentiary proof that the date appearing at the beginning of the agreement should not control the inception of rights and liability thereunder.129
Hence, disclosing the date of execution in an agreement intended by the parties to be operative on an earlier date could jeopardize the parties’ objectives.130 At a minimum, it can create a legal issue that could be costly and time consuming to resolve.131
2. Utilizing “As Of” Dating
Identifying the execution date on a backdated document is not the only way of revealing that the document was executed subsequent to the date of the underlying event. Some other mechanism might be utilized to show that the document was backdated. As long as the document conveys on its face that is was executed subsequent to the document date, the risk that a third party will be misled should be minimized even if the specific date of execution is not identified.
Rather than identifying the date of execution, a common drafting practice for disclosing backdating is to qualify the date stated in the document with an “as of” or “effective as of” modifier.132 For example, rather than categorically stating an event occurred “on July 14, 2009,” the backdated document might state that the event occurred “as of July 14, 2009.” “As of” dating highlights the document was executed after the event occurred without creating potential confusion as to the actual or effective date of an arrangement.133
“As of” dating utilized in good faith should minimize the risk that a backdated document could mislead a third party. In light of the “as of” language, a third party should not be surprised that the document was executed subsequent to the “as of” date. The “as of” language normally belies any intent to hide the backdating and effectively invites any third party to whom the actual date of execution might possibly be relevant to inquire about that date. If the attorney is asked when the document was executed, he or she should of course disclose that date.
Tribunals have confirmed that “as of” dating belies any attempt to mislead— indeed, courts have gone so far as to regard the convention to be inconsistent with backdating. For example, in In re Blazina,134 the hearing board stated:
[I]t was considered by us, and weighed in favor of the Respondent that the amendments [to a partnership agreement] each say they are entered into “as of” a specific date and are signed “as of” that same date. As a result, if an amendment were typed up some time after the decision was made, the Respondent in fact did not backdate the document. The document would be backdated if . . . , the document stated “I have hereunto set my hand and seal this 14th day of September 1990” when in fact it was signed on a later date. That was not done on the documents at issue in the complaint.135
Similarly, in Moore v. Commissioner,136 the court stated as follows:
“[B]ackdating” generally involves an effort to make it appear that the document in question was executed on a date prior to its actual execution date; i.e., there is an effort to mislead the reader. That is not true of the . . . agreement [at issue], where the “effective as of” phrase makes clear that the intended effective date differs from the execution date.137
Hence, “as of” dating often serves as an optimal way of disclosing backdating.
Like any other drafting technique, “as of” dating can be employed to achieve illegitimate ends. If the time of an event is fabricated to reap an undeserved benefit by compromising the rights of a third party or violating a law, utilizing “as of” dating might serve to camouflage impropriety, rather than disclose conduct believed to be legitimate. In this situation, “as of” dating does not mitigate the wrongdoing.
For example, in United States v. Delaney,138 a Philadelphia tax lawyer was indicted for allegedly creating documents in 1998 dated “as of January 1, 1996” in which it appeared that certain partners in a tax shelter were liable for partnership debts.139 The apparent objective of the alleged backdating was to enable the partners to deduct approximately $15 million of the partnership’s 1996, 1997, and 1998 losses on their personal tax returns.140 The indictment stated that the lawyer “knew no such agreement had ever been reached” in 1996.141 If this allegation was true,142 the backdated document evidenced an event that never occurred and supported a violation of the tax laws.143
The press reporting of the Delaney case demonstrates significant misunder-standing about “as of” dating and disclosure. One source reported the following:
Local tax lawyers . . . expressed mixed feelings about filing a criminal indictment . . . based solely on the “as of” documents, saying it is a common practice. “The point of using the ‘as of’ language in an agreement is to say that the parties intended the agreement to be effective as of the date in question, even though it was, in all likelihood, executed on a later date,” a tax partner at a large Center City firm said. “While it is both unethical and illegal to tell the IRS that a document was signed before the date it actually was signed, it is not clear that giving the IRS a document dated ‘as of’ a particular date should be viewed as a representation that the agreement was actually signed on that date . . . . ” Another tax partner at a large firm said that standing alone, he does not believe that submitting an “as of” document to the IRS constitutes an indictable offense, but it is clearly not good practice. “Though it’s not the same as back-dating, there is an issue as to whether you are defrauding the government by implying through the document that it had been signed at a certain point,” the tax partner said.144
The lawyers quoted above seem to miss the fundamental point that “as of” dating is neither a legitimate nor illegitimate drafting technique per se.145 Rather, it is the ends to which the technique is employed that determine its propriety. Unless the in-dicted lawyer could have disproved the alleged facts, the backdating supported tax fraud. Hence, this would appear to have been a case where the fabrication was used for a “bad” purpose. Backdating of this type is improper regardless of whether or how it might be disclosed. The problem has nothing to do with “as of” dating—the same problem would exist if the actual date of execution had been identified. When backdating is utilized to deceive a third party or violate a law, it is clearly improper and disclosure of any form will not mitigate the wrongdoing.146
In sum, backdating should always be disclosed. Disclosure normally minimizes the risk that a third party will be misled into believing the document was executed on an earlier date. However, when backdating is utilized to mislead a third party, adversely affects the rights of a third party, or violates a law, disclosure will not cure the impropriety.
IV. PROBLEMS
To aid the reader in employing the analyses set forth in this Article, Part IV relates a series of hypothetical problems involving backdating. These fact patterns offer the opportunity to apply the principles previously discussed to concrete illustrations. A short discussion follows the facts of each problem.
PROBLEM 1
Facts: Employer and Employee verbally agree to an employment arrangement on January 15, 2009. A written agreement is subsequently drafted. The written agreement is dated “as of” January 15, 2009, and is executed by the parties on January 30. The agreement is governed by the law of State X which establishes that a contract arose on January 15, 2009.
Discussion: The written agreement memorializes an event that occurred on January 15, 2009. The fact that the written agreement was drafted and executed after January 15 is irrelevant to the timing of the event. Nevertheless, the “as of” reference should deter any third party from inferring that the document was executed on January 15.
PROBLEM 2
Facts: Same as Problem 1, but the agreement is governed by the law of State Y. Under State Y law, the contract arose on January 30, 2009, the date the agreement was executed.
Discussion: The written agreement fabricates the date of the event. Thus, the backdating is improper unless it was not intended to harm a third party, does not adversely affect the rights of any third party, and does not violate any law.
PROBLEM 3
Facts: The personnel policies of Employer state that anyone employed on January 1 who works for a full calendar year is eligible for a bonus. On January 15, 2009, Employer and Employee agree to an employment arrangement pursuant to which Employee is to be compensated at a level that would include the 2009 bonus Employee would have received had his employment commenced on January 1. Employer could legitimately have conferred this economic benefit by increasing Employee’s salary or by creating a new bonus plan. Instead, Employer backdates the employment contract to January 1 to allow Employee to receive a bonus for 2009 under the existing plan. Employer does not intend to harm a third party by this action.
Discussion: The employment agreement fabricates the date of the event (i.e., the commencement of Employee’s employment). Although Employer could have legitimately conferred the benefit in other ways and did not intend to harm a third party, the backdating is improper unless no third party’s rights are adversely affected and no law is violated.
PROBLEM 4
Facts: Same as Problem 3, however, Employer’s bonus plan covers ten other employees and requires that any amount set aside for bonuses shall be divided equally among all covered employees at yearend.
Discussion: The agreement fabricates the commencement date of Employee’s employment. The rights of third parties are compromised by the backdating because participation by Employee means that the other participants will get a lesser share of the amount set aside for bonuses (i.e., each of the other participants will receive 1/11 of the bonus money if Employee is included and 1/10 of the bonus money if Employee is not included). As such, the backdating is improper.
PROBLEM 5
Facts: Sole Shareholder of Closely Held Corporation (“CHC”) would like Key Executive to come to work for CHC. CHC is a C corporation for federal tax purposes.147 To attract Key Executive, Sole Shareholder agrees on January 1, 2009, to give her 10 percent of his CHC stock. On that same date, Key Executive and CHC enter into an employment agreement which makes no reference to the CHC stock. In December, it is discovered that the paperwork to transfer 10 percent of Sole Shareholder’s shares to Key Executive was never completed. The paperwork is completed on December 31, 2009, and the transfer documents are dated “as of” January 1, 2009.
Discussion: If, as a matter of law, Sole Shareholder’s January 1, 2009, agreement to transfer 10 percent of her stock to Key Executive caused Key Executive to become the owner of the shares on that date, the December paperwork merely memorializes the transfer. By contrast, if the transfer of ownership of the shares does not occur until December 31, 2009, the backdating fabricates the date of the transfer. In this event, the backdating is improper unless it was not intended to harm a third party, does not adversely affect the rights of any third party, and does not violate any law.
PROBLEM 6
Facts: Same as Problem 5, but CHC is an S corporation for federal tax purposes.148 As such, the income of CHC is taxed proportionately to its shareholders on each day of the year.149 Because the parties treat the stock transfer as occurring on January 1, 90 percent of CHC’s 2009 income is reported on Sole Shareholder’s 2009 tax return and the remaining 10 percent of CHC’s 2009 income is reported on Key Executive’s 2009 tax return.
Discussion: If, as a matter of law, the transfer of ownership occurred on January 1, the December paperwork memorialized the transfer. But if the transfer of ownership does not occur until December 31, the backdating fabricates the date of transfer and is improper because it supports erroneous tax reporting. Specifically, if the transfer of ownership did not occur until December 31, Sole Shareholder would be responsible for reporting 100 percent of the S corporation’s 2009 income.150
PROBLEM 7
Facts: General Partnership (“GP”) is treated as a partnership for federal tax purposes and uses the calendar year for tax reporting.151 As such, the income of GP is taxed directly to its partners in accordance with their partnership agreement.152 On January 1, 2009, GP has two partners (Partner A and Partner B) who have always shared profits and losses equally. On January 1, 2009, the partners agree to amend their agreement to cause Partner A to be entitled to 2/3 of GP’s 2009 profits. However, the paperwork to implement this amendment is not completed until December 31, 2009, and is dated “as of” January 1, 2009. The parties treat the amendment as effective on January 1, 2009. As such, 2/3 of GP’s 2009 profits are reported on Partner A’s tax return and 1/3 of GP’s 2009 profits are reported on Partner B’s tax return.
Discussion: If, as a matter of law, the amendment to the partnership agreement is effective on January 1, 2009, the December paperwork merely memorializes the amendment. But if the amendment is effective on December 31, 2009, the December paperwork fabricates the date of the amendment. The fabrication does not violate federal tax law because, under these circumstances, the partnership agreement can be retroactively amended to January 1, 2009, until April 15, 2010.153 Consequently, even if the amendment did not occur until December 31, 2009, it would be permissible for the partners to report GP’s 2009 income in accordance with the agreement reached on that date. Nevertheless, the backdating would still be improper unless it was not intended to harm a third party, does not adversely affect the rights of any third party, and does not violate any other law.
PROBLEM 8
Facts: On December 29, 2009, a new client asks attorney to prepare a deed reflecting the client’s desire to make a gift to the client’s daughter of certain real estate. In January 2010, attorney prepares the deed and sends it to client. The deed is signed by the client but no date is inserted. When attorney brings the missing date to client’s attention, client asks attorney to insert “as of December 31, 2009,” the date on which he says he told his daughter about the gift. No extraneous in-formation suggests the gift was actually made on December 31, 2009.
Discussion: The attorney has no evidence the gift was made on December 31, 2009, and contrary evidence exists because the attorney knows the deed was executed after that date. Moreover, the attorney has no past experience with the client that might prove helpful in assessing the client’s veracity. Thus, it appears the client is requesting the attorney to fabricate the date of the transfer of ownership which would violate state law and could adversely impact the rights of a third party.154 Hence, the backdating would be improper.
PROBLEM 9
Facts: Same as Problem 8, but assume that the attorney has worked with the client for many years and that all of client’s past actions have reflected integrity.
Discussion: Although it will likely be harder for the attorney to say “no” in this situation, it remains prudent to reject the request because no extrinsic evidence exists that the gift was in fact made on December 31. Acceding to the client’s wishes could cause the attorney to be participating in a fabrication that violates state law and compromises the rights of a third party.155
PROBLEM 10
Facts: Same as Problem 8, but client indicates the gift was made on December 1, 2009, and requests that the lawyer insert “as of December 1, 2009” on the deed. In addition, objective evidence exists that the daughter had actually assumed the benefits and burdens of ownership of the real estate on December 1. Specifically, she moved onto the property, paid the real estate taxes, and began to improve the property with her own funds.
Discussion: After verifying the facts and applying the facts to the relevant law, the lawyer might conclude that the backdating memorialized a gift that occurred on December 1.156 If the lawyer’s conclusion is correct, the backdating is legitimate. Otherwise, the backdating would be a fabrication that violates state law and could compromise the rights of a third party in which case the backdating would be improper.157
V. RECOMMENDATIONS
Based on the foregoing discussion, the following analysis should be employed whenever a lawyer is confronted with a backdating situation:
The lawyer should initially assess whether the backdating in question involves: (i) a fabrication intended to deceive or harm a third party; (ii) a fabrication utilized to achieve the goals of the parties involved where no intent exists to deceive or harm a third party; or (iii) the memorialization of a prior event.
An attorney should never participate in backdating that fabricates the time of an event when the backdating is intended to deceive or harm a third party.
Even when no intent exists to deceive or harm a third party, a lawyer should not participate in backdating that fabricates if the backdating could adversely affect the rights of a third party or violates a law. Lawyers should be extremely cautious about this form of backdating because it will often be difficult to identify all third parties who might be harmed and to assess whether the rights of any of these parties might be violated.158
If the backdating is intended to memorialize a prior event, the lawyer must confirm that the event in fact occurred on the earlier date. If the event is governed by ambiguous legal standards, a disciplined analysis should be undertaken to determine the actual time of the event. In all cases, the lawyer should critically evaluate all the evidence before reaching a conclusion as to when the event occurred and carefully document the facts establishing the event. If, after taking these actions, the lawyer remains uncertain as to when the event occurred, the lawyer must realize that the backdating could be a fabrication and evaluate its propriety on that basis.
An attorney should never assume a backdated document will remain private. The possibility of a controversy always exists and any backdated document might someday appear before a court, government entity, or some private party who was not privy to the backdating. Thus, the attorney should not participate in the backdating unless he or she is prepared to defend the legitimacy of the document in a truthful and forthright manner.
Backdating should always be disclosed. In the case of backdating that memorializes, utilizing “as of” dating should normally minimize the risk that a third party will be misled into believing that the document was executed on the earlier date, without creating confusion about the effective date of the document. In the case of backdating that fabricates where no intent to harm a third party exists, disclosure can provide notice to third parties who otherwise might be harmed, as well as reinforce the lack of any intent to deceive. Disclosure will not ensure the propriety of such backdating, however, because a third party could still be harmed by the backdating, notwithstanding the disclosure.
CONCLUSION
In an ideal world, backdating would never occur. No lawyer would ever be asked to fabricate the time of an event and every event would be documented contemporaneously with its occurrence. In the real world, however, backdating questions cannot be avoided.
Certain forms of backdating are an integral part of the practice of law. Events can and must be documented after the fact so long as it can be established that the event actually occurred at the earlier time. Moreover, backdating utilized to implement the economic objectives of private parties can potentially be innocuous if the backdating is not intended to harm a third party, and does not in fact compromise the rights of any third party or violate any law. Although these standards are easy to state, they are often difficult to apply.
Whenever a backdating question arises, it is critical for the lawyer to confront the issue and to understand exactly what he or she is being asked to do. The lawyer should never assume that any backdating situation is harmless. Instead, careful thought and analysis is necessary in every case to ensure the propriety of the action. The consequences of an error in judgment can be severe.
It is high time to remedy the dearth of guidance that exists with respect to backdating. Both legal academics and practitioners have an important role to play in educating lawyers to deal with this pervasive issue. Hopefully, this Article will begin that process.
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* Jeffrey L. Kwall is the Kathleen and Bernard Beazley Professor of Law and Director of the Tax LL.M. Program, Loyola University Chicago School of Law. B.A., Bucknell University; M.B.A., The Wharton School of the University of Pennsylvania; J.D., University of Pennsylvania Law School. Former Chair of the Federal Taxation Committee of the Chicago Bar Association.
Stuart Duhl is a Partner, Harrison & Held, LLP, and an Adjunct Professor of Law, Loyola University Chicago School of Law. B.S., Northwestern University; J.D., Northwestern University School of Law; LL.M. (Taxation), John Marshall Law School. Former Chair of the National Conference of Bar Examiners; Former President of the Illinois Board of Admissions to the Bar.
The authors thank Shelly Banoff, John Breen, Jenny Brendel, Mike Duhl, Vic Fleischer, Jim Grogan, Stan Meadows, Bill Popkin, Anne-Marie Rhodes, Adam Rosenzweig, and Bob Wootton for commenting on drafts of this Article. The views expressed are solely those of the authors. We also received helpful comments at a workshop at Loyola University Chicago School of Law. We thank our student assistants Olivia Seagle, Diane Crary, Robert Grignon, Andrew Katsoulas, Richard Kienzler, Becky Lauber, and David Pritzker. Thanks also to Loyola University Chicago School of Law for research support.
1. The issue is touched upon in Sheldon Banoff, Unwinding or Rescinding a Transaction: Good Tax Planning or Tax Fraud?, 62 TAXES 942, 980 (1984). None of the leading professional responsibility case-books devote much, if any, attention to backdating. See, e.g., STEPHEN GILLERS, REGULATION OF LAWYERS: PROBLEMS OF LAW AND ETHICS 401–02 (7th ed. 2005); GEOFFREY C. HAZARD, JR., SUSAN P. KONIAK, ROGER C. CRAMTON & GEORGE M. COHEN, THE LAW AND ETHICS OF LAWYERING (4th ed. 2005); THOMAS D. MORGAN & RONALD D. ROTUNDA, PROFESSIONAL RESPONSIBILITY (9th ed. 2006); DEBORAH L. RHODE & DAVID LUBAN, LEGAL ETHICS 537–39 (4th ed. 2004); MORTIMER D. SCHWARTZ, RICHARD C. WYDICK, REX R. PERSCHBACHER & DEBRA
LYN BASSETT, PROBLEMS IN LEGAL ETHICS (8th ed. 2007). Even the leading tax ethics books offer very limited coverage. See, e.g., BERNARD WOLFMAN, JAMES P. HOLDEN & KENNETH L. HARRIS, STANDARDS OF TAX PRACTICE § 502.2.2, at 414–16 (6th ed. 2004); BERNARD WOLFMAN, DEBORAH H. SCHENCK & DIANE RING, ETHICAL PROBLEMS IN FEDERAL TAX PRACTICE 259–60 (4th ed. 2008).
2. Stock options generally allow executives and key employees of publicly traded corporations to buy employer stock at the trading price on the day the option is issued. The options backdating scandal involved dozens of public corporations that backdated options to an earlier date when the company’s stock was trading at a lower value thereby allowing the recipients to buy the stock at a bargain price. See generally Victor Fleischer, Options Backdating, Tax Shelters, and Corporate Culture, 26 VA. TAX
REV. 1031, 1037 (2007); Randall A. Heron & Erik Lie, Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants?, 83 J. FIN. ECON. 271 (2007); Erik Lie, On the Timing of CEO Stock Option Awards, 51 MGMT. SCI. 802 (2005); David I. Walker, Unpacking Backdating: Economic Analysis and Observations on the Stock Option Scandal, 87 B.U. L. REV. 561 (2007).
3. Robert W. Wood, Tax Effects of the Stock Options Backdating Flap, 115 TAX NOTES 137, 137 (Apr. 9, 2007).
4. The term “backdate” is defined as “predate,” and the term “predate” as “antedate.” WEBSTER’S THIRD NEW INTERNATIONAL DICTIONARY, UNABRIDGED 158, 1785 (1986) (defining “backdate” and “predate” respectively). Several definitions are offered for “antedate.” Id. at 91. The definitions set forth in the text accompanying notes 5 and 6 are the most relevant to this discussion.
7. Both actions could occur in the same situation. Specifically, a document dated prior to the date of execution might also assign an event to a date prior to when the event occurred. For purposes of this Article, the two actions are treated as mutually exclusive.
8. See infra Part I.B (discussing backdating that fabricates at the expense of a third party or in violation of a law).
10. See infra Part I.C (discussing backdating that memorializes).
11. See infra Part II.A.1.a (discussing when, as a matter of law, an agreement is reached).
12. In cases where the act of execution causes the relevant event to occur, however, backdating the document would necessarily fabricate the date of the event. See, e.g., U.S. Projector & Elecs. Corp. v. Comm’r, 28 T.C.M. (CCH) 549, 553–54 (1969) (finding that the act of executing a rescission agreement fixed petitioner’s liability to return funds previously received, thus determining the timing of a tax deduction).
13. See Fleischer, supra note 2, at 1038 (acknowledging “the innocuous sort of ‘as of’ dating that lawyers engage in every day as a matter of practical necessity”).
14. See, e.g., United States v. Wilson, 118 F.3d 228, 231–32 (4th Cir. 1997) (involving an attorney’s effort to conceal a client’s assets from the Internal Revenue Service by backdating promissory notes to make it appear that the client was obligated to repay certain unconditionally received amounts); Quick v. Samp, 697 N.W.2d 741, 743 (S.D. 2005) (involving a malpractice suit against an attorney who back-dated a document to make it appear that a corporation had assigned its rights under a contract to the corporation’s sole shareholder because the attorney had erroneously named the shareholder, rather than the corporation, as the plaintiff in a breach of contract lawsuit against a third party); Medieval Attractions N.V. v. Comm’r, 72 T.C.M. (CCH) 924, 936–44 (1996) (involving an effort to claim tax deductions by backdating documents to make it appear that intangible property had been transferred to a related party so that payments to the related party could be treated as tax deductible royalties); In re Boyd, 430 N.W.2d 663, 663–64 (Minn. 1988) (involving an attorney’s effort to avoid the expense and inconvenience of probate by backdating a deed conveying real property from a client’s deceased father to the client who forged her father’s name on the deed); State ex rel. Counsel for Discipline of Neb. Sup. Ct. v. Rokahr, 675 N.W.2d 117, 120–21 (Neb. 2004) (involving an attorney who, after a trust for which the client had served as a trustee terminated, backdated an easement to secure access by the client’s children to property previously held in the trust); Office of Disciplinary Counsel v. Shaffer, 785 N.E.2d 429, 429–30 (Ohio 2003) (involving an attorney’s effort to avoid the expense of guardian-ship for a client’s incapacitated grandmother by backdating a power of attorney to a date prior to the grandmother’s stroke—to which the client forged the grandmother’s signature).
15. See generally Moore v. Comm’r, 93 T.C.M. (CCH) 1275, 1284 (2007) (“[E]ach of the . . . cases petitioners cite in support of their argument that courts uniformly disregard (and may even find fraudulent) backdated documents involves taxpayer efforts to use those documents solely in order to achieve a tax result dependent upon timely action by the taxpayer, where the time to act had already passed.”).
16. Comm. on Prof’l Ethics & Conduct of the Iowa State Bar Ass’n v. O’Donohoe, 426 N.W.2d 166, 169 (Iowa 1988) (involving an attorney who was disciplined for making a false statement of fact on a document filed for public record, thereby misleading opposing counsel and the general public).
18. U.C. Castings Co. v. Knight, 754 F.2d 1363, 1370–71 (7th Cir. 1985) (finding that the “jury could have found that one of the motives for the [backdating] practice was continuously to record income from the future and thus to increase profits shown so that when Universal should be offered for sale, its profits record would appear better than it really was”).
20. Confer v. Custom Eng’g Co., 952 F.2d 41, 42–43 (3d Cir. 1991) (involving backdating that occurred after a corporation learned it was liable for coverage because both an oral modification and a subsequent written modification were insufficient to change the terms of the plan).
22. Dobrich v. Comm’r, No. 98-70693, 1999 WL 650572, at *2–3 (9th Cir. Aug. 25, 1999) (involving a taxpayer’s attempt to defer gain on the sale of real estate pursuant to Internal Revenue Code section 1031).
24. Berger v. United States, 87 F.3d 60, 61–62 (2d Cir. 1996) (involving an employee benefits attorney who filed documents indicating his clients’ pension plans were amended in a timely manner where the plans were actually amended after the deadline thereby causing the affected plans to lose qualified status for some years).
26. See, e.g., United States v. Solomon, 825 F.2d 1292, 1295 (9th Cir. 1987) (involving the back-dating of tax shelter documents to precede the date on which the law was changed); United States v. Drape, 668 F.2d 22, 24–25 (1st Cir. 1982) (involving a taxpayer whose attorney, in 1977, backdated the taxpayer’s investment in a coal mining tax shelter to December 15, 1976, to generate deductions for the taxpayer’s 1976 tax return); Popkin v. Comm’r, 56 T.C.M. (CCH) 294, 295–96 (1988) (involving a taxpayer who entered into leases, providing for the payment of advance royalties, that were backdated to precede the date the income tax regulations were amended to disallow the deduction of advance royalties), aff’d, 899 F.2d 21 (11th Cir 1990); Fried v. Comm’r, 57 T.C.M. (CCH) 1300 (1989) (involving another party in Popkin case), aff’d, 954 F.2d 730 (11th Cir. 1992); In re Spear, 774 P.2d 1335, 1338 (Ariz. 1989) (involving an attorney/CPA who advised his client to purchase property in November 1983 from a partnership and then backdated the contract of sale to March 31, 1983, so the client could claim additional depreciation deductions); Fla. Bar v. Adler, 505 So. 2d 1334, 1335 (Fla. 1987) (involving an attorney who backdated a tax shelter investment to avoid a change in the tax law (enactment of the “atrisk” rules) that caused non-recourse obligations to no longer provide tax deductions for investors); Comm. on Prof’l Ethics & Conduct of the Iowa State Bar Ass’n v. Bauerle, 460 N.W.2d 452, 452–53 (Iowa 1990) (involving an attorney who was instructed by a client in 1982 to backdate a partnership agreement to January 1, 1981, to enable the client to claim additional depreciation deductions).
27. Parties accused of fraudulently backdating documents often defend themselves by claiming that the backdating merely memorializes a prior event. See, e.g., Medieval Attractions N.V. v. Comm’r, 72 T.C.M. (CCH) 924, 959 (1996) (“Petitioners attempt to justify backdating as a common practice to memorialize agreements.”); Herman v. Zatzkis, 632 So. 2d 302, 303–04 (La. Ct. App. 1993) (involving a divorce case in which the husband (Ralph) attempted to increase retroactively the fee paid to his attorney-brother with a backdated letter where “Ralph and his attorneys contend[ed] that the letter represents only a written memorialization of what had always been the oral fee arrangement between Ralph and his brother”).
29. Various corporate actions require approval of the board of directors. See, e.g., MODEL BUS. CORP. ACT § 8.01 (2005).
30. In the case of a closely held corporation, director approval will normally be effectuated by unanimous consent, rather than a meeting. See, e.g., id. § 8.21(a) (providing that “action . . . by the board of directors may be taken without a meeting if each director signs a consent describing the action”).
41. Note that the Internal Revenue Service bore the burden of proof in Baird because the issue of ownership was raised late in the proceedings. See id. at 124. It is uncertain whether the court would have found that ownership was transferred on the earlier date if the taxpayer had borne the burden of proof.
42. See Crystal Tandon, ABA Tax Section Meeting: Fraud Referral Program Paying Off, IRS Official Says, 111 TAX NOTES 777, 777 (May 15, 2006) (“Asked about whether backdated documents in themselves raise scrutiny, [IRS Criminal Investigation Division Chief Nancy] Jardini said that legitimate memorialization of a transaction after the fact is not CI’s concern.”).
43. See Moore v. Comm’r, 93 T.C.M. (CCH) 1275, 1283 (2007).
45. The court inferred that the majority member (Dr. Joffe) did not report the income from the disputed 10 percent membership interest because “[p]etitioners’ failure to question Dr. Joffe with respect to his returns or require him to produce those returns raises an inference that they would reflect Dr. Joffe’s belief that he, in fact, possessed a 68-percent membership interest [rather than a 78 percent interest] as of January 1, 1997.” Id. at 1285.
48. If the event occurred prior to the date stated in the document, a fabrication would also exist. That situation involves postdating, a subject beyond the scope of this Article.
49. RESTATEMENT (SECOND) OF CONTRACTS § 27 cmt. a (1981) (“Parties . . . often . . . before the final writing is made . . . agree upon all of the terms which they plan to incorporate therein. This they may do orally or by exchange of several writings.”).
50. U.C.C. § 2-204(2) (2002) (“An agreement sufficient to constitute a contract for sale may be found even though the moment of its making is undetermined.”).
51. RESTATEMENT (SECOND) OF CONTRACTS § 27 (1981) (“Manifestations of assent that are in themselves sufficient to conclude a contract will not be prevented from so operating by the fact that the parties also manifest an intention to prepare and adopt a written memorial thereof; but the circumstances may show that the agreements are preliminary negotiations.”).
52. Compare Finley v. Atl. Richfield Co., No. 95-7055, 1996 WL 80380, at *2 (10th Cir. 1996) (involving a preliminary letter agreement treated as effective—even though the final settlement agreement differed in many ways—because “[t]he Settlement Principles reflected in the final document . . . remained unchanged. Additional terms were collateral or immaterial matters which did not affect the formation of a contract.”), with Debreceni v. Outlet Co., 784 F.2d 13, 18–19 (1st Cir. 1986) (involving a preliminary agreement that was expressly subject to the execution of definitive documents where the court stated, “Even if we were [willing] to accept [the claim that the later, definitive agreement is] retroactively binding [between the parties to the contract], we are unwilling to go a step further and hold that parties to a contract can make it retroactively binding to the detriment of third persons not party to the contract.”).
53. Compare 13 SAMUEL WILLISTON & RICHARD A. LORD, A TREATISE ON THE LAW OF CONTRACTS §§ 38:4, 38:7 (4th ed. 2000 & Supp. 2007) (focusing on a condition precedent to the existence of contract), with City of Haverhill v. George Brox, Inc., 716 N.E.2d 138 (Mass. App. Ct. 1999) (focusing on a condition precedent to liability under an existing contract).
54. See 13 WILLISTON & LORD, supra note 53, § 38.10, at 413 (noting that conditions subsequent are generally only subsequent in form and tend to be conditions precedent to the duty of immediate performance).
55. Id. at 414 (noting that the terminology has been abandoned for the most part); see also RESTATEMENT (SECOND) OF CONTRACTS § 224 reporter’s note (1982) (introducing the more contemporary distinction between express and implied conditions).
56. In certain cases, the standard and its application are clear. See, e.g., United States v. Solomon, 825 F.2d 1292, 1295–96 (9th Cir. 1987) (finding that because “patents could be assigned only in writing,” defendant’s claim that parties had entered into an oral agreement was irrelevant).
57. See EDWARD H. RABIN, ROBERTA ROSENTHAL KWALL & JEFFREY L. KWALL, FUNDAMENTALS OF MODERN PROPERTY LAW 901–18 (5th ed. 2006). The issue of when ownership is transferred can be complex even under property law because of the passage of equitable title at the time of the agreement of sale. Under the doctrine of equitable conversion, when the purchaser and seller enter into a contract for the sale of land, the purchaser becomes the equitable owner of the land and the seller retains legal title until closing occurs. Id. at 1127–47.
58. The determination of tax ownership has generated significant litigation. Richard E. Marsh, Tax Ownership of Real Estate, 39 TAX LAW. 563, 564–65 (1986). These cases are not limited to real property. See, e.g., H.J. Heinz Co. v. United States, 76 Fed. Cl. 570 (2007) (stock ownership); Georgiou v. Comm’r, 70 T.C.M. (CCH) 1341 (1995) (stock ownership).
59. See supra note 26 and text accompanying notes 34–41. When income, rather than a deduction, is at issue, the purchaser can be expected to argue that ownership was transferred at a later date. See, e.g., Moore v. Comm’r, 93 T.C.M. (CCH) 1275, 1282 (2007).
60. See, e.g., Comm’r v. Union Pac. R.R. Co., 86 F.2d 637, 638–39 (2d Cir. 1936); Baird v. Comm’r, 68 T.C. 115, 119–28 (1977); Pomeroy v. Comm’r, 54 T.C. 1716, 1724–26 (1970).
61. See Alex Raskolnikov, Contextual Analysis of Tax Ownership, 85 B.U. L. REV. 431, 460–65 (2005). See also Banoff, supra note 1, at 980 (“[O]ne should consider backdating a document only where the dating is consistent with the parties’ intent. In such case, it is, of course, necessary for the parties to allocate the benefits, and suffer the burdens, of ownership as of that earlier date, i.e., give economic effect to the earlier date.”).
62. Burdens of ownership include the risk of loss and liability for real estate taxes while benefits usually include the right to use the property, the profits from that use, and any appreciation in the value of the property. See Marsh, supra note 58, at 575.
63. See Raskolnikov, supra note 61, at 463–64 (discussing that when “a meaningful condition precedent has not been fulfilled, the contract . . . will remain executory,” while “an insubstantial condition will not delay the sale”).
75. See also Pittsburgh Realty Inv. Trust v. Comm’r, 67 T.C. 260, 280–81 (1976). This case involved a factual question as to whether a corporate liquidation occurred on September 30, 1968—resulting in no tax liability—or on October 4, 1968—resulting in a significant tax liability. Id. at 278–79. Ul-timately, the court determined that the liquidation occurred on the later date, notwithstanding the existence of documents suggesting the liquidation occurred on the earlier date. Id. at 280. These documents included the deed conveying the corporation’s property to its shareholders, the closing sheet, the IRS Form 966, and the articles of dissolution filed with the state. Id.
76. Daniel L. Schacter, Kenneth A. Norman & Wilma Koutstaal, The Cognitive Neuroscience of Constructive Memory, 49 ANN. REV. OF PSYCHOL. 289, 290 (1998) (noting that since 1932 psychological studies have indicated that memory is not an exact reproduction of events, rather it is a constructive process that can be distorted).
77. See Giuliana Mazzoni & Manila Vannucci, Hindsight Bias, The Misinformation Effect, and False Autobiographical Memories, 25 SOC. COGNITION 203, 208–09 (2007).
78. See Valerie F. Reyna, Robyn Holliday & Tammy Marche, Explaining the Development of False Memories, 22 DEVELOPMENTAL REV. 436, 441–42 (2002). See also Mazzoni & Vannucci, supra note 77, at 211 (stating that factors such as familiarity, plausibility, and memorability of an event as well as social variables can cause people to have biased recollections and false memories).
80. See Raymond S. Nickerson, Confirmation Bias: A Ubiquitous Phenomenon in Many Guises, 2 REV. OF GEN. PSYCHOL. 175, 178 (1998).
81. In an analogous situation, a lawyer who prepares a will for a testator of uncertain ability can be regarded as having made the judgment that the testator is competent.
82. Most lawyers will likely be concerned about the loss of future business from an existing client whose credibility is being questioned.
83. See 31 C.F.R. § 10.37 (2008) (Circular 230) (stating a practitioner should not give tax advice that “unreasonably relies upon representations . . . of the taxpayer or any other person [and] does not consider all relevant facts that the practitioner knows or should know”); id. § 10.33 (listing best practices, which include “evaluating the reasonableness of any assumptions or representations”). But see Louis Mezzullo, College of Tax Counsel Criticizes Sweep of Circular 230 Amendments, 2005 LEXIS TNT 111–18 ( June 10, 2005) (criticizing section 10.37 of the Circular 230 Regulations as “vague in its application” and opining that “[p]ractitioners should not be required to independently verify that the facts and statements provided by a client are correct if they appear to be reasonable”).
84. See supra Part I.B (illustrating when backdating that fabricates is improper).
85. See 2 WILLISTON & LORD, supra note 53, § 6:61, at 895 (“[I]t seems clear that, where the parties themselves agree that a contract between them should be given effect as of a specified date, absent the intervention of third-party rights, there is no sound reason why that agreement should not be given effect.” (emphasis added)). Courts often acknowledge and follow this rule. See, e.g., Viacom Int’l Inc. v. Tandem Prods. Inc., 368 F. Supp. 1264, 1270 (S.D.N.Y 1974) (stating, “as a general rule[,] when a written contract provides it shall be effective ‘as of’ an earlier date, it generally is retroactive to the earlier date”), aff’d, 526 F.2d 593 (2d Cir. 1975); Du Frene v. Kaiser Steel Corp., 231 Cal. App. 2d 452, 458 (Dist. Ct. App. 1964) (finding that an agreement applied to an accident occurring on November 6, where the agreement stated it was “approved and accepted” as of November 4, even though it was dated November 15 and presented for signature on November 22); Am. Cyanamid Co. v. Ring, 286 S.E.2d 1, 3 (Ga. 1982) (stating that “the effective date of a contract is not the date of execution where the contract expressly states that its terms are to take effect at an earlier date”); Buffalo Police Benevolent Ass’n v. Buffalo, 114 Misc. 2d 1091, 1092–93 (Erie Co. Ct. 1982) (treating a collective bargaining agreement as effective on its stated effective date of July 1, 1980, notwithstanding the court’s acknowledgment that execution did not occur until February 10, 1982, and that the “parties were without an agreement from July 1, 1980, to February 10, 1982”). Cf., e.g., Pittsburgh Realty Inv. Trust v. Comm’r, 67 T.C. 260, 280 (1976) (stating that “[i]n a business context, where both parties to a transaction are agreed, the custom of backdating documents or dating them ‘as of’ a prior date may be acceptable”); SEC v. Solucorp Indus. Ltd., 197 F. Supp. 2d 4, 11 (S.D.N.Y. 2002) (stating that “[w]e do not dispute that certain contracts may be legitimately backdated”). The Supreme Court has tacitly approved of a dating pattern appearing to involve a fabrication. See Comm’r v. Phila. Transp. Co., 174 F.2d 255, 256 (3d Cir. 1949), aff’d per curiam , 338 U.S. 883 (1949). This case involved a corporation that did not come into existence until January 1, 1940, but issued bonds dated January 1, 1939, bearing interest from that date. Id. at 255. The court acknowledged this dating occurred “for reasons best known to management,” sanctioned the corporation’s deduction of the 1939 interest in 1940, and determined that the corporation was satisfying its own obligation, not that of another party. Id. at 256.
86. Retroactivity is a two-edged sword, however. If retroactivity harms the parties involved, courts have been willing to enforce the harm. See, e.g., Am. Cyanamid Co., 286 S.E.2d at 2–3 (involving an indemnification agreement that was executed on July 15, 1975, but was held to be effective “as of July 1, 1975”—the effective date stated in the agreement. This caused American Cyanamid to be held liable for the death of an employee five days before the agreement was executed.); Diamond Int’l Corp. v. Glad, 330 N.W.2d 526, 526–27 (S.D. 1983) (involving a partnership agreement restated in October 1978 to convert Glad’s status from a limited partner to a general partner retroactive to March 1978, pursuant to which Glad was held responsible for a claim that arose in September 1978 when he was a limited partner).
88. By treating the options as having been awarded on an earlier date when the stock price was lower, the options are “in the money” on the date they are actually received. See Fleischer, supra note 2, at 1036–39; Walker, supra note 2, at 570–73.
89. [$100 per share value x 1,000 shares]-[$70 per share price x1,000 shares] = $30,000.
90. The statement in the text assumes that no relationship exists between employer and employee that might activate regulatory rules restricting their arrangement.
91. See supra Part I.B (illustrating when backdating that fabricates is improper).
93. See infra Part III for a discussion of the relevance of disclosure to the propriety of backdating.
94. In re Computer Sciences Corp., No. CV 06-05288, 2007 WL 1321715, at *2 (C.D. Cal. Mar. 26, 2007) (emphasis added). See Fleischer, supra note 2, at 1034 n.7 (acknowledging that options backdating would be “perfectly acceptable” under the conditions set forth by the In re Computer Sciences Corp. court, though “I have yet to hear about any companies that followed this path”).
95. See supra Part I.B (illustrating when backdating that fabricates is improper).
96. In this regard, all types of taxes must be considered, including income taxes, transfer taxes, and property taxes.
108. Id. (internal quotation marks omitted). Each of these disciplinary rules has been codified in substantial part by the Model Rules of Professional Conduct and the Model Code of Professional Responsibility, one or the other of which has been adopted by most states. See AM. BAR ASS’N & BUREAU OF NAT’L AFFAIRS, ABA/BNA LAWYERS’ MANUAL ON PROFESSIONAL CONDUCT § 1:3 (2008). Model Rule 8.4(c) and its corollary DR 1-102(A)(4) prohibit attorneys from engaging in “conduct involving dishonesty, fraud, deceit or misrepresentation.” Id. § 101:401. Model Rule 3.3(a)(1) and its corollary DR 7-102(A)(5) prohibit attorneys from “knowingly mak[ing] a false statement of fact or law [to a tribunal].” Id. § 61:301. Model Rule 8.4(d) and its corollary DR 1-102(A)(5) prohibit attorneys from engaging in “conduct that is prejudicial to the administration of justice.” Id. § 101:501.
112. See, e.g., MODEL RULES OF PROF’L CONDUCT R. 8.4(c) (2006). Model Rule 8.4(c) has been adopted by each of the forty-seven states that have adopted the Model Rules of Professional Conduct, and a similar rule is employed by the minority of states that have adopted the Model Code of Professional Responsibility. See ABA & BUREAU OF NAT’L AFFAIRS, supra note 108, §§ 1:3, 101:401.
113. The Model Rules of Professional Conduct define “fraud” as “conduct that is fraudulent under the substantive or procedural law of the applicable jurisdiction and has a purpose to deceive.” MODEL RULES OF PROF’L CONDUCT R. 1.0(d) (2006). States that have adopted the Model Rules similarly require that the attorney have a “purpose to deceive” to sustain a fraud charge. See, e.g., ARIZ. RULES OF PROF’L CONDUCT 1.0(d); ILL. RULES OF PROF’L CONDUCT, Terminology; PA. RULES OF PROF’L CONDUCT 1.0(d). The Model Rules shed no light on the requisite mental state for dishonesty, deceit, or misrepresentation, and the law varies from state to state. Compare Florida Bar v. Fredericks, 731 So. 2d 1249, 1252 (Fla. 1999) (“In order to find that an attorney acted with dishonesty, misrepresentation, deceit or fraud, the Bar must show the necessary element of intent.”), with Parese v. Statewide Grievance Comm., No. CV88-0348079, 1993 WL 137568, at *3 (Conn. Super. Ct. 1993) (stating that “[t]here is no requirement under rule 8.4(c) that the prohibited misrepresentation be intentional . . . ; in general, legal liability for misrepresentations rests on false statements made either intentionally or negligently” (emphasis added)).
114. See, e.g., Fla. Bar v. Adler, 505 So. 2d 1334, 1335 (Fla. 1987) (disciplining attorney for back-dating documents to precede a change in the law that eliminated certain tax deductions). See also In re Brown, 766 N.E.2d 363, 364 (Ind. 2002) (disciplining an attorney for forging his client’s signature on a check and stealing a portion of his client’s settlement); In re Perrini, 662 N.Y.S.2d 445, 448 (App. Div. 1997) (disciplining attorney for backdating letter submitted to bankruptcy court because he failed to file timely proof of claim); In re Graham, 503 N.W.2d 476, 477 (Minn. 1993) (disciplining attorney for submitting backdated documents to the bankruptcy court to conceal his assets from creditors).
115. Even in Illinois, the jurisdiction where Stern was decided, some confusion exists about the standard. See In re Howard, No. 96 CH 531, 1998 WL 772167, at *8 (Review Bd. of the Ill. Attorney Registration & Disciplinary Comm’n June 4, 1998) (“[While Rule 8.4(a)(4)’s statement] that ‘a lawyer shall not engage in dishonesty, fraud, deceit or misrepresentation’ . . . appears to be aimed at intentional acts of deception, our review of relevant cases provides no clearcut statement as to the requirements of the rule. Some cases have premised a violation of Rule 8.4(a)(4) on a finding of dishonest motive. Conversely, this Board has stated that ‘a violation of Rule 8.4(a)(4) can be found even without proof that anyone was actually deceived’ and ‘malice is not an element the [a]dministrator must prove.’” (citations omitted)).
116. The American Bar Association has suggested that an attorney be admonished for submitting false statements to a court that cause little or no harm or adverse consequences to a party. AM. BAR ASS’N, ABA STANDARDS FOR IMPOSING LAWYER SANCTIONS, Standard 6.14 (1992).
117. For example, a party who originally consented to the arrangement might have second thoughts resulting in a dispute that causes the backdating to surface. See, e.g., Moore v. Comm’r, 93 T.C.M. (CCH) 1275, 1284–85 (2007) (discussing dispute between members of LLC as to when a transfer of membership interests occurred).
118. The mechanics of disclosure are explored in Part III.
119. See supra Part II.C (discussing how backdating that memorializes can be problematic). See, e.g., Herman v. Zatzkis, 632 So. 2d 302, 304 (La. Ct. App. 1993) (“[The parties] contend that the letter represents only a written memorialization of what had always been the oral fee arrangement . . . . They argue that the court should not ascribe bad faith and fraud to the failure to disclose the fact that the letter was backdated. . . . The date on the letter was a material issue and we find that there was an affirmative duty to disclose whether asked or not.”); In re Jagiela, 517 N.W.2d 333, 335 (Minn. 1994) (“It appears from the record that the back-dated agreement may well have memorialized a prior oral agreement, at least to some extent. The back-dated agreement, however, was given to opposing counsel . . . , submitted to the . . . court, and testified to by various parties. . . . [The attorney] did not inform the court or opposing counsel of the back-dating of the agreement. Thus, there is clear and convincing evidence of [the attorney]’s misconduct with regard to the agreement.”).
120. See supra Part II.B (discussing backdating that fabricates).
122. Cf., e.g., Cipparone v. Comm’r, 49 T.C.M. (CCH) 1492, 1498 (1985) (“Any conduct, the likely effect of which would be to mislead or conceal, is indicative of fraud.”); The Curious Capitalist, blog. com/curious_capitalist/2007/03/actually_holman_stockoption_ba.html (Mar. 7, 2007, 15:49 EST) (“Actually, Holman, Stock-Option Backdating Is Never Ok”) (“Backdating is, by its very definition, not disclosing what you’re doing.” (emphasis in original)).
123. Backdating utilized to deceive a third party is per se improper and disclosure will not mitigate the wrongdoing. In fact, the purported disclosure of such backdating might actually reflect an effort to impede authorities from ascertaining the truth. See infra notes 138–46 and accompanying text.
124. See supra Part II.A.1 (exploring how a contract can exist and ownership of property can be transferred before corresponding documents are executed).
126. Id. at 1321 (internal quotation marks omitted).
127. Id. After discussing the April 22 effective date, the court states that “a later date does appear following the signature.” Id. at 1322. That “later date” was presumably the June 22 execution date but this is not clear.
130. See also Am. Cyanamid Co. v. Ring, 286 S.E.2d 1, 2–3 (Ga. 1982) (involving a contract dated “as of July 1, 1975” where one party inserted the July 15, 1975, execution date next to his signature, resulting in the trial court determining that “the two dates on the contract created an ambiguity which was appropriate for the jury to resolve”); Suffolk Constr. Co. v. Lanco Scaffolding Co., 716 N.E.2d 130, 133 (Mass. App. Ct. 1999) (affirming in dicta that the appearance of multiple dates “might create ambiguity or confusion as to a different effective date for the contract” even though only one date appeared in the contract at issue).
131. The research for this Article revealed only three backdating cases where the date of execution was disclosed. See Pittsburgh Realty Inv. Trust v. Comm’r, 67 T.C. 260, 268 (1976) (involving a stock purchase agreement disclosing the execution date as follows: “10-4-68 (as of 9-30-68)”); Sweetman, 389 A.2d at 1321 (involving a contract stating it was “made this 22nd day of April 1976” and that it was executed on June 22, 1976); Am. Cyanamid Co., 286 S.E.2d at 2(involving a contract dated “as of July 1, 1975” where one party inserted the July 15, 1975, execution date next to his signature). The absence of cases involving disclosure of the date of execution could mean either that the practice rarely occurs or that litigation rarely occurs when the date of execution is identified.
132. This technique might also be utilized when it is difficult or impossible to gather all parties together to execute a document at one time. Geographic differences or strained relationships might make it impractical for everyone to convene in one place. Hence, a document might be executed in counterparts at different times and places. In these circumstances, the “as of” date can establish a specific time for the event.
133. To guard against any inference that the “as of” date reflects the execution date, a clause could be added stating: “The date on this document shall not be construed to imply that the document was executed on that date.”
138. No. 2:02-cr-00134-BMS (E.D. Pa. filed Mar. 5, 2002).
139. Amended Indictment at 4, United States v. Delaney, No. 2:02-cr-00134-BMS (E.D. Pa. Mar. 29, 2005) [hereinafter “Amended Indictment”].
140. See id. at 3. See also I.R.C. § 704(d) (2000) (limiting partner’s deduction of partnership losses to partner’s basis in partnership interest); id. § 752(a) (allowing partner to augment basis in partnership interest for partnership liabilities with respect to which partner bears a risk of loss).
142. The evidence supporting the government’s view included the following: “In or about April 1998, defendant [lawyer] advised one of the . . . partners that he would keep the false guarantees dated ‘as of August 25, 1995’ hidden in his desk drawer and not provide them to [one of the limited partners].” Id. at 7.
143. The attorney pled guilty and was sentenced to six months of imprisonment and three years of supervised release. Criminal Docket Report at nos. 20, 34, United States v. Delaney, No. 2:02-cr-00134-BMS (E.D. Pa. filed Mar. 5, 2002).
144. Jeff Blumenthal, Tax Bar Debates Merits of Jacobs Indictment, LEGAL INTELLIGENCER, Mar. 7, 2002, at 1.
145. The quoted lawyers might not have been aware of the fact that the Delaney case apparently involved the alleged fabrication of an event that never occurred. Their comments seem to be contemplating the use of “as of” dating in situations intended to memorialize a prior event.
146. See also Melnick v. Comm’r, 91 T.C.M. (CCH) 741, 748 (2006) (involving a transaction where the documents suggested a “willingness to manipulate the relevant chronology in a way that does not enhance the credibility of petitioner’s evidence” where the court found that “[t]he ‘effective as of’ dating and backdating of relevant documents impede our review of the substance of the transactions . . . and lead us to conclude that the chronology reflected by those documents is not credible”).
147. A C corporation is a corporation not governed by Subchapter S of the Internal Revenue Code. See I.R.C. § 1361(a)(2) (2000). As such, a C corporation is treated as a separate taxpaying entity and subject to a corporate-level tax on its income. See id. § 11. In addition, the shareholders of a C corporation are normally taxed on dividends and other corporate distributions. See id. §§ 301, 302, 331 (2000 & Supp. V 2005).
148. An S corporation is governed by Subchapter S of the Internal Revenue Code. See id. § 1361(a)(1) (2000). As such, the income of the S corporation is generally taxed directly to its shareholders, and no additional tax is normally imposed when earnings are distributed to shareholders. See I.R.C. §§ 1366– 68 (West 2002 & Supp. 2007); but see I.R.C. §§ 1374–75 (2000 & Supp. V 2005) (imposing corporate-level taxes on certain S corporations that were formerly C corporations).
149. See I.R.C. §§ 1366, 1377 (West 2002 & Supp. 2007). 150. Id. See also Treas. Reg. § 1.1377-1(a)(2)(ii) (as amended in 2006) (treating seller of S corporation stock as owner of the shares for the day of disposition).
151. A partnership for tax purposes is an unincorporated enterprise governed by Subchapter K of the Internal Revenue Code. I.R.C. § 761(a) (2000); see generally I.R.C. §§ 701–61 (West 2002 & Supp. 2007). The income of a partnership is taxed directly to its partners and no additional tax is normally imposed when partnership profits are distributed to the partners. See I.R.C. §§ 702, 705, 731, 733 (2000 & Supp. V 2005).
152. See id. §§ 702, 704. For purposes of this Problem, assume that all agreed to allocations have “substantial economic effect.” See id. § 704(b) (2000).
153. See id. § 761(c) (defining partnership agreement as incorporating all amendments made by the fifteenth day of the fourth month after the close of the tax year); Treas. Reg. § 1.761-1(c) (as amended in 1997) (allowing the partnership agreement to be modified with respect to a taxable year after the close of that taxable year but before the filing date for the partnership return). The government can be adversely affected when partners retroactively allocate income or deductions if the partners are taxed at different rates. See Moore v. Comm’r, 93 T.C.M. (CCH) 1275, 1284 (2007) (“A retroactive increase in [two members’] shares of LLC profits would have necessarily resulted in a retroactive decrease in [another member’s] share of those profits. Thus, aside from possible tax rate differentials among . . . the individuals (unsupported by any evidence in the record), the [Internal Revenue Service] . . . is indifferent as regards [to] the respective profit shares of each.”). Limits exist on the ability of partners to allocate retroactively profits and losses for any year in which a change in a partner’s interest in the partnership occurs. See I.R.C. § 706(d) (2000).
154. For example, daughter might have included the property as an asset on a December 31, 2009, financial statement that a bank relied on in granting daughter a loan.
156. See supra Part II.A.1.b (discussing when, as a matter of law, ownership is transferred).
157. See supra Problem 8. Problems 8–10 also raise the issue of whether the deed could be properly notarized under these circumstances, a subject beyond the scope of this Article.
158. The lawyer should also realize that this form of backdating might be enforced to the detriment of a party to the backdating. See supra note 86. Unless those parties agree to bear this risk, the lawyer could also be subject to claims by those parties.
Civil liability for aiding and abetting provides a cause of action that has been asserted with increasing frequency in cases of commercial fraud, state securities actions, hostile takeovers, and, most recently, in cases of businesses alleged to be supportive of terrorist activities. The U.S. Supreme Court, in its 1994 decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, ended decades of aiding and abetting liability in connection with federal securities actions. However, the doctrine since has flourished in suits arising from prominent commercial fraud cases, such as those concerning Enron Corporation and Parmalat, and even in federal securities cases some courts continue to impose relatively broad liability upon secondary actors. This article reviews Central Bank and its limitations, before turning to an analysis of the elements of civil liability for aiding and abetting fraud. The article then similarly identifies and analyzes the elements of liability for aiding and abetting breach of fiduciary duty, which predominantly concerns professionals, such as accountants and attorneys, that are alleged to have assisted wrongdoing by their principal. The analysis then examines aiding and abetting liability in the context of particular, frequently-occurring, factual matrices, including banking transactions, directors and officers, state securities actions, and terrorism. The article concludes by summarizing emerging principles evident from judicial decisions applying this very flexible and potent source of civil liability
I. Introduction
Allegations of corporate fraud and misdealing pervade the commercial marketplace. In a sequence that has become familiar, exposure of the primary fraud perpetrator leads swiftly to bankruptcy for a company later revealed to have been technically insolvent for months or years prior to the disclosure. When the debacle is reported, the bankrupt’s former auditor, investment bank and outside counsel know litigation soon may be at their door, even though they were not the primary actors in the alleged fraud. The principal concern? Secondary liability—increasingly based on the theory that the secondary actor aided and abetted fraud or other misconduct by the primary actor.
Liability for aiding and abetting is a doctrine with ancient roots that has sprouted new and significant offshoots during the last twenty years. During the 1980s the doctrine increasingly ensnared auditors and other professionals alleged to have facilitated misconduct by their clients. Significant relief for many securities industry participants came in 1994 when the U.S. Supreme Court, in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., held there is no cause of action for aiding and abetting violations of the Securities Exchange Act.1 But while one important basis for liability was cut off, claims of aiding and abetting, in areas such as breach of fiduciary duty, commercial fraud, and state law securities liability, steadily have increased. And terrorism, with its myriad facilitators and statutes providing compensation for victims, is a development that very soon may transform aiding and abetting law.
This article examines the current state of the law of civil liability for aiding and abetting, prefaced by a discussion of the doctrine’s origin in criminal law. Because of the still rippling effect of Central Bank, that 1994 opinion is analyzed, and the scope of its effect discussed. The hub of the article is an explanation of the legal elements of the civil causes of action for aiding and abetting fraud and breach of fiduciary duty, respectively. Whether there are four elements required for the tort, or potentially five or six, depends on the judicial forum, as will be shown. The article then shifts perspective and concludes with a discussion how the outcome may depend on the factual matrix and role of the defendant. We find that attorneys may have less to fear than corporate officers, for example, and, as the law develops, we see that terrorists’ associates may be subject to far-reaching liability.
Aiding-abetting law has adapted to emerging business torts and new variations of commercial misconduct though if it is part of a legal trend there is no unifying theme—other than adaptability itself. This article posits no such theme, but synthesizes common elements where they exist and identifies the doctrine’s many variations.
II. HISTORICAL ANTECEDENTS
Civil liability for aiding-abetting pre-existed such well-established doctrines as joint and several liability and product liability, as well as the modern concept of a duty of professional loyalty (which is now a frequent context for aiding-abetting claims). The antiquity of aiding-abetting liability has interested the courts in various important decisions, on occasion subtly deployed in support of broadened liability,2 while on other occasions leading to the conclusion that against the historical background a statute that fails to specify aiding-abetting liability cannot be deemed implicitly to provide for it.3 Consequently, the doctrine’s origins remain relevant even now.
A. ORIGIN IN CRIMINAL LAW
Criminal liability for aiding and abetting was codified in the sixth century by the Roman emperor Justinian,4 and in Anglo-American law has its origin in the ancient doctrine concerning accessories to crime.5 At common law, the inquiry concerning the liability of accessories to crime was plagued by “intricate” distinctions.6 Persons might be charged with a felony as: (i) principals in the first degree who actually perpetrated the offense; (ii) principals in the second degree who were actually or constructively present at the scene of the crime and aided and abetted its commission; (iii) accessories before the fact who aided and abetted the crime, although not present when it was committed, or; (iv) accessories after the fact who rendered assistance after the crime was complete.7
Though there is no federal common law of crimes, Congress in 1909 enacted what is now 18 U.S.C. § 2, a general aiding and abetting statute applicable to all federal criminal offenses.8 Under the statute, all those who knowingly provide aid to persons committing federal crimes, with the intent of facilitating the crime, are themselves committing a crime.9
In the civil liability context, secondary liability arising from concert of action, though probably incorporating some element of conspiracy between the primary and secondary actor, can be traced back at least 400 years.10 In the United States, liability for lending encouragement or aid to a tortfeasor is reported in cases appearing at least from the mid-nineteenth century.11 Many of the early reported cases of civil liability purely for aiding and abetting (that is, without any element of conspiracy) are said to have concerned “isolated acts of adolescents in rural society.”12
B. DISTINGUISHED FROM CONSPIRACY
Aiding-abetting and conspiracy have been regarded as “closely allied forms of liability.”13 However, a conspiracy generally requires an agreement as well as an overt act causing damage.14 Aiding and abetting does not require any agreement, but rather assistance given to the principal wrongdoer.15
Nevertheless, common to both conspiracy and aiding-abetting is “concerted wrongful action.”16 Because of this commonality, it has (erroneously) been said that evidence that would permit a reasonable finder of fact to conclude that defendants conspired to breach a duty necessarily must support a determination that defendants aided and abetted it by knowingly and substantially participating in a breach of such duty.17 However, an agreement with another to perpetrate wrongdoing is not the same thing as actively facilitating the act, and thus proof of mere agreement does not give rise to traditional aiding-abetting liability.18
Unlike a conspirator, an aider and abettor does not “‘adopt as his or her own’” the tort of the primary violator.19 Instead, the act of aiding and abetting “is distinct from the primary violation; liability attaches because the aider and abettor behaves in a manner that enables the primary violator to commit the underlying tort.”20 The D.C. Circuit Court of Appeals has distinguished conspiracy from aiding and abetting by observing that a conspiracy consists of “concerted action by agreement” while aiding and abetting is “concerted action by substantial assistance.”21 To illustrate: When in baseball a pitcher strikes out a hitter the putout is the product of a prearranged conspiracy between the pitcher and the pitcher’s manager; by contrast, when fans heckle to distract the batter they do so absent any bilateral agreement and thus are aiding and abetting the pitcher, not conspiring with him.
Aiding and abetting is, in some instances, easier to establish than conspiracy. For example, while California law holds that one may not be subject to liability for conspiracy unless one owed a preexisting duty to the plaintiff, no such requirement exists with respect to aiding and abetting liability.22
C. NATIONWIDE ACCEPTANCE OF CIVIL LIABILITY FOR AIDING AND ABETTING
Of the jurisdictions that have addressed the doctrine of civil liability for aiding and abetting as set forth in the RESTATEMENT (SECOND) OF TORTS section 876(b), thirty permit a claim for aiding and abetting in some context.23 The Central Bank Court observed that courts in Georgia, Maine, Montana and Virginia had declined to recognize a cause of action for aiding and abetting fraud.24 Commentators have perceived a trend toward increased recognition,25 which probably is either (i) the inexorable progression (or expansion) of tort liability, (ii) the result of an increased perception that fraud actors often rely on accessories to perpetrate large-scale, complicated schemes, or (iii) both.
III. THE CENTRAL BANK DECISION: NO AIDING AND ABETTING CAUSE OF ACTION UNDER THE SECURITIES EXCHANGE ACT
The current state and likely future development of the body of law of aiding and abetting cannot properly be understood without an analysis of the 1994 decision that performed a dramatic amputation: Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.26 There, the Supreme Court held that Section 10(b) of the Securities Exchange Act does not create or support a private cause of action for aiding and abetting securities fraud.27 The reasoning of the decision has since been held applicable to other federal statutes, such as RICO, though it has been less persuasive in connection with state law remedies, including state “Blue Sky” laws.28 While the Central Bank decision provoked some controversy when it was decided, it generated considerably more seven years later when it came to light that secondary actors, such as Arthur Anderson, LLP, had played critical roles in facilitating multi-billion dollar securities frauds.
A. PRE-CENTRAL BANK FEDERAL SECURITIES LAW JURISPRUDENCE
One of the most important elements of Rule 10b-5 pursuant to the Securities Exchange Act is its statement of the proscribed conduct. Rule 10b-5 sets forth separately articulated proscriptions for fraud, deceit, misleading statements and fraudulent “devices,” “schemes” and “artifices.”29 Each subsection of the Rule prohibits slightly different conduct in connection with the purchase or sale of a security. The second subsection prohibits the making of a material misstatement or omission.30 The first and third subsections prohibit a person from employing a fraudulent device and engaging in conduct that “operates or would operate as a fraud.”31
Prior to Central Bank, a significant number of federal courts in nearly every circuit had held that an aider-abettor was subject to civil liability under section 10(b) of the Securities Exchange Act and Rule 10b-5.32 Such liability was described as having been grounded in tort law, and as a “logical and natural complement” to the private right of action under section 10(b), furthering the “maintenance of a post-issuance securities market that is free from fraudulent practices.”33 Consequently, entities such as financial advisors to corporations,34 auditors of a brokerage firm,35 accounting firms providing tax opinions on which investors relied,36 corporate insiders interested in the sale of securities of a parent company,37 and corporations themselves38 had been held subject to potential liability for aiding and abetting federal securities fraud. Perhaps because of the agreement among federal circuits as to aiding and abetting liability for securities fraud, the issue did not reach the Supreme Court until nearly sixty years after enactment of section 10(b) of the Securities Exchange Act.
B. REASONING OF CENTRAL BANKOPINION
Section 10(b) of the Securities Exchange Act of 1934 provides: “It shall be unlawful for any person directly or indirectly . . . (b) To use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest to the protection of investors.”39 Aiding and abetting was not, however, expressly made unlawful in the 1934 Act.
In Central Bank, the majority opinion observed that Congress had not enacted a general civil aiding and abetting statute, “either for suits by the Government (when the Government sues for civil penalties or injunctive relief ) or for suits by private parties.” The Court held that when Congress enacts a statute under which a person may sue and recover damages from a private defendant for the defendant’s violation of some statutory norm, one cannot presume Congress intended to create a cause of action for aiders and abettors.40 And while Congress had amended the securities laws more than once during a period when courts were interpreting section 10(b) to cover aiding and abetting, the Court regarded this alleged “acquiescence” as “inconclusive evidence” of what Congress intended.41
The Court, did, however, speculate as to policy reasons why Congress may not have wished to allow for aiding and abetting liability:
[T]he rules for determining aiding and abetting liability are unclear, in “an area that demands certainty and predictability.” [citation omitted]. That leads to the undesirable result of decisions “made on an ad hoc basis, offering little predictive value” to those who provide services to participants in the securities business . . . . Because of the uncertainty of the governing rules, entities subject to secondary liability as aiders and abettors may find it prudent and necessary, as a business judgment, to abandon substantial defenses and to pay settlements in order to avoid the expense and risk of going to trial.42
Accordingly, “newer and smaller companies may find it difficult to obtain advice from professionals . . . .” Further, “the increased costs incurred by professionals because of the litigation and settlement costs under 10b-5,” the Court commented, might be “passed on to their client companies, and in turn incurred by the company’s investors, who were the intended beneficiaries of the statute.”43 Further, Congress had declined to enact a general statute to authorize public or private civil suits against aiders and abettors.44
Therefore, in a decision often regarded as unfortunate in public policy terms because of the apparent upsurge in large-scale commercial misconduct subsequently associated with it—though its interpretation of the Securities Exchange Act remains largely unscathed45—the Court held there is no cause of action under section 10(b) for aiding and abetting securities fraud.46
C. POST-CENTRAL BANK SECURITIES FRAUD LIABILITY
Significantly, the Central Bank Court explained that the absence of aiding-abetting liability under Section 10(b) did not mean secondary actors were insulated from liability under the securities laws. Any individual or company who employs a manipulative device or makes a material misstatement on which a purchaser or seller of securities relies may be liable as a primary violator under Rule 10b-5.47 In Newby v. Enron Corp. (In re Enron Corp. Securities, Derivative & ERISA Litigation),48 the U.S. District Court for the Southern District of Texas held that corporate advisors can be deemed “participants” in a fraud if they created transactions with the knowledge that those transactions might mislead investors.49
Seeking recourse against companies that often are the only solvent entities among those responsible for their losses, plaintiffs increasingly have alleged “primary liability” for conduct which, some have contended, the judicial system previously considered a secondary (that is, aiding and abetting) violation.50 It has been said in this regard:
Arguably, many of the recent “scheme” cases are attempts to revive aiding and abetting under a different name. Under the scheme theory, a person who substantially participates in a manipulative or deceptive scheme can incur primary liability, even if the fraudulent statements linking the scheme to the securities markets are made by others. But this sounds like a reformulation of the “substantial assistance” element of an aiding and abetting claim.51
It has, however, been observed that during the thirty years in which aiding-abetting liability was recognized, courts generally failed to establish clear distinctions between conduct giving rise to aiding-abetting liability and conduct giving rise to primary liability.52
In the decade following Central Bank, plaintiffs alleging inadequate disclosure by a securities issuer not uncommonly have included claims that third party professionals knowingly or recklessly assisted or participated in the preparation of an issuer’s alleged misrepresentations or omissions. Such conduct, plaintiffs maintain, is sufficient for a violation of Rule 10b-5 even after Central Bank, because the violator was a primary offender (even if others were more directly responsible).53
The controversy concerns a distinction between claims that professionals “knowingly provided ‘substantial assistance’ to the issuer in preparing allegedly misleading communications to investors (which constitutes aiding and abetting) and claims that professionals knowingly ‘participated’ in the making of those communications (which plaintiffs have claimed to be sufficient for an independent violation).”54 Certainly, primary responsibility for a violation of Rule 10b-5 contemplates more than simple assistance in the dissemination of misstatements and omissions.55 For example, an outside accountant probably only aids and abets a violation of Rule 10b-5 if the accountant merely physically compiles and delivers placement memoranda to a brokerage firm, even if this is done after an officer of the issuer tells the accountant the memoranda contains material misstatements.
The Second, Third, and Eleventh Circuits apply a relatively strict “attribution” test that requires the “making” of a statement. These courts have held that a secondary actor cannot incur liability under Rule 10b-5 for a statement not attributed to that actor at the time of its dissemination. Mere “review and approval” is not sufficient.56 The Second Circuit has explained that because “‘[r]eliance only on representations made by others cannot itself form the basis of liability’ ” for securities fraud, “a secondary actor cannot incur primary liability under the Act for a statement not attributed to that actor at the time of its dissemination.”57 The Third Circuit, moreover, has held that a securities fraud plaintiff must allege “a more exacting threshold of scienter—‘a mental state embracing intent to deceive, manipulate or defraud . . .’”58 Failing that, the plaintiff must alternatively show “‘highly unreasonable (conduct) involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care’ . . . which presents a danger of misleading buyers and sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.”59
The Ninth Circuit has followed a less rigorous standard—the “substantial participation test”—under which actors may be primarily liable under section 10(b) for statements attributable to others if the actor “significantly participated” in generation of the statement.60 In In re Software Toolworks, Inc. Securities Litigation, it was alleged, sufficiently to state a claim, that the accountants and underwriters knowingly had “assisted” in defrauding investors in violation of section 10(b) and Rule 10b-5 by issuing a misleading securities prospectus.61 Notably, in Newby v. Enron Corp., the district court relied substantially on a liability standard urged by the SEC.62 There, the SEC stated that primary Section 10(b) liability can attach to secondary actors if they created fraudulent documents, irrespective of whether misrepresentations to the public were publicly attributable to the secondary actor. The district court applied this test and denied motions to dismiss brought by Arthur Andersen, the Vinson & Elkins law firm, and others.63 The “substantial participation” test arguably bears a resemblance to traditional aiding and abetting liability though it requires participation in the actual offense, whereas aiding and abetting liability does not.
After Global Crossing, Worldcom and Enron followed one another in alarming fashion (having been foreshadowed by less celebrated but hardly less fraudulent schemes involving Sunbeam Corporation, Bennett Funding, Inc., and others), some predicted Congress soon would act to “restore” aider-abettor liability to section 10(b).64 Congress has not done so, however, notwithstanding the arguably indispensable role played by bond underwriters, accountants and law firms in the perpetuation of certain securities frauds. Imposition of liability on those actors for securities fraud is left, therefore, to state securities acts, and common law principles of aiding and abetting, the requisites of which are discussed below, both in the context of securities violations and other misconduct.
IV. SUBSTANTIVE ELEMENTS OF CIVIL LIABILITY FOR AIDING AND ABETTING
Aiding and abetting liability concerns, to a significant extent, a particular state of mind. The plaintiff must show whether the defendant intended to facilitate wrongdoing. However, the analysis may, in a departure from general tort principles, consider not merely intent, but motive. Did the alleged aider-abettor have a noteworthy, perhaps undue, pecuniary interest in the consummation of the fraud or misdealing?
More broadly, the judicial decisions explore what the defendant knew regarding the misconduct, for none would argue that one who has unwittingly held the door for the bank robber intended to aid and abet through such assistance. And assistance (when knowledge of the misconduct is shown) also receives a careful inquiry, which differs from the usual tort analysis in that such “assistance” need not proximately cause any injury, in the traditional sense; rather, it must meet standards unique to aiding and abetting liability principles, as discussed below.
A. AIDING AND ABETTING FRAUD
Under the law of most states, a party may be regarded as an “aider and abettor of fraud if the following requirements are satisfied:65
(1) the existence of an underlying fraud;
(2) knowledge of this fraud on the part of the aider and abettor, and;
(3) substantial assistance by the aider and abettor in perpetration of the fraud.66
It also has been held that one may be subject to aiding-abetting liability if one “gives substantial assistance to the other in accomplishing a tortious result and the person’s own conduct, separately considered, constitutes a breach of duty to the third person.”67
An aider and abettor of a fraud is regarded as equally responsible, in terms of civil liability, with the perpetrators of the scheme. However, because aiders and abettors, unlike conspirators, do not agree to commit, and are not subject to liability as joint tortfeasors for committing, the underlying tort, they may be subject to liability irrespective of whether they owed to the plaintiff the same duty as the primary violator.68
1. Existence of Underlying Fraud
The plaintiff must allege and prove that it has been defrauded or otherwise victimized by tortious conduct by one other than the aiding-abetting defendant. If the claim is for aiding and abetting fraud, then the elements of fraud must be alleged with the requisite specificity,69 though the other elements of aiding and abetting ordinarily are subject to a liberal notice pleading standard, pursuant to Rule 8(a) of the Federal Rules of Civil Procedure.70
Because the primary actor may not be party to the case, establishing the primary wrong may be a particular challenge.71 The plaintiff may need independently to build the case against the perpetrator for fraud while at the same time establishing its liability claim against the defendant. The plaintiff ’s task is of course simplified where the defendant, as sometimes it must, is compelled to admit the underlying misconduct was fraudulent.72
2. Aider-Abettor’s Knowledge of the Fraud
In order adequately to plead “knowledge” (or scienter) in an aiding and abetting fraud claim, it has been held the plaintiff must allege sufficient facts to support a “strong inference of fraudulent intent.”73 Plaintiffs may support such an inference (i) by alleging facts showing a motive for participating in a fraudulent scheme and a clear opportunity to do so, or (ii) by identifying circumstances indicative of conscious behavior.74
In one case, for example, a bankrupt company alleged that an ex-director of another company (Bioshield) had aided and abetted the acts of a current officer (Moses) in subverting a planned merger.75 Moses and the ex-director, Elfersy, originally were officers of Bioshield, the prospective partner to the merger. Moses allegedly had fraudulently represented to plaintiff that Bioshield’s board (including Elfersy) had approved the merger.76 Prior to the consummation of the merger, however, Elfersy quit Bioshield, and ultimately voted his shares against the merger. Plaintiff sued Elfersy individually for having aided and abetted alleged fraud by Bioshield in the merger negotiations.
However, the only evidence cited by plaintiff in its opposition to the defendant’s motion for summary judgment was the fact that Elfersy had continued to do some work for Bioshield after his resignations from the Board of Directors and as an officer. (Elfersy had continued to advise Bioshield concerning patent, technological and scientific matters). The court concluded that no reasonable juror could draw from that fact an inference that Elfersy was aware of Moses’s alleged misstatements concerning the prospects of the merger, or that Elfersy and Moses even discussed the proposed merger. Furthermore, though Elfersy may have had his own economic interests in mind that was not alone sufficient to satisfy the scienter requirement.77
More expansive holdings, however, abound. Courts have found direct proof of scienter, or facts sufficient to permit the requisite inference, to have been evidenced by (a) knowledge of wrongdoing, (b) motive on the part of the alleged aiderabettor, or, occasionally, by (c) reckless disregard by the aider-abettor of information that it was facilitating wrongful acts, as discussed more fully below.
(a) Knowledge of Wrongdoing
Commentators have stated that the knowledge of wrongdoing requirement means the aider-abettor must do more than merely provide assistance: he or she must have known the nature of the act being assisted. “The defendant’s knowledge that he is providing assistance or encouragement to another’s action by no means establishes the defendant must also possess knowledge that the other’s act is wrongful (the ‘factual knowledge’ requirement).”78 Thus, for example, one who happened to promote a fraudulent investment scheme without knowledge the scheme is fraudulent, hoping to secure commissions, ordinarily is not subject to liability. The Fifth Circuit has stated that “[a] remote party must not only be aware of his role, but he should also know when and to what degree he is furthering the fraud.”79
Knowledge of the fraud must be pled by stating how the defendant knew of the wrongdoing. It has been held that a complaint must contain factual allegations either stating directly or implying that those dealing with the tortfeasor knew or should have known the tortfeasor was breaching a duty to the victim.80 Allegations that defendants “have aided and abetted and are aiding and abetting” the defendants, accompanied only be a broad characterization of the transaction as a “plan or scheme,” have been deemed insufficient.81 Rather, courts look for defendant’s usage of “atypical” business procedures, as well as prolonged involvement with the fraud actor, and motive.
In bank fraud cases, defendant’s use of atypical banking procedures is a judicially recognized basis for an inference of “knowledge” the bank is aiding another’s misconduct. In a leading case, Neilson v. Union Bank of California, N.A.,82 the complaint adequately pled knowledge by alleging the banks utilized atypical banking procedures to service the perpetrator’s accounts, raising an inference they knew of the Ponzi scheme and sought to accommodate it by altering their normal ways of doing business. “This supports the general allegations of knowledge.”83 The court rejected the bank’s argument that the complaint did not allege that the bank knew particular victims were being defrauded, given that the complaint alleged the banks must be deemed to have known that the perpetrator was defrauding all his clients.84 This conclusion is consistent with the Second Circuit’s view, that “[p]roof of a defendant’s knowledge or intent will often be inferential.”85
For insight into the “knowledge” prong, the facts in Aetna Casualty & Surety Co. v. Leahey Construction Co.86 are instructive. There, Keybank was found liable for aiding and abetting its borrower’s defrauding of a surety, Aetna. The borrower had fraudulently induced Aetna to act as its surety by obtaining a four-day loan from Keybank in order to mislead Aetna into believing that the capitalization requirements for issuance of Aetna’s bond had been met. The court found that the requisite knowledge on the part of the bank was shown by the following circumstances:
1. The bank had known the principal for five years and on several occasions had assisted the principal in obtaining loans for bonding purposes;
2. The bank understood that the principal’s entrance into commercial construction would “require[ ] special bonding” and that as a result the principal had been “putting funds into the business”;
3. The bank’s own documents revealed that prior to issuance of the subject loan it was informed by the principal that the purpose of the loan was “to obtain approval from a new bonding company”;
4. A bank memo revealed that even though the loan was classified as a thirty-day agreement, the principal intended to repay it just two days after the month-end that the surety was examining for credit purposes.87
Notably, the four-day loan in Leahy was an unusual transaction and thus easily gave rise to an inference the bank knew what was going on. Courts have held that: “A party who engages in atypical business transactions . . . may be found liable as an aider and abettor with a minimal showing of knowledge.”88
A contrasting result is found in Ryan v. Hunton & Williams,89 where plaintiffs failed adequately to plead “actual knowledge” by Chase Manhattan Bank of its depositor’s Ponzi scheme notwithstanding allegations that (1) Chase suspected the perpetrator was running an “advance fee scheme”; (2) Chase knew the perpetrator had defrauded it on another matter, and; (3) Chase had shut down the account of a cohort of the perpetrator because of a bounced check. “Allegations that [Chase] suspected fraudulent activity,” the court held, “do not raise an inference of actual knowledge” of the fraud.90 Similarly, knowledge on one’s part of past misconduct by the fraud actor, without more, ordinarily will not give rise to liability for rendering assistance.91
Substantial familiarity over an extended period with the course of conduct relating to the scheme at issue also may support a reasonable inference of “knowledge.” In Jaguar Cars, Inc. v. Royal Oaks Motor Car Co.,92 the alleged aider-abettor’s son directed the fraudulent scheme, but it was the father’s “experience and active participation in the . . . dealership, combined with the extent of the fraud,” that presented a sufficient basis for imposition of aiding-abetting liability.93 The evidence of the father’s control over the dealership, included his having (1) spent significant time there, (2) reviewed the financial statements, and (3) discussed the dealership’s operations on a daily basis with his son, “the architect” of the fraudulent scheme “combined with evidence of the pervasive nature of the fraudulent scheme.”94 These facts allowed the jury to find the father liable for aiding and abetting the predicate acts of mail fraud.
In Leahey, the court observed that there is “no conflict between the position that an aider and abettor must have actual knowledge of the primary party’s wrongdoing and the statement that it is enough for the aider and abettor to have a general awareness of its role in the other’s tortious conduct for liability to attach.”95 However, allegations that a bank (which had financed a fraud actor) merely “suspected” fraudulent activity would not satisfy the actual knowledge requirement.96 And “actual knowledge” is not established by the mere allegation of the aider-abettor’s knowledge that an audit was not conducted properly.97
(b) Relevance of Motive
An inference supporting requisite scienter (knowledge of the fraud) on the aider-abettor’s part may be established by facts showing a motive for participating in the fraudulent scheme and the clear opportunity to do so.98 Thus, in criminal law, for example, knowledge of wrongdoing may be inferred on the part of one who lends a car to a bank robber if the facts show the individual solicited an inordinate amount of money in exchange for lending the car.99 Aiding and abetting gross negligence was held actionable, for example, in a case where the defendants were attorneys who had advised an S&L institution that later failed.100 In that case the court ruled that whereas mere unknowing participation in another’s wrongful act does not subject one to liability the requirement of knowledge may be less strict where the alleged aider and abettor derives “benefits” (such as attorney’s fees) from the wrongdoing.101
California courts have suggested that, in addition to the conventional elements for aiding-abetting, a plaintiff also must allege the defendant participated in the breach for reasons of its own financial gain or advantage.102 In Neilson, however, the court held that statements in prior decisions—to the effect that a true aider-abettor is one “reaping the benefit”—should not be regarded as adding an element to the tort.103 Rather, the financial gain emphasized in aiding-abetting decisions is evidence the aider-abettor knew of and substantially assisted the primary violator’s breach of fiduciary duty.104 A profit motive supports an inference of knowing participation, but is not itself an element of the tort.
(c) “Reckless Disregard” Equating to “Awareness” of Misconduct
A literal “actual knowledge” standard may be overly restrictive given the inherent difficulty of pleading the state of mind of a defendant.105 So, it occasionally has been held that, unlike a cause of action for conspiracy, the knowledge requirement for aiding and abetting liability may be satisfied by proof that a defendant acted recklessly.106 Where facts are known to the defendant from which the conclusion objectively follows that a fraud is being perpetrated (and assisted by defendant), aider-abettor liability may exist even if the defendant lacked “actual knowledge.”107 It is questionable, however, whether reckless disregard satisfies the “knowledge” requirement under New York law, at least outside of cases in which the actor owed the plaintiff a fiduciary duty.108 Federal cases in New York, home to the financial industry, not infrequently have gravitated toward insulating financial institutions and professionals from charges of having facilitated financial fraud.109
“Reckless disregard,” in jurisdictions other than New York, has been found where the actor was “deliberately indifferent” to the propagation of the fraud scheme.110 “Reckless disregard” is not, however, evidenced by “mere suspicion,” but rather requires proof the aider-abettor ignored obvious “danger signals.”111 In this regard, it has been held that even if a defendant “should have discovered” the fraud and could have done so by duly exploring financial questions, liability will not attach absent recklessness.112
In Geman v. Securities Exchange Commission,113 a brokerage firm began an undisclosed practice of executing trades as principal with its brokerage customers. The firm without notice ceased reporting to its customers trades executed as “principal” and customers later sued on the ground the trades had been concealed from them and disadvantaged them.114 The Court observed that Geman, the alleged aider-abettor, “clearly was aware of the cessation of reporting under the former system and, with his extensive background and experience, surely knew that an alternative reporting practice [to disclose the trades on which the brokerage acted as purchaser of customers’ securities] was necessary (which he does not deny).” Notwithstanding this awareness, Geman “took no steps to ensure that— or inquire whether—[the firm] was making alternative arrangements to satisfy record keeping obligations.” Geman’s simple “inaction,” which the court regarded as “reckless,” was sufficient to support the finding that he willfully aided and abetted the firm’s record keeping violations.115
Similarly, where a bank’s cashiers “cashed so many checks for such large amounts without verification” from the owner of a currency exchange, that evidence could support a finding that the cashiers, but not the owner (who had safeguarding procedures in place which his employees disregarded), acted recklessly.116 Defendants cannot, it is plain, rely on an “ostrich defense,” even where plaintiff finds it difficult or impossible to allege facts showing conscious appreciation of a particular wrongdoing against a specific victim.
3. “Substantial Assistance”
Mere knowledge of the underlying misconduct is insufficient to give rise to aider-abettor liability.117 The aider-abettor must also knowingly facilitate commission by the principal actor of the primary fraud. Generally speaking, the most common reason for failure on the part of plaintiffs seeking to establish aider-abettor liability for fraud is the absence of sufficient facts to demonstrate that the defendant “substantially assisted” the fraud.
Commentary to the RESTATEMENT (SECOND) OF THE LAW OF TORTS § 876 identifies five relevant factors for evaluating whether encouragement or assistance was “substantial.” Traditional factors include: (1) the nature of the act encouraged; (2) the amount and kind of assistance given; (3) the defendant’s relation to the tortious actor, and; (4) the defendant’s state of mind.118 In addition to these criteria, some courts have indicated another factor: the “duration of the assistance provided.”119 These factors may establish “affirmative assistance”—the surest basis for liability—or may indicate aiding of fraudulent concealment or “wrongful inaction,” which are less certain predicates for liability, as discussed below.
(a) Affirmative Assistance
Some courts have set the standard for “affirmative assistance” relatively high. For example, a federal court in New York has held that even “affirmative actions of opening [bank accounts for the perpetrators], approving various transfers, and then closing the accounts on the basis of suspected fraud, without more, do not constitute substantial assistance.”120 In Leahey, by contrast, the court found that Keybank’s making of a questionable loan enabled the fraud principal to “verify” to the surety that he had complied with its first funding request, thereby establishing an indispensable level of credibility the primary actor required to obtain a bond from plaintiff.121 Thus, for some courts even the mere act of lending money or otherwise transacting business with the fraud actor may give rise to aider-abettor status if the institution knows the loan or other transaction will assist the fraudulent scheme.122
Affirmative assistance also has been deemed adequately pled where a weather derivatives trading company knowingly agreed to pay any proceeds obtained under dummy policies in order to conceal from an insurer the existence of reinsurance policies.123 There, aiding and abetting was adequately alleged with respect to a broker who, apart from being the perpetrator of the scheme, also was a principal owner and chairman of the alleged aider and abettor. Similarly, in Unicredito, aider-abettor liability adequately was premised on allegations that financial institutions helped form the various special purpose entities and financing structures that were used to hide Enron’s debt.124 By contrast, relatively few decisions have found affirmative assistance to exist where the affirmative acts of the defendant consist solely of providing financing.125 Usually, courts require evidence that the alleged aider-abettor wished to bring about the fraud and sought by its actions to make it succeed: “Mere negative acquiescence in the fraud is insufficient.”126
Recently the Second Circuit decided Sharp International Corp. v. State Street Bank and Trust Co.,127 a case that concerned efforts by a lender to extricate itself from bad loans extended to the alleged fraud actors, former officers of Sharp International. There, the complaint pled five acts by State Street Bank and Trust Company that were alleged to satisfy the standard of either inducement or rendering aid to the breach of duty, which consisted of a scheme to cause new and unwitting lenders to lend sums to Sharp, thus concealing debt and perpetuating a fraud on Sharp’s noteholders.128
State Street Bank allegedly had demanded that Sharp, its borrower, obtain new sources of financing to retire the State Street debt. However, the court held that the demand for repayment of a bona fide debt was not, alone, a “corrupt inducement that would create aider and abettor liability.”129 But Sharp’s trustee in bankruptcy further alleged the bank had concealed its knowledge of the fraud of Sharp, elected not to foreclose on the loan, and avoided the noteholders’ repeated attempts to contact the bank in order to discuss the Sharp credit. Nevertheless, the court held that all of these allegations were merely omissions or failures to act. “Substantial assistance occurs when a defendant affirmatively assists, helps conceal or fails to act when required to do so, thereby enabling the breach to occur.”130
Sharp’s trustee in bankruptcy did allege one affirmative act; namely, that State Street Bank participated in the fraud by providing contractually required consent: the bank gave Sharp its express written consent to the noteholders’ purchase of an additional $25 million of subordinated notes. When it gave this consent, it allegedly knew the noteholders were purchasing these notes in reliance on Sharp’s fraudulent representations concerning the accuracy of its financial statements. The bank also allegedly knew that absent its consent, the transaction would not be consummated. The court held, however, that the bank’s consent was mere “forbearance”; it did no more than remove a contractual impediment the bank had the right to invoke or not in its own interest.131 In language that manages to be enigmatic yet revealing, the court explained:
The nub of the complaint is that State Street knew that there would likely be victims of the [Sharp officer’s] fraud, and arranged not to be among them. On the one hand, this seems repugnant; on the other hand, [the] discovery that Sharp was rife with fraud was an asset of State Street, and State Street had a fiduciary duty to use that asset to protect its own shareholders [from the consequences of its own bad loan], if it legally could. One could say that State Street failed to tell someone that his coat was on fire or one could say that it simply grabbed a seat when it heard the music stop. The moral analysis contributes little.132
The allegations amounted to nothing more, the Court concluded, than that State Street Bank was “in a position to blow the whistle on the [Sharp officers’] fraud, but did not; instead, State Street arranged to extricate itself from the risk.”133
Why the Sharp noteholders’ allegations do not describe aiding and abetting of fraud was not fully explained by the court. “Moral analysis” aside, the allegations described some degree of knowing facilitation by State Street of the Sharp officers’ fraud, though perhaps in circumstances the court regarded as protected by State Street’s obligation to protect its shareholders’ interests. It may also have been important to the Second Circuit that there was no allegation of “atypical barking procedures,” nor special services, provided in order to assist the fraud.
“Substantial assistance” also may take the form of inducement.134 “Inducement” is “[t]he act or process of enticing or persuading another person to take a certain course of action.”135 Thus, if one persuades the perpetrator to engage in misconduct one may be subject to liability even if that is the only act done in furtherance of the fraud.136 Few defendants will slip up and reveal evidence of inducement, so inducement cases are rare, though highly effective when they can be supported.
The duration of the defendant’s involvement with the primary actor may weigh in favor of liability. Where the fraud has involved a course of conduct occurring over an extended period of time or a series of transactions, it may not be necessary to include detailed allegations of the facts of each transaction of the fraudulent scheme.137 “The length of time an alleged aider-abettor has been involved with a tortfeasor almost certainly affects the quality and extent of their relationships and probably influences the amount of aid provided as well; additionally, it may afford evidence of the defendant’s state of mind.”138 Of course, an extended period of contact without assistance of wrongdoing weighs against liability.139
(b) Aiding Concealment
Most successful fraud claims involve active misrepresentations, as opposed to concealment, because many jurisdictions do not recognize fraudulent concealment absent a duty to disclose or other special circumstances.140 Where, however, a defendant has encouraged another to rely on the defendant (or on the perpetrator), concealment legally may be equivalent to misrepresentation, and in such cases aider and abettor liability may follow, though under a different analysis.
For example, in 2003, in connection with the Enron scandal, a United States district court sitting in New York issued the first decision holding financial institutions potentially culpable with respect to the Enron Ponzi scheme. In Unicredito, the court held “substantial assistance” was adequately pled where the plaintiffs alleged that financial institutions knowingly participated in and helped structure the transactions “that enabled Enron to distort its public financial statements, specifically with respect to Enron’s revenues and its ratio of balance sheet debt to balance sheet capital.”141 These actions aided Enron’s efforts to conceal from its fraud victims debts that should have been reflected on Enron’s balance sheet. The Unicredito decision cogently recognizes that some types of structured financing arrangements may play an indispensable role in facilitating corporate fraud.142
(c) Enabling Fraud to Proceed by Failing to Speak When Obligated
Mere inaction, even with knowledge of another’s wrongdoing, usually is insufficient to give rise to aider-abettor liability. However, an important exception exists when the circumstances gave rise to a duty to warn, advise, counsel, or instruct the plaintiff.
Courts have stated that in certain cases of fraud aiding-abetting status may not depend on whether the party assisted the primary tortfeasor by direct advice or support, but on whether the actor was obligated to disclose or halt another’s wrongdoing discovered in the performance of customary business activities. For example, where the defendant breached a governmentally imposed (and public) obligation to disclose information to the Internal Revenue Service, which was alleged to have caused plaintiff to be misled, the defendant was subject to liability as aider and abettor.143 However, a law firm’s failure to disclose its client’s insolvency and inability to fulfill future obligations did not create liability for aiding and abetting fraud. Given that the law firm had no duty to disclose the information, its silence was not “substantial assistance” under Massachusetts law.144
In most jurisdictions, aider-abettor status based solely on non-disclosure by the defendant probably can be established only when the defendant had a confidential or fiduciary relationship with the victim. “Absent a confidential or fiduciary relationship between the plaintiff and the aider and abettor, the inaction of the latter does not constitute substantial assistance warranting aider and abettor liability.”145 Thus, a lending institution, at least one court has said, ordinarily has no duty to disclose merely based on its status as a lender.146
One group of investors alleged, in the context of federal securities law, that a surety for an investment trust owed the investors a duty of disclosure (the breach of which gave rise to aider-abettor status).147 However, the court declined to hold such a duty existed where (1) the parties had relatively the same access to the information to be disclosed; (2) the financial benefit and risk was roughly equivalent, and (3) the defendant was not aware plaintiff was relying on it to provide the information.148
(d) Sliding Scale Approach
In civil aiding-abetting cases, the Second Circuit employs a “sliding scale approach,” effectively requiring a higher degree of intent when the level of assistance is slight.149 “The sliding scale, or in-tandem, analysis has been proposed as a way of dealing with the difficulty of proving the knowledge and substantial assistance elements.”150 Where all that is alleged is “mere inaction,” the intent requirement “scales upward,” and plaintiffs have the additional burden of showing that the assistance rendered by such inaction is “‘both substantial and knowing,’ in other words, ‘there must be something close to an actual intent to aid in fraud’ . . .”151
This analysis has been said to require that “the second and third elements of the test for civil aiding and abetting liability be analyzed in tandem.”152 “In tandem” signifies that where there is relatively good proof of the defendant’s general awareness of the alleged wrongful activity, then relatively less evidence of substantial assistance may be required, and vice-versa.153 A number of courts, in addition to those in the Second Circuit, have employed the “sliding scale” analysis.154
4. Causation
Causation is an essential element of an aiding and abetting claim. “Substantial assistance” requires the plaintiff to plead that the actions of the aider-abettor “proximately caused” the harm on which the primary liability is predicated.155 However, such causation has been interpreted to mean the injury was “a directly reasonably foreseeable result of the conduct.”156 Some courts have held the plaintiff must demonstrate the aider and abettor provided assistance that was a substantial factor in causing the harm suffered.157 But courts have not generally held that there must be an indisputable “but for” relationship between (i) the assistance rendered, and (ii) the harm to plaintiff.
Loss causation also will need to be established between the primary fraud and the victim’s losses.158 Thus, if plaintiff ’s harm was not proximately caused by the primary actor’s wrongdoing, no further inquiry is needed.
B. AIDING AND ABETTING BREACH OF FIDUCIARY DUTY
Fiduciary duties exist on the part of such persons as attorneys, trust administrators, and director and officers.159 Such parties are often claimed to have failed to uphold their duties of loyalty. Consequently, while fraud constitutes the largest source of aiding and abetting claims, breaches of fiduciary duty are close behind. As is not infrequent in the case of fraud, the perpetrator of the breach of fiduciary duty may be an individual or small company with little resources, whereas the aider-abettor may be a large institution with deep pockets.
In order to recover for aiding and abetting a breach of fiduciary duty, a plaintiff must establish: “(1) a fiduciary duty on the part of the primary wrongdoer, (2) a breach of this duty, (3) knowledge of the breach by the alleged aider and abettor, and (4) the aider and abettor’s substantial assistance or encouragement of the wrongdoing.”160 Eighteen states have recognized a cause of action for aiding and abetting breach of fiduciary duty.161
Below we discuss the “knowledge” and “substantial assistance” elements in the context of breach of fiduciary duty cases.
1. Knowledge
Knowledge on the part of the aider-abettor that a fiduciary relationship was being breached can adequately be pled by allegations that a fiduciary relationship existed, that the defendant knew of it, and that the defendant knew it was being breached.162 In the context of aiding and abetting, having “knowledge” of the underlying misconduct has been held to mean “[a]n awareness or understanding of a fact or circumstance; a state of mind in which a person has no substantial doubt about the existence of a fact.”163
One court rejected a “constructive knowledge” standard in the context of aiding and abetting breach of fiduciary duty, and required instead the following instruction:
[T]o act knowingly means to act with actual knowledge. This means that [plaintiff ] must prove [defendant] knew two things: That [defendant] owed a fiduciary duty to [plaintiff ], and that [defendant] was breaching that duty. It is not enough for [plaintiff ] to show that [defendant] would have known these things if it had exercised reasonable care.”164
The court noted, however, that plaintiff is not required to show the defendant acted with an intent to harm the plaintiff.165
A notable recent breach of fiduciary duty case, employing a relatively liberal standard, is Higgins v. New York Stock Exchange, Inc.166 This dispute arose out of the merger, announced in April 2005, between the New York Stock Exchange, Inc. and Archipelago Holdings, LLC, through which the New York Stock Exchange would become a publicly traded company. Plaintiffs alleged that the terms of the merger agreement heavily and unfairly favored existing shareholders of Archipelago over the NYSE owners.167
The CEO of NYSE, defendant Thain, was allegedly self-interested in the merger, based on his financial involvements with defendant Goldman Sachs, a brokerage house that also was a major shareholder in Archipelago. It was alleged that Thain slanted the proposed merger agreement in favor of Archipelago for the ultimate benefit of Goldman Sachs and himself (as a large Goldman Sachs shareholder).168
Plaintiffs noted that Goldman Sachs was retained by both the NYSE and Archipelago to act as a “facilitator” in exploring a potential combination, and to provide various financial services, notwithstanding that Goldman Sachs had substantial relations with Archipelago. The decision to retain Goldman Sachs to advise NYSE in the merger was approved by the NYSE board and by CEO Thain, who refused to recuse himself from the decision despite his close ties to Goldman Sachs and his fiduciary duties to the NYSE, which, according to the complaint, prohibits directors from deliberating in a matter in which they are personally interested.169 Plaintiffs alleged that in order to structure a deal that benefited Archipelago, Goldman Sachs provided “substantial assistance” to NYSE defendants in breaching their fiduciary duties by exerting its influence through Thain, its former CEO, as well as through a former NYSE Director and current Goldman Sachs CEO and other Goldman Sachs-affiliated NYSE directors who were “overly accommodating” to Goldman Sachs in order to structure a deal that benefited Archipelago.170
Goldman Sachs contended that it was insulated from charges of aiding-abetting breach of fiduciary duty by an “engagement letter,” which stipulated that the NYSE “understands and acknowledges that [Goldman Sachs is] rendering services to the [NYSE] and to Archipelago in connection with a Transaction. [NYSE] understands that potential conflicts of interest or a perception thereof, may arise as a result of our rendering services to both the Company and Archipelago.”171
The court rejected Goldman Sachs’ argument, holding that the disclosure of the conflict by no means compels the conclusion that Goldman Sachs did not aid and abet the NYSE defendant’s breach of fiduciary duty, as alleged by plaintiffs.172 Ironically, the letter established Goldman Sachs’ knowledge of the conflicts; and those conflicts may of course have constituted a breach of fiduciary duty. The court deemed legally sufficient plaintiffs’ allegations that Goldman Sachs substantially assisted the NYSE in breaching its fiduciary duties by “exerting its influence through its former CEO, Thain, and other Goldman Sachs-affiliated directors, in order to structure a deal that benefited Archipelago.”173
“Knowledge” that an insider was breaching his or her fiduciary duty to the company requires a relatively high level off awareness. “Red flags” may not be enough. A recent and illustrative case of “red flags” involved a precious metals trading company that had opened a revolving line of credit with the defendant bank, secured by an inventory of precious metals. The bank knew the trading company was in the business of selling precious metals as a dealer, and had other knowledge of how the trading company’s president disposed of assets (ultimately leading to the company’s demise), but, according to the court, lacked knowledge of the president’s breach of duty.174
The complaint alleged that when the defendant bank decided to end its own metals financing program, it had looked for alternative lenders to assume the loans it had extended to dealers. The plaintiff trading company was urged by brokers, who may or may not have been acting at the bank’s behest, to become a successor lender with respect to the bank’s existing borrowers. The trading company agreed, and ultimately assumed approximately 200 of the bank’s loans so that by 1993 it had a total loan balance of $17.5M and, importantly, should have held $24.4M in collateral posted by those lenders. However, the company’s president, Clark, secretly had been misappropriating these assets, selling off the precious metal collateral in the company’s daily operations, according to the complaint.175
As these “take-out” loans were paid off by the trading company, the bank disposed of the collateral, per directions from Clark, typically returning it to the control of Clark (ostensibly acting for the trading company). Clark sold all or nearly all of the metals the bank transferred to the trading company, frequently to purchase additional loans from the bank, as well as metals futures contracts. However, when the price of silver rose in 1993, the company lost a large sum, was unable to purchase enough metals to replace the collateral it had sold, and filed for bankruptcy.176
The trading company’s trustee in bankruptcy sued the bank, alleging it had aided and abetted Clark’s breach of fiduciary duty to the company. The court held, however, that the trustee needed to come forward with evidence to show the bank “knew” Clark was breaching a duty owed to the company. Though it was undisputed the bank knew the company was in some manner disposing of the metals it was acquiring, the bank’s senior officers testified, apparently persuasively, that they were unaware Clark had been misappropriating the collateral metals. They pointed out: (i) the company was a metals dealer which regularly traded metals, and; (ii) the bank had no reason to believe the company had not otherwise covered its positions (for example through futures contracts). The trustee contended the bank knew the company was selling the metals and was close to insolvent, and that the bank knew the silver metals market was volatile and typically full of unscrupulous lenders.177
While the court conceded such evidence could have raised “red flags,” that circumstance was not conclusive: the bank “owed no duty” to the company. “In the absence of any duty, proof of actual knowledge is required.” And absent knowledge of the scheme or breach, the bank “could have had no intent to further either.”178
A plaintiff alleging aider-abettor liability should plead the defendant knew the principal’s conduct contravened a fiduciary duty at the time it occurred.179 In an ERISA case, for example, a plaintiff was required to show
not only that when [the ERISA Fund] was paying defendant’s invoices, it was tapping the Plaintiff ’s reserve account (rather than a general operating or legal defense account), but also that the Defendants were or should have been aware of the particular internal bookkeeping account [the Fund] was drawing on to pay them, and that such payment constituted a breach of [the Fund’s] fiduciary duty.180
Plaintiffs failed to adequately allege scienter (the requisite state of mind) where, according to the complaint, a management company falsely had represented to investors: that it had reviewed prices charged by the fund company it managed to ensure their consistency with market values; that defendant was vested generally with “management and control” of the fund company; that it had the authority to require the fund company to adhere to applicable laws; that it undertook risk management services for the fund company; that it communicated with the individual defendants, and that it knew about the fund company’s fiduciary obligations to investors.181 Even viewed collectively, the court held, those facts did not “permit an inference that [the management company] had actual knowledge of the alleged fraud.”182
Nevertheless, unlike an action based on conspiracy, aiding and abetting liability may, according to several decisions, be satisfied by proof that a defendant acted recklessly.183 And as in fraud cases, aiding and abetting may be shown inferentially, such as by the existence of a conflict of interest and encouragement on the part of the aider-abettor to the actor to negotiate contracts that were prejudicial to plaintiff,184 though, seemingly incorrectly, it also has been held that “[w]hat is clear from all the cases and the RESTATEMENT is that there is not a lower level of culpability or scienter for aiding and abetting than for the underlying tort.”185
2. Substantial Assistance
“Substantial assistance” in aiding-abetting breach of fiduciary duty cases may be easier to establish than in fraud cases. For example, substantial assistance has been evidenced by mere advice by attorneys to a company president on how he might “warehouse premiums” so he could purchase illicit off-shore insurance policies.186 Similarly, where counsel for a partnership failed to inform a principal of material business dealings, counsel was subject to aider-abettor liability.187 And where a bank lent sums to the fiduciary (a trust) knowing the loan was made for purposes of misleading a plaintiff creditor, the lender was liable to the plaintiff.188
The relative ease of alleging “substantial assistance” in breach of fiduciary duty cases is noteworthy, and likely stems in part from the high level of duty owed by the fiduciary. Because of this elevated duty, when a secondary actor renders assistance the nexus between assistance and harm to the plaintiff frequently is apparent, or should be.
V. FACTUAL MATRICES IN WHICH AIDING-ABETTING CLAIMS ARE COMMON
Aiding and abetting doctrine is reasonably well defined; however, close analysis reveals nuances that may be distinct to a particular fact pattern. Greenmail cases, for example, have a body of law practically their own, as in such cases the “assistance” is often pronounced, though evidence of “knowledge” frequently is more debatable. Given such distinctions, there is much to be learned from a comparative discussion of aiding and abetting law from the standpoint of some noteworthy fact-patterns. There are no over-arching themes common to the varying relationships and circumstances. Rather, aiding-abetting doctrine has tended more to adjust to the particular relationship in question than to crystallize around immutable principles.
A. ATTORNEYS
Certain courts have adopted the principles of the RESTATEMENT (SECOND) OF TORTS section 876(b) to subject to liability attorneys who have aided a client in the client’s breach of duty to a third party.189 As discussed above,190 the threshold for substantial assistance appears markedly lower in breach of fiduciary duty cases where a professional, such as an attorney, is the alleged secondary actor.
In Reynolds v. Schrock, the court held that a jury could find aiding-abetting liability where plaintiff alleged the attorney, having drafted the settlement agreement between the partners and knowing the partners owed each other fiduciary duties, nonetheless advised one partner to breach her duty to the other, then helped her conceal that breach, and received over $130,000 for his role in the transaction that constituted the breach.191 By contrast, however, an attorney’s advice to the client outlining the range of options and the consequences that might flow from them, does not give rise to secondary liability if, after hearing the advice, the client chooses upon her own to engage in conduct that results in a breach of duty.192 Substantial assistance or encouragement of the client’s breach of fiduciary duty needs to rise to “affirmative conduct that actually furthers the client’s breach of fiduciary duty, done by the attorney with knowledge that he or she is furthering the breach.”193
Recently, the Third Circuit undertook a careful analysis of the “substantial assistance” prong of aider-abettor liability, in a case concerning the aftermath of the financial demise of automotive entrepreneur John DeLorean.194 DeLorean owed fees for legal services, and ultimately the creditor law firm sued him, seeking a substantial judgment. As attachable funds seemingly were either non-existent or elusive, the chief asset targeted by the creditor law firm was DeLorean’s country estate, the 430-acre “Lamington Farm.” However, the alleged aider-abettor, DeLorean’s new law firm, had prepared a Memorandum of Life Lease in which “Genesis,” the purported title holder of Lamington Farm, acknowledged a preexisting life lease created in 1987 between DeLorean, as lessor, and DeLorean, as guardian for his children, as lessee.195
At this point, the alleged machinations became somewhat convoluted. The complaint alleged that the defendant law firm created the life lease memorandum after entry of judgment in favor of plaintiff (the creditor law firm). The plaintiff alleged the life lease was a fiction and that the defendant law firm knew it was, having created it in support of a wrongful attempt to obstruct plaintiffs’ enforcement of their judgment against DeLorean.196
Two weeks before DeLorean was to be deposed in connection with disposition of his assets, the defendant law firm recorded the purported life lease memorandum with the Somerset County Clerk. The firm subsequently misrepresented to the clerk that the order had the effect of dissolving a prior order in favor of plaintiffs that had set aside DeLorean’s fraudulent conveyance of Lamington Farm to Genesis. The clerk relied on this deceptive letter and entered on the public record erroneous marginal notations in that regard.197
After the creditor law firm obtained a writ of execution from the U.S. District Court that included personal property (and DeLorean’s shares in a Nevada corporation (CRISTINA)), DeLorean’s counsel contacted counsel for DeLorean Cadillac, which was controlled by DeLorean’s brother. (DeLorean Cadillac had obtained a writ of execution against DeLorean.) DeLorean Cadillac’s attorney agreed to a request not to contact the creditor law firm concerning furniture described in the writ, which John DeLorean was removing to a warehouse owned by DeLorean Cadillac. Nor did the defendant law firm disclose to the Court when they moved to vacate plaintiffs’ writ that DeLorean had delivered the CRISTINA shares to the marshal to facilitate the execution by DeLorean Cadillac on its writ.198
The Third Circuit Court of Appeals, taking all of this in, observed that, unlike in a conspiracy case, plaintiffs did not need to plead “shared intent.” Civil liability for aiding and abetting arises when one knows the other’s conduct constitutes a breach of duty “and gives substantial assistance or encouragement to the other so to conduct himself . . . .”199 Because the defendant law firm knew DeLorean was seeking to perpetuate a fraud on his creditor, the firm’s extensive involvement and assistance in the scheme subjected it to liability as aider-abettor.
The attorney aider-abettor decisions draw a line between the mere rendering of advice to a wrongdoer, on the one hand, and actively misleading or affirmative conduct directed toward a third party on the other. The attorney, as counselor, almost certainly will receive better protection than the attorney who acts as the public and active agent of a wrongdoer.
B. BANKING TRANSACTIONS
Financial institutions are among those entities most frequently charged with aiding and abetting fraud. Because modern banks provide an array of valuable, and frequently innovative, financing services, banks often are regarded as having been a “partner in crime” with a company the bank may have considered merely a “borrower” or “customer.” The factual elements frequently recurring in bank fraud cases include, most notably: (i) financing, through a series of transactions, of a fraudulent enterprise over an extended duration; (ii) the bank’s use of actual or alleged “atypical” banking practices, and; (iii) an ultimate bankruptcy (or absconding with funds) by a borrower or client of the bank.
In Chance World Trading E.C. v. Heritage Bank of Commerce,200 plaintiff Chance World undertook to invest in a related business venture (Construction Navigator) by placing $200,000 in an account at Heritage Bank. The investing agreement limited use of the funds to technical development, and required the signatures of all three of Construction Navigator’s principals for withdrawals. However, one of the principals of the venture allegedly misappropriated funds to pay her personal salary, office rent, and other general corporate expenses not related to the Company’s chartered purpose.201
To effectuate this misappropriation, the alleged primary actor had opened a second account at Heritage Bank. This account did not require signatures of all three of the company’s principals. The fraud actor then transferred funds from the original account into the new account. The bank permitted the withdrawal without requiring the authorization of the other principals.202
Chance World sought to establish the bank knew the fraud actor was misappropriating the $200,000 investment based on the following facts: (1) the bank had been informed that Chance World provided the financial backing for Construction Navigator, a start-up company; (2) the bank understood that Chance World was the source of the first $200,000 in Construction Navigator’s money market account; (3) the bank was in possession of the Chance World/Construction Navigator “term sheet”; (4) the bank had learned Chance World was buying 51% of the total shares of Construction Navigator; (5) the Construction Navigator charter, as well as California law and the conditions of the bank account itself barred withdrawals in excess of $100,000 where the authorization was by but one officer, and (6) the bank permitted Construction Navigator to open a corporate banking account without any advance corporate resolution authorizing such action.203
Nevertheless, the court observed that the term sheet only contained in very general terms the substance of the agreement between Chance World and Construction Navigator and, importantly, contained no restrictions on Construction Navigator’s use of funds. As a matter of California law, the court held, the violation by the bank of its own internal policies and procedures, without more, is insufficient to show a bank was aware of fiduciary breaches committed by customers.204 The court held that Chance World needed to produce evidence that Heritage Bank had actual knowledge of the fraud actor’s crimes; it could not rely on inferences drawn from “sloppy work” by the Bank.205
In another case, in May 2003 Allied Irish Banks, PLC filed suit in the Southern District of New York against Bank of America and Citibank.206 Allied sought to recover for losses incurred by its then subsidiary, Allfirst, between 1997 and 2002 by a rogue foreign exchange trader, John Rusnak. Rusnak had hid his losses for several years by booking fictitious trades and manipulating Allfirst’s internal controls. He pled guilty to bank fraud and was sentenced to seven and one-half years in prison, according to the Complaint.
Allied has alleged that Citibank and Bank of America: (1) carefully tailored their reporting to Allfirst to omit information concerning Allfirst’s profits and losses, mark-to-market positions, and risks; (2) were persuaded not to seek margin from Rusnak, which would have disclosed his trading losses; (3) provided to Rusnak $200 million in funding disguised as the proceeds of Rusnak’s foreign exchange trading; (4) executed $170 million in trades that helped Rusnak undermine Allfirst’s controls but had no business purpose, and; (5) doctored trade confirmations to cover up Rusnak’s fake trades. The unusual procedures allegedly helped to avoid detection by Allfirst’s internal controls.207
Rusnak allegedly persuaded the banks to utilize unusual trading “recaps,” which omitted information concerning the price of Rusnak’s positions, the risk, or its current mark-to-market value. The confirmation also excluded transfer activity and profit and loss information. Because of Rusnak’s unusual requests concerning documentation, “BofA and Citibank knew or should have known that Rusnak wanted to hide material information from Allfirst,” according to the complaint.208
Further, Bank of America allegedly executed currency trades with Rusnak that were disguised loans. For payment of a small premium on a call option that could never be exercised, Rusnak received $120 million in funds (a premium on a put option) coupled with future liability well in excess of that amount on the put option to Bank of America. In March 2001, Bank of America allegedly paid Allfirst $74.9 million for a “put option” on $230 million worth of yen with an exercise date of March 7, 2002.209 Though it created a short-term gain, the transaction created an unbalanced long-term liability, according to the complaint.210
The Court held the complaint properly stated a claim for aiding and abetting fraud.211 Bank of America’s actual knowledge of the fraud was adequately pled based on the allegations Rusnak told the bank he wanted information omitted from daily trade confirmations, monthly reports, and communications between the bank and Allfirst “because he sought to conceal such information from his employer.”212 “Substantial assistance,” in the form of “deliberate concealment” properly was pled by alleging the bank concealed information by withholding it, and by “actively and deliberately altering documents.”213
Bank of America was also the subject of aiding-abetting charges in In Re Parmalat,214 where it contended that the breach of fiduciary duty at issue merely concerned a supposed duty owed to Parmalat’s stakeholders. Because, according to Bank of America, Parmalat owed no such duty to its stakeholders, there could have been no breach of fiduciary duty (and thus no liability for aiding and abetting). The court disagreed, holding that the complaint adequately had alleged that the bank aided insiders in breaching duties the insiders owed to Parmalat.215
Bank of America was alleged to have assisted Parmalat affiliates’ managers in “structuring and executing a series of complex, mostly off-balance sheet, financial transactions that were deliberately designed to conceal Parmalat’s insolvency.”216 According to plaintiffs, Bank of America’s knowing assistance ensured that Parmalat’s financial statements were false and misleading, which resulted in Parmalat’s bankruptcy.217
Specifically, plaintiffs alleged that in 1997, Bank of America had entered into an $80 million five-year credit agreement with one of Parmalat’s Venezuelan subsidiaries. The parties did not disclose a side letter that gave Bank of America additional guarantees, a $120,000 “arrangement fee” and interest beyond the publicly disclosed rate. According to plaintiffs, that transaction made Parmalat appear healthier and more creditworthy than, as Bank of America allegedly knew, Parmalat really was.218
In addition, in 1998, Bank of America allegedly entered into an $80 million eight-year credit agreement with two of Parmalat’s Venezuelan subsidiaries and a $100 million credit agreement with a Brazilian subsidiary. These loans were secured by cash deposits made by an Irish Parmalat subsidiary in the entire amounts of their respective loans. The Irish subsidiary obtained the funds through issuance of eight-year notes to institutional investors in the U.S. in private placements arranged by Bank of America. Consequently, the funds from investors flowed to South American subsidiaries; Bank of America took no risk and, when Parmalat’s troubles surfaced in December 2003, Bank of America foreclosed on the collateral. The fact that the loans were secured by cash put up by Parmalat was not disclosed publicly. Thus, the purchasers of the eight-year notes did not know they were contributing collateral for Bank of America loans. Nor, importantly, did the purchasers of Parmalat’s stock know that Parmalat had approximately $180 million less available cash than its financial statements indicated. Again, side letters increased the fees and interest payable to Bank of America and were not disclosed, further distorting Parmalat’s financial picture. Also, the actual purpose of the Venezuelan loans was to extinguish debt under the December 1997 agreement with Bank of America, rather than as the public disclosure indicated, “to fund import/ export activities by the Venezuelan companies,” according to the complaint.219
Bank of America also allegedly structured a set of transactions pursuant to which a Brazilian Parmalat subsidiary issued $300 million of privately placed debt that was “disguised as an equity investment.” To accomplish this, Bank of America formed two special purpose entities that bought $300 million of stock in the Brazilian entity, whereupon the SPEs issued four-year notes purchased by (i) Bank of America, (ii) U.S. institutional investors, and (iii) another Parmalat subsidiary. The Brazilian entity accounted for $130 million of the $300 million as “equity.” In December 1999, a Bank of America employee educated Parmalat “how to describe the transaction in a press release so that it would appear to be equity rather than debt,” according to the complaint.220
Furthermore, Bank of America allegedly made a succession of loans to Parmalat subsidiaries while simultaneously executing a supposed interest rate swap agreement with Parmalat’s African subsidiary. The “swap” required Bank of America, in effect, to pay $5.2 million each year to a Swiss bank account “ostensibly owned by Parmalat Africa.” The ostensible purpose of the swap was cancelled out by side letters, which required Parmalat Chile and Parmalat South Africa to pay Bank of America additional interest on their loans roughly equating to Bank of America’s yearly $5.2 million installments to Parmalat Africa’s “ostensible bank account.” And, the account was not Parmalat Africa’s; rather, allegedly, it “has been linked to Bank of America officials.”221
In addition, the swap agreements were not actually swaps, according to the complaint: they specified no currency or interest rate exchanges and offered the counter-parties no ability to hedge. The complaint alleged the agreements were nothing more than a device for Parmalat to make illicit payments to Bank of America officials.222
Bank of America did not deny that the complaint sufficiently alleged that it aided and abetted actual breaches of fiduciary duty. Rather, Bank of America characterized the claim as one of aiding and abetting a breach of duty owed to Parmalat’s shareholders—to whom the Bank argued Parmalat owed no duty. The court held that this argument was entirely beside the point: the complaint alleged the banks aided insiders in breaching duties the insiders owed to Parmalat.223 Thus, the complaint properly alleged aiding-abetting liability as a matter of law.
Aiding and abetting charges have been brought by one bank against another. In Rabobank Nederland v. National Westminster Bank,224 the plaintiff, who funded a “take out” of another bank’s (“the debtor”) interest in a credit facility, alleged the debtor’s officers breached their fiduciary duty by approving the debtor’s funding of over $600,000 for the purchase of almond farms for no consideration to the almond farm entities they controlled, and approving the debtor’s entry into long-term leases at above-market rates.225 The claim was premised on law holding that a debtor’s officers and directors owe to a successor (or take-out) lender a fiduciary duty to preserve the debtor’s corporate assets for the benefit of its creditors (including the take-out lender).226
The complaint alleged the original lender aided and abetted this breach by loaning $1.2 million to a particular trust that purchased the almond farms property while knowing that several debtor’s officers had formed the almond farm entities. The loan was made for the express purpose of acquiring the almond acreage; and the original lender “knew or should have known” that the individual defendants could not develop the almond farms without draining additional funds from the debtor. Construing these allegations “broadly,” the court found they supported the “inference” that the original lender knew its loan to the trust assisted the officers and directors of the debtor in their breach of fiduciary duties to the take-out lender.227
The original lender, however, contended that because it did not owe the same fiduciary duties as the debtors, it could not face liability for aiding and abetting their breach of fiduciary duty. The appellate court held this theory was erroneous because it essentially treated the cause of action identically to one for conspiracy, where a duty is owed directly by the defendant. By contrast, “[a] party need not owe any fiduciary duty, let alone the same fiduciary duty, to be subject to liability for aiding and abetting another’s breach.”228
In Neilson v. Union Bank of California, N.A.,229 a private money manager (Slatkin) allegedly set up investment funds as part of a classic Ponzi scheme: “i.e., he used monies paid by later investors to pay artificially high returns to initial investors, with the ultimate goal of attracting still more investors.”230 Investors alleged the banks “rubber-stamped” false information Slatkin gave to them and treated the client accounts as “one common pool of fungible and liquid assets.”231 They alleged the banks “knew or should have known that Slatkin was operating a Ponzi scheme, and that without the assistance provided by the banks, Slatkin’s Ponzi scheme could not have succeeded.”232
The court observed that while under Rule 9(b) of the Federal Rules of Civil Procedure, fraud must be pled with specificity, “‘[m]alice, intent, knowledge, and other condition of mood of a person may be averred generally.’”233 Nevertheless, the pleader must allege the nature of the information the defendant possessed; that is, “actual knowledge of the primary violation.”234 In Neilson, the complaint pled that “the banks knew [the primary actor, Slatkin] was committing fraud and was breaching his fiduciary duties to class members,” and that each bank “actively participated in Slatkin’s Ponzi scheme with knowledge of his crimes.” These allegations, notably supported by use of “atypical banking procedures to service Slatkin’s accounts,” adequately stated the “knowledge” requirement for aidingabetting breach of fiduciary duty.235
Clearly, the more a bank knows about its borrower’s business the greater the exposure to the bank in the event that “business” proves to have been a fraud scheme. Equally important is the number of financing transactions and extent of time over which the bank has furthered the borrower’s objectives. And, as previously observed, the use of “atypical” banking procedures is considered very strong evidence of scienter.
C. BANKRUPTCY TRUSTEES’ ACTIONS
A common fact-pattern involves a bankrupt corporation that formerly operated as a fraudulent enterprise. In bankruptcy, after ringleaders in upper management have been thrown out, the bankruptcy trustee not infrequently discovers that third-parties, such as suppliers, accountants or law firms, appeared to have facilitated the fraud.236 Bankruptcy trustees in this position have sought recourse against these alleged aiders-abettors.
However, when the bankrupt corporation joined with a third party in defrauding its creditors, the trustee cannot recover against the third party for the damage to the creditors. “A bankruptcy trustee has no standing generally to sue third parties on behalf of the estate’s creditors, but may only assert claims held by the bankrupt corporation itself . . . .”237 The in pari delicto defense may be raised in aiding-abetting actions brought by the bankruptcy trustee when a participant in illegal, fraudulent or inequitable conduct (here, the trustee) seeks to recover from another participant in that conduct. Under those circumstances, the parties may be deemed in pari delicto, and the “law will aid neither, but rather, will leave them where it finds them.”238 For example, a claim against investment banks for aiding and abetting fraud by shareholders’ representatives was subject to dismissal where the “essence” of the claims was a failure to tell others at the now-bankrupt company “what the shareholders-representatives already knew.”239
However, in bankruptcy, the in pari delicto doctrine applies primarily to the trustee as representative of the “debtor” under Section 541 of the Bankruptcy Code, and not necessarily to the trustee in its status as “creditor.” As “creditor,” the trustee is not stepping into the shoes of the debtor company, but is assuming the status of hypothetical lien creditors who were not party to the breach of fiduciary duty.240 Section 544(a)(1) of the Bankruptcy Code provides that the trustee shall have, as of the commencement of the case, the rights and powers of a “creditor that extends credit to the debtor . . . and that obtains . . . a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien, whether or not such a creditor exists.”241 Thus, in Anstine v. Alexander,242 the trustee had standing to bring aiding-abetting claims, given that any hypothetical judgment lien creditor would have had standing to sue the company’s attorneys for malpractice causing injury to the company or for the president’s breach of duty to his company. “Such a lien creditor would also have a cause of action against anyone who aided and abetted that breach of fiduciary duty.”243
The availability of the in pari delicto defense in the case of creditors of a bankrupt estate depends upon the jurisdiction, with the Ninth Circuit, based on equitable considerations, restricting the defense, and the Second and Third Circuits, relying on their interpretation of Section 541 of the Bankruptcy Code, giving the defense broad sway.244
D. CORPORATE AFFILIATES
Separate corporate entities in the same family of entities under common control or controlling one another may be alleged to be perpetrator and aider-abettor, respectively. However, complexities arise when some affiliates are alleged to be primarily and others secondarily responsible. Subsidiaries are ordinarily treated as independent corporate entities; however, in reality they are sometimes “mere vehicles” through which an improper scheme is effectuated.245 In Rabkin v. Philip A. Hunt Chemical Corp.,246 former minority shareholders of the Philip A. Hunt Chemical Corp. presented such a case. Olin Corporation, Hunt’s majority shareholder was named as defendant. The plaintiffs claimed that “since Olin allegedly breached its fiduciary duty in connection with a merger and Olin Acquisition was the corporate vehicle through which the merger was consummated, the subsidiary was a knowing participant liable for its parent’s breach.”247 The court rejected the contention, though only because “no allegation [was ever made] that Olin Acquisition even existed at the time the merger proposal was presented to Hunt.”248
It has been held that a corporation had requisite guilty knowledge and knowingly rendered substantial assistance in connection with securities fraud by a corporately separate “family business,” where the family that committed the fraud owned and controlled the defendant corporation.249 In that circumstance, the defendant corporation was deemed to possess the knowledge held by the company that primarily committed the fraud.250
E. DIRECTORS AND OFFICERS
Directors and officers of a company owe a fiduciary duty to the shareholders.251 A rival, or corporate raider, may become liable for aiding and abetting breach of that duty should the rival or takeover suitor induce an officer of the company to act disloyally. In “greenmail” cases, the putative acquiring company may be exposed to liability after seeking to persuade the directors and officers to make business decisions that are antithetical to the company’s interests in an attempt to fend off a takeover (that might be in the shareholders’ interest).252
Allegations of a “street sweep” scheme, to defeat a hostile takeover, formed the subject of aiding-abetting claims in Ivanhoe Partners v. Newmont Mining Corp.253 There, the board approved a dividend allegedly to finance a stock purchase by the company’s largest corporate shareholder. That shareholder, if permitted, intended to acquire a sufficient share of the company to prevent the hostile tender offeror from acquiring a controlling share.254 When the directors enacted a standstill agreement that bound the corporate shareholder to vote its shares for the company’s director nominees, “it severely restricted” the shareholder’s ability to dispose of its stock free of the standstill restrictions. “That agreement operated to entrench the [Company’s] Board” and thus went beyond the reasonable goals of limiting a shareholder’s ability to acquire a majority share.255 This was a violation of the company’s directors’ duties, and given that the shareholder, as a contracting party, obviously knew of the “entrenchment effect” of those provisions, the shareholder “aided and abetted” that violation.256
Another legally viable aiding-abetting claim alleged that officers caused the company to “deepen its insolvency,” to the prejudice of the plaintiff creditors, by “wrongfully prolonging the company’s existence through the incurrence of spurious debt,” largely by allowing sales on credit to an affiliated entity that they knew was becoming insolvent.257 Applying New Jersey law, the court held that such allegations met the standard that (1) there had been a wrongful act in an underlying securities violation, (2) the alleged aider-abettor knew it, and (3) the aider-abettor “knowingly and substantially participated in the wrongdoing.”258
As discussed above,259 the in pari delicto defense often will bar claims by the bankruptcy trustee, including claims based on misconduct by the bankrupt entity’s former officers and directors. However, in In re Parmalat,260 the plaintiff sought to avoid the in pari delicto defense by alleging the officers and directors had been acting strictly for themselves in “looting” Parmalat. The court agreed: “By any standard, theft from a corporation by insiders is self-dealing by the insiders,” not in the interest of the company, and thus the insiders’ knowledge is not imputed to the company.261
F. GREENMAIL
“Greenmail” typically refers to the payment by a publicly traded company of a premium over market price to a “corporate raider” to repurchase the raider’s shares of stock in the company. Corporate raiders, or takeover artists, may threaten a takeover of a company, thereby jeopardizing the job security of directors and officers (who may believe they will be ousted under the raider’s regime). Such directors and officers have a duty to disregard that personal risk. Should those directors and officers, aiming to preserve their power and perks, cause the company to overpay to buy back the raider’s shares in order to defeat the takeover, they may have breached their fiduciary duty to the company’s shareholders. If the raider intends this result, the raider (or “greenmailer”) may be liable to shareholders of the target company as an aider and abettor. The entity pursuing the takeover must offer consideration to the company, not to officers at the company.
In seeking to establish liability on the part of the greenmailers, shareholders have alleged that the corporate directors breached their fiduciary duty to shareholders by incurring harmful debt and by paying the price of a targeted stock repurchase.262 For example, in 1984, Saul Steinberg and Associates acquired more than two million shares of Walt Disney Productions.263 Interpreting this action as an initial step in a takeover action, the Disney directors countered by acquiring a new company (Arvida) and thereby assuming $190 million in debt. Three months later the Disney directors repurchased all of the Steinberg shares for approximately $77 a share, which included a premium over the market price. This repurchase, which the court categorized as greenmail, was financed through increased borrowing. With the new combined borrowing, corporate debt rose to two-thirds of equity. This action harmed the shareholders because it negatively affected the corporation’s credit rating and stock prices.264
In reviewing a lower court decision to issue an injunction, which, in effect, imposed a constructive trust on the profits of the repurchase, the court of appeals concluded that at the trial on the merits Steinberg could be held liable as an aider and abettor in the breach of fiduciary duty. Steinberg “knew or should have known” Disney was borrowing the $325 million purchase price. From his previous dealings with Disney, including an aborted purchase of Arvida, he knew the increased debt load would negatively affect Disney’s credit rating and the price of its stock.265 The argument that Steinberg had actual knowledge of harm flowing to Disney shareholders was strengthened by the fact that Steinberg, while still a shareholder, had brought his own derivative action in an attempt to block an acquisition of Arvida and the assumption of $190 million in debt. These facts suggested that Steinberg knew that the actual harm to shareholders exceeded the benefits.266
In Gilbert v. El Paso. Co.,267 shareholders of the target corporation (El Paso) brought a class action. The putative acquirer, Burlington, had made a tender offer of $24 per share. The offer contained several conditions (“outs”) which Burlington had the option to use. El Paso’s Board initially opposed the offer, claiming the $24 price was inadequate; however, El Paso’s shareholders evidently liked the offer, which represented a premium over market price because it was oversubscribed.
Surprisingly, to outsiders, the conflict suddenly became amicable. Burlington and El Paso announced they had an agreement. A new tender offer was announced at the same price, but for fewer shares. Some of El Paso’s Directors were granted golden parachutes. The agreement allegedly had the effect of reducing the amount of the participation from the first to the second offer, thus denying the shareholders the premium for all shares tendered under the first offer.268
The court was able to infer that several conspiracy scenarios were possible. Under each, Burlington’s superior bargaining position, was crucial. Burlington responded that its duty to its shareholders obligated it to get the best price possible, and that the transaction was an arm’s length one. According to Burlington, “pursuit of the best available price in negotiations with opposing management can be undertaken without regard to the target management’s fiduciary obligations to its shareholders.”269
The court disagreed, ruling that if participation in a breach of duty occurred, there could have been no arm’s length deal: “Thus, although an offeror may attempt to obtain the lowest possible price for stock through arm’s length negotiations with the target’s board, it may not knowingly participate in the target board’s breach of fiduciary duty by extracting terms which require the opposite party to prefer its interests at the expense of the shareholders.”270
Offering terms that afford special consideration to board members is a clear path to aider-abettor liability. When terms hold value that inures exclusively, or even disproportionately, to officers and directors, courts have not found it difficult to infer the offeror knew it was inducing a breach of fiduciary duty to shareholders.
G. RICO
Based on Central Bank, it has been suggested that civil aiding and abetting liability under RICO appears to be traveling a path toward extinction. “[A] private cause of action for aiding and abetting a RICO violation cannot survive the Supreme Court’s decision in Central Bank . . . . ,” according to the Third Circuit Court of Appeals.271 The Third Circuit has observed that the Central Bank court quoted directly from the text of the federal securities laws in abolishing all future civil aiding and abetting claims under § 10(b).272 The Third Circuit and other courts have applied the reasoning of Central Bank to RICO and concluded the statute does not provide for aiding and abetting liability.273 Nevertheless, state RICO laws, which may be more expansively construed than federal statues, may permit aiding and abetting actions.274
H. STATE LAW SECURITIES ACTIONS
The Securities Act of 1933 and the Securities Exchange Act of 1934 both contain explicit savings clauses that preserve state authority with regard to securities matters.275 Consequently, courts long have recognized aiding-abetting liability in connection with securities actions brought pursuant to state law.276
The Texas Securities Act, for example, establishes both primary and secondary liability for securities violations.277 An “aider” is defined as “[a] person who directly or indirectly with intent to deceive or defraud or with reckless disregard for the truth or the law materially aids a seller, buyer or issuer of a security.”278 The Texas Supreme Court has held in this context that “reckless disregard” requires that the aider be aware of the primary violator’s improper activities. Thus, a broker’s mere disregard for internal procedures that would have brought the fraud to light was, without more, insufficient to give rise to secondary liability.279
Post-Central Bank, much of the law of aider-abettor liability is developing in state courts, including under state securities statutes. This environment likely will produce a rich, and varied, body of decisional law.
I. TERRORISM
The Federal Anti-Terrorism Act provides civil remedies for victims of international terrorism, stating: “Any national of the United States injured in his or her person, property, or business by reasons of an act of international terrorism, or his or her estate, survivors or heirs, may sue therefore in any appropriate district court of the United States and shall recover threefold the damages he or she sustains and the cost of the suit, including attorney’s fees.”280 While funding that indirectly reaches terrorist organizations itself may not, depending on the circumstances, always be sufficient to constitute an act of international terrorism under the Act, assistance that meets the definition of aiding and abetting terrorism does give rise to liability under the Act.281
In Boim v. Quranic Literacy Institute and Holy Land Foundation for Relief and Development, the court found that section 2333 can give rise to aiding and abetting liability because it provided for an express right of action for plaintiffs, and it was reasonable to infer that Congress intended to allow for aiding-abetting liability.282 Further, the history of section 2333 showed Congress had intended to make applicable general tort principles. Moreover, Congress expressed its intent to “render civil liability at least as extensive as criminal liability in the context of terrorism cases.” Given that criminal actors are subject to aiding-abetting liability under section 2339B,283 civil liability should attach as well.284
Lastly, the court observed that Congress’ intent to thwart financing of terrorism cannot be met unless liability extends beyond those directly involved in the acts of terrorism: “if we failed to impose liability on aiders and abettors who knowingly and intentionally funded acts of terrorism, we would be thwarting Congress’ clearly expressed intent to cut off the flow of money to terrorists at every point along the causal chain of violence.”285 In Boim, therefore, plaintiffs were permitted to attempt to prove that the defendants “knew of Hamas’ illegal activities, that they desired to help those activities succeed, and they engaged in some act of helping the illegal activities.”286
In early 2005, the U.S. District Court for the Southern District of New York ruled on a host of motions filed by defendants in In re Terrorist Attacks on September 11, 2001,287 a multidistrict proceeding consolidating actions brought by victims and insurance carriers for injuries and losses arising from the September 11, 2001 terrorist attack. Citing Boim, the court observed that aider-abettor liability under the Anti-Terrorism Act required “general knowledge of the primary actor’s conduct.”288 Therefore, absent allegations that a defendant, for example, knew its charities were supporting terrorism, certain of the aiding-abetting claims against defendants were deemed insufficient as a matter of law.289
A second round of motions, decided in November 2005, dismissed several additional defendants largely on the same basis, but ruled that claims that alleged “material support,” in the form of financial transactions with al Qaeda, could be maintained under section 2339A.290 Further, the court denied the motion to dismiss of a defendant who was alleged to be affiliated with al Qaeda operatives and to have aided al Qaeda by arranging for the delivery of a battery for a satellite phone used by Osama bin Laden.291 This litigation is ongoing in the Southern District of New York.
Also late in 2005, the U.S. District Court for the Eastern District of New York agreed with Boim that section 2333 “does not limit the imposition of civil liability only to those who directly engage in terrorist acts.”292 U.S. citizens, estates, survivors and heirs of United States citizens, who had been victims of terrorist attacks in Israel, have sued a Jordanian bank, alleging the bank had provided financing and support to agents of terrorist organizations, such as Hamas. In ruling that the Anti-Terrorism Act allowed for aiding-abetting liability, the court distinguished Central Bank on the basis that in enacting the Anti-Terrorism Act Congress had expressed a desire to “import general tort law principles,” including aiding and abetting liability.293 Congress also had expressed an intent to make civil liability at least as expansive as criminal liability. Moreover failing to allow aiding and abetting liability would be “contrary to Congress’ stated purpose of cutting off the flow of money to terrorists at every point along the chain of causation.”294
The court, applying the fact pleading standard pursuant to Federal Rule of Civil Procedure 8(a), held the plaintiffs’ allegations properly pled aiding and abetting liability. Plaintiffs had alleged the bank had facilitated terrorism chiefly by (1) creating a death and dismemberment plan for the benefit of Palestinian terrorists, and (2) knowingly provided banking services to Hamas (a designated terrorist organization) and its fronts. The allegations supported the inferences that (i) the bank would supply needed financial services to organizations that would themselves carry out terrorist acts, which constituted “substantial assistance,” and (ii) that administration of the benefit plan encouraged terrorists to act.295
The court rejected the bank’s protestation that plaintiffs needed to show knowledge as to each specific terroristic act. Aiding and abetting violations of the AntiTerrorism Act require only knowledge “that the organization to which material support is provided is designated or is engaged in terrorist activities . . . .”296 Nor, for purposes of “causation,” did plaintiffs need to prove that acts of “assistance” caused a particular injury from terrorism: the creation of an incentive to commit such acts, generally, imposes secondary liability. The court did conclude that for purposes of the Anti-Terrorism Act, allegations of recklessness would fall short of the statutory standard.297
VI. CONCLUSION
The doctrine of civil liability for aiding and abetting warrants, and promises to receive, expansive treatment in the context of suits for personal injuries resulting from terrorism that has been assisted by its financiers and others facilitators. Tort liability expanded during the twentieth century in large part to provide a measure of civil deterrence for defendants regarded, in isolated instances, as having put the public at risk.298 The public risk from a single act of terrorism may vastly exceed the risk created by corporate negligence or distribution of defective products.
More generally, aiding and abetting liability is in the process of achieving broad acceptance as a doctrine uniquely suited to address wrongdoing that occurs in transactional matrices that as of the year 2006 frequently are of breathtaking complexity. The former centerpiece of aiding-abetting liability—suits against facilitators of federal securities fraud—was removed by the Supreme Court’s 1994 decision in Central Bank.299 But the doctrine itself has flourished, perhaps in part because of the attention it received when Central Bank was followed within seven years by massive financial scandals.
As of this writing, the larger scandals temporarily have subsided (though this may well be a temporary lull preceding the demise of one or two large hedge funds).300 The scandal cases, including those involving Enron and WorldCom, have contributed with other aiding and abetting case law addressing conventional financial fraud and commercial misconduct to produce a body of law that has helped to refine the law of aiding-abetting civil liability.
This refinement is particularly evident in connection with the test for “knowledge of wrongdoing,” where recognized fact patterns have emerged as predictive of liability or nonliability (as the case may be).301 Recent court decisions have shown that use of “atypical” banking procedures are a critical signifier of “knowledge” and thus potential liability.302 Motive has emerged as a significant factor in favor of showing unlawful scienter, though motive is not, or should not be, itself an element of liability.303 It has become equally plain that even with knowledge of wrongdoing one may stand by, absent the existence of some affirmative duty or other special circumstances, and allow another to be defrauded by one’s own client or customer.304 Also, decisions, particularly those concerning terrorism, have held that “causation” usually requires only that the harm caused by the principal actor was a reasonably foreseeable result of the aider-abettor’s assistance.305
The increase in well-considered decisional law is timely. Based on apparent trends in the number of reported decisions, aiding-abetting cases are increasing in frequency. From its beginning as an obscure civil doctrine concerned with “isolated acts of adolescents in rural society”306 to a modern liability doctrine flexible enough to provide remedies for bank fraud, greenmail, and terrorism, civil liability for aiding and abetting has evolved because of the special need for recourse where the wrongdoer had the assistance of important allies.
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* Member, Cozen O’Connor, Philadelphia, Pa., where he is Chair of the Firm’s Financial Risk Transfer Practice Group. Mr. Mason is a member of the Financial Institutions Litigation Committee of the Business Law Section of the American Bar Association, and the Excess, Surplus Lines and Rein- surance Committee of the Tort, Trial and Insurance Practice Section of the American Bar Association, and is Editor-in-Chief of the TORT, TRIAL AND INSURANCE PRACTICE LAW JOURNAL. The views expressed in this article are those of the author and not of Cozen O’Connor or its clients.
2. See Linde v. Arab Bank, PLC, 384 F. Supp. 2d 571, 583 (E.D.N.Y. 2005).
3. See generally Central Bank, 511 U.S. at 182–83.
4. See Book 47, Title 2, Corpus Juris Civilis (“Anyone who assists a thief is not always himself a manifest thief; hence it happens that he who furnished assistance is liable for non-manifest theft, and he who was caught in the act is guilty of manifest theft of the same property.”).
5. 1 M. Hale, PLEAS OF THE CROWN 615 (1736), cited in United States v. Peoni, 100 F.2d 401, 402 (2d Cir. 1938).
6. 2 J. STEPHEN, A HISTORY OF THE CRIMINAL LAW OF ENGLAND 231 (1883), cited in Standefer v. United States, 447 U.S. 10, 15 (1980).
8. Act of Mar. 4, 1909, ch. 321, § 332, 35 Stat. 1088, 1152.
9. Nye & Nissen v. United States, 336 U.S. 613 (1949). As such, under the 1909 Act, and under the law of most states, an accessory to a crime is subject to criminal liability even if the principal actor is acquitted. Standefer, 447 U.S. at 20.
10. See Sir John Heydon’s Case, 11 Co. Rep. 5, 77 Eng. Rep. 1150 (1613).
11. See generally Bird v. Lynn, 10 B.Mon. 422, 49 Ky. 422 (Ky. Ct. App. 1850) (Defendant who said that a child, who “sauced” defendant, deserved to be whipped, may be subject to liability for a whipping the child received but only if defendant incited such act desiring that it occur); Brown v. Perkins, 83 Mass. 89 (1861) (defendant subject to liability if it were to be found he encouraged crowd of women armed with hatchets to ransack liquor store).
12. Halberstam v. Welch, 705 F.2d 472, 489 (D.C. Cir. 1983); Doe I v. Unocal Corp., 395 F.3d 932, 947–53 (9th Cir. 2002), opinion vacated and rehearing in banc granted, 395 F.3d 978, 979 (9th Cir. 2003) (“[I]t is ordered that this case be reheard by the en banc court pursuant to Circuit Rule 35-3. The three-judge panel opinion shall not be cited as precedent by or to this court or any district court of the Ninth Circuit, except to the extent adopted by the en banc court.”), on rehearing en banc, 403 F.3d 708 (9th Cir. 2005) (district court opinion vacated and case dismissed with prejudice pur- suant to parties’ stipulation).
13. Neilson v. Union Bank of Cal., N.A., 290 F. Supp. 2d 1101, 1133 (C.D. Cal. 2003).
22. Applied Equipment Corp. v. Litton Saudi Arabia Ltd., 869 P.2d 454, 459–60 (Cal. 1994).
23. See Wells Fargo Bank v. Ariz. Laborers, Teamsters and Cement Masons Local No. 395 Pension Trust Fund, 38 P.3d 12, 23 (Ariz. 2002); Saunders v. Superior Court, 33 Cal. Rptr. 2d 438, 446 (Cal. Ct. App. 1994); Holmes v. Young, 885 P.2d 305, 308 (Col. Ct. App. 1994); Feen v. Benefit Plan Adm’rs, Inc., No. 406726, 2000 WL 1398898, *10–11 (Conn. Super. Ct. Sept. 7, 2000); Pipher v. Burr, No. C.A. 96C-08-011, 1998 WL 110135, *9–10 (Del. Super. Ct. Jan. 29, 1998); Halberstam v. Welch, 705 F.2d 472, 477–78 (D.C. Cir. 1983); Tew v. Chase Manhattan Bank, N.A., 728 F. Supp. 1551, 1568–69 (S.D. Fla. 1990), amended on reconsideration, 741 F. Supp. 220 (S.D. Fla. 1990); Sanke v. Bechina, 576 N.E.2d 1212, 1218–19 (Ill. Ct. App. 1991), appeal denied, 584 N.E.2d 140 (Ill. 1991); Heick v. Bacon, 561 N.W.2d 45, 51–52 (Iowa 1997); Emig v. Am. Tobacco Co., Inc., 184 F.R.D. 379, 386 (D. Kan. 1998); Hart Enterp., Inc. v. Cheshire Sanitation, Inc., No. 98-416-P-H, 1999 WL 33117189, *3 (D. Me. Feb. 22, 1999); Alleco, Inc. v. Harry & Jeanette Weinberg Found., Inc., 665 A.2d 1038, 1049 (Md.1995); Kurker v. Hill, 689 N.E.2d 833, 837 (Mass. Ct. App. 1998); Echelon Homes, LLC v. Carter Lumber Co., 683 N.W.2d 171 (Mich. Ct. App. 2004), rev’d in part, 694 N.W.2d 544 (Mich. 2005); Casino Res. Corp. v. Harrah’s Entm’t, Inc., No. 98-2058ADM/AJB, 2002 WL 480968, *13 (D. Minn. March 22, 2002); Joseph v. Marriott Int’l, Inc., 967 S.W.2d 624, 629–30 (Mo. Ct. App. 1998); Invest Almaz v. Temple-Inland Forest Prods. Corp., 243 F.3d 57, 82-82 (1st Cir. 2001) (New Hampshire); Judson v. People’s Bank and Trust Co., 134 A.2d 761 (N.J. 1957); GCM, Inc. v. Ky. Cent. Life Ins. Co., 947 P.2d 143, 147–48 (N.M. 1997); Koken v. Steinberg, 825 A.2d 723 (Pa. Commw. Ct. 2003); Hirsch v. Penn. Textile Corp., Inc. (In re Centennial Textiles, Inc.), 227 B.R. 606, 611 (Bankr. S.D.N.Y. 1993); Dow Chemical Co. v. Mahlum, 970 P.2d 98, 112–13 (Nev. 1998); Mc- Millan v. Mahoney, 393 S.E.2d 298, 300 (N.C. Ct. App. 1990); Aetna Cas. & Sur. Co. v. Leahey Constr. Co., Inc., 219 F.3d 519, 533–34 (6th Cir. 2000) (Ohio); Granewich v. Harding, 985 P.2d 788, 792–93 (Or. 1999); Groff v. Maurice, C.A. No. 86-3808, 1993 WL 853801, *3 (R.I. Super. April 7, 1993); Future Group, II v. Nationsbank, 478 S.E.2d 45, 50 (S.C. 1996); Lawyers Title Ins. Corp. v. United Am. Bank of Memphis, 21 F. Supp. 2d 785, 795 (W.D. Tenn. 1998); Estate of Hough ex rel. LeMaster v. Estate of Hough ex rel. Berkeley County Sheriff, 519 S.E.2d 640, 648–49 (W. Va.1999); Winslow v. Brown, 371 N.W.2d 417, 421–23 (Wis. Ct. App.1985), rev. denied, 378 N.W.2d 291 (Wis. 1985). Courts in three other states have held that the viability of such claims remains an open question. See Unity House, Inc. v. N. Pac. Invests., Inc., 918 F. Supp. 1384, 1390 (D. Haw. 1996); Daniel Boone Area Sch. Dist. v. Lehman Bros., Inc., 187 F. Supp. 2d 400, 413 (W.D. Pa. 2002); Shinn v. Allen, 984 S.W.2d 308, 310 (Tex. Ct. App. 1998).
24. Central Bank, 511 U.S. at 181–82. See Premier/Georgia Mgt. Co., Inc. v. Realty Mgt. Corp., 613 S.E.2d 112 (Ga. Ct. App. 2005); FDIC v. S. Prawer & Co., 829 F. Supp. 453, 457 (D. Me. 1993) (in Maine, “[i]t is clear . . . that aiding and abetting liability did not exist under the common law, but was entirely a creature of statute”); Meadow Ltd. Partnership v. Heritage Sav. & Loan Assn., 639 F. Supp. 643, 653 (E.D. Va. 1986) (aiding and abetting tort “not expressly recognized by the state courts of the Commonwealth of Virginia); Sloane v. Fauque, 784 P.2d 895, 896 (Mont. 1989) (aiding and abetting tort liability is issue of “first impression” in Montana).
25. See generally Ronald M. Lepinskas, Civil Aiding and Abetting Liability in Illinois, 87 ILL. B.J. 532, 533 (Oct. 1999).
29. To implement § 10(b) of the Securities Exchange Act of 1934, ch. 404, Title I § 10, 48 Stat. 881, 891 (codified at 15 U.S.C. § 78j), in 1942, the SEC adopted Rule 10b-5, which provides, in relevant part:
It shall be unlawful for any person, directly or indirectly . . . (a) [t]o employ any device, scheme or artifice to defraud; (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
17 C.F.R. § 240.10b-5 (2005).
30. 17 C.F.R. § 240.10b-5(b) (2005). See Robert S. DeLeon, The Fault Line Between Primary Liability and Aiding and Abetting Claims Under Rule 10b-5, 22 J. CORP. LAW 723, 729 (1997).
31. 17 C.F.R. § 240.10b-5(a), (c) (2005). “The first and third subsections of Rule 10b-5, which use the verbs ‘employ’ and ‘engage,’ have narrower meanings than the second subsection.” DeLeon, supra note 30, at 728. For statements or omissions, “make” can mean to “create,” to “bring into being,” to “compose” or “write,” to “give rise to,” or to “cause to be announced.” Id at 729. “Accordingly, to the extent a defendant can be said to ‘employ’ a fraudulent device or ‘engage’ in fraudulent conduct in the preparation of issuer disclosures, that conduct arguably is captured by Rule 10b-5’s prohibition on ‘making’ misstatements or omissions.” Id.
32. See, e.g., Cleary v. Perfectune, Inc., 700 F.2d 774, 777 (1st Cir. 1983); IIT v. Cornfeld, 619 F.2d 909, 922 (2d Cir. 1980); Monsen v. Consol. Dressed Beef Co., 579 F.2d 793, 799–800 (3d Cir.), cert. denied, 439 U.S. 930 (1978); Schatz v. Rosenberg, 943 F.2d 485, 496–497 (4th Cir. 1991), cert. denied, 503 U.S. 936 (1992); Fine v. American Solar King Corp., 919 F.2d 290, 300 (5th Cir. 1990), cert. dismissed, 502 U.S. 976 (1991); Moore v. Fenex, Inc., 809 F.2d 297, 303 (6th Cir.), cert. denied sub nom. Moore v. Frost, 483 U.S. 1006 (1987); Schlifke v. Seafirst Corp., 866 F.2d 935, 947 (7th Cir. 1989); K & S P’ship v. Cont’l Bank, N.A., 952 F.2d 971, 977 (8th Cir. 1991), cert. denied, 505 U.S. 1205 (1992); Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1483 (9th Cir. 1991); Farlow v. Peat, Marwick, Mitchell & Co., 956 F.2d 982, 986 (10th Cir. 1992); Schneberger v. Wheeler, 859 F.2d 1477, 1480 (11th Cir. 1988), cert. denied, 490 U.S. 1091 (1989). The only court not to have squarely recognized aiding and abetting in private section 10(b) actions prior to Central Bank did so in an action brought by the SEC, see Dirks v. SEC, 681 F.2d 824, 844 (D.C. Cir. 1982), rev’d on other grounds, 463 U.S. 646 (1983), though it suggested that such a claim was available in private actions. See Zoelsch v. Arthur Andersen & Co., 824 F.2d 27, 35–36 (D.C. Cir. 1987).
33. Brennan v. Midwestern United Life Ins. Co., 259 F. Supp. 673, 680 (N.D. Ind. 1966).
34. Zatkin v. Primuth, 551 F. Supp. 39 (S.D. Cal. 1982).
35. Resnick v. Touche Ross & Co., 470 F. Supp. 1020 (S.D.N.Y. 1979).
36. Sandusky Land, Ltd. v. Uniplan Groups, Inc., 400 F. Supp. 440 (N.D. Ohio 1975).
37. In re Caesar’s Palace Sec. Litig., 360 F. Supp. 366 (S.D.N.Y. 1973).
38. Brennan, 259 F. Supp. at 680–81 (corporation alleged to have assisted improper actions of brokerage firm).
40. Central Bank, 511 U.S. at 182. Instead, Congress had taken a “statute-by-statute approach to civil liability for aiding and abetting.” Id. In statutes such as the Commodity Exchange Act, 7 U.S.C. § 25(a)(1)(2000), the National Bank Act, 12 U.S.C. §504(h) (2000), and the Packers and Stockyards Act, ch. 64, § 202, 42 Stat. 161 (1921) (codified at 7 U.S.C. § 192(g)), Congress had been “quite explicit” in imposing aiding and abetting liability. In contrast, in connection with Securities Exchange Act violations, it had neither in 1934 nor since employed express language to impose such liability. Central Bank, 511 U.S. at 182–83.
41. Id. at 186 (“[O]ur observations on the acquiescence doctrine indicate its limitations as an expression of congressional intent.”) (quoting Pension Benefit Guaranty Corp. v. LTV Corp., 496 U.S. 633, 650 (1990)).
43. Id. at 189. The Court observed that on the other hand there were policy arguments in favor of aiding and abetting liability. “The point here, however, is that it is far from clear that Congress in 1934 would have decided that the statutory purposes would be furthered by the imposition of private aider and abettor liability.” Id. at 189–90.
45. While commentators, supported by abundant evidence, have identified Central Bank as one factor leading to the encouragement, during the 1990s, of misconduct by accountants and other players in the financial industry, e.g., Scott Siamas, Primary Securities Fraud Liability for Secondary Actors: Revisiting Central Bank of Denver in the Wake of Enron, Worldcom, and Arthur Andersen, 37 U.C. DAVIS L. REV. 895, 897 (2004), critics of Central Bank have had less success exposing any genuine error in the reasoning of that opinion. Most commonly, commentators emphasize the Court’s over- ruling of nearly thirty years of lower court precedent dating back to 1966, e.g., Tauine, M. Zeitzer, In Central Bank’s Wake, RICO’s Voice Resonates: Are Civil Aiding and Abetting Claims Still Tenable?, 29 COLUM. J.L.& SOC. PROBS. 551, 557 (1996), a point that may only beg the question why courts deciding cases closer in time to enactment of the 1933 and 1934 acts seemingly did not perceive any cause of action for aiding and abetting.
51. Daniel L. Brockett, Line Between Primary and Secondary Liability Still Blurred in Securities Cases, 50 FED. LAW. 29, 32 (Aug. 2003).
52. See Shapiro v. Cantor, 123 F.3d 717, 721 n.2 (2d Cir. 1997). Until recently, however, most courts adhered to a “bright line” test pursuant to which a party cannot be liable unless it directly made the offending statement to the public. Wright v. Ernst & Young, 152 F.3d 169, 175 (2d Cir. 1998), cert. denied, 525 U.S. 1104 (1999); In re MTC Elec. Tech. Shareholders Litig., 898 F. Supp. 974 (E.D.N.Y. 1995), vacated in part on reconsideration, 993 F. Supp. 160 (E.D.N.Y. 1997).
53. DeLeon, supra note 30, at 732 (citing Knapp v. Ernst Whinney, 90 F.3d 1431, 1440–41 (9th Cir. 1996); O’Neil v. Appel, 897 F. Supp. 995, 1000 (W.D. Mich. 1995)).
54. DeLeon, supra note 30, at 730 (citing SEC v. Fehn, 97 F.3d 1276, 1293 (9th Cir. 1996)).
65. A “liberal notice pleading” standard should govern aiding-abetting claims, pursuant to FED. R. CIV. P. 8(a). See Linde v. Arab Bank, PLC, 384 F. Supp. 2d 571, 579–80 (E.D.N.Y. 2005).
66. Unicredito Italiano SpA v. J.P. Morgan Chase Bank, 288 F. Supp. 2d 485, 502 (S.D.N.Y. 2003) (quoting Gabriel Capital, L.P. v. Nat. West Fin., Inc., 94 F. Supp. 2d 491, 511 (S.D.N.Y. 2000) (financial institutions subject to liability for assisting Enron Ponzi scheme)).
67. Fiol v. Doellstedt, 58 Cal. Rptr. 2d 308, 312 (Cal. Ct. App. 1996); Saunders v. Superior Ct., 33 Cal. Rptr. 2d 438, 446 (Cal. Ct. App. 1994). See also RESTATEMENT (SECOND) OF TORTS § 876(c) (1979).
70. See Conley v. Gibson, 355 U.S. 41, 47 (1957), cited in Picinich v. United Parcel Service, 321 F. Supp. 2d 485, 517 (N.D.N.Y. 2004); see also Linde, 384 F. Supp. 2d at 579–80.
71. See PROSSER & KEETON ON LAW OF TORTS §§ 322–24 (1984).
72. See generally In re Parmalat Sec. Litig., 383 F. Supp. 2d 587 (S.D.N.Y. 2005); cf. Unocal, 395 F.3d 932 (human rights violations by foreign government). In Unocal, the court applied a slightly modified version of the RESTATEMENT test, given the international nature of the controversy. 395 F.3d at 951.
73. In re AHT Corp., 292 B.R. 734, 746 (S.D.N.Y. 2003), aff ’d, 123 Fed. Appx. 17 (2d Cir. 2005).
78. Nathan Isaac Combs, Civil Aiding and Abetting Liability, 58 VAND. L. REV. 241, 291 (2005).
79. Woodward v. Metro Bank of Dallas, 522 F.2d 84, 95 (5th Cir. 1975), cited in Combs, supra note 78, at 291.
80. Ronald A. Brown, Jr., Note, Claims of Aiding and Abetting a Director’s Breach of Fiduciary Duty— Does Everybody Who Deals with a Delaware Director Owe Fiduciary Duties to that Director’s Shareholders?, 15 DEL. J. CORP. L. 943, 956 (1990) (citing numerous unpublished cases).
81. See generally Javitch v. First Montauk Financial Corp., 279 F. Supp. 2d 931 (N.D. Ohio 2003).
83. Id. at 1120–21 (citing Aetna Cas. & Sur. Co. v. Leahey Constr. Co., 219 F.3d 519, 536 (6th Cir. 2000)); Camp v. Dema, 948 F.2d 455, 459 (8th Cir. 1991); Woods v. Barnett Banks of Ft. Lau- derdale, 765 F.2d 1004, 1010 (11th Cir. 1985); Woodward v. Metro Bank of Dallas, 522 F.2d 84, 87 (5th Cir 1975)).
84. Neilson, 290 F. Supp. 2d at 1122 n.70 (“While it may ultimately prove to be the case that the Banks did not know Slatkin had investors other than the account holders, the court must, for purposes of this motion, accept as true the allegations to the contrary contained in plaintiffs’ third amended complaint.”).
85. Rolf v. Blyth, Eastman & Dillon & Co., 570 F.2d 38 (2d Cir. 1978), amended, 1978 WL 4098 (2d Cir. May 22, 1978), cert. denied, 439 U.S. 1039 (1978).
88. Leahey, 219 F.3d at 536 (citing Camp. v. Dema, 948 F.2d 455, 459 (8th Cir. 1991) and Wood- ward v. Metro Bank of Dallas, 522 F.2d 84, 97 (5th Cir. 1975) (“[I]f the method or transaction is atypical . . . , it may be possible to infer the knowledge necessary for aiding and abetting liability.”)); see also Neilson, 290 F. Supp. 2d at 1120.
91. Ins. Co. of N. Am. v. Dealy, 911 F.2d 1096, 1100 (5th Cir. 1990) (an investor in a limited partnership could not escape liability under an indemnification it owed to the surety, holding that the mere contention that the surety may have known the general partner had engaged in prior securities law violations was insufficient to establish that the surety was an aider or abettor).
105. “[T]he very nature of fraud tends to be sneaky, behind-the-scenes, and indirect . . .” Robert A. Prentice, Locating that “Indistinct” and “Virtually Nonexistent” Line Between Primary and Secondary Liability under Section 10(b), 75 N.C. L. REV. 691, 732 (1997).
106. See Tew v. Chase Manhattan Bank, N.A., 728 F. Supp. 1551 (S.D. Fla. 1990), amended on reconsideration, 741 F. Supp. 220 (S.D. Fla. 1990); see also Levine v. Diamanthusel, Inc., 950 F.2d 1478, 1483 (9th Cir.1991); FDIC v. First Interstate Bank of Des Moines, N.A., 885 F.2d 423, 432–33 (8th Cir. 1989).
107. See generally Javitch v. First Montauk Fin. Corp. 279 F. Supp. 2d 931, 941 (N.D. Ohio 2003).
108. See In re WorldCom, Inc. Sec. Litig., 382 F. Supp. 2d 549, 560 (S.D.N.Y. 2005); Primavera Familienstifung v. Askin, 130 F. Supp. 2d 450, 507 n. 64 (S.D.N.Y. 2001), amended on reconsideration, in part, 137 F. Supp. 2d 438 (S.D.N.Y. 2001).
109. See, e.g., In re Citigroup, Inc. Sec. Litig., 330 F. Supp. 2d 367 (S.D.N.Y. 2004).
110. Commodity Futures Trading Corp. v. Sidoti, 178 F.3d 1132, 1136 (11th Cir. 1999) (aiding and abetting occurred though decision to hire sales personnel exclusively from various companies with histories of sales practice fraud coupled with absence of training or attempt to restrain practices).
111. Abbott v. Equity Group, Inc., 2 F.3d 613, 623 n.33 & 626 (5th Cir. 1993), cert. denied sub nom, 510 U.S. 1177 (1994).
112. See generally In re IKON Office Solutions, Inc., 277 F.3d 658, 673 (3d Cir. 2002).
120. Ryan v. Hunton & Williams, No. 99-CV-5938 ( JG), 2000 WL 1375265, at *9 (E.D.N.Y. 2000); accord Abbott v. Equity Group, Inc., 2 F.3d 613, 623 n. 33 (5th Cir. 1993), cert. denied sub nom, 510 U.S. 1177 (1994) (merely acting as surety and bonding agent for fraud perpetrator was, “even if substantial . . . merely ‘grist of the mill.’ ”). In connection with the Bennett Funding equipment-leasing Ponzi scheme, investors alleged that Sphere Drake Insurance Co. had aided and abetted the perpe- trators. See In re Bennett Funding Group, Inc., 258 B.R. 67 (N.D.N.Y. 2000). There, it was alleged that a reinsurer assisted the perpetrators in deceiving investors by issuing reinsurance subject to a hidden indemnity owed to it by the insured. This arrangement allegedly created an illusion of financial protection that helped persuade investors to participate in Bennett’s investment proposals.
122. Leahey, 219 F.3d at 535; Rolf, 570 F.2d at 48; see also Linde, 384 F. Supp. 2d at 582 (financing provided to known terrorist subjects bank to aiding-abetting liability).
123. Diamond State Ins. Co. v. Worldwide Weather Trading LLC, No. 02 Civ. 2900 LMM GWG, 2002 WL 31819217, at *5 (S.D.N.Y. Dec. 16, 2002).
149. See McDaniel v. Bear Stearns & Co., 196 F. Supp. 2d 343, 352 (S.D.N.Y. 2002); Martin v. Pepsi-Cola Bottling Co., 639 F. Supp. 931, 934–35 (D. Md. 1986).
150. Combs, supra note 78, at 268 (citing Josephine Willis, Note, To (B) or Not to (B); The Future of Aider and Abettor Liability in South Carolina, 51 S.C.L. REV. 1045, 1056 (2000)). Combs criticizes the premise of the “sliding scale” test and calls into question its logic. Id.
153. Id. (citing In re Temporomandibular Joint (TMJ) Implants Prod. Liab. Litig., 113 F.3d 1484, 1495 (8th Cir. 1997)).
154. E.g., In re Temporomandibular Joint (TMJ) Implants Prod. Liab. Litig., 113 F.3d at 1495; Witzman v. Lehrman, Lehrman & Flom, 601 N.W. 2d 179, 188 (Minn. 1999).
155. Cromer Finance Ltd. v. Berger, 137 F. Supp. 2d 452, 470 (S.D. NY 2001).
156. Id. (quoting Kolbeck v. LIT Am., Inc., 939 F. Supp. 240, 249 (S.D.N.Y. 1996)).
157. Neilson, 290 F. Supp. 2d at 1135; Metge v. Bachler, 762 F. 2d 621, 624 (8th Cir. 1985), cert. denied sub nom, 474 U.S. 1057, 1072 (1986) (must be a “ ‘substantial causal connection between the culpable conduct of the alleged aider and abettor and the harm to the plaintiff[,]’ . . . or a showing that ‘the encouragement or assistance is a substantial factor in causing the resulting tort’ ”).
158. See Primavera Familienstifung v. Askin, 130 F. Supp. 2d 450, 503 n.54 (S.D.N.Y. 2001), amended on reconsideration, in part, 137 F. Supp 2d 438 (S.D.N.Y. 2001).
159. See generally, Bondi v. Citigroup, Inc., No. BER-L-10902-04, 2005 WL 975856, at *18 (N.J. Super. Law Div. 2005).
160. E.g. AmeriFirst Bank v. Bomar, 757 F. Supp. 1365, 1380 (S.D. Fla. 1991).
161. Casey v. U.S. Bank Assoc., 26 Cal. Rptr. 3d 401, 405-06 (Cal. Ct. App. 2005); Holmes v. Young, 885 P.2d 305, 308 (Colo. Ct. App. 1994); Malpiede v. Townson, 780 A.2d 1075, 1097 (Del. 2001); Nerbonne, N.V. v. Lake Bryant Int’l Properties, 689 So.2d 322, 325 (Fla. Dist. Ct. App. 1997); Thornwood, Inc. v. Jenner & Block, 799 N.E.2d 756, 768–69 (Ill. App. Ct. 2003), appeal denied, 807 N.E.2d 982 (Ill. 2004); Kuhlman Elec. Corp. v. Chappell, Nos. 2003-CA-001232-MR, 2004-CA-000633-MR, 2005 WL 3243498, at *8 (Ky. Ct. App. Dec. 2, 2005.); Cacciola v. Nellhaus, 733 N.E.2d 133, 139 (Mass. Ct. App. 2000); Carson Fischer, PLC v. Standard Fed. Bank, Nos. 248125, 248167, 2005 WL 292343, at *6 (Mich. Ct. App. Feb. 8, 2005), rev’d in part, 2006 WL 1303137 (Mich. May 12, 2006); Witzman v. Lehrman, Lehrman & Flom, 601 N.W.2d 179, 186–87 (Minn. 1999); Branch Banking & Trust Co. v. Lighthouse Fin., No. 04 CVS 1523, 2005 WL 1995410, at *7 (N.C. Super. Ct. July 13, 2005); Bondi v. Citigroup, Inc., No. BER-L-10902-04, 2005 WL 975856, at *18 (N.J. Super. Ct. Law Div. Feb. 28, 2005); Fate v. Owens, 27 P.3d 990, 997–98 (N.M. Ct. App. 2001), cert. denied, 27 P.3d 476 (N.M. 2001); Shearson Lehman Bros. Inc. v. Bagley, 614 N.Y.S.2d 5 (N.Y. App. Div. 1994); Future Group II v. Nationsbank, 478 S.E.2d 45, 50 (S.C. 1996); Chem-Age Indus., Inc. v. Glover, 652 N.W.2d 756, 773–76 (S.D. 2002); Toles v. Toles, 113 S.W.3d 899, 917 (Tex. Ct. App. 2003); Halifax Corp. v. Wachovia Bank, 604 S.E.2d 403, 412–14 (Va. 2004); Lenticular Europe, LLC ex rel Van Leeuwen v. Cunnally, 693 N.W.2d 302, 309 (Wis. Ct. App. 2005). Georgia does not recognize a claim for aiding and abetting a breach of fiduciary duty. Monroe v. Board of Regents of the University System of Georgia, 602 SE 2d 219, 224 (Ga. Ct. App. 2004). There are conflicting decisions concerning Pennsylvania law. Compare Adena, Inc. v. Cohn, 162 F. Supp. 2d 351, 357 (E.D. Pa. 2001) (predicting Pennsylvania would recognize a claim for aiding-abetting breach of fiduciary duty) with Daniel Boone Area School Dist. v. Lehman Bros., Inc., 187 F. Supp. 2d 400, 413 (W.D. Pa. 2002) (concluding adoption of RESTATEMENT (SECOND) OF TORTS § 6876 would “expand” Pennsylvania law).
162. Metro. Trans. Auth. v. Contini, No. 04-CV-0104 DGTJMA, 2005 WL 1565524, at *7 (E.D.N.Y. July 6, 2005).
163. In Re Lee Memory Gardens, Inc., 333 BR 76, 81 (Bankr. M.D.N.C. 2005) (citing BLACK’S LAW DICTIONARY at 888 (8th Ed. Rev. 2004)).
167. The NYSE reportedly settled with the group, agreeing to undertake a fresh opinion on the deal. In December 2005, the merger was approved by a vote of NYSE members. See http://www.secinfo.com/drDX9.z1b2.htm (last visited, May 23, 2006).
168. Higgins, 806 N.Y.S.2d at 344. The discussion here relates to the allegations in plaintiff ’s complaint.
183. Tew, 728 F. Supp. at 1568; Andreo v. Friedlander, Gaines, Cohen, Rosenthal & Rosenberg, 660 F. Supp. 1362, 1367 (D. Conn. 1987); cf. OSRecovery, Inc. v. One Groupe, Int’l, Inc., 354 F. Supp. 2d 357, 378 (S.D.N.Y. 2005).
184. Gen. Cable Corp. v. Highlander, No. 1:05-CV-00083, 2005 WL 2875380, at *4 (S.D. Ohio Nov. 2, 2005).
185. Sompo Japan Ins., Inc. v. Deloitte & Touche, LLP, No. 03 CVS 5547, 2005 WL 1412741, *4 (N.C. Sup. Ct. June 10, 2005). In Sompo, the court concluded that knowledge of the underlying fraud (plus assistance) was prerequisite to aiding-abetting fraud and because, in the court’s view, these elements duplicated a fraud claim, aider-abettor liability was superfluous. The court made a fairly obvious error. Fraud arises from the making of a misrepresentation or the commission of some other deception, whereas aiding-abetting may involve a degree of assistance that in no way (by itself ) deceives anyone.
187. Cacciola, 733 N.E. 2d at 139–40. There, however, counsel had an independent duty to the partnership. Id. at 137.
188. Rabobank Nederland v. Nat’l. Westminster Bank, Nos. A104604, A104632, A106145, 2005 WL 1840108, at *9–11 (Cal. Ct. App. Aug. 4, 2005).
189. E.g., Reynolds v. Schrock, 107 P.3d 52 (Or. Ct. App. 2005), appeal allowed, 124 P.3d 1248 (Or. 2005); Morganroth & Morganroth v. Norris, McLaughlin & Marcus, P.C., 331 F.3d 406, 412, 414 (3d Cir. 2003); Thornwood, Inc. v. Jenner & Block, 799 N.E. 2d 756 (Ill. Ct. App. 2003), appeal denied, 807 N.E.2d 982 (Ill. 2004); Cacciola v. Nellhaus, 733 N.E.2d 133, 136, 139–40 (Mass. Ct. App. 2000); Kurker v. Hill, 689 N.E.2d 833, 837 ( Mass. Ct. App. 1998); Noel v. Hall, No. Civ. 99-649-AS, 2000 WL 251709, at *7 (D. Or. Jan. 18, 2000), on reconsideration, 2000 WL 1364227 (D. Or. Sept. 15, 2000). A trustee’s attorney may be liable for a trustee’s breach of the trust if the attorney “knew or should have known that he was assisting the trustee to commit a breach of trust.” AUSTIN WAKERMAN SCOTT AND WILLIAM FRANKLIN FRATCHER, THE LAW OF TRUSTS, § 326.4 (4th ed. 1989) (emphasis added).
236. See generally Tanvir Alam, Fraudulent Advisors Exploit Confusion in the Bankruptcy Code: How In Pari Delicto Has Been Perverted to Prevent Recovery for Innocent Creditors, 77 AM. BANKR. L.J. 305, 306–08 (2003).
237. In re M. Silverman Laces, Inc., No. 01 Civ. 6209 (DC), 2002 WL 31412465, at *7 (S.D.N.Y. Oct. 24, 2002) (trustee could not sue bank for allegedly acting in concert with the debtor’s share- holders and principals to defraud the creditors, because the debtor itself could not file such a suit).
243. 128 P.3d at 254; but see Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001) (creditors’ committee had standing to pursue “deepening insolvency claim on behalf of debtor corporations” but defense of in pari delicto barred claim).
244. See Alam, supra note 236, at 306–08. Section 541 provides that all legal and equitable causes of action belong to the estate, 11 U.S.C. §541(a)(1), which, some courts hold, situates all trustees’ actions in the shoes of the bankrupt company. Alam, supra note 236, at 306–08.
262. Marcia L. Walter, Aiding and Abetting the Breach of Fiduciary Duty: Will the Greenmailer Be Held Liable?, 39 CASE W. RES. L. REV. 1271, 1272 (1989).
273. See, e.g., Jubelirer v. MasterCard Int’l, 68 F. Supp. 2d 1049, 1054 (W.D. Wis. 1999); Touhy v. Northern Trust Bank, No. 98 C 6302, 1999 WL 342700, at *3–4 (N.D. Ill. May 17,1999) (“Thus, even though this court must construe RICO liberally . . . this court cannot ignore the clear indication by Congress in failing to reference 18 U.S.C. § 2 in the language of § 1962(c) as well.”); Sorrano v. New York Life Ins. Co., No. 96 C 7882, 1999 WL 104403, *7–8 (N.D. Ill. Feb. 24, 1999); In re Lake States Commodities, Inc., 936 F. Supp. 1461, 1475 (N.D. Ill. 1996); Pennsylvania Ass’n of Edwards Heirs v. Rightenour, 235 F.3d 839, 843–44 (3d Cir. 2000); Ling v. Deutsche Bank, No. 04 CV 4566 (HB), 2005 WL 1244689 (S.D.N.Y. May 26, 2005); Hayden v. Paul, Weiss, Rifkind, Wharton & Garrison, 955 F. Supp. 248, 256 (S.D.N.Y. 1997) (“Following the reasoning in Central Bank, this Court declines to create a private right of action for aiding and abetting a RICO violation. Nowhere in the text of Section 1962 is there any indication that Congress intended to impose aiding and abetting liability for a violation of the RICO statute.”); Dep’t of Econ. Dev. v. Arthur Andersen & Co., 924 F. Supp. 449, 475–77 (S.D.N.Y. 1996); Wuliger v. Liberty Bank, N.A., No. 3:02 CV 1378, 2004 WL 3377416 (N.D. Ohio Mar. 4, 2004); In re MasterCard Int’l, Inc., 132 F. Supp. 2d 468, 494–95 (E.D. La. 2001), aff ’d, 313 F.3d 257 (5th Cir. 2002).
274. See Bondi v. Citigroup, Inc., No. BER-L-10902-04, 2005 WL 975856, *24 (N.J. Super. Law Div. Feb. 28, 2005), leave to appeal granted, 878 A.2d 850 (N.J. 2005).
276. State v. Superior Court of Maricopa County, 599 P.2d 777, 784 (Ariz. 1979), overruled in part, State v. Gunnison, 618 P.2d 604 (Ariz 1980); In re LTV Steel Co., Inc., 333 B.R. 397, 414–15 (Bankr. N.D. Ohio 2005).
277. Adderly, 168 S.W. 3d at 839 (citing TEX. REV. CIV. STAT. ANN. ART. 581-33A(2) (Vernon Supp. 2004–05)).
290. In re: Terrorist Attacks on September 11, 2001, 392 F. Supp. 2d 539, 572 (S.D.N.Y. 2005). These claims met the statutory standard for “material” support of terrorism.
291. Id. at 567. Cozen O’Connor represents certain insurers in connection with this litigation.
292. Linde v. Arab Bank, PLC, 384 F. Supp. 2d 571, 582 (E.D.N.Y. 2005).
293. Id. at 583 (citing Boim, 291 F.3d at 1018–21). The court, citing Boim, further observed that in Central Bank the court was addressing an implied right of action (private securities fraud suits), not an express right of action such as that provided by the Anti-Terrorism Act. Id.
300. See More Heat on Hedge Funds: Regulators are Probing Trades by Managers With Inside Access, BUSINESS WEEK ONLINE (Feb. 6, 2006), available at www.BusinessWeek.com (last visited, Feb. 13, 2006).
Whistle-blowers, take heart. The Supreme Court is on your side. And that certainly includes those reporting health-care fraud.
In recent years, the federal government has turned to a Civil War era statute to attack health-care fraud and other types of fraud committed against taxpayer dollars. That statute, the False Claims Act (FCA), 31 U.S.C. ? 3729 et seq., permits the United States to recover treble damages and penalties of up to $10,000 per knowing false claim, and allows private whistle-blowers to sue in the name of the United States and recover sizable bounties.
In a critical decision in May, the Supreme Court for the first time addressed whether the False Claims Act’s whistle-blower provision withstands scrutiny under Article III of the U.S. Constitution. In Vermont Agency of Natural Resources v. United States ex rel. Stevens , 120 S. Ct. 1858, 146 L. Ed. 2d 836 (2000), the court confirmed the continued viability of this tool by holding that whistle-blowers do have standing to pursue claims under the FCA. After addressing this issue, the court did, however, hold that whistle-blowers may not sue states under this statute and left unclear whether the federal government could pursue those claims.
Stevens is basically good news for the FCA in that a recurring and troubling constitutional challenge to whistle-blower suits has been resolved. Left in place is a powerful, financial incentive that brings considerable fraud to light. However, the ruling also narrows the universe of fraud that will be brought to the attention of the Department of Justice, while containing language that likely will serve as ammunition for future defense challenges to FCA proceedings. This article discusses the expected effect of this decision in the context of the FCA’s history.
The False Claims Act permits either the federal government or a private party acting on the government’s behalf (a qui tam plaintiff, relator or colloquially, whistle-blower) to sue any “person” for damages and penalties caused by “knowing” false claims for government funds. The qui tam plaintiff can receive a share of any recovery. The government may assume control of the whistle-blower’s case, but if it does not, the whistle-blower may proceed on his or her own.
Although enacted in 1863, the FCA was used sparingly before the late 1980s. Courts had barred whistle-blower suits if the information were already known to the government. In addition, several federal circuit courts had imposed high standards of proof and scienter, requiring “clear and convincing evidence” and “intentional” false claims.
Congress removed these roadblocks in 1986. The amended FCA authorized whistle-blowers to bring FCA suits regardless of whether the government already was aware of the fraud, so long as they were “original sources” of any allegations that had been publicly disclosed.
Congress also specified that the burden of proof had to have the usual civil “preponderance of the evidence” standard and clarified that the act authorized suits against (1) the “ostrich with its head in the sand” who submits false claims with recklessness or with deliberate ignorance of their truth or falsity, and (2) those paid by third parties receiving federal funds under grants or contracts.
In addition, Congress raised the possible award for a proper qui tam plaintiff in cases taken over by the government from a maximum of 10 percent, to a guaranteed 15 to 25 percent of the recovery (depending on their contribution to the success of the action.) Congress also increased the government’s remedies from double to treble damages, and from $2,000, to $5,000 to $10,000 for each false claim.
It is important to note that Congress signaled its intent that the law be used to combat health-care fraud. The Senate Judiciary Committee explained that the law “is intended to reach all fraudulent attempts to cause the government to pay out sums of money or to deliver property or services . . . A false claim for reimbursement under the Medicare, Medicaid or similar program is actionable under the act.” S. Rep. No. 99-345 at 9.
As a direct result of the 1986 amendments, the government saw a tremendous increase in qui tam filings. The number rose from 33 in fiscal year 1987 to 483 in fiscal year 1999. By February 2000, the United States had recovered more than $3.5 billion through FCA qui tam cases, with $550 million of this amount having been paid to the private whistle-blowers who brought the cases. Initially, the greatest percentage of these recoveries involved defense-contract fraud. This changed as the magnitude of the health-care fraud problem became apparent.
In 1992, the General Accounting Office released a report estimating that 10 percent of provider billings to Medicare were fraudulent. In 1993, Attorney General Janet Reno set health-care fraud as one of her top priorities. Subsequently, in the Health Insurance Portability and Accountability Act of 1996, Congress provided more than $150 million in new health-care fraud enforcement funds for the DOJ and the Department of Health and Human Services (HHS) for FY 1997, and 15 percent more each year thereafter until 2003 (assuming the government recovered at least as much in multiple damages and penalties in health-care fraud cases.)
By 1993, recoveries in FCA cases against health-care providers began climbing significantly, and, in 1997, surpassed the government’s recoveries from defense contractors. In Fiscal Year 1997, the government brought in almost $1 billion in False Claims Act judgments and settlements in the area of health-care fraud alone. By February 2000, more than half of the $3.5 billion that Justice had recovered under the amended qui tam provision since 1986 came from cases alleging fraud against HHS.
Most of the FCA cases in the health-care area have targeted private insurance companies, clinical laboratories, hospitals and other providers, although the government has also investigated the conduct of state agencies and state-owned medical facilities.
Examples of the latter cases include United States ex rel. Zissler v. University of Minnesota ($32 million settlement of grant-fraud claims) and United States ex rel. Kready v. University of Texas Health Science Center at San Antonio ($17.2 million settlement of allegations that the teaching hospital violated Medicare rules on billing for faculty doctors). (Also note Department of Justice press releases concerning additional settlements with state-owned teaching hospitals in the so-called “Physicians at Teaching Hospitals” or “PATH” project; and, U.S. ex rel. Denoncourt v. New York State Department of Social Services ($27-million settlement resolving claims that New York submitted false claims for funds to train Medicaid and other social service workers).
Since 1992, there have been dramatic increases in the size of recoveries in individual health-care fraud cases, both by the government and by whistle-blowers. After a $111-million settlement with National Health Laboratories in 1992, additional record settlements were reached with Smith-Kline Beecham Clinical Laboratories ($325 million), Blue Cross and Blue Shield of Illinois ($140 million), and National Medical Care ($375 million). In several health-care cases, whistle-blowers received more than $5 million of the government’s money.
On Nov. 13, 1999, the New York Times reported that Medicare spending had dropped for the first time in the history of the program, and that “efforts to rein in fraud” were at least partially responsible for the decline.
The government’s aggressive and very successful enforcement program was met by allegations by the hospital industry that the government was improperly and overzealously enforcing the statute, and prompted repeated defense challenges to the constitutionality of the whistle-blower provision.
The American Hospital Association (AHA) was particularly aggrieved by the department’s “national initiatives” that targeted violations of Medicare billing rules, and launched a grassroots campaign to persuade Congress to create new FCA defenses for health-care providers. The AHA was not successful, largely because the Senate recognized that the FCA effectively addresses a serious national problem. Nonetheless, to respond to the criticisms, in June 1998, Deputy Attorney General Eric Holder issued “Guidelines on the Use of the FCA in Civil Health Care Fraud Cases” to formalize policies on using the FCA, and, in doing so, provided the Senate with a viable alternative to amending the FCA.
Meanwhile, various court challenges to the FCA’s qui tam provisions were winding their way through the courts, mostly without success. By the fall of 1999, five courts of appeals had rejected the argument that relators lacked “standing” under Article III of the U.S. Constitution to bring claims on behalf of the government. Three courts of appeals had held that qui tam suits did not violate the “take care” clause in Article II, and the “separation of powers” doctrine, which gave the executive branch the power to decide how to enforce the laws, while the opposite conclusion was reached by one circuit in Riley v. St. Luke’s Episcopal Hospital, 196 F.3d 514, reh’g en banc granted, 196 F.3d 561 (5th Cir. 1999).
The Supreme Court finally put the Article III standing issue to rest in Stevens. Stevens is a qui tam suit filed by Jonathan Stevens against his former employer, the Vermont Agency of Natural Resources. Stevens claimed that Vermont had submitted false claims in connection with EPA-administered grant programs. The state had challenged the suit under the 11th Amendment, and on the ground that a state is not a “person” who can be sued under the FCA.
Before reaching Vermont’s challenges, the court determined sua sponte to address the threshold issue of whether relators had Article III standing to bring qui tam actions. Justice Scalia’s opinion for the court ruled that whistle-blowers do have standing because the bounty provision for relators operates as a partial assignment of the government’s damages claims under the FCA. Scalia noted “the long tradition of qui tam actions in England and the American colonies,” and concluded that the partial assignment suffices to give qui tam plaintiffs the “injury in fact” required for standing to sue in federal court. (120 S.Crt. at 1863)
This resolution of one constitutional question is qualified by Footnote 8, which states that two other constitutional issues remain open, specifically whether qui tam suits could pass muster under the Article II “take care” clause and the “appointments” clause of Article II, Section 2, which vests the president with exclusive power to select the government’s principal officers. (120 S.Crt. at 1865)
Proceeding to the central issue, the majority then held that qui tam plaintiffs may not sue states under the FCA. The majority applied to the FCA’s text the court’s “long-standing interpretive presumption that ‘person’ does not include the sovereign” and examined whether the statute’s liability provision (which imposes liability on “any person”) contained any “plain statement” that the term “person” includes states. (120 S.Crt. at 1866) The majority concluded that relators may not sue states because the FCA’s provisions “far from providing the requisite affirmative indications that the term ‘person’ included states for purposes of qui tam liability, indicate quite the contrary.” Id. at 1870.
The majority also noted that, “the current version of the FCA imposes damages that are essentially punitive in nature, which would be inconsistent with state qui tam liability in light of the presumption against imposition of punitive damages on governmental entities.” Id. at 1869. In doing so, the court for the first time found the FCA’s remedies to be punitive on their face.
Scalia seemingly took pains to limit the majority’s ruling to “private” FCA actions (that is, those initiated by qui tam relators.) He consistently used the term “qui tam” or “private” when referencing the suits at issue, and in a footnote distinguished Supreme Court holdings that authorize federal suits against states. Id. at 1866, n. 9. Moreover, Justices Ginsburg’s and Breyer’s concurring opinion explained that, “the clear statement rule applied to private suits against a state has not been applied when the United States is a plaintiff,” and commented that the majority’s decision left open the issue of whether the government may sue states under the FCA. Id. at 1871.
Notwithstanding the foregoing, it is not at all clear that the Supreme Court would authorize government FCA actions against states if the issue were squarely before it. The court not only held that the FCA lacks “affirmative indications” that Congress meant for the law to be used against states, it also concluded that the statutory language affirmatively indicates the contrary.
With regard to the most far-reaching issue decided by the court — whether whistle-blowers may sue at all under the FCA — Stevens is great news for the federal government’s health-care fraud enforcement efforts. The court’s resolution of the Article III standing question eliminates an issue that has bedeviled qui tam actions for years.
In finding Article III standing, the court affirmed the constitutionality of a masterfully crafted statute that turns silent witnesses into government informers. Moreover, the court put to bed an argument that has repeatedly delayed the resolution of qui tam cases and also handicapped the government’s efforts to expeditiously recover dollars lost to Medicare and other fraud. However, not all the possible constitutional challenges to the qui tam provision have been resolved, as Scalia’s Footnote 8 expressly stated.
Stevens’ main holding that private individuals cannot sue states under the FCA likely will adversely affect Uncle Sam’s ability to recover damages from state entities committing fraud on federal programs. While there may well be litigation to determine whether the court’s ruling affects municipal entities and state-owned medical facilities as well as state governing bodies, within the category of affected cases, Stevens will have unfortunate, chilling effects.
In the first instance, the government will be less likely to learn of the frauds involving states since whistle-blowers have lost the financial incentive to report such matters. In addition, the ruling may discourage federal agencies from pursuing these cases because of the legal uncertainty as to whether the government has a cause of action.
Finally, the court’s conclusive statement — bereft of any empirical analysis — that the FCA imposes damages “that are essentially punitive in nature” is likely to spawn litigation in a number of areas. For example, this language may be cited in support of challenges under the “double-jeopardy” clause of the Fifth Amendment of the Constitution in instances in which the government elects both to allege violations of the FCA and prosecute a provider under a criminal law.
The double-jeopardy clause provides that no “person [shall] be subject for the same offence to be twice put in jeopardy of life or limb” and bars successive criminal punishments for the same offense. Hudson v. United States, 522 U.S. 93, 98-99 (1997). Under certain circumstances, a civil sanction can be deemed criminal punishment for purposes of the double-jeopardy clause. Id..
The court’s characterization of the FCA as “essentially punitive” also may be cited in support of challenges to FCA actions under the Eighth Amendment’s proscription against “excessive fines.” This clause applies to penalties so long as they are “punitive in part” (United States v. Bajakajian, 524 U.S. 321, 329, n. 4, and 331, n. 6 (1998)), and applies whether the penalties are criminal or civil (see, for example, United States v. Ahmad, 2000 U.S. App. LEXIS 11728, at 31, n.4).
However, there are responses to these constitutional arguments if they arise in litigation. With regard to double jeopardy, even if the government uses a traditional criminal law along with the FCA to address the same offense, a court nonetheless could find that the FCA’s damages are not a “criminal penalty” subject to the constraints of the double-jeopardy clause since “only the clearest proof will suffice to override legislative intent and transform what has been denominated a civil remedy into a criminal penalty.” United States v. Ward, 448 U.S. 242, 249 (1980).
Courts must resolve the question of whether a civil remedy is, in fact, a criminal penalty, through an analysis of seven factors. See Hudson, supra, 522 U.S. at 99-100. While several of these factors examine whether the sanction is considered punishment, several other factors, including whether the sanction involves an affirmative disability or restraint, and whether a purpose other than punishment is assignable to it, point to a conclusion that the FCA’s damages and penalties are not “criminal” punishment.
The government also could answer the excessive-fines argument on its merits. A court may only find a “penalty” subject to the excessive-fines clause to violate the clause if it is “grossly disproportional to the gravity of a defendant’s offense.” United States v. Bajakajian, 524 U.S. at 334. This analysis is case-specific and fact-intensive. In Bajakajian, the Supreme Court reviewed a forfeiture of $357,144 from a traveler who failed to declare that he was transporting more than $10,000 out of the United States. The court found an Eighth Amendment violation. The court noted that his offense was an isolated “reporting” offense unconnected to other illegal activities, and caused minimal harm, “no fraud on the U.S.” and “no loss to the public fisc.” Id. at 337-39.
Recently, the Fourth Circuit distinguished Bajakajian in a case involving an elaborate, long-running, currency-transaction reporting scheme that was related to customs and tax fraud, and put at risk numerous players. Ahmad, supra.
Health-care fraud cases often involve thousands of relatively small claims submitted over a period of years. Defendants conceivably could be liable for FCA penalties many times in excess of the actual damages since the penalties could be assessed at the statutory maximum of $10,000 per claim plus treble damages even when the amounts of the individual claims are much less than $10,000. But unlike Bajakajian, such cases ordinarily involve persistent misconduct, damage to the federal treasury, and considerable societal harm, and so, under Ahmad’s rationale, heavy penalties are more likely to survive an Eighth Amendment challenge.
Moreover, the government can avoid both the double-jeopardy and excessive-fines arguments through careful prosecutive and litigation choices. Since the double-jeopardy clause prohibits successive prosecution only for the “same offense,” the double-jeopardy issue will not even arise if the criminal prosecutors either (1) charge a provider with an offense that does not include knowing, false claims as elements, or (2) prosecute the provider for specific health-care claims not covered in the allegations in the civil action. See Blockburger v. United States, 284 U.S. 299, 304 (1932) (setting forth “same elements” test).
With regard to excessive fines, the government can and does refrain from reflexively seeking statutory penalties in addition to treble damages for every false claim. In fact, it rarely seeks penalties in negotiated settlements — which are how civil FCA disputes are usually resolved.
Stevens has not resolved all the questions about the FCA’s use, and some of its language may be used in future challenges to the statute. But the court has resolved the Article III standing question and in doing so has sent a strong signal that this useful statute will remain important in fighting health-care fraud.
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